The road to hell is paved with good intentions. With all due respect to my Foolish colleagues Brian Richards and Ilan Moscovitz, that unfortunate fact of life seems to have been missed in their eloquent defense of the Consumer Financial Protection Bureau, or CFPB.

Even in a perfect world, and even if you assume the purest of intentions, no law Congress can create is more powerful than the Law of Unintended Consequences. The side effects from those unintended consequences of legislation often wind up being quite worse than the problems the legislation meant to address.

The lessons from Prohibition
Think back to the 18th Amendment to the U.S. Constitution, which criminalized most alcohol in the United States, thereby beginning Prohibition. While the law's intentions of protecting people from the downside of their own and their neighbors' poor behavior while under the influence may have been noble, its consequences were anything but.

It was Prohibition, after all, that enabled organized crime in America to flourish. People wanted their alcohol, and with it deemed illegal, those who provided it had to operate criminal organizations to produce and distribute it. During Prohibition, tens of thousands of "speakeasies" provided access to illegal booze at a very expensive price.

Rather than ridding the country of alcohol, Prohibition simply made it more costly and moved it underground, where it could do even more damage. That's not exactly what Prohibition's supporters wanted, but it's what they got. Ultimately, Prohibition's unintended consequences were bad enough that the 18th Amendment was repealed and alcohol again legalized.

So what happens when, in the name of "protecting consumers from unfair treatment in consumer finance," the CFPB forces lending to risky borrowers underground? Do loan sharks again proliferate? And instead of paying high market rates with civil penalties for breach of a valid borrowing contract, do deadbeat borrowers risk life and limb for failing to pay the local loan shark rates that are even higher than today's payday lenders charge?

How that could happen
There's more to the CFPB than simply assuring clear disclosure or enforcing existing laws. Disclosure doesn't require a new bureau, and if lenders are breaking laws, there are already courts and both criminal and civil penalties to deal with them. To the extent it uses its authority to "issue rules" to actively regulate from the bureaucracy, the CFPB forces lenders to work around those rules to be able to be sufficiently compensated for their risks.

Lenders, after all, only have a handful of levers they can pull when it comes to their products:

  • The interest rate they charge for the use of their money,
  • The fees they charge to set up and service those loans,
  • The other terms (like prepayment penalties, late charges, and balloon clauses), and
  • The lending standards they follow in order to choose who to lend money to.

So what happens when the CFPB determines that one of the levers a lender is using is "unfair" to a prospective borrower? After all, one of the bureau's stated missions is to "Restrict unfair, deceptive, or abusive acts or practices." Well, to some extent, the lender finds another way to get compensated for its risks by pulling on a different lever.

After enough of that "whack-a-mole" between regulator and lender, the lender has no real choice but to tighten lending standards and simply refuse to lend that risky borrower money. At that point, it's goodbye to open, transparent, legal (though expensive) lending to risky borrowers -- and hello to Louie the Loan Shark and his "left or right kneecap?" concierge service. If you really need money and can't get it legally, the only options you're left with are illegal ones.

Or fan the flames of the next crisis
Of course, the other tack CFPB could take in its quest to "protect" consumers from the finance industry is to strong-arm captive lenders into loaning money to anyone with a pulse. If that sounds familiar, it's because that's essentially what happened when Fannie Mae and Freddie Mac (both "government-sponsored enterprises") started buying and insuring risky mortgages. And we all know what an absolute nightmare that turned into.

Banks do stupid things, and people do stupid things, too. But when an individual or a private company does stupid stuff, the consequences are limited to the reach of whoever screwed up. It takes active government action to turn stupid lending standards into a nationwide financial crisis.

When it comes to the CFPB, it's not the "education" or "disclosure" that creates risk. The power to judge what's fair and the rule-making authority that goes along with it makes the agency a potential incubator of either dangerous loan-sharking or the next nationwide financial crisis.

What do you think? Let me know or let me have it in the comments below.