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The Current Crisis in Subprime Lending

By Charlotte M. Bahin

Is a Regulation on Unfair and Deceptive Acts or Practices the Answer?


There has been much discussion on what could have been done or whether additional regulation of banks could have prevented the current subprime lending meltdown. There are suggestions that the federal banking regulators could have taken actions that would have mitigated, if not prevented, the problems. Some members of Congress and community groups believe that if the federal banking regulators had a regulation prohibiting unfair and deceptive acts or practices, that many adjustable-rate mortgage borrowers would not be facing interest rate resets they cannot afford and possible foreclosure.
Would such a regulation have addressed the cause of what has emerged as a significant problem in the mortgage market today? Such a regulation would have had some effect; however, it could not have prevented all of the problems. Many of the loans now facing foreclosure were made to consumers who might have benefited from additional, different disclosures. It is unclear whether the terms of the loans were accurately explained. This is because many of the loans were made by third-party brokers, not by community banks that take the time to work with customers.
Unfortunately, there is not one simple answer. The rise in interest rates has caused the majority of adjustable rate mortgages to reset to a significantly higher rate, sometimes to levels unaffordable to the homeowner. Rapid house price appreciation in many areas of the country resulted in potential homeowners taking out mortgages they could not afford after the initial low interest-rate period ended. In most of those areas, housing values are declining, so that homeowners who need to refinance to better meet their needs are not able to do so. Another significant factor was the influence of the secondary market in the origination of loans to be packaged into mortgage-backed securities.
As a result, an additional regulation that prohibits unfair and deceptive acts or practices would have helped some borrowers, but not all. The principal reason is that the regulation would not have reached the lenders that made many of the defaulting loans. The increase in the use of third-party brokers by many insured depository institutions and mortgage companies has resulted in a lack of contact by many consumers with traditional banks. House Financial Services Chairman Barney Frank and the federal banking agencies acknowledge that many of the problems with the subprime loans now surfacing do not involve insured depositories, but are still calling for additional regulation and supervision of banks.
While banks are supervised and their practices are reviewed for compliance with safety, soundness and consumer protection requirements, mortgage brokers are supervised by state regulators who do not have the resources to monitor the practices of all brokers.
In response to the calls from Congress and others, the Office of Thrift Supervision (OTS) has issued an advance notice of rulemaking as part of a review of the agency’s current rules issued to implement its authority under the Federal Trade Act (FTA) in the area of unfair or deceptive acts or practices. While any rule issued would apply to savings associations and possibly their affiliates, but not to banks, the issues raised in the advanced notice are instructive and provide a useful guide to some of the factors that need to be addressed.

A Number of Questions
The OTS has authority under Section 5 of the FTA to issue regulations for savings associations implementing the requirement that unfair and deceptive acts or practices be prevented. The Federal Reserve and the National Credit Union Administration have similar authority for their constituencies. The OTS issued a regulation in the mid-1980s that addressed credit practices in the consumer lending area. These regulations, however, have not been updated and do not address mortgage lending. Over the past five years, the FDIC, the Office of the Comptroller of the Currency (OCC) and the Federal Reserve each issued guidance specifically incorporating the Section 5 prohibitions.
The advance notice poses a number of questions about the possible approaches the agency may take, including developing a rule that follows the Federal Trade Commission model. The OTS would adopt guidance that provides that acts and practices are unfair when they cause, or are likely to cause, substantial injury to consumers; consumers cannot reasonably avoid the injury; and the injury is not outweighed by countervailing benefits. An act or practice is deceptive when it involves a representation, omission, or other practice that misleads or is likely to mislead the consumer; and the consumer reasonably interprets under the circumstances.
The agency also solicits input on whether existing guidance should be converted into rules or whether a principles-based approach should be used. The agencies, including the OTS, have issued guidance on a number of consumer protection topics, including nontraditional mortgage products, overdraft protection products and gift card programs. The OTS also suggests it may look to other agencies for examples of how to develop a model. The advance notice refers to the guidelines for residential mortgage lending practices adopted by the OCC, which mention specific lending practices the agency finds predatory or abusive.
The advance notice also provides an example of state law models that have been developed using a more targeted approach, which would list acts or practices regarding specific products. For example, in the area of credit cards, residential lending, deposit accounts and gift cards, unfair or deceptive practices would be prohibited.
Other agencies may follow the lead of the OTS or decide to engage in joint rulemaking. In any case, this is not the last heard from any of the federal banking agencies, Congress or the states. Community banks will have to be able to respond to any number of legal, regulatory and legislative developments in the area. 

Charlotte M. Bahin is a partner in the corporate department and financial services group of the law firm of Locke Lord Bissell & Liddell LLP (

Posted on Thursday, November 01, 2007 (Archive on Wednesday, January 30, 2008)
Posted by Scott  Contributed by Scott


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