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WINTER 2009 | 2010
Volume 1 Number 1

F refront

New Ideas on Economic Policy from the federal reserve bank
of cleveland

Making Financial Markets
Safer for Consumers

INSIDE:
How to Rein in
Systemically Important Institutions
The Curious Case of
Cleveland’s Foreclosure Rate
Q&A with Urban Economist
Matthew Kahn

F refront

New Ideas on Economic Policy from the federal reserve bank
of cleveland

		 WINTER 2009|2010

Volume 1 Number 1

		 CONTENTS
1	President’s Message

8

2	Housing and the Federal Reserve
6	Upfront
New Rules on Overdraft Fees; Rethinking Credit Rating Organizations

8	COVER STORY
Making Financial Markets Safer for Consumers:
Lessons from Consumer Goods Markets and Beyond

14	A Framework for Systemically Important Institutions
Too Big to Fail or Not Too Big to Fail?

14

18	The Foreclosure Timeline:
The Curious Case of Cleveland’s Foreclosure Rate

22	Interview with Matthew Kahn
28	View
Can Foreclosures Be a Neighborhood’s Best Friend?

18

22

The views expressed in Forefront are not necessarily those of the
Federal Reserve Bank of Cleveland or the Federal Reserve System.
Content may be reprinted with the disclaimer above and credited
to Forefront. Send copies of reprinted material to the Public Affairs
Department of the Cleveland Fed.
Forefront
Federal Reserve Bank of Cleveland
PO Box 6387
Cleveland, OH 44101-1387
forefront@clev.frb.org
clevelandfed.org/forefront

President and CEO: Sandra Pianalto
Editor-In-Chief: M
 ark Sniderman,
Executive Vice President and Chief Policy Officer
Managing Editor: Robin Ratliff
Editor: Doug Campbell
Associate Editors: Amy Koehnen, Michele Lachman
Art Director: Michael Galka
Designer: Natalie Bashkin
Web Managers: Stephen Gracey, David Toth
Contributors:
Jean Burson
Thomas Fitzpatrick
Daniel Littman
Todd Morgano

Mary Helen Petrus
Francisca Richter
Guhan Venkatu
Stephan Whitaker

Editorial Board:
Ruth Clevenger, Vice President, Community Development
Stephen Ong, Vice President, Supervision and Regulation
James Savage, Vice President, Public Affairs
Mark Schweitzer, Senior Vice President, Research
James Thomson, Vice President, Policy Analysis

PRESIDENT’S MESSAGE
Sandra Pianalto
President and Chief Executive Officer
Federal Reserve Bank of Cleveland

We’re out there talking.
In the face of the most
wrenching economic
crisis since the Great
Depression, the Federal
Reserve has stepped up its
communications program
over the past couple of
years. Chairman Ben Bernanke has added to his already packed
schedule of testimony and speeches, held town hall meetings,
and appeared on 60 Minutes. A number of Reserve Banks are
now on Twitter. You can find clips of my own speeches, as well
as a series of entertaining and informative Drawing Board videos,
on YouTube. The Federal Reserve Bank of Cleveland is even on
Facebook.
All of this communicating is done with purpose. We at the
Federal Reserve believe that a well-informed public is crucial to
our efforts in fulfilling our dual mandate of price stability and
maximum sustainable economic growth. The more you know,
the easier it is for us to do our job. This is particularly true in
these turbulent economic times.
We also believe that a decentralized central bank is essential to
keeping the interests of Main Street and Wall Street balanced as
we conduct monetary policy. An independent Federal Reserve
System, with the Board of Governors in Washington, DC,
and the 12 Reserve Banks across the country, brings regional
conditions and concerns to the policy table, free from political
overtones.

In that spirit, I welcome you to Forefront, the Federal Reserve
Bank of Cleveland’s new policy magazine. Whether online or in
print, Forefront is our vehicle for advancing ideas on economic
policy. The language will be clear, the concepts accessible. Although
many articles will be penned by highly trained economists, you
don’t have to hold a PhD to understand them. Forefront is not
homework. But it is informative.
Our premiere issue focuses on the sometimes complicated topic
of regulatory reform. We take a look at consumer protection
through the lens of a recent seminar that our Bank hosted in
Cleveland. Some of the nation’s top researchers in consumer
protection gathered to discuss new approaches, building from
lessons learned in products beyond financial services, from food
and drugs to internet marketing. We also explain our favored
approach for regulating large financial institutions to avoid the
turmoil that visited the financial system in 2008.
With Forefront, we hope to give you a glimpse into the policy­
making decisions happening inside our Bank. But we don’t
want this to be a one-sided conversation. In fact, it is through
my contacts throughout the Fourth Federal Reserve District
that I develop my views on the most important policy issues
of the day­— the classic Main Street to Wall Street connection.
We’d like to hear from you: What do you think of Forefront?
Do you agree with our economists on consumer protection?
How can we make housing policy more effective?
Please help us contribute to better policy by sharing your
perspective. You can comment on specific articles at
www.clevelandfed.org/forefront, or email us at
forefront@clev.frb.org. We look forward to hearing from you.

■

F refront

1

Housing and
the Federal Reserve
Sandra Pianalto
President and CEO
Federal Reserve Bank of Cleveland

The Federal Reserve influences the housing sector through three key roles:
as a monetary policymaker; as a banking regulator;
and as a community development collaborator.

This article is based on remarks presented at the Ohio Housing
Conference, Columbus, Ohio, November 17, 2009.
As a national policymaker, living through the recent
economic crisis has been a humbling experience. It has
been sobering to realize that financial market participants
and regulators alike did not fully appreciate how complex
and interconnected our financial markets had become.
Nor did we fully appreciate how much risk was building
up in the financial system. These are a few of the many
lessons all of us have learned over the past couple of years.
At the Federal Reserve, we now have a better under­
standing of the conditions that led to the challenges we
face, but understanding alone isn’t enough. We have
been responding vigorously on many fronts­— including
working to find solutions to the problems of delinquencies,
fore­closures, and access to credit­— and there is still more
work to do. Progress is being made, but it will take the
work of many and a considerable amount of time for
housing markets to fully recover.
I want to share some of the Federal Reserve’s efforts on
the housing front. I will first discuss the role of the Federal
Reserve as a monetary policymaker and the actions we
have been taking to put the economy on the road to
recovery. I will then address the regulatory steps we are
taking to ensure the safety of the financial sector and to
protect consumers and borrowers. I will conclude by
detailing our activities here in Ohio and across our Federal
Reserve District as a community development partner.

2

Winter 2009|2010

How Monetary Policy Can Affect Housing

The combination of this severe housing contraction and
the steep national recession is not a coincidence. During
the boom years leading up to this debacle, housing finance
became intertwined with broader financial and economic
developments. Rising property values supported more
consumer spending, banking profits, and more lending of
all kinds. When this growth cycle began to unwind, and
spin in the other direction, mortgage-related losses eroded
the capital of many financial institutions and cut deeply
into the wealth of many homeowners. These problems
led financial institutions to reduce lending to consumers
and businesses, and induced consumers to curtail their
spending. Weakness in the housing markets restrained the
broader economy which, in turn, further weakened the
housing markets.
The Federal Reserve has taken historic measures to address
these problems. Monetary policy is the responsibility of
the Federal Open Market Committee, or FOMC, which
consists of the members of the Board of Governors in
Washington, DC, and the 12 Reserve Bank presidents from
across the nation. This decentralized structure ensures
that the Committee takes into account Main Street as
well as Wall Street. The FOMC has a dual mandate from
Congress—to maintain price stability and to promote
maximum sustainable economic growth.
When economic activity weakens, the FOMC typically
lowers its short-term policy target, known as the federal
funds rate, and this time was no exception. As the outlook for the economy deteriorated, the FOMC repeatedly
cut the federal funds rate target, and it now stands at
essentially zero.

This recession has been far from a typical one, however.
Many financial markets seized up, crippling the flow of
credit to many parts of the economy, including such impor­
tant Main Street activities as housing finance, auto loans,
and even student loans. Federal Reserve officials knew that
we had to do more than rely on interest rate actions alone.
Beginning in the spring of 2008, we designed a number of
new lending programs and facilities to get credit flowing
once again to these important financial markets. Our
objective was to help thaw a broad range of financial
markets and steer the wider economy away from a cliff.
We have also taken unprecedented steps in how we conduct
monetary policy. For instance, we have been purchasing
mortgage-backed securities issued by the governmentsponsored enterprises Freddie Mac, Fannie Mae, and
Ginnie Mae. Our strategy has been to reduce the cost and
increase the availability of credit for home purchases, which
we expected would support housing and financial markets
more generally. We are now well into this program, which
will culminate in the purchase of $1.25 trillion in agency
mortgage-backed securities by next spring. Today, mortgage rates stand more than a full percentage point lower
than they were one year ago.
Fortunately, we have seen some recent progress in the
housing sector. Housing prices and sales levels have begun
to stabilize, and in the first half of the year, refinancing was
up by more than 150 percent, which has lowered the debt
burden of many homeowners. Of course, the Administration and Congress also had a strong hand in helping to
stabilize real estate markets—most notably with the firsttime homebuyer tax credit. The combined efforts of these
initiatives seem to be working. Three out of five home
sales are now to first-time buyers, compared with one in
five in a typical market. But this also illustrates that many
move-up home purchasers are still sitting on the sidelines,
so there is a long way to go before anyone can breathe a
sigh of relief.
At this point, monetary policy can most effectively
support the housing sector by fostering stronger growth
in the broader economy, which would lead to more stable
property values, increased consumer confidence, and
lower unemployment. Economic conditions have certainly
improved since the beginning of this year, but resource
utilization levels still remain low, bank lending is restrained,
and credit terms are tight. I expect our recovery to be a
gradual and bumpy one.

Responding to Regulatory Issues

The Federal Reserve’s supervisory and regulatory roles
also affect the housing sector. While much of the initial
financial crisis originated in the mortgage markets, there
is still much to correct there and in the broader financial
markets.
Everyone with a role and a stake in the financial system
needs to take a careful look at the various failures of market incentives and regulations that supported mortgages
and securities that are now being described as “toxic.” In
looking at what went wrong, we need to react in a thorough
and thoughtful manner to limit similar problems in the
future. We at the Federal Reserve have been examining
our past actions to understand where opportunities are
available for strengthening our supervisory approach.
Where we can act under existing authorities, we are taking
strong steps to make our financial system safe, sound,
and fair.
We have broadened the scope of our supervision. For
example, we have heard complaints that while a given
bank might be complying with regulations, one of the
same bank’s holding company affiliates might not be. To
address this issue, the Federal Reserve announced that
we will conduct consumer compliance exams of nonbank
subsidiaries of bank holding companies and foreign
banking organizations, and we will investigate consumer
complaints against them. Our goal is to ensure consistent
practices within all subsidiaries of bank holding companies,
not just banks.
In addition to these and other supervisory efforts, the
Federal Reserve has adopted new regulations and revised
existing ones to protect consumers. In July 2008, the
Federal Reserve strengthened a key regulation designed
to protect consumers in the mortgage market from unfair,
abusive, or deceptive lending and servicing practices. The
rule also establishes advertising standards, requires certain
mortgage disclosures to be given to consumers earlier
in the transaction, and adds important protections for a
newly defined category of “higher-priced mortgage loans.”
When developing new regulations, the Board of Governors
is working carefully and creatively to craft regulations that
people can better understand—even using consumer focus
groups to give us feedback on the clarity of our proposals.
The Federal Reserve also has rule-writing authority for the
provisions of the Community Reinvestment Act (CRA).
The CRA has been a significant driver of access to credit
and capital in traditionally under-served communities since
it was passed in 1977. Yet the financial services landscape
has changed dramatically in the past 30 years, and the
problems we face are now different.

