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Monday, July 2, 2012

Can a Financial Ombudsman save your Marriage? Probably not, but She could Help with your Retail Customers


Marriage counselors often advise the quality of a relationship is not determined by the number of fights that a couple has. Rather the best test is the way in which problems are resolved.

The same is true of the relationships between consumers and their financial institutions. Consumers recognize that they need financial firms. Consumers have checks to cash. They want to send money to relatives. They need to save for a rainy day—or a season of rainy days. They want to borrow to finance their big purchases such as houses and automobiles. However consumers also want to be treated fairly. When they have a problem with a financial firm, they want the problem to be fixed--or at a minimum they want to be informed as to how to avoid the same problem in the future.

So how should consumers’ problems with financial firms be addressed? For most people, finance makes them feel less than brilliant. (See blogpost on “Why Isn’t Finance Understandable?”) However this twin sense of inferiority and vulnerability is not limited to individuals who work with their hands. The truth is that if you were to give enough wine to a senior banker or insurance executive--and he or she was prepared to admit the truth--the answers would be startling. Sitting in well-tailored business suits, they would tell you that even they feel that they do not fully comprehend finance or the risks that they wager.

“Honestly I don’t even understand what you guys do,” admitted Will Emerson (played by Paul Bettany) as the head of a Wall Street trading desk in the 2011 movie, Margin Call. Just tell me what it means was his plea. We can hardly expect Working Joe or Jane will understand finance better than the experts. This means that consumers’ questions will often be based on misunderstandings. In countries ranging from Azerbaijan to Canada to Zambia, most consumer complaints over financial services are based on a vague sense of unfairness. This puts financial institutions—and their government regulators and supervisors in a difficult position. Consumer confidence is essential to public confidence in financial institutions but how should such confidence be built?

More and more countries have set up financial ombuds services. The UK led the way with a financial ombudsman that covers all retail financial services, including debt collection. In Eastern Europe, financial ombudsmen are popping up in many places, from Armenia to Russia.

But how should such financial ombuds services be structured? There are lots of solutions but how should one choose the best approach?

Fortunately two financial ombudsmen—one from the UK and another from France—collaborated to develop a set of fundamentals for any financial ombudsman. The project was conducted for your correspondent when she was at the World Bank in Washington, DC. Last week she had the opportunity to catch up with one of co-authors, Francis Frizon, the head of the Insurance Mediator’s Office in France.  (She had previously spoken with the first co-author, David Thomas, former Head of the UK’s Financial Ombudsman, who had talked about problems in the UK, especially with payment protection insurance.)

Here are the 11 key principles that David and Francis developed.

Governance and funding

1.     The ombudsman should be (and also be seen to be) as independent and impartial as a judge – as well as having the necessary legal and technical expertise to resolve financial disputes authoritatively. This needs to be reflected in the appointment and governance arrangements.

2.      Government funding may be constrained. Industry funding can comprise a levy on all financial businesses, case fees payable by financial businesses that have cases decided by the ombudsman or a combination of the two. Even a modest fee for consumers would be a barrier for the vulnerable.

3.      The title “ombudsman” should not be used for a body that does not comply with ombudsman principles – including independence and effectiveness – or which is unable in practice to secure redress for consumers. Otherwise, consumer confidence will be undermined.

Coverage and procedure

4.      Ombudsman coverage of financial businesses within the relevant sector(s) should be comprehensive. It should include all financial businesses that are based in the country – including any that are foreign-owned.

5.      Where financial businesses based in the country do business cross-border with consumers in other countries, the financial ombudsman should accept complaints against those financial businesses from those consumers.

6.      Financial businesses should be required to have a published complaints procedure for consumers to use as a first step. If financial businesses handle complaints well, this will reduce the number of disputes referred to the financial ombudsman.

7.      The financial ombudsman’s procedure should include enquiry-handling, so that some problems can be resolved before they turn into full-blown cases. Resolution of cases should include informal mediation, where this is possible, as well as formal decision.

Accessibility, transparency and accountability

8.      Consumers can only access the financial ombudsman if they know about it, and where to find it. In addition to the ombudsman making information widely available, financial businesses should be required to tell dissatisfied consumers about the ombudsman.

9.      The financial ombudsman should publish clear details about its powers and procedures and about the type and effect of its decisions. It is useful to publish case studies and/or guidance notes to illustrate the financial ombudsman’s approach to typical cases.

10.   Financial ombudsmen should publish a report at least yearly, explaining the work that they have done. They should provide appropriate statistics about the disputes they have handled and the way in which they have handled them (including the arrangements for quality-control).

11.    Where financial ombudsmen identify systemic issues that financial regulators (or even government) would be better placed to tackle, the financial ombudsman should draw those issues to the attention of the financial regulators.

The view of the Safe and Fair Finance Blog is that if all countries could create financial ombuds services following these 11 principles, then relationships between consumers and financial institutions would be solid and sustained.

Such relationships would be similar to those of the couples who have been together over many decades. Not everything is perfect. But when there’s a problem, the weaker party (in this case, the consumer) can be comforted that he or she will be treated fairly. That would be enough for most of us.

Help to establish a financial ombudsman—or strengthen an existing service---can be found through the International Network ofFinancial Ombudsmen. David and Francis are members of the Network. Tell them that the Safe and Fair Finance Blog sent you.

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Saturday, April 28, 2012

Will I have Enough Money to Retire? A Question for 4.9 Billion World Citizens


Will I have enough money to retire? This is the question millions of future retirees keep asking themselves. How do I know if my nest-egg of x dollars is enough? How can I be sure that I won’t run out of money before I die?

For most of my 5o-something friends, they have only one answer. I will just keep working. Fortunately they work in temperature-controlled offices that keep their working spaces cool in summer and warm in winter. Their idea of heavy lifting is writing a memo arguing against a new expenditure by their homeowner’s association. Their concept of an exhausting day is sitting on an airplane that covers six time zones between stops. For my friends, working until age 7o or 75 is a realistic possibility. However for anyone with a more physically exhausting job, working beyond 7o is a grind rather than an emotionally fulfilling mission.

