By Lon S. Cohen
After the disaster comes the relief team. But those who would stop the bleeding of the battered mortgage industry haven’t yet agreed on where to put the tourniquet. For months, federal and state lawmakers have been busy taking sides – often against each other.
New York State is in the forefront of finance reform. New York Attorney General Andrew Cuomo’s sweeping investigation of the state’s mortgage and ratings industries have resulted in reform proposals the scope of which we haven’t seen since the 1930s, which could become national models. That’s what some state and federal financial leaders don’t want to see. The fight for standards versus structure has been joined at the federal level by the Comptroller of the Currency, John Dugan, who calls Cuomo’s proposed reform “draconian” and unenforceable.
New York Attorney General
What They Should Have Done All Along
In a yearlong and ongoing investigation, Cuomo has issued subpoenas to Government Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac, the country’s two largest mortgage lenders, last November, and its three largest ratings agencies – Fitch, Moody’s, and Standard & Poor’s. The agreements struck with these parties are as controversial as they are unprecedented.
The pact with Fannie, Freddie and the Office of Federal Housing Enterprise Oversight, announced in March, calls for new standards for independent property appraisals. The subpoenas, issued under the state’s Martin Act which gives the AG’s Office the authority to review practices the Office deems fraudulent in regard to investments made in the state. The Office sought information on loans Fannie and Freddie purchased from banks, as well as information on Fannie and Freddie’s due diligence practices – and their valuations of appraisals.
In March, Cuomo announced a deal with Fannie, Freddie, and OFHEO to forbid mortgage lenders from submitting loans backed by in-house appraisers or an appraisal company that they control or own. His proposal also prohibits brokers from choosing appraisers and calls for the creation of a clearinghouse for appraisals, essentially forcing every Fannie- and Freddie- backed mortgage to have the attached appraisal vetted, regardless of where it was originated. All this was outlined in a “Home Valuation Code of Conduct,” then approved by the Office of Federal Housing Enterprise Oversight, which applies to every mortgage originator. A period of public comment that ended in April brought forth a slew of viewpoints both for and against the code. If everything goes as Cuomo plans, the whole thing would be put in effect on Jan. 1, 2009.
The agreement with the ratings agencies, announced in June, changes their form of compensation to make them more independent from the investment banks they serve. Recently, the SEC has proposed a similar reform package. Cuomo is not through with the federal lenders or the ratings agencies yet, though. They have also agreed to cooperate in the AG’s ongoing investigation.
Cuomo’s agreements with Moody’s Investors Service Inc., Fitch Inc., and Standard & Poor’s, changes their compensation to fee for service from contingency. Under the old system, they didn’t get paid unless the investment bank seeking the securities rating accepted that rating. It also requires that they post their rating standards on their web sites. And it requires more information to be supplied to prospective investors, including whether an offering has been “rate-shopped” to seek a better rating.
Astoundingly, the agreement calls for something one would guess should have been the rule all along: Ratings agencies would have to receive information on the loans underlying securities and to conduct loan-level due diligence. Formerly, “exceptions” were made on the mortgages backing the securities, meaning that the loans were granted exception status to regular underwriting guidelines layering risk upon risk, and became significantly more susceptible to default.
As Cuomo described it in a June 5 press conference, these were products that had never been securitized before. The capital they generated stimulated the primary side of the market – mortgage brokers and mortgage banks – which got creative and aggressive in finding new mortgage products.
“In the marketplace, if you’re willing to buy, someone will sell. And we had the big ‘buy’ sign up by the secondary market, and the primary side got over aggressive in my opinion,” he said. “So I believe people received mortgages that shouldn’t have.”
U.S. Comptroller of the Currency
But John Dugan, U.S. Comptroller of the Currency, calls Cuomo’s Home Valuation Code of Conduct “de facto rulemaking.” On May 27, he wrote to OFHEO’s director John Lockhart stating his belief that the Code is in conflict with federal law and should be withdrawn. He warned that the Code would force most banks and brokers to adopt Fannie’s and Freddie’s clearinghouse for every mortgage originated. But accountability for work, a comparison process and quality controls, all have to be worked out before this clearinghouse becomes effective.
Dugan described the agreement as “draconian,” saying states lack “the power to require national banks to choose between their right to operate under federal law and their ability to sell loans to GSEs.” He stated that the Code would supersede with already established rules set down by Congress and impose a “dramatically different new set of operational standards for appraisal practices” that conflict with that national scheme. At the time this article was written, the office of the New York State Attorney General had yet to react to the letter.