F refront

3

For example, there is evidence that the CRA is of limited
use in addressing the problem of foreclosure spillovers,
especially when it comes to dealing with real-estate-owned
(REO) properties and the disposition of vacant properties.
This is an especially important issue for Ohio, which is
saddled with a very high inventory of REO properties.
The CRA was designed to encourage banks to support
building and renovation, not to tear down dilapidated
housing. But one of the CRA’s hallmarks is its flexibility.
There may be ways to adapt the regulation to encourage
lenders to support the kinds of housing activities that
many communities need in this time of crisis. I think
the CRA can become a more effective tool in providing
incentives for banks to donate some of the distressed real
estate they own to qualified community development
corporations, and to engage in services and investments
that benefit foreclosure mitigation and neighborhood
recovery efforts. The Federal Reserve Bank of Cleveland
is currently working with others on a practical way to adapt
the CRA for these purposes, although ultimately, changes
in CRA regulations involve the other bank regulatory
agencies in addition to the Federal Reserve.

Proactive Steps by Community Development

While regulatory efforts are important, regulation alone
is not a panacea and often addresses problems only after
they have become problems. Despite renewed activity on
the regulatory front by the Federal Reserve and others, we
need strategies to tackle the wider housing challenges of
today and tomorrow. This raises the third area of focus for
the Federal Reserve: our work as a community development partner.
Through the Community Development function at each
of the 12 Reserve Banks, the Federal Reserve maintains
relationships with community and economic development
practitioners. We regularly share our findings with bankers
and legislators at the state and national levels, and with
our colleagues at the Board of Governors in Washington.
And we use the knowledge we gain to inform our super­
visory and regulatory policy responsibilities.
We also apply this knowledge in our work with other
government agencies at all levels to promote community
development. This leads to more flexible and targeted
solutions that can make a difference in all neighborhoods.
At the Federal Reserve Bank of Cleveland, a critical theme
that has surfaced from our community development work
—and that continues to guide our efforts—is that recovery
in Ohio will be affected by the challenges we face as a slowgrowth region, where population declines over the years
left a serious excess of housing well before the crisis began.

4

Winter 2009|2010

Even though Ohio never experienced the sharp appreciation in housing prices that other parts of the country did
earlier in this decade, the pain of the crisis has been just as
real here, if not more so. In some parts of Ohio, housing
sales began to weaken as early as 2004. Simply put, Ohio’s
problems are more entrenched because they are tied to
structural and not just cyclical weaknesses in the state’s
economy.
This makes it all the more necessary to investigate what
housing programs might work within our region. Last
November, we held a series of public events to connect
distressed borrowers, counselors, and loan servicers to
find ways to keep people in their homes. At that time, we
thought loan modifications would prove to be an important tool for stabilizing the housing market. Outreach to
distressed borrowers has met with mixed success, and
only a very small percentage of distressed loans has been
modified successfully across the nation—and the figure
has been even lower here in Ohio.
Well-intended efforts often do not work well in practice
for any number of reasons. We discovered a variety of
factors that inhibited the loan modification process, some
of which are currently being addressed by lenders, servicers,
counseling agencies, and program administrators. Other
factors are not so easily addressed, such as the fact that
many of the mortgage loans that borrowers received were
poorly underwritten in the first place.
If a homeowner cannot avoid foreclosure and has to
leave his or her home, what happens to the property if
it happens to be in a place where there is either no ready
buyer or simply too few people left to occupy yet one more
empty house among many others? The Neighborhood
Stabilization Program, or NSP, was put in place to help
municipalities acquire such properties for possible
rehabilitation and resale, or in some cases, demolition
and land banking. The Federal Reserve Bank of Cleveland
and the Federal Reserve Bank of Richmond are partnering
with the National Vacant Properties Campaign to conduct
case studies of different kinds of communities that receive
NSP funds to find out where the NSP is working, and
where improvements might need to be made. We are
sharing our findings here, in our region, and also with
the Department of Housing and Urban Development.
Our Community Development office also conducts
research and analyzes data to uncover patterns, trends,
and relationships in the housing markets. Through this
body of knowledge, we are gaining valuable insight into
other potential solutions, where problems are occurring,
and whether there are any similarities or differences
throughout the region that can help improve public policy.

An example of this approach in practice: Data analysis
is helping us uncover what factors contributed to very
different foreclosure rates in 2007 among demographically
similar neighborhoods in Cleveland and Pittsburgh.
Cleveland’s foreclosure rates are far greater than Pittsburgh’s,
especially in poor neighborhoods.
One major discovery of our research was that most of
the mortgage lending in Cleveland’s poorest areas was
originated by a small number of nonbank mortgage
companies. However, this source of lending was not nearly
as much of a problem in Pittsburgh. Residents of poor
Cleveland neighborhoods appear to have less access to, or
less reliance on, traditional financial service providers.
We are working to understand why such differences exist
between the foreclosure experiences of these two communities and where some improvements might be found,
such as in the way states regulate and supervise the mortgage origination process. Other opportunities might be
found in homeowner counseling and assistance programs.
The work undertaken by the Federal Reserve in the
area of community development aims to help lowand moderate-income communities, but none
of our community development efforts can
possibly offset the losses and hardship that

these communities have experienced. Decades of progress
have been wiped away in many low-income communities
in this dramatic two-year burst of foreclosures. The Federal
Reserve’s activities are only a small part of a wider effort.

Time and Teamwork: Keys to Solutions

In conclusion, I want to emphasize that the Federal
Reserve recognizes the need for action and that we
have been aggressive in monetary policy, banking super­
vision, con­sumer protection regulation, and community
develop­ment. Collectively, these efforts are designed
to help restore housing markets in pursuit of a better-­
functioning economy. However, the scale of the recession,
the financial turmoil, and the focused impact of the crisis
on many communities pose an unprecedented challenge
to all policymakers. While we certainly see ourselves as
part of the solution, many partners and much time will
be needed to heal these problems.
It’s going to take a creative, coordinated, and collaborative
effort to get our housing market back on track—especially
here in Ohio. That’s why I encourage all of our readers to
please stay in touch. Let us know what you’re thinking and
how you think we can help. ■

F refront

5

Upfr nt
Fed: Say Goodbye to Hidden
Overdraft and Gift Card Fees
The Federal Reserve recently took
steps to shore up consumer protection rules on two fronts­— the first
dealing with overdraft fees, the
second with retail gift cards.
Under rules that will take effect next
summer, banks can no longer charge
overdraft fees on point-of-sale and
ATM debit card transactions without explicit customer permission.
Customers can either sign a document opting in to their banks’ overdraft protection policies, or they can
opt out and forgo overdraft protection on debit card transactions (in
which case their transaction would
simply be denied). U.S. banks today
collect about $38 billion a year in
overdraft fees, although that figure
includes fees for checks and some
electronic transactions not covered
by the new rules.
In the past, disclosure of overdraft
fees for debit cards tended to be
lumped in with overdraft protection
for checks. Research has shown,
though, that consumers are more
frustrated by fees applied to over­
drafts on point-of-sale or ATM
transactions than on those that
involve checks.
The innovation with the new opt-in
rules is that it helps ensure that consumers pay attention. “The assumption is that if you require a consumer
to opt-out, that requires them to
take action they may or may not
have otherwise taken depending on
their level of inter­est or concern,”
says Paul Kaboth, assistant vice
president in Super­vision and Regulation at the Federal Reserve Bank
of Cleveland. “With an opt-in, you
will clearly delineate those consumers who want that service from
those who aren’t paying attention.”

6

Winter 2009|2010

Separately, the Fed has proposed
new rules that would place restrictions on gift card expiration dates
as well as on inactivity or service
fees associated with the cards.
The proposed rules, which would
take effect in August 2010, require
that retailers
provide “clear
and conspicuous”
disclosures of
inactivity fees,
which could be
Paul Kaboth
assessed only
after a full year of inactivity and
then charged no more than once
per month. Expiration dates would
extend to at least five years after
the card is issued or the funds are
loaded.
The Federal Reserve began accepting comments on the proposal in
November and will review them
before announcing the final rules.
About 95 percent of Americans
have received or bought gift cards.
In 2008, they spent $88 billion on
them. “It would put some order in
the marketplace by adding some
universal standards,” Kaboth says.
­— Doug Campbell, editor

Regulating the Raters:
Key Provisions in
Proposed Reforms
The financial crisis has produced
no shortage of culprits—from Wall
Street executives who were highly
compensated for taking excessive
risks to woefully undercapitalized
insurance companies. Then there
are the so-called credit rating
organizations, or CROs, which have
largely flown under the radar. How
was it possible that CROs such as
Moody’s and Standard & Poor’s
handed out so many high-quality
ratings to investment vehicles that
turned out to be so high-risk?

	Regulators have
long viewed CROs
as financial gate-­
­­keepers and
counted on them
to provide invesThomas J.
tors with impartial
Fitzpatrick IV
assessments of
companies’ creditworthiness or pools
of assets. As a result, some institu­
tions have relied on CRO ratings
instead of due diligence.
Academics have been calling for
rating organization reforms for
years, and their calls became more
urgent after the housing crash.
When foreclosures began to mount
in 2006, CROs at first did nothing.
Then, on July 10, 2007, the nation’s
two largest CROs downgraded
$20 billion of subprime mortgagebacked securities, causing enormous
losses throughout the financial system. A month later, the Securities
and Exchange Commission (SEC)
launched a formal investigation of
the CROs.
In its 2008 report, the SEC described
CROs’ failings in detail. Among the
most glaring deficiencies reported
was that none of the leading CROs
kept specific, comprehensive written
procedures for rating subprime
mortgage-backed securities and
the structured investment vehicles
known as collateralized debt obligations. At the same time, CROs’
internal emails suggested they
were rating deals that their analysts
thought should not be rated.
Today, calls for reform are leading
to regulatory proposals, including
one that would create an SEC office
dedicated to CRO oversight. These
proposals tend to focus on five areas:
ending regulatory reliance
on CROs

■	

ensuring that CROs provide
new disclosures

■	

increasing competition

■	

reducing conflicts of interest

■	

ensuring that CROs establish
adequate internal controls

■	

Ending Regulatory
Reliance on Credit Ratings
Government supervisors use ratings
to limit the types of assets regulated
institutions can hold. As it stands,
CROs are effectively governmentsanctioned gatekeepers, creating a
market for credit ratings sometimes
regardless of their quality. At the
same time, it is hard to unwind the
extensive regulatory reliance on
credit ratings, which are referenced
in scores of statutes, regulations,
and interpretive letters.
One way to encourage long-term
reform on this front would be to
give a government supervisor the
mandate to work toward ending
regulatory reliance on CRO ratings,
building on the decades of research
already conducted.
Providing New Disclosures
In the past, CROs were forthcoming
about their credit rating methodologies and how traditional ratings
(such as those for corporate bonds)
differ from structured ratings (such
as those for asset-backed securities).
The assumptions underlying those
methodologies, however, have
not been available to the investing
public. Moreover, the difference
between structured products and
traditional corporate bonds is not
captured in the ratings symbols.
For instance, both corporate bonds
and mortgage-backed securities
can be rated AAA (or Aaa), but their
risk characteristics are materially
different.

Those are conspicuous omissions.
To fully inform ratings users, it is
necessary to disclose underlying
assumptions, especially the likelihood of a default and the loss it
would cause. Adopting new symbols
for structured products would signal
that these products differ from
traditional ones. The new symbols
would also make structured products ineligible for satisfying many
regulatory requirements that are
based on traditional “investment
grade” symbols.
Increasing Competition
The CRO market is heavily concentrated. In 2006, the SEC certified
only five companies as nationally
recognized statistical rating organizations. Just two of the five held
80 percent of the market by revenue
and 99 percent of publicly traded
debt and preferred stock. Subsequent
efforts to encourage new entrants
have not yielded results.
Reformers aim to increase competition by requiring all CROs to register
with the SEC. Their premise is that
there will be increased demand for
CROs other than the “big three” if
they all have the same government
seal of approval. Registration, how­
ever, does not guarantee price and
quality competition, and empirical
research suggests it will not improve
the accuracy of ratings. Furthermore,
the regulatory burden imposed on
registered CROs may make this
provision harmful to small organizations with limited resources to
spend on compliance.
Reducing Conflicts of Interest
The SEC’s 2008 investigation
highlighted two major conflicts of
interest: First, issuers, who seek
the highest possible ratings, pay
CROs to rate them. Second, CROs
sell advice on structuring products
before rating those products.