But even for my friends I ask, what happens then? Will you have saved enough?

Writing in The New York Times, Joe Nocera explores the dilemma. This month he is turning 6o years of age, finding that his physical strengths are waning and wondering what to do. He considered himself a smart investor because he invested in the technology bubble of the 199os and made money—or at least paper profits—for many years. A stock market crash and a divorce later depleted his retirement savings. Then he joined the housing mania and invested in renovation of his home, hoping to make his money back many times over. As a New York Times columnist covering business and finance issues, Mr. Nocera is among the most articulate and literate of consumers worldwide. Yet even he worries about his personal finances.

However Mr. Nocera's problems are those shared by many in the rising global middle class that earns between $1o and $1oo a day. That global middle class is estimated to increase from its current level of 2 billion today to 3.2 billion by 2020 and 4.9 billion in 2030. As noted by the Financial Times, according to the Paris-based Institute for Security Studies in its report Global Trends 2030, within two decades the almost 5 billion in middle class citizens will constitute more than half of the world’s population. By 2o3o, more people will be middle class than poor.

This is encouraging but also rather frightening. The poor suffer from reliance on informal financial service providers, such as loan sharks, and they have no safe way of setting aside their savings for a rainy day. But their biggest problem is in earning enough money to start with.

However it is the new middle class that is most vulnerable to weaknesses in consumer protection for financial services. They are first-time consumers who sign contracts for formal financial services on a hope and a prayer. For such consumers, they are often the first among their family or friends who have entered into a long-term contract with a financial institution. They are the forerunners of others in their family and social groups who need financial services. They need long-term financing to buy their houses and apartments. They need short-term financing between pay-checks. They need a safe and secure place for their savings for a rainy day. They need safe and inexpensive ways to send money home to relatives. They need insurance against catastrophic events. They need to learn the basics of how to use financial services—the risks and rewards of using financial services, their legal rights and obligations when they do so. But financial education will not be enough, any more than it was enough for Mr. Nocera.

It is for all these people that Safe and Fair Finance Blog is written—to help government policy-makers, industry leaders, heads of consumer organizations, members of the academia find ways to help financial consumers. All of their efforts will be needed.
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Friday, April 27, 2012

Can Vampires help us with Financial Education? Maybe.


The financial crisis of 2007-09 hurt us all but some were hit harder than others. In particular, those with weak skills in financial literacy were particularly vulnerable to mortgage brokers selling subprime loans, with adjustable interest rates (but only upwards) and massive prepayment penalties. But the key question is how to improve the financial literacy levels of consumers? The traditional methods of classroom education have only had limited success in raising financial literacy scores for those who chose to sit through the classes. One must therefore ask, “What other methods might work?”

Professor Annamaria Lusardi of George Washington University’s School of Business is setting out to answer just that question. Working with the US Federal Reserve Board, GWU has established a series of lectures and discussions on financial literacy through its Financial Literacy Seminar Series. The lecture on April 20 presented three very different approaches: (1) beefing up the rural library system in the US, (2) distributing both videos and written materials to selected households and (3) providing online games to help gamers learn better financial management skills. All three are geared towards encouraging consumers to save for the future.

The first approach of delivering financial education through the library system was tried in the state of Iowa. Professor Cynthia Fletcher of Iowa State University explained how they developed a program for rural libraries (smart investing@your library), piloting it in one library then expanding the project to 25 more libraries. They put together a user-friendly website of educational materials for users.  With support from the FINRA Investor Education Foundation, they also expanded the libraries’ finance collections, such as a subscription to Value Line which provides valuable investor research on companies. However the third area was probably the most important—they trained librarians in financial literacy. In many small towns, librarians are highly respected as source of information and advice. The thought was to give the front-line staff of the libraries key information on how to access and interpret investment information so that they could share their insights with the users of the library. The researchers noted a 14-28 percent improvement in knowledge of users--and a 53 percent increase in the confidence of all the participating librarians. Best of all, the total budget for the program was under $100,000. It appears that this was a clear winner for rural areas where libraries are an important part of the social infrastructure.

The second approach of using both written materials and videos to reach young workers was presented by Dr. Joanne Yoong of the RAND Corporation. This study was funded by the Social Security Administration through the Financial Literacy Center, and focuses on teaching five key lessons that form the foundation of financial planning for the long-term: (1) harness the power of compounding for investments, (2) understand the impact of inflation on investments, (3) diversify investment portfolios, (4) take advantage of tax-preferred investments and (5) make the most of employer-sponsored matching within your corporate-sponsored 401(k) pension program. Using simple rules of thumb, the videos were able to make clear and easy-to-remember points. The movie we saw emphasized the need to start saving early. If you begin to set aside $4,000 a year at age 21 (and can obtain a 7 percent return), you will have over $1 million by the age of 65. Starting just ten years later at age 31 requires double the amount--$8,000 each year. With stacks of $100 bills, the two actors were able to show just how effective compounding can be over a lifetime.

However it was the third approach that was the most fun. Nick Maynard of Doorways to Dreams described one of their most popular games, FarmBlitz. Their strategy is to use visual clues to motivate the users. In the game, the user inherits a farm and then learns how to borrow to buy seeds and fertilizer for the crops. Debt service is represented by bunny rabbits, which rapidly multiply over time. The farm earnings are represented by trees that grow at glacial pace. What we did not see—but is probably part of the game—is if the bunnies start to eat the crops if a player’s debt gets out of control. The D2D program also includes Bite Club, complete with vampires as disco dancers. The gamer is the manager of a vampire “day” club and needs to successfully manage her club while also taking care of personal finance matters like paying off students and saving for retirement.

