[Senate Hearing 111-59]
[From the U.S. Government Publishing Office]
S. Hrg. 111-59
CONSUMER PROTECTIONS IN FINANCIAL SERVICES: PAST PROBLEMS, FUTURE
SOLUTIONS
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
ON
ESTABLISHING STRONG CONSUMER PROTECTIONS WHILE ENSURING A SAFE AND
SOUND FINANCIAL SYSTEM IN THE UNITED STATES
__________
MARCH 3, 2009
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York JIM BUNNING, Kentucky
EVAN BAYH, Indiana MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey MEL MARTINEZ, Florida
DANIEL K. AKAKA, Hawaii BOB CORKER, Tennessee
SHERROD BROWN, Ohio JIM DeMINT, South Carolina
JON TESTER, Montana DAVID VITTER, Louisiana
HERB KOHL, Wisconsin MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia KAY BAILEY HUTCHISON, Texas
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado
Colin McGinnis, Acting Staff Director
William D. Duhnke, Republican Staff Director and Counsel
Amy Friend, Chief Counsel
Lynsey Graham Rea, Counsel
Julie Chon, Senior International Adviser
Jonathan Miller, Professional Staff Member
Matthew Pippin, Professional Staff Member
Tamara Fucile, Professional Staff Member
Mark Oesterle, Republican Chief Counsel
Jim Johnson, Republican Counsel
Mark Calabria, Republican Senior Professional Staff Member
Dawn Ratliff, Chief Clerk
Devin Hartley, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
(ii)
?
C O N T E N T S
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TUESDAY, MARCH 3, 2009
Page
Opening statement of Senator Dodd................................ 1
Opening statements, comments, or prepared statements of:
Senator Shelby............................................... 4
Senator Akaka................................................ 6
Senator Merkley.............................................. 6
Senator Schumer.............................................. 23
WITNESSES
Steve Bartlett, President and Chief Executive Officer, Financial
Services Roundtable............................................ 7
Prepared statement........................................... 37
Response to written question of Senator Vitter............... 73
Ellen Seidman, Senior Fellow, New America Foundation, and
Executive Vice President ShoreBank Corporation................. 9
Prepared statement........................................... 48
Response to written question of Senator Vitter............... 74
Patricia A. McCoy, George J. and Helen M. England Professor of
Law,
University of Connecticut School of Law........................ 11
Prepared statement........................................... 52
Response to written question of Senator Vitter............... 75
(iii)
CONSUMER PROTECTIONS IN FINANCIAL SERVICES: PAST PROBLEMS, FUTURE
SOLUTIONS
----------
TUESDAY, MARCH 3, 2009
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:06 a.m., in room 538, Dirksen
Senate Office Building, Senator Christopher J. Dodd (Chairman
of the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD
Chairman Dodd. Good morning. The Committee will come to
order. Let me welcome those of you here in the room, my
colleagues and our witnesses, who will spend a few moments with
us as we discuss ``Consumer Protections in Financial Services:
Past Problems and Future Solutions.''
Let me begin by commending all three of our witnesses. I
went over your testimony yesterday and I found it very, very
interesting, with different perspectives on this issue, not so
much on how we got where we are, but where we need to go from
here. I found it very, very worthwhile, very enlightening and
interesting. And really, what I liked about it is, given we
have spent a lot of time over the last year talking about it in
general terms, it talks specifically about where we go, and all
three of you really have offered some very specific ideas on
how to move forward. That is what we need to be doing in the
coming days.
And, of course, I am delighted to be with my friend and
colleague here from Alabama, who was the former Chairman of the
Committee. We have had some great times working together over
the last 2 years, some difficult times, but he has been a great
partner and a good Senator. We have our differences from time
to time, but we try to minimize those and do whatever we can to
work together.
And this is a subject matter where I am determined, and I
believe he is determined, as I hope our colleagues are, too, to
come together and do something historic in light of all the
problems that we face in our country. You need only to pick up
our morning newspapers to appreciate what people are going
through. We read the numbers, but, obviously, out there behind
all of those numbers are people watching their jobs disappear,
their retirements evaporate, and they are losing their homes,
and their children's future and education are in question. And
that is what has to motivate us and drive us. We keep them in
mind through all of this.
So this morning, we continue the conversation we have been
having about how we can make our economy stronger, our
institutions more stable and reliable, and of course, in the
final analysis, to make sure that the consumers of all of these
products are going to receive the protection that they deserve.
So today, the Banking Committee meets for another time in a
series of hearings to discuss ways to modernize our financial
architecture to help our nation grow, to prosper, and to lead
our nation into the 21st century. This hearing will focus on
critical consumer, investor, and shareholder protections in
financial services.
For the past year, as I have traveled in my home State of
Connecticut, along, I am sure, with my colleagues in their own
respective States, and our constituents have underscored the
importance of rebuilding our financial system by injecting
tough new consumer investor protections that have been missing
or overlooked for far too long. They are literally banking on
change in this area, and I believe we must give it to them this
year, and our common hope is to do just that, because efficient
and effective markets only work when all actors have good
information.
It also means increased accountability, disclosure and
transparency to ensure that consumers and investors understand
the rules of the road regarding their transactions. And it
means doing these things in a way which doesn't unduly cramp
the vitality, innovation, and creativity, which is the source
of genius in our financial system. Striking that balance is a
tall order, but that must be our charge.
The President has now made clear that regulatory
modernization, which will protect consumers and investors in
this way, is a top priority for him. Senator Shelby and I,
joined by Chairman Barney Frank and Ranking Member Spencer
Baucus, met last week met at the White House, and we agreed to
work toward that goal, informed by key principles outlined by
the President in that meeting.
It is an historic undertaking, one of the most important
debates in which we have engaged here in a long time, maybe the
most important debate that members of this Committee may ever
engage in, considering the significance of what we are about to
undertake. It will be challenging, and no doubt it will take
twists and turns in the coming months. But I hope and expect
that the process will culminate in a comprehensive regulatory
modernization bill at its end.
Senator Shelby and his colleagues have been partners in
many such legislative efforts over the past couple of years
that I have chaired this Committee, and I am very grateful to
him specifically and to my colleagues as well, for the fine
work they have done with us on this Committee.
In the last Congress, this Committee and its subcommittees
held 30 hearings to identify the causes and consequences of the
financial crisis, which is at the root of our economic
troubles. We looked at everything from predatory lending and
foreclosures to the risks of derivatives in the banking system,
and security and insurance industries. What we found at the
heart of the problem in these areas was a single fundamental
breakdown, an almost total failure to protect consumers,
investors, and shareholders.
By no means is this problem exclusive to financial
services. Whether it is poisoned toys imported from China or
meat with deadly pathogens knowingly sold to supermarkets, some
for too long have been willing to cross the bright lines of
basic business operations, and fair treatment of the consumer
to bolster their bottom lines.
Nowhere was that failure starker or more catastrophic for
our economy than the housing market, where lenders, brokers,
and banks offered or financed an array of unsuitable mortgage
products without regard to the borrower's ability to repay. For
too long, many in the industry focused solely on large profits
and ignored the major risks that accompanied them. They were
willing to gamble with not only their own futures, but those of
their customers, who were encouraged to take on more and more
risk.
And the result is clear. With unemployment now at its
highest in 16 years, 8 million homes in danger of foreclosure,
and some of our largest financial institutions either in ruins
or at the risk of being such, this house of cards has
collapsed, and today the Committee meets to continue our
discussion on how to rebuild a stronger and more stable
structure.
I pledge personally over the coming months that we will
rebuild the nation's financial architecture from the bottom up
and put the needs of consumers, investors, and shareholders who
own these firms not at the margins of our financial service
system, but at its very center. Just as failure to protect the
American people was the cause of our financial collapse, so too
must our efforts to rebuild be premised on a strong foundation
of consumer and investor protections.
Certainly, we have a ways to go, as we all know, when
mortgage brokers can charge yield spread premiums for directing
customers into riskier, costlier mortgages, and when credit
card companies can raise rates on customers who have always
paid their bills on time.
Recently, I learned of a woman named Samantha Moore from
Guilford, Connecticut, a paralegal whose husband owns a small
business. Not long ago, she was 3 days late on a credit card
payment, the first late payment in 18 years. For that seemingly
minor transgression, she had her interest rate raised from 12
percent to 27 percent and her credit line slashed from $31,400
a year to $4,500. What is a middle-class family like the Moores
supposed to do if they were counting on that credit line to
help them through a medical crisis? That single decision could
mean the difference between scraping by during a recession and
a lifetime of financial catastrophe, all because a single
payment after 18 years was 3 days late.
With the average household carrying more than $10,000 in
revolving debt on their credit cards and millions trapped in
home loans with exploding interest rates, sweeping reform of
abusive credit card and mortgage lending practices will be an
essential component of this Committee's financial modernization
efforts.
Today, we will discuss broader regulatory reform questions
that focus on how we treat customers of financial institutions.
For instance, should bank regulators continue to have that
authority? In 1994, Congress gave the Fed authority to ban
abusive home mortgages and it failed miserably. Is it time to
create a new regulator whose sole function is the fair
treatment of individual customers?
Certainly, we need strong cops on the beat in every
neighborhood. Fifty-two percent of subprime mortgages
originated with companies like stand-alone mortgage brokers and
others that have no Federal supervision whatsoever. Who should
be charged with consumer protection for these financial
institutions? Some have suggested that we set up an entity
modeled on the Consumer Product Safety Commission, which
protects the public from products used in the home, the school,
and for recreation. In this day and age, financial products are
just as commonplace and some can be equally as dangerous.
No one suggests that the buyer is to blame for a dangerous
toaster that catches fire or a toy for a child that is
contaminated with lead. Should it be any different for a
borrower who takes out a mortgage or signs up for a credit
card? I think it is a fair thing to ask, and one thing is
clear: These complex financial transactions, including
mortgages, can be much more dangerous than a family toaster.
We are talking about huge financial decisions, often the
most significant in a family's life, on which they stake their
life's savings. We must do everything we can to make sure that
they understand precisely the terms of those transactions and
their implications and that they are protected from the kinds
of abuses we have seen in recent years. These protections must
be comprehensive and consistent over our regulatory
architecture.
For too long, we have allowed a misguided belief to
persist, that when you protect a consumer, you stifle
innovation and growth. That is truly a false choice. Efficient,
dynamic marketplaces don't function in spite of people like
Samantha Moore, they function because of people like her and
millions of others who work, invest, and save to send their
children to school, to buy homes, and to live the often-spoken-
of American dream.
If we are going to grow a more sensible economy, a
sustainable economy, with a safe and sound financial
architecture that supports it, we need to protect and nurture
and invest in our most precious resource, the American people.
That starts with the work of this Committee.
With that, let me turn to my colleague, Senator Shelby, and
then I will ask my colleagues who are here if they would like
to make any opening comments, and then we will turn to our
witnesses. Richard?
STATEMENT OF SENATOR SHELBY
Senator Shelby. Thank you, Mr. Chairman.
There is no question that many home buyers were sold
inappropriate mortgages over the past several years. We have
heard their stories. We have heard some of those stories right
here. There is also no question that many home buyers were
willing parties to contracts that stretched them far beyond
their financial means. Some of these home buyers were even
willing to commit fraud to buy a new home. We have heard their
stories, as well.
As with any contract, there must be at least two parties to
each mortgage. If either party chooses not to participate,
there is no agreement. Unfortunately, during the real estate
boom, willing participants were in abundance all along the
transaction chain, from buyers to bankers, from Fannie and
Freddie to investment banks, and from pension funds to
international investors. There appeared to be no end to the
demand for mortgage-backed securities. Underwriting standards
seemed to go from relaxed to nonexistent as the model of
lending known as originate to distribute proliferated the
mortgage markets. The motto in industry seemed to be risk
passed, risk avoided.
However, as the risk was then passed around our financial
markets like a hot potato, everyone taking their piece along
the way, some of the risk was transferred back onto the balance
sheets of regulated financial institutions. In many cases,
banks were permitted to hold securities backed by loans that
they were proscribed from originating. Interesting. How did our
regulators allow this to happen? This is just one of the many
facets of this crisis that this Committee will be examining
over the months ahead.
A key issue going forward is how do we establish good
consumer protections while also ensuring the safety and
soundness of our financial system? In many respects, consumer
protection and safety and soundness go hand in hand. Poorly
underwritten loans that consumers cannot afford are much more
likely to go bad and inflict losses on our banks. In addition,
an essential element of consumer protection is making sure that
a financial institution has the capital necessary to fulfill
its obligations to its customers.
This close relationship between consumer protection and
safety and soundness argues in favor of a unified approach to
financial regulation. Moreover, the ongoing financial crisis
has shown that fractured regulation creates loopholes and blind
spots that can, over time, pose serious questions to our
financial system.
It is regulatory loopholes that have also spawned many of
the worst consumer abuses. Therefore, we should be cautious
about establishing more regulatory agencies just to create the
appearance of improving consumer protections.
We should also be mindful of the limits of regulation. Our
regulators cannot protect consumers better than they can
protect themselves. We should be careful not to construct a
regulatory regime that gives consumers a false sense of
security. The last thing we need to do is lead consumers to
believe that they don't have to do their own due diligence. If
this crisis teaches us anything, it should be that everyone,
from the big banks and pension funds to small community banks
and the average consumer, has to do a better job of doing their
own due diligence before entering into any financial
transactions. At the end of the day, self-reliance may prove to
be the best consumer protection.
Thank you, Mr. Chairman.
Chairman Dodd. Thank you very much, Senator.
Senator Akaka, any opening comments?
STATEMENT OF SENATOR AKAKA
Senator Akaka. Thank you very much, Mr. Chairman. I want
you to know that I appreciate your conducting this hearing and
also appreciate your advocacy on behalf of consumers, Mr.
Chairman and Ranking Member, Senator Shelby.
I also want to welcome our witnesses this morning to this
hearing.
Well before the current economic crisis, our financial
regulatory system was failing to adequately protect working
families, home buyers, individuals from predatory practices and
exploitations. Prospective home buyers were steered into
mortgage products with risks and costs that they could not
afford. Working families were being exploited by high-cost
fringe financial service providers, such as payday lenders and
check cashers. Low-income taxpayers had their Earned Income Tax
Credit benefits unnecessarily diminished by refund anticipation
loans. Individuals trying to cope with their debt burdens were
pushed into inappropriate debt management plans by disreputable
credit counselors.
We must increase consumer education so that individuals are
able to make better informed decisions. However, although it is
essential, education is not enough. We must also restrict
predatory policies, ensure that consumers' interests are better
represented in the regulatory process, and increase effective
oversight of financial services.
Mr. Chairman, you mentioned this in your opening statement
and I will certainly work with you on these measures. I
appreciate the witnesses today and I look forward with all of
you to educate, protect, and empower consumers.
Thank you very much, Mr. Chairman.
Chairman Dodd. Thank you.
Senator Merkley, any opening thoughts?
STATEMENT OF SENATOR MERKLEY
Senator Merkley. Thank you very much, Mr. Chair, and
welcome to the experts testifying before us.
I will say just simply that too often, the failure of
regulation has turned the American dream of home ownership into
an American nightmare of home ownership, and that the failure
of regulation on Wall Street has created the situation where
these same mortgages have contributed enormously to the
meltdown of our economy, and just not our economy, but now to
the world economy.
So this is incredibly important to the success of our
families that we get this right, and to the success of our
economy and the world economy. I look forward to your
testimony.
Thank you very much, Mr. Chair.
Chairman Dodd. Thank you very much, as well, Senator. I
appreciate your opening comments.
Let me just introduce our witnesses so we can get to them.
As I said at the outset, I was very impressed with your
testimony. It is very thorough and, in fact, my constituent is
extremely thorough. His testimony was 28 pages. We are going to
try and limit you this morning. I am going to challenge my
colleagues to read all of it, but we will try and keep it down
to about somewhere between five and 8 minutes or so, so that we
can get to some questions with you.
Our first witness is truth in advertising. He is a good
friend of mine, Steve Bartlett. Steve is CEO of the Financial
Services Roundtable, previously served as the Mayor of Dallas,
a former Member of the Congress. In fact, he served on the
Financial Services Committee when he served in the House, and
so he has a familiarity with these issues as a chief executive
of a city, as a Member of the Congress serving on the
counterpart Committee to this Committee, and, of course, as the
CEO of the Financial Services Roundtable. Steve, we thank you
immensely for joining us today and being with us.
Ellen Seidman is the former Director of the Office of
Thrift Supervision and currently Senior Fellow of the New
America Foundation and Executive Vice President on National
Policy and Partnership Development at ShoreBank Corporation. We
thank you very much once again for being before the Committee.
And I am proud to introduce Professor Patricia McCoy, a
nationally recognized authority on consumer finance law and
subprime lending. She is the George J. and Helen M. England
Professor of Law at the University of Connecticut. She was a
partner of Mayer, Brown, Rowe and Maw in Washington, D.C.,
where she specialized in complex securities banking and
commercial constitutional litigation. It is a pleasure to have
you. I hope you are enjoying your tenure in Connecticut.
Ms. McCoy. Very much so, Senator.
Chairman Dodd. That is good.
We will begin with you, Steve, and again, thank you all for
your excellent testimony.
STATEMENT OF STEVE BARTLETT, PRESIDENT AND CHIEF EXECUTIVE
OFFICER, FINANCIAL SERVICES ROUNDTABLE
Mr. Bartlett. Thank you, Chairman Dodd and Ranking Member
Shelby and members of the Committee.
To start with the obvious, it is true that many consumers
were harmed by the mortgage-lending practices that led to the
current crisis, but what is even more true is that even more
have been harmed by the crisis itself. The root causes of the
crisis, to overly simplify, are twofold: One, mistaken policies
and practices by many, but not all, not even most, financial
services firms; and two, the failure of our fragmented
financial regulatory system to identify and to prevent those
practices and the systemic failures that resulted.
This crisis illustrates the nexus, then, between consumer
protection regulation and safety and soundness regulation.
Safety and soundness, or prudential regulation, is the first
line of defense for protecting consumers. It ensures that
financial services firms are financially sound and further
loans that borrowers can repay with their own income are
healthy both for the borrower and for the lender. In turn,
consumer protection regulation ensures that consumers are
treated fairly. Put another way, safety and soundness and
consumer protection are self-reinforcing, each strengthening
the other.
Given this nexus, we do not support, indeed, we oppose
proposals to separate consumer protection regulation from
safety and soundness regulation. Such a separation would
significantly weaken both.
An example, Mr. Chairman, in real time, today, a provision
in the pending omnibus appropriations bill that would give
State attorneys general the authority to enforce compliance
with the Federal Truth in Lending Act illustrates this problem.
It would create additional fragmented regulation, and
attempting to separate safety and soundness and consumer
protection would harm both.
My testimony has been divided into two parts. First, I
address what went wrong, and second, I address how to fix the
problem.
What went wrong? The proximate cause of the current
financial crisis was the nationwide collapse of housing values.
The root cause of the crisis are twofold. The first was a
breakdown, as I said, in policies, practices, and processes at
many, but not all financial services firms. Since 2007,
admittedly long after all the horses were out of the barn and
running around in the pasture, the industry identified and
corrected those practices. Underwriting standards have been
upgraded. Credit practices have been reviewed and recalibrated.
Leverage has been reduced as firms were rebuilt. Capital
incentives have been realigned. And some management teams have
been replaced.
The second underlying cause, though, is our overly complex
and fragmented financial regulatory structure which still
exists today as it existed during the ramp-up to the crisis.
There are significant gaps in the financial regulatory system
in which no one has regulatory jurisdiction. The system does
not provide for sufficient coordination and cooperation among
regulators and does not adequately monitor the potential for
market failures or high-risk activities.
So how to fix the problem? The Roundtable has developed
over the course, literally, of 3 years a draft financial
regulatory architecture that is intended to close those gaps,
and our proposed architecture, which I submit for the record,
has six key features.
First, we propose to expand the membership of the
President's Working Group on Financial Markets and rename it
the Financial Markets Coordinating Council, but key, to give it
statutory authority rather than merely executive branch
authority.
Second, to address systemic risk, we propose that the
Federal Reserve Board be authorized as a market stability
regulator. The Fed would be responsible for looking across the
entire financial services sector to identify interconnections
that could pose a risk to the entire financial system.
Third, to reduce the gaps in regulation, we propose a
consolidation of several existing Federal agencies, such as OCC
and OTS, into a single national financial institutions
regulator. The new agency would be a consolidated prudential
and consumer protection agency for three broad sectors:
Banking, securities, and insurance. The agency would issue
national prudential and consumer protection standards for
mortgage origination. Mortgage lenders, regardless of how they
are organized, would be required to retain some of the risk for
the loans they originate, also known as keeping some skin in
the game, and likewise, mortgage borrowers, regardless of where
they live or who their lender is, would be protected by the
same safety and soundness and consumer standards.
Fourth, we propose the creation of a national capital
markets agency with the merger of the SEC and the Commodities
Futures Trading Commission.
And fifth, to protect depositors, policy holders, and
investors, we propose that the Federal Deposit Insurance
Corporation would be renamed the National Insurance Resolution
Authority and that it manage insurance mechanisms for banking,
depository institutions, but also federally chartered insurance
companies and federally licensed broker dealers.
Before I close, Mr. Chairman, I have also included in my
testimony two other issues of importance to this Committee and
the policymakers and the industry. One, lending by institutions
that have received TARP funds is a subject of great comment
around this table. And second, the impact of fair value
accounting in illiquid markets.
I have attached to my statement a series of tables that the
Roundtable has compiled on lending by some of the nation's
largest institutions. These tables are designed to set the
record straight. The fact is that large financial services
firms have increased their lending as a result of TARP capital.
And second, fair value accounting continues to be of
gargantuan concerns for the industry and should be for the
public in general. We believe that the pro-cyclical effects of
existing and past policies, which have not been changed, are
unnecessarily exacerbating the crisis. We urge the Committee to
take up this subject and deal with it.
We thank you again for the opportunity to appear. I yield
back.
Chairman Dodd. Thank you, Steve, very, very much. I
appreciate the testimony. You laid out, as well, rather
specifically the structure of an architecture, which I found
very interesting and appreciate the detailed proposal and
worthy of our consideration.
Mr. Bartlett. Thank you.
Chairman Dodd. Ms. Seidman, thank you for being with us.
STATEMENT OF ELLEN SEIDMAN, SENIOR FELLOW, NEW AMERICA
FOUNDATION, AND EXECUTIVE VICE PRESIDENT, SHOREBANK CORPORATION
Ms. Seidman. Thank you very much, Chairman Dodd, Ranking
Member Shelby, and members of the Committee. I appreciate your
inviting me here this morning. As the Chairman mentioned, my
name is Ellen Seidman. I am a Senior Fellow at the New America
Foundation as well as Executive Vice President at ShoreBank.
My views are informed by my current experience, although
they are mine alone, not those of New America or ShoreBank, as
well as by my years at the Treasury Department, Fannie Mae, the
National Economic Council, and as Director of the Office of
Thrift Supervision.
In quick summary, I believe the time has come to create a
single well-funded Federal entity with the responsibility and
authority to receive and act on consumer complaints about
financial services and to adopt consumer protection regulations
that with respect to specific products would be applicable to
all and would be preemptive. However, I believe that prudential
supervisors, and particularly the Federal and State banking
regulatory agencies, should retain primary enforcement
jurisdiction over the entities they regulate.
Based on my OTS experience, I believe the bank regulators,
given proper guidance from Congress and the will to act, are
fully capable of effectively enforcing consumer protection
laws. Moreover, because of the system of prudential supervision
with its onsite examinations, they are ultimately in an
extremely good position to do so and to do it in a manner that
benefits both consumers and the safety and soundness of the
regulated institutions.
In three particular cases during my OTS tenure, concern
about consumer issues led directly to safety and soundness
improvements. However, I think the time has come to consider
whether the consolidation of both the function of writing
regulations and the receipt of complaints would make the system
more effective.
The current crisis has many causes, including an over
reliance on finance to solve many of the problems of our
citizens. Those needs require broader social and fiscal
solutions, not financial engineering. Nevertheless, there were
three basic regulatory problems.
First, there was a lack of attention and sometimes
unwillingness to effectively regulate products and practices,
even where regulatory authority existed. The clearest example
of this is the Federal Reserve's unwillingness to regulate
predatory mortgage lending under HOEPA.
Second, there were and are holes in the regulatory system,
both in terms of unregulated entities and products and in terms
of insufficient statutory authority.
Finally, there was and is confusion for both regulated
entities and consumers and those who work with them.
The solutions are neither obvious nor easy. Financial
products, even the good ones, can be extremely complex. Many,
especially loans and investments, involve both uncertainty and
difficult math over a long period of time. The differences
between a good product and a bad one can be subtle, especially
if the consumer doesn't know where to look. And different
consumers legitimately have different needs.
The regulatory framework, of course, involves both how to
regulate and who does it. With respect to how, I suggest three
guiding principles.
First, products that perform similar functions should be
regulated similarly, no matter what they are called or what
kind of entity sells them.
Second, we should stop relying on consumer disclosure as
the primary method of protecting consumers. While such
disclosures can be helpful, they are least helpful where they
are needed the most, when products and features are complex.
Third, enforcement is at least as important as writing the
rules. Rules that are not enforced or are not enforced equally
across providers generate both false comfort and confusion and
tend to drive through market forces all providers to the
practices of the least well regulated.
As I mentioned at the start, I believe the bank regulators,
given guidance from Congress to elevate consumer protection to
the same level of concern of safety and soundness, can be
highly effective in enforcing consumer protection laws.
Nevertheless, I think it is time to give consideration to
unifying the writing of regulations as to major consumer
financial products, starting with credit products, and also to
establish a single national repository for the receipt of
consumer complaints.
A single entity dedicated to the development of consumer
protection regulations, if properly funded and staffed, will be
more likely to focus on problems that are developing and to
propose and potentially take action before the problems get out
of hand. In addition, centralizing the complaint function in
such an entity will give consumers and those who work with them
a single point of contact and the regulatory body early warning
of trouble. Such a body will also have the opportunity to
become expert in consumer understanding and behavior, so as to
regulate effectively without necessarily having a heavy hand.