Research has shown that the first
conflict could cause some issuers to
pressure CROs for inflated ratings
that would make the issuer’s products more attractive to investors.
The SEC’s report found evidence of
ratings shopping, for example. To
make this conflict more transparent,
one recommendation would require
CROs to disclose the number of
ratings an issuer and its affiliates pay
for. It would also require CROs to
disclose fees charged for the most
recent rating and total fees charged
over the previous two years.
Ensuring Adequate
Internal Controls
The SEC found that CROs did not
effectively implement systems to
monitor their regulatory compliance.
One way to address this problem
is to require that CROs establish
procedures to ensure compliance.
They would also have to designate
a compliance officer who would
take primary responsibility for
implementing systems of internal
controls, due diligence, methodology,
and ratings surveillance.
The Upshot
Naturally, it is difficult to predict
the effects any reform will have on
CROs and the credit ratings market.
However, it is essential to address
the problems identified by the
SEC and scholarly critics of CROs.
Legislation itself need not address
every problem. If regulators have
rule-writing authority, they can use
flexibility and creativity to keep
recent history from repeating itself.
—Thomas J. Fitzpatrick IV, economist

F refront

7

Making Financial Markets Safer for Consumers:
Lessons from Consumer Goods Markets and Beyond
Thomas J. Fitzpatrick IV,
Economist

Daniel Littman,
Economist

Stephan Whitaker,
Research Economist

In the wake of the mortgage meltdown, policy­makers are discussing how best to protect consumers in financial
product markets. The Federal Reserve Bank of Cleveland hosted a seminar, “Consumer Protection in Financial
Product Markets,” in September 2009 to exchange ideas with other regulators about consumer protection and
the role of the courts. Conference participants zeroed in on four areas of reform:
■

Increasing oversight of lightly regulated lenders

	Ensuring that disclosure statements are rigorously tested for comprehensibility and effectiveness

■

	Encouraging market interventions that make comparison shopping easier

■

	Introducing new legal requirements that firms match buyers with the most suitable products

■

Some mainstay economic principles were suggested to guide reforms, such as supporting competition and
consumer choice, and strengthening borrowers’ and lenders’ incentives to deal in safer products.
All quotations in this article come from discussions and panelists’ statements during the conference.

The Exploding Toaster Analogy
The exploding toaster holds a special place in consumer
protection lore. It is obviously an unsafe product: If they
knew about the danger, consumers would not buy the
toaster and regulators would pull it off store shelves.
The exploding toaster analogy highlights the differences
between consumer goods markets and the often more
complicated market for financial services. Some believe
that although consumers wouldn’t knowingly buy an
exploding toaster, in the past few years millions of them
took out an “exploding mortgage.”
Granted, this is a simplified analogy. But it underlines the
observation that ordinary consumer goods seem a lot safer
than some financial products. How do consumer goods
markets—and their regulators—differ from consumer
finance markets?
8

Winter 2009|2010

Quite a bit, actually.
For some time, consumer finance regulation in this country
has been guided by a couple of fundamental (and still true)
economic principles: First, competition usually works
in consumers’ favor. It lowers prices, raises quality, and
gives people more choices. Second, information, often in
the form of disclosures, helps consumers understand a
product’s strengths and weaknesses.
Both of those notions have been tested in the current
financial crisis. Competition was intense, to judge by
the sheer number of mortgage brokers and lenders.
Unfortunately, competition did not always translate into
high-quality, affordable products for consumers.
How about disclosures? Anyone who has been to a
mortgage signing ceremony has witnessed the lengthy

dis­closures involved in the borrowing process. But
borrowers’ ability to fully digest and comprehend page
after page of disclosures is doubtful.
It is time to step back and re-evaluate our approach to
consumer protection in financial markets. To get started,
we can examine how a consumer’s shopping experience
could be affected by product regulation and pre-market
approval; information and disclosures; and gatekeepers.

Product Regulation and Pre-Market Approval
In 1970, the National Commission on Product Safety
reported to Congress on a two-year study of consumer
goods safety. The findings were appalling: a total of
30,000 deaths and 20 million injuries from common
household products each year. Lawn mower blades
chopped off hands and feet. Infants strangled when they
wedged their heads between crib slats. Hair dryers, even
when turned off, fell into bathtubs and electrocuted people.
Most of these products were labeled clearly with easy-tounderstand warnings, but those labels proved disastrously
inadequate. Today’s regulation of financial products is not
much different. Regulators require disclosures, which we
assume will protect consumers from harm.

The safety commission’s experience shows the power of
information gathering. When data for a household product
show clear patterns of injury and death, firms can respond
—or can be compelled to do so. We have no comprehensive data linking financial products to foreclosures, however.
As a result, subprime loan abuses reported early in this
decade could be dismissed as isolated incidents.
In addition, products that pose serious potential danger
to consumers must have regulatory approval before they
go on the market. That is how it works with the processed
food and pharmaceuticals overseen by the Food and Drug
Administration (FDA), which has partial or full veto power
over new product releases.

“That was an indifferent marketplace. That was a market­
place where year in and year out, these things were happening, and unless you knew one of those people [the victims],
you wouldn’t even know this happened,” said David Pittle,
one of the original five members of the U.S. Consumer
Product Safety Commission and former senior vice president for technical policy at Consumers Union.
Today, by federal mandate, lawn mowers shut off within
three seconds after the operator lets go of the handle,
the spaces between crib slats are too narrow to trap an
infant’s head, and hair dryers have a ground-fault circuit
interrupter that prevents electrocutions. “Those changes
don’t happen by themselves,” Pittle said. “It takes a federal
presence to make that happen.”
The Consumer Product Safety Commission was formed
in 1973. According to Pittle, this was an essential step in
identifying safety issues and forcing corrective action.
Before the commission was formed, consumer goods
were regulated by a variety of agencies and some were
completely unregulated. For financial products, the same
situation still prevails.

CHRIS PAPPAS

Legal experts, academics, and government officials presented research, practitioner
experiences, and the current state of the law at the Cleveland Fed’s September 11, 2009,
seminar on consumer protection.
Top row: Mark Sniderman
Fourth row, from left: Stephan Whitaker, Susan Wachter, Kathleen Engel
Third row, from left: Janis Pappalardo, Patricia McCoy
Second row, from left: David Pittle, Gregory Elliehausen, Dan Carpenter, Tom Fitzpatrick
Bottom row, from left: Ray Brescia, Jerry Fons, John Lynch, Creola Johnson, Alan Levy

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9

Harvard political scientist Dan Carpenter argued that
the FDA has produced positive outcomes because it has
focused on high-quality research, which has benefited
food and pharmaceuticals consumers immensely. “In the
FDA model for drugs—and I’m not saying it’s the right
model for consumer finance—the veto power [to keep
products off the market] induces this experimental
incentive,” Carpenter said.
After a product has FDA approval based on information
rigorously acquired from randomized clinical trials, the
product must have clear labeling that tells consumers
what it has been approved for. “Institutions are needed as
well as markets for the provision of that kind of information,” Carpenter said. “I just don’t think markets [alone]
are going to get you there.”
In the case of financial products, some firms already have
databases to identify their own potential risks. The issue
is whether a regulator can gather comprehensive data for
consumer protection, or give firms an incentive to use
those data internally to avoid harming consumers.
Standard economic theory would suggest that pre-market
approval would decrease supply and eventually would
hurt consumers by restricting choice. But several research
papers on regulatory standards for food that were established in the early 1900s reached the opposite conclusion:
Consumption of processed food greatly expanded in
states that adopted standards for regulating food quality.
The notion that regulation can actually spur innovation may
also apply to the withdrawal of products from a market.
For example, what happened in the early 1970s when
the FDA removed mental health drugs that had bad side
effects? Pharmaceutical companies conducted research that
developed several new drugs, including antidepressants
such as Prozac. “In large part, the sort of revolution in
psychopharmacology has occurred because we got rid of
the lemons in the marketplace,” Carpenter said.

Information and Disclosures
Let’s visit the supermarket. People shopping for low-fat
yogurt usually don’t have the means to perform a nutri­
tional analysis, so the FDA requires the manufacturer to
provide that information; it also regulates the manufacturers’ claims closely. Yogurt can’t be called low-fat unless
it satisfies the FDA’s definition of the term. But even
10		 Winter 2009|2010

accurate information, clearly displayed on the carton,
doesn’t guarantee that the consumer will make the decision
that is best for him. Research shows that very few shoppers
turn the yogurt carton around to read the ingredients list
and nutritional information on the back.
Many claims are made for financial products as well. Instead
of reading a small label, consumers must read through
stacks of disclosure statements to test those claims.
The danger with claims, according to Alan Levy, a senior
scientist with the FDA, is that they can truncate the search
for information. Consumers may get a product that only
partly meets their needs, or they may miss out on a much
better product.
People read labels because they want to make good decisions. “But their sense of what constitutes a good decision
is quite different from a search for truth and the cost–
benefit calculation that is often assumed to characterize
their choices,” Levy said. “Too much of our policy attention
is devoted to perfecting claim language, and not enough
is devoted to getting consumers to ask better questions.”
If product labels aren’t enough, what else can be done?
John Lynch, a University of Colorado psychologist who
studies consumers’ decisionmaking, thinks that the most
significant predictor of choice is whether the product is
in the consumer’s “consideration set” in the first place.
“For an option to be chosen, it has to be considered. It
sounds obvious, but it’s profound,” Lynch said. “Most of
the time when an option is not chosen, it’s not because it
was examined and found wanting. Rather, it was not even
considered.”
This brings us to the concept of nudging. Richard Thaler
and Cass Sunstein wrote the book that made the term
famous. “A nudge is trying to help consumers make better
decisions by changing the choice context subtly or by
changing defaults that make the most likely mistakes less
likely,” Lynch said. Nudges preserve choice but subtly
direct people either to the choice that is best for them or
to the most socially desirable choice. The authors have
called it “libertarian paternalism.”
Nudging has shown some promising results. For example,
it is becoming standard practice to make 401(k)s the
default choice when employees sign up for benefits. That
means that employees must opt out if they don’t want to

set up a company-sponsored retirement savings plan. The
optimal decision—to participate—is the same however
it is reached. But with opt-out nudging, more employees
make the optimal choice because of the way it’s offered to
them. Similarly, European countries with opt-out for organ
donation programs have about 90 percent participation;
only 20 percent participate in countries where donation
is opt-in.
This is not to say that disclosures don’t matter at all. In a
nudging regime, they matter a lot. The least safe products
in a consideration set, for example, would have to carry
detailed disclosures (see sidebar below).

Gatekeepers
Today’s financial instruments are so complicated that an
expert gatekeeper is often needed to guide consumers
through the selection process, much as doctors are the
gatekeepers of prescription medications, and attorneys
guide clients through complex legal proceedings.
At the business level, credit rating organizations, such as
Moody’s and Standard & Poor’s, are intended to serve as
gatekeepers who evaluate companies’ creditworthiness

so that people who buy and sell securities have accurate
information. Government regulation makes these ratings
the “keys” that open “gates” for investable assets. That is,
receiving an investment-grade rating opens a world of
investors that would otherwise be closed.
For consumers, mortgage brokers or loan officers are
obvious candidates for the role of gatekeeper in home
loan markets, said Federal Reserve Bank of Cleveland
economist Thomas Fitzpatrick. Many borrowers assume
that their mortgage broker has their best interests in mind.
“By one study, 40 percent of American adults believe that
lenders are lawfully required to give them the best possible
rates,” Fitzpatrick said. The fact is that no such law exists.
Although brokers may not commit fraud and must abide
by laws governing unfair or deceptive practices, they have
no obligation to get their clients the best rate.
To overcome this problem, Fitzpatrick proposed applying
“duty-of-care principles” to the mortgage broker business.
Some jurisdictions impose such duties on brokers, but only
in circumstances so specific that it is relatively easy to
avoid liability.