D2D is testing how its games can improve the financial capability of employees, particularly around retirement savings. As the introduction to Bite Club warns, when you are a vampire, being dead can be fun. Being dead broke is something else altogether. The game has been tested with Staples in conjunction with New York Life, which provides retirement services for employees. By using product placement as part of the game of Bite Club, the game encourages employees to click on the website of Staples’s retirement funds manager and obtain more information about the savings program. In addition, at key moments, in the game, players are prompted to take real world actions to build financial capability.  The Staples pilot tests have observed strong employee response, with over 9,000 employees engaging with the game.  Most interesting, one pilot tracked that 11% of employees took a positive action in their retirement account.  You can find the games and try them out yourself at http://financialentertainment.org/

In the meantime, Safe and Fair Finance Blog would like to thank Professor Lusardi and all of her presenters for a fascinating look into the future of financial education.
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Saturday, April 21, 2012

Recipe for Fraud: A Fake Robot to Choose Penny Stocks

For individual investors on the stock exchange, the biggest risk is simple investor fraud. As noted this week in the Financial Times, the US SEC has accused two British twins of touting a phony robot that was able to choose stocks about to double in price. This is a classic example of penny stock fraud, found in all developed capital markets but particularly in the U.S. and the U.K. (where pennies are still used as coin of the realm.)

Alexander and Thomas Hunter allegedly began their scheme in 2007, when they were just 16 years old. Their newsletter talked about a robot named Mari, which supposedly used “algorithms” to identity their stock picks. However this was no ordinary robot stock-picker. The brothers’ newsletter, Doubling Stocks, exclaimed, “Just think, had you put $5,000 on each of Marl’s recommended trades over the last 4 months – you would now have $387,684 clear profit sitting in your bank account.”

However this was not all it seemed to be. According to the SEC’s complaint, the brothers separately advertised to find a programmer to create the necessary software. However one of the brothers, Hunter, clarified that the software should “not actually find stocks at all”, according to the complaint.  Rather, “It should connect to my database and simply request any new stocks I have put in.”

The Hunter brothers made money in two ways. About 75,000 investors (primarily Americans) paid in total $1.2 million to subscribe to the newsletter and obtain a copy of the robot software for installation on their personal computers. In addition, according to the complaint, a stock promoter paid $1.8 million to the brothers to tout certain stocks.

As early as January 2009, the U.K. authorizes froze the bank account of the two brothers. However according to the SEC, they simply opened an offshore account in Panama under a new company name, Regency Investment Group.

Growing up in Canada, I was taught, “if it’s too good to be true, it probably is.” However for many consumers, even those with advanced college degrees, the financial markets appear to be an insider’s game they cannot win. Traditionally investors in U.S. stock market have been 60 percent retail investors (folks like you and me) and 40 percent institutional investors, such as insurance companies and pension funds. However following the stock market crash of September 2008, retail investors have largely pulled out of the stock market and by 2009 represented just 30 percent of the market.

Safe and Fair Finance Blog argues that investor fraud, through schemes such as penny stocks, further erodes that base of retail investor support for the stock market. Safe and Fair Finance Blog thus strongly supports work by financial regulators such as the SEC in cracking down on schemes such as the Mari stock-picking robot.

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Sunday, April 15, 2012

Rising Consumer Debt May be Dangerous for the Economy—but Getting Out from Under is neither Easy nor Fair


It is clear that the rise of household debt--combined with weak consumer protection and financial literacy--contributed to the global financial crisis of 2007-09 and the Great Recession that followed. But the question is whether improved consumer protection and financial literacy can help to address the crisis, once it has landed upon us. That is a far more difficult question to answer.

In its chapter on household debt released this week, the World Economic Outlook of the International Monetary Fund highlights the risks to an economy when household debt rises very quickly—and then housing prices fall. It is with alarm that the IMF report explains how the leverage of the consumer sector rose rapidly. In just five years, household debt in the advanced economies rose by 39 percentage points as the level of debt increased to an average of 139 percent of annual income. Similar levels were seen in the former transition economies of Hungary, Estonia, Latvia and Lithuania.

All countries were hit hard by falling housing prices. By 2011, in the U.S. real housing prices had fallen 23 percent from the peak, 29 percent in Iceland and 41 percent in Ireland. The result has been a drastic decline in spending by households and economic stagnation.

The problem is not primarily the fall in housing prices, argues the World Economic Outlook. It is the combination of a fall of housing prices and very high levels of leverage among households. The report estimates that the difference in four-fold. Consumer spending fell by only 0.4 percent in the low-debt economies that had falling housing prices. However in the parts of the world with both high household debt and declining asset prices, consumption by households declined 4.3 percent over five years.

The report continues to explain how all this happened. Looking at housing crises in the U.S. in the 1930s and today, Colombia in 1999, the Scandinavian countries in the early 1990s and Hungary and Iceland today, the report cites two common characteristics seen just prior to the collapse of the economies: (1) financial innovation and (2) declining lending standards.

Looking at the U.S., in the 1920s, it was the introduction of installment financing of consumer durable goods that brought financial innovation (and looser credit). In particular, General Motors Acceptance Corporation provided consumer financing for automobiles, allowing consumers to pay for cars over time rather up-front with cash. The result was a huge expansion in the credit available to households. A similar form of financial innovation developed in the 2000s. Consumer credit grew by leaps and bounds as “private-label securitization” permitted residential mortgages to be bundled together and sold in the global capital markets, all without a government guarantee. At the same time, standards for extending credit fell with the creation of mortgages described as interest-only, "negative amortization" and the all-time favorite, NINJNA loans referring to mortgages with the borrower had no income, no job and no assets (or at least, none that could be documented.)

By 1925, housing prices had peaked and started to fall. Asset prices were further undermined in October 1929, when the stock market crashed. Some eight decades later, in 2005, housing prices again hit a peak. The bankruptcy of the investment bank, Lehman Brothers, followed in September 2008 and caused the global capital markets to collapse.

