Senate Banking Committee Chairman Chris Dodd's effort to house a new Consumer Financial Protection Agency under the Federal Reserve is fatally flawed. For the past two decades, the Fed has aligned itself with any policy that boosts short-term profits for America's largest banks, regardless of the consequences for consumers or the broader economy. But even worse is Dodd's effort to block the new agency from enforcing the rules it writes, leaving enforcement up to the same regulators who ignored rampant predation and outright fraud throughout the housing bubble.
The bank lobby and its boosters in the Republican Party have been targeting the CFPA since President Barack Obama proposed creating it in July. It's easy to see why: for the first time, a regulatory agency would be concerned with protecting the public, rather than bank balance sheets. That's good news for the economy, but bad news for quarterly earnings at major U.S. banks. Republicans are doing anything they can to gut the proposal, and several back-lobby-backed Democrats are reluctant to push for a strong agency. But instead of forcing lawmakers to cast vote siding with the bankers, Dodd appears ready to let the agency die without even extracting a political pound of flesh.
If the new CFPA cannot enforce its own rules, it is effectively powerless. All the good rules in the world don't amount to anything without strong enforcement, and the existing federal bank regulators--the Federal Reserve, the Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (OCC)--have proven time and again that they simply are not interested in enforcing consumer protection laws.
All of the major federal banking regulators were fully aware of the dangers of predatory mortgage lending well before the mortgage meltdown destroyed the financial system in 2008. In 1994, Congress gave the Fed power to police the entire mortgage market, from small specialty subprime shops to banking behemoths. As early as 2001, the Fed and other bank regulators issued a guidance warning about subprime loans. That guidance included simple, common-sense standards: make sure you can afford to make these loans, and watch out for predatory lending. The trouble is, as soon as these rules were issued, the Fed and fellow regulators developed a policy of actively looking the other way on abusive subprime lending. The rules were good. They simply decided not to enforce them.
The Fed identified three key aspects of predatory lending that it was would crack down on with its 2001 rules, including:
"Making unaffordable loans based on the assets of the borrower rather than on the borrower's ability to repay an obligation;
Inducing a borrower to refinance a loan repeatedly in order to charge high points and fees each time the loan is refinanced ('loan flipping'); or
Engaging in fraud or deception to conceal the true nature of the loan obligation, or ancillary products, from an unsuspecting or unsophisticated borrower."
All three of these practices were rampant from at least 2004 through 2007, but the Fed, the OCC and the OTS ignored all of them. Everyone in the mortgage business began issuing loans based on the assumption that home prices would increase forever, ignoring pesky details like whether or not a borrower could afford the loan. Industry lobbyists don't even dispute the point. Denise Leonard of the National Association of Mortgage Brokers admitted to Congress in April 2009 that, "Underwriting standards for mortgage loans were significantly relaxed and greater emphasis was placed on home valuation as opposed to other factors traditionally used to determine a borrower's likelihood of repaying a loan."
"It now appears that the most elementary notion of predatory lending - failure to underwrite based on the borrower's ability to pay - became prevalent in the subprime mortgage market," FDIC Vice Chairman Martin J. Gruenberg said in a 2007 speech.
And the mortgage industry was an absolute fraud nightmare. Loan officers and mortgage brokers actively falsified paperwork without borrower consent in order to push borrowers into expensive loans they could not afford. As a result, the loan officers would get rewarded with kickbacks, and the bank would get an expensive loan they could sell off to investors at a handsome profit. When the borrower finally ran out of rope and couldn't pay off the loan, it wasn't the bank's problem anymore--whoever bought the loan had to deal with the mess.
The Fed, the OCC and the OTS had clear authority to police this activity, and had even said they believed it to be predatory, yet refused to go after lenders who systematically engaged in the behavior. Under Dodd's latest legislative capitulation, these same regulators will be responsible for enforcing the rules issued by the CFPA. The FBI warned of an "epidemic" of mortgage fraud as early as 2004, and continued sounding the alarm for years, only to watch bank regulators cover their ears and ignore the catastrophe.
