Consumer Law & Policy Blog

Incentives and the Secondary Market: Ted Frank Responds to Chris Peterson

by Ted Frank

Christopher Peterson disagrees with my assessment of subprime mortgages:

In [Ted Frank's] view the market is currently adjusting to the problems in mortgage origination. Everything will work out if we just leave the markets alone because "lenders have every incentive to lend only to those who can repay." I disagree. The current legal system creates the incentive for loan brokers and originators to (1)take large commissions and closing costs, (2) pass off bad loans to the secondary market, (3) distribute the revenue from lots of closings to management and employees, (4) wait for the bankruptcy code's preference window to close, then (5) declare bankruptcy when the secondary market tries to exert its recourse options.

Except what Peterson is describing is intentional securities fraud, for which there already exists plenty of civil and criminal deterrent. Management doesn't escape scot-free: in the First Alliance Mortgage case, its chairman and CEO, Brian Chisick, was on the hook for $20 million in an FTC action over that bankrupt company's mortgage practices, even aside from the losses he incurred from the drop in value in his equity interest in the company.

Moreover, in such a scenario, the secondary market investors lose their money in their investments—surely deterrent enough to engage in appropriate due diligence to not invest in a fly-by-night operation that is issuing bogus loans. Why victimize them twice? The only thing that accomplishes is to punish the honest by creating an infeasible risk premium.

The multiply-illegal scam Peterson posits (involving mortgage fraud, securities fraud, and possibly bankruptcy fraud and breaches of fiduciary duty) just is not a viable business model for any reasonable length of time: can we identify anyone who is living high off the hog through these means?

What happens when lenders don't care if they are repaid?

by Christopher Peterson

In today's Wall Street Journal, Ted Frank, with the American Enterprise Institute, argues that the current meltdown in the subprime mortgage market justifies neither legislative nor judicial reform. In his view the market is currently adjusting to the problems in mortgage origination.  Everything will work out if we just leave the markets alone because "lenders have every incentive to lend only to those who can repay."

I disagree.  The current legal system creates the incentive for loan brokers and originators to (1)take large commissions and closing costs, (2) pass off bad loans to the secondary market, (3) distribute the revenue from lots of closings to management and employees, (4) wait for the bankruptcy code's preference window to close, then (5) declare bankruptcy when the secondary market tries to exert its recourse options.

Mr. Frank’s analysis ignores the agency costs of front line players in the industry, and it conflates the profitability of loan originating companies with the profits kept by the management of those companies.  While there is nothing inherently wrong with securitization of mortgage loans, or other financial assets, we must accept the reality that the current system of funding subprime mortgages does not preserve the traditional mortgage market’s underwriting incentives.  Instability and predatory lending will persist as long as the secondary market, and in particular, the investment banks that package mortgage backed securities can pass off bad loans to investors without fear of liability.

Elizabeth Renuart on Line-Drawing and the Practical Effects of Watters v. Wachovia

by Elizabeth Renuart (National Consumer Law Center)

Rather than discussing why the majority may be legally wrong (the dissent does an excellent job of that), my thoughts focus on the lines drawn by the decision and its potential practical effects.

    One line that arguably became brighter is that between operating subsidiaries and other entities that are hired by or act as agents for national banks. The majority focuses on the legal relationship between operating subsidiaries and the banks, the OCC's position that it oversees both entities in a similar fashion, and the added "support" it found in the Gramm-Leach-Bliley Act for Congressional recognition of these closely related companies. The specificity with which the majority details its view of the legal support in federal statutes for its conclusion weighs against the authority of the OCC to extend preemption rights to agents or third party contractors who work closely with national banks, even if the OCC claims it can examine them. (The OCC put its foot in this pool a few years ago when it issued an opinion letter related to car dealers acting on behalf of banks in Michigan). Where an entity is not the equivalent of a national bank (see slip op. at 13), preemption ought not to extend to that business.

As for practical consequences, the decision should cause those remaining independent mortgage companies to reconsider whether they will seek federal charters to parent them in a bank holding structure. Any doubt about whether to go this route, at least as far as the regulatory playing field goes, is now eliminated. The OCC should be careful what it prays for: it is now crystal clear that it must examine and enforce all preempted state laws against all of the operating subsidiaries of national banks in all 50 states (and to know the ins and outs of those state laws). It has not hired scores of new examiners or enforcement attorneys. Its public record in enforcement has been weak over the last few years since it decided to take on this job.

