Fed didn’t bark at subprime loan abuses

Fed didn’t bark at subprime loan abuses
Regulator didn’t police lenders’ compliance with laws protecting borrowers

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Sept. 24: Ron Paul, R-Texas, discusses whether it’s time to get rid of the Federal Reserve.

By Binyamin Appelbaum

updated 2 hours, 10 minutes ago

The visits had a ritual quality. Three times a year, a coalition of Chicago community groups met with the Federal Reserve and other banking regulators to warn about the growing prevalence of abusive mortgage lending.

They began to present research in 1999 showing that large banking companies including Wells Fargo and Citigroup had created subprime businesses wholly focused on making loans at high interest rates, largely in the black and Hispanic neighborhoods to the south and west of downtown Chicago.

The groups pleaded for regulators to act.

The evidence eventually led Illinois to file suit against Federal Reserve in July for discrimination and other abuses.

But during the years of the housing boom, the pleas failed to move the Fed, the sole federal regulator with authority over the businesses. Under a policy quietly formalized in 1998, the Fed refused to police lenders' compliance with federal laws protecting borrowers, despite repeated urging by consumer advocates across the country and even by other government agencies.

The hands-off policy, which the Fed reversed earlier this month, created a double standard. Banks and their subprime affiliates made loans under the same laws, but only the banks faced regular federal scrutiny. Under the policy, the Fed did not even investigate consumer complaints against the affiliates.

"In the prime market, where we need supervision less, we have lots of it. In the subprime market, where we badly need supervision, a majority of loans are made with very little supervision," former Fed Governor Edward M. Gramlich, a critic of the hands-off policy, wrote in 2007. "It is like a city with a murder law, but no cops on the beat."

Between 2004 and 2007, bank affiliates made more than 1.1 million subprime loans, around 13 percent of the national total, federal data show. Thousands ended in foreclosure, helping to spark the crisis and leaving borrowers and investors to deal with the consequences.

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The Federal Reserve is best known as an economic shepherd, responsible for adjusting interest rates to keep prices steady and unemployment low. But since its creation, the Fed has held a second job as a banking regulator, one of four federal agencies responsible for keeping banks healthy and protecting their customers. Congress also authorized the Fed to write consumer protection rules enforced by all the agencies.

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During the boom, however, the Fed left those powers largely unused. It imposed few new constraints on mortgage lending and pulled back from enforcing rules that did exist.

The Fed's performance was undercut by several factors, according to documents and more than two dozen interviews with current and former Fed governors and employees, government officials, industry executives and consumer advocates. It was crippled by the doubts of senior officials about the value of regulation, by a tendency to discount anecdotal evidence of problems and by its affinity for the financial industry.

Fed Chairman Ben S. Bernanke testified before Congress this summer that the Fed has protected consumers with renewed vigor in recent years, writing new rules and responding to problems more quickly. The Fed has avoided a public position on the new agency, but Bernanke has testified that Congress instead could choose to strengthen the Fed's responsibilities.

Subprime mortgage lending sneaked up on the Federal Reserve.

Most subprime affiliates began life as independent consumer finance companies, beyond the watch of banking regulators. These firms made loans to people whose credit was not good enough to borrow from banks, generally at high interest rates, often just a few thousand dollars for new furniture or medical bills. But by the 1990s, thanks to big changes in laws, markets and lending technology, the companies increasingly were focused on the much more lucrative business of mortgage lending.

As profits soared, hundreds of banking companies took notice, buying or creating finance businesses for themselves. Consumer advocates demanded that regulators take notice, too.

The advocates amassed evidence of abusive practices by lenders, such as Fleet Finance, an affiliate of a New England bank that eventually paid the state of Georgia $115 million to settle allegations that it charged thousands of lower-income black families usurious interest rates and punitive fees on home-equity loans. The National Community Reinvestment Coalition pressed the Fed to investigate allegations against other affiliates.

On Jan. 12, 1998, the Fed demurred. Acting on a recommendation from four Fed staffers including representatives of the Philadelphia, St. Louis and Kansas City regional reserve banks, the Fed's Board of Governors unanimously decided to formalize a long-standing practice, "to not conduct consumer compliance examinations of, nor to investigate consumer complaints regarding, nonbank subsidiaries of bank holding companies."

The Fed could balk because Congress had allowed the laws governing the financial industry to become outdated.

Little oversight

Banks and the companies that own them, known as holding companies, have long operated under federal oversight. But a growing share of loans were made by companies that competed with banks, such as consumer finance firms. The money they gave to borrowers came from Wall Street rather than depositors. As a result, those firms operated beyond the authority of banking regulators, and Congress did not task anyone else with oversight.

The Fed Board decided that even when a nonbank was purchased by a bank holding company, the Fed still lacked authority to police its operations.

Fed staff recommended that it continue to investigate complaints from Congress, which oversees the central bank's performance as an industry regulator. Everything else was passed to the Federal Trade Commission, which has law-enforcement powers but neither the authority nor the resources to oversee the fast-growing industry.

The Fed's hands-off policy was quickly criticized by other parts of the federal government.

A 1999 report by the General Accounting Office warned that the Fed's decision created "a lack of regulatory oversight," because the Fed alone was in a position to supervise the affiliates.

"If the Fed really wants to take action against predatory lending, here is a clear opportunity," John Taylor, president of the National Community Reinvestment Coalition, told Congress after the report was issued.

A 2000 joint report on predatory lending by the Treasury Department and the Department of Housing and Urban Development made a similar recommendation. The report said the Fed clearly had the authority to investigate evidence of abusive lending practices, and urged a policy of targeted examinations.

Even inside the Fed, there was dissent. Gramlich was starting to express concern about predatory lending in his public speeches. He had voted for the hands-off policy in 1998, but by 2000 concluded that the Fed could demonstrate leadership by subjecting the lending affiliates to examinations. "A good defense against predatory lending, perhaps the best defense society has devised, is a careful compliance examination for banks," Gramlich later told a 2004 meeting of bankers in Chicago.

Alan Greenspan, then chairman of the Fed, recalled that Gramlich broached the subject at a private meeting in 2000. Greenspan said that he disagreed with Gramlich, telling him that such inspections would require a vast effort with no certainty of results, and that the Fed's involvement might give borrowers a false sense of security.

Gramlich did not press the issue. Years later, in 2007, after an account of the meeting appeared in newspapers, he sent Greenspan a note that read in part, "What happened was a small incident, and as I think you know, if I had felt that strongly at the time, I would have made a bigger stink."