In both cases, as asset prices fell, the household sector began to shed debt, or “deleverage” as it is called in the vernacular. The national and global economies slowed down.

The World Economic Outlook estimates that in the U.S. another three million homes will be subject to foreclosure—in addition to the 2.4 million properties that were still in that deep hole at the end of 2011. The report further estimates that for every one million foreclosed homes, between 0.3 and 0.4 percent of national output is lost. If only there were a way to avoid the three million foreclosures, then U.S. gross domestic product would be another 0.9 to 1.2 percent higher. With such large amounts at stake, the report looks at what could be done.

The report suggests four possible solutions. First, monetary policy should be expanded as much as possible so that interest rates are very low. This makes most sense where mortgages are provided at adjustable interest rates. However most variable rate mortgages have already been converted to fixed rate loans. Furthermore the problem is one of a “zero lower bound on interest rates” as economists describe it. Borrowing rates cannot go below zero percent before an Alice-in-Wonderland situation arrives and borrowers are paid to borrow money.

Second, the social safety net should be strengthened. This generally means that unemployment benefits should be extended so that homeowners have some income with which to make their monthly payments. Again the report points to a difficulty—if the government has already taken on so much debt that it cannot (or should not) borrow more. This is the problem for advanced economies worldwide.

Third, the banks should be bailed out. More precisely, the government should buy all distressed debt held by the banks, as was done in the U.S. with the Troubled Asset Relief Program (TARP). However there may be some political limitations on such bailouts. In September 2008, I recall sitting in an outdoor cafĂ© in Washington discussing financial consumer protection policy with one of my colleagues. It was a Friday and office workers were wearing business casual dress. One had a t-shirt with a bold question. “Where is my bailout?” it read, expressing the view of many Americans that households should be given assistance, not the banks.

Fourth, homeowners should also be bailed out by restructuring their residential mortgage debt. It is only in the fourth and last solution that consumer protection and financial literacy play any role at all.

It is this last area—restructuring of mortgage debt—that is gaining attention at the global level. The chief of the International Monetary Fund, Christine Lagarde, is now recommending that—for the sake of the world economy—the U.S. and European governments should restructure mortgage debt of their heavily indebted borrowers. The World Economic Outline provides some justification for this approach. The report argues that for every $1 spent by the government in reducing mortgage debt of financially strapped homeowners, the U.S. economy will grow by $1.30. A similar program for the European Union would raise output by $1.10.

However what the report does not say is that the real question is one of fairness and equity. Should all taxpayers be obliged to bail out the reckless homeowners who would have kept all their earnings, had their bets paid off? Is that fair?

Instead the report provides technical details on two programs that seem to have worked--Iceland after 2008 and the U.S. in the 1930s. The two approaches are very different, even though that had the same objective in mind.

In Iceland, the government revised four different areas to prepare a comprehensive (and effective) solution. First, the laws were changed. The legislation on bankruptcy was amended to allow consolidation of secured and unsecured debt and permit short discharge periods. In addition, the law on mitigation of residential mortgage payments was changed to permit the write-down of secured debt to the amount of the appraisal and conversion of the remaining obligations to unsecured debt. Both revisions allowed the courts to take effective decisions on restructuring personal debt. Second, out-of-court mechanisms were put in place. Third (and most interestingly), a system of debtor ombudsmen were established to supervise negotiations of household debts. Fourth, the banks were encouraged to write down their loans to households.

The U.S. solution from the 1930s was very different. A new government agency was established, the Home Owners’ Loan Corporation. HOLC issued government bonds, which the agency exchanged with the banks for distressed mortgages. Once the mortgages were in the hands of the HOLC, its agents renegotiated the mortgages, one by one, often with debt counseling and even training on family budgeting. It is not clear if the accompanying “financial education” was helpful but it was clearly a resource-intense activity.

According to the World Economic Outlook, the final cost of the HOLC program was just 5.4 percent of GDP even though it rescued one in every five residential mortgages.

Thus the World Economic Outlook provides some useful ideas on ways in which consumer protection and financial literacy might help countries avoid the heavy burden of foreclosures of residential mortgages. Taking ideas from the experience of Iceland, a debtor’s ombudsman might be a useful way of encouraging (and supervising) restructuring of household debts one-by-one with the banks. From the U.S. experience emerge suggestions on effective financial education, at least to provide debt counseling and assistance in preparing family budgets.

However the larger story remains. To avoid the risk of a major slowdown in consumer spending, it would be best to discourage the household sector from taking on too much debt. Safe and Fair Finance Blog proposes a combination of clear consumer disclosure (to make sure that consumers have understandable information about their debts) plus a healthy dose of financial education (to help consumers understand the risks of high leverage).

But then, there is still that pesky question of how to establish basic fairness in a program to restructure household debt. For that, the World Economic Outlook has no suggestions.

Safe and Fair Finance Blog argues that if the system is not fair, it will not be accepted by taxpayers who must pay the costs of the restructuring. It will become yet another argument how capitalism in the 2010s is stacked against those who are honest and play by the rules.
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Wednesday, April 11, 2012

Will We Ever be Able to Trust the Banks Again?


The global financial collapse of 2007-08 was no ordinary crisis. It meandered along, starting in August 2007 with the collapse of the AA and AAA-rated hedge funds managed by the investment bank, Bear Stearns, followed by the merger of Bear Stearns with a leading commercial bank, JP Morgan Chase. The crisis peaked with the bankruptcy of the venerable investment bank, Lehman Brothers, in September 2008 and the first of many Oh-My-God (OMG) moments in the global financial sector. Trouble continued as the U.S. taxpayers bailed out first AIG, one of the largest insurance groups in the world, and then Citigroup, once the biggest bank on the globe. Between September 2008 and March 2009, the global economy appeared to fall off a cliff, as indicated by the graphical charts showing the decline in global economic production. The world’s economy was declining at a pace faster than in the six months after the stock market crash of October 1929, which heralded in the greatest economic depression the world had known. That ended the debate on whether or not extraordinary measures were in order. There was no longer any question that massive action was needed.