It could also become the focus for the myriad of Federal
activities surrounding financial education.
The single regulator concept is not, however, a panacea.
Three issues are paramount.
How will the regulator be funded, and at what level? It is
essential that this entity be well funded. If it is not, it
will do more harm than good as those relying on it will not be
able to count on it.
What will be the regulator's enforcement authority? My
opinion is that regulators who engage in prudential
supervision, whether Federal or State, with onsite
examinations, should have primary regulatory authority with the
new entity having the power to bring an enforcement action if
it believes the regulations are not being effectively enforced,
and having primary authority where there is no prudential
supervision.
And finally, will the regulations written by the new entity
preempt both regulations and guidance of other Federal and
State regulators? This is a difficult issue, both ideologically
and because there will be disagreements about whether the
regulator has set a high enough standard. Nevertheless, my
opinion is that where the new entity acts with respect to
specific products, their regulations should be preemptive. We
have a single national marketplace for most consumer financial
products. Where a dedicated Federal regulator has acted, both
producers and consumers should be able to rely on those rules.
The current state of affairs provides a golden opportunity
to make significant improvements in the regulatory system to
the benefit of consumers, financial institutions, and the
economy. If we don't act now, what will compel us to act?
Thank you, and I would be pleased to respond to questions.
Chairman Dodd. Thank you very much, Ms. Seidman.
Ms. McCoy?
STATEMENT OF PATRICIA A. McCOY, GEORGE J. AND HELEN M. ENGLAND
PROFESSOR OF LAW, UNIVERSITY OF CONNECTICUT SCHOOL OF LAW
Ms. McCoy. Chairman Dodd and members of the Committee,
thank you for inviting me here today to discuss restructuring
financial regulation. My name is Patricia McCoy and I am a law
professor at the University of Connecticut. I also had the
pleasure of living in Alabama where I clerked for Judge Vance
some years ago.
I applaud the Committee for exploring bold new approaches
to this issue. In my remarks today, I propose transferring
consumer protection for consumer credit from Federal banking
regulators to one agency whose sole mission is consumer
protection. We need this to fix three problems.
First, during the housing bubble, fragmented regulation
drove lenders to shop for the easiest regulators and laws.
Second, this put pressure on banking regulators, State and
Federal, to relax credit standards.
Finally, banking regulators often dismiss consumer
protection in favor of the short-term profitability of banks.
During the housing bubble, risky subprime mortgages and
non-traditional mortgages crowded out safer, fixed-rate loans.
Between 2003 and 2005, the market share of non-prime loans
tripled, from 11 percent to 33 percent. Over half of them were
interest-only loans and option payment ARMs. These loans seemed
appealing to many borrowers because their initial monthly
payments were often lower than fixed-rate loans, but they had
many hidden risks that many borrowers did not suspect. So
borrowers flocked to the loans with the lower monthly payments,
causing dangerous loans to crowd out the safer loans.
Conventional lenders then decided, well, if we can't beat them,
let us join them, and they expanded into dangerous loans, as
well.
Meanwhile, lenders were able to shop for the easiest laws
and regulators. There was one set of laws that applied to
federally chartered depository institutions and their
subsidiaries. There is a wholly different set of laws that
applied to independent non-bank lenders and mortgage brokers.
At the Federal level, of course, we all know that we have four
banking regulators plus the Federal Trade Commission. The
States add another 50 jurisdictions on top. Because lenders
could threaten to change charters, they were able to play off
regulators against one another. This put pressure on regulators
to relax their standards in enforcement.
For example, in 2007, Countrywide turned in its charters in
order to drop the Federal Reserve and the OCC as its regulators
and to switch to OTS. The result was a regulatory race to the
bottom.
We can see evidence of regulatory failure by the Federal
Reserve, the OTS, and OCC. As the Committee knows, the Federal
Reserve refused to exercise its authority under HOEPA to
regulate unfair and deceptive mortgages under Chairman
Greenspan. The Fed did not change its mind until last summer
under the leadership of Chairman Ben Bernanke.
Meanwhile, OTS allowed thrifts to expand aggressively into
option payment ARMs and other risky loans. In 2007 and 2008,
five of the seven largest depository failures were regulated by
OTS, including IndyMac and WaMu. In addition, Wachovia Mortgage
FSB and Countrywide Bank FSB were forced into shotgun marriages
to avoid receivership. By the way, none of this happened on my
colleague Ellen Seidman's watch. She was a leader in fighting
mortgage abuses when she was Director of OTS.
Finally, how about the OCC? During the housing boom, the
OCC allowed all five of the largest banks--Bank of America,
JPMorgan Chase, CitiBank, Wachovia, and Wells Fargo--to expand
aggressively into low-doc and no-doc loans. The results were
predictable. Today, as a result, the country is struggling with
how to handle banks that are too big to fail as a result.
Bottom line, when you look at all types of depository
charters, State banks and thrifts had the best default rates.
Federal thrifts had the worst, and national banks had the
second worst. Placing consumer protection with bank regulators
turned out to be no guarantee of safety and soundness. Having
it in a separate agency would counteract the over-optimism of
Federal banking regulators at the top of the credit cycle.
To fix these problems, we need three reforms. First,
Congress should adopt uniform minimum safety standards for all
providers of consumer credit, regardless of the type of entity
or charter. This should be a floor, not a ceiling. First of
all, that is necessary to make sure that the entity, the
regulator, does not have too weak of a standard. And second, we
have seen that States are closer to people at home and more
responsive to their problems.
Second, the authority for administering these standards
should be housed in one Federal agency whose sole mission is
consumer protection. This agency could either be a new agency
or the Federal Trade Commission. All responsibility for
oversight of consumer credit should be transferred from Federal
banking regulators to this agency.
And then finally, to avoid the risk of agency inaction,
Congress should give parallel enforcement authority to the
States and allow consumers to bring private causes of action to
recover for injuries they sustain.
I would be glad to take any questions. Thank you.
Chairman Dodd. Well, again, I thank our witnesses for their
very excellent testimony and thoughts this morning.
We have been joined by Senator Bennet of Colorado, as well.
Michael, thank you for being here with us this morning.
I have a series of questions. I will put a 5-minute clock
on each of us up here. Actually, given the numbers we have, we
can engage, and I would invite, by the way, if I raise a
question with one of you and the other two would like to
comment on it, that you please do. This is a very important
discussion we are in the process of undertaking. In many ways,
while we have had obviously a number of witnesses before us,
including Paul Volcker and others, in many ways, today, the
three of you are representing some ideas that really are far
more specific than things we have heard, so I would invite the
kind of conversation back and forth that could help us, even in
a formal hearing like this, which is always a little more
difficult.
Let me begin, if I can, with you, Ms. Seidman. You note
that while you were at OTC, there were situations when, I am
quoting, ``a concern about consumer issues led directly to
safety and soundness improvements.'' You also note that
compliance has always had a hard time competing with safety and
soundness for the attention of regulators. If we do not create
a separate consumer protection regulator, how do we ensure that
consumer protection will be given equal standing and attention?
Ms. Seidman. I appreciate that dichotomy and I obviously
put it in the testimony on purpose. I believe that there is a
difference between writing the rules and enforcing them, and
with respect to enforcement, I think that not only is it
extremely valuable for the banking regulators to have
responsibility for enforcing consumer protection laws, but as
Mr. Bartlett has said, that can lead to safety and soundness
improvements and it certainly did during my tenure at OTS.
On the other hand, I will say that the writing of
regulations on consumer protection issues is something that I
found incredibly difficult when I was at OTS. There were any
number of times where we wanted to move and we couldn't get the
other three, or the other four regulators--either three or
four, depending on whether the credit unions were in or out--to
move with us. There were times when we wanted to take action
and it was really hard to find the statutory authority on the
consumer protection side because many of the consumer
protection laws are written very, very specifically. They are
sort of ``thou shalt not'' rules. Payday lending was a major
example of that.
And so I think that we need three things. One, I think it
really would be useful to establish a separate regulator to
write the rules, and whether it is the FTC expanded or a new
agency I think is definitely worth a serious conversation.
But I do think that we will benefit on both the safety and
soundness side and the consumer protection side by leaving the
initial enforcement authority, the primary enforcement
authority, with the bank regulators where they have prudential
supervision. The results of prudential supervision may not be
perfect, but they are better than a complaint-based system
where there has to be a lot of bad acting by a single entity
with a lot of consumers who realize they have a problem and
take the time to complain in order to get cases going. So I
think we shouldn't throw away the prudential system.
But the final piece is, I think if Congress is serious
about consumer protection, and certainly this Committee is, it
is time to amend the National Banking Act, amend HOLA, change
the basic banking laws to say that consumer protection and
making the financial system work for consumers is a critical
element of our banking system.
Chairman Dodd. Yes. Steve, let me say, you in effect are
positioned here on the table, ironically, in a way in which you
represent three different models that we are talking about.
Ellen was the middle model. The question for you is, you heard
me say in my previous question that compliance has always had a
hard time competing with safety and soundness for the attention
of regulators. I don't think there is much debate about that.
I think most would probably agree with that statement, and
history over the last 5 years certainly underscores that point.
The Federal regulators clearly put consumer protection on the
back burner, acting only well after it was too late to avoid a
catastrophe, and even then, I might add, over the objections of
many that we do anything at all.
In the face of all the evidence, how do you conclude that
keeping prudential and consumer regulation together won't
simply result in consumer regulation continuing to be on the
back bench here, as we have seen in the last 5 years?
Mr. Bartlett. Mr. Chairman, Lyndon Johnson used to have a
saying when he was Senate Majority Leader, and I will
paraphrase it for this Committee: ``Grab them by the throats
and their hearts and minds will follow.''
[Laughter.]
Mr. Bartlett. The fact is the prudential regulators, it is
the supervisors that have them by the throats, that have the
ability to get the attention with a cease and desist order and
a requirement, and worse, in a receivership. So if you separate
the power and the mandate to protect the consumers away from
the grabbing them by the throat, well, at best, it will be the
two different sets of regulators will give conflicting goals
and one of them will be advice, the other one will be the
throat. Or at worst, we would continue to have the system in
which the consumer protection is ignored and it is only safety
and soundness.
I have to say that we are not advocating the status quo. We
are not at all advocating that we just continue what we have
been doing. We are, by contrary, advocating that we provide the
specific and clear mandates for consumer protection, the
mandates for enforcement, and then to consolidate the agencies
so that these agencies that have them by the throats have the
ability to enforce those, all of the sets of regulations.
And then I guess last is safety and soundness and consumer
protection are mirror images of the same thing. The ability to
repay or documentation is both a consumer protection and it is
also a safety and soundness protection.
Chairman Dodd. Ms. McCoy, that is a pretty good argument.
You are a law professor and have debates like this in your law
school. We have had similar debates over the years in Congress
on matters not relating to financial services, but in the area
of consumer protection. There has been a strong argument that
because the traditional regulators were not doing their job,
there should be a Consumer Protection Agency in place to insist
they do their job.
The counter-argument was, well, they already should be
doing their job. The fact that they were not doing it doesn't
mean they shouldn't be, and therefore we ought to empower them
to do it rather than creating yet a separate agency that would
end up with the kind of potential conflicts that Steve just
talked about. What is the answer to that?
Ms. McCoy. Well, for the most part, they are empowered to
do it, and what we saw over the past six or 8 years was a
prolonged failure to exercise that power. I have been spending
the last few months looking at the enforcement record of the
three agencies I described, and I found with the OCC, the
Federal Reserve, and OTS a distinct reluctance to bring formal
cease and desist orders or anything stricter. In fact, in
autopsies of failed institutions, generally what the regulators
were doing at most--at most--was negotiating some sort of
voluntary agreement with the banks' management. There were
usually protracted delays in negotiating that agreement and
over that period more lax lending happened and the banks slid
toward insolvency. So while the regulators have the ability to
hold the banks by the throats, they are distinctly reluctant to
exercise it.
With respect to Ms. Seidman's proposal, she and I, I think,
are 95 percent in agreement. The two places where we have some
difference are whether the enforcement authority should be
consolidated strictly in this separately consumer product
regulator or should be parceled out between the Federal banking
regulators and this other regulator.
My one concern there is if we parcel out the compliance
examinations and other enforcement, leaving enforcement with
Federal banking regulators for banks, that there still will be
this opportunity to shop for the agency with the weakest, most
accommodating enforcement posture.
Now, one way, if we go with that model, to try to
counteract that is to give this separate consumer protection
agency the independent ability to institute enforcement if it
feels that a Federal banking regulator is lax, so that it would
not have to wait for the regulator to act.
Chairman Dodd. Well, those are great answers and I
appreciate it very, very much. It took a long time just on that
one, but let me turn to Senator Shelby because I have overrun
my time already.
Senator Shelby. Thank you, Mr. Chairman.
Professor McCoy, I know you had not only good leadership
under Robert S. Vance, the late judge who was tragically
murdered----
Ms. McCoy. He was my hero.
Senator Shelby. That is right, but he was also very
exacting, was he not?
Ms. McCoy. Yes. I can attest to that.
Senator Shelby. Sure. Enforcement failures--I will ask you
this first question--many have suggested, Professor McCoy, that
the Federal Reserve should have acted much sooner under its
Home Ownership Equity Protection Act rulemaking authority to
regulate the conduct of all parties originating mortgage
products. Are there other areas where you believe that the
Federal banking regulators could have acted but failed to act
to either draft rules or appropriately enforce rules that it
promulgated?
Ms. McCoy. Yes. So first of all, also with respect to the
Federal Reserve, the Federal Reserve, of course, has
jurisdiction over the Truth in Lending Act and it still
astonishes me that to this day, the Fed has not updated its
TILA rules on closed-end mortgages. It turns out that TILA
disclosures just didn't work well for risk-based pricing. The
Federal Reserve issued a report----
Chairman Dodd. ``TILA'' is Truth in Lending, just so the
record is clear.
Ms. McCoy. Yes. My apologies. It is lawyer lingo. The
Federal Reserve actually wrote a report in 1998 diagnosing this
problem, but here we are 11 years later. It hasn't fixed it.
That is one thing.
The other Federal banking regulators also had authority
under Section 5 of the Federal Trade Commission Act to regulate
unfair and deceptive acts and practices. Their rulemaking
authority was somewhat limited. I think that needs to be
addressed. But they had full enforcement authority, and again,
as I mentioned, they failed to exercise it.
Senator Shelby. Well, that is troubling to me and I think
to Senator Dodd, too, as we look toward a regulatory process
that will work. The role of the Fed seems to have been a role
of failure in a lot of instances as far as the regulation. They
have been the regulator of a lot of things, especially our
largest banks, and I think the question arises, where were
they? Did they know what the banks were doing? Did they know
the risk they were taking? Obviously, they didn't.
Competition among regulators--the OCC and the OTS are
funded by assessments on the institution that they regulate.
Professor McCoy raises the possibility of regulators lowering
their enforcement standards in order to attract more
institutions to their specific charter. Specifically mentioned
in her testimony is the long-term decline in the number of
thrift institutions.
Ms. Seidman, during your tenure as the OTS Director, did
the OTS lower enforcement standards in order to maintain or
increase the number of financial institutions that you
supervised, and do you believe it is appropriate for financial
regulators to be funded by assessments on the institutions that
they regulate?
Ms. Seidman. First of all, the answer to the first question
is no, and I----
Senator Shelby. OK. How about the second question?
Ms. Seidman. I worked very hard to discourage charter
shopping.
Senator Shelby. OK.
Ms. Seidman. As to the second question, Jerry Hawke, who
was the Comptroller part of the time that I was at OTS, and I
spent quite a while attempting to shop the notion that OTS and
the OCC should not, in fact, be funded by the industries and
that instead there should be some way of funding them through
the Deposit Insurance System as the FDIC is funded.
I think the issue of the industry funding government
agencies is a difficult one under all circumstances, but it is
an especially difficult one where there is not a monopoly. You
know, we do have the agriculture industry to some extent
funding the agriculture inspections and the pharmaceutical
industry to some extent funding the FDA. But there is only one
FDA. There is only one Department of Agriculture.
Senator Shelby. The role of securitization in consumer
protection generally--many argue that the securitization market
lessens the incentive for financial institutions to make
prudent loans based on a borrower's ability to repay. The
rationale was simple. So long as the loans did not sit on the
balance sheet, then the financial institution no longer carried
the risk.
Do you believe that realigning the incentive structure to
give everyone within the securitization chain a stake in the
loans' performance would greatly enhance consumer protection,
or would it compound it? I want to ask Professor McCoy first.
Ms. McCoy. Senator Shelby, thank you. This is a really
critical question and the answer is yes. The basic problem
which you put your finger on was the ability to shift risk to
entities down the line, and so we need to make sure that every
participant in the securitization process has skin in the game,
and that can be through capital and also prudential regulation.
In the end, we need to make sure that investors have an
incentive to put pressure on investment banks to do proper due
diligence and to have full, honest disclosures.
My proposal for doing that is carefully crafted assignee
liability that gives the investors incentives to put pressure
on the investment banks to do their job right. We have seen
from the State experience that this does not reduce loan
volumes. I am working with economists. We have empirically
tested that. It does not reduce access to credit because if it
is carefully crafted, it can be priced into the loan. So it is
eminently doable and a very good idea.
Senator Shelby. Ms. Seidman, do you have any comment on
that?
Ms. Seidman. I also agree that one of the critical elements
is that people need to have skin in the game, and Pat's
assignee liability proposal is one that I have looked at and I
would support.
I would point out two other things. Pat mentioned this
really briefly, but the capital rules are also absolutely
critical here. To the extent that institutions were not
required to hold capital against loans that they thought they
had gotten rid of but, in fact, came back to them, that just
encouraged more of that kind of origination for sale. We need
to deal with that issue. And as Steve mentioned, we need to
deal with it in a manner that is counter cyclical, not pro
cyclical.
And finally, I think that this is where the very tough
issue of compensation also comes into play.
Senator Shelby. Steve, do you have any comments?
Mr. Bartlett. I think skin in the game or risk retention is
an essential part of the set of reforms, not the only part, of
course, but it is essential. It has to be combined with
systemic risk regulation, which is currently done de facto but
not de jure, so the Federal Reserve has sort of assumed
authority, but not necessarily statutory authority. So we think
that systemic risk regulation ought to be combined with risk
retention in some form.
Senator Shelby. Mr. Bartlett, in your draft financial
regulatory architecture, you envision giving the Federal
Reserve veto power over pro cyclical actions by FASB. Wouldn't
giving the Federal Reserve this sort of power undermine the
function of accounting standards, which are intended to provide
investors with transparency? How do you explain?
Mr. Bartlett. We think that accounting standard should give
the investors transparency and strength and we think that is
not happening right now in the case of fair value accounting.
So in some part, our call for the Fed to help is out of
desperation because all of the Federal agencies at this point,
individually and collectively, are telling us that it is
somebody else's problem and yet it is that misapplication of
fair value accounting that is a large source of the current
liquidity crisis portion of the crisis. So perhaps my call for
the Fed to do it is just simply knowing that somebody has to do
it and so we are looking for help.
Ms. Seidman. Can I respond briefly to that, too?
Chairman Dodd. Certainly.
Ms. Seidman. I think that calling for counter cyclical
capital regulations now turns into a conversation about fair
value accounting. But 6 or 8 years ago--8 years ago, the
question being asked was about loan loss reserves. In Spain,
where their banking system has gone through a bubble and not
been in as much trouble as ours, the loan loss reserves are
required without particular reference to historical conditions.
The banking regulators worked really hard to try to get the SEC
to understand that bankers make more loans in good times and
then those loans go bad in bad times and that we really need to
have far greater loan loss reserves than historic experience,
particularly with untested products, which is what the subprime
mortgages were.
Senator Shelby. By loan loss reserves, you talking about
capital, aren't you?
Ms. Seidman. Well, you know, loan loss reserves are the
first line of defense and capital is the second, and frankly,
if we can increase the loan loss reserves to the point where
the combination is counter cyclical, that will do.
Chairman Dodd. Those are good points, good questions by the
former Chairman, as well.
Let me turn now to Senator Merkley.
Senator Merkley. Thank you very much, Mr. Chair, and I
appreciate the diversity of models that you are presenting for
us to wrestle with.
I wanted to present one specific issue and see how you
might view that issue and how it might fit into the different
models you are presenting, and that is the issue of steering
payments. It has been an item of concern to me that consumers
by and large have enormous protection in terms of conflict of
interest when they go to a real estate agent. It is very
clearly declared whether that agent is working for the buyer or
for the seller, all kinds of disclosure. When they turn around
and go to a broker, very few consumers realize that that broker
whom they are paying and who is giving them advice that they
think they are paying for is also being paid secretly, that is
not on the settlement sheet, to provide--paid different amounts
according to what type of loan they sell, and often the
incentives are all for the broker to sell an expensive loan
that is not in the interest of the consumer. But it is really a
consumer, a lamb to the slaughter, if you will, because they
aren't aware of this fundamental conflict of interest in that
transaction.
This is an issue States have tried to wrestle with but
really have been prohibited from dealing with except with
State-chartered institutions, which creates a distinction at
the State level between State and federally chartered groups.
So there is always the advocacy to do it at the Federal level.
So if each of you could take your model and say, one, do
you consider steering payments to be a problem? Second, how do
you envision that the regulatory regime you are proposing would
tackle such an item? And maybe we will just start in the order
that the testimony was given.
Mr. Bartlett. Thank you, Senator. Senator, we have long
called for the national licensing and regulation of mortgage
brokers, not as a way of casting blame, but just simply to say
that they are the front end of it.
Second is we believe that there should be a system within
that national license for some type of a retention of risk by
the brokers. Currently, the system of payment is that brokers
get paid--and they should get paid, but they get paid for
creating a loan or selling a loan, whether it is a good loan or
a bad loan, and we think that is a misguided compensation.
Third is that we believe that the originators, as the
Chairman said, I believe it is 58 percent of all subprime loans
were originated by non-regulated entities, but the originators,
regulated and unregulated, should accept the responsibility for
accepting a good loan and then should they sell those loans in
a securitized model, the securitizers should accept the
responsibility for those being good loans. So it is
responsibility up and down the chain, but beginning with the
brokers when that is appropriate.
Senator Merkley. Just before I go on, would you envision,
then, all the power occurring at the Federal level in this
framework or giving any alternative power to the States to
enhance----
Mr. Bartlett. No. We believe in the dual banking system in
the sense that there should be State-chartered banks. But the
power of actually insisting that the system be regarded as a
system has to come from the Federal level, of which the States
have a big role. But the system itself, it is an interstate
system. It is a national system, so it should be thought of as
a national system with uniform standards.
Senator Merkley. Thank you.
Ellen?
Ms. Seidman. By steering payments, I assume among other
things you mean yield spread premiums. I believe, having
wrestled with the problem of yield spread premiums, that the
right answer really is to get rid of them, that disclosure
isn't sufficient. There have been proposals that say, well, you
should just disclose it. The Fed actually tried that and then
backed off because they came to the conclusion that no consumer
could understand the disclosure. They, of course, then didn't
take the next step, which would have been to ban them.
An alternative which I think is a partial solution but
probably not the full solution here, but a good solution in
general, is that it is time to put a fiduciary responsibility
on brokers. At the very least, that creates the legal
responsibility to behave in the best interest of the consumer.
I think Steve's point and the point we have all made about skin
in the game with respect to compensation is also important.
In terms of how this would work in the system that I
proposed, the single regulator would face the issue and make a
decision about whether these payments should be banned or
should be disclosed or make the relevant decision, and then the
enforcement would be in the case of the banks with their
prudential supervisors, in the case of mortgage bankers in
Massachusetts, who are subject to prudential supervision with
the Massachusetts regulator, and otherwise the primary
jurisdiction would be with the single Federal entity.
Senator Merkley. Thank you.
Ms. McCoy?
Ms. McCoy. Senator, I have personal experience with this.
Back in 2003, when I applied for a mortgage to buy my house in
Connecticut, I walked in with complete copies of my pay stubs,
tax returns, my new contract, my job contract, and the broker
said, oh no, we will put you in a no-doc loan. So I walked out.
But I later got the rate sheet from the lender which showed
that the no-doc loan would have paid a higher YSP, yield spread
premium, to that broker.
So in my mind, this is a legalized kickback and we need to
ban it. Probably broker compensation needs to be a percentage
of loan principal and also the full payout of that commission
should probably be linked and to urge appending good
performances alone.
I agree that a fiduciary duty should be placed on brokers
and we need to seriously think about higher capital
requirements for brokers because they have very, very little
skin in the game today.
Finally, the responsibility for administering this under my
plan would be with the consumer credit regulator. Thank you.
Senator Merkley. Thank you very much, Mr. Chairman.
Chairman Dodd. Thank you, Senator, very much.
Senator Bennet?
Senator Bennet. Thank you, Mr. Chairman. I appreciate it.
Ms. Seidman, you mentioned earlier in passing that even
good products are complex or can be complex, which is true in
these markets, and good products being ones that actually are
collateralized, that actually have some value. When we are
thinking about how to create a regulatory structure and a
bureaucratic structure that makes sense, on the one hand, there
is the issue of wanting the capital markets to be inventive,
wanting to be able to lower costs for people that are in their
homes and borrowing money or other kinds of things, and on the
other hand we find ourselves in a place where we securitized--
we didn't, but all these loans were securitized. The bad
products became very complex as well as good products and it
inspired lots of, or incentivized a lot of behavior that
probably wouldn't have happened otherwise because the market in
some sense was insatiable and people started to say, well, we
don't need to do 70 percent loan to value anymore, let us do
100 percent, just to create a take-up, or a product for that
take-up.
And I wonder what the implications of all of that are for
thinking about the bureaucratic design here so that we can
allow the markets to continue to invent, on the one hand, but
on the other hand say, is there a degree of complexity that we
simply can't sustain or that the regulators will never catch up
to, or--I am sorry for the long-winded question--or does it
imply something about who needs to be in the room to pass on
whether these structures actually make sense or not, these
structures being these products?
