More than five years ago, in April 2003, the attorneys general of two small states traveled to Washington with a stern warning for the nation's top bank regulator. Sitting in the spacious Office of the Comptroller of the Currency, with its panoramic view of the capital, the AGs from North Carolina and Iowa said lenders were pushing increasingly risky mortgages. Their host, John D. Hawke Jr., expressed skepticism.
Roy Cooper of North Carolina and Tom Miller of Iowa headed a committee of state officials concerned about new forms of "predatory" lending. They urged Hawke to give states more latitude to limit exorbitant interest rates and fine-print fees. "People out there are struggling with oppressive loans," Cooper recalls saying.
Hawke, a veteran banking industry lawyer appointed to head the OCC by President Bill Clinton in 1998, wouldn't budge. He said he would reinforce federal policies that hindered states from reining in lenders. The AGs left the tense hour-long meeting realizing that Washington had become a foe in the nascent fight against reckless real estate finance. The OCC "took 50 sheriffs off the job during the time the mortgage lending industry was becoming the Wild West," Cooper says.
This was but one of many instances of state posses sounding early alarms about the irresponsible lending at the heart of the current financial crisis. Federal officials brushed aside their concerns. The OCC and its sister agency, the Office of Thrift Supervision (OTS), instead sided with lenders. The beneficiaries ranged from now-defunct subprime factories, such as First Franklin Financial, to a savings and loan owned by Lehman Brothers, the collapsed investment bank.
Some states, including North Carolina and Georgia, passed laws aimed at deterring rash loans only to have federal authorities undercut them. In Iowa and other states, mortgage mills arranged to be acquired by nationally regulated banks and in the process fended off more-assertive state supervision. In Ohio the story took a different twist: State lawmakers acting at the behest of lenders squelched an attempt by the Cleveland City Council to slow the subprime frenzy.
A number of factors contributed to the mortgage disaster and credit crunch. Interest rate cuts and unprecedented foreign capital infusions fueled thoughtless lending on Main Street and arrogant gambling on Wall Street. The trading of esoteric derivatives amplified risks it was supposed to mute.
One cause, though, has been largely overlooked: the stifling of prescient state enforcers and legislators who tried to contain the greed and foolishness. They were thwarted in many cases by Washington officials hostile to regulation and a financial industry adept at exploiting this ideology.
The Bush Administration and many banks clung to what is known as "preemption." It is a legal doctrine that can be invoked in court and at the rulemaking table to assert that, when federal and state authority over business conflict, the feds prevail — even if it means little or no regulation.
"There is no question that preemption was a significant contributor to the subprime meltdown," says Kathleen E. Keest, a former assistant attorney general in Iowa who now works for the Center for Responsible Lending, a nonprofit in Durham, N.C. "It pushed aside state laws and state law enforcement that would have sent the message that there were still standards in place, and it was a big part of the message to the industry that it could regulate itself without rules."
"That's bull----," says Hawke, the former comptroller. He returned to private law practice in late 2004 with the prominent Washington firm Arnold & Porter. Once again representing lenders as clients, he confirms the substance and tone of the April 2003 meeting with the state AGs, saying they "simply had a fundamental disagreement." But he denies that federal preemption played a role in the subprime debacle.
Hawke blames much of the mess on mortgage brokers and originators who, he says, were the responsibility of states. "I can understand why state AGs would try to offload some responsibility here," he adds. "It's important to remember when people are trying to assign blame here that the courts uniformly upheld our position."
His arguments have some merit. The federal judiciary has bolstered preemption in the name of uniform national rules, not just for banks but also for manufacturers of drugs and consumer products. And state oversight alone is no panacea, as the chaotic state-regulated insurance market illustrates. Inadequate supervision of mortgage companies in some states contributed to the subprime explosion. But the hands-off signals sent from Washington only invited complacency. When some state officials fired warning flares, the Administration doused them.