Banks also paid mortgage brokers a special kickback for steering borrowers into expensive subprime mortgages, when those borrowers would have qualified for cheaper prime loans. According to the Center for Responsible Lending, in 2002, between 85 percent and 90 percent of all loans that banks issued through mortgage brokers included these kickbacks. By 2006, over half of subprime mortgages were refinancings--banks had set up exactly the kind of predatory incentive structure that the Fed said it wanted to prevent back in 2001. In 2007, Federal Reserve Chairman Ben Bernanke even admitted that this predatory behavior had become standard practice under the Fed's watch, noting that, "Fees tied to loan volume made loan sales a higher priority than loan quality."
"This was a festival of fraud," according former Capital One Financial executive Raj Date. Date left Capital One shortly after the company acquired subprime lender GreenPoint Mortgage, and is now a strident financial reform advocate at the Cambridge Winter Center for Financial Institutions Policy.
Astonishingly, even after the FBI warned that 80 percemt of the fraud involved in mortgage lending was perpetrated by lenders, not borrowers, bank regulators continued to pretend there was nothing wrong.
So the Fed, the OCC and the OTS refused to enforce all three tenets of their regulatory guidance from 2001. This charade was repeated in 2006, when all three regulators again issued guidance on "non-traditional" mortgage lending, only to look the other way when abuses occurred.
All of today's bank regulators are all charged with both protecting consumers and making sure that banks do not fail (this is called "safety and soundness" regulation), but in practice, they're only interested in one thing: bank profits. The more profit a bank books, the harder it is for that bank to fail, and regulators consider anything that threatens profitability a major threat, including consumer protection rules. If the CFPA says that banks can't gouge customers with outrageous credit card fees, deceptive mortgage maneuvering or even unfair payday loans, the OCC isn't going to enforce the law.
Consumer advocates want the CFPA to be independent for a reason: They don't want to see this kind of profit-pressure dictating the CFPA's rule-making and enforcement powers. The Fed is a particularly poor place to house the new agency. For years, the Fed has maintained a Consumer Advisory Council, but Fed policymakers have routinely ignored its warnings. University of Connecticut Law School Professor Patricia McCoy served on the council from 2002 to 2004, and notes that Fed Chair Alan Greenspan did not attend a single meeting of the consumer board during her entire tenure.
"At that time, I had recently moved from Cleveland where I was aware of some pretty dicey subprime lending by national banks, so I was very concerned that the OCC was not going to get the job done," says McCoy. "And the reaction of the Fed staff--there were no governors at this meeting, it was only Fed staffers--was, 'We're not going to discuss this. We refuse to engage. That's not our problem' . . . . There was no political will to even have a discussion.'"
In addition to its reputation as a consumer scourge, the Fed is the single most secretive agency in the American government, and it defends that secrecy to the point of absurdity. The Fed is currently embroiled in a lawsuit with Bloomberg News over a request for Fed documents under Freedom of Information Act. The Fed maintains--with a straight face--that it is not subject to FOIA requests, despite its status as a public agency that even prints the public's money. The case is still in court, but it's easy to imagine the Fed blocking the CFPA from issuing strong rules, and then blocking any public disclosure about its bureaucratic maneuvering.
Democrats have a significant majority on the Banking Committee, and can get a strong, independent CFPA to the Senate floor if they want to. The question is whether the bill can then overcome a filibuster. Dodd can either preemptively cave at the Committee stage, and allow Republicans to vote on a weak bill that doesn't protect consumers, or he can force politicians of every stripe to take sides. If Dodd includes a strong CFPA in the bill at the committee level, then every lawmaker in the Senate will have to tell the public whether they're backing the bailout barons or ordinary citizens. Republicans would be very reluctant to side with our financiers over the rest of their constituents, but if they did so, it would be a huge political gift to the Democratic Party. Imagine defending that vote ahead of November's elections.
President Barack Obama and Congress had three major tasks they had to accomplish with financial reform: End too-big-to-fail, rein in the over-the-counter derivatives market that brought down A.I.G. and put an end to consumer abuses. Obama punted on too-big-to-fail before even submitting a plan to Congress, refusing to break up the big banks into small-enough-to-fail units. In the House, lawmakers effectively sacrificed derivatives to salvage the CFPA. If Dodd proceeds with a gutted version of the CFPA, every aspect of the Wall Street overhaul will have been entirely undermined.