Finally, the pressure now will build on the FDIC to create a similar playing field for state-chartered banks and their operating subsidiaries even though the legal infrastructure to do so is much weaker than the National Bank Act (arguably non-existent). Attempts to pressure the FDIC along these lines occurred 2 years ago but the FDIC shelved the industry's petition. I expect that pressure to resurface in light of this decision.

Ann Graham on the Surprises in Watters v. Wachovia

Professor Ann Graham, a banking law scholar, focuses on a few of the surprises in today's decision in the Watters v. Wachovia case:

1.  Justice Ginsburg authored the majority opinion, joined by Justices Kennedy, Souter, Breyer, and Alito.  In oral argument, Justice Ginsburg asked few questions of either party.  The Dissenting Opinion was written by Justice Stevens, joined by Chief Justice Roberts and Justice Scalia.  All these dissenting justices were active participants in the oral argument, displaying clear concern for the impact of this case on preemption jurisprudence.

2.  This is perhaps the biggest surprise:  The majority opinion did not examine Chevron deference at all.  According to the majority, the National Bank Act preempts the Michigan statute affecting state-chartered mortgage lending corporations which are structured as operating subsidiaries of national banks.  The majority opinion cannot point to any National Bank Act language for this preemption and does not examine Congressional intent.

3.  As Justice Stevens points out in the dissenting opinion, "the Court's eagerness to infuse congressional silence with preemptive force threatens the vitality of most state laws as applied to national banks -- a result at odds with the long and unbroken history of dual state and federal authority over national banks, not to mention our federal system of government.  It is especially troubling that the Court so blithely preempts Michigan laws designed to protect consumers.  Consumer protection is quintessentially a 'field which the States have traditionally occupied.' [citations omitted]"

4.  Here's the concluding statement of the dissent regarding the impact of this decision:  "Never before have we endorsed administrative action whose sole purpose was to preempt state law rather than to implement a statutory command."

(cross-posted from the Banking Law Prof Blog)

Supreme Court Decides Watters v. Wachovia

by Deepak Gupta

SCOTUSblog is reporting that the Supreme Court has ruled that federal law, not state law, controls the regulation of mortgage lending activity by national banks, even when that is carried on by an operating subsidiary of the bank. The vote was 5-3.  Ginsburg, joined by Kennedy, Souter, Breyer, and Alito, announced the opinion of the Court.  Stevens, joined by Roberts and Scalia, dissented.  Thomas took no part in the decision.  The opinions are available here.

Announcing the ruling in Watters v. Wachovia Bank (05-1342), Justice Ruth Bader Ginsburg said: "Where a national bank engages in real estate lending through an operating subsidiary, the subsidiary is subject only to the same terms and conditions as those that would govern the bank itself" -- that is, federal regulation under the National Bank Act. ""Though state law, in this case North Carolina law, governs matters pertaining to an operating subsidiary's incorporation, state regulators cannot interfere with the 'business of banking' by subjecting national banks or their [federal]-licensed subsidiaries to rival oversight regimes."   

Much of the debate and briefing over this case concerned the interaction between preemption and the power of federal administrative agencies--a dicey and dangerous can of worms. Did Congress confer authority on the agency to preempt state law? Can Congress do that? Should the courts defer to the agency under these circumstances?    The Court avoided that can of worms today:

Watters disputes the authority of OCC to promulgate this regulation and contends that, because preemption is a legal question for determination by courts, [the regulation] should attract no deference. . . . This argument is beside the point, for under our interpretation of the statute, the level of deference owed to the regulation is an academic question. Section 7.4006 merely clarifies and confirms what the NBA already conveys: A national bank has the power to engage in real estate lending through an operating subsidiary, subject to the same terms and conditions that govern the national bank itself; that power cannot be significantly impaired or impeded by state law.

D.C.'s New Attorney General on the High Cost of Being Poor

Linda Singer is the District of Columbia's new Attorney General.  In yesterday's Washington Post, she spelled out what sounds like a promising new agenda on predatory lending issues.  Her target list includes payday lending, check-cashing fees, refund-anticipation loans and rent-to-own arrangements:

It goes without saying that it's hard to be poor -- hard to find affordable housing, hard to pay for health care, hard to make ends meet. But it can be expensive to be poor, too.

In the District, the high cost of being poor is most evident in financial services. While moderate- to upper-income people commonly use credit cards if they are short of cash, many poor people turn to deferred-deposit check-cashing services for short-term loans.