Consider a clash in 2004 between the OCC and regulators in Michigan. In January of that year attorneys working for Hawke filed a brief in federal court in Grand Rapids on behalf of Wachovia, the national bank with $800 billion in assets based in Charlotte, N.C. Michigan wanted to continue to examine a Wachovia-controlled mortgage unit in the state, which the bank had converted to a wholly owned subsidiary. The parent bank sued, claiming Michigan could no longer look at the mortgage lender's books. Citing the threat of unspecified "hostile state interests," the OCC argued in its brief that "states are not at liberty to obstruct, impair, or condition the exercise of national bank powers, including those powers exercised through an operating subsidiary."
Michigan countered that Wachovia Mortgage was not itself a national bank. The Constitution preserves state authority to protect its residents when federal statutes don't explicitly bar such regulation, Michigan contended. Ken Ross, the state's top financial regulator, says his department fought Wachovia all the way to the U.S. Supreme Court in part because it feared a growing subprime mortgage problem: "We knew there needed to be [state] regulation in place or there could be gaps." The OCC, he adds, "did not have robust regulatory provisions over these operating subsidiaries."
The nation's highest court sided with the Bush Administration, ruling in April 2007 that the OCC had exclusive authority over Wachovia Mortgage. Justice Ruth Bader Ginsburg, writing for a five-member majority, pointed to the potential burdens on mortgage lending if there were "duplicative state examination, supervision, and regulation." In a dissenting opinion, Justice John Paul Stevens said that it is "especially troubling that the court so blithely preempts Michigan laws designed to protect consumers."
By the time of the Supreme Court decision last year, Wachovia and its mortgage operations in Michigan and elsewhere were feeling the ill effects of unwise lending. As real estate prices continued to fall this year, pushing many borrowers into default, Wachovia teetered on the edge of failure. In late September the federal government stepped in to arrange a fire sale. On Friday, federal antitrust regulators cleared Wells Fargo's $11.7 billion acquisition of Wachovia, a day after Citigroup Inc. walked away from its own efforts to buy the Charlotte, N.C.-based bank.
Confrontations such as Michigan's battle with Wachovia became far more common after George W. Bush took over the White House in 2001 and instituted a broad deregulatory agenda. The OCC, an arm of the Treasury Dept., has adhered closely to it. The agency oversees more than 1,700 federally chartered banks, controlling two-thirds of all U.S. commercial bank assets. Historically, its examiners have monitored bank capital levels and lending to corporations more attentively than they have the treatment of individual borrowers. "Consumer protection has always been an orphan [among federal bank regulators]," says Adam J. Levitin, a commercial law scholar at Georgetown University Law Center.
The OCC brought 495 enforcement actions against national banks from 2000 through 2006. Thirteen of those actions were consumer-related. Only one involved subprime mortgage lending. OCC spokesman Robert Garsson says the figures could be misinterpreted because the agency addresses many problems informally during bank examinations. He declined to provide any examples.
Beyond the influence of free-market theory, turf concerns have reinforced the Administration's determination to exercise responsibility for as many lenders as possible — and prevent state incursions, notes Arthur E. Wilmarth Jr., a professor at George Washington University Law School. Almost all of the funding for the OCC and OTS comes from fees paid by nationally chartered institutions.
The fight in Georgia
Hawke says the OCC seeks only to exercise powers that it has long held under federal law. It is far more efficient for national banks to deal with one set of federal rules than a hodgepodge of state directives, he argues, echoing the Supreme Court's majority view. By the late 1990s, he adds, more state legislatures and AGs were trying to bully national banks by, for example, restricting ATM fees charged to nondepositors. State officials "found it politically advantageous to assert these kinds of initiatives," he says. The OCC's heightened preemption campaign "was occasioned by the fact the states were becoming more aggressive."
The current head of the OCC, John C. Dugan, concurs. "To claim that it is our fault from preemption is just a total smokescreen to shield the fact that the state mortgage brokers and mortgage companies were just not regulated," Dugan says.
Efforts in Georgia to rein in unwise lending provoked a particularly fierce federal reaction. In 2002 the state passed a law that imposed "assignee liability" on the mortgage-finance process. Understanding the significance of this requires a little background.
One of the forces that accelerated the proliferation of dangerous home loans was the Wall Street business of buying up millions of mortgages, bundling them into bonds, and selling the securities to pension funds and other investors. Securitization, which grew to a $7 trillion industry, meant the lenders could pass along the risk of default to a huge universe of investors. Many of those investors, in turn, relied uncritically on reassurances from fee-collecting investment banks and ratings agencies that mortgage-backed securities were high-quality. When many of the reassurances proved hollow, the securitization market collapsed this year.