The Mortgage Decision: How Nudging Might Work

■	The site asks questions about personal

circumstances that affect the borrower’s
relative level of risk for different loans.
■	It inquires about the borrower’s preferences

about the trade-offs between different loan
features.
■	Software searches a database with offerings

from various providers and recommends
five loans that regulators consider safe for
the current borrower and that have the
characteristics he prefers. The best fits—
which might even recommend an optimal
down-payment level—head the list.

■	A borrower is more likely to investigate

at least some options if he is not faced with
hundreds of loan products. Having too many
choices can overwhelm people, causing
them either to avoid purchasing anything
or to pick a product without any serious
investi­gation. (This phenomenon has been
observed with 401(k) plans: When companies
offered hundreds of choices, employees
dropped out of the program or chose what
they considered “safest,” reducing their
return on investment.)
■	Freedom of choice is maintained. Borrowers

can ask to see loans further down the ranking,
and even select a loan considered unsafe
(off the recommended list), but experience
in other contexts suggests that the vast
majority will select one of the five suggested
loans. As a rule, no loan can be originated
without the borrower’s signature on a printout of his “recommended” list.

If the nudging system is optional or only
available online, it may fail to reach lesssophisticated consumers, who need it the
most. If automating the selection process
proves too difficult, a broker who is obligated
to select safe products could recommend five
products or providers.
As University of Colorado psychologist John
Lynch puts it, the recommender system is
“a form of a nudge
that allows for
the possibility that
people in different
circumstances could
be affected by
different risk levels
for different kinds
of loans.” In some
John Lynch
ways, it resembles
a supermarket for mortgage loans, which
organizes products by standards that are
relevant to consumers.
CHRIS PAPPAS

A prospective homeowner logs on to a
mortgage recommender website, which could
be required, designed, and maintained by a
regulator.

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11

Under duty-of-care principles, brokers could be held liable
for selling faulty loans, much as investment advisers are
liable for violating their fiduciary duty to clients. “A duty
of care would allow a borrower to collect [damages] from
a broker if that broker violated its duties,” Fitzpatrick said.
But broker liability may not be enough, he warned; it
may also be necessary to add a step so that mortgage loan
holders could not force a victim of unlawful origination
practices to pay the full amount of the loan. “The idea is
that once secondary market purchasers are liable, they’re
going to start paying more attention to the practices of
originators,” Fitzpatrick said.
As evidence, he cited a case from the consumer product
market. In the 1970s, people could buy refrigerators by
signing a promissory note. The retailer would sell the
promissory note to a finance company, which would
collect the buyer’s payments. If the refrig­erator was defective, the consumer would still have to make payments to
the finance company while trying to get compensation
from the retailer that sold the faulty product. Consumer
complaints mounted until the Federal Trade Commission
assigned liability to finance companies. As a result, finance
companies changed their contracts by inserting buy-back
provisions, which could force the retailer to buy back the
notes. The commission’s new rule was not reported to
restrict credit or hurt small retailers.
Preserving consumers’ legal claims and defenses “forces
the market to internalize those costs and re-price credit
appropriately,” Fitzpatrick said. “By many accounts, it’s
been effective in accomplishing its goals.”
The details are complex, of course. The roughly 8,000
banks in the country are all closely supervised by state or
federal regulators, and often by both. But there are many
thousands more mortgage brokers than banks. How
specific and flexible should the rules be as the market
evolves? Will regulators merely supervise the market,
or will violators be prosecuted? Will it be a federal effort?
“If we leave it to the states alone, we end up with a patch­
work of laws that is somewhat more difficult for companies
to comply with if they operate over state lines,” said Pat
McCoy, a law professor at the University of Connecticut.

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Winter 2009|2010

On July 30, 2008, the Fed issued a rule regulating a broad
spectrum of mortgages, which it may broaden further. As
both Fitzpatrick and McCoy noted, some reformers argue
that liability should be imposed not only on brokers and
lenders but also on secondary market purchasers, such as
the government-sponsored enterprises Fannie Mae and
Freddie Mac. That liability would encourage lenders to
suggest loans that the borrower has a good chance of
repaying, and would encourage secondary market investors
to deny funds to firms engaged in fraudulent practices.

A New, Reality-Based Approach
Gatekeeping, product regulation, and pre-market approval
already exist in consumer finance—but to a smaller extent
than in consumer goods.
The dangers from faulty consumer goods include death,
injury, disease, and destruction of property. Financial
dangers take the form of bankruptcy, foreclosure, and a
diminished standard of living.
The recent financial crisis has shown that disclosure-based
regulation of mortgage products is inadequate. Given the
comments of the conference participants, how might a new
consumer protection regime affect the mortgage market?
It would track mortgage products by classification
according to their risk to better identify dangerous
products.

■	

The concept of disclosure would change from giving
consumers all of the details about one product to
encouraging and enabling them to comparison shop.
This might mean selecting a manageable number of
important details and requiring consumers to consider
a minimum number of products or providers before
entering into a contract.

■	

There is strong evidence that consumers greatly
value convenience and avoid extensive search efforts.
Establishing financial services “supermarkets,” perhaps
structured as recommender systems, would help make
the market more competitive and shopper-friendly.

■	

Disclosures should be rigorously tested for effectiveness.
In the realm of pre-market approval, firms should build
and test products for safety before releasing them to the
market.

■	

Disclosure Disorder
Competition benefits only those consumers who get
honest information. Multipage disclosure forms do
not help if they are too complicated for a non-expert
to decipher, too long to read in one sitting, and too
late to affect the key choices of house and lender.
Even diligent shoppers have trouble breaking through
the noise.
The Federal Trade Commission’s Janis Pappalardo and
Jim Lacko noticed that in many deceptive lending
cases, disclosure statements had been properly filled
out, yet borrowers were still deceived. Their research
showed that many borrowers “were unaware of,
did not understand, or misunderstood key costs or
features of their loans.” Did they have up-front
points? An ARM? Prepayment penalties? Borrowers
were often confused, and for good reason.

Many mortgage disclosure forms tell borrowers
to check boxes that offer choices like “may have
prepay­ment penalty” or “may not have prepayment
penalty.” May? Which is it? “The thing that’s really
shocking was that, in some respects, the disclosures
were worse than ineffective,” Pappalardo said.
“They actually seemed to create consumer misunder­
standings.”
More information is not the solution. Simplicity
would be a step in the right direction, but what’s
really needed is solid, objective, quantitative testing
of disclosure forms. The results would help regulators
take into account consumers’ preferences, differing
educational backgrounds, and time constraints.

Incentives for firms and gatekeepers should be aligned
with the interests of consumers. The costs of providing
unsafe products should be internalized: If a borrower is
unlawfully led into a loan product—perhaps deceived
or tricked with fraudulent promises—he should be
able to use the loan originator’s unlawful conduct as
a defense against paying on the loan, no matter who
currently owns it. If loan purchasers were made liable
for originators’ conduct in this way, purchasers would
insure themselves against such losses and could spread
the cost across all borrowers, instead of externalizing or
passing it off on the wronged borrowers.

■	

To understand why consumer protection in financial
product markets misfired during the mortgage meltdown,
it is instructive to think about some of the factors that play
into people’s decisions.
First, people respond to incentives. Second, they differ from
one another in their preferences, financial means, and time
constraints and generally choose what seems best for them
over the long term.
Therein lies the challenge in consumer finance markets.
Products like adjustable-rate mortgages (ARMs) or payday
loans are far more complicated to use than toasters. How
do you structure incentives so that consumers make the
choices that best suit their preferences, incomes, and time
constraints?

For instance, many would consider an ARM with prepayment penalties the financial equivalent of an exploding
toaster, but it’s not necessarily so. A borrower who is fully
informed about his options—and the risks of each—
might still choose an ARM, and it might well be the best
choice. For this borrower, the mortgage probably won’t
explode.
That’s because credit helps people smooth their lifetime
income. Janis Pappalardo, a Federal Trade Commission
economist who looked into consumers’ different ways
of making choices, came away convinced that we should
not jump to conclusions when it comes to consumer
behavior. “One person came in with an ARM—I think it
was a piggy­back [a second loan­used in place of a down
payment]—and he knew exactly why he was doing it,”
Pappalardo said. “He was in graduate school. His future
income stream was going to be going up, so it was the
right deal for him.”
That lesson is as important as any: Consumer protection
can go too far. The trick is to find an equilibrium between
helping people choose and making sure they are free to
make the choices that are best for them. ■
Papers and Presentations
Consumer Protection in Financial Product Markets, a Sept. 11, 2009
conference. www.clevelandfed.org/research/Conferences/2009/
9_10-11-2009/index.cfm

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13

A Framework for Systemically
Important Institutions
Too big to fail or not too big to fail—that,
it turns out, is not the question.

CORBIS

Jean Burson,
Policy Advisor

This article is based on James Thomson’s “On Systemically Important
Financial Institutions and Progressive Systemic Mitigation,” Federal
Reserve Bank of Cleveland Policy Discussion Paper, August 2009.

The too big to fail problem is not an either–or proposition.
Sometimes a firm is systemically important—with the
potential to endanger the broader financial system if it
fails. Other times, the same or a similar firm may not be
systemically important. And while size can sometimes be
the essential criterion for determining whether a firm is
systemically important, the definition also depends on the
circumstances and characteristics of a particular institution.
Was Bear Stearns too big to fail? In the spring of 2008,
federal regulators thought so. They quickly moved to
provide financial backing for a sale. But confusion lingered
among market watchers over what precisely made Bear
Stearns important on a systemic scale. Was Lehman
Brothers too big to fail? In the fall of 2008, federal regulators didn’t think so. But the rapid deterioration of the
financial markets following the bankruptcy of Lehman
14

Winter 2009|2010

Brothers has led some to conclude that in hindsight, it
was systemically important in the context of the fragile
market conditions at the time of its collapse.
These twin cases underline the need for a framework to
classify systemically important institutions. By framework,
we mean a comprehensive method for determining—on
a case-by-case, moment-by-moment basis—just which
firms are too big to fail. From there, it is much easier for
policymakers to craft a response.
A first step is to recognize that two institutions might be
considered systemically important for unrelated reasons.
For example, a firm might be systemically important simply
because of its size—in terms of revenue, employees, or
assets. In this category, we almost certainly can include
top financial institutions such as CitiGroup and Bank of
America.
Another firm might be considered systemically important
because it is a major player—or the only player—in an
important financial market. The insurance giant AIG Corp.,
for example, was by far the leading seller of credit default
swaps (CDS). When AIG couldn’t live up to its promises
to pay off buyers of CDS instruments, its imminent failure
would have likewise toppled scores of counterparties.

Still another institution might not be systemically
important in its own right, but when considered as part
of a group of institutions engaged in similar activities or
exposed to common risks, the collective activities of that
group create the potential for systemic risk. The recent
meltdown in the subprime mortgage market is just such a
case—since “everybody” was doing it, the risk increased
far beyond what it would have been had only a few firms
engaged in this type of lending. A number of factors and
permutations of factors can present systemic risk, creating
a formidable challenge for any regulator or policymaker.
It would be a mistake to go into regulatory overdrive and
impose new requirements on all financial institutions in
the wake of the 2008–09 financial crisis. When the pendulum swings toward an overly restrictive regulatory environment, innovation is stifled and the economy’s longterm growth potential suffers. A more effective framework
is consistent with longer-term regulatory goals, allows the
sources of systemic risk to be managed without unduly
increasing regulatory burden, and creates disincentives for
firms to become systemically important in the first place.