Ms. Seidman. I think that this current situation is really
forcing us to take another look at the question of whether
innovation and complexity in consumer financial products is
something that we ought to value. It is not to say that
everybody should have a 30-year fixed-rate mortgage. There are
certainly situations in which a 30-year fixed-rate mortgage is
not the best instrument for the consumer. And it is not to say
that some good products like savings bonds aren't inherently
complex. They are. They are extremely complex. But I do think
that the notion that allowing continuous redesign and
complexity is a good thing needs to be reevaluated.
I do think that there are some suggestions that have been
made recently about how to sort of come in the middle. The
default product suggestion that I mentioned in my testimony is
one of them. There would be a standard, relatively simple
product that was the product that needed to be offered first in
all situations, to avoid the situation that Pat's broker tried
to get her into. If a consumer nevertheless decided to buy one
of the non-default products, the seller's ability to enforce
the contract would be subject to the seller having to prove
that whatever disclosures they made initially were
understandable to a reasonable man, which is your classic legal
standard.
I would prefer a system of standardized contracts, but I
think that at least in certain areas like mortgages, we
probably need multiple standardized contracts in order to cover
the waterfront.
Senator Bennet. Does anybody else have a comment on that?
Mr. Bartlett. Well, Senator, it is awfully tempting, given
the crisis that we are in now, to sit around this table and
say, well, let us design the financial products and we will
have three of them, but that would be a disaster for the
American people, if not in the short-run, at least in the
medium-run. Innovation does help consumers. That is why it is
innovative.
That is not to say that nothing should happen. In fact, I
am calling for some massive additional more effective
regulation to regulate the standards, responsibility, accepting
the responsibility and accountability both by the agencies and
by the companies, uniform national standards, and a system of
enforcement. But the idea to then convert over to a system
where the government simply in whatever form designs what a
financial product should look like, I think would do a great
disservice, both in the near-term and the long-term.
Senator Bennet. Mr. Chairman, that is not what I am
suggesting, but I think that even the most simple products, in
some respects, at the consumer level, I think what we are
seeing now is that in their aggregation and in the secondary
markets into which they are sold, there is a level of
complexity at that point that has, at the very least, created a
lack of transparency about what is going on on the balance
sheets of our major banks, and in the worst cases helped
contribute to where we are. I think I am just trying to, with
the other Committee members, figure out what we can do to
redesign things so that we don't find ourselves here again, not
to rewrite these rules.
Professor McCoy, just one question. You mentioned this in
your testimony, both written and spoken. I just wanted to come
back to it. Tell us a little more about--and you proposed
setting up a separate agency for consumer protection. But one
of the reasons for that is your observation that you think
there has been a reluctance on the part of the existing
regulatory agencies to exercise their enforcement authority.
Can you talk more about where you think that reluctance springs
from?
Ms. McCoy. I think there are various sources. One is this
longstanding bank regulatory culture of dialog and cooperation
with regulated banks. It may, in fact, be that the reluctance
to bring formal enforcement action is part of a longstanding
tradition of secrecy, lack of transparency in bank regulation
due to fears about possible runs on deposit. But what we have
ended up with is an enforcement system that is entirely opaque.
It is very, very difficult to see what is happening behind the
curtain.
One other thing I failed to mention was that the late
Governor Gramlich in 2007 stated that the Federal Reserve had
not been doing routine examinations of the mortgage lending
subsidiaries that were under its watch. It was not going in and
examining at all except in emergency situations. Thank you.
Senator Bennet. Thank you, Mr. Chairman.
Chairman Dodd. Thank you, Senator. Very good.
Senator Schumer?
STATEMENT OF SENATOR SCHUMER
Senator Schumer. Thank you, Mr. Chairman. Thank you for
holding this hearing, and unfortunately I got here a little
late, so I am going to take a little bit of my time and read my
opening statement, if you don't mind.
And I want to thank you and Senator Shelby for holding this
hearing. I think this hearing is really important. We have a
great economic crisis in our country and it extends from one
end to the other. We have had an explosion of consumer debt.
Now we have 12 million households that owe more on their
mortgages than their house is worth. The average American
family has over $8,000 in credit card debt. Mortgages and
credit cards are ordinary features of middle-class life and now
they are at the heart of our financial crisis. Something went
awry, seriously awry.
During the 1980s, I worked to pass legislation that would
require disclosure on credit card terms, the ``Schumer box,''
and it had a real effect. But it doesn't do enough now, because
disclosure isn't enough, and when you hear of banking
institutions just raising the rates, boom, for some small
almost induced mistake, you say, well, we need more, and I know
that Senator Dodd, Senator Menendez, and I have been working on
credit card legislation.
But the deceptive practices, the predatory practices, we
have seen them in the mortgage industry. The Federal Reserve
was in charge of all this and did nothing. Home buyers were
enticed and misled, sometimes by banks, sometimes by
independent mortgage brokers, more often by the latter, but
there is a serious problem.
And so I would say complexity ultimately stacks the deck in
favor of the financial experts who peddle the products at the
expense of the consumer. So again, I am not trying to point
fingers of blame here. I am trying to correct the situation.
In the early 1900s, Congress created the Food and Drug
Administration to protect consumers from peddlers of medicinal
concoctions whose miracle elixirs did more harm than good. In
today's world, we need a comparable response to peddlers of
unfair and deceptive financial practices and services.
And I would just say to Mr. Bartlett that all too often,
they don't come only from major banking institutions or
financial institutions. They come from everywhere.
So this week Senator Durbin and I plan to introduce
legislation to create a new regulator to provide consumers with
stronger protection from excessively costly and predatory
financial products and practices. The idea for a Financial
Product Safety Commission was first proposed by Elizabeth
Warren, professor at Harvard, in 2007. She recognized that
substantial changes in the credit markets have made debt far
riskier for consumers today than a generation ago and that
ordinary credit transactions have become complex undertakings.
Consumers are at the mercy of those who write the contracts,
and simple disclosure--it is never simple anymore because the
terms are so complicated--it doesn't do the job.
So consumers deserve to have someone on their side, a
regulator that will watch out for the average American, who
will review financial products and services to ensure they work
without any hidden dangers or unreasonable tricks. So the time
is right for a financial services regulator with consumer
focus. Professor Warren and consumer groups--CFA, Consumers
Union, Public Citizen, Center for Responsible Lending--have
been instrumental in helping develop the objectives and
responsibilities of such a regulator and I appreciate their
efforts.
I also think we have got to think beyond regulatory reform
of the financial system. We need to think about a new way to
live, because what has happened basically over the last decade
and a half is we became a country that consumed more than we
produced, borrowed more than we saved, and imported more than
we exported. Something has to give. And I would say the
greatest challenge President Obama has after he gets us out of
this financial mess is to figure out how we get back to those
traditional values.
We have seen it up and down the line. There are the CEOs
and their salaries. We all know about that, excessive, huge,
based on the short-term. We have seen it here in government
with all the deficits. And we have seen it with individuals who
get into debt far beyond their means. So it has been a whole
societal problem that we have to do something about.
The proposal that Senator Durbin and I are making is one
part of that, but there are lots of other parts, and I thank
you all for listening. I particularly want to thank both Ellen
Seidman and Professor McCoy for arguing for this kind of thing.
Do I have time for one question, Mr. Chairman? Is that OK?
Chairman Dodd. Yes.
Senator Schumer. OK. My question is to both Ms. Seidman and
Professor McCoy about this new agency. How would you propose it
be funded? Should there be some kind of user fee, whether on
the lender or the borrower? And how do you think enforcement
ought to be done? Should it be done by the agency itself, by
attorneys general, by the Justice Department? I will let Ellen
Seidman answer first, and then Professor McCoy. And I won't ask
Steve Bartlett because he probably does not support such an
agency.
Ms. Seidman. Thank you, Senator Schumer. As I said in my
testimony, I think the critical thing is that this entity be
well funded. My preference, just because I think it has
something to do with honesty in budgeting, is that it be funded
through appropriations rather than by user fees. If it were
funded by user fees, it would be very good to be able to come
up with a system something like the SEC's--actually, not the
way the SEC is, the way the SEC brings in money. As we all
know, it only gets a part of that to use.
Senator Schumer. Yes.
Ms. Seidman. But an automatic, very small tax on
transactions rather than by an entity kind of funding.
In terms of enforcement, I believe that where there is
prudential supervision, it would be a mistake to throw it away
with respect to consumers. So I think where there is prudential
supervision, the primary enforcement entity should be the
prudential supervisor. I think where there is not, the new
entity ought to have the primary jurisdiction and it should
have the back-up jurisdiction on its own motion. I mean, it
would just have to make a finding with respect to the
situations where there is prudential supervision.
Senator Schumer. Right. Sort of like the FTC a little bit?
Ms. Seidman. A little bit.
Senator Schumer. Professor McCoy?
Ms. McCoy. Thank you. The key thing that we are trying to
fix here is regulatory arbitrage, this ability to shop for lax
enforcement. If we consolidate both rulemaking and enforcement
in this one agency, then I am comfortable with the funding
model that Ms. Seidman proposed. If we parcel out enforcement
among Federal banking regulators plus this other agency, we are
going to have this same shopping phenomenon go on and then
funding through assessments is going to become problematic and
we will have to look at an appropriations model. So I think the
two are linked. If you consolidate it in one agency, you stop
the shopping problem and then you can have a user fee approach.
Senator Schumer. Thank you, Mr. Chairman. Thank you both.
Chairman Dodd. Thank you, Senator, very much.
Let me say, if I can, and some of these questions have been
asked, that we have talked a lot about the brokers and the lack
of regulation at that level of the chain. In fact, I remember
at a hearing we had here, I think Senator Shelby and Senator
Schumer will remember, we had displayed the Web site of the
brokers at the time--this was back about 2 years ago--and on
the Web site, the first rule was, convince the borrower you are
their financial advisor. That was the first rule. And, of
course, that was fairly easy to do in Committee ways. You are
talking about people who are relatively unaccustomed to all of
this.
I was with a group of bankers not long ago and I asked them
a question I suppose all of us ask ourselves any time we have
been to a closing. How many times do we find ourselves with the
lawyers there with the tabs and sign the tabs and we don't find
ourselves reading everything. We assume that these things are
pretty boilerplate, standardized stuff and accept it for what
it is.
And so the idea that there is this level playing field
between the borrower and the lender, any more than there is
between the patient and a physician in cases of medical
malpractice, is questionable. Obviously, the borrower and the
patient have responsibilities. That is not to suggest they
don't have any, but the suggestion somehow that they are both
equal in terms of that moment of bargaining is, I think,
something that most of us--all of us--would recognize as being
unrealistic.
I am interested in, and this is a point that Professor
McCoy made, why we have focused largely on the problem at
origination. Professor McCoy, you lay out in your testimony the
role played by Wall Street. Essentially, you argue that it was
the demand for product to securitize that drove the lending
standards down, not the other way around. And I wonder whether
or not you, Ms. Seidman, would agree with that and how you feel
about that, Steve.
Ms. Seidman. I think both work. The collapse of the
subprime market was the trigger here, but the fact that there
was a gigantic bubble to break happened because of the
investment side demand. Who knows what other products would
have been created to fill that demand if the mortgage products
hadn't. The mortgage products had a big advantage. They were
regarded as extremely safe and producing rates of return that
were significantly higher than Treasuries. And, of course, back
in the 1990s, mortgage products were extremely safe and
produced higher returns than Treasuries.
So I think both were definitely part of the problem and
that if we had just had lax consumer protection without the
investment side, we would have had a problem for a lot of
consumers, but we probably wouldn't have had a global
international crisis.
Chairman Dodd. Steve, how do you----
Mr. Bartlett. Mr. Chairman, I am here to posit for systemic
reform and systemic regulation and for comprehensive reform. So
to use your example in the case of the mortgage base, yes, the
mortgage brokers were a significant part of the problem, but
that doesn't eliminate the responsibility from the other parts.
Then the originators, say what you will, the originators
originated the loans, and they originated in many cases in the
subprime markets bad loans for them and bad loans for the
borrower. But at that point, some of those originators had
regulators, 42 percent. Those regulators in many cases noticed
that those were, quote, ``bad loans,'' what you and I would
call bad loans, but they either didn't have or didn't believe
they had the authority to say, therefore, you cannot originate
those loans. They believe they only had the authority to say
you couldn't own them, and so the originators said, OK, we
won't own them. We will sell them upstream.
And then there was no nexus, or there was a huge gap in the
regulatory structure of no one from the originator, or
supervising their originator, had any ability to talk to anyone
on Wall Street who was buying the loans to say, that is a pool
of bad loans, and yet it was sort of--it was clear. I mean, it
was not as opaque as we like to make it out to be. There was
transparency within those pools. So the pools were formed
consisting of some number of bad loans and then sold to buyers,
unregulated, and then those buyers then relied on mortgage
insurance backed by the State insurance commissioners, both
unregulated and not talking to each other.
So there were literally hundreds--are, not were--are, in
real time today, are literally hundreds of regulatory agencies
that are each regulating individual toenails of the elephant
while the elephant is stomping all over us. So the problem is
the lack of systemic regulation. I have heard some talk about a
twin peaks theory, and it is not twin peaks. It is multiple
flagpoles, if you will, where people are sitting on the top of
the flagpoles and there are more gaps between the flagpoles
than there are the pillars of the regulation of the flagpoles.
So it requires systemic, uniform national standards among
them, and each of the pillars taking responsibility for their
piece, but also a systemic regulation taking responsibility for
the entire system.
Chairman Dodd. That is a good point.
Ms. McCoy, in your testimony, you raised a subject that I
find interesting and I would like to get your co-panelists to
respond to this. You called a light touch regulation by the OTS
and the OCC, whereby most enforcement actions are done behind
closed doors, privately through negotiations without any public
knowledge. Would you describe the process to us and why you
find this informal process inadequate, and would public
disclosure of such actions create more accountability for
regulators and give other institutions a signal of what kind of
behavior is unacceptable?
And the other side obviously is that you have got to have
some gradation, I suppose, in all of this between what may be a
minor infraction of some kind and a larger. But that debate
about the light touch, the privacy, if you will, and not the
public accountability, which can have its own--if you know
something else has gone on, then other institutions start
taking a closer look at what they are doing themselves. So that
is an interesting point I thought you raised.
Ms. McCoy. Sure. So with the light touch regulation, it had
two major components. One was a preference for guidances rather
than binding rules. Now, the banks were supposed to follow the
guidances, but what I have been doing is going into securities
filings of major banks after the issuance of each guidance to
see if they are reporting continuing making loans that violate
the guidances, and with most of the major five banks, I did
find disclosures showing violations. And in some cases, they
continued all the way until 2007. So apparently regulated
banks, including ``too big to fail'' banks, felt that they
could ignore guidances. So part of light touch is avoiding
rules, guidances, and in my mind, it doesn't work.
The enforcement side is relying on examinations and
informal enforcement, which usually consists of these
negotiated agreements and which are done on a confidential
basis so that it is impossible on a real-time basis for me or
any other researcher outside to know what is happening. I can
only find that out if there are inadvertent press releases or
if an institution fails afterwards.
And we saw that, at least with the Federal Reserve, that it
didn't do the examinations at all. We saw with the three
agencies I mentioned that they were extremely reluctant to take
any public formal enforcement action, and whatever informal
action they took was really delayed, in some cases literally
just days before the FDIC seized the institution, because the
negotiations were drawn out.
And I will just close by saying we saw this exact same
pattern during the S&L crisis. It is not new. Thank you.
Chairman Dodd. But is the complaint-driven process better?
Ms. McCoy. The complaint-driven process, I think needs to
be augmented with registration of all market actors and regular
reporting. One of the problems that the FTC has in its
complaint-driven process is a lack of information on a periodic
basis from regulated institutions about what they are doing.
And it seems to me that I would prefer to go with the SEC
model, where you have registration, you have periodic
reporting, and you have the ability based on that reporting to
go in at any time to do an examination.
One thing that I left out of my voluminous written
testimony was I would also have a self-regulatory organization
for the industry akin to FINRA. I think FINRA is an excellent
supplement to the SEC's enforcement power and I would strongly
urge the Committee to look at a model that includes a mandatory
SRO.
Chairman Dodd. Thank you very much.
Senator Shelby?
Senator Shelby. Thank you.
If we make bad loans and they are securitized, you don't
have bad securities. That is a given, is it not? And that is
where we are today, isn't it?
Ms. Seidman, the suitability standard for credit products,
in your written testimony, you state, quote, ``the difference
between a good product and a bad one can be subtle, especially
if the consumer doesn't know where to look.'' You then
suggested that perhaps a suitability standard such as the one
used in the securities arena should be fashioned for consumer
credit transactions. Who would be the person charged with
carrying out that standard? Would it be the loan officers in a
bank? How would this apply to credit card transactions and so
forth? And how would the regulators enforce this provision?
Ms. Seidman. I think--first of all, with respect to
mortgage lending, most mortgage lending, particularly purchase
money mortgages, is still done on a face-to-face basis and I
see no difference in terms of the responsibility that a loan
officer or a broker or somebody else would have with respect to
the suitability of a mortgage product compared to the
securities side. In fact, it is probably the case that the
originator of the mortgage should be acquiring at least as much
information as the broker acquires in order to understand what
product is right.
The credit card situation is somewhat more difficult, but I
do think that in general, or in the old days, at least, one
actually had to fill out a fairly extensive form in order to be
able to get a credit card. I think that there are ways of
determining from that kind of information--what is my income
source, what other kinds of debts do I have--whether a credit
card of one type or another is the most appropriate for that
consumer.
You know, we would have to work it through. There would be
uncertainty, but this is not rocket science. This is really not
very far away from the ability to pay standard. It just says,
not only should you look at whether in the worst possible
circumstances the borrower could pay, but also try to figure
out what is good for that borrower.
Senator Shelby. Professor McCoy, the subject would be the
GSE affordable lending practices. You explain in your
testimony, Professor McCoy, why you believe reckless lenders
will crowd out good lenders. A variety of Federal efforts are
aimed at providing borrowers alternatives. For instance, Fannie
Mae and Freddie Mac have often claimed as their mission right
here in this Committee the expansion of responsible home
ownership, which we have supported--responsible home ownership.
Do you believe that Fannie Mae and Freddie Mac's purchase
of private-label subprime mortgage-backed securities added to
borrowers' options for responsible home ownership?
Ms. McCoy. Senator Shelby, first of all, while Fannie and
Freddie starting around 2005 joined the party with respect to
origination standards, they didn't start the party. They were
one of these conventional good guys who----
Senator Shelby. They got on the truck, didn't they?
Ms. McCoy. They got on the truck, but they didn't start it
and it is really the private-label market that started it.
I did find it highly problematic that Fannie and Freddie
purchased as part of their investment portfolios subprime
mortgage-backed securities. They were among many other global
investors, part of the glut of money that drove the
securitization crisis and the drop in lending standards, but
they do not deserve sole blame.
Senator Shelby. Sure. So the rationale for the GSEs
providing liquidity to the subprime market, although later,
rather than focusing on the purchase of whole loans,
exacerbated that problem, did it not?
Ms. McCoy. Yes, I think that is right. But the purchase of
loans by Fannie and Freddie is a very, very important device
and I wouldn't want that to be compromised in the efforts to
remove the investment portfolio authority.
Senator Shelby. Absolutely. I agree with that. But on the
other hand, they should purchase good loans or responsible
loans, shouldn't they?
Ms. McCoy. Yes. Yes. And they were doing that around 2000.
They were----
Senator Shelby. Oh, they were doing great for a while.
Ms. McCoy. Right.
Senator Shelby. But----
Ms. McCoy. Things changed.
Senator Shelby. They got on the truck. Sure.
Mr. Bartlett, you would suppose that financial institutions
have strong incentives well beyond legal compliance to treat
their customers well, treat them fairly, and to maintain long-
term relationships. In other words, you take care of your
customers and your customers will be around. In other words,
consumer protection should amount to consumer retention, is
what people try to do, I hope. Yet it seems that financial
institutions sometimes have not chosen to pursue this course.
How can we realign the incentives so that they will be
realigned in the future?
Mr. Bartlett. Senator, first of all, I believe firmly that
that is what financial institutions do because that is their
goal in life, is to help their customers and to keep their
healthy customers. We got away from that during the subprime
market, or many companies did, and those companies have taken
action----
Senator Shelby. Then there is no loyalty to your bank that
way, is there?
Mr. Bartlett. No. I think both the banks and the other
financial institutions create a loyalty to their bank and with
customer retention, so I think your proposition of your
question is exactly correct. That is not to say that we don't
need some more effective regulation to be certain that all of
the sides of the bank talk to each other. There were banks that
didn't participate in the subprime market because they believed
those were bad loans, but their Wall Street affiliates
purchased those same bad loans from their competitors so you
didn't have the connection between the two, even within the
same bank.
Senator Shelby. What, Ms. Seidman----
Ms. Seidman. Can I just add that one of the things that we
sometimes lose sight of is that there are a lot of different
kinds of banks and there are about 8,000 banks that have under
a billion dollars in assets. There are Community Development
Financial Institution banks, like ShoreBank. And those banks,
in general, really did keep contact with their customers, not
only their consumer customers, but their small business
customers.
I do think that one of the things that we need to be a
little careful about in this rush to consolidation that we seem
to be going through right now is retaining the best of the
banking system.
Senator Shelby. I hope we will not rush to consolidate all
the bank regulatory systems. But I do believe that we need to
go down that road and we need to do it right. Senator Dodd
alluded to it earlier. We have seen gaps, big gaps out there in
the regulation of institutions. We have seen sometimes, and I
am going to bring up the Fed again, the Fed is the central
bank, supposed to be the lender of last resort. Now it has
become the lender of first resort, it seems to me. The big
banks that they have regulated, gosh, so many of them are in
trouble. So you have to ask from this podium up here, why?
Where were they? And so forth.
So we have to have, I believe, a comprehensive regulator,
and along those same lines, look at AIG. Who were they
regulated by basically? Their primary regulator was the New
York State Insurance Commission, because under McCarran-
Ferguson, there are a lot of things the Fed even to this day
doesn't have the power over. It assumed a lot of power over AIG
because of systemic risk that Steve talks about. But I believe
that whatever we do, we are going to have to be comprehensive
and we are going to have to do it right, and I believe we are
not going to rush to it, but we are really going to focus on
it. We have no other choice.
Ms. Seidman. My concern, let me just clarify, is the
consolidation of the institutions, of the banking institutions,
not the regulatory issue.
Senator Shelby. OK.
Chairman Dodd. Well, I am going to turn to Senator Merkley
for any additional questions he has, but I want to thank you,
Ms. Seidman, for making the point. I try to make it at every
hearing we have on this subject matter and I didn't do it today
and I should have at the outset.
You are absolutely correct. There are 8,000 banks in the
country. My community banks in Connecticut made choices,
obviously, more conservative choices, thank goodness, and as a
result, they get drawn into the pejorative, and I think we need
to be very careful. There are so many different institutions
that have the label of ``bank'' and there are very, very huge
differences that exist within that universe of banks, and these
differences have been rightly raised with me, as I am sure they
have with my other colleagues. When we talk about banks, we
ought to take a moment to make sure we are distinguishing
between those who engage in some of these practices we are
talking about and have accumulated many of these bad assets and
the vast majority that have not.
In fact, there are only a handful of banks--I forget the
exact number, and one of you may correct me here--I think it is
around 18 to 20 banks that have 80 or 85 percent of the assets
in the country out of the 8,000 we are talking about. We too
often draw everyone else into this discussion, so it is
important to differentiate. And I appreciate your point about
making sure that as we move forward with this we keep that in
mind.
I will have some closing thoughts in a minute, but let me
turn to Senator Merkley.
Senator Merkley. Thank you very much, Mr. Chair.
Thank you for all of your responses related to steering
payments. It sounded like there was a consensus that there is a
real problem there that needs to be fixed and I appreciated the
range of remedies you mentioned, from fiduciary responsibility
to an outright ban to a fixed-fee arrangement that doesn't
depend on the type of the loan.
I wanted to turn to another piece of this puzzle which are
prepayment penalties combined with teaser rates. Very often,
brokers have been able to say, hey, you don't want a fully
amortizing 30-year loan. You want to have a discount for a
couple of years. Your family can save up money. Your house will
increase in value. You can refinance. And the teaser rates have
been kind of the bait on the front end and the prepayment
penalty has been the steel trap that captures families on the
back end. Is this product inherently flawed and should it be
banned?
Mr. Bartlett. Senator, my sense is the market has spoken to
that. Most of our companies don't have prepayment penalties.
There was a value to them, but in some cases they were abused
and the value, in essence, is you could give someone a lower
rate if they planned to stay in that house and keep that
mortgage for a longer period of time because you could lock in
the rate. Having said that, the value has sort of long since
been overcome by the abuses, so most of our banks--as far as I
know, all of them--don't have the prepayment penalties anymore,
I believe.
Senator Merkley. Would it be appropriate to back up what
the market has done with a specific ban on teaser rates and
prepayment penalties?
Mr. Bartlett. You know, it never strikes me as appropriate
to go out and lock the barn door after the horses are out, but
it wouldn't do any harm in the near term. The difficulty is any
time that you create some kind of a Federal ban for something
that somebody used to do, well, then 5 years from now, you will
discover that it is getting in the way of something that
consumers want. It wouldn't do any harm. It just doesn't strike
me as being all that useful at this point.
Senator Merkley. Ellen Seidman?
Ms. Seidman. I think that the combination of teaser rates
and a prepayment penalty is a combination that has no redeeming
social value. I would ban it. And I am pleased to hear that
Steve says that, in general, prepayment penalties are
disappearing. I think they are pernicious and if they are to
exist, they should be limited to a very short period of time,
certainly as the Fed has done, no longer than the initial
adjustment. They should come off before the initial adjustment
in the mortgage rate.
Senator Merkley. Thank you, and Professor?
Ms. McCoy. I have nothing more to add with Ms. Seidman. I
totally agree with her.