These check-cashers charge an extra fee for agreeing to postpone depositing a customer's check. Customers often pay these fees again and again over many months to keep deferring the deposit. The fees for these "payday loans" are subject to a legal cap, but charging the maximum allowable fees enables a check-casher to earn the equivalent of 336 percent annual interest, 14 times the District's usury law ceiling of 24 percent. Many states, including Maryland, do not allow payday lending that exceeds usury limits.

In addition, poor people without checking accounts are likely to use check-cashing services whose fees, on average, skim about 2.5 cents per dollar off a payroll or government benefit check.

Lawmakers, Lenders Target Subprime-Loan Issue

Today on NPR's Morning Edition:

Efforts are under way on several fronts to forestall a wave of home foreclosures due to problems in the mortgage market. Legislative solutions are one option, but non-profits and many smaller lenders are also stepping up efforts to help borrowers.

Listen here.

Consumer Groups Express Disappointment with Proposed DoD Regs

by Deepak Gupta

Three consumer groups -- Consumer Federation of America, Center for Responsbile Lending, and National Consumer Law Center -- issued a statement today expressing disappointment with the Pentagon's new proposed rules on predatory lending to servicemembers.  According to the groups' statement, loopholes in the proposed rules would inexplicably exempt some types of high-cost loans, such as military installment loans, that were specifically criticized by the Defense Department and covered by the legislation.

The statement gives the following examples of predatory loans that would be allowed under the proposed regs:

• Advance America offered an open-end loan in Pennsylvania that included a $149 monthly “participation fee” plus a nominal interest of 6 percent. The effective annual interest on a $500 loan is 364 percent. This would be permitted under the proposed rules.

• Most payday lenders in Illinois now structure their triple-digit interest loans with terms that exceed the 120-day definition of Illinois law. This would be permitted under the proposed rules.

• A sailor reported getting a subprime credit card from a South Dakota bank that imposed $294.60 in fees for $84.85 in purchases after just two months. This open-end credit card cost over 2,000 percent interest. This would be permitted under the proposed rules.

• First Bank of Delaware offers 350 percent internet installment loans through PurposeLoans.com. These loans could be offered to Service Members if the payment period is extended from 6 to 13 weeks under the proposed rules.

• In asking Congress for action last fall, Admiral Charles Abbot, director of the Navy- Marine Corp Relief Society, testified before the Senate Banking Committee that an installment loan from a California company cost a Service member $30,000 to repay $5,000 over a ten year period.

Defense Department Seeks Comments

by Deepak Gupta

Wanna give the Pentagon a piece of your mind?  No, not about the War in Iraq.  In today's Federal Register, the Department of Defense is issuing a notice of proposed rulemaking to implement the landmark predatory lending protections enacted as part of the defense authorization bill earlier this year.  As many of you are probably aware, this legislation is a big deal; among other things, it included a ban on arbitration clauses and a usury cap, and may signal a new willingness on the part of Congress to limit mandatory binding arbitration in consumer contracts and rein in predatory lending abuses.  The impetus was a DoD report on predatory lending, which drew heavily on an empirical study by co-blogger Christopher Peterson.  (We've previously discussed the issue here, here, here, here, here, and here.)

The proposed rules cover a lot of ground.  Consumer advocates watching this issue had feared that the DoD would give in to industry pressure to severely limit the scope of the protections in the new bill; that appears to be what has happened.  For example, the rules define the scope of the protections so that they would not cover residential mortgages, home equity loans, auto finance loans, and a wide range of transactions other than payday loans, refund anticipation loans (a.k.a. RALs), and auto title lending.  The regs also set strict duration limits and monetary limits on the amount of loans included in the definition of "payday loans." 

Comments on the NPRM are due by June 11, 2007.   At this link, you can read the comments previously filed by the consumers groups that have been leading the charge on this issue: the National Consumer Law Center, Consumer Federation of America, Center for Responsible Lending, and Consumers Union, and the National Association of Consumer Advocates.

Two Consumer Lending Articles of Interest

I wanted to alert readers to two articles in today's USA Today, both concerning consumer debt.  This article is about the serious legal and practical difficulties faced by sub-prime mortgage borrowers who want to restructure their debt and avoid foreclosure.  And this article concerns New York Attorney General Andrew Cuomo's on-going antitrust investigation into the student loan market.  The investigation apparently focuses on unearthing exclusionary relationships between colleges and lenders.