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The creation of a crisis - Part II

In my previous article, I discussed the Report issued this month by the Consumer Education Foundation with lists 12 events that have created the “perfect storm” that has caused the present financial meltdown and crisis that has affected the world. I summarized the first six of these.  In my next and final post on this matter, I will recount the billions of dollars spent to influence legislators and administrations of both parties over the past 30 years, efforts that, to our collective shame, were successful. We are now suffering from the failure of government to act to protect us. The remaining issues and factors from the Foundation’s Report follow.

 

VII

 

Even in a deregulated environment, the banking regulators retained authority to crack down on predatory lending abuses. Such enforcement activity would have protected homeowners, and lessened, though not prevented, the current financial crisis. But the regulators sat on their hands. The Federal Reserve took a grand total of three formal actions against subprime lenders from 2002 to 2007.

 

The Office of Comptroller of the Currency, which has authority over almost 1,800 banks, took three consumer-protections actions between 2004 and 2006. By the middle of this decade, the philosophy that “the market was the best source of regulation - weak government oversight was more in keeping with limited-government - government is the problem not the solution” mantra of the Conservative movement was adopted by the GOP. But all of the fault cannot be laid at the feet of Republicans; there were plenty of Democratic lapses, too.

 

VIII

 

When the Federal government stopped regulating or even trying to enforce the law against predatory lending practices, many states tried to fill the void. The Federal authorities’, proving that swift action was possible, quickly moved to stop the states! The Feds pre-empted all state action. Eliot Spitzer n New York reported, “During the height of the predatory lending crisis, the Office of the Comptroller of the Currency invoked a clause from the 1863 National Bank Act to issue formal opinions preempting all state predatory lending laws, thereby rendering them inoperative. The OCC also promulgated new rules that prevented states from enforcing any of their own consumer protection laws against national banks.”

 

IX

 

This issue continues to amaze. Again, some explanation of legal principles is needed as a preface. “Assignee liability” is the principle that legal responsibility for wrongdoing in issuing a loan extends to a third party that acquires a loan. Therefore, if a mortgage bank issues a predatory loan and then sells the loan to another bank, assignee liability would hold the second bank liable for any legal claims that the borrower might be able to bring against the original lender. But (and there is always a “but”) competing in the law with “assignee liability” is the “holder-in-due-course” doctrine, which stands for the more commercial-friendly rule that a third party purchasing a debt instrument is not liable for problems with the instrument, so long as those problems are not apparent on its face. Under the “holder in due course” doctrine, a second bank acquiring a predatory loan is not liable for claims that may be brought by the borrower against the original lender, so long as those potential claims are not obvious. And under normal practices nothing would be “obvious”; all preliminary discussions and assurances made to induce the borrower to sign the papers are merged into the final instrument and do not count!

 

Federal statutes shifted the focus from assignee liability to the doctrine of holder in due course in connection with the transfer of, among other things, subprime and fraudulent mortgages. The Report discusses in great detail the efforts of some legislators to see that Federal law mandated, with only limited exceptions,  that only the original mortgage lender be liable for any predatory and illegal features of a mortgage — even if the mortgage is transferred to another party. This arrangement effectively immunized acquirers of the mortgage (“assignees”) for any problems with the initial loan, and relieved illegal loan terms. The arrangement left borrowers with no claim against any but the original lender, and typically with no defenses against foreclosure. Wall Street interests could purchase, bundle and securitize subprime loans — including many with pernicious, predatory terms — without fear of liability for illegal loan terms.

 

X

 

The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddy Mac), are government supported entities. The former was established in as a private organization in 1968; its purpose is to purchase mortgages from private bankers and other lenders so that they have additional funds to continue originating new mortgages. Freddy Mac was later established, for the same purpose and function of its older “sister” in order that the former had competition. 

 

Originally, the Freddies maintained high and conservative criteria for the mortgage loans they purchased. Between 1999 and 2001, however, they started to invest in subprime mortgage loans. By the middle of the first decade of the 21^st century, these entities were heavily into the purchase of risky and subprime loans. Since they were quasi-government agencies, they had instant credibility and assumed value. Why the switch? Democrats, and a few Republicans, wanted to encourage loans to buy homes by people who were likely not qualified financially. Wall Street had a less altruistic reason: making subprime loans made a great profit and the mortgagee could always get rid of the risky loans by selling them to the Freddies.

 

XI

 

Over the past 20 or 25 years, the long-established prohibition against monopolies has been weakened or ignored. There became a belief in mergers in the financial industry that led to “banks too big to fail”. The merger of Bank of America and Nations’ Bank and that of Chase into JP Morgan Chase and its acquisition of Bank One are illustrations that come to mind. From 1975 to 1985, the number of commercial banks was stable at about 14,000. By 2005 that number stood at 7,500, a nearly 50 percent drop.By mid-2008 — before a rash of mergers consummated during and resulting from the financial crash — the top 5 banks held more than half the assets controlled by the top 150. Regulators rarely challenged bank mergers and acquisitions as stock prices skyrocketed and the financial party on Wall Street drowned out the critics. But many argued that “bigger is not better” because it raised the specter that any one individual bank could become “too big to fail” (TBTF) or at least “too big to discipline adequately” by regulators. The current financial crisis has confirmed these fears.

 

The Report continues:

 

 

XII

 

The final nail in the coffin was the allowing of credit rating agencies to issue glowing opinions with respect to the worth of assets and collateral notwithstanding patent conflicts of interest. Again, quoting the Report,