Senator Merkley. There are those who have argued that,
really, if you get rid of the prepayment penalty, teaser rates
take care of themselves because obviously you are only going to
get a slight discount. A finance lender is not going to offer
you a big discount if you could go ahead and refinance 2 years
later into another low discount. Do you all share that opinion,
that really the focus is on the prepayment penalty? If you take
care of that, the teaser rate issue takes care of itself?
Ms. Seidman. That is probably right in logic. However, I
think the problem on the teaser rates is that when you are
dealing with a population that doesn't have a fiduciary looking
out for them and is not really familiar with how mortgages
work, it is too easy to sell the low monthly payment.
Mr. Bartlett. Senator, our group concluded about 2 years
ago, and I am joined here with the President of the Housing
Policy Council that led this, we concluded about 2 years ago
that the focus should be on the ability to repay, that a
mortgage should have the ability to repay. There are a lot of
ingredients to that, of which teaser rates and prepayments is
part of it, but that should be the focus. It should be the
ability to repay for the life of the loan. We adopted it
ourselves for our companies, which is about 80 percent of the
mortgage market, but then equally important, we then
recommended it to the Fed, which they adopted it in perhaps a
slightly less fulsome form than we did, but the same thing.
Ms. McCoy. The problem with focusing just on the prepayment
penalty is that assumes the consumer has the ability to
refinance during the introductory period, and we have seen that
that may not be true for a couple of reasons. First of all,
their credit scores may be sinking. And second, house prices
may fall.
Now, we are in a very unusual situation now, but in the
1990s, I lived in Cleveland, where housing price appreciation
was pretty fragile. It was going up in other parts of the
country, but you were never quite sure if you could sell your
house for what you bought it at.
Senator Merkley. Thank you. I think that is a very good
point, and if I could just restate and make sure that we are on
the save wavelength here, that even without a prepayment
penalty, you may be locked into a loan, if it has a short
teaser rate followed by high interest, but you may be locked in
because the value of your house falls and you no longer have
the equity to be able to refinance in a prime loan.
Ms. McCoy. Correct.
Senator Merkley. Thank you very much, Mr. Chairman.
Chairman Dodd. Thank you, Senator. Those are good questions
and ones we have spent a lot of time on over the last 2 years
on going through the predatory lending practices. The yield
spread premium issue is one that consumed a lot of attention of
this Committee, as did teaser rates and prepayment penalties,
so I am very appreciative of you raising it again here in
today's discussion as we look down the road our work on
predatory lending as well as credit cards.
I wanted to make note, as well, that on Thursday, we will
have a hearing on AIG before this Committee and a very
interesting group of panelists to come, particularly in light
of the decisions in the last 24 hours or so--36 hours--and so
there will be a lot of interest, I presume, in hearing where
that stands and where we are going with all of it.
Let me underscore the point that Senator Shelby has made
and I attempted to make at the outset. This is a large task we
have in front of us and our common determination here is to get
this right. I am very grateful to have a partner in this in
Senator Shelby, who has sat in the chair that I am sitting in
as Chair of this Committee and has a good understanding of
these issues, as you have witnessed by his questions here today
and his interest in the subject matter.
And so it is our common determination to try and, as the
Chair and Vice Chair or Co-Chair or Ranking Member of this
Committee here, to work closely together with people like
yourselves who are very, very informative and have a lot to
offer in this discussion. This is a formal hearing today, but
our intention is to have informal conversations and discussions
with people as well, so we can have the kind of give and take
as we move forward and start to build that architecture. So I
am very grateful to all three of you for your participation
today.
Richard, do you have something else?
Senator Shelby. Yes. I just want to follow up on the number
of banks. You were talking about 8,000, more or less, smaller
banks. And then we have the top 19 banks they are going to
apply the stress test to if they can find the pulse and so
forth.
Steve, if you put the 19 banks that they are going to do a
stress test on together, roughly how much of the deposits in
the United States is that, roughly?
Mr. Bartlett. Senator Shelby, I don't have the exact
numbers----
Senator Shelby. I know that.
Mr. Bartlett. It is a significant portion----
Senator Shelby. Would it be 80 percent?
Mr. Bartlett. No, it wouldn't be 80 percent, but it perhaps
could be around 70 percent----
Senator Shelby. Seventy percent.
Mr. Bartlett.----so you were closer than I was.
Senator Shelby. You have got some good help back here.
Mr. Bartlett. Yes, I do.
Senator Shelby. Seventy percent, so say 19 banks in the
United States have approximately 70 percent of all the
deposits. Then you say every other bank, the 8,000 banks have
30 percent. But a lot of those 30 percent, a lot of those
banks, although small, are very important to their communities
and a lot of them have stayed with the fundamentals of banking
and are relatively, as I understand Professor McCoy, in
relatively good shape, considering the plight of some of the
bigger ones. Is that fair?
Ms. McCoy. Yes. Yes. When I looked at the smaller banks,
for the most part, they were not into these mortgages.
Senator Shelby. They weren't buying credit default swaps
and all this from AIG, were they?
Ms. McCoy. No. They had pretty simple balance sheets.
Senator Shelby. Balanced.
Ms. Seidman. Let me just say, though, that while in general
the small banks are doing better than the very big ones, it
would be hard to do a lot worse. But even though they didn't
participate in the kind of lending we are talking about, some
smaller banks, particularly those that are in communities that
have been devastated by that kind of lending----
Senator Shelby. Sure.
Ms. Seidman.----are running into trouble because the value
of their loans is declining, and where you also have
unemployment, the borrowers, even the prime borrowers, are in
trouble. This is a big issue for some smaller banks.
Senator Shelby. So a lot of that--I know it is everywhere
to some extent, but a lot of the things you are referencing are
in California, Florida, Nevada----
Ms. Seidman. And in the Upper Midwest.
Senator Shelby. In the Upper Midwest, the Rust Belt.
Mr. Bartlett. Senator, Mr. Chairman, if I could take 30
seconds, I think it is, though, fair to say that it is too
broad a brush to say, well, the small banks are good and the
big banks are bad----
Senator Shelby. Sure.
Mr. Bartlett.----because that is simply not accurate.
Senator Shelby. That is what she was saying.
Mr. Bartlett. I think that regions, being there in
Birmingham, and BBVA in Birmingham and Webster Financial in
Connecticut, Sun Trust in Atlanta, and others are banks that
serve their communities quite well, make good decisions, good
loans, have increased their lending as a result of TARP
participation, and, in fact, we have an economic decline with
unemployment and with frozen liquidity markets, but it is not a
matter of those individual banks having made bad decisions.
There are lots of bad decisions that have been made by all
kinds--and lots of good decisions. Now the issue is how do we
build out of it. So I think the banks I cited and others made
quite good decisions. They are a big part of the solution.
Chairman Dodd. No, no, you are right, absolutely right. Go
ahead.
Senator Shelby. Ms. Seidman, a lot of the smaller banks--
and large ones, too--bought mortgage-backed securities that
were rated investment grade, you know, were packaged and sold
back. In other words, they came right around the merry-go-
round. But they weren't allowed to hold those loans
individually on their banking sheets, I understand it. Do you
understand what I am getting at? Professor McCoy, do you want
to comment?
Ms. McCoy. Yes, I certainly do. First of all, there was a
way to get around that, which was to make it on a low-doc or
no-doc basis, so a seemingly safe loan actually didn't have the
proper documentation. We did see that a lot among regulated
depositories.
But apart from that, yes. Banks were allowed to invest in
investment grade subprime mortgage-backed securities under the
standard rules that we have. I had a very interesting
conversation with a regulator at the Bank of Italy who said
that several years ago, the Bank of Italy called up all the
banks in Italy and said, you shall not invest in these bonds. I
don't care if they are investment grade. We forbid you from
doing it.
Senator Shelby. Deemed investment grade by a rating agency?
Ms. McCoy. Correct.
Senator Shelby. After they bought insurance and were
wrapped and everything, is that correct?
Ms. McCoy. Correct.
Senator Shelby. Because anybody that was doing real due
diligence knew there was a risk there, did they not?
Ms. McCoy. That is right. That is right. Or they knew they
couldn't tell what the risk was.
Senator Shelby. OK. Thank you.
Chairman Dodd. Let me just--one point I wanted to make
before the conclusion, we are allowing the words ``subprime''
and ``predatory lending'' to become interchangeable and that is
dangerous, in my view. If you have good underwriting standards,
subprime lending can work, provided you don't have a lot of
bells and whistles on it. This has been one of the great wealth
creators for people who are moving up economically to be able
to acquire a home and to watch equity build up. It becomes a
great stabilizer, not to mention it does a lot for families and
neighborhoods. Equity interest in homes is, I think, one of the
great benefits. I think we are one of the few countries in the
world that ever had a 30-year fixed-rate mortgage for people.
Now, that is not always the best vehicle, I understand that, as
well.
But I wonder if you would agree with me or disagree with
me. I just worry about this idea that we are going to exclude
the possibility of poorer people becoming home owners. They
have to meet standards, obviously. I think you pointed out
where Community Investment Act requirements are in place, I
think only 6 percent of those institutions ended up in some
kind of problems. There has been an assumption that the
Community Reinvestment Act gave mortgages to a lot of poor
people who couldn't afford them. But, in fact, the evidence I
have seen is quite the contrary. Where institutions followed
CRA guidelines here and insisted upon those underwriting
standards, there were very few problems, in fact. I wonder if
you might comment on those two points.
Ms. McCoy. If I may, Senator Dodd, the performance of CRA
loans has, in fact, been much better. That turned out to be a
viable model for doing subprime lending, and there are two
other viable models. One are FHA guaranteed loans. That works
pretty well. And then the activities, the lending activities of
CDFIs such as ShoreBank are an excellent model to look at, as
well.
Ms. Seidman. Let me just add, first of all, you are
certainly right that subprime used to mean a borrower with less
than stellar credit.
Chairman Dodd. Right.
Ms. Seidman. It did not mean an ugly loan. And one has,
unfortunately, morphed into the other.
I think we did lending to borrowers with lower incomes and
lower wealth extremely well during the 1990s because we worked
on the notion that the borrower and the instrument should match
and that the borrower should be well counseled. And I commend
to the Committee and would ask you to put into the record a
recent study by the Center for Community Capital at the
University of North Carolina, who looked at essentially matched
pairs of borrowers, one who had gotten a CRA loan and one who
had gotten brokered loans with various other gizmos, ARMs or
prepayment penalties. For the 2004 originations, the ARM-
brokered loans with prepayment penalties defaulted at 5.3 times
the rate of the low-downpayment loans made to lower-income
borrowers under CRA programs.
Chairman Dodd. In fact, I think that--I forget which
publication it was, it may have been the Wall Street Journal,
and I may be a little bit off on this--somewhere around 60
percent of the subprime loans to borrowers actually would have
qualified for conventional mortgages.
Ms. Seidman. That is right. Governor Kroszner, former Fed
Governor Kroszner, has cited a study by Glenn Canner at the Fed
that only 6 percent of the high-cost loans to low-income people
were made by CRA-regulated institutions in their assessment
areas.
Chairman Dodd. Steve, do you want to comment on that at all
before I call----
Mr. Bartlett. Yes, I do, Mr. Chairman. Mr. Chairman,
lending decisions should not be made by political correctness
or by government fiat or by a law or by regulation. Those
lending decisions should be based on safety and soundness, good
underwriting standards and consumer protection, and every time
we get into an attempt to have that, then we sort of skew the
outcome. So subprime lending is in and of itself not bad. It is
a good thing. We had a large number of terrible abuses, but it
shouldn't be therefore outlawed.
Second, loans, though, and mortgages should be made for the
benefit of consumers by a competitive marketplace where 8,000
lenders or 15,000 lenders compete against each other for the
consumers' business. And then those lenders should be regulated
for safety and soundness and for consumer protection. But the
regulation should not be to design the exact terms and
conditions of the loan, as in, well, I think this is what a
good loan should be and somebody else says, I think this. The
marketplace will do the best job.
And then last, and I have some considerable experience with
CRA as both a mayor and as a member of the other body, the
purpose of CRA has worked quite well. It can be clumsy and so
there are exceptions to that, but CRA is the government's
requirement that regulated lenders, depository institutions,
figure out how they should be making good loans in low-income
neighborhoods because that was not occurring prior to CRA in
large part, I regret to say, but it was not. So that is the
purpose of CRA. That should be kept. It shouldn't be expanded
to some other purpose or contracted for other purposes. But
that was the underlying purpose and I think that is why the CRA
debate is outside this debate that we are having today.
Chairman Dodd. Very worthwhile, all of you. I can't thank
you enough and thank my colleagues here. We will leave the
record open for additional questions. By unanimous consent, we
will accept that article you suggested to us from the
University of North Carolina.
With that, the hearing stands adjourned.
[Whereupon, at 12:07 p.m., the hearing was adjourned.]
[Prepared statements and responses to written questions
follow:]
STATEMENT OF STEVE BARTLETT
President and Chief Executive Officer,
Financial Services Roundtable
March 3, 2009
Chairman Dodd, Ranking Member Shelby and Members of the Senate
Banking Committee. I am Steve Bartlett, President and Chief Executive
Officer of the Financial Services Roundtable. The Roundtable is a
national trade association composed of the nation's largest banking,
securities, and insurance companies. Our members provide a full range
of financial products and services to consumers and businesses.
Roundtable member companies provide fuel for America's economic engine,
accounting directly for $85.5 trillion in managed assets, $965 billion
in revenue, and 2.3 million jobs.
On behalf of the members of the Roundtable, I wish to thank you for
the opportunity to participate in this hearing on the role of consumer
protection regulation in the on-going financial crisis. Many consumers
have been harmed by this crisis, especially mortgage borrowers and
investors. Yet, the scope and depth of this crisis is not simply a
failure of consumer protection regulation. As I will explain in a
moment, the root causes of this crisis are found in basic failures in
many, but not all financial services firms, and the failure of our
fragmented financial regulatory system.
I also believe that this crisis illustrates the nexus between
consumer protection regulation and safety and soundness regulation.
Consumer protection and safety and soundness are intertwined.
Prudential regulation and supervision of financial institutions is the
first line of defense for protecting the interests of all consumers of
financial products and services. For example, mortgage underwriting
standards not only help to ensure that loans are made to qualified
borrowers, but they also help to ensure that the lender gets repaid and
can remain solvent.
Given the nexus between the goals of consumer protection and safety
and soundness, we do not support proposals to separate consumer
protection regulation and safety and soundness regulation. Instead, we
believe that the appropriate response to this crisis is the
establishment of a better balance between these two goals within a
reformed and more modern financial regulatory structure.
Moreover, I would like to take this opportunity to express the
Roundtable's concerns with the provision in the Omnibus Appropriations
bill that would give State attorneys generals the authority to enforce
compliance with the Truth-in-Lending Act (TILA) and would direct the
Federal Trade Commission to write regulations related to mortgage
lending. As I will explain further, we believe that one of the
fundamental problems with our existing financial regulatory system is
its fragmented structure. This provision goes in the opposite
direction. It creates overlap and the potential for conflict between
the Federal banking agencies, which already enforce compliance with
TILA, and State AGs. It also creates overlap and the potential conflict
between the Federal banking agencies, which are responsible for
mortgage lending activities, and the Federal Trade Commission. While it
may be argued that more ``cops on the beat'' can enhance compliance,
more ``cops'' that are not required to act in any coordinated fashion
will simply exacerbate the regulatory structural problems that
contributed to the current crisis.
My testimony is divided into three parts. First, I address ``What
Went Wrong.'' Second, I address ``How to Fix the Problem.'' Finally, I
take this opportunity to comment on the lending activities of TARP-
assisted firms, and the Roundtable's continuing concerns over the
impact of fair value accounting.
What Went Wrong
The proximate cause of the current financial crisis was the nation-
wide collapse of housing values, and the impact of that collapse on
individual homeowners and the holders of mortgage-backed securities.
The crisis has since been exacerbated by a serious recession.
The root causes of the crisis are twofold. The first was a clear
breakdown in policies, practices, and processes at many, but not all,
financial services firms. Poor loan underwriting standards and credit
practices, excessive leverage, misaligned incentives, less than robust
risk management and corporate governance are now well known and fully
documented. Corrective actions are well underway in the private sector
as underwriting standards are upgraded, credit practices reviewed and
recalibrated, leverage is reduced as firms rebuild capital, incentives
are being realigned, and some management teams have been replaced,
while whole institutions have been intervened by supervisors or merged
into other institutions. So needed corrective actions are being taken
by the firms themselves.
More immediately, we need to correct the failures that the crisis
exposed in our complex and fragmented financial regulatory structure.
Crises have a way of revealing structural flaws in regulation,
supervision, and our regulatory architecture that have long-existed,
but were little noticed until the crisis exposed the underlying
weaknesses and fatal gaps in regulation and supervision. This one is no
different. It has revealed significant gaps in the financial regulatory
system. It also revealed that the system does not provide for
sufficient coordination and cooperation among regulators, and that it
does not adequately monitor the potential for market failures, high-
risk activities, or vulnerable interconnections between firms and
markets that can create systemic risk and result in panics like we saw
last year and the crisis that lingers today.
The regulation of mortgage finance illustrates these structural
flaws in both regulation and supervision. Many of the firms and
individuals involved in the origination of mortgage were not subject to
supervision or regulation by any prudential regulator. No single
regulator was held accountable for identifying and recommending
corrective actions across the activity known as mortgage lending to
consumers. Many mortgage brokers are organized under State law, and
operated outside of the regulated banking industry. They had no
contractual or fiduciary obligations to brokers who referred loans to
them. Likewise, many brokers were not subject to any licensing
qualifications and had no continuing obligations to individual
borrowers. Most were not supervised in a prudential manner like
depository institutions engaged in the same business line.
The Federal banking regulators recognized many of these problems
and took actions--belatedly--to address the institutions within their
jurisdiction, but they lacked to power to reach all lenders.
Eventually, the Federal Reserve Board's HOEPA regulations did extend
some consumer protections to a broader range of lenders, but the Board
does not have the authority to ensure that those lenders are engaged in
safe and sound underwriting practices or risk management.
The process of securitization suffered from a similar lack of
systemic oversight and prudential regulation. No one was responsible
for addressing the over-reliance investors placed upon the credit
rating agencies to rate mortgage-backed securities, or the risks posed
to the entire financial system by the development of instruments to
transfer that risk worldwide.
How to Fix the Problem
How do we fix this problem? Like others in the financial services
industry, the members of the Financial Services Roundtable have been
engaged in a lively debate over how to better protect consumers by
addressing the structural flaws in our current financial regulatory
system. While our internal deliberations continue, we have developed a
set of guiding principles and a ``Draft Financial Regulatory
Architecture'' that is intended to close the gaps in our existing
financial regulatory system. We are pleased that the set of regulatory
reform principles that President Obama announced last week are broadly
consistent and compatible with the Roundtable's principles for much
needed reforms. Our first principle in our 2007 Blueprint for U.S.
Financial Modernization was to ``treat consumers fairly.'' Our current
principles for regulatory reform this year build on that guiding
principle and call for: 1) a new regulatory architecture; 2) common
prudential and consumer and investor protection standards; 3) balanced
and effective regulation; 4) international cooperation and national
treatment; 5) failure resolution; and 6) accounting standards. Our plan
also seeks to encourage greater coordination and cooperation among
financial regulators, and to identify systemic risks before they
materialize. We also seek to rationalize and simplify the existing
regulatory architecture in ways that make more sense in our modern,
global economy. The key features of our proposed regulatory
architecture are as follows.
Financial Markets Coordinating Council
To enhance coordination and cooperation among the many and various
financial regulatory agencies, we propose to expand membership of the
President's Working Group on Financial Markets (PWG) and rename it as
the Financial Markets Coordinating Council (FMCC). We believe that this
Council should be established by law, in contrast to the existing PWG,
which has operated under a Presidential Executive Order since 1988.
This would permit Congress to oversee the Council's activities on a
regular and ongoing basis. We also believe that the Council should
include representatives from all major Federal financial agencies, as
well as individuals who can represent State banking, insurance, and
securities regulation.
This Council could serve as a forum for national and State
financial regulators to meet and discuss regulatory and supervisory
policies, share information, and develop early warning detections. In
other words, it could help to better coordinate policies within our
still fragmented regulatory system. We do not believe that the Council
should have independent regulatory or supervisory powers. However, it
might be appropriate for the Council to have some ability to review the
goals and objectives of the regulations and policies of Federal and
State financial agencies, and thereby ensure that they are consistent.
Federal Reserve Board
To address systemic risk, we believe the Federal Reserve Board
(Board) should be authorized to act as a market stability regulator. As
a market stability regulator, the Board should be responsible for
looking across the entire financial services sector to identify
interconnections that could pose a risk to our financial system. To
perform this function, the Board should be empowered to collect
information on financial markets and financial services firms, to
participate in joint examinations with other regulators, and to
recommend actions to other regulators that address practices that pose
a significant risk to the stability and integrity of the U.S. financial
services system.
The Board's authority to collection information should apply not
only to depository institutions, but also to all types of financial
services firms, including broker/dealers, insurance companies, hedge
funds, private equity firms, industrial loan companies, credit unions,
and any other financial services firms that facilitate financial flows
(e.g., transactions, savings, investments, credit, and financial
protection) in our economy. Also, this authority should not be based
upon the size of an institution. It is possible that a number of
smaller institutions could be engaged in activities that collectively
pose a systemic risk.
National Financial Institutions Regulator
To reduce gaps in regulation, we propose the consolidation of
several existing Federal agencies into a single, National Financial
Institutions Regulator (NFIR). This new agency would be a consolidated
prudential and consumer protection agency for banking, securities and
insurance.
More specifically, it would charter, regulate and supervise (i)
banks, thrifts, and credit unions, currently supervised by the Office
of the Thrift Supervision, the Office of the Comptroller of the
Currency, and the National Credit Union Administration; (ii) licensed
broker/dealers, investment advisors, investment companies, futures
commission merchants, commodity pool operators, and other similar
intermediaries currently supervised by the Securities and Exchange
Commission or the Commodities Futures Trading Commission; and (iii)
insurance companies and insurance producers that select a Federal
charter. The AIG case illustrates the need for the Federal Government
to have the capacity to supervise insurance companies. Also, with the
exception of holding companies for banks, the NFIR would be the
regulator for all companies that control broker/dealers or national
chartered insurance companies.
The NFIR would reduce regulatory gaps by establishing comparable
prudential standards for all of these of nationally chartered or
licensed entities. For example, national banks, Federal thrifts and
federally licensed brokers/dealers that are engaged in comparable
activities should be subject to comparable capital and liquidity
standards. Similarly, all federally chartered insurers would be subject
to the same prudential and market conduct standards.
In the area of mortgage origination, we believe that the NFIR's
prudential and consumer protection standards should apply to both
national and State lenders. Mortgage lenders, regardless of how they
are organized, should be required to retain some of the risk for the
loans they originate (keep some ``skin-in-the-game''). Likewise,
mortgage borrowers, regardless of where they live or who their lender
is, should be protected by the same safety and soundness and consumer
standards.
As noted above, we believe that is it important for this agency to
combine both safety and soundness (prudential) regulation and consumer
protection regulation. Both functions can be informed, and enhanced, by
the other. Prudential regulation can identify practices that could harm
consumers, and can ensure that a firm can continue to provide products
and services to consumers. The key is not to separate the two, but to
find an appropriate balance between the two.
National Capital Markets Agency
To focus greater attention on the stability and integrity of
financial markets, we propose the creation of a National Capital
Markets Agency through the merger of the Securities and Exchange
Commission (SEC) and the Commodities Futures Trading Commission (CFTC),
preserving the best features of each agency. The NCMA would regulate
and supervise capital markets and exchanges. As noted above, the
existing regulatory and supervisory authority of the SEC and CFTC over
firms and individuals that serve as intermediaries between markets and
customers, such as broker/dealers, investment companies, investment
advisors, and futures commission merchants, and other intermediaries
would be transferred to the NFIR. The NCMA also should be responsible
for establishing standards for accounting, corporate finance, and
corporate governance for all public companies.
National Insurance Resolution Authority
To protect depositors, policyholders, and investors, we propose
that the Federal Deposit Insurance Corporation (FDIC) would be renamed
the National Insurance and Resolution Authority (NIRA), and that this
agency act not only as an insurer of bank deposits, but also as the
guarantor of retail insurance policies written by nationally chartered
insurance companies, and a financial backstop for investors who have
claims against broker/dealers. These three insurance systems would be
legally and functionally separated. Additionally, this agency should be
authorized to act as the receiver for large non-bank financial services
firms. The failure of Lehman Brothers illustrated the need for such a
better system to address the failure of large non-banking firms.
Federal Housing Finance Agency
Finally, to supervise the Federal Home Loan Banks and to oversee
the emergence and future restructuring of Fannie Mae and Freddie Mac
from conservatorship we propose that the Federal Housing Finance Agency
remain in place, pending a thorough review of the role and structure of
the housing GSEs in our economy.
TARP Lending and Fair Value Accounting
Before I close I would like to address two other issues of
importance to policymakers and our financial services industry: lending
by institutions that have received TARP funds, and the impact of fair
value accounting in illiquid markets. Lending by institutions that have
received TARP funds has become a concern, especially given the
recessionary pressures facing the economy. I have attached to this
statement a series of tables that the Roundtable has compiled on this
issue. Those tables show the continued commitment of the nation's
largest financial services firms to lending.
Fair value accounting also is a major concern for the members of
the Roundtable. We continue to believe that the pro-cyclical effects of
existing policies are unnecessarily exacerbating this crisis. We urge
this Committee to direct financial regulators to adjust current
accounting standards to reduce the pro-cyclical effects of fair value
accounting in illiquid markets. We also urge the U.S. and international
financial regulators coordinate and harmonize regulatory policies to
development accounting standards that achieve the goals of
transparency, understandability, and comparability.
Conclusion
Thank you again for the opportunity to appear today to address the
connection between consumer protection regulation and this on-going
financial crisis. The Roundtable believes that the reforms to our
financial regulatory system we have developed would substantially
improve the protection of consumers by reducing existing gaps in
regulation, enhancing coordination and cooperation among regulators,
and identifying systemic risks. We also call on Congress to address the
continuing pro-cyclical effects of fair value accounting.
