Thirty Years, Give or Take XII: Federalism in Indian Summer

Mortgage regulation -- or not -- in the run-up to the Financial Crisis

During Indian Summer, the disaggregation of the home mortgage lending led to fraud and abusive conduct by bad actors taking advantage of Mr. Market’s inattention to detail. Through licensing proceedings under the North Carolina Mortgage Lending Act (NCMLA), my colleagues and I removed a significant number of perpetrators (or potential perpetrators) from the market; through investigations and enforcement actions, we did our best to stop what they were doing. We did so without help either from Mr. Market or our federal colleagues.

The work we did under the NCMLA was eye-opening. In presiding over appeals of licensure denials, I had to pass judgement on people with checkered pasts or horrible credit or both, who had no business originating mortgage loans on commission. I broke the appellants down into three categories: crooked, ignorant or crooked and ignorant. The fact that gullible borrowers had relied on these people made me shudder.

Under the statute, individual loan originators could only operate when employed by a licensed mortgage bank or brokerage, which was responsible for training and supervision. While there were a lot of reputable firms in the market, a number were not. Examinations of these outfits under NCMLA led to enforcement proceedings, Mr. Justice Smith presiding, usually to revoke their licenses. These proceedings involved an array of malfeasance: low-income people signing a stack of documents that they hadn’t read, and could not have understood, obligating them to debts they could not possibly pay, in the back seats of cars or at tables in fast food restaurants; straw (invented) purchasers; minimum wage workers applying for — and getting — mortgages on multiple properties, each of which was supposed to be the borrower’s “primary residence.” The only saving grace in our enforcement activities was that the bad guys were inept and did a very poor job of hiding their wrongdoing.

How could the purchasers of loans from the bad actors not see what was going on? It seemed to me that Mr. Market should be an ally in cleaning up his mortgage pipeline, both by better risk management and support for the licensing systems North Carolina and other states were setting up. So, I wangled an invitation to speak at an investor conference sponsored by one of the leading mortgage securitization firms. My pitch was simple: cleaning up the market is in both the public interest and the interest of investors. Working together, we could provide better product to capital markets and reduce or prevent consumer abuse.

It didn’t take long for me to realize that my optimism was misplaced. Participants at the conference, with varying degrees of condescension, told me I was full of it; a well-meaning bureaucrat from the provinces driving up the cost of doing business and harming the people I was seeking to help. Borrowers always paid the mortgage first, I was told, so large-scale default was unlikely. And the holders of the super senior tranches of mortgage-backed securities were totally secure (AAA!). What could go wrong? Sadder but wiser, I went home and back to work.

Whatever the folks at the investor conference thought, the reality was different and uglier. Fraud was being committed in what a senior FBI official called “epidemic proportions." Low- and moderate-income borrowers were being put in loans they could not possibly repay. Middle income borrowers in “hot” markets were stretching to the max and then some, either to get in the market or to strip the equity from their homes to finance a trip to Disney World. Investors were getting cheated. The structure of the home mortgage market was being undermined. Something had to be done, but what and by whom?

The federal government took a pass. Responding to the fraudulent and predatory conduct of home repair and consumer finance companies in an earlier era, Congress had enacted the Homeowners Equity Protection Act in 1994. HOEPA amended the Truth In Lending Act to sanction “high-cost loans” and gave the Federal Reserve authority for rulemaking with regard to the mortgage market as a whole.

While laudable in intention, HOEPA was ineffective in practice. The Fed is a remarkable institution, but, in its institutional oversight role, it is a supervisory rather than regulatory agency. And it was led at the time by a chairman who was opposed in general to governmental intervention in markets. So, the Fed, after conducting minimal hearings mandated by HOEPA, did little more.

In the vacuum created be federal inaction, the states stepped up.

State attorneys general conducted investigations and litigation, generally under their statutes outlawing “unfair and deceptive acts and practices.” Working together, the AG’s obtained significant cash settlements and injunctive relief against some very large mortgage lenders.

