Is the Fed Culpable in the Subprime Meltdown?

On Thursday, both Democratic and Republican members of the Senate Banking Committee chewed out Roger Cole, the Federal Reserve’s director of supervision and regulation, for failing to intervene in the rapid rise of the issuance of mortgages to customers who were clearly likely to default, and now are, losing their homes and their investment in them.

Now when lots people are hurt, the impulse is to blame someone. The question here therefore is, are the regulators at fault?

You aren’t going to like this answer. For the most part, no. But as we will discuss later, I consider Greenspan to be personally culpable.

Federal banking regulators (and this means the Federal Reserve, the Office of the Comptroller of the Currency, which supervised state-chartered banks, and the Federal Deposit Insurance Corporation), by charter supervise and regulate banks to assure their soundness and safety. They are not in the business of consumer protection. If they were, we would not see banks charging 30+% interest rates to chronically indebted credit card holders.

The only basis the Fed and the OCC might have had for stepping in to the subprime mess would have been if bank safety was at risk. And it wasn’t. Because the loans are mortgages, with homes as collateral, the banking industry is going to come out of this with a few not so hot quarters of earnings (and that only at banks that are strictly consumer banks; this event won’t even register at Citibank or JP Morgan) and a mild dent to capital.

Consumer safety, in fact, has never been much of a concern in banking regulation, at least at the level of individual products. The FDIC assures safety of deposits. State usury laws were gutted by the effects of a 1978 Supreme Court decision that allowed banks to charge customers anywhere in the country interest rates permitted in its home states. Banks went jurisdiction shopping and states revised or scrapped usury laws to attract banking jobs.

It may seem odd that banking regulations are not very interested in consumers, but consider the nature of most banking relationships. With consumers having insured deposits, their risks (that the bank will collapse and take their savings with it) are, for the most part, handled. In lending, it’s the bank that is taking the risk. Products like subprimes, where lenders target weak borrowers and can wind up profiting at their expense, are outside the scope of traditional banking practices, and hence are not contemplated in regulatory oversight.

In a Washington Post article, “Fed Faulted For Inaction On Mortgages,” the Fed is accused of not using powers it had:

Dodd said the Fed could have invoked the 1994 Home Ownership and Equity Protection Act, or HOEPA, which obligates the agency to stop unfair and deceptive lending practices by federally and state-regulated mortgage lenders.

This law “has never been utilized” by the Fed, Dodd contended….

Fed officials noted that they used their HOEPA authority twice in 2001 to prohibit two lending practices as “unfair and deceptive.”

If you read the HOEPA guidelines that the Fed issued to banks (see this as an example), it’s pretty clear that the Fed saw its charter as narrow. The instructions to banks are on how to analyze loans to determine whether they needed to be designated as HOEPA, meaning high interest (or subprime) and reported. So the Fed saw its job as mainly monitoring the level of HOEPA activity, not proscribing it (indeed changes were made in 2002 to lower the interest rate spread at which loans had to be reported, and to strengthen “truth in lending” requirements, particularly telling borrowers they weren’t obligated to complete a transaction).

Even if one believes that the Fed should have done more, it’s doubtful that it actually could have done much. An excellent page one Wall Street Journal story, “Regulators Scrutinized In Mortgage Meltdown,” discusses how fragmented authority and the rise of new, unregulated institutions would have impeded any efforts to intervene:

Changes in the lending business and financial markets have moved large swaths of subprime lending from traditional banks to companies outside the jurisdiction of federal banking regulators. In 2005, 52% of subprime mortgages were originated by companies with no federal supervision, primarily mortgage brokers and stand-alone finance companies. Another 25% were made by finance companies that are units of bank-holding companies and thus indirectly supervised by the Federal Reserve; and 23% by regulated banks and thrifts….

Lenders that aren’t federally regulated are generally state-licensed. But many state regulators lack the resources and mandates of their federal counterparts. Some of the biggest subprime blowups have happened in California. The home-state regulator, the California Department of Corporations, has 25 examiners to oversee more than 4,800 state-licensed lenders, including many of the country’s largest subprime companies. By comparison, San Francisco-based Wells Fargo & Co. alone has 34 examiners from the federal Office of the Comptroller of the Currency and the equivalent of 12 Fed examiners assigned to it.

Nevertheless, I fault the federal regulators for having squashed state attempts to protect consumers. From the same story:

State regulators defend their record, noting they secured multimillion dollar settlements in January 2006 with Ameriquest Mortgage Co., a unit of ACC Capital Holdings Corp., and in October 2002 with Household International Inc., which HSBC Holdings acquired in 2003.

They also say federal regulators fostered an environment in which Wall Street and other secondary market players were permitted to fund loans made without regard for a borrower’s ability to repay. Both OTS [Office of Thrift Supervision] and OCC said banks they regulate don’t have to comply with state lending laws, which were frequently tougher on lending standards than federal statutes, a policy called “pre-emption.”

“The OCC’s pre-emption policy really neutered the states’ ability to really aggressively address predatory lending issues,” says John Ryan, executive vice president of the Conference of State Bank Supervisors.

In 2002, Georgia passed one of the country’s toughest antipredatory-lending laws. Among other things, it would have made not just the originator of a loan liable for abusive practices, but any investor who purchased the loan in the secondary market. Numerous lenders threatened to stop doing business in Georgia. Shortly afterward, both the OTS and the OCC said that Georgia’s law didn’t apply to their regulated institutions. The state later weakened the law’s most contentious provisions.

Regulators need to strike a balance between the needs of the industry they regulate and its customers. It appears the federal banking regulators may have become too sympathetic to the industry.

Finally, Greenspan gave a wink and a nod in favor of adjustable rate mortgages precisely at the time subprime growth was growing rapidly. He denies now that he was indicating these instruments were appropriate for most borrowers, but Dean Baker of Beat the Press begs to differ:

The [Washington Post] article cites Greenspan’s denial that he had encouraged people to take-out nontraditional mortgages. The immediate point at issue was that Greenspan had suggested in early 2004 that homebuyers often wasted money by taking out fixed rate mortgages. Greenspan claims that he was referring to limited segment of the market and had qualified his remarks in subsequent weeks.

Sorry, that one doesn’t pass the laugh test. Greenspan saw what was taking place in the subprime market. There was readily available data showing that this sector was exploding, that mortgages were being issues with zero money down and that many of these mortgages included teaser rates that were sure to reset to considerably higher levels in two to three years.

Alan Greenspan knew that his comments, whether misinterpreted or not, contributed to this irrational exuberance. In addition to the regulatory powers of the Fed, he could have used his enormous bully pulpit as the revered chairman of the Fed to warn of the dangers of the situation. Instead, he chose to look the other way, and let millions of low income homebuyers get way over their heads in mortgage debt.

This was a conscious decision and any good reporter should know this and tell their readers.

I sincerely doubt that a single subprime borrower heard, much the less acted on, Greenspan’s 2004 remark. But bankers did, and took it as at least official sanction, and possibly even encouragement, of adjustable rate mortgages. And all subprimes are ARMs.

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