Broader regulatory reform is important not only to ensure that
financial institutions continue to meet the needs of all consumers but
to restart economic growth and much needed job creation. Financial
reform and ending the recession soon are inextricably linked--we need
both. We need a financial system that provides market stability and
integrity, yet encourages innovation and competition to serve consumers
and meet the needs of a vibrant and growing economy. We need better,
more effective regulation and a modern financial regulatory system that
is unrivaled anywhere in the world. We deserve no less.
At the Roundtable, we are poised and ready to work with you on
these initiatives. As John F. Kennedy once cited French Marshall
Lyautey, who asked his gardener to plant a tree. The gardener objected
that the tree was slow growing and would not reach maturity for 100
years. The Marshall replied, ``In that case, there is no time to lose;
plant it this afternoon!'' The same is true with regard to the future
of the United States in global financial services--there is no time to
lose; let's all start this afternoon.
______
PREPARED STATEMENT OF ELLEN SEIDMAN
Senior Fellow, New America Foundation and
Senior Vice President, ShoreBank Corporation
March 3, 2009
Chairman Dodd, Ranking Member Shelby and members of the Committee.
I appreciate your inviting me here this morning to discuss consumer
protection and oversight in the financial services industry in the
context of the current economic crisis, and to provide my thoughts on
how the regulatory system should be restructured to enhance consumer
protection in the future. In quick summary, I believe that the time has
come to create a well-funded single Federal entity with the
responsibility and authority to receive and act on consumer complaints
about financial services and to adopt consumer protection regulations
that would be applicable to all and would be preemptive. However, I
believe that prudential supervisors, in particular the Federal and
State banking regulatory agencies, should retain primary enforcement
jurisdiction over the entities they regulate.
My name is Ellen Seidman, and I am a Senior Fellow at the New
America Foundation as well as Executive Vice President, National
Program and Partnership Development at ShoreBank Corporation, the
nation's first and leading community development bank holding company,
based in Chicago. My views are informed by my current experience--
although they are mine alone, not those of New America or ShoreBank--as
well as by my years at the Treasury Department, at Fannie Mae, at the
National Economic Council under President Clinton, and as Director of
the Office of Thrift Supervision from 1997 to 2001.
During my tenure at OTS, we placed significant emphasis on both
consumer and compliance issues and on the responsibility of the
institutions we regulated to serve the communities in which they were
chartered, both because of their obligations under the Community
Reinvestment Act and because it was good business. We paid particular
attention to compliance, building up our staff and examination
capability, establishing a special award (done away with by my
successor) to honor the best performer in compliance and community
affairs, reaching out to consumers and communities, and enhancing our
complaint function. We were by no means perfect, but we worked to put
compliance on an equal footing with safety and soundness.
Since I left OTS, I have spent much of my time working on issues
relating to asset building and banking the underbanked, in which
context the importance of consumer protection, for both credit and
other products, is plainly apparent. Finally, my years at Fannie Mae
and at ShoreBank and the community development work I have been doing
have made me both conscious of and extremely sad about what has
happened in the mortgage market and the effects it is having on both
households and communities.
Based on my OTS experience, I believe the bank regulators, given
the proper guidance from Congress and the will to act, are fully
capable of effectively enforcing consumer protection laws. Moreover,
because of the system of prudential supervision, with its onsite
examinations, they are also in an extremely good position to do so and
to do it in a manner that benefits both consumers and the safety and
soundness of the regulated institutions. In three particular cases
during my OTS tenure, concern about consumer issues led directly to
safety and soundness improvements. Two involved guidance that got
thrifts out of sub-prime monoline credit card lending (just months
before that industry got into serious trouble) and payday lending. In
another case involving a specific institution, through our compliance
examiners' concern about bad credit card practices, we uncovered
serious fair lending and safety and soundness issues. Consumer
protection can be the canary that gives early warning of safety and
soundness issues--but only if someone is paying attention to dying
birds.
We also sounded the alarm on predatory lending. Sub-prime guidance
issued in 1998 by all the bank regulators warned of both safety and
soundness and consumer protection issues. In speeches and testimony I
gave in 2000, concerns about predatory lending and discussion about
what we were doing to respond were a consistent theme. Nevertheless, as
I will discuss below, I think it is time to consider whether
consolidation of both the function of writing regulations and the
receipt of complaints would make the system more effective for
consumers, for financial institutions and for the economy.
The Current Crisis
The current crisis has many causes, including an over-reliance on
finance to ``solve'' many of the needs of our citizens. When real
incomes stagnate while the cost of housing, health care and education
skyrocket, there are really only two possible results: people do
without or they become more and more overleveraged. Financial
engineering and cheap investor funding, largely from abroad, enabled
the overleveraging, but a lack of adequate attention to the manner in
which the financial services system interacted with consumers certainly
kept the process going and caused consumers and the economy to fall
harder when it ended. There were really two parallel problems: the
proliferation of bad products and practices and the sale of hard-to-
understand credit and investment products to consumers for whom they
were not suitable; and the lack of high quality products that meet
consumer needs, well priced and effectively marketed, especially in
lower income communities.
I believe that there where three basic regulatory problems. First,
there was a lack of attention, and sometimes unwillingness, to
effectively regulate products and practices even where regulatory
authority existed. The clearest example of this is the Federal
Reserve's unwillingness to regulate mortgage lending under HOEPA.
However, as the recent actions by the Federal Reserve, OTS and NCUA
have demonstrated, there was also authority under the FTC Act that went
unused. It is important to understand that this is not only an issue of
not issuing regulations or guidance; it is perhaps even more
importantly a lack of effective enforcement.
Compliance has always had a hard time competing with safety and
soundness for the attention of regulators--which is one reason I spent
a good deal of my tenure at OTS emphasizing its importance--but there
was a deliberate downgrading of the compliance function at the Federal
level at the start of the Bush Administration. Moreover, neither the
Federal Reserve nor the OTS--at least until fairly recently--has
seriously probed the consumer practices of non-depository subsidiaries
of the holding companies they regulate. This is not just an issue at
the Federal level. While there are certain states--North Carolina,
Maryland and Massachusetts prominent among them--that have consistently
engaged in effective enforcement of consumer protection laws with
respect to the entities under their regulation, others, including
California, the home of many of the most aggressive mortgage lenders,
were even less aggressive than the Federal regulators. Moreover,
ineffective enforcement is not just an issue of consumer protection
regulation per se; the ability to move badly underwritten products
completely off the balance sheet, earning fees for originating them,
but holding no responsibility for them and no capital against them,
only encouraged the proliferation of such activities.
Second, we need to acknowledge that there were, and are, holes in
the regulatory system, both in terms of unregulated entities and
products, and in terms of insufficient statutory authority. The
clearest case relates to mortgage brokers, where there was no Federal
regulation at all, no regulation beyond simple registration in many
states, and ineffective regulation even in most of the states that
actually asserted some regulatory authority. But there are other
examples--payday lending is prohibited in some states, regulated more
or less effectively in others, and pretty much allowed without
restriction in still others. And then of course there is the question
of what kind of responsibility sellers of non-investment financial
products have to customers. We know we have not imposed a fiduciary
duty on them, but does that mean there is no responsibility to match
customer with product?
Finally, there is and was confusion, for both the regulated
entities and consumers and those who work with them. Consumer
protection comes in many forms, from substantive prohibitions like
usury ceilings and payday lending prohibitions, through required terms
and practices, to disclosures and marketing rules. I would assert it
also includes the affirmative mandate of the Community Reinvestment
Act; recent experience has demonstrated that where well-regulated
entities do not provide quality services that meet needs and are well
marketed, expensive and sometimes predatory substitutes will move in.
Multiple regulators and enforcement channels exacerbate the
confusion. At the Federal level, there are multiple bank regulators,
not to mention the NCUA, the FTC and HUD, and their jurisdiction is
frequently overlapping. States and even localities also regulate
consumer protection, again often through multiple agencies. And of
course, sometimes the Federal and State laws overlap. The enforcement
mechanisms are just as confusing, involving examinations, complaints,
collateral consequences such as limitations on municipal deposits or
procurement, and both public and private lawsuits.
The system clearly could be improved. But as we do so, we should
not be lulled into thing the solutions are obvious or easy. In general
they're not, and I would assert that they are harder and more subtle
than is the case with manufactured consumer products. The products,
even the good ones, can be extremely complex. Just try describing the
lifetime interest rate on a Savings Bond or how a capped ARM works. Or
for that matter whether a payday loan or a bounced check is more
expensive. Many products, especially loans and investments, involve
both uncertainty and difficult math over a long period of time, which
is hard for even the most educated consumer. And the differences
between a good product and a bad one can be subtle, especially if the
consumer doesn't know where to look. An experienced homeowner knows the
importance of escrowing insurance and taxes, but the dire consequences
of the lack of an escrow are easy for a first-time homebuyer to miss.
And a relatively safe ARM can turn into a risky one when caps are
removed or a prepayment penalty added.
Finally, different consumers legitimately have different needs. To
take the example economists love, when there is a normal, upward
sloping yield curve, most homebuyers are better off with a 5-year ARM
than with a 30-year fixed rate mortgage, because with the long-term
loan they are paying a higher interest rate for an option they are
unlikely ever to use, since they will likely move, prepay or refinance
long before 30 years are up. But for a consumer whose income is
unlikely to increase, who has few other resources, or who has
difficulty budgeting--or who is just plain risk-averse--the certainty
of the fixed rate mortgage may well be worth the additional cost.
Looking Forward
Before turning to regulatory issues, I suggest there is a broader
social context of change that we need to consider. To what extent can
we turn some of the complex, long-term financial obligations that we
have foisted on individual consumers--most clearly retirement and
health care--back to more collective management? We also should
recognize that there is some level of interest and some level of
financial engineering at which ``availability of credit'' is an excuse
for both not having sufficient income and collateral supports (such as
health care) and an insufficient level of financial understanding--it's
not a way of life. We need to educate our children from day one about
what money means, how interest rates work, and who to get help from,
and we need to create systems of helpers, which can include the
internet and things like overdraft alarms, but which also requires low-
cost access to people who are competent to give advice and have a
fiduciary duty to the consumer.
In this period when consumers are being forced to deleverage and
cut back, and are actually beginning to save more on their own accord,
we should once again make saving easy and an expected part of life.
Having an account at a bank or credit union helps encourage saving,
although the account needs to be designed so consumers have the
liquidity they need without paying for it through excessive overdraft
fees. Tying savings to credit, such as by requiring part of a mortgage
payment to go into a savings account for emergencies like repairs or
temporary inability to make a payment, can also help. And so would
moving toward more savings opt-outs, like payroll deductions for non-
restricted savings accounts that can be used in an emergency (as well
as for retirement accounts), a concept we are testing at the New
America Foundation as AutoSave.
Principles for Regulation
The regulatory framework, of course, involves both how to regulate
and who does it. With respect to how, I suggest three guiding
principles. First, to the maximum extent possible, products that
perform similar functions should be regulated similarly, no matter what
they are called or what kind of entity sells them. For example, we know
that many people regarded money market mutual funds and federally
insured deposit accounts as interchangeable. Either they are, and both
the products and--to the extent the regulation has to do with making
sure the money is there when the customer wants it--the regulation
should be similar, or they are not and they should not be treated as
such, including by regulators who are assessing capital requirements.
To take another example, payday loans and bounced check protection have
a good deal in common, and probably should be regulated in a similar
manner. This also means that a mortgage sold directly through a bank
should be subject to the same regulatory scheme and requirements as one
sold through a broker.
Second, we should stop relying on consumer disclosure as the
primary method of protecting consumers. While such disclosures can be
helpful, they are least helpful where they are needed the most, when
products and features are complex. The Federal Reserve's recognition of
this with respect to double cycle credit card billing was a critical
breakthrough: by working with consumers, they came to understand that
no amount of disclosure was going to enable consumers to understand the
practice. The same is true of very complex mortgage products. The ``one
page disclosure'' is great for simple mortgage products, but where
there are multiple difficult-to-understand concepts in a single
mortgage--indexes and margins, caps on rate increases and on payments,
per adjustment and over the loan's lifetime, escrows or not, prepayment
penalties that change over time, option payments and negative
amortization, and many different fees--the likelihood is low that any
disclosure will enable those for whom these issues really make a
difference to understand them.
In the last few years, several academics have suggested some
potential substitutes for disclosure that go beyond the traditional
type of prohibitory consumer protection rules. For example, Professor
Ronald Mann has suggested that credit card contracts be standardized,
with competition allowed on only a few easily understood terms, such as
annual fees and interest rates.\1\ In some ways, this is what the
situation was with mortgages well into the 1990s. Professors Michael
Barr, Eldar Shafir and Sendil Mullainathan have suggested the
development of high quality, easily understood ``default'' products
such as mortgages, credit cards and bank accounts, allowing other
products to be sold, but with more negative consequences for sellers if
the products go bad, such as requiring the seller to prove that the
disclosures were reasonable as a condition to enforcing the contract,
including in a mortgage foreclosure action.\2\
---------------------------------------------------------------------------
\1\ Ronald Mann, `` `Contracting' for Credit,'' 104 Mich LR 899
(2006) at 927-28.
\2\ Michael Barr, Sendhil Mullainathan, and Eldar Shafir, ``A One-
Size-Fits-All Solution,'' New York Times, December 26, 2007, available
at http://www.nytimes.com/2007/12/26/opinion/
26barr.html?scp=1&sq=michael percent20barr percent20mortgage&st=cse.
See also Michael Barr, Sendhil Mullainathan, and Eldar Shafir,
``Behaviorally Informed Financial Services Regulation'' (Washington,
DC: New America Foundation, October 2008), available at http://
www.newamerica.net/files/naf_behavioral_v5.pdf.
---------------------------------------------------------------------------
Third, enforcement is at least as important as writing the rules.
Rules that are not enforced, or not enforced equally across providers,
generate both false comfort and confusion, and tend to drive, through
market forces, all providers to the practices of the least well
regulated. This is in many ways what we have seen with respect to
mortgages; it is not just that some entities were not subject to the
same rules as others, but also that the rules were not enforced
consistently across entities.
Who Should Regulate
As discussed above, that there are currently a myriad of regulators
both making the rules and enforcing them. This situation makes
accomplishment of the substantive principles discussed above very
difficult. To a substantial extent, both the Federal Reserve and the
FTC have broad jurisdiction already; whether they take action to write
rules depends to some extent on capacity, will and priorities. But even
where they have such authority and take it, significant problems remain
concerning both enforcement and to what extent their rules trump State
rules. The bank regulators, both together when they can agree and
separately when they can't, also write rules and guidance that is often
as effective as rules, but those apply only to entities under their
jurisdiction, and generate very substantial controversy concerning the
extent to which regulations of the OCC and OTS preempt State laws and
regulations.
As I mentioned at the start, I believe the bank regulators, given
the guidance from Congress to elevate consumer protection to the same
level of concern as safety and soundness, can be highly effective in
enforcing consumer protection laws. Nevertheless, I think it is time to
give consideration to unifying the writing of regulations as to major
consumer financial products--starting with credit products--and also to
establish a single national repository for the receipt of consumer
complaints.
The mortgage situation has shown that a single set of regulations
that governs all parties is a precondition to keeping the market at the
level of those engaged in best practices--or at least the practices
condoned by the regulators--not the worst. The situation with payday
lending, especially in multi-State metropolitan areas, is similar. And
among regulators with similar jurisdictions, whether the Federal bank
regulators or State regulators, having major consumer products governed
by a single set of regulations will reduce the opportunity for
regulatory arbitrage.
A single entity dedicated to the development of consumer protection
regulations, if properly funded and staffed--unfortunately the
experience of both the FTC and CPSC over the last 8 years, but in fact
for many more years suggests that's a big ``if''--will be more likely
to focus on problems that are developing and to propose, and
potentially, take action before they get out of hand. In addition,
centralizing the complaint function in such an entity will give
consumers and those who work with them a single point of contact and
the regulatory body the early warning of trouble that consumer
complaints provide.
Such a body will also have the opportunity to become expert in
consumer understanding and behavior. This will enable it to use the
theories and practices being developed about consumer understanding and
how to maximize positive consumer behavior--the learnings of behavioral
economics--to regulate effectively without necessarily having a heavy
hand. The regulator could also become the focus for the myriad of
scattered and inefficient Federal efforts surrounding financial
education.
The single regulator concept is not, however, a panacea. Three
major issues that could stymie such a regulator's effectiveness are
funding, preemption, and the extent of its enforcement authority.
How will the new regulator be funded, and at what level? It is
tempting to think that annual appropriations will be sufficient, but is
that really the case? Political winds and priorities change, and
experience suggests that consumer regulatory agencies are at risk of
reduced funding. Is this a place for user fees--a prospect more
palatable if there is a single regulator covering all those in the
business rather than multiple regulatory bodies for whom lower fees can
become a marketing tool? In any event, it is essential that this entity
be well funded; if it is not, it will do more harm than good, as those
relying on it will not be able to count on its being effective.
What will be the regulator's enforcement authority? Will it have
primary authority over any group of entities? Will the authority be
secondary to other regulatory bodies that license or charter those
providing financial services? My opinion is that regulators who engage
in prudential supervision (Federal and State), with onsite
examinations, should have primary regulatory authority, with the new
entity empowered to bring an enforcement action if it believes the
regulations are not being effectively enforced. Coupled with
Congressional direction to the prudential supervisors to place
additional emphasis on consumer protection, the supplemental authority
of the consumer protection regulator to act should limit the number of
situations in which the new regulator is forced to take action.
And finally, will the regulations written by the new entity preempt
both regulations and guidance of other Federal regulators and State
regulation? My opinion is that where the new entity acts, their
regulations should be preemptive. We have a single national marketplace
for most consumer financial products. Whereas in the past the argument
that providers can't be expected to respond to a myriad of rules held
sway, as technology has advanced this argument has lost its potency.
But consumers are entitled to a consistent level of protection no
matter where they live and with whom they deal. Yes, there may be times
when the agency does not work as fast or as broadly as some advocates
would like. But the point of having a single agency with responsibility
in this area is to create a single focal point for action that will
benefit all Americans. Where the agency does take action, it should
fill the field. But preemption may well be the most difficult issue of
all, not only because preemption is ideologically difficult, but also
because the uniformity that a single regulator can provide will always
be in tension with the attempts of some actors to get around the
regulations and of regulators and other parties to move in to respond.
Conclusion
While the current crisis has many causes, the triggering event was
almost certainly the collapse of the sub-prime mortgage market. That is
an event that need never have happened if both our regulatory system
and regulators had been more completely and effectively focused on
protecting consumers. For many years, many of us have been pointing out
that bad consumer practices are also bad economic practices. Not only
because of the damage it does to consumers, but also because when the
music stops, we all get hurt. The current state of affairs provides a
golden opportunity to make significant improvements in the regulatory
system. If not now, when?
______
PREPARED STATEMENT OF PATRICIA A. McCOY
George J. and Helen M. England Professor of Law
University of Connecticut School of Law
March 3, 2009
Chairman Dodd and Members of the Committee: Thank you for inviting
me here today to discuss the problem of restructuring the financial
regulatory system. I applaud the Committee for exploring bold new
approaches to financial regulation on the scale needed to address our
nation's economic challenges.
In my remarks today, I propose transferring consumer protection
responsibilities in the area of consumer credit from Federal banking
regulators to a single, dedicated agency whose sole mission is consumer
protection. This step is essential for three reasons. First, during the
housing bubble, our current system of fragmented regulation drove
lenders to shop for the easiest legal regime. Second, the ability of
lenders to switch charters put pressure on banking regulators--both
State and Federal--to relax credit standards. Finally, banking
regulators have routinely sacrificed consumer protection for short-term
profitability of banks. Creating one, dedicated consumer credit
regulator charged with consumer protection would establish uniform
standards and enforcement for all lenders and help eliminate another
death spiral in lending. Although I examine this issue through the lens
of mortgage regulation, my discussion is equally relevant to other
forms of consumer credit, such as credit cards and payday lending.
The reasons for the breakdown of the home mortgage market and the
private-label market for mortgage-backed securities are well known by
now. Today, I wish to focus on lax lending standards for residential
mortgages, which were a leading cause of today's credit crisis and
recession. Our broken system of mortgage finance and the private actors
in that system--ranging from mortgage brokers, lenders, and appraisers
to the rating agencies and securitizers--bear direct responsibility for
this breakdown in standards.
There is more to the story, however. In 2006, depository
institutions and their affiliates, which were regulated by Federal
banking regulators, originated about 54 percent of all higher-priced
home loans. In 2007, that percentage rose to 79.6 percent.\1\ In some
states, mortgages originated by State banks and thrifts and independent
nonbank lenders were regulated under State anti-predatory lending laws.
In other states, however, mortgages were not subject to meaningful
regulation at all. Consequently, the credit crisis resulted from
regulatory failure as well as broken private risk management. That
regulatory failure was not confined to states, moreover, but pervaded
Federal banking regulation as well.
---------------------------------------------------------------------------
\1\ Robert B. Avery, Kenneth P. Brevoort & Glenn B. Canner, The
2007 HMDA Data, Fed. Res. Bull. A107, A124 (Dec. 2008), available at
http://www.federalreserve.gov/pubs/bulletin/2008/pdf/hmda07final.pdf.
---------------------------------------------------------------------------
Neither of these phenomena--the collapse in lending criteria and
the regulatory failure that accompanied it--was an accident. Rather,
they occurred because mortgage originators and regulators became locked
in a competitive race to the bottom to relax loan underwriting and risk
management. The fragmented U.S. system of financial services regulation
exacerbated this race to the bottom by allowing lenders to shop for the
easiest regulators and laws.
During the housing bubble, consumers could not police originators
because too many loan products had hidden risks. As we now know, these
risks were ticking time bombs. Lenders did not take reasonable
precautions against default because they able to shift that to
investors through securitization. Similarly, regulators failed to clamp
down on hazardous loans in a myopic attempt to boost the short-term
profitability of banks and thrifts.
I open by examining why reckless lenders were able to take market
share away from good lenders and good products. Next, I describe our
fragmented financial regulatory system and how it encouraged lenders to
shop for lenient regulators. In part three of my remarks, I document
regulatory failure by Federal banking regulators. Finally, I end with a
proposal for a separate consumer credit regulator.
I. Why Reckless Lenders Were Able To Crowd Out the Good
During the housing boom, the residential mortgage market was
relatively unconcentrated, with thousands of mortgage originators.
Normally, we would expect an unconcentrated market to provide vibrant
competition benefiting consumers. To the contrary, however, however,
highly risky loan products containing hidden risks--such as hybrid
adjustable-rate mortgages (ARMs), interest-only ARMs, and option
payment ARMs--gained market share at the expense of safer products such
as standard fixed-rate mortgages and FHA-guaranteed loans.\2\
---------------------------------------------------------------------------
\2\ A hybrid ARM offers a 2- or 3-year fixed introductory rate
followed by a floating rate at the end of the introductory period with
substantial increases in the rate and payment (so-called ``2-28'' and
``3-27'' mortgages). Federal Reserve System, Truth in Lending, Part II:
Proposed rule; request for public comment, 73 Fed. Reg. 1672, 1674
(January 9, 2008). An interest-only mortgage allows borrowers to defer
principal payments for an initial period. An option payment ARM
combines a floating rate feature with a variety of payment options,
including the option to pay no principal and less than the interest due
every month, for an initial period. Choosing that option results in
negative amortization. Department of the Treasury et al., Interagency
Guidance on Nontraditional Mortgage Product Risks: Final guidance, 71
Fed. Reg. 58609, 58613 (Oct. 4, 2006).
---------------------------------------------------------------------------
These nontraditional mortgages and subprime loans inflicted
incalculable harm on borrowers, their neighbors, and ultimately the
global economy. As of September 30, 2008, almost 10 percent of U.S.
residential mortgages were 1 month past due or more.\3\ By year-end
2008, every sixth borrower owed more than his or her home was worth.\4\
The proliferation of toxic loans was the direct result of the ability
to confuse borrowers and to shop for the laxest regulatory regime.\5\
---------------------------------------------------------------------------
\3\ See Mortgage Bankers Association, Delinquencies Increase,
Foreclosure Starts Flat in Latest MBA National Delinquency Survey (Dec.
5, 2008), available at www.mbaa.org/NewsandMedia/PressCenter/66626.htm.
\4\ Michael Corkery, Mortgage `Cram-Downs' Loom as Foreclosures
Mount, Wall St. J., Dec. 31, 2008.
\5\ The discussion in this section was drawn, in part, from
Patricia A. McCoy, Andrey D. Pavlov, & Susan M. Wachter, Systemic Risk
through Securitization: The Result of Deregulation and Regulatory
Failure,__Conn. L. Rev. __(forthcoming 2009) and Oren Bar-Gill &
Elizabeth Warren, Making Credit Safer,__ U. Penn. L. Rev. __
(forthcoming 2009).
---------------------------------------------------------------------------
A. The Growth in Dangerous Mortgage Products
During the housing boom, hybrid subprime ARMs, interest-only
mortgages, and option payment ARMs captured a growing part of the
market. We can see this from the growth in nonprime mortgages.\6\
Between 2003 and 2005, nonprime loans tripled from 11 percent of all
home loans to 33 percent.\7\
---------------------------------------------------------------------------
\6\ I use the term ``nonprime'' to refer to subprime loans plus
other nontraditional mortgages. Subprime mortgages carry higher
interest rates and fees and are designed for borrowers with impaired
credit. Nontraditional mortgages encompass a variety of risky mortgage
products, including option payment ARMs, interest-only mortgages, and
reduced documentation loans. Originally, these nontraditional products
were offered primarily in the ``Alt-A'' market to people with near-
prime credit scores but intermittent or undocumented income sources.
Eventually, interest-only ARMs and reduced documentation loans
penetrated the subprime market as well.