As noted in a previous installment of this series, state legislatures enacted anti-predatory lending statutes that used the HOEPA format but lowered the thresholds for violations and made the coverage of all mortgage loans explicit. Many states also enacted licensing laws that covered non-bank mortgage brokers and bankers.

So long as state efforts to clean up the mortgage market were against non-bank mortgage bankers, brokers and finance companies, industry pushback was minimal and ineffectual. When the states began to encroach on the activities of federally chartered banks and thrifts, and their subsidiaries, the game changed. The opposition was no longer the industry alone: it was the industry plus its federal regulators.

The federales’ line of attack was phased. Having failed to act under authority conferred by Congress, they argued — more in sorrow than in anger, of course — that the problems in the mortgage market were the result of the absence or failure of state regulation. When the states began to act, they argued that the result was a “crazy patchwork quilt” of inconsistent standards that was both ham-handed and destructive of market efficiency. Not only that: it was potentially denying access to credit to those who had been shut out in the past, “harming the people it is intended to help.” And state attempts to exercise authority over national banks were in contravention of the Constitution and federal law and were pre-empted.

With regard to the application of state authority to national banks and thrifts, the Office of Controller of the Currency had always vigorously asserted the doctrine of federal preemption of state law. Congress had by statute established a system of national banks and conferred jurisdiction over the banks in federal law and the federal supervisory and regulatory agencies established by such law. While jurisdiction wasn’t absolute, the federales’ view was that it was presumptive, and exceptions had to be established by litigation or their gracious favor.

So, why did preemption become a hot issue in Indian Summer? Because national banks, directly or through bank subsidiaries or subsidiaries of their holding companies, had gotten into consumer finance and mortgage lending and securitization in a big way. The corporate “families” of major national banks now included The Money Store (or its remains), Associates, Household Finance, and home-grown consumer finance or mortgage subsidiaries. These enterprises, and other like them, were directly affected by anti-predatory lending laws, and by state AGs’ or regulatory agencies’ assertion of the right to “visitation” through investigations or examinations.

In response, the OCC issued an order specifically pre-empting provisions of the Georgia Fair Lending Act (a more aggressive version of North Carolina’s anti-predatory lending law) and then published a rule defining the types of state laws that impermissibly “obstruct, impair, or condition” the operations of national banks and were, accordingly, pre-empted. It also revised its rules regarding visitation (examination and enforcement) to assert (or restate, perhaps) its exclusive powers in that domain. Essentially, OCC (and its smaller colleague OTS) drew a line in the sand that attempted to exempt national banks and thrifts from state anti-predatory lending laws and visitations.

The conflict between the states and the federal government came to a head in two Supreme Court cases: Watters v Wachovia and Cuomo v Clearing House Association. To the dismay of state regulators, SCOTUS (majority opinion by Notorious RBG) upheld the claim of Wachovia that by moving its mortgage subsidiary from the holding company parent to Wachovia Bank, it obtained the benefit of federal pre-emption — no examinations by the state of Michigan. In Cuomo (Scalia, J., writing for the majority) the Court invalidated the OCC’s rule attempting to pre-empt the exercise by state law enforcement officials of enforcement powers under appropriate process.

So, state AGs continued the fight against predatory lending in the courts. State regulators continued their work in the non-bank segment of the market — no small task — and began to work together on coordinated national examinations and a nationwide licensing system. And, of course, the damage to the market continued.

It is easy enough to make the state / federal fight something about “white hats” versus “black hats.” This would be unfortunate. The federal government has been a force for good in addressing systemic racism, in banking and society generally, often opposed by the states. The states, as noted by Justice Brandeis, were laboratories of democracy in consumer protection. The federal agencies’ assertion of pre-emptive authority was an understandable attempt to preserve a system of national banks that would serve the nation as a whole. In exercising their authority, they would have done well to pay attention to what they were being told by consumer advocates and by state and local officials. They would learn better, from hard experience.

The same could be said for Mr. Market. The securities firm whose investment conference I attended was called Bear Stearns. It and its investors also had some hard lessons coming.