Thursday, April 1, 2010

Ending Snake Oil Salesmen

To get a driver’s license, we have to pass written and driving tests. To buy life insurance, we have to pass a medical exam. To be admitted to most colleges and universities, we have to earn reasonably good scores on the SAT or ACT entrance exam. To practice law we have to pass the BAR exam. Ditto for medicine, electrician, plumber, contractor, engineering, land surveying, real estate, social work, insurance, counselors, and so on.

In the last two years, several dozen books and numerous articles have been published trying to identify the causes of the financial and economic crisis of 2007-09. Most authors agree that an important cause was the subprime mortgage crisis; many individuals signed up for mortgages they did not understand. Most agree that another cause was the proliferation of complex financial instruments, such as asset backed securities (ABS), mortgage backed securities (MBS), collateralized debt obligations (CDO), synthetic CDOs, that many investors did not understand. Most agree that government agencies bore some responsibility for failing to regulate financial institutions undertaking excessive risk. And so on.

I propose, then, a regime of extending testing to specific financial decisions. To prevent another subprime housing crisis, home buyers applying for a loan must first pass an exam in which the applicant demonstrates knowledge of fixed interest rates, variable interest rates, principal payments, no-principal loans, prepayment penalties, property taxes, escrow, points, closing costs, insurance, monthly-payment-to-income ratio, and so forth. Passing an exam will reduce the ability of overly aggressive salesmen and lenders to confuse, deceive, or mislead buyers.

Ditto for investors. Anyone opening a brokerage account must first pass an exam demonstrating knowledge of different kinds of securities, margin, government guarantees, risk, rates of return, and so on.

The old adage of caveat emptor was replaced long ago by consumer protection, which clearly fell short in the areas of home buying and investing. Consumers would be better protected and make better choices if they commanded some level of understanding and proficiency in financial affairs instead of relying on the recommendations of salesmen whose incentive is to close the deal, however sound.

1 comment :

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