\7\ FDIC Outlook, Breaking New Ground in U.S. Mortgage Lending
(Summer 2006), available at www.fdic.gov/bank/analytical/regional/
ro20062q/na/2006_summer04.html.
---------------------------------------------------------------------------
If we unpack these numbers, it turns out that hybrid ARMs,
interest-only mortgages, and option payment ARMs accounted for a
growing share of nonprime loans over this period. Option payment ARMs
and interest-only mortgages went from 3 percent of all nonprime
originations in 2002 to well over 50 percent by 2005. (See Figure 1).
Low- and no-documentation loans increased from 25 percent to slightly
over 40 percent of subprime loans over the same period. By 2004 and
continuing through 2006, about three-fourths of the loans in subprime
securitizations consisted of hybrid ARMs.\8\
---------------------------------------------------------------------------
\8\ See generally McCoy, Pavlov & Wachter, supra note 5; FDIC
Outlook, Breaking New Ground in U.S. Mortgage Lending (Summer 2006),
available at www.fdic.gov/bank/analytical/regional/ro20062q/na/
2006_summer04.html.
---------------------------------------------------------------------------
Figure 1. Growth in Nontraditional Mortgages, 2002-2005\9\
---------------------------------------------------------------------------
\9\ FDIC Outlook, Breaking New Ground in U.S. Mortgage Lending
(Summer 2006), available at www.fdic.gov/bank/analytical/regional/
ro20062q/na/2006_summer04.html.
As the product mix of nonprime loans became riskier and riskier,
two default indicators for nonprime loans also increased substantially.
Loan-to-value ratios went up and so did the percentage of loans with
combined loan-to-value ratios of over 80 percent. This occurred even
though the credit scores of borrowers with those loans remained
relatively unchanged between 2002 and 2006. At the same time, the
spreads of rates over the bank cost of capital tightened. To make
matters worse, originators layered risk upon risk, with borrowers who
were the most at risk obtaining low equity, no-amortization, reduced
documentation loans. (See Figure 2).
Figure 2. Underwriting Criteria for Adjustable-Rate Mortgages, 2002-
2006
Many of these risky mortgage instruments were made in areas where
housing was least affordable, such as California, Florida and Arizona,
leading to concentrated areas of unsustainable housing values. (See
Figures 3 and 4). This concentration of risky loans put the entire
local markets at risk, due to the sudden and extreme withdrawal of
credit in the aftermath of a bubble.\10\
\10\ See Susan M. Wachter, Andrey D. Pavlov & Zoltan Pozsar,
Subprime Lending and Real Estate Markets, in Mortgage and Real Estate
Finance__(Stefania Perrucci, ed., Risk Books 2008).
---------------------------------------------------------------------------
Figure 3. Geographic Distribution of Interest-Only Loans, 2006.\11\
---------------------------------------------------------------------------
\11\ Anthony Pennington-Cross, Mortgage Product Substitution and
State Predatory Lending Laws, Presentation at the 2008 Mid-Year Meeting
of the American Real Estate and Urban Economics Association,
Washington, D.C., May 27, 2008.
Figure 4. Geographic Distribution of Low-Documentation Loans,
2006\12\
---------------------------------------------------------------------------
\12\ Id.
The combination of easing credit standards and a growing economy
resulted in a sharp increase in homeownership rates through 2004. As
the credit quality of loans steadily grew worse over 2005 through
2007,\13\ however, the volume of unsustainable loans grew and
homeownership rates dropped.\14\ (See Table 1).
---------------------------------------------------------------------------
\13\ Subprime mortgage originated in 2005, 2006 and 2007 had
successively worse default experiences than vintages in prior years.
See Freddie Mac, Freddie Mac Update 19 (December 2008), available at
www.freddiemac.com/investors/pdffiles/investor-presentation.pdf.
\14\ See Jesse M. Abraham, Andrey Pavlov & Susan Wachter,
Explaining the United States' Uniquely Bad Housing Market, XII Wharton
Real Estate Rev. 24 (2008).
---------------------------------------------------------------------------
Table 1. U.S. Homeownership Rates, by Year (U.S. Census Bureau)
The explosion of nontraditional mortgage lending was timed to
maintain securitization deal flows after traditional refinancings
weakened in 2003. The major take-off in these products occurred in
2002, which coincided with the winding down of the huge increase in
demand for mortgage securities through the refinance process. Coming
out of the recession of 2001, interest rates fell and there was a
massive securitization boom through refinancing that was fueled by low
interest rates. The private-label securitization industry had grown in
capacity and profits.
But in 2003, rising interest rates ended the potential for
refinancing at ever lower interest rates, leading to an increased need
for another source of mortgages to maintain and grow the rate of
securitization and the fees it generated. The ``solution'' was the
expansion of the market through nontraditional mortgages, especially
interest-only loans and option payment ARMs offering negative
amortization. (See Figure 1 supra). This expansion of credit swept a
larger portion of the population into the potential homeowner pool,
driving up housing demand and prices, and consumer indebtedness.
Indeed, consumer indebtedness grew so rapidly that between 1975 and
2007, total household debt soared from around 43 percent to nearly 100
percent of gross domestic product.\15\
---------------------------------------------------------------------------
\15\ U.S. Federal Reserve Board, Bureau of Economic Analysis.
---------------------------------------------------------------------------
The growth in nonprime mortgages was accomplished through market
expansion of nontraditional mortgages and by qualifying more borrowing
through easing of traditional lending terms. For example, while
subprime mortgages were initially made as ``hard money'' loans with low
loan-to-value ratios, by the height of their growth, combined loan-to-
value ratios exceeded that of the far less risky prime market. (See
Figure 3 supra). While the demand for riskier mortgages grew fueled by
the need for product to securitize, the potential risk due to
deteriorating lending standards also grew.
B. Consumer Confusion
If borrowers had been able to distinguish safe loans from highly
risky loans, risky loans would not have crowded out the market. But
numerous borrowers were not able to do so, for three distinct reasons.
First, hybrid subprime ARMs, interest-only mortgages, and option
payment ARMs were baffling in their complexity. Second, it was
impossible to obtain binding price quotes early enough to permit
meaningful comparison shopping in the nonprime market. Finally,
borrowers usually did not know that mortgage brokers got higher
compensation for steering them into risky loans.
Hidden Risks--The arcane nature of hybrid ARMs, interest-only
loans, and option payment ARMs often made informed consumer choice
impossible. These products were highly complex instruments that
presented an assortment of hidden risks to borrowers. Chief among those
risks was payment shock--in other words, the risk that monthly payments
would rise dramatically upon rate reset. These products presented
greater potential payment shock than conventional ARMs, which had lower
reset rates and manageable lifetime caps. Indeed, with these exotic
ARMs, the only way interest rates could go was up. Many late vintage
subprime hybrid ARMs had initial rate resets of 3 percentage points,
resulting in increased monthly payments of 50 percent to 100 percent or
more.\16\
---------------------------------------------------------------------------
\16\ Statement of Sheila C. Bair, Chairman, Federal Deposit
Insurance Corporation, on Strengthening the Economy: Foreclosure
Prevention and Neighborhood Preservation, before the Committee on
Banking, Housing and Urban Affairs, U.S. Senate, 538 Dirksen Senate
Office Building, January 31, 2008, www.fdic.gov/news/news/speeches/
chairman/spjan3108.html.
---------------------------------------------------------------------------
For a borrower to grasp the potential payment shock on a hybrid,
interest-only, or option payment ARM, he or she would need to
understand all the moving parts of the mortgage, including the index,
rate spread, initial rate cap, and lifetime rate cap. On top of that,
the borrower would need to predict future interest rate movements and
translate expected rate changes into changes in monthly payments.
Interest-only ARMs and option payment ARMs had the added complication
of potential deferred or negative amortization, which could cause the
principal payments to grow. Finally, these loans were more likely to
carry large prepayment penalties. To understand the effect of such a
prepayment penalty, the borrower would have to use a formula to compute
the penalty's size and then assess the likelihood of moving or
refinancing during the penalty period.\17\ Truth-in-Lending Act
disclosures did not require easy-to-understand disclosures about any of
these risks.\18\
---------------------------------------------------------------------------
\17\ Federal Reserve System, Truth in Lending, Part III: Final
rule, official staff commentary, 73 Fed. Reg. 44522, 44524-25 (July 30,
2008); Federal Reserve System, Truth in Lending, Part II: Proposed
rule; request for public comment, 73 Fed. Reg. 1672, 1674 (January 9,
2008).
\18\ Patricia A. McCoy, Rethinking Disclosure in a World of Risk-
Based Pricing, 44 Harv. J. Legis. 123 (2007), available at http://
www.law.harvard.edu/students/orgs/jol/vol44_1/mccoy.pdf.
---------------------------------------------------------------------------
Inability to Do Meaningful Comparison Shopping--The lack of binding
rate quotes also hindered informed comparison-shopping in the nonprime
market. Nonprime loans had many rates, not one, which varied according
to the borrower's risk, the originator's compensation, the
documentation level of the loan, and the naivety of the borrower.
Between their complicated price structure and the wide variety of
products, subprime loans were not standardized. Furthermore, it was
impossible to obtain a binding price quote in the subprime market
before submitting a loan application and paying a non-refundable fee.
Rate locks were also a rarity in the subprime market. In too many
cases, subprime lenders waited until the closing to unveil the true
product and price for the loan, a practice that the Truth in Lending
Act rules countenanced. These rules, promulgated by the Federal Reserve
Board, helped foster rampant ``bait-and-switch'' schemes in the
subprime market.\19\
---------------------------------------------------------------------------
\19\ Id.; Federal Reserve System, Truth in Lending--Proposed rule;
request for public comment, 73 Fed. Reg. 1672, 1675 (Jan. 9, 2008).
---------------------------------------------------------------------------
As a result, deceptive advertising became a stock-in-trade of the
nonprime market. Nonprime lenders and brokers did not advertise their
prices to permit meaningful comparison-shopping. To the contrary,
lenders treated their rate sheets--which listed their price points and
pricing criteria--as proprietary secrets that were not to be disclosed
to the mass consumer market. Subprime advertisements generally focused
on fast approval and low initial monthly payments or interest rates,
not on accurate prices.
While the Federal Reserve exhorted people to comparison-shop for
nonprime loans,\20\ in reality, comparison-shopping was futile.
Nonprime lenders did not post prices, did not provide consumers with
firm price quotes, and did not offer lock-in commitments as a general
rule. Anyone who attempted to comparison-shop had to pay multiple
application fees for the privilege and, even then, might not learn the
actual price until the closing if the lender engaged in a bait-and-
switch.
---------------------------------------------------------------------------
\20\ See, e.g., Federal Reserve Board, Looking for the Best
Mortgage, www.federalreserve.gov/pubs/mortgage/mortb_11.htm.
---------------------------------------------------------------------------
As early as 1998, the Federal Reserve Board and the Department of
Housing and Urban Development were aware that Truth in Lending Act
disclosures did not come early enough in the nonprime market to allow
meaningful comparison shopping. That year, the two agencies issued a
report diagnosing the problem. In the report, HUD recommended changes
to the Truth in Lending Act to require mortgage originators to provide
binding price quotes before taking loan applications. The Federal
Reserve Board dissented from the proposal, however, and it was never
adopted.\21\ To this day, the Board has still not revamped Truth in
Lending disclosures for closed-end mortgages.
---------------------------------------------------------------------------
\21\ See Bd. of Governors of the Fed. Reserve Sys. & Dep't of Hous.
& Urban Dev., Joint Report to the Congress, Concerning Reform to the
Truth in Lending Act and the Real Estate Settlement Procedures Act, at
28-29, 39-42 (1998), available at www.federalreserve.gov/boarddocs/
rptcongress/tila.pdf.
---------------------------------------------------------------------------
Perverse Fee Incentives--Finally, many consumers were not aware
that the compensation structure rewarded mortgage brokers for riskier
loan products and higher interest rates. Mortgage brokers only got paid
if they closed a loan. Furthermore, they were paid solely through
upfront fees at closing, meaning that if a loan went bad, the losses
would fall on the lender or investors, not the broker. In the most
pernicious practice, lenders paid brokers thousands of dollars per loan
in fees known as yield spread premiums (or YSPs) in exchange for loans
saddling borrowers with steep prepayment penalties and higher interest
rates than the borrowers qualified for, based on their incomes and
credit scores.
In sum, these three features--the ability to hide risk, thwart
meaningful comparison-shopping, and reward steering--allowed lenders to
entice unsuspecting borrowers into needlessly hazardous loans.
C. The Crowd-Out Effect
The ability to bury risky product features in fine print allowed
irresponsible lenders to out-compete safe lenders. Low initial monthly
payments were the most visible feature of hybrid ARMs, interest-only
loans, and option payment ARMs. During the housing boom, lenders
commonly touted these products based on low initial monthly payments
while obscuring the back-end risks of those loans.\22\
---------------------------------------------------------------------------
\22\ See, e.g., Julie Haviv & Emily Kaiser, Web lenders woo
subprime borrowers despite crisis, Reuters (Apr. 22, 2007); E. Scott
Reckard, Refinance pitches in sub-prime tone, Los Angeles Times,
October 29, 2007.
---------------------------------------------------------------------------
The ability to hide risks made it easy to out-compete lenders
offered fixed-rate, fully amortizing loans. Other things being equal,
the initial monthly payments on exotic ARMs were lower than on fixed-
rate, amortizing loans. Furthermore, some nonprime lenders qualified
borrowers solely at the low initial rate alone until the Federal
Reserve Board finally banned that practice in July 2008.\23\
---------------------------------------------------------------------------
\23\ In fall 2006, Federal regulators issued an interagency
guidance advising option ARM lenders to qualify borrowers solely at the
fully indexed rate. Nevertheless, Washington Mutual (WaMu) apparently
continued to qualify applicants for option ARMs at the low,
introductory rate alone until mid-2007. It was not until July 30, 2007
that WaMu finally updated its ``Bulk Seller Guide'' to require its
correspondents to underwrite option ARMs and other ARMs at the fully
indexed rate.
---------------------------------------------------------------------------
Of course, many sophisticated customers recognized the dangers of
these loans. That did not deter lenders from offering hazardous
nontraditional ARMs, however. Instead, the ``one-sizefits-one'' nature
of nonprime loans permitted lenders to discriminate by selling safer
products to discerning customers and more lucrative, dangerous products
to naive customers. Sadly, the consumers who were least well equipped
in terms of experience and education to grasp arcane loan terms \24\
ended up with the most dangerous loans.
---------------------------------------------------------------------------
\24\ Howard Lax, Michael Manti, Paul Raca & Peter Zorn, Subprime
Lending: An Investigation of Economic Efficiency, 15 Housing Pol'y
Debate 533, 552-554 (2004), http://www.fanniemaefoundation.org/
programs/hpd/pdf/hpd_1503_Lax.pdf.
---------------------------------------------------------------------------
In the meantime, lenders who offered safe products--such as fixed-
rate prime loans--lost market share to lenders who peddled exotic ARMs
with low starting payments. As conventional lenders came to realize
that it didn't pay to compete on good products, those lenders expanded
into the nonprime market as well.
II. The Regulatory Story: Race to the Bottom
Federal banking regulators added fuel to the crisis by allowing
reckless loans to flourish. It is a basic tenet of banking law that
banks should not extend credit without proof of ability to repay.
Federal banking regulators \25\ had ample authority to enforce this
tenet through safety and soundness supervision and through Federal
consumer protection laws. Nevertheless, they refused to exercise their
substantial powers of rulemaking, formal enforcement, and sanctions to
crack down on the proliferation of poorly underwritten loans until it
was too late. Their abdication allowed irresponsible loans to multiply.
Furthermore, their green light to banks to invest in investment-grade
subprime mortgage-backed securities and CDOs left the nation's largest
banks struggling with toxic assets. These problems were a direct result
of the country's fragmented system of financial regulation, which
caused regulators to compete for turf.
---------------------------------------------------------------------------
\25\ The four Federal banking regulators include the Federal
Reserve System, which serves as the central bank and supervises State
member banks; the Office of the Comptroller of the Currency, which
oversees national banks; the Federal Deposit Insurance Corporation,
which operates the Deposit Insurance Fund and regulates State nonmember
banks; and the Office of Thrift Supervision, which supervises savings
associations.
---------------------------------------------------------------------------
A. The Fragmented U.S. System of Mortgage Regulation
In the United States, the home mortgage lending industry operates
under a fragmented regulatory structure which varies according to
entity.\26\ Banks and thrift institutions are regulated under Federal
banking laws and a subset of those institutions--namely, national
banks, Federal savings associations, and their subsidiaries--are exempt
from State anti-predatory lending and credit laws by virtue of Federal
preemption. In contrast, mortgage brokers and independent non-
depository mortgage lenders escape Federal banking regulation but have
to comply with all State laws in effect. Only State-chartered banks and
thrifts in some states (a dwindling group) are subject to both sets of
laws.
---------------------------------------------------------------------------
\26\ This discussion is drawn from Patricia A. McCoy & Elizabeth
Renuart, The Legal Infrastructure of Subprime and Nontraditional
Mortgage Lending, in Borrowing to Live: Consumer and Mortgage Credit
Revisited 110 (Nicolas P. Retsinas & Eric S. Belsky eds., Joint Center
for Housing Studies of Harvard University & Brookings Institution
Press, 2008).
---------------------------------------------------------------------------
Under this dual system of regulation, depository institutions are
subject to a variety of Federal examinations, including fair lending,
Community Reinvestment Act, and safety and soundness examinations, but
independent nondepository lenders are not. Similarly, banks and thrifts
must comply with other provisions of the Community Reinvestment Act,
including reporting requirements and merger review. Federally insured
depository institutions must also meet minimum risk-based capital
requirements and reserve requirements, unlike their independent non-
depository counterparts.
Some Federal laws applied to all mortgage originators. Otherwise,
lenders could change their charter and form to shop for the friendliest
regulatory scheme.
B. Applicable Law
Despite these differences in regulatory regimes, the Federal
Reserve Board did have the power to prohibit reckless mortgages across
the entire mortgage industry. The Board had this power by virtue of its
authority to administer a Federal anti-predatory lending law known as
``HOEPA.''
1. Federal Law
Following deregulation of home mortgages in the early 1980's,
disclosure became the most important type of Federal mortgage
regulation. The Federal Truth in Lending Act (TILA),\27\ passed in
1968, mandates uniform disclosures regarding cost for home loans. Its
companion law, the Federal Real Estate Settlement Procedures Act of
1974 (RESPA),\28\ requires similar standardized disclosures for
settlement costs. Congress charged the Federal Reserve with
administering TILA and the Department of Housing and Urban Development
with administering RESPA.
---------------------------------------------------------------------------
\27\ 15 U.S.C. 1601-1693r (2000).
\28\ 12 U.S.C. 2601-2617 (2000).
---------------------------------------------------------------------------
In 1994, Congress augmented TILA and RESPA by enacting the Home
Ownership and Equity Protection Act (HOEPA).\29\ HOEPA was an early
Federal anti-predatory lending law and prohibits specific abuses in the
subprime mortgage market. HOEPA applies to all residential mortgage
lenders and mortgage brokers, regardless of the type of entity.
---------------------------------------------------------------------------
\29\ 15 U.S.C. 1601, 1602(aa), 1639(a)-(b).
---------------------------------------------------------------------------
HOEPA has two important provisions. The first consists of HOEPA's
high-cost loan provision,\30\ which regulates the high-cost refinance
market. This provision seeks to eliminate abuses consisting of ``equity
stripping.'' It is hobbled, however, by its extremely limited reach--
covering only the most exorbitant subprime mortgages--and its
inapplicability to home purchase loans, reverse mortgages, and open-end
home equity lines of credit.\31\ Lenders learned to evade the high-cost
loan provisions rather easily by slightly lowering the interest rates
and fees on subprime loans below HOEPA's thresholds and by expanding
into subprime purchase loans.
---------------------------------------------------------------------------
\30\ 15 U.S.C. Sec. 1602(aa)(1)-(4); 12 C.F.R. 226.32(a)(1),
(b)(1).
\31\ 15 U.S.C. Sec. 1602(i), (w), (bb); 12 C.F.R. 226.32(a)(2)
(1997); Edward M. Gramlich, Subprime Mortgages: America's Latest Boom
and Bust 28 (Urban Institute Press, 2007).
---------------------------------------------------------------------------
HOEPA also has a second major provision, which gives the Federal
Reserve Board the authority to prohibit unfair or deceptive lending
practices and refinance loans involving practices that are abusive or
against the interest of the borrower.\32\ This provision is potentially
broader than the high-cost loan provision, because it allows regulation
of both the purchase and refinance markets, without regard to interest
rates or fees. However, it was not self-activating. Instead, it
depended on action by the Federal Reserve Board to implement the
provision, which the Board did not take until July 2008.
---------------------------------------------------------------------------
\32\ 15 U.S.C. 1639(l)(2).
---------------------------------------------------------------------------
2. State Law
Before 2008, only the high-cost loan provision of HOEPA was in
effect as a practical matter. This provision had a serious Achilles
heel, consisting of its narrow coverage. Even though the Federal
Reserve Board lowered the high-cost triggers of HOEPA effective in
2002, that provision still only applied to 1 percent of all subprime
home loans.\33\
---------------------------------------------------------------------------
\33\ Gramlich, supra note 31 (2007, p. 28).
---------------------------------------------------------------------------
After 1994, it increasingly became evident that HOEPA was incapable
of halting equity stripping and other sorts of subprime abuses. By the
late 1990s, some cities and states were contending with rising
foreclosures and some jurisdictions were contemplating regulating
subprime loans on their own. Many states already had older statutes on
the books regulating prepayment penalties and occasionally balloon
clauses. These laws were relatively narrow, however, and did not
address other types of new abuses that were surfacing in subprime
loans.
Consequently, in 1999, North Carolina became the first State to
enact a comprehensive anti-predatory lending law.\34\ Soon, other
states followed suit and passed anti-predatory lending laws of their
own. These newer State laws implemented HOEPA's design but frequently
expanded coverage or imposed stricter regulation on subprime loans. By
year-end 2005, 29 States and the District of Columbia had enacted one
of these ``mini-HOEPA'' laws. Some States also passed stricter
disclosure laws or laws regulating mortgage brokers. By the end of
2005, only six States--Arizona, Delaware, Montana, North Dakota,
Oregon, and South Dakota--lacked laws regulating prepayment penalties,
balloon clauses, or mandatory arbitration clauses, all of which were
associated with exploitative subprime loans.\35\
---------------------------------------------------------------------------
\34\ N.C. Gen Stat. 24-1.1E (2000).
\35\ See Raphael Bostic, Kathleen C. Engel, Patricia A. McCoy,
Anthony Pennington-Cross & Susan Wachter, State and Local Anti-
Predatory Lending Laws: The Effect of Legal Enforcement Mechanisms, 60
J. Econ. & Bus. 47-66 (2008), full working paper version available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1005423.
---------------------------------------------------------------------------
Critics, including some Federal banking regulators, have blamed the
states for igniting the credit crisis through lax regulation.
Certainly, there were states that were largely unregulated and there
were states where mortgage regulation was weak. Mortgage brokers were
loosely regulated in too many states. Similarly, the states never
agreed on an effective, uniform system of mortgage regulation.
Nevertheless, this criticism of the states disregards the hard-
fought efforts by a growing number of states--which eventually grew to
include the majority of states--to regulate abusive subprime loans
within their borders. State attorneys general and State banking
commissioners spearheaded some of the most important enforcement
actions against deceptive mortgage lenders.\36\
---------------------------------------------------------------------------
\36\ For instance, in 2002, State authorities in 44 states struck a
settlement with Household Finance Corp. for $484 million in consumer
restitution and changes in its lending practices following enforcement
actions to redress alleged abusive subprime loans. Iowa Attorney
General, States Settle With Household Finance: Up to $484 Million for
Consumers (Oct. 11, 2002), available at www.iowa.gov/government/ag/
latest_news/releases/oct_2002/Household_
Chicago.html. In 2006, forty-nine states and the District of Columbia
reached a $325 million settlement with Ameriquest Mortgage Company over
alleged predatory lending practices. See, e.g., Press Release, Iowa
Dep't of Justice, Miller: Ameriquest Will Pay $325 Million and Reform
its Lending Practices (Jan. 23, 2006), available at http://
www.state.ia.us/government/ag/latest_news/releases/jan_2006/
Ameriquest_Iowa.html.
---------------------------------------------------------------------------
C. The Ability to Shop For Hospitable Laws and Regulators
State-chartered banks and thrifts and their subsidiaries had to
comply with the State anti-predatory lending laws. So did independent
nonbank lenders and mortgage brokers. For the better part of the
housing boom, however, national banks, Federal savings associations,
and their mortgage lending subsidiaries did not have to comply with the
State anti-predatory lending laws due to Federal preemption rulings by
their Federal regulators. This became a problem because Federal
regulators did not replace the preempted State laws with strong Federal
underwriting rules.
1. Federal Preemption
The states that enacted anti-predatory lending laws did not
legislate in a vacuum. In 1996, the Federal regulator for thrift
institutions--the Office of Thrift Supervision or OTS--promulgated a
sweeping preemption rule declaring that henceforth Federal savings
associations did not have to observe State lending laws.\37\ Initially,
this rule had little practical effect because any State anti-predatory
lending provisions on the books then were fairly narrow.\38\
---------------------------------------------------------------------------
\37\ 12 C.F.R. 559.3(h), 560.2.
\38\ Bostic et al., supra note 35; Office of Thrift Supervision,
Responsible Alternative Mortgage Lending: Advance notice of proposed
rulemaking, 65 Fed. Reg. 17811, 17814-16 (2000).
---------------------------------------------------------------------------
Following adoption of the OTS preemption rule, Federal thrift
institutions and their subsidiaries were relieved from having to comply
with State consumer protection laws. That was not true, however, for
national banks, State banks, State thrifts, and independent nonbank
mortgage lenders and brokers.
