In his speech before Women in Housing and Finance on Sept. 24, Comptroller of the Currency John Dugan repeated three arguments that have frequently been advanced in recent months by representatives of big financial institutions.
First, he claimed that mortgage brokers and nonbank mortgage lenders were mainly to blame for our current financial crisis. Second, he maintained that national banks did not play a significant role in precipitating the crisis. Third, he contended that federal preemption of state consumer protection laws has provided big benefits to our economy. Dugan is mistaken on all three points.
Brokers and nonbank lenders did play supporting roles in the lending spree that led to the financial crisis. However, large, federally regulated financial institutions were undeniably the leaders in creating today's mess.
Large national banks, federal thrifts and securities firms supplied most of the funding for subprime and Alt-A mortgages.
Citigroup Inc., JPMorgan Chase & Co., Countrywide Financial Corp., HSBC Holdings PLC, Wachovia Corp., Wells Fargo & Co., National City Corp., Washington Mutual Inc., IndyMac, Bear Stearns, Lehman Brothers and Merrill Lynch & Co. all ranked among the top 20 subprime or Alt-A direct lenders at various times between 2001 and 2007. The same institutions and Bank of America Corp. provided indirect funding for risky loans by furnishing wholesale lending and securitization services to nonbank mortgage lenders such as Ameriquest, New Century and Option One.
When major financial institutions cut off their wholesale lines of credit in 2007, many nonbank lenders and brokers quickly went out of business. The rapid disappearance of nonbank lenders and brokers demonstrated that they were merely conduits for the big financial players.
Large national banks and securities firms also created collateralized debt obligations and credit default swaps whose performance was linked to nonprime mortgages. CDOs and credit default swaps magnified the impact of nonprime mortgage defaults and triggered a global contagion of losses when the U.S. housing market collapsed.
Until the crisis exploded in August 2007, federal regulators did little to stop their supervised entities from feeding the nonprime bonfire. Federal regulators — including the Office of the Comptroller of the Currency, Office of Thrift Supervision, Federal Reserve Board and Securities and Exchange Commission — blessed the mortgage-backed securities, CDOs and swaps that were peddled by the financial giants.
In addition, federal regulators issued no binding regulations placing meaningful constraints on the terms of nonprime mortgages until July 2008. By then, the proverbial horses were not only out of the barn but dead in the field.
By contrast, the states did act. Thirty states adopted anti-predatory-lending laws from 1999 to 2006. State officials also brought landmark enforcement actions against nonbank subprime lenders, including Household and Ameriquest.
Unfortunately, the OCC and OTS issued regulations preempting the application of state laws to national banks, federal thrifts and their operating subsidiaries.
The two agencies also declared that the states could not regulate mortgage brokers who arranged loans funded at closing by national banks and federal thrifts. In order to gain protection from state regulation, Household and Ameriquest sold their subprime lending operations to big national banks (HSBC and Citigroup) without any objection from federal agencies.
Thus, the OCC and OTS hamstrung the states' efforts to protect their citizens from predatory nonprime lending. This was a significant loss because the states could not respond to predatory lending with the same vigor that they displayed in exposing scandalous abuses on Wall Street after the collapse of Enron and WorldCom. A report issued in July by the Government Accountability Office said the worst nonprime loans were made from 2004 through 2007. Those were the years that came after the issuance of preemption rules by the OCC and OTS.
The central role played by federally regulated institutions in the present crisis is obvious from the failures and federal bailouts of many large financial institutions. Wachovia, Wamu, IndyMac and Lehman all failed. Bear Stearns, Countrywide, Merrill and National City were forced into emergency mergers supported by costly federal bailouts. Citigroup and B of A are now operating under close federal supervision after getting $90 billion of capital infusions and $400 billion of asset guarantees from the federal government.
Why did federal regulators fail to prevent our leading financial institutions from creating the worst financial crisis since the Great Depression? The full story is not yet known, but the influence exerted by financial giants on federal agencies apparently played an important role. The OCC and OTS used their preemption campaigns as a marketing tool to persuade large, multistate institutions to convert to federal charters in order to gain immunity from state laws.
Since the budgets of the OCC and OTS are funded by their regulated constituents, it is hardly surprising that these agencies consistently aligned their policies with the views and interests of big banks and thrifts while ignoring complaints and warnings from consumer groups.
The Fed and the SEC similarly failed to control reckless gambling by big commercial and investment banks on Wall Street. During the boom period that led to the present crisis, both agencies were led by avowed champions of deregulation (Alan Greenspan and Christopher Cox, respectively) who opposed any meaningful constraints on Wall Street.
The Treasury Department's regulatory reform plan offers promising remedies for the causes of the financial crisis. Two of its proposed reforms are particularly noteworthy.
First, a new Consumer Financial Protection Agency would be established with broad authority to protect people from abusive financial products. The agency would also have significant guarantees of independence from the influence of financial giants.
Second, the unwarranted and counterproductive preemption rules issued by the OCC and OTS would be struck down, and the states would once again be able to protect their citizens from predatory financial practices.
Both reforms are urgently needed to restore fairness and trust in our financial marketplace.