Assignee liability would radically reshape that market by making everyone involved potentially responsible when things go bad. Investment banks that created mortgage-backed securities and investors who bought them would be liable for financial damage if mortgages turned out to be fraudulent. The financial industry opposed assignee liability, maintaining that it would cripple the market for asset-backed securities. Major ratings agencies later agreed that allowing unlimited damages would be disruptive. The agencies threatened to stop evaluating many bonds tied to mortgages covered by the Georgia law.
But some banking experts speculate that if Georgia's example had spurred more states to adopt broad assignee liability, greater caution would have prevailed in the mortgage-securities market, possibly preventing the blowups of Lehman, Bear Stearns, and other once-mighty institutions. "If the Georgia law had held, it is possible that other states would have followed and there might have been change earlier," says Ellen Seidman, who headed the OTS from 1997 through 2001.
Roy Barnes, Georgia's governor in 2002, understood the potential significance of assignee liability when he signed the state's new Fair Lending Act that year. He recalls a breakfast meeting with banking lobbyists during which he admonished the industry to clean up reckless lending. He jokingly threatened to hire "the longest-haired, sandal-wearing bank commissioner you ever saw." But the bankers fought back, seeking to undermine the new law.
The OCC's Hawke assisted the industry by issuing a ruling in July 2003 saying the Georgia law did not apply to national banks or their subsidiaries. A fact sheet prepared at the time — and still available on the OCC's Web site — says: "There is no evidence of predatory lending by national banks or their operating subsidiaries, in Georgia or elsewhere."
The OCC ruling had been requested by Cleveland-based National City Bank on behalf of several of its units, including First Franklin Financial, a subprime lender that operated in Georgia and other states. First Franklin, which was acquired by Merrill Lynch in 2006, has been hit with dozens of suits alleging unfair lending practices. Merrill shut down First Franklin's troubled lending business in March. Itself hobbled by mortgage-securities losses, Merrill agreed last month to be acquired by Bank of America. The bank and Merrill declined to comment.
In August 2004, Hawke went a step further in a letter to the Georgia Banking Dept. He said even state-chartered mortgage brokers and lenders were exempt from the Georgia law — if the loans they handled were funded at closing by a national bank or its subsidiary.
By then support for the Georgia law was already eroding. Barnes, a Democrat, lost his reelection campaign in November 2002, and his Republican successor moved to dilute the lending act. Still, supporters mobilized to defend the legislation. One was William J. Brennan Jr., an Atlanta legal aid attorney who specializes in housing and had testified before the U.S. Congress in 2000 about what he saw as the looming mortgage mess. He told the House Financial Services Committee: "The entry of many prominent national banks into the subprime mortgage-lending business has resulted not in reform, but in the expansion of the abusive practices." Federal regulators, he testified, "have done little to stop" the trend. In early 2003, Brennan and a legal aid colleague, Karen E. Brown, consulted with Georgia legislators trying to block amendments softening the lending law. At a hearing in February, Brennan requested a police escort because he feared that angry mortgage brokers would block his way. "The words that come to mind are 'outgunned' and 'overwhelmed,' " says Brown.
The Georgia legislature sharply curtailed the assignee liability provision in March 2003 and eliminated other elements of the law as well. Subprime lenders such as Ameriquest Mortgage that had halted lending in Georgia in protest of the law resumed marketing high-interest, high-fee mortgages. But by late 2007, Ameriquest had gone out of business after agreeing to a $325 million settlement to resolve suits alleging that it had made fraudulent loans.
Escaping state enforcement
Georgia now has the sixth-highest rate of foreclosure in the country. Consumer advocates and state attorneys general contend the weakening of the state's law was a severe blow to efforts to curb careless lending. "Had the Georgia Fair Lending Act not been watered down, we would be in a very different place right now," says Brown.