The Four C’s
The framework begins with the four C’s of systemic importance: contagion, correlation, concentration, and context.
Contagion occurs when one firm’s insolvency affects other

firms connected to it. These connections might result from
intertwined loans, deposits, or other types of financial
relationships. Eventually, a chain reaction can begin that
could threaten the entire financial system.
This domino effect of contagion can be thought of as
the too connected to fail problem. It was contagion that
prompted the Federal Reserve Bank of New York to
arrange the acquisition of Bear Stearns by JP Morgan
Chase based on the very real potential for spiraling losses
among players in the mostly unregulated credit default
swaps market. Because contracts were not traded through
a centralized exchange, the total exposure of all counterparties was not known. Regulators were concerned that
sellers might not have been able to meet their net obligations on contracts related to such a large and presumably
solvent institution. Companies holding positions on Bear
Stearns might have been perceived as risky, potentially
resulting in runs on those institutions even if they were
fully capable of meeting those obligations.

Correlation as a source of systemic importance can be

thought of as the too many to fail problem. Two aspects of
correlation risk are important for policymakers to consider.
First, institutions have clear incentives to take on risks that
affect other institutions, recognizing that regulators will
be unlikely to allow any one of these institutions to fail.
For example, financial institutions were willing to assume
widespread exposure to subprime mortgages, mortgagebacked securities, and products related to mortgage-backed
securities over the past decade. At some level, it was
understood that regulators would be likely to bail out
troubled firms rather than allowing all of them to fail.

When the pendulum swings toward an overly restrictive
regulatory environment, innovation is stifled and the economy’s
long-term growth potential suffers.
A second source of correlation risk occurs when activities
that appear to be unrelated during normal times become
highly correlated during periods of financial stress. This
behavior occurs when many institutions take similar actions
in response to a development in the economy. Consider
the fallout, for example, if a large group of hedge funds took
similar positions on oil prices; a price shock would lead
the hedge funds to reverse their positions all at the same
time. Those synchronized activities can suddenly present
systemic risk.
Correlation presents a particularly significant challenge
for policymakers because it can be difficult to classify a
group of institutions as presenting systemic risk before
the trouble starts. An important first step in defining
appropriate regulatory treatments is to determine what

What Is a Stress Test?
A stress test tries to determine whether a financial institution could
survive under some very bad economic conditions. For instance, the stress
test used earlier this year for the nation’s leading financial institutions
challenged whether a bank’s balance sheet could hold up in the face
of 11 percent unemployment, or if home prices crashed by 25 percent.
How many loans would default under such a scenario, and what would
happen to a bank’s capital base as a result?
Depending on the results, regulators might require institutions to raise
more capital to ensure that they could endure a lengthy slump. Last
spring, stress tests of the nation’s 19 largest banks showed 10 of them
needed a larger capital buffer. Those 10 quickly responded with plans
to sell more stock or raise capital in other ways.
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Not Too Big to Fail After All

GETTY IMAGES

The story of how Drexel Burnham
Lambert was forced into bankruptcy is a painfully familiar one.
For most of the 1980s, the firm
made its living in relatively lowrated “junk” bonds—debt of
other companies whose ability
to repay was judged as fair at
best. One day in early 1990, one
of Drexel’s creditors declined to

renew a $30 million credit line.
Given that Drexel’s bond portfolio
was mostly illiquid, Drexel was
suddenly in the position of not
being able to meet its ongoing
debt obligations. The firm tried to
persuade both private banks and
the Federal Reserve to provide a
lifeline, arguing that its collapse
would have serious ripple effects.

level of correlation across portfolios poses a systemic threat
through the development of stress testing, scenario analysis,
and comprehensive risk management tools. In fact, the
type of risk modeling and scenario analysis required is
already taking place in many large financial institutions.
Concentration as a source of systemic importance can

be thought of in the classic sense of the definition of too
big to fail: An institution has a highly concentrated market share of assets, loans, and deposits. However, even a
firm that might not be considered too big to fail based on
size can present systemic risk due to a concentration of
activities. Firms that dominate key financial markets or
payments systems therefore require careful monitoring.
The previously mentioned dominance of AIG in the credit
default swaps market is an example of how concentration
can elevate a large, complex institution to a systemically
important one.
Context becomes a source of systemic importance when

regulators are reluctant to recognize the failure of a
distressed financial institution under fragile economic or
financial market conditions. This same firm would be
allowed to fail under more normal conditions. Firms
that might be systemically important based on context
are often the most difficult to identify before conditions
deteriorate, but stress testing and scenario analysis can
help spot potential candidates and the likelihood and
impact of triggering events. When anticipating these
types of events, regulators need to consider that during
periods of financial market distress, risk exposures can
become highly correlated, and the number of systemically
important institutions can quickly escalate.
A recent example of context as a source of systemic risk
is the government’s response to the failure of Bear Stearns.
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Winter 2009|2010

But regulators determined that
the securities markets would be
able to endure in the face of a
Drexel meltdown—and they did.
Although the losses were large,
most creditors turned out to
have sufficient cash reserves to
weather the fallout.

In 1990, Drexel Burnham Lambert became insolvent
due to activities in the junk bond market. Even though
it was the fifth-largest U.S. investment bank at the time,
its bankruptcy had no adverse impact on the economy.
But consider what happened in March 2008, when the
subprime mortgage crisis claimed its first victim in Bear
Stearns. Facing severe financial instability as a result of
frozen credit markets, regulators brokered a deal with
JPMorgan Chase to acquire the firm rather than allowing
it to fail. Had this failure not taken place in the context
of financial fragility and fear, regulators would have likely
allowed the firm to face the consequences of its actions
through a traditional bankruptcy process.

Bird’s-Eye View
Once the sources of systemic importance are identified,
regulators will be better able to understand how much
potential systemic risk a firm presents to the entire financial
system. Adopting this bird’s-eye view offers real benefits.
To complement a microprudential supervisory approach,
where regulators monitor the safety and soundness of
individual institutions, a single macroprudential supervisor
focuses on aggregate systemic risk for the entire financial
system, helping to put the financial industry on far more
stable footing.
A “tiered parity” approach to macroprudential supervision
places firms within one of three tiers—highly complex,
moderately complex, and noncomplex—based on the
four C’s of contagion, correlation, concentration, and
context. Only two of the three tiers would include firms
considered to be systemically or potentially systemically
important. This approach would allow regulators to focus
on firms of relative systemic importance and to ensure a
consistent application of regulatory taxes and supervisory
oversight across each tier.

Tier 1—Highly complex financial institutions considered

Tier 3­— Noncomplex financial institutions not included in

to be systemically important due to size or concentration

the other tiers, largely consisting of community financial

and the potential risk of contagion. This tier would

institutions. These firms fall outside the purview of the

include both banks and nonbanks whose sheer size or
concentration presents a material risk to the financial
system and increases the risk of contagion. Regulators
would reserve the most stringent requirements for these
firms, including the highest levels of supervisory oversight
and reporting requirements, regular stress tests, and
mandatory requirements that encourage the markets to
discipline these firms. For example, these firms might be
required to issue subordinated debt, which automatically
converts to common equity if capital ratios fall below a
predetermined level. Tier 1 firms might also be required
to participate in simulations conducted by the financial
stability regulator and to ensure that executive compensation is appropriately aligned with the long-term viability
of the firm and the safety and soundness of the financial
system.

macroprudential supervisor due to the low probability of
the threat of systemic risk. Tier 3 firms would be subject
to a basic level of safety and soundness regulation and
supervisory oversight. No special reporting requirements
or regulatory treatments would be required.

Tier 2—Moderately complex financial institutions
considered to be systemically important due to interconnectedness, as a result of correlated risk exposures
(either systemically or as part of a group) or as a result
of the context presented by the economic or financial
market environment. This tier would also include large

financial institutions whose failure could significantly affect
regional economies. Large regional banks and large insurance companies would be examples of firms included in
this tier, although smaller companies might be included
based on context or correlation.
Periodic stress tests, conducted to predict the response of
the financial system to correlated risk or certain economic
or financial market conditions, would provide regulators
with guidance on how to manage the risk these firms
present. Tier 2 firms would likely be subject to additional
reporting requirements and more rigorous and frequent
supervision than their less complex Tier 3 counterparts.
Depending on the sources of potential systemic risk, they
might be required to develop contingency plans to address
insolvency. Other regulatory options might include portfolio limits and additional requirements for capital or loss
reserves, as well as limits on exposures to counterparties,
as ways to limit the potential for contagion.

Some details about these tiers remain to be determined:
•	Will regulators identify firms as “too big to fail” (and will
market watchers be able to figure out the identity of
these firms on their own)?
•	How much will market discipline figure into the new
regulatory regime?
•	Will systemically important firms increase the likelihood
of moral hazard and alter the market’s perceptions about
whether the government will allow those firms to fail?
•	Will the market be able to identify these firms regardless of disclosure based on regulatory requirements
such as debt structure, frequency of supervision, and
reporting requirements?
The tiered parity approach builds on the lessons learned
from the current crisis—the risk presented by systemically important institutions—and lays a foundation of
macroprudential oversight that will help regulators understand and manage emerging systemic risks. In addition, it
provides a balanced approach to regulatory taxes that does
not unduly punish firms that are unlikely to contribute to
the next crisis. ■

President’s Speech
Cleveland Fed President Sandra Pianalto introduces the concept
of tiered parity in “Steps Toward a New Financial Regulatory
Architecture” in an April 1, 2009, speech.
www.clevelandfed.org/For_the_Public/News_and_Media/Speeches/
2009/Pianalto_20090401.cfm

Policy Discussion Paper
Read “On Systemically Important Financial Institutions and
Progressive Systemic Mitigation,” Cleveland Fed Vice President
James Thomson’s proposal on tiered parity.
www.clevelandfed.org/research/policydis/pdp27.cfm

Three-Tiered Proposal on the Drawing Board
To help explain the proposal to people who aren’t policy wonks.
www.clevelandfed.org/research/topics/finstability/three_tier_risk/
F refront

17

The Foreclosure Timeline:
The Curious Case of Cleveland’s Foreclosure Rate
Timothy Dunne,
Professor of Economics,
University of Oklahoma
Guhan Venkatu,
Economist,
Federal Reserve Bank of Cleveland

­The foreclosure process—from the initial f¡ling to the sheriff’s sale of the
home—is expected to take about seven months in Ohio. But for a time in the
Cleveland metro­politan area, it wasn’t unusual for foreclosure proceedings
to drag on for more than a year … or even two. Cleveland is well known for its high foreclosure rate,
but less so for its lengthy foreclosure process. Economists Tim Dunne and Guhan Venkatu thought that
not enough attention was being paid to the latter, and to its importance in determining the foreclosure
rate. The average time for a foreclosure episode also has implications for borrowers trying to resume
payment on delinquent loans, as well as for individuals considering acquiring a new mortgage.

The Foreclosure Process
The foreclosure process has become all too familiar in
Cleveland. By the early 2000s, several years before the
foreclosure crisis swept across the rest of the country,
the region was already reeling.
Cleveland’s reputation as the epicenter of the housing
crisis is known far and wide. Between 2005 and 2008, the
metro area’s average foreclosure rate for prime fixed-rate
loans was 2.33 percent, and for subprime fixed-rate loans,
it was 10.5 percent. Both of those rates were twice as high
as in Cincinnati and Columbus areas during the same
period, and 35 percent higher than the average in Ohio.
Economists Dunne and Venkatu wanted to understand
what might be driving the differences in these rates, and
approached the issue as they would approach questions
about the unemployment or poverty rate. For example,
18

Winter 2009|2010

a 12 percent unemployment rate could be driven largely
by high num­bers of workers churning in and out of joblessness in relatively short time spans, or it could reflect a
large stock of workers unable to stay employed for longer
spells. The same holds true for foreclosures: A high rate
might mean that large numbers of properties could be
moving in and out of foreclosure very quickly, or it could
mean that relatively smaller numbers of properties are
trapped in foreclosure for lengthy periods.
To Dunne and Venkatu, a high foreclosure rate was one
thing. But understanding why it was high would allow
policymakers to target their responses effectively. After
all, the appro­priate policy response to foreclosures may
be different in situations where there is large churning of
properties in default versus large numbers of properties
simply held in the process for long periods of time.