The stakes rose considerably starting in 1999, when North Carolina
passed the first comprehensive State anti-predatory lending law. As
State mini-HOEPA laws proliferated, national banks lobbied their
regulator--a Federal agency known as the Office of the Comptroller of
the Currency or OCC--to clothe them with the same Federal preemption as
Federal savings associations. They succeeded and, in 2004, the OCC
issued its own preemption rule banning the states from enforcing their
laws impinging on real estate lending by national banks and their
subsidiaries.\39\ In a companion rule, the OCC denied permission to the
states to enforce their own laws that were not federally preempted--
state lending discrimination laws are one example--against national
banks and their subsidiaries. After a protracted court battle, the
controversy ended up in the U.S. Supreme Court, which upheld the OCC
preemption rule.\40\
---------------------------------------------------------------------------
\39\ Office of the Comptroller of the Currency, Bank Activities and
Operations; Final rule, 69 Fed. Reg. 1895 (2004) (codified at 12 C.F.R.
7.4000); Office of the Comptroller of the Currency, Bank Activities
and Operations; Real Estate Lending and Appraisals; Final rule, 69 Fed.
Reg. 1904 (2004) (codified at 12 C.F.R. 7.4007-7.4009, 34.4).
National City Corporation, the parent of National City Bank, N.A., and
a major subprime lender, spearheaded the campaign for OCC preemption.
Predatory lending laws neutered, Atlanta Journal Constitution, Aug. 6,
2003.
\40\ Watters v. Wachovia Bank, N.A., 550 U.S. 1 (2007); Arthur E.
Wilmarth, Jr., The OCC's Preemption Rules Exceed the Agency's Authority
and Present a Serious Threat to the Dual Banking System, 23 Ann. Rev.
Banking & Finance Law 225 (2004). The Supreme Court recently granted
certiorari to review the legality of the OCC visitorial powers rule.
Cuomo v. Clearing House Ass'n, L.L.C.,__U.S.__, 129 S. Ct. 987 (2009).
The OCC and the OTS left some areas of State law untouched, namely,
State criminal law and State law regulating contracts, torts, homestead
rights, debt collection, property, taxation, and zoning. Both agencies,
though, reserved the right to declare that any State laws in those
areas are preempted in the future. For fuller discussion, see. McCoy &
Renuart, supra note 26.
---------------------------------------------------------------------------
OTS and the OCC had institutional motives to grant Federal
preemption to the institutions that they regulated. Both agencies
depend almost exclusively on fees from their regulated entities for
their operating budgets. Both were also eager to persuade State-
chartered depository institutions to convert to a Federal charter. In
addition, the OCC was aware that if national banks wanted Federal
preemption badly enough, they might defect to the thrift charter to get
it. Thus, the OCC had reason to placate national banks to keep them in
its fold. Similarly, the OTS was concerned about the steady decline in
thrift institutions. Federal preemption provided an inducement to
thrift institutions to retain the Federal savings association charter.
2. The Ability to Shop for the Most Permissive Laws
As a result of Federal preemption, State anti-predatory lending
laws applied to State-chartered depository institutions and independent
nonbank lenders, but not to national banks, Federal savings
associations, or their mortgage lending subsidiaries. The only anti-
predatory lending provisions that national banks and federally
chartered thrifts had to obey were HOEPA and agency pronouncements on
subprime and nontraditional mortgage loans.\41\ Of these, HOEPA had
extremely narrow scope. Meanwhile, agency guidances lacked the binding
effect of rules and their content was not as strict as the stronger
State laws.
---------------------------------------------------------------------------
\41\ Board of Governors of the Federal Reserve System et al.,
Interagency Guidance on Subprime Lending (March 1, 1999); OCC, Abusive
Lending Practices, Advisory Letter 2000-7 (July 25, 2000); OCC et al.,
Expanded Guidance for Subprime Lending Programs (Jan. 31, 2001); OCC,
Avoiding Predatory and Abusive Lending Practices in Brokered and
Purchased Loans, Advisory Letter 2003-3 (Feb. 21, 2003); OCC,
Guidelines for National Banks to Guard Against Predatory and Abusive
Lending Practices, Advisory Letter 2003-2 (Feb. 21, 2003); OCC, OCC
Guidelines Establishing Standards for Residential Mortgage Lending
Practices, 70 Fed. Reg. 6329 (2005); Department of the Treasury et al.,
Interagency Guidance on Nontraditional Mortgage Product Risks; Final
guidance, 71 Fed. Reg. 58609 (2006); Department of the Treasury et al.,
Statement on Subprime Mortgage Lending; Final guidance, 72 Fed. Reg.
37569 (2007). Of course, these lenders, like all lenders, are subject
to prosecution in cases of fraud. Lenders are also subject to the
Federal Trade Commission Act, which prohibits unfair and deceptive acts
and practices (UDAPs). However, Federal banking regulators were slow to
propose rules to define and punish UDAP violations by banking companies
in the mortgage lending area.
---------------------------------------------------------------------------
This dual regulatory system allowed mortgage lender to play
regulators off one another by threatening to change charters. Mortgage
lenders are free to operate with or without depository institution
charters. Similarly, depository institutions can choose between a State
and Federal charter and between a thrift charter and a commercial bank
charter. Each of these choices allows a lender to change regulators.
A lender could escape a strict State law by switching to a Federal
bank or thrift charter or by shifting its operations to a less
regulated State. Similarly, a lender could escape a strict regulator by
converting its charter to one with a more accommodating regulator.
Countrywide, the nation's largest mortgage lender and a major
subprime presence, took advantage of this system to change its
regulator. One of its subsidiaries, Countrywide Home Loans, was
supervised by the Federal Reserve. This subsidiary switched and became
an OTS-regulated entity as of March 2007. That same month, Countrywide
Bank, N.A., converted its charter from a national bank charter under
OCC supervision to a Federal thrift charter under OTS supervision.
Reportedly, OTS promised Countrywide's executives to be a ``less
antagonistic'' regulator if Countrywide switched charters to OTS. Six
months later, the regional deputy director of the OTS West Region,
where Countrywide was headquartered, was promoted to division director.
Some observers considered it a reward.\42\
---------------------------------------------------------------------------
\42\ Richard B. Schmitt, Regulator takes heat over IndyMac, Los
Angeles Times, Oct. 6, 2008; see also Binyamin Appelbaum & Ellen
Nakashima, Regulator Played Advocate Over Enforcer, Washington Post,
November 23, 2008.
---------------------------------------------------------------------------
The result was a system in which lenders could shop for the loosest
laws and enforcement. This shopping process, in turn, put pressure on
regulators at all levels--state and local--to lower their standards or
relax enforcement. What ensued was a regulatory race to the bottom.
III. Regulatory Failure
Federal preemption would not have been such a problem if Federal
banking regulators had replaced State laws with tough rules and
enforcement of their own. Those regulators had ample power to stop the
deterioration in mortgage underwriting standards that mushroomed into a
full-blown crisis. However, they refused to intervene in disastrous
lending practices until it was too late. As a result, federally
regulated lenders--as well as all lenders operating in states with weak
regulation--were given carte blanche to loosen their lending standards
free from meaningful regulatory intervention.
A. The Federal Reserve Board
The Federal Reserve Board had the statutory power, starting in
1994, to curb lax lending not only for depository institutions, but for
all lenders across-the-board. It declined to exercise that power in any
meaningful respect, however, until after the nonprime mortgage market
collapsed.
In the mortgage lending area, the Fed's supervisory process has
three major parts and breakdowns were apparent in two out of the three.
The only part that appeared to work well was the Fed's role as the
primary Federal regulator for State-chartered banks that are members of
the Federal Reserve System.\43\
---------------------------------------------------------------------------
\43\ In general, these are community banks on the small side. In
2007 and 2008, only one failed bank--the tiny First Georgia Community
Bank in Jackson, Georgia, with only $237.5 million in assets--was
regulated by the Federal Reserve System. It is not clear whether the
Fed's performance is explained by the strength of its examination
process, the limited role of member banks in risky lending, the fact
that State banks had to comply with State anti-predatory lending laws,
or all three.
In the following discussion on regulatory failure by the Federal
Reserve Board, the OTS, and the OCC, the data regarding failed and
near-failed banks and thrifts come from Federal bank regulatory and
S.E.C. statistics, disclosures, press releases, and orders; rating
agency reports; press releases and other web materials by the companies
mentioned; statistics compiled by the American Banker; and financial
press reports.
---------------------------------------------------------------------------
As the second part of its supervisory duties, the Fed regulates
nonbank mortgage lenders owned by bank holding companies but not owned
directly or indirectly by banks or thrifts. During the housing boom,
some of the largest subprime and Alt-A lenders were regulated by the
Fed, including the top- and third-ranked subprime lenders in 2006, HSBC
Finance and Countrywide Financial Corporation, and Wells Fargo
Financial, Inc.\44\ The Fed's supervisory record with regard to these
lenders was mixed. On one notable occasion, in 2004, the Fed levied a
$70 million civil money penalty against CitiFinancial Credit Company
and its parent holding company, Citigroup Inc., for subprime lending
abuses.\45\ Apart from that, the Fed did not take public enforcement
action against the nonbank lenders that it regulated. That may be
because the Federal Reserve did not routinely examine the nonbank
mortgage lending subsidiaries under its supervision, which the late
Federal Reserve Board Governor Edward Gramlich revealed in 2007. Only
then did the Fed kick off a ``pilot project'' to examine the nonbank
lenders under its jurisdiction on a routine basis for loose
underwriting and compliance with Federal consumer protection laws.\46\
---------------------------------------------------------------------------
\44\ Data provided by American Banker, available at
www.americanbanker.com.
\45\ Federal Reserve, Citigroup Inc. New York, New York and
Citifinancial Credit Company Baltimore, Maryland: Order to Cease and
Desist and Order of Assessment of a Civil Money Penalty Issued Upon
Consent, May 27, 2004.
\46\ Edward M. Gramlich, Boom and Busts, The Case of Subprime
Mortgages, Speech given August 31, 2007, Jackson Hole, Wyo., at
symposium titled ``Housing, Housing Finance & Monetary Policy,''
sponsored by the Federal Reserve Bank of Kansas City, pp. 8-9,
available at www.kansascityfed.org/publicat/sympos/2007/pdf/
2007.09.04.gramlich.pdf; Speech by Governor Randall S. Kroszner At the
National Bankers Association 80th Annual convention, Durham, North
Carolina, October 11, 2007.
---------------------------------------------------------------------------
Finally, the Board is responsible for administering most Federal
consumer credit protection laws, including HOEPA. When former Governor
Edward Gramlich served on the Fed, he urged then-Chairman Alan
Greenspan to exercise the Fed's power to address unfair and deceptive
loans under HOEPA. Greenspan refused, preferring instead to rely on
non-binding statements and guidances.\47\ This reliance on statements
and guidances had two disadvantages: one, major lenders routinely
dismissed the guidances as mere ``suggestions'' and, two, guidances did
not apply to independent nonbank mortgage lenders.
---------------------------------------------------------------------------
\47\ House of Representatives, Committee on Oversight and
Government Reform, ``The Financial Crisis and the Role of Federal
Regulators, Preliminary Transcript'' 35, 37-38 (Oct. 23, 2008),
available at http://oversight.house.gov/documents/20081024163819.pdf.
Greenspan told the House Oversight Committee in 2008:
Well, let's take the issue of unfair and deceptive practices,
which is a fundamental concept
to the whole predatory lending issue.
The staff of the Federal Reserve . . . say[ ] how do they
determine as a regulatory group
what is unfair and deceptive? And the problem that they were
concluding . . . was the
issue of maybe 10 percent or so are self-evidently unfair and
deceptive, but the vast
majority would require a jury trial or other means to deal with
it . . .
Id. at 89.
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The Federal Reserve did not relent until July 2008, when under
Chairman Ben Bernanke's leadership, it finally promulgated binding
HOEPA regulations banning specific types of lax and abusive loans. Even
then, the regulations were mostly limited to higher-priced mortgages,
which the Board confined to first-lien loans of 1.5 percentage points
or more above the average prime offer rate for a comparable
transaction, and 3.5 percentage points for second-lien loans. Although
shoddy nontraditional mortgages below those triggers had also
contributed to the credit crisis, the rule left those loans--plus prime
loans--mostly untouched.\48\
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\48\ Federal Reserve System, Truth in Lending: Final rule; official
staff commentary, 73 Fed. Reg. 44522, 44536 (July 30, 2008). The Board
set those triggers with the intention of covering the subprime market,
but not the prime market. See id. at 44536-37.
---------------------------------------------------------------------------
The rules, while badly needed, were too little and too late. On
October 23, 2008, in testimony before the U.S. House of Representatives
Oversight Committee, Greenspan admitted that ``those of us who have
looked to the self-interest of lending institutions to protect
shareholder's equity (myself especially) are in a state of shocked
disbelief.'' House Oversight Committee Chairman Henry Waxman asked
Greenspan whether ``your ideology pushed you to make decisions that you
wish you had not made?'' Greenspan replied:\49\
---------------------------------------------------------------------------
\49\ House of Representatives, Committee on Oversight and
Government Reform, ``The Financial Crisis and the Role of Federal
Regulators, Preliminary Transcript'' 36-37 (Oct. 23, 2008), available
at http://oversight.house.gov/documents/20081024163819.pdf.
Mr. GREENSPAN. . . . [Y]es, I found a flaw, I don't know how
significant or permanent it is, but I have been very distressed
by that fact . . .
Chairman WAXMAN. You found a flaw?
Mr. GREENSPAN. I found a flaw in the model that defines how the
world works, so to speak.
Chairman WAXMAN. In other words, you found that your view of
the world, your ideology, was not right, it was not working.
Mr. GREENSPAN. Precisely. That's precisely the reason I was
shocked, because I had been going for 40 years or more with
very considerable evidence that it was working exceptionally
well.\50\
\50\ Testimony of Dr. Alan Greenspan before the House of
Representatives Committee of Government Oversight and Reform, October
23, 2008, available at http://oversight.house.gov/documents/
20081023100438.pdf.
---------------------------------------------------------------------------
B. Regulatory Lapses by the OCC and OTS
Federal preemption might not have devolved into a banking crisis of
systemic proportions had OTS and the OCC replaced State regulation for
their regulated entities with a comprehensive set of binding rules
prohibiting lax underwriting of home mortgages. Generally, in lieu of
binding rules, Federal banking regulators, including the OCC and OTS,
issued a series of ``soft law'' advisory letters and guidelines against
predatory or unfair mortgage lending practices by insured depository
institutions.\51\ Federal regulators disavowed binding rules during the
run-up to the subprime crisis on grounds that the guidelines were more
flexible and that the agencies enforced those guidelines through bank
examinations and informal enforcement actions.\52\ Informal enforcement
actions were usually limited to negotiated, voluntary agreements
between regulators and the entities that they supervised, which made it
easy for management to drag out negotiations to soften any restrictions
and to bid for more time. Furthermore, examinations and informal
enforcement are highly confidential, making it easy for a lax regulator
to hide its tracks.
---------------------------------------------------------------------------
\51\ See note 41 supra.
\52\ Office of the Comptroller of the Currency, Bank Activities and
Operations; Real Estate Lending and Appraisals; Final rule, 69 Fed.
Reg. 1904 (2004).
---------------------------------------------------------------------------
1. The Office of Thrift Supervision
Although OTS was the first agency to adopt Federal preemption, it
managed to fly under the radar during the subprime boom, overshadowed
by its larger sister agency, the OCC. After 2003, while commentators
were busy berating the OCC preemption rule, OTS allowed the largest
Federal savings associations to embark on an aggressive campaign of
expansion through option payment ARMs, subprime loans, and low-
documentation and no-documentation loans.
Autopsies of failed depository institutions in 2007 and 2008 show
that five of the seven biggest failures were OTS-regulated thrifts. Two
other enormous thrifts during that period--Wachovia Mortgage, FSB and
Countrywide Bank, FSB--were forced to arrange hasty takeovers by large
bank holding companies to avoid failing. By December 31, 2008, thrifts
totaling $355 billion in assets had failed in the previous sixteen
months on OTS' watch.
The reasons for the collapse of these thrifts evidence fundamental
regulatory lapses by OTS. Almost all of the thrifts that failed in 2007
and 2008--and all of the larger ones--succumbed to massive levels of
imprudent home loans. IndyMac Bank, FSB, which became the first major
thrift institution to fail during the current crisis in July 2008,
manufactured its demise by becoming the nation's top originator of low-
documentation and no-documentation loans. These loans, which became
known as ``liar's loans,'' infected both the subprime market and credit
to borrowers with higher credit scores. By 2006 and 2007, over half of
IndyMac's home purchase loans were subprime loans and IndyMac Bank
approved up to half of those loans based on low or no documentation.
Washington Mutual Bank, popularly known as ``WaMu,'' was the
nation's largest thrift institution in 2008, with over $300 billion in
assets. WaMu became the biggest U.S. depository institution in history
to fail on September 25, 2008, in the wake of the Lehman Brothers
bankruptcy. WaMu was so large that OTS examiners were stationed there
permanently onsite. Nevertheless, from 2004 through 2006, despite the
daily presence of the resident OTS inspectors, risky option ARMs,
second mortgages, and subprime loans constituted over half of WaMu's
real estate loans each year. By June 30, 2008, over one fourth of the
subprime loans that WaMu originated in 2006 and 2007 were at least
thirty days past due. Eventually, it came to light that WaMu's
management had pressured its loan underwriters relentlessly to approve
more and more exceptions to WaMu's underwriting standards in order to
increase its fee revenue from loans.\53\
---------------------------------------------------------------------------
\53\ Peter S. Goodman & Gretchen Morgenson, Saying Yes, WaMu Built
Empire on Shaky Loans, N.Y. Times, Dec. 28, 2008.
---------------------------------------------------------------------------
Downey Savings & Loan became the third largest depository
institution to fail in 2008. Like WaMu, Downey had loaded up on option
ARMs and subprime loans. When OTS finally had to put it into
receivership, over half of Downey's total assets consisted of option
ARMs and nonperforming loans accounted for over 15 percent of the
thrift's total assets.
In short, the three largest depository institution failures in 2007
and 2008 resulted from high concentrations of poorly underwritten
loans, including low- and no-documentation ARMs (in the case of
IndyMac) and option ARMs (in the case of WaMu and Downey) that were
often only underwritten to the introductory rate instead of the fully
indexed rate. During the housing bubble, OTS issued no binding rules to
halt the proliferation by its largest regulated thrifts of option ARMs,
subprime loans, and low- and no-documentation mortgages. Instead, OTS
relied on oversight through guidances. IndyMac, WaMu, and Downey
apparently treated the guidances as solely advisory, however, as
evidenced by the fact that all three made substantial numbers of
hazardous loans in late 2006 and in 2007 in direct disregard of an
interagency guidance on nontraditional mortgages issued in the fall of
2006 and subscribed to by OTS that prescribed underwriting ARMs to the
fully indexed rate.\54\
---------------------------------------------------------------------------
\54\ Department of the Treasury et al., Interagency Guidance on
Nontraditional Mortgage Product Risks; Final guidance, 71 Fed. Reg.
58609 (2006).
---------------------------------------------------------------------------
The fact that all three institutions continued to make loans in
violation of the guidance suggests that OTS examinations failed to
result in enforcement of the guidance. Similarly, OTS fact sheets on
the failures of all three institutions show that the agency
consistently declined to institute timely formal enforcement
proceedings against those thrifts prohibiting the lending practices
that resulted in their demise. In sum, OTS supervision of residential
mortgage risks was confined to ``light touch'' regulation in the form
of examinations, nonbinding guidances, and occasional informal
agreements that ultimately did not work.
2. The Office of the Comptroller of the Currency
The OCC has asserted that national banks made only 10 percent of
subprime loans in 2006. But this assertion fails to mention that
national banks moved aggressively into Alt-A low-documentation and no-
documentation loans during the housing boom.\55\ This mattered a lot,
because the biggest national banks are considered ``too big to fail''
and pose systemic risk on a scale unmatched by independent nonbank
lenders. We might not be debating the nationalization of Citibank and
Bank of America today had the OCC stopped them from expanding into
toxic mortgages, bonds, and SIVs.
---------------------------------------------------------------------------
\55\ Testimony by John C. Dugan, Comptroller, before the Senate
Committee on Banking, Housing, and Urban Affairs, March 4, 2008.
---------------------------------------------------------------------------
Like OTS, ``light touch'' regulation was apparent at the OCC.
Unlike OTS, the OCC did promulgate one rule, in 2004, prohibiting
mortgages to borrower who could not afford to repay. However, the rule
was vague in design and execution, allowing lax lending to proliferate
at national banks and their mortgage lending subsidiaries through 2007.
Despite the 2004 rule, through 2007, large national banks continued
to make large quantities of poorly underwritten subprime loans and low-
and no-documentation loans. In 2006, for example, fully 62.6 percent of
the first-lien home purchase mortgages made by National City Bank,
N.A., and its subsidiary, First Franklin Mortgage, were higher-priced
subprime loans. Starting in the third quarter of 2007, National City
Corporation reported five straight quarters of net losses, largely due
to those subprime loans. Just as with WaMu, the Lehman Brothers
bankruptcy ignited a silent run by depositors and pushed National City
Bank to the brink of collapse. Only a shotgun marriage with PNC
Financial Services Group in October 2008 saved the bank from FDIC
receivership.
The five largest U.S. banks in 2005 were all national banks and too
big to fail. They too made heavy inroads into low- and no-documentation
loans. The top-ranked Bank of America, N.A., had a thriving stated-
income and no-documentation loan program which it only halted in August
2007, when the market for private-label mortgage-backed securities
dried up. Bank of America securitized most of those loans, which may be
why the OCC tolerated such lax underwriting practices.
Similarly, in 2006, the OCC overrode public protests about a
``substantial volume'' of no-documentation loans by JPMorgan Chase
Bank, N.A., the second largest bank in 2005, on grounds that the bank
had adequate ``checks and balances'' in place to manage those loans.
Citibank, N.A., was the third largest U.S. bank in 2005. In
September 2007, the OCC approved Citibank's purchase of the
disreputable subprime lender Argent Mortgage, even though subprime
securitizations had slowed to a trickle. Citibank thereupon announced
to the press that its new subsidiary--christened ``Citi Residential
Lending''--would specialize in nonprime loans, including reduced
documentation loans. But not long after, by early May 2008 after Bear
Stearns narrowly escaped failure, Citibank was forced to admit defeat
and dismantle Citi Residential's lending operations.
The fourth largest U.S. bank in 2005, Wachovia Bank, N.A.,
originated low- and no-documentation loans through its two mortgage
subsidiaries. Wachovia Bank originated such large quantities of these
loans--termed Alt-A loans--that by the first half of 2007, Wachovia
Bank was the twelfth largest Alt-A lender in the country. These loans
performed so poorly that between December 31, 2006 and September 30,
2008, the bank's ratio of net write-offs on its closed-end home loans
to its total outstanding loans jumped 2400 percent. Concomitantly, the
bank's parent company, Wachovia Corporation, was reported its first
quarterly loss in years due to rising defaults on option ARMs made by
Wachovia Mortgage, FSB, and its Golden West predecessor. Public concern
over Wachovia's loan losses triggered a silent run on Wachovia Bank in
late September 2008, following Lehman Brothers' failure. To avoid
receivership, the FDIC brokered a hasty sale of Wachovia to Wells Fargo
after Wells Fargo outbid Citigroup for the privilege.
Wells Fargo Bank, N.A., was in better financial shape than
Wachovia, but it too made large quantities of subprime and reduced
documentation loans. In 2006, over 23 percent of the bank's first-lien
refinance mortgages were high-cost subprime loans. Wells Fargo Bank
also securitized substantial numbers of low- and no-documentation
mortgages in its Alt-A pools. In 2007, a Wells Fargo prospectus for one
of those pools stated that Wells Fargo had relaxed its underwriting
standards in mid-2005 and did not verify whether the mortgage brokers
who had originated the weakest loans in that loan pool complied with
its underwriting standards before closing. Not long after, as of July
25, 2008, 22.77 percent of the loans in that loan pool were past due or
in default.
As the Wells Fargo story suggests, the OCC depended on voluntary
risk management by national banks, not regulation of loan terms and
practices, to contain the risk of improvident loans. A speech by the
then-Acting Comptroller, Julie Williams, confirmed as much. In 2005,
Comptroller Williams, in a speech to risk managers at banks, coached
them on how to ``manage'' the risks of no-doc loans through debt
collection, higher reserves, and prompt loss recognition.
Securitization was another risk management device favored by the OCC.
Three years later, in 2008, the Treasury Department's Inspector
General issued a report that was critical of the OCC's supervision of
risky loans.\56\ Among other things, the Inspector General criticized
the OCC for not instituting formal enforcement actions while lending
problems were still manageable in size. In his written response to the
Inspector General, the Comptroller, John Dugan, conceded that ``there
were shortcomings in our execution of our supervisory process'' and
ordered OCC examiners to start initiating formal enforcement actions on
a timely basis.\57\
---------------------------------------------------------------------------
\56\ Office of Inspector General, Department of the Treasury,
``Safety and Soundness: Material Loss Review of ANB Financial, National
Association'' (OIG-09-013, Nov. 25, 2008).
\57\ Id.
---------------------------------------------------------------------------
The OCC's record of supervision and enforcement during the subprime
boom reveals many of the same problems that culminated in regulatory
failure by OTS. Like OTS, the OCC usually shunned formal enforcement
actions in favor of examinations and informal enforcement. Neither of
these supervisory tools obtained compliance with the OCC's 2004 rule
prohibiting loans to borrowers who could not repay. Although the OCC
supplemented that rule later on with more detailed guidances, some of
the largest national banks and their subsidiaries apparently decided
that they could ignore the guidances, judging from their lax lending in
late 2006 and in 2007. The OCC's emphasis on managing credit risk
through securitization, reserves, and loss recognition, instead of
through product regulation, likely encouraged that laissez faire
attitude by national banks.
C. Judging by the Results: Loan Performance By Charter
OCC and OTS regulators have argued that their agencies offer
``comprehensive'' supervision resulting in lower default rates on
residential mortgages. The evidence shows otherwise.