On the heels of Dugan’s letter, Office of Thrift Supervision (OTS) Director John Reich, issued his own statement that the OTS should get the job of regulating the nation’s mortgage industry. No matter which agency prevails, this power struggle is sure to mean major changes.
One local law expert observes, “The default rule is that the states retain their traditional regulatory ‘police powers’ per the 10th amendment, unless there is some compelling federal interest that displaces it,” said Associate Professor of Law Robert Hockett of Cornell Law Schoool. According to him, Dugan is arguing as though he were a New York state lawmaker disagreeing with Cuomo about what kind of regulation is best in New York.
On the other hand, James Calimopulos drills down to the effects on appraisers. He’s director of N.Y. Lending Operations at Fort Funding, and a former manager in the mortgage sales department at a regional New York bank. “I don’t agree with a central clearinghouse for appraisals,” he said. “What a clearinghouse will do is make a few companies hold a monopoly on valuation and shut down every mom and pop appraisal company. Even if the appraisal companies do decide to become members [of the clearinghouse], their fees are drastically reduced, to where they would have a tough time surviving.”
President & CEO,
New York Bankers Association
More Than They
Meanwhile, the New York Bankers Association is battling against proposed bills calling for a moratorium on foreclosures and designating certain mortgage loans as “non-conventional.” The latter measure would require banks to add to their risk-based capital funds.
NYBA President Michael Smith warns that the moratorium may cause some serious financial and regulatory concerns for banks. “Under risk-based capital rules, loans that are 90 days or more past due are subject to a 100 percent risk weighting,” he said. “Application of a work-out period such as the one set forth in the foreclosure moratorium bill will certainly affect a financial institution’s capital requirements and rankings.”
Even more important to the way we do business is the parts of another proposed legislation, “New York State Responsible Lending Act of 2008,” that establish a “non-conventional loan” category.
The new “threshold” is for loans with an annual percentage rate of 3 percent higher than the treasury securities with a comparable maturity period on first mortgages and 5 percent for second lien loans. The bill would impose new restrictions that expand New York State’s Anti-Predatory Lending Law provisions to include loans up to $750,000 as well as the “non-conventional loans.”
“We are hearing from many bankers that, if the bill becomes law, then about 30 percent of prime loans would become ‘unconventional’ loans given current rate conditions.” Smith said – and if the threshold became law, new mortgage activity would be restricted, because lenders whose loans fall into the new category may face greater financial costs and legal risk than they bargained for.
Superintendent, New York State Banking Department
Advocating for a
While U.S. Congressman Barney Frank is advocating for a loan workout structure that repays Uncle Sam for taking on extra risk to rescue homeowners, New York Superintendent of Banks Richard Neiman calls for a middle ground – keeping the market innovations of recent years, while instituting adult supervision of those evaluating a borrower’s ability to repay.
In his March 2008 address to the New York Bankers Association (NYBA) while he concurred with the notion that “the securitization process helped to create a culture of reduced accountability,” he cautioned that the process was still “an innovation worth preserving,” yet with a more “disciplined approach to risk assessment.” He observed that assessing the ability of a borrower to repay was a huge failure on the part of lenders, and that setting a new standard requiring ability to pay would be critical in preventing a repeat of the present market failure.
On the mortgage reform front, the nation is not keeping up with New York State, a situation of which Superintendent Neiman is well aware. “We are not looking to put New York industry or the state charter at a disadvantage,” he told NYBA. “That’s also why we are advocating for a national standard,” Neiman said. “To function as a floor and further level the playing field.”
The future of loose guidelines and layering of exceptions on loans — even the less risky than true subprime but still non-conventional Alt-A loans — seems doomed to extinction. But will lenders turn back the clock, to the days before the exotic loans came in fashion—when banks had fewer options of where to sell off loans, a time when GSE’s and FHA were barely supplemented by a few niche portfolio lenders?
“There are those who believe that homeownership should fall back to prior levels,” said NYBA’s Smith. “But the banking industry does not agree and would like to keep making good loans to well-informed and able borrowers.” Smith says that in the new era of larger GSE and FHA influence and declining options in alternative markets “it is possible that lenders would choose to make fewer loans and under the extremely low thresholds.”
But with the expanded role of both Fannie and Freddie in the mortgage market, and the federal government using the FHA to help ease the