Here is what they found: From 2005 to 2008, Cleveland’s
average monthly foreclosure start rate for prime fixed-rate
loans, at 0.22 percent, was surprisingly close to that of
Cincinnati and Columbus, at 0.17 percent. So why was
the overall foreclosure rate doubly large in Cleveland?
Dunne and Venkatu discovered the answer in the fore­
closure transition rate, which measures the speed at which
mortgages exit the foreclosure process. The lower the
transition rate, the longer a mortgage slogs through the
foreclosure process. In Cleveland, the transition rate
for prime fixed-rate loans was 9 percent, versus about
13 percent for both Cincinnati and Columbus. Put another
way, properties in Cleveland took 30 percent longer to
finish the foreclosure process than their counterparts in
Cincinnati and Columbus.
So Cleveland’s relatively higher foreclosure rate can be
tied directly to the length of the foreclosure process there.
If that process were as short as in Cincinnati, Cleveland’s
foreclosure rate would drop by a third. “You’ve got to
think about both of those flows [the number of mortgages
entering and then exiting the process] to get a sense of
what’s driving the rates,” Venkatu said.

Why Is Cleveland’s Process Longer?
Dunne and Venkatu then considered the possible reasons
that the foreclosure process took longer in Cleveland.
One explanation has to do with the severe economic hit
Cleveland has taken in recent years. Its weaker housing

market means that properties often appreciated very little.
This means that many borrowers may not have been able
to pay off their lender by selling their new home (if they
could find a buyer), and that they likely wouldn’t be able
to refinance their existing mortgage. Loan modifications
may also be less practical in a weaker housing market,
because the borrowers themselves may be less equipped
to shore up their credit if they have lost their jobs, and
their prospects for finding a new one aren’t as great as they
might be elsewhere.
All of these differences correlate with foreclosure lengths,
but not as much as the variation in foreclosure statistics
would suggest. Dunne and Venkatu now believe that
it boils down to an administrative issue­— the courts in
Cuyahoga County, where Cleveland is located, were overwhelmed and undere­quipped with technology to process
cases in a timely manner. This is evident when examining
neighboring counties in the Cleveland metro area. Cuyahoga
County’s fore­closure transition rate was 7.3 percent,
compared with an average 12.2 percent across its four
neighboring counties in the Cleveland metro area.
“We ended up with this persistent story about Cleveland,
corroborated by city officials, that it’s a matter of the
administrative process,” Venkatu said. “Also, the county
courts enforce state foreclosure laws—that’s why we
focused on counties. You see that in the outlying counties,
the issue goes away.”

The Foreclosure Process
A foreclosure generally works this way (though the process differs from
state to state): First, a borrower misses a mortgage payment. Within
15 days, the mortgage servicer assesses a late fee. After a month, the
mortgage is reported as in default. The servicer sends several letters to
the homeowner offering mitigation opportunities, and at the 90-day
mark, legal foreclosure begins.

By month four, a summons and complaint are mailed to the borrower.
A minimum of 90 days must elapse before a sale is held, plus a 30-day
period after the sale when the borrower can still “redeem” the loan.
Otherwise, the former homeowner is evicted. If nobody buys the house,
it reverts to the lender, becoming a real-estate-owned (REO) property.

Borrower misses a
mortgage payment
Mortgage reported in default;
borrowers notified

30

60

Legal foreclosure begins

90

120

Notice of sheriff ’s sale

150

180

210

240

Sheriff ’s sale and
eviction (if necessary)

270

DAYS
Mortgage servicer
assesses a late fee

Summons and complaint
mailed to borrower

Borrower can no longer
redeem the loan

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19

What’s Normal?
What is an optimal length for the foreclosure process?
Laws and procedures vary by state. The current average
length is about one year between the due date of the last
payment made and the sheriff’s sale. Researchers with
Freddie Mac put the “sweet spot” at four months—which
is really closer to nine months after adding in five more
months for workout efforts.1 They note that most fore­
closures associated with prime loans are mitigated early in
the process, either because borrowers are able to regroup
and restart payments or because lenders aggressively
attempt loan modifications.

Cleveland Lags:

Average Monthly Foreclosure Transition Rate, June 2005–January 2008
The lower the transition rate, the longer the foreclosure process
Percent
16
Prime loans
14

Percent
16
Subprime loans
14

12

12

10

10

8

8

6

6

4

4

2

2

0

Fixed rate Adjustable rate
Ohio

Cincinnati

0

But in some instances, the borrower has already left the
property, whether for lack of income or lack of interest in
maintaining it. These are cases that create the opportunity
for the vacant property to fall into disrepair.
Over the long term, there is evidence that regions with
longer foreclosures feel the impact in the cost of credit.
Lenders may actually factor in the length of the foreclosure
process in pricing their mortgage terms, a Federal Reserve
researcher concludes.2 The upshot is that a community’s
very reputation for lengthier foreclosures may raise costs
for all borrowers in the community.
So we are left with a complicated tangle of policy implications. A foreclosure process that is too short risks leaving
behind borrowers who might otherwise be able to work
out new loan terms and keep their homes. Too long, and
the process provides a free ride to disinterested borrowers.
Foreclosures are also related to vacancy and abandon­
ment. And once vacant, homes drive down neighboring
property values and invite crime and further deterioration
around them.

Fixed rate Adjustable rate
Cleveland

Columbus

Note: Rates are for metro areas.
Source: Dunne and Venkatu.

The longer the process drags on, however, the more costs
mount and borrower incentives increase to continue
missing payments and essentially get free rent on homes
they know they will soon lose, the Freddie Mac researchers
argue. Regions with longer foreclosure timelines may not
be providing proper incentives for borrowers to act early
with servicers on alternatives. Four months is a period
“in which the borrower’s incentives are aligned with both a
high probability of curing out of the foreclosure and keeping
the pre-foreclosure costs to the investor contained,” the
researchers conclude.

20

because the people who can’t reinstate right away are the
people with the worst income prospects. Moreover, lenders
can vary the timing of foreclosure actions to maximize the
chances the borrower will be able to restart payments.

Policy Decisions
Whether to take the foreclosure process fast or slow
depends on the borrower and property in question, says
Lou Tisler, executive director of the nonprofit Neighborhood Housing Services of Greater Cleveland. In some
instances, the owners quickly vacate their homes and the
properties deteriorate. “We need to possibly speed up the
foreclosure process for vacant and abandoned properties,
while exhausting every available avenue for occupied
homes,” Tisler said. Problematically, even when borrowers
might benefit from loan modifications, an increasing
number of borrowers are unable to meet even the improved
terms because of job losses.

The likelihood of reinstating diminishes as the time in
default (not necessarily the time in legal foreclosure) grows

Kermit Lind, a lawyer and assistant director with the Urban
Development Law Clinic at Cleveland State University,
says pegging the “correct” length of a foreclosure can be
tricky. Many cases call for a drawn-out process, he says.

1.	Cutts and Merrill.

2.	Pence.

Winter 2009|2010

“If it’s a primary residence and occupied, from a community as well as a justice perspective, that person should
have every opportunity to survive the default situation,”
Lind explained. “Judges in those cases need to pay
attention to the harm being done­— to all affected. To
ignore the impact of an abandoned property that poisons
a neighbor­hood is counterproductive.”

References

Cutts, Amy Crews, and William A. Merrill. 2008. “Interventions in Mortgage
Default: Policies and Practices to Prevent Home Loss and Lower Costs.”
Working Paper. Freddie Mac (March).
Dunne, Timothy, and Guhan Venkatu. 2009. “Foreclosure Metrics.” Federal
Reserve Bank of Cleveland Economic Commentary (April).

Pence, Karen. 2006. “Foreclosing on Opportunity: State Laws and Mortgage
Credit.” Review of Economics and Statistics 88: 177–82.

Lind says he suspects a new factor is lengthening fore­
closures in Cleveland—many lenders are walking away
from properties after the default judgment and never filing
for a sheriff’s sale. Lenders have an incentive to merely
secure the foreclosure decree so they can collect on various
related financial contracts. The home—which is the
underlying collateral—may be the least valuable part of
the deal and no longer worth maintaining. This incentive
may be one reason that foreclosure starts have risen in
Cuyahoga County but sheriff’s sales have not, Lind says.
Dunne and Venkatu are particularly interested in the
possible correlation between lengthy foreclosures and
borrowing costs. They think that when states set about
writing rules for the fore­­closure process, they should keep
in mind the implications for borrower pocketbooks.

Reforms Make a Difference
Stephen Bucha, chief magistrate in Cuyahoga County
Common Pleas Court, which oversees foreclosures, says
the county’s low transition rate is now in the rearview
mirror. “The county hired some new administrative
employees and mowed through the backlog of cases,” he
explained. “Now, it’s a six-month process.” (An exception
is when loans go to a new mediation program that allows
borrowers and lenders the time and means to work out
new terms.) When complaints arise, they are often from
people who say the process is going too fast for borrowers
to keep up.
In fact, the pace of foreclosure proceedings in Cuyahoga
County has caught up and in some months has surpassed
the pace in other large counties like Hamilton and Franklin,
Bucha says. “Now we are hitting on all cylinders,” he said.
Of course, efficiency gains in the administrative process
raise a new set of issues. The relatively brisk six-month
average foreclosure process may mask the ongoing
mounting of foreclosure starts. “We could mistakenly
conclude that the crisis has passed,” Venkatu noted.
F refront

21

Interview with Matthew Kahn
JEFF ROGERS PHOTOGRAPHY

Matthew E. Kahn

You could describe Matthew Kahn as a hybrid. Here is a University of Chicago-

Position:

trained economist—as freshwater as they come—who now makes his home in

Professor of Economics,
UCLA Institute of the Environment,
Department of Economics
and Department of Public Policy
Books:

Green Cities: Urban Growth
and the Environment. 2006.
Brookings Institution Press.
Heroes and Cowards: The Social Face
of War, with Dora Costa. 2009.
Princeton University Press.
Selected Papers:

“The Greenness of Cities:
Carbon Dioxide Emissions and Urban
Development,” with Ed Glaeser. 2008.
NBER Working Paper #14238, under
revision for Journal of Urban Economics.
“Urban Growth and Climate Change.”
2009. Annual Review of Resource
Economics. 16:1, 1-17.

saltwater territory at the University of California, Los Angeles. His field of emphasis
is environmental and urban economics, and he spends much of his time explaining
both the virtues and pitfalls of the green economy. Though he is the author of dozens
of scholarly papers—with co-authors ranging from Harvard economist Ed Glaeser to
Kahn’s own wife, economist Dora Costa—he finds true joy in posting sometimeswhimsical missives to his blog.
Kahn is a professor at the UCLA Institute of the Environment, the Department of
Economics, and the Department of Public Policy. He is also a research associate
with the National Bureau of Economic Research. He has taught at Columbia, Tufts,
Harvard, and Stanford. He earned his PhD in economics in 1993 from the University
of Chicago. His 2006 book, Green Cities: Urban Growth and the Environment,
has made him one of the nation’s leading authorities on the subject. In July, the
Wall Street Journal named Kahn’s blog—“Environmental and Urban Economics”
at greeneconomics.blogspot.com—one of the top 25 economics blogs. “UCLA’s
Matthew Kahn is a bright light among economists studying environmental and
urban issues,” the Journal said. “He has a breezy writing style that puts most other
econobloggers to shame.”

Education:

On October 1, 2009, Kahn visited Lexington, Kentucky, to present a paper at the

University of Chicago, PhD, 1993
Hamilton College, BA, 1988

Conference on Appalachia and the Legacy of the War on Poverty at the University
of Kentucky. Francisca Richter, research economist in the Community Development
Department of the Federal Reserve Bank of Cleveland, interviewed Kahn before
the conference. An edited transcript follows.

22

Winter 2009|2010

Richter: We will start with your work on
green cities. To begin with, what types
of cities would you say have boomed
over the past 35 years?
Kahn: Let me point to three big facts.