Data from the Federal Deposit Insurance Corporation show that among
depository institutions, Federal thrift institutions had the worst
default rate for one-to-four family residential mortgages from 2006
through 2008. (See Figure 5).
Figure 5. Total Performance of Residential Mortgages by Depository
Institution Lenders
Source: FDIC Statistics on Depository Institutions
The second-worst performance record among depository institution
lenders went to national banks. State thrifts had better default rates
than either type of federally chartered institution in 2007 and 2008.
State banks consistently had the lowest default rates of all.
Among these charter types, the only ones that enjoy Federal
preemption are national banks regulated by the OCC and Federal thrift
institutions regulated by the OTS. State banks and State thrift
institutions do not. Thus it appears, at least among depository
institutions, that Federal preemption was associated with higher
default rates, not lower rates, during 2006 through 2008, when credit
standards hit bottom and the mortgage market imploded.
These data do not address whether that independent nonbank lenders
have even higher default rates in some states and that may in fact be
the case. Nevertheless, the data undercut the assertion that Federal
preemption reduces default rates among mortgages by depository
institution lenders. To the contrary, the lowest default rates were at
State banks and thrifts, which are subject both to State and Federal
regulation.
IV. What to Do
Dual regulation and the resulting crazy quilt of laws encouraged
lenders to shop for the lightest rules. In turn, this pressured
regulators to weaken their standards and to relax enforcement of safety
and soundness and consumer protection laws.
Casting underwriting standards to the wind in a seemingly obscure
corner of the consumer credit market ended up triggering a global
recession. This crisis shows that the United States ignores consumer
protection at its peril. If it was not clear before, we now know that
systemic stability and consumer protection are inextricably linked.
To correct the regulatory lapses that I have described, our
financial regulatory system needs to adopt three reforms:
First, Congress should adopt uniform minimum safety
standards for all providers of consumer credit, regardless of
the type of entity or charter.
Second, the authority for administering and enforcing these
standards should be housed in one Federal agency whose sole
mission is consumer protection.
Third, to avoid the risk of agency inaction, Congress
should give parallel enforcement authority to the states and
allow consumers to bring private causes of action to recover
for injuries they sustain.
I expand on these proposals below.
A. Uniform Federal Safety Standards For Consumer Credit
The downward spiral in underwriting standards drove home the need
for minimum, uniform consumer credit safety standards. Adopting a
uniform Federal floor would prevent lenders and brokers from seeking
safe havens in legal regimes that do little or nothing to protect
consumers.
The purpose of these uniform Federal standards is three-fold.
First, the standards should ensure proper loan underwriting based on
the consumer's ability to repay. Second, the standards should prohibit
unfair or deceptive practices in consumer credit products and
transactions. Finally, the standards should promote transparency
through improved consumer disclosures, product simplification and
product standardization. Bottom-line, Federal standards should make it
possible for consumers to engage in meaningful comparison shopping,
with no hidden surprises.
The experience with the high-cost loan provisions of HOEPA reveals
that a detailed regulatory statute limited to specific loan terms is
not an effective approach. HOEPA has proven too rigid and has failed to
address new abuses as they appeared in the mortgage market. Instead,
Congress should authorize a broad statutory mandate to give the
implementing agency the flexibility to respond promptly to industry
innovations (both good and bad) in the consumer credit industry. This
broad statutory model would be akin to the open-ended provisions found
in Section 5 of the Federal Trade Commission Act and Section 10(b) of
the Securities Exchange Act of 1934, instead of the highly detailed
prohibitions found in HOEPA. Congress should then delegate broad
authority to the implementing agency to promulgate rules--preferably
objective ones--to implement the statute.
The uniform standards should constitute a floor, in which weaker
State laws are federally preempted. Under the statute, however, states
should remain free to enact stricter consumer protections so long as
those protections are consistent with the Federal statute.
A minimum Federal floor, instead of a ceiling, is critical for
three reasons. First, states are closer to local conditions and often
more responsive to emerging problems at home. A Federal floor would
preserve the states' ability to protect their citizens. Second, giving
latitude to states to adopt stricter standards would preserve the
states' important role as laboratories of experimentation. Finally, a
Federal floor, not a ceiling, would provide an important safeguard
against the possibility that the implementing agency might adopt weak
rules or fail to update the rules.
As part of or in addition to creating the uniform Federal standards
just outlined, Congress should transfer the authority to administer
other existing Federal consumer credit laws to the implementing agency.
At a minimum, oversight for the Truth in Lending Act, HOEPA, the Real
Estate Settlement and Procedures Act, the Fair Credit Reporting Act,
the Fair Debt Collection Practices Act, the fair lending laws, the Fair
Credit Billing Act, and the Home Mortgage Disclosure Act should be
transferred to this agency.\58\ Responsibility for administering
Section 5 of the Federal Trade Commission Act as it applies to all
providers of consumer credit should also be consolidated in this
agency.
---------------------------------------------------------------------------
\58\ This agency should also receive sole responsibility for
administering the Consumer Leasing Act, the Right to Financial Privacy
Act, the Electronic Fund Transfer Act, the Expedited Funds Availability
Act, the Women's Business Ownership Act, the Fair Credit and Charge
Card Disclosure Act, the Home Equity Loan Consumer Protection Act, the
Truth in Savings Act, title V of the Gramm-Leach-Bliley Act, and the
Fair and Accurate Credit Transaction Act.
---------------------------------------------------------------------------
B. A Dedicated Federal Agency Whose Sole Mission is Consumer Protection
1. Federal Regulators Cannot Serve Two Masters
The housing bubble and hazardous mortgages by federally regulated
depository institutions show that we cannot expect consumer protection
to be paramount to Federal banking regulators. Recent history has shown
that the safety and soundness mandate of Federal banking regulators
regularly eclipses concern for consumer protection. For this reason,
the consumer protection function should be removed from Federal banking
regulators and housed in its own agency whose sole mission is consumer
protection.
The bank regulatory agencies' own mission statements make it clear
that consumer protection is a low priority. For example, the Federal
Reserve Board divides its duties into four general areas:\59\
---------------------------------------------------------------------------
\59\ The Federal Reserve System, Purposes & Functions 1 (9th ed.
2005).
``conducting the nation's monetary policy by influencing
the monetary and credit conditions in the economy in pursuit of
maximum employment, stable prices, and moderate long-term
---------------------------------------------------------------------------
interest rates
``supervising and regulating banking institutions to ensure
the safety and soundness of the nation's banking and financial
system and to protect the credit rights of consumers
``maintaining the stability of the financial system and
containing systemic risk that may arise in financial markets
``providing financial services to depository institutions,
the U.S. Government, and foreign official institutions,
including playing a major role in operating the nation's
payments system.''
In the Fed's description, monetary policy comes first, followed by
banking supervision. Consumer protection does not even merit its own
bullet point.
Similarly, safety and soundness regulation is the paramount mission
of the OCC and OTS. The OCC describes its mission as having four
objectives, the last of which is consumer protection:\60\
---------------------------------------------------------------------------
\60\ Comptroller of the Currency, About the OCC (viewed February
28, 2009), available at http://www.occ.treas.gov/aboutocc.htm.
``To ensure the safety and soundness of the national
---------------------------------------------------------------------------
banking system.
``To foster competition by allowing banks to offer new
products and services.
``To improve the efficiency and effectiveness of OCC
supervision, including reducing regulatory burden.
``To ensure fair and equal access to financial services for
all Americans.''
Like the OCC, OTS describes safety and soundness as its principal
job:\61\
---------------------------------------------------------------------------
\61\ Office of Thrift Supervision, Mission and Goals (viewed
February 28, 2009), available at http://www.ots.treas.gov/
?p=MissionGoal.
To supervise savings associations and their holding companies
in order to maintain their safety and soundness and compliance
with consumer laws, and to encourage a competitive industry
---------------------------------------------------------------------------
that meets America's financial services needs.
In theory, safety and soundness should serve consumer protection.
In practice, it has not, as recent experience shows. During the housing
boom, Federal banking regulators too often mistook short-term
profitability, including profits from excessive fees on consumers,\62\
with safety and soundness. In their effort to protect the short-term
profitability of banks and thrifts, Federal regulators often dismissed
consumer protection as conflicting with that mission. When agencies
derive most of their operating budgets from assessments on the entities
they regulate--as do the OCC and OTS--the pressure to sacrifice
consumer protection for profit maximization by those entities can be
overwhelming.\63\
---------------------------------------------------------------------------
\62\ Examples include regulators' slow response to curtailing large
prepayment penalties and their continued indecision on costly overdraft
protection.
\63\ For instance, the OCC derives 95 percent of its budget from
assessments on national banks. The twenty largest national banks
contribute almost 60 percent of those assessments. See, e.g., Bar-Gill
& Warren, supra note 5, at 193-94 (working draft version); Testimony of
Arthur E. Wilmarth, Jr., Hearing before the Subcomm. on Financial
Institutions and Consumer Credit of the House Comm. on Financial
Services (Apr. 26, 2007).
---------------------------------------------------------------------------
I served on the Federal Reserve Board's Consumer Advisory Council
from 2002 through 2004 and saw firsthand how resistant Federal banking
regulators were to instituting basic consumer protections during the
run-up to the current crisis. Repeatedly over that period, I and other
members of that Council warned the Federal Reserve's staff and
Governors about rising foreclosures and other dangers associated with
reckless subprime loans. We urged the Board to exercise its powers
under HOEPA to strengthen protections for subprime and nontraditional
mortgages, but to no avail. During my tenure on the Council, the late
Governor Gramlich told me during a break at one of the Council's public
meetings that there was not enough support on the Board to expand
HOEPA's protections. These experiences confirmed my belief that banking
regulators often dismiss the consumer protection piece of their
mission.
Some critics argue that removing consumer protection
responsibilities from Federal banking regulators and housing them in
their own dedicated agency would undercut the safety and soundness of
banks. As the current crisis shows, however, entrusting consumer
protection to the Federal banking agencies is no guarantee of bank
safety and soundness. Indeed, having a separate Federal watchdog for
consumer credit would help place healthy, countercyclical constraints
on the tendency of Federal banking regulators to sacrifice long-term
safety for short-term profits at the top of the credit cycle. It would
also encourage forward-looking regulation as new problems arise,
instead of laggard, backward-looking regulation of the type recently
issued by the Federal Reserve.
Congress could institute mechanisms to avoid agency conflicts or to
resolve them if they occur. Such mechanisms could include formal or
informal consultation with Federal banking regulators or judicial
dispute resolution.
2. A Separate Federal Consumer Credit Agency Offers Other Strong
Advantages
A wide range of experts across the political spectrum, from the
Treasury Department under former Secretary Paulson to the Congressional
Oversight Panel, have recommended housing consumer credit protection in
its own separate agency.\64\ A separate Federal agency dedicated to
consumer protection for all consumer credit would offer several
distinct advantages. First, it would consolidate industry-wide
enforcement in one agency, which would mean that all providers of
credit would be subject to the same level of enforcement. Under the
current regime, even though the Federal Reserve Board administers most
Federal consumer credit laws, compliance examinations and enforcement
are divided among Federal banking regulators and sometimes other
agencies. Other Federal consumer protection laws--such as Section 5 of
the Federal Trade Commission Act and the Community Reinvestment Act--
are individually implemented by the four Federal banking regulators
with respect to their regulated entities. Each agency can make its own
choice about the extent to which it enforces or does not enforce the
law. Ending this fragmentation of enforcement would discourage lenders
from switching charters in search of the easiest regulator.
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\64\ The Department of the Treasury, Blueprint for a Modernized
Financial Regulatory Structure 170-74 (March 2008) (proposing a Conduct
of Business Regulatory Agency), available at www.treasury.gov;
Congressional Oversight Panel, Special Report on Regulatory Reform 30-
37 (Jan. 2009), available at http://cop.senate.gov/documents/cop-
012909-report-regulatoryreform.pdf. The Committee on Capital Markets
Regulation recommended an independent consumer protection agency as one
alternative. Committee on Capital Markets Regulation, Recommendations
for Reorganizing the U.S. Financial Regulatory Structure 5 (Jan. 14,
2009), available at http://www.capmktsreg.org. While the Government
Accountability Office has not taken a position, last month it advised
that ``[c]onsumer protection should be viewed from the perspective of
the consumer rather than through the various and sometimes divergent
perspectives of the multitude of Federal regulators that currently have
responsibilities in this area.'' General Accountability Office,
Financial Regulation: a Framework for Crafting and Assessing Proposals
to Modernize the Outdated U.S. Financial Regulatory System 18 (GAO-09-
349T Feb. 4, 2009), available at www.gao.gov. See also Heidi Mandanis
Schooner, Consuming Debt: Structuring the Federal Response to Abuses in
Consumer Credit, 18 Loyola Consumer L. Rev. 43, 77-78, 82 (2005)
(``while there are benefits to combining prudential regulation and
consumer protection, serious doubt remains as to whether it is the best
arrangement''; ``[t]he most sensible approach to correcting the
structural defect in the current regime would be to eliminate entirely
the Federal banking regulators' role in consumer protection'').
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Transferring consumer credit laws to one agency whose sole mission
is consumer protection would also provide regulators with a complete
overview of the entire consumer credit market, its structure, and
emerging issues. Right now, consumer credit regulation suffers from a
silo mentality because it is parceled out among so many agencies.
Consolidating consumer credit oversight would overcome this silo
mentality. In addition, consolidation would have the benefit of
concentrating expertise for consumer credit products in one agency.
3. Agency Responsibilities and Oversight
In assigning consumer credit protection to its own separate agency,
it is necessary to ask whether the agency should adopt a supervisory
model based on routine examinations akin to banking regulation or an
enforcement model akin to that used by the Security and Exchange
Commission or the Federal Trade Commission.
Banking regulators are supposed to examine all of their regulated
entities for consumer compliance on a routine basis. Requiring regular
examinations of all credit providers and related entities, from
depository institutions and nonbank lenders to mortgage brokers and
payday lenders, would be extremely costly and not the best use of tax
dollars.
Given the large number of participants in the consumer credit
market, it would make more sense to adopt an enforcement model similar
to that used by the Securities and Exchange Commission.\65\ Under that
model, market participants would be required to register with the
agency and obtain licenses. Regular reporting would provide the agency
with a steady flow of needed information to pinpoint possible
violations and identify new problems. Under its broad statutory
mandate, the agency would issue binding rules and interpretations to
prohibit unfair and deceptive acts and practices. The agency's research
arm would conduct empirical tests of the effects of new financial
products and proposed regulations. Finally, the agency should have
strong enforcement authority, including the power to conduct special
examinations and issue subpoenas; the power to take agency enforcement
action and levy restitution and sanctions; and criminal and civil
enforcement authority.
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\65\ A consumer complaint model alone, such as that employed by the
FTC, would not provide an oversight agency with enough information or
authority to keep abreast of the rapid pace of financial innovation.
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4. Should Congress Create a New Agency or Transfer All Consumer Credit
Oversight to the Federal Trade Commission?
In removing consumer credit oversight from Federal banking
regulators and transferring it to a dedicated agency, Congress must
decide where to house it. There are two obvious choices. One would be
to create a new agency for consumer credit oversight. The other would
be to transfer this responsibility to the Federal Trade Commission.
Each approach has advantages and disadvantages. Unlike the FTC, a
brand new agency would be solely responsible for consumer credit
products and would not be distracted by other duties, such as policing
antitrust violations or the marketing of home appliances, over-the-
counter drugs, dietary supplements, computer software, and other
products, that fall under the FTC's purview.
A new agency would also have the benefit of starting on a clean
slate. If, as I recommend, the model for consumer protection is based
on the SEC's registration and reporting scheme, the FTC would have to
transform itself away from its current consumer complaint enforcement
model. The FTC, like any other agency, has a bias toward the status quo
that could make it hard to implement a new enforcement model and
otherwise change the way the agency functions. A new agency would not
suffer under this handicap.
On the other hand, creating a new Federal agency would be costly
and entail substantial startup time. The FTC already has the
institutional expertise and single-minded commitment to consumer
protection to regulate consumer credit industry-wide. This is
particularly true within the FTC's Division of Financial Practices and
the Division of Privacy and Identity Protection, which fall in the
FTC's Bureau of Consumer Protection. In 2008, the Division of Financial
Practices specifically ramped up its staff and in-house training in
anticipation of heightened enforcement activity.
Of course, for the FTC to succeed as the consumer protection
enforcer, the agency would need dramatic increases in funding. A new
agency would also need a substantial commitment of resources to
properly do its job. Presumably, some of this cost could be defrayed by
transferring resources from the consumer compliance operations of
Federal banking regulators.
Consolidating oversight in one Federal agency--whether that agency
is new or the FTC--poses a final concern about agency capture and
inaction. The FTC, for example, had a vigorous enforcement record
regarding mortgage abuses during the Clinton Administration but a
lackluster record during the George W. Bush Administration until
recently. Whether consumer credit protection is consolidated in a new
agency or the FTC, the best antidote to agency inaction is outside
enforcement. Accordingly, Congress should give parallel enforcement
authority for Federal consumer credit laws to State regulators and
private causes of action (including carefully crafted assignee
liability) to injured consumers. Congress could also set target
consumer protection goals, such as maximum default rates, and require
the implementing agency to report to Congress on its performance.
Finally, that agency should be funded through congressional
appropriations instead of assessments on regulated entities to assure
that the agency remains independent.
RESPONSE TO WRITTEN QUESTION OF SENATOR VITTER
FOR STEVE BARTLETT BY IRVING E. DANIELS
Q.1. In my experience, TILA violations are small, technical
violations related to the TILA mortgage disclosure. In the
past, they have been used by the trial lawyers to file numerous
class action law suits that were frivolous in nature, but very
serious for the industry--and consumers that would ultimately
bear the burden of any costs of litigation. Some of my
colleagues may recall the infamous ``Rodash'' decision that was
rendered in Florida in the mid-1990s. Mrs. Rodash was a
sympathetic complainant who could not afford to repay the
mortgage she took out. Her attorney claimed that the
disclosures of the Federal Express charge and the taxes imposed
by the State of Florida were disclosed on the wrong lines on
the form. There was no doubt that she owed the money, but the
attorney alleged that the charges were simply disclosed on the
wrong line of the forms. The judge felt sorry for her and ruled
in favor of Mrs. Rodash. The tolerance for error at that time
was $10 and both the Federal Express charge and the Florida
State taxes exceeded that $10 tolerance. The ``Rodash''
decision spawned more than 250 class action law suits and would
have cost the mortgage industry more than $1.3 trillion in
liability had Congress not intervened and passed retroactive
legislation to right this wrong.
The issue of mortgage disclosures is a thorny one.
There are two Federal laws that govern the disclosures in
the mortgage transactions--RESPA and TILA. Last year, HUD
finalized a rule to revise the RESPA disclosures. Currently,
the Fed is currently working on revamping the TILA disclosure.
Neither HUD nor the Fed have worked to combine and coordinate
their disclosures so the result is going to be that the
consumer is going to get more disclosures that are even more
confusing--and that will not conflict--than the disclosures
they currently receive. I doubt that anyone in this room thinks
that the pile of paper you get in the mortgage process is not
confusing.
So, now that the Feds are working to confuse consumers even
more with their ``new and improved'' disclosures, we are going
to turn the enforcement of this mess over to the State AGs.
This will, undoubtedly, result in an enormous increase in
litigation.
This Committee has heard testimony recommending that it
should work to close regulatory gaps. The TILA provisions
inserted in the Omnibus spending bill allows State attorneys
general to enforce consumer issues. Therefore, adding more
duplication to a fragmented system. Why are we doing this? We
have enough of a mess on our hands without creating a new one.
A.1. The Financial Services Roundtable has regularly urged
the agencies to work together in crafting regulations that
overlap practices and activities in the economy. Most recently,
The Roundtable, its Housing Policy Council and other industry
groups spent considerable time explaining to Congress and to
HUD and the Federal Reserve that the RESPA regulations HUD was
creating would overlap the broader jurisdiction of the Federal
Reserve and its TILA responsibilities. In addition, we pointed
out that the TILA revision project of the Federal Reserve was
underway at the time HUD staff was drafting. The staff of the
Federal Reserve also commented directly to HUD on that same
point.
HUD issued its RESPA rules anyway without coordinating with
the Federal Reserve. Now lenders are faced with the
responsibility of making major changes in our RESPA practices,
technology and training only to likely face the need to make
additional ones in the same areas as the Federal Reserve
announces its regulations under TILA. Most likely there will be
irreconcilable conflicts between the two.
To the Roundtable, it is a further demonstration of the
harm that the regulatory silo effect can have in conducting
business, and the confusion that it sews in the minds of
consumers who, in the case we are discussing, will have yet
more mortgage disclosures that will be confusing. We urge
Congress to look closely at the Blueprint for regulatory reform
that the Roundtable has published where we have proposed
solutions to some of these issues. We strongly support agency
coordination on issues such as mortgage term disclosures.
------
RESPONSE TO WRITTEN QUESTION OF SENATOR VITTER FROM ELLEN
SEIDMAN
Q.1. In my experience, TILA violations are small, technical
violations related to the TILA mortgage disclosure. In the
past, they have been used by the trial lawyers to file numerous
class action law suits that were frivolous in nature, but very
serious for the industry--and consumers that would ultimately
bear the burden of any costs of litigation. Some of my
colleagues may recall the infamous ``Rodash'' decision that was
rendered in Florida in the mid-1990s. Mrs. Rodash was a
sympathetic complainant who could not afford to repay the
mortgage she took out. Her attorney claimed that the
disclosures of the Federal Express charge and the taxes imposed
by the State of Florida were disclosed on the wrong lines on
the form. There was no doubt that she owed the money, but the
attorney alleged that the charges were simply disclosed on the
wrong line of the forms. The judge felt sorry for her and ruled
in favor of Mrs. Rodash. The tolerance for error at that time
was $10 and both the Federal Express charge and the Florida
State taxes exceeded that $10 tolerance. The ``Rodash''
decision spawned more than 250 class action law suits and would
have cost the mortgage industry more than $1.3 trillion in
liability had Congress not intervened and passed retroactive
legislation to right this wrong.
The issue of mortgage disclosures is a thorny one.
There are two Federal laws that govern the disclosures in
the mortgage transactions--RESPA and TILA. Last year, HUD
finalized a rule to revise the RESPA disclosures. Currently,
the Fed is currently working on revamping the TILA disclosure.
Neither HUD nor the Fed have worked to combine and coordinate
their disclosures so the result is going to be that the
consumer is going to get more disclosures that are even more
confusing--and that will not conflict--than the disclosures
they currently receive. I doubt that anyone in this room thinks
that the pile of paper you get in the mortgage process is not
confusing.
So, now that the Feds are working to confuse consumers even
more with their ``new and improved'' disclosures, we are going
to turn the enforcement of this mess over to the State AGs.
This will, undoubtedly, result in an enormous increase in
litigation.
This Committee has heard testimony recommending that it
should work to close regulatory gaps. The TILA provisions
inserted in the Omnibus spending bill allows State attorneys
general to enforce consumer issues. Therefore, adding more
duplication to a fragmented system. Why are we doing this? We
have enough of a mess on our hands without creating a new one.
A.1. I completely agree with the Senator that greater
coordination between government agencies who are working to the
same end is highly desirable; consumers have enough difficulty
understanding mortgage documents without having to attempt to
decipher documents that are written for different purposes with
potentially different outcomes. With respect to the role of
State attorneys general, in the current mortgage crisis, State
attorneys general were early movers in uncovering, litigating,
and recovering for plaintiffs damages from abusive mortgage
practices. The Ameriquest and Countrywide cases stand out--
serious, non-duplicative cases that generated major changes in
practice, albeit too late. There is no reason to believe the
AGs would not hold themselves to a similar standard with
respect to TILA litigation.
------
RESPONSE TO WRITTEN QUESTION OF SENATOR VITTER FROM PATRICIA A.
McCOY
Q.1. In my experience, TILA violations are small, technical
violations related to the TILA mortgage disclosure. In the
past, they have been used by the trial lawyers to file numerous
class action law suits that were frivolous in nature, but very
serious for the industry--and consumers that would ultimately
bear the burden of any costs of litigation. Some of my
colleagues may recall the infamous ``Rodash'' decision that was
rendered in Florida in the mid-1990s. Mrs. Rodash was a
sympathetic complainant who could not afford to repay the
mortgage she took out. Her attorney claimed that the
disclosures of the Federal Express charge and the taxes imposed
by the State of Florida were disclosed on the wrong lines on
the form. There was no doubt that she owed the money, but the
attorney alleged that the charges were simply disclosed on the
wrong line of the forms. The judge felt sorry for her and ruled
in favor of Mrs. Rodash. The tolerance for error at that time
was $10 and both the Federal Express charge and the Florida
State taxes exceeded that $10 tolerance. The ``Rodash''
decision spawned more than 250 class action law suits and would
have cost the mortgage industry more than $1.3 trillion in
liability had Congress not intervened and passed retroactive
legislation to right this wrong.
The issue of mortgage disclosures is a thorny one.
There are two Federal laws that govern the disclosures in
the mortgage transactions--RESPA and TILA. Last year, HUD
finalized a rule to revise the RESPA disclosures. Currently,
the Fed is currently working on revamping the TILA disclosure.
Neither HUD nor the Fed have worked to combine and coordinate
their disclosures so the result is going to be that the
consumer is going to get more disclosures that are even more
confusing--and that will not conflict--than the disclosures
they currently receive. I doubt that anyone in this room thinks
that the pile of paper you get in the mortgage process is not
confusing.
So, now that the Feds are working to confuse consumers even
more with their ``new and improved'' disclosures, we are going
to turn the enforcement of this mess over to the State AGs.
This will, undoubtedly, result in an enormous increase in
litigation.
This Committee has heard testimony recommending that it
should work to close regulatory gaps. The TILA provisions
inserted in the Omnibus spending bill allows State attorneys
general to enforce consumer issues. Therefore, adding more
duplication to a fragmented system. Why are we doing this? We
have enough of a mess on our hands without creating a new one.
A.1. Did not respond by publication deadline.