The foreclosure fiasco is yet another systemic risk that regulators failed to see coming.
Some of you are shaking your heads saying this isn't "systemic," and you could be right. But no one has yet defined the term; we're all still operating on the you-know-it-when-you-see-it standard.
Even if the foreclosure crisis isn't systemic, its timing is terrible. The industry was just starting to stabilize, and now it's been hit with a new uncertainty that's expected to turn into legal problems that drag on for years in the courts.
As one regulator put it this week, the industry is beyond waiting for the other shoe to drop: "We are dealing with Imelda Marcos here."
Regardless of how big or widespread the losses are from the foreclosure mess, the regulators are asking themselves how they failed to pick up on the problem before it was too late — again.
Paul Volcker highlighted past failures in a recent speech in Chicago.
"It still boggles my mind … [that] the subprime mortgage market could grow from practically nothing to close $1.5 trillion in the space of a few years … without anybody doing something about it," the former Fed chairman said. "And what about all those credit-default swaps? Sixty trillion outstanding … it rose in the space of 10 years to a market that has 10 times as many CDS outstanding as you had potential defaults to protect against. You wonder what was going on."
His conclusion: "The existing regulators were unable or unwilling to keep up."
In an attempt to play catch-up, the Federal Reserve and the Office of the Comptroller of the Currency are conducting a horizontal review of the 10 largest mortgage servicers. Teams of examiners from both agencies are going in and asking the same set of questions of each servicer about documentation procedures, staffing and internal controls. "We want to better understand how they got to this place and verify the facts," another regulator explained.
The agencies are still debating how and when the results will be released.
The Federal Deposit Insurance Corp. is in on the exams, too, and its chairman became the first regulator to take some responsibility. "In retrospect, there were warning signs that servicing standards were eroding," Sheila Bair said Monday. "We should have been asking how servicers were able to achieve such efficiencies without sacrificing quality."
In announcing the horizontal review, Fed Chairman Ben Bernanke said, "We are looking intensively at the firms' policies, procedures and internal controls related to foreclosures and seeking to determine whether systematic weaknesses are leading to improper foreclosures."
But isn't this exactly the sort of detailed work bank examiners do routinely — check to see if a bank has the internal controls, policies and procedures for safe and sound operation, and then check to be sure the bank is following them.
Why didn't that happen?
There are many reasons, but here's the biggest reason: when things are going well, when money is being made, regulators are at their weakest. They do not feel they have the power to slow a successful product or activity down.
And that may be the Achilles' heel of the Dodd-Frank Act. Yes, it attempts to identify the next systemic risk by creating the Financial Stability Oversight Council and the Office of Financial Research. And the law extended prompt corrective action to holding companies so that as their capital diminishes, regulators can take increasingly aggressive sanctions.
But the reform law did not give the agencies any new tools to curb an activity, a product or a practice while it is still going gangbusters.
Regulators need to get ahead of problems. When they see the sort of growth Volcker noted or they see a market spiraling into a sloppy mess as with foreclosures, they need to be able to step in and either slow a market down or demand order be restored.
What the foreclosure crisis shows is just how hard it is for regulators to do anything as they watch bubbles inflate. Even when bloating bubbles are obvious, it's tough for them to do much.
Take the bond market. Are regulators going to tell bankers to stop buying Treasuries because the market's pricing is so out of whack? Or how about the problems so many states are facing with underfunded pensions. Maybe regulators should be telling banks to back off municipal debt as some states or local governments may default as they meet rising demands from their retirees.
Bair highlighted the overall problem last week, and added a new bubble to the list.
"Experience has shown that it is critically important to monitor markets for potential asset-price bubbles that could lead to instability down the road," she said. "Over the past dozen years or so, the United States has experienced classic asset-price bubbles in the stock market and the housing market."
Answering her own question about where the next bubble may be, Bair noted that farmland values have risen 58% from 2000 levels. "A sharp decline in farmland prices similar to the early 1980s could have a severe adverse impact on the nation's 1,579 farm banks," she said. "While the credit structure underlying U.S. farmland does not appear to involve excessive leverage or inappropriate loan products, this is a situation that will continue to require close monitoring."
But will the FDIC tell banks to dial back lending to farmers? Unlikely. At least not until it's too late. That's exactly what happened with commercial real estate. The examiners saw that bubble coming. The agencies proposed curbs; the industry — as well as its allies in Congress — weighed in and forced the agencies to water down their rules. When "guidelines" to curb commercial real estate lending finally came out in 2006 they were too little too late.
Dodd-Frank did not change that dynamic. As long as money is being made, regulators will have a hard time stopping bankers.
"To stop systemic risk in its tracks, regulators have to identify it and say we are going to slow it down a lot, and I don't know if people especially in good times have the stomach to do that," said Cliff Rossi, a former banker who is an executive-in-residence at the University of Maryland's Center for Financial Policy. "You have to stop it in its tracks early on. You cannot let it go on.
"We do not have the structure in place to prevent the next systemic crisis."