The world’s financial regulators then pulled out all the stops, with coordinated massive injections of cash into the money supplies of the world’s largest economies. It was the shining moment of the Group of Twenty (G20) countries that represent 85 percent of the world’s total economic output each year.

And yet, something far more fundamental has changed. It came down to trust. Public trust in government, in banks, in financial service providers had been deeply eroded. Public trust had shifted—and it shifted worldwide.

The Edelman Trust Barometer bears witness to the changes. The Barometer consists of a survey of over 25,000 respondents in the 25 largest countries in the world. The survey has been conducted every year for 12 years. The 2012 survey provides fascinating insights and some very useful suggestions for leaders in government, business and civil society.

The 2012 survey shows that the publics in fewer than half the countries trust their governments to “do the right thing.” The governments coming out best are those with strong civil responsibilities—the United Arab Emirates, China, Singapore. Those who garner the least public trust are all in Western Europe, starting with Ireland.

Furthermore when asked about the best role for government, 31 percent said that governments should “protect consumers” and another 25 percent responded that governments should curb “irresponsible business practices.” Other roles, such as building the necessary infrastructure for business, were also important but far down the list of priorities. It is clear that the general publics feel that the priority of their political leaders should be to ensure consumers are protected from abusive business practices.

Banks and financial firms come under particular attack. The 2012 survey looked at which industries were the most trusted. At the very bottom of the list were banks, second only to financial service providers. What would you guess would be the number one must trusted industry? The first was technology. The second was telecommunications.

One can also ask why. Safe and Fair Finance Blog argues that it is the technology and telecommunications companies that make consumers feel more powerful—and indeed make them more powerful. No one watching the huge crowds on the streets of Egypt and Tunisia in 2011 and Russia in 2011-12 could doubt how technology and telecommunications have enabled consumers to march together and make their voices heard through their numbers.

Safe and Fair Finance Blog also suggests that governments and financial firms should find ways to join forces with technology and telecommunications to make consumers of financial services more powerful.

The Edelman Survey provides some useful hints. The survey identifies which types of individuals are most respected in the public eye. Academics remain the first most trusted but the 2012 survey shows that other traditional sources are not trusted as deeply as earlier. Technical experts are no longer second on the list, as they were as recently as 2011. Chief executive officers have fallen to the near-bottom of the list of respected sources. Rather it is a person “like me” or a “regular employee” (i.e. not the chief executive) who are most relied upon.

This suggests that finding ways of tapping into the ideas of other users “like me” may be one of the best ways of building public confidence in banks and other financial institutions. On a recent trip to Ukraine, one of my colleagues had used tripadvisor.com to find out the quality of the hotel we had chosen. Yelp is an excellent way of finding out which are the best service providers--from hair stylists to morticians to car wash companies. One might ask if the same could done for financial service providers.

The Edelman Survey quotes Vikram Pandit, chief executive of Citigroup as saying that the loss “of trust arose not from a failure of capitalism but from specific failures by certain participants in the finan­cial system. We could go a long way to regaining that trust by making the system more transparent, by clearing some of the obscurity that causes people to believe the system is a game rigged against their own inter­ests.” Safe and Fair Finance Blog would like to suggest that Mr. Pandit may be on to something. Making finance transparent and ensuring that consumers are treated fairly are critical building blocks if the public is ever to trust the banks (and other financial firms) again.

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Monday, March 5, 2012

Why isn't Finance Understandable? Here are some Ideas on Fixes


When I talk to my non-finance friends about safe and fair finance, their first response is that, as a first priority, finance should be understandable. One can only wonder why consumer finance is not easy to understand.

From a conceptual perspective, consumer finance is super simple. Financial products sold to households consist of just a few variations of a theme. Loans are provided for a short period of time (such as for credit card borrowing or payday lending) or a long period (to finance a residential mortgage, for example). The interest rates are either fixed or floating, or fixed for a while and then floating for a while, or vice versa. Fees are due when you set up the loan or you pay it back early or you don’t pay on time. It gets more complicated if you provide your house or apartment as collateral, or if your lender insists on life insurance (in case you die before the loan is repaid). It is the same in reverse when you make deposit money in the bank--except that you can't ask for life insurance for the bank. That is why deposit insurance was put in place.

Investing in securities may seem to be same as betting in the casino but there are lots of rules (although maybe not enough rules) on how companies treat retail investors. In general, if Apple sells lots of iPhones and iPads, you (the investor) see the value of your shares rise. But if your company declares bankruptcy, your stock certificates have value only as framed collectors’ items. Buying into a mutual fund (or collective investment fund in Europe) means that you hire a professional to choose stocks for you. You just have to decide on your risk profile and the manager does the rest (for a fee).

Even insurance is not so difficult to understand. If you have a car accident or a house fire, the insurance company pays for most of the damage. The complicated part is if you buy a variable annuity (or investment-linked annuity in Europe), which is really a securities investment camouflaged as insurance. A variable annuity is indistinguishable from a mutual fund but supervised under the insurance regulation rather than securities regulation. But most consumer financial products are not that convoluted.

The hard part in all of this is figuring out how much money you need to save to cover you if you don't work again for the rest of your life, i.e. when you retire. But that's another issue.

In itself, figuring out how to use financial products is simple stuff—or should be. Why is it that people with advanced college degrees have difficulty understanding what they are buying? Why is it more fun to buy a sweater at Nordstrom’s than open a certificate of deposit with Bank of America? Clearly financial service providers have not clued into the idea that consumers like retail therapy—and that for most people, dealing with personal finance is a painful experience. Indeed a 2005 survey by the Royal Bank of Canada found that for most people, selecting the right investment for their retirements was more stressful than going to the dentist.

So what is the solution?

Safe and Fair Finance Blog suggests that as a starting point, financial institutions should be obliged to make consumer information easy to understand. The standard for consumer health information is that it should be understandable for people with just a ninth grade education. Given that 90 percent of Americans have graduated from high school or have equivalency diplomas, this would seem to be a reasonable standard. Why is the same not also required for consumer financial information?

Some people are trying. In a video from Tristan Cooke and Tom Nelson of the Australian firm, Humans in Design, they lay out how residential mortgage statements (in this case from Westpac Bank) could be redesigned. Their view is that customers want to receive clear and concise information about their mortgages. The proposed layout provides clear information that is useful for consumers in making decisions, such as whether to increase their repayments of their mortgages. The graphs also show the impact of changes in interest rates. The idea is that by giving customers clear and concise information about their monthly statements, consumers will feel empowered to make informed decisions about managing their mortgages.

Some of the government regulators are also working on it. The U.S. Federal Reserve Board conducted extensive surveys of shoppers to work out the government-mandated format for credit card statements. What used to be complicated and hidden in fine print is now easy to read—and even easier to understand. What is most striking is the estimate of how many months (or years) it will take to pay off your credit card debt if you only make the minimum monthly payment. Thank you, Federal Reserve.

Safe and Fair Finance Blog hopes that other regulators, consumer groups and just marketing folks also try their hand at making consumer finance understandable for us all.
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Sunday, March 4, 2012

Housing and the Economy -- Which is the Chicken and Which is the Egg?


For those who ask why I continue to forecast declining U.S. housing prices, here is the core of the issue. U.S. housing will not likely recover until the U.S. economy improves...but the economy will not improve until the housing market recovers. It is a classic chicken and egg problem.

Getting out of this vicious circle is difficult. Recovery of the economy depends on spending by middle-class consumers, which represent almost 70% of the US Gross Domestic Product. But spending by those consumers has been stalled by declining housing prices. 

Some suggest modifying the personal bankruptcy code. This is a good idea but its proponents tried to include such revisions as part of the Dodd-Frank financial legislation of July 2010--and failed. Other ideas have also been floating, including the suggestion that government agencies own part of people's houses in exchange for forgiveness of debt. This also seems a little far-fetched.

In the meantime, our current tax policies favor the top 10% of the population (including myself) and leave the rest to suffer declining real wages, increasing expenses for oil and food and health care, and rising costs of a college education. The current strategy of allowing inflation back into the economy (so that borrowers will have an easier time in repaying their debts) is surely not one likely to succeed.

In the author’s view, what is needed is: (1) a fundamental restructuring of the personal tax code to simplify and lower taxes (which always increases tax revenues by eliminating the loopholes), (2) reform of the business environment to make it easy for small businesses to operate and grow, (3) a national education policy to increase the college-educated population to 50% (from just over 20%) of all adults and (4) a viable long-term strategy to reduce total government debt (including state and local government obligations) from the current level of 120% of Gross Domestic Product.

Along the way, we also need to bring our telecommunications policies in line with international practice and increase effective competition among the carriers. In financial services, we are only half-way through the reforms needed to avoid another financial crisis similar to September 2008. Improving consumer protection in financial services and raising financial literacy will eventually be critical but for the moment, regulating financial instruments such as credit derivatives is far more pressing. Stopping banks from using tax-payer funds to finance speculative investments, as former Federal Reserve Chairman Paul Volcker has proposed, is at the top of the agenda but remains difficult to put in place.

Big agenda, eh?

Of this, so far the administration has announced efforts to: (1) reduce corporate taxes, (2) make it easier to borrow for college, (3) develop a bipartisan plan for government debt reduction, (4) strengthen consumer protection in lightly regulated financial services, such as payday lending and debt collection, and (5) adopt the Volcker rule on banks' use of depositor funds. It is a start but not enough to get the economy moving--or solve the housing dilemma--or give the middle-class a chance to realize the American dream once again. 

But at least, we don't have to figure out which is the chicken and which is the egg.
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What can Baseball Teach us about Financial Education?


On a recent flight from Armenia back to Washington, D.C., your correspondent took advantage of the in-flight entertainment to watch Brad Pitt in his 2011 movie, Moneyball. No doubt the story of the success of a small regional (and low-budget) baseball team will appeal to the heart of all true baseball fans. But for the Safe and Fair Finance Blog, some lessons also emerge.

The story’s author, Michael Lewis, is famous for Liar’s Poker, published in 1990 describing Wall Street and the famous investment bank, Salomon Brothers. Anyone who worked in investment banking in the 1980s will find his stories arrestingly accurate.

The basic premise of Moneyball is that players have traditionally been bought and sold based on the wrong criteria. A manager’s decisions about which player to trade for another is based on perception, i.e. the manager’s biases and gut-feel, all of which are based on years of experience but selective recall of that experience. Unfortunately such perceptions are often inaccurate and lead to faulty decision-making. The young assistant to manager of the Oakland A’s baseball team suggests that instead focus be placed on just one data point—the number of times each player reaches a base, called “time on base”. The argument is that the more times a player reaches a base, the higher the probability that the player will move from first base, then to second to third and then home for a run. The more times a player is on base, the more runs will be chalked up and the more likely the team will win the game.

In selecting ball players, managers are often influenced by consensus thinking rather than hard data. Some players look funny when they throw the ball. Some play it safe too often. A once star athlete may have lost much of his power and so is considered ineffective when he still has a lot to give. For one reason or another, some talented players have undervalued qualities. Their market price is based on biases and gut feel. But their value to the team is reflected in the data.

Here Michael Lewis tapped into his experience on Wall Street. Finding tradable assets where the market value differs from the true value—and buying and selling based on the discrepancies—lies at the essence of successful financial investing. Better to buy and sell players using concrete data rather than gut-feel, suggests the young manager’s assistant. For the Oakland A’s in Moneyball, it was a highly successful strategy that changed the way that baseball teams were selected throughout America. It changed the way managers thought about how to win the World Series without busting the budget.

So how can Moneyball help figure out how best to design programs of financial education? Most government officials design economic policies based on a combination of their gut and their interpretation of recent historical experience. However neither is a reliable guide. Instinct is helpful when sudden decisions must be made but economic policy is almost never made in a matter of moments and such gut-feel can lead to poor choices. Better to focus on using concrete data to achieve policy goals. Unfortunately such evidence-based policy-making remains very rare, particularly when related to warm and fuzzy issues such as financial education.

Safe and Fair Finance Blog suggests that financial education programs focus on just two concrete data-points. First, one needs to define a target for success of financial education programs. This might be to achieve a certain level of measured financial literacy among the adult population--or perhaps having your country’s population rank at the top of a survey of financial literacy worldwide.

Second, one needs to identify the critical measure that ensures success in reaching the goal—something equivalent to “time on base”. Is this number of hours of classroom training in personal finance? Currently time in classroom is the most commonly used indicator. Unfortunately it is the least useful of all possible choices. A more helpful target might be the percentage of adult population that maintains bank account (reflecting sufficient public confidence in using keeping extra cash in a bank rather than under the mattress or in a sock). Whatever indicator is selected, detailed and comprehensive statistics need to be collected, published and analyzed.

Only financial education programs are designed based on data of what works will financial literacy measurably improve. Otherwise the best alternative might be to cancel the classes on personal finance and let students enjoy playing baseball.
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Sunday, February 12, 2012

Financial Literacy & Consumer Behavior: Can a Nudge work better than a School Book--or a Government Regulation?

Advocates for improved financial literacy suffer from a clear dilemma. Almost everyone supports that idea that all consumers need to be financially literate so that they can make informed decisions. Yet very few of financial education programs have proven effective in improving the levels of financial literacy.

A comprehensive review of the success of financial literacy education programs was conducted by Lauren Willis, Professor of Law at Loyola Law School and published in 2008. In study after study, Professor Willis came to the conclusion that financial education is not worth the investment. She found that education in financial literacy did not make individuals better able to make sound decisions in their use of financial services. Furthermore in some cases, the training provided a false level of confidence, encouraging investment in speculative stock market deals.

However the real problem is that even financially literate consumers can make “bad” economic decisions.

It may therefore be time to think about alternative approaches. In their 2009 book, Nudge: Improving Decisions About Health, Wealth, and Happiness, Richard Thaler and Cass Sunstein show how “choice architecture” can be established to nudge consumers in beneficial directions without restricting their freedom of choice.

Decisions about retirement planning provide a good case in point. Most people do not save enough money for retirement. In the U.S., data was collected of households with a 401(k) retirement account and where the primary earner was between 60 and 62. The study found that median households had saved less than one-quarter of what is needed to maintain income at the 85% pre-retirement level (according to data compiled by the Federal Reserve and analyzed by the Center for Retirement Research at Boston College for The Wall Street Journal.)

However a 2007 paper by the Vanguard Center for Retirement Research found that where new employees are automatically signed up in employer-supported pension plans (i.e. the 401(k) defined-contribution matching plans found in the U.S.), 86 percent stay in the plan, even when they have the option to opt out and withdraw from the plan. By contrast, when new employees are informed about the corporate pension plan and merely invited to join, only 45 percent do so. However the employees that were automatically enrolled were three times more likely to allocate all of their contributions to the default investment fund than were those investing in voluntary plans (67% versus 21%).

The implications are obvious. Since almost everyone will need a pension plan when they retire, the “default” option should be to register all new employees in the plans. But more still will be needed. The U.K. provides some intriguing ideas.

With Professor Thaler and a U.K.-based research team, the U.K. Government has established a Behavioural Unit Team (BIT a.k.a. the Nudge Team). They have not yet started working on consumer protection in financial services but their annual report for the first year provides some interesting ideas that might be applicable for financial consumer protection.

On public sector reform, BIT proposes two approaches. First, BIT suggests using transparency and feedback loops from users. Comments from other consumers can have a powerful impact on selection of choices as anyone who has used eBay, Amazon or Yelp can attest. Safe and Fair Finance Blog suggests that the difficulty is to ensure that feedback loops are not abused—by disgruntled former employees or the marketing staff of competitors. However well-designed consumer feedback sites can help consumers express their views of the quality of the customer experience in buying and using financial services and products.

Second, BIT suggests that whistle-blowers be encouraged. Regulators can be blind to the problems that can only be seen from the inside of a business or service. Providing rewards to whistle-blowers can help bring the issues to the surface. The amount of the rewards should be based on evidence that allows for the identification of significant harm to consumers. Safe and Fair Finance Blog suggests that encouraging whistle-blowers in the mortgage brokers to come forward might have helped save millions of consumers from toxic subprime borrowings.

Cutting red tape and reducing regulation is a goal for all governments. Such efforts are more likely to succeed when policy-makers (and industry and consumers) can identify an alternative process that delivers the same result—or better.  Safe and Fair Finance Blog suggests that both ideas from BIT might prove to be powerful not just for public sector reform but also for improvements in consumer protection related to financial services.

Safe and Fair Finance Blog would like to thank Tim Harford (a.k.a. the Undercover Economist) of the Financial Times for his opinion article about the Nudge Team and their valuable work.

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Tuesday, February 7, 2012

Financial Education in Pakistan: Will it work to increase financial inclusion?


For all its popular support, financial education needs to be very carefully evaluated. As part of a nationwide program launched last month, the central bank of Pakistan (known as the State Bank) started a pilot financial education program targeting poor and marginalized populations. About 50,000 low-income households will receive training in six areas: (1) budgeting, (2) savings, (3) investments, (4) debt management, (5) financial products, including branchless banking, and (6) consumer rights and responsibilities. The training materials will be translated into the national language as well as the five main regional languages, Urdu, Sindhi, Punjabi, Pushto and Balochi. Following completion of an independent assessment, the program will be expanded to 500,000 beneficiaries.

The training programs will be complemented by consumer awareness campaign using such novel approaches as street theater, board games, comic strips and activity-based competitions. Website and media campaigns will also be used.

The issues are important for financial inclusion. The State Bank has found that only 12 percent of Pakistani households use formal financial services, with the balance relying on unreliable informal arrangements. Of those outside the formal financial system, 40 percent cite lack of understanding of financial products as the main reason for not using financial services.

Safe and Fair Finance Blog supports this initiative by the State Bank of Pakistan but recommends that its impact be carefully evaluated. Research by Shaun Cole, Thomas Sampson and Bilal Zia on effectiveness of financial education programs show that low-income households benefit from basic financial training. However financial education is generally an expensive process with unclear results. Cole et al found that a more cost-effective approach is to give low-income households a small amount of money – if they open a basic bank account. All this suggests that the evaluation by an independent third-party will be a critical part of making the nationwide program as effective as possible. That assessment should look at more than just the issue of whether the trainees better understand financial products. The evaluation should also try to determine if households receiving training in personal and household finance are more likely to use formal financial services that those not receiving such training.

However financial education cannot solve problems due to weak regulation. Safe and Fair Finance Blog recommends that a systemic review of the financial consumer protection laws and regulations compared to international practice also be conducted and published.

* Cole, Shawn, Thomas Sampson, and Bilal Zia. 2009. “Financial Literacy, FinancialDecisions, and the Demand for Financial Services: Evidence from India and Indonesia”. Harvard Business School Working Paper 09-117
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Sunday, February 5, 2012

Is Facebook using your Personal Data?


Part of consumer protection in financial services relates to protection of personal data – how financial institutions use and share the data and how consumers can correct inaccuracies. Today’s The New York Times article, "Facebook is Using You", describes how data aggregators collect and share consumers’ data without advising consumers of the use of such data. If this happens with Google searches, email and Facebook pages, can consumers be assured that personal data is not similarly abused by financial institutions?
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Friday, February 3, 2012

Banks should not be allowed to use an Inaccurate Data-base to evict Homeowners

Earlier this week, Safe and Fair Finance Blog wrote about Hernando de Soto’s article on the need to clean up public registries of assets, in particular the US electronic registry of mortgages known as MERS. The registry remains a mess. It holds an estimated 60 percent of all residential mortgages in the U.S., i.e. about 70 million individual loans. Yet the MERS records are widely believed to be less than accurate.

On Friday, New York State Attorney General Eric Schneiderman filed a lawsuit against MERS and three banks -- Bank of America, J.P. Morgan Chase and Wells Fargo. The complaint accuses MERS and the banks of engaging in “deceptive and fraudulent practice.”

The complaint under the lawsuit identifies six specific ways in which homeowners and the public have been harmed by MERS.
  1. By bringing foreclosures without proper legal standing, MERS subjected homeowners to improper foreclosures;
  2. By submitting to the court invalid assignments of mortgages, MERS obtained foreclosure judgments through fraudulent and illegal means;
  3. By making misrepresentations regarding the identity of the holder of mortgage notes, MERS undermined the integrity of the court system and impeded the ability of homeowners to present legal defenses;
  4. By creating foreclosure  judgments for entities that did not hold the notes, the actions of MERS created invalid liens and clouds on title, thus subjecting foreclosure victims to the risk of monetary judgments by the true holders of the notes;
  5. By creating mortgage assignments by MERS employees who were not adequately trained or supervised, MERS misled and deceived homeowners and the courts; and
  6. By obscuring the identity of the beneficial owners of mortgages and the chain of title, MERS deprived homeowners and the public of the ability to determine true property ownership through publicly available records.
One wonders how it was the MERS was created – and allowed to continue to operate.

Financial innovation in the 1990s allowed residential mortgages to be easily bought and sold by financial institutions. The traditional way of recording changes in ownership was a visit to the county clerk, where for a fee of $30 or so, the seller could record the sale of the mortgage to a buyer. With the securitization of residential mortgages into mortgage-backed securities, such re-registrations became cumbersome. The major mortgage banks got together and created a private registry – Mortgage Electronic Registration Systems or MERS – to act as the holder of record of the mortgages. The problem was that MERS had weak governance. With a staff of under 100 employees, and no legal responsibility to ensure the accuracy of its records, MERS hired employees from its member firms to certify the loan documentation.

However MERS remains a private registry. Even homeowners cannot obtain reliable information from MERS on which financial institution legally holds their mortgage. So when it is time to try to find someone in the bank who is authorized to discuss a modification of the loan … there is no one to be found. More accurately, there is often no one who is sure which financial institution has the authority to modify the loan.

In this environment, no amount of financial incentives will be effective in helping homeowners renegotiate their home loans.

In the opinion of Safe and Fair Finance Blog, this is simply a mess. Surely as a starting point, a public registry should be established for all new residential mortgages. The registry should be run by a government agency, operating with clear rules of corporate governance and an electronic data-base accessible to the public at no charge.

For the existing mortgages, financial institutions should be obliged to accurately reconstruct the legal records before initiating any foreclosures. Alternatively financial institutions might be encouraged to offer all existing clients a discount on the monthly payment if they are willing to provide the legal documentation for the mortgage and submit it to the new public registry. Finally all mortgage lenders should be obliged to set up special departments to deal with existing murky mortgages until all have finally been repaid. 

If nothing is done, it is likely that the threat of foreclosures -- invalid or not -- will continue to hang over the residential real estate market. Such uncertainly makes it difficult for the real estate market to become efficient. It is also a question of fairness in the way that financial institutions treat their retail customers.

Safe and Fair Blog would be interested to hear your views on how to solve this problem in a way that helps financial consumers while maintaining the soundness of the financial sector. This is a problem that certainly will not go away very easily.
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