WASHINGTON — The Federal Reserve's proposals this week to address deception and fraud in mortgage lending will all be for naught unless the states, the Fed and other federal agencies tighten their enforcement of the lending rules.
Lending standards weakened sharply in 2005 and 2006 as home prices soared. Fraud and predatory lending were rampant in the subprime market, which served the weakest borrowers.
Yet there wasn't any federal sheriff.
At least eight federal agencies, including the Federal Reserve and even the FBI, had some oversight responsibility for mortgage lending. Apart from this dispersed and fractured federal regulation, the two biggest sources of abusive lending — mortgage brokers and non-bank lenders — were, and are, regulated at the state level. That amounts to a gaping hole in the regulatory net.
"This does not change the current enforcement scheme," a senior Fed official acknowledged when explaining the Fed's proposed rules. He was one of a team of officials who briefed reporters on the condition that they not be identified by name.
Status-quo enforcement is a problem, given the weak track record on self- regulation by industry and widely varied enforcement by the states.
"I think with the subprime blowup, we've seen that markets aren't good at governing themselves," said Kurt Eggert, a law professor at Chapman University in Orange, Calif.
Eggert, who's finishing a three-year term on the Fed's consumer advisory committee, credited Fed Chairman Ben Bernanke with recognizing the need for tighter rules where his predecessor Alan Greenspan did not.
"I think the Fed is now more interested in putting in consumer protections, whereas under Greenspan there was not that much interest in consumer protection, and there was the general feeling that markets should govern themselves," said Eggert, whose time on the advisory panel spans both chairmen.
While the proposed rules enhance consumer protection, the Fed governor who has spearheaded the proposed regulatory revisions, Randall S. Kroszner, admitted this week that rules can achieve only so much.
"Ultimately it's really about the enforcement. It's not the rules themselves, but how they're enforced," he said, noting that many of the enforcement problems are beyond the Fed's reach.
The Fed and other banking regulators, such as the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency, enforce rules through their normal supervisory contact with banks.
But for the new Fed rules to succeed, effective enforcement of them will have to come from the states, and they've been widely varying in their ability and desire to do it regarding mortgage lending.
"I think we really need to see an increase in the resources that are available in states ... to do proper enforcement," Kroszner said.
The Fed and two other federal regulators late this year began an important pilot project with the Conference of State Bank Supervisors. The Fed, the Treasury's Office of Thrift Supervision and the Federal Trade Commission will examine a sample of mortgage-lending subsidiaries of federally regulated banks and thrifts. State banking supervisors will conduct similar examinations of state-licensed subprime lenders and mortgage brokers.
At federal and state levels, regulators will be gauging underwriting standards and whether senior management is properly managing risks as various state and federal lending laws require. These inspections could result in enforcement actions.
Consumer advocates note that dozens of large non-bank subprime lenders have gone bankrupt since 2006, including the two biggest players, New Century Financial Corp. and Ameriquest. Market forces punished those who weakened subprime lending standards well before regulators responded.
Consumer advocates also complain that the Fed rules may weaken enforcement because they stipulate that, to show injury, a consumer must prove that the alleged improper actions of a lender were part of a "pattern and practice."
"In 1998 the Fed recognized that this pattern-and-practice approach made it hard for individual borrowers to get redress and suggested it wasn't the most effective approach. So we're puzzled by their decision to rely on 'pattern and practice,'" said Evan Fuguet, a policy adviser for the Center for Responsible Lending in Durham, N.C.
The Fed's proposals also are silent about a key player in today's housing meltdown: Wall Street.
The bad actors, principally regulated on the state level, were aided and abetted by big investment banks that snapped up mortgages with little regard to quality or the ability of borrowers to repay. They packaged home loans together into financial instruments such as mortgage-backed securities and collateralized debt obligations that were sold to investors, many of them overseas.
This packaging of home loans is called securitization. It helped many Americans get into their first homes — and then lose them in many cases.
Spottily regulated mortgage brokers and non-bank lenders got a pass from companies that securitized loans and sold them. No one was accountable anywhere along the investment chain, yet everyone profited, for a while.
Legislation passed by the House of Representatives seeks to hold securitization companies such as Morgan Stanley and others liable if they don't do enough due diligence about loan originators.