In some states, dubious local mortgage firms sold themselves to national banks, gaining protection against state enforcement. The Iowa Division of Banking in 2006 sought to examine a subprime broker called Okoboji Mortgage in the town of Arnolds Park. A borrower had accused the firm (named for an area lake) of duplicitous lending practices. Cheryl Riley, a 52-year-old janitor, told state officials she had not received the 30-year fixed-rate mortgage she thought she had arranged with Okoboji in 2005. Instead of one monthly statement, Riley got two: one for a 9.25 percent adjustable-rate loan and another for a 15-year fixed loan at 12 percent. Both rates were far higher than what Riley and her husband thought they had negotiated. "We were horrified," she says.
A preliminary state investigation found that Okoboji's manager had headed a mortgage firm in Nebraska that lost its license for falsifying loan documents. But Okoboji refused Iowa's demand for an examination, forcing the agency to file suit in August 2006. Okoboji responded by announcing that it had been acquired by Wells Fargo, a nationally chartered bank regulated by the OCC. Okoboji handed in its state license, saying it no longer had to comply with Iowa rules. "We'd had red flags but were now blocked from investigating," says Shauna Shields, an Iowa assistant AG.
Okoboji's former manager, Lyda Neuhaus, calls Nebraska's earlier actions "a witch hunt" based on "12 miserable complaints." Her father, Juan Alonso, who owned Okoboji, says he sold his company because he wanted to retire, not to escape state regulation. Both deny any wrongdoing. A Wells Fargo spokesman declined to comment on Iowa's concern about Okoboji and defended the acquisition as benefiting customers and shareholders.
A playing field with no rules
The experience with Okoboji was the sort of thing that Iowa AG Miller had warned about when he joined his counterpart from North Carolina on their visit to OCC chief Hawke in 2003. "Now, we could not do anything with federally chartered banks or subsidiaries," Miller says. In 2006 and 2007 the Iowa legislature shot down proposals by Miller for more-restrictive lending laws. Lax regulatory standards at the federal level helped undermine his efforts, he explains. State-chartered banks insisted that tougher rules in Iowa would put them at a competitive disadvantage with federally chartered banks overseen by the OCC. "We had to acknowledge the [political] environment we were in," Miller says.
The banking industry repeated the argument for regulatory "parity" in many states that tried and failed to tighten supervision of subprime lenders, says Keest of the Center for Responsible Lending: "State institutions then wanted a level playing field, which was a playing field with no rules."
Hawke says that it would have been inappropriate for the states to impose more-stringent standards on federally chartered institutions: "Had they tried to apply those rules to national banks, they clearly would have been preempted."
In Cleveland in 2002, Frank G. Jackson, then a member of the City Council, could see that many lower-income residents were being persuaded by lenders to pile on high-interest debt. "It was pure greed, based on exploitation," he says. "[Some subprime lending] is just the same as organized crime." He started negotiating with mortgage lenders for more-favorable terms. To his surprise, the lenders bypassed him and persuaded the state legislature to enact a less stringent version of an anti-predatory lending act he was drafting. "I figured the good faith had ended, so I passed my law [at the city level]," Jackson says. That law required lenders to register with the city and provided counseling to prospective borrowers.
His accomplishment was short-lived. That same year, the American Financial Services Assn. (AFSA), a national trade group, sued to block Ohio municipalities from passing lending laws that conflicted with state statutes. The Ohio Supreme Court later sided with the industry. AFSA's goal was to ward off conflicts between federal, state, and local rules, says spokesman Bill Himpler. "Different municipalities moving different anti-predatory lending legislation ... would have brought the credit markets to a screeching halt."
Fulfilling Jackson's fears, the Cleveland area has become one of the places worst hit by the mortgage catastrophe. More than 80,000 homes have gone into foreclosure since 2000, the highest per capita rate in the country.
In January, Jackson, elected the city's mayor in 2005, tried a new tactic. He filed suit in state court against Lehman, Wells Fargo, and 19 other lenders, alleging that they sold "toxic subprime mortgages ... under circumstances that made the resulting spike in foreclosures a foreseeable and inevitable result." The city's attorneys based the suit on an Ohio law banning "public nuisances," which is usually used against defendants such as manufacturers whose factories emit pollution. The idea was to steer clear of conventional banking law and head off any claim of federal preemption. The suit is pending; the banks all deny wrongdoing.