In the United States, urban economists
have noted—and everyone else has
as well —that people seek out warmweather cities. This is behind the boom
of Phoenix, Las Vegas, and Dallas.
Warm weather is one exogenous
factor that people want. Second is a
coastal city. Jordan Rappaport and
Jeffrey Sachs have done some nice
work documenting that the U.S.
population wants to be on the coast
rather than in “flyover” country. I was
born in Chicago and I guess that’s
part of the country they’re flying over.
And finally, booming cities have been
the skilled cities, those having more
educated residents. Skill is usually
measured by what percentage of adults
are college graduates, and those cities
with a lot of college graduates have
greater wage growth and population
growth than other cities.

Richter: And how do so-called green
cities fare? How would you even define
green cities?
Kahn: An example of a green city

would be San Francisco, where a
large chunk of its livability is from
its climate. No government policy
can get rid of humidity or cold winter
temperatures. What goes right in
San Francisco is that it has a feel of
new urbanism, of having a walkable,
outdoor life.
On local environmental criteria, San
Francisco has clean air, clean water, no
public health outbreaks. And then on
global environmental criteria, while the
United States has the largest carbon
footprint per capita of any nation,
San Francisco is one of our greener
cities in terms of carbon dioxide per
capita because people don’t use a lot of
air conditioning there. The electricity
they use is generated from natural
gas-powered plants, which are cleaner
than coal-fired plants. And people do
use public transit there more than in

other cities. So to finally answer your
question, a green city scores high
on local and global environmental
criteria. But a mayor would really only
care about the local criteria in terms of
pleasing his or her constituents.
That said, green cities are not a free
lunch. What happens in many cases,
such as in Marin County in San
Francisco, with open space initiatives
—you’re taking that land out of the
housing supply. So from a simple
supply and demand angle, you’re going
to get higher home prices in these
communities. That’s because the community has become more desirable
and also you’re making it harder to
build on this chunk of desirable land.
Homeowners become richer but
renters (and minority households
are often renters) get punished by
gentrification and may not be able to
afford to live in their old community.
Some urban economists are studying
this churning—getting priced out
of your own neighborhood. This has
been documented in Harlem as crime
has fallen in Manhattan.
Richter: This leads into the question
of how you measure the greenness of a
city. The value of residents not imposing
negative externalities on other places is
a desirable characteristic you have just
mentioned. A “GPI”—Genuine Progress
Indicator—has also been put out as a
measure of sustainability and greenness.
I assume it’s not easy to measure greenness, but could you comment on that?
Kahn: I teach environmental econom-

ics and I talk about green accounting.
A nation like Saudi Arabia is wealthy
per capita, but it has destroyed the
whole place in mining and extracting
these resources. Is it really a highincome society? The answer is no,
because we haven’t netted out the
destruction, the depreciation of natural
capital, and the health damage done
in the production of that income.
The challenge with this GPI is that it’s
a great idea in theory, but how do you
operationalize it?

Economists for decades have debated
this. Joseph Stiglitz released a report
saying national income accounting is
incomplete [because environmental
effects are not recognized] but you
say, OK, Nobel Laureate Stiglitz, what
should we do? The report didn’t give
an answer.
So let’s see if I can quickly sketch
an answer. Let’s do greenhouse gas
emissions because it’s easier. Nicholas
Stern of the London School of
Economics, Lord Stern, has been
raising interest in the issue of climate
change. He has argued that every ton
of carbon dioxide we release causes
roughly $40 of social damage to the
world. Suppose that’s true. In that case
we can do the GPI calculation—if a
factory in Cleveland produces $1 million of output but also creates 50 tons
of carbon dioxide, Lord Stern would
say that factory’s value-added to the
world economy is that $1 million of
production minus the $40 per ton
times the 50 tons. We need to net off
the pollution damage but we have to
be macho enough, if I could use that
word, to estimate these damages. The
hard part is figuring out for every extra
unit of air pollution or ton of carbon
dioxide, how much damage has been
created.
I’m more optimistic that we can do
this type of calculation for greenhouse
gases than for local pollutants. Let
me tell you about the challenge with
air pollution. Suppose a factory in
Cleveland produces some output,
perhaps Twinkies, but it also produces
air pollution. As an economist, if you
said to me, Matt, what is the total
value-added of this factory? I will of
course say we need to net off pollution
damages. But how are we going to
do that? I would need to talk to an
atmos­pheric chemist about how many
people live near that factory. Not every­
body in Cleveland will be affected by
that factory. If the wind blows east, it’s
only the people who live to the east of
the factory will be affected.

F refront

23

Then we get into the next question:
Who are those individuals? Are
they old and asthmatic, or are they
young supermen, a bunch of LeBron
Jameses who can take air pollution
without any damage? A bunch of
LeBron Jameses can be exposed to the
Twinkie factory and not suffer at all,
whereas a bunch of elderly people
might all die. The public health costs
of the pollution would be huge, so
determining the GPI indicator for
measuring the environmental impact
of that factory in Cleveland would
require a huge amount of data.
Unfortunately I think it has to be
done on a case-by-case basis. Harvard
researchers have estimated the social
damage caused by coal-fired power
plants, where they calculate how many
people live near these plants and who
they are in terms of their demographics
and how much they are likely to suffer
from the power plant’s pollution.

On demographics in many major cities:
What we are seeing are highly educated
young people who are not yet married,
		
without children, wanting
		
to live downtown and
		
people like my parents,
		
who after their suburban
days want the hipness of downtown.
Richter: This gets to the relationship
between greener standards and the
economic development of cities: As
cities grow, they affect the environment. At earlier stages of development,
the economic growth of cities
could contribute to environmental
degradation.
Kahn: Let me tell you a story about

Los Angeles, my new home. In the
1950s, people in L.A. started to drive
more and more. There were more and
more people in L.A., with more and
more money, driving more and more
miles, but the cars did not have catalytic converters. In the United States,
we only began to phase in catalytic
converters starting in 1972. What an
economist would say is the scale of
the economic activity increased—

24

Winter 2009|2010

more and more people driving more
and more cars more and more miles,
and emissions per mile did not decline
and this led to the horrible smog
problems that Los Angeles is famous
for, the orange city.
What you’re referring to is an environmental Kuznets Curve. With
economic development, many urban,
environmental problems first get
worse and then get better. In 1972
when I was six years old, I was not in
L.A., but I can imagine the city was
getting richer and it was choking on
the pollution. Middle-class people
must have said, what the heck is going
on? This is not a green city. We are in
the United States. Can’t we do better?
Starting in 1972, there was a regime
break. California got tough on demand­
ing that emissions of driving per mile
get much lower, and by the 1980s and
the 1990s, smog got much better in
L.A. Emissions per mile of driving
were falling faster, even though the
total number of miles driven was
rising. More people, richer people,
were driving more, but emissions per
mile fell, because of the technological
advance of the catalytic converter—
technology offset the consumption.
Many environmentalists point to
the quantity effect of capitalism,
the American Dream that people
want more, more, more. But people
ignore the quality effect that a richer
nation can have higher-quality [i.e.,
cleaner] products. In a nutshell, it’s
a race between quantity and quality
that generates this inverted U with
economic development—first you
get pollution, but then you actually
solve pollution problems with further
economic development.
Richter: How would you respond to the
concerns of poorer cities—they are at
the first stage of development and dealing
with issues of low incomes, stressed
budgets, crime, under-performing
schools. Are there still ways for them
to pursue some green policies?
Kahn: I think this is a crucial question
for cities. Your question is both about
local public finance and about green
cities. Let me tell you an optimistic

story. Imagine a city that, because of
its ability to be green, its ability to
overcome its crime problem, young
urbanites feel safe downtown and
want to live and work downtown.
They will pay their taxes grudgingly,
and the mayor will use a fair chunk
of those taxes to redistribute to the
urban poor in the same city. So there
can be a win–win. A mayor whose
focus is perhaps urban minorities
might actually want to create a green
city to create a revenue base in order
to redistribute to constituents who
he’s worried about.
I believe that story. I think there is
some evidence for that story. On
demographics in many major cities:
What we are seeing are highly educated young people who are not yet
married, without children, wanting
to live downtown and people like my
parents, who after their suburban days
want the hipness of downtown. Both
of those demographic groups are living in the center city, and this creates
a tax revenue source off the sales tax
base and the income tax base for a
center city mayor. I agree the mayor
has problems. Schools have issues.
There are still large pockets of urban
poverty. But one way to address these
issues is to build this golden goose,
this tax revenue off the green, livable
city, and then to engage in redistribution that the society needs.
Richter: On your blog, you noted that
you can buy 100 homes in Detroit for the
price of one in Westwood [where UCLA
is located]. Is that a good deal?
Kahn: I started this blog because my

wife wanted me to stop telling her all
my ideas, and this was a cheap way
to communicate with all my friends
in academia. Many of them read it
and then send me rude remarks. But
to your question, UCLA has been
suffering from high local real estate
prices! A sign to economists of great
quality of life is high real estate prices,
but UCLA is having trouble recruiting
faculty because of it. Faculty at an Ohio
State or a university in Boston say,
“UCLA is a great school, but I can’t
afford the housing nearby.” I’m talking
about a $1.3 million, 2,000 square

foot house, not the Playboy mansion,
that is affecting the ability of UCLA
to recruit.
Then I read another webpage that
Detroit homes are $13,000 each. So
my thinking was along these lines: I’m
writing a new book about how climate
change will affect cities’ quality of
life. For example, if winter becomes
warmer in Cleveland and Detroit and
other Midwest and Northeast cities,
then by the year 2075 the current
huge home price differential between
Los Angeles and these cities could
sharply shrink. If these cities become
warmer, will Cleveland and Detroit by
the year 2075 be much more desirable
places? A good economist should
react to that news before it is reflected
in prices. So I should be selling my
Westwood house and making this
purchase now.
But when people commented on
my piece they pointed out that most
of these Detroit homes have been
stripped down, no metal. You would
have to invest a huge amount of
money to make these livable homes.
While you can buy a Detroit home for
$13,000, you cannot move into it.
Richter: Cities with greater skills experience greater growth. So with regards to
Appalachia, should efforts in this region
be focused on retaining recent graduates,
or on recruiting them?
Kahn: This is an excellent and very

important question. Appalachia could
increase its stock of skilled people in
two ways. First, if they can grow their
own, such as young people who go to
Appalachian State University and after
graduation stay. Second, if someone
goes to UCLA in Los Angeles and
says to heck with this and moves to
Appalachia.
But in truth, when I looked at the
data, nobody outside of Appalachia
who is highly skilled is moving to the
region. In my opinion, Appalachia’s
best chance to raise its skill level is to
grow its own and then get aggressive
in retaining them. It’s like a baseball
team with a minor league farm system
for growing new stars and then doesn’t
lose them to free agency.

If I were a mayor or governor in
the states that comprise Appalachia,
I think I would talk more to the
22-year-olds finishing Appalachian
State University and West Virginia
University, and ask them—are you
staying? If they are going, what was
the factor that pushed them out?
Was it jobs? Was it that it’s boring
here? And then use the clues from
that survey to design a set of policies
to encourage them to stay. The challenges Appalachian cities face are:
They are relatively small, not on the
coast, many have cold winters, and the
economy is undiversified. They have
manufacturing and mining but not
much “Google” activity.
So if a computer science major at
Appalachian State wanted to stay in
the region, what are the set of jobs he
could get right now? That’s the question I’d like to ask the governor. Those
are the fights the governor needs to win
to increase the skill base of the region.
Richter: Small cities are often characterized by very little economic diversification.
How can cities achieve economic development in that context?
Kahn: The oldest question in urban

economics is the chicken and egg
riddle: Do people follow jobs or do
jobs follow people? One strategy is
what Berkeley and MIT economists
documented with the “million dollar
plant.” Enrico Moretti and Michael
Greenstone have documented that
rural counties that successfully recruit
big manufacturing plants, like a new
car factory, offer direct economic
opportunities by creating new jobs
and stimulating increased demand by
other firms in the same county. For
example, if a new car manufacturer
opens, an input supplier who makes
tires might locate nearby to supply
these tires.
There are two different paths for
achieving economic development.
You can use incentives to attract new
jobs to the region and hope that this
attracts young people, or you can
attract skilled people and if word gets

out that there is a high-quality-of-life
place where the skilled want to live,
then employers who want to hire
them will show up. My advice for
Appalachia’s politicians is that they
should experiment and try out both
strategies.

In my opinion, Appalachia’s
best chance to raise its skill level is to
grow its own and then get aggressive
in retaining them.
I’m an honest man. I think it’s important to know what you don’t know.
When you know that you don’t know
something, the answer is to experiment! Too often in the past, develop­
ment economists have told poor
nations do this, do that—where I
think this is a case where we want to
experi­ment and see what works using
a field experiment approach.
We have evidence that poverty is
declining in communities and that per
capita income and employment are
rising in cities and areas that are trying
these various treatments, whether it
is sub­sidizing college graduates who
remain in the region or subsidizing
million-dollar plants to move into a
county. The key issue here is having a
well-defined “control group” to determine what local poverty rates would
have been if the specific policy being
evaluated had not been tried.
Richter: Pittsburgh was built as a manufacturing hub and now has transformed
itself into something quite different, in fact
becoming a recent economic development
success story. What lessons can a city
such as Cleveland learn from Pittsburgh?
Kahn: One special thing about

Pitts­burgh is that both Carnegie
Mellon University and the University
of Pittsburgh are downtown. But
I would hope that Cleveland could
follow a very similar arc. I actually
want to hear your views on that. I see
no reason why Cleveland couldn’t
have the same success unless we’re
talking about Super Bowls!

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25

For economic growth, you can either
		
retain your own or
		
attract others to move
		
in, but you can only
		
attract others if they
		
have a generally
		
favorable assessment
		
of the city.
Richter: Cleveland is a small-enough city
that it allows one to go from one place
to the next in a short period of time.
Enough culture, wonderful music with
the Cleveland Orchestra….
Kahn: The United States has over 200

metro areas, and it would interest
me to learn about perceptions about
Cleveland for people who live in other
cities. If we asked people in Orlando
what they think about Cleveland,
putting LeBron James aside, what
would they say? Would they say it’s
the “mistake by the lake,” or talk about
the water catching on fire in 1969?
If I were the Cleveland Chamber
of Commerce, I think it would be
worth commissioning a study to see
if there’s a fundamental disconnect in
perceptions. Should they be buying
everyone a ticket to visit Cleveland?
Tourism brings people in from Kansas
and allows them to experience New
York, and some of those folks move in!

For economic growth, you can either
retain your own or attract others to
move in, but you can only attract
others if they have a generally favorable
assessment of the city.
Richter: In three generations, will
Americans be worse off? Specifically, I
wonder about small towns in Kentucky,
or about Cleveland.
Kahn: I’m a big-time optimist. Eco-

nomic growth will continue because
we have the world’s best universities.
My own research focuses on “smaller”
quality-of-life issues. I hope we can get
a handle on traffic congestion. Economists have proposed road pricing, like
what London did with its congestion
charge. But no one is listening to us.

26

Winter 2009|2010

In terms of crime in cities, we’ve made
great progress. Air pollution? We’ve
made great progress. Water pollution
in cities? My father now goes fishing
on the Hudson River, which was disgusting 30 years ago, and he’s catching
fish! There are people canoeing and
jogging near the river. On several
dimensions we’ve reclaimed pieces of
our cities. But I do worry about climate
change in our cities, in particular how
that will affect our coastal cities. But,
I’m highly optimistic about our longrun quality of life.
In terms of small cities in Appalachia,
I think they will find their niche. They
certainly have the right incentives to
do so. One question I have been asking
is about the future of coal in Appalachia.
When coal prices have been high,
Appalachia has been doing great. But
in a world of carbon pricing, as coalbased electric utilities substitute away
from coal, that whole industry might
collapse, which will have huge shortrun costs for Appalachia. But as a
green cities guy, I would argue there
are long-run benefits.
Richter: Along those lines, some people,
including members of the current
Administration, view climate change
as an opportunity for innovation and
job creation. Do you agree with that
assessment?
Kahn: I hope so, but it takes an incen-

electricity prices will go up and some
of this activity will migrate abroad.
I think we need to have an honest
discussion about job creation and job
destruction once we introduce this
carbon legislation.
Richter: Why did you become an
economist? Did you know since you
were three years old that you wanted
to become an economist?
Kahn: My father had me reading the

New York Times from an early age.
I was looking for a subject that would
help me think about the real world.
Now, this deep recession has been
a little humbling for economists. It
has caused a lot of debate at lunch
at UCLA! But I find on average that
micro­economics is a powerful tool for
understanding the world.
I can’t claim to be an activist. I would
love people to say that Kahn was
good at understanding this transition
of cities from areas that focused on
industrial activity to consumer cities,
where people get to play and live out
their lives in a high-quality-of-life
setting. To answer your question,
economics, both incentive theory
and the statistics that we’re taught,
has been a powerful tool for helping
me understand the dynamics of city
quality of life.
Richter: Thank you very much. ■

tive. Ninety-nine percent of economists
agree that we need a carbon tax or some
sort of cap-and-trade system to put a
price on releasing carbon-greenhouse
gas emissions. That would create all
sorts of new opportunities.
This hotel we’re in right now, how
energy efficient is it? And if this hotel
faced a carbon tax, it would have the
right incentives to hire a weatherizer
to take a new look at this building
to see if it could use energy more
efficiently. That’s the type of job that
would be created. Some jobs would
be destroyed, such as very energyintensive manufacturing. Certain
steel activity uses a high amount of
electricity. If we have coal pricing,

Watch video clips
of this interview
www.clevelandfed.org/forefront

Forefront Roundtable
Watch economists with the Federal Reserve Bank of Cleveland discuss
their takeaways from the September 11, 2009, seminar on consumer
protection at www.clevelandfed.org/forefront.

Stephan Whitaker on the need for
new approaches to consumer protection:
The recent crisis has revealed a couple of major gaps in consumer protections.
One of them is that a lot of consumer protections in the past focused on access.
We were really concerned about making sure that people could get consumer
credit if they needed it, or get mortgages. And there wasn’t so much attention
paid to making sure that they didn’t get into a product that would cause them
a financial hardship in a matter of months or years. So now we need to rethink
what we’re doing and adjust it for the new realities.

Daniel Littman on the search for consumer
protection tools beyond disclosures:
A mixture of tools probably needs to be used because disclosures aren’t enough
to keep people from products that are not suitable for them or products offered
to them involving fraud. There probably needs to be some mixture of compulsion
that keeps certain kinds of products off the market or that targets products to
the right kinds of people—along with better disclosures.

Thomas Fitzpatrick on the challenge of
improving disclosures in mortgage contracts:
I think there’s a lot of room for improvement there. It’s commonly said that
disclosures are written by lawyers for lawyers. And as a lawyer, I can tell you that
they’re really not written for us, either. They’re very, very complicated.

F refront

27

View:	Can Foreclosures Be a

Neighborhood’s Best Friend?
Mary Helen Petrus,
Community Development
Manager

Rampant foreclosures present a dichotomy for communities.
On the one hand, foreclosure can deal a crushing blow to
the American Dream of homeownership, and it certainly can
accelerate the decline of neighborhoods. But often overlooked
is the other hand: Foreclosure can sometimes serve as a useful
tool to stave off community blight. Using the proper legal
tools, older industrial cities can use foreclosure to acquire property that otherwise would become vacant or abandoned.
As a result, crisis can be transformed into opportunity—the rare opportunity to rethink redevelopment and land use.
Mark Wiseman, attorney and former director of the Foreclosure Prevention Program in Ohio’s Cuyahoga County, once
described the foreclosure process as akin to cutting sacks of sand from an air balloon’s gondola. These sacks are the debt
and title disputes weighing down the property. As they are severed, the property is unleashed. Wiseman argues that
communities need to get organized about setting more of these balloons free—and they can do it with foreclosure.
I am not talking about forcing people from their homes. I am talking about homes that have been long abandoned, or
that are very likely to become abandoned, and are stuck in legal limbo. Consider what happens in a so-called “toxic title”
situation. First, the homeowner leaves the property as soon as the lender starts the foreclosure process. Then, as the
property deteriorates from lack of care, the lender halts foreclosure proceedings because the underlying home has lost
so much value that it’s not worth pursuing the action. In the end, government officials have a difficult time figuring out
who should be held accountable—the absent homeowner or the disinterested lender. Even in cases when homeowners
want to surrender their property, they often can’t do so because of title complications. If enough properties get locked
in toxic-title limbo, entire neighborhoods can quickly fall into disrepair.
The fact is, foreclosure in many cases is the only tool that communities have at their disposal to reclaim and reuse abandoned
property. Tax foreclosure—that is, when governments launch the foreclosure process because a property is delinquent on
taxes—is a particularly useful tool. It has been endorsed by the City of Buffalo and the National Vacant Properties Campaign
as a way for land banks to acquire vacant and abandoned properties that are saddled with unpaid liens.
28

Winter 2009|2010

Foreclosures of unoccupied property can
help clear the way for something weakmarket cities need more than homes:
safe, open space.

But foreclosure is far from a perfect tool for clearing title. As the housing crisis has unfolded, public perception about
the personal tragedies associated with foreclosure has tended to sway legislators to impose restrictions on the process.
The danger with this perception is that we risk losing sight of foreclosure’s relationship to property acquisition and reuse.
The stigma of being associated in any way with encouraging foreclosure, which many envision strictly as efforts to remove
people from their homes, understandably makes neighborhood development groups skittish. Even so, when houses are
vacant and abandoned, foreclosure is the most straightforward way to clear title. What is really more controversial—using
foreclosure in an effort to save neighborhoods, or watching vacant homes topple others nearby like dominos?

Policy Implications
To be clear, in viable neighborhoods, the focus ought to be on improving the quality and affordability of housing for
the people who still live there. This could be done by rehabbing homes and improving rental housing stock and supply.
For nonviable neighborhoods, a completely different prescription is needed. The key is to create better legal tools to clear
title—ways that do not depend on the self-interest and timing of debt collectors. Among them:
•	Quiet title actions, in which governments go to court to “quiet” any and all other claims to a property’s title
•	Laws to facilitate nuisance abatement through receivership, in which courts can assign an overseer to repair or improve
vacant properties
•	New rules making it easier for willing homeowners to forfeit their properties so that governments can take stewardship
•	Processes for tax foreclosures that don’t have to go through the courts
All of these methods should be further explored. In the meantime, instead of waiting until all collateral value is lost on
foreclosed properties, communities should enforce housing codes more rigorously, make mortgagees responsible for the
condition of abandoned property, and regulate property transfers when properties have serious code infractions on record.
Of course, these strategies can be difficult for cash-strapped communities to achieve in practice. We in Cleveland are all too
familiar with the painful and expensive process of trying to locate title holders to hold them accountable.
The rewards can be worth the struggles, however. Foreclosures of unoccupied property can help clear the way for something weak-market cities need more than homes: safe, open space. Too many homes now in foreclosure should be demolished because of obsolescence or profound disrepair. Communities and policymakers should explore ways to facilitate
demolition through adequate funding mechanisms. Moreover, it’s time to discard the old operating assumption of “if we
build it, they will come.”
Our challenge—and perhaps the silver lining in the foreclosure crisis for the Fourth Federal Reserve District—is making
the leap from a traditional community development model to one featuring sustainable redevelopment designed to promote
truly viable neighborhoods. These are the essential ingredients of healthy communities in weak-market regions. ■
F refront

29

Next in Forefront:
The Community Reinvestment Act
Strengths and weaknesses

Early Warning

Post-Crisis Policymaking

Incorporating credit and the potential for financial
instability into policy models

A new model for spotting systemic financial risk

Neighborhoods on the Brink

How are troubled communities spending their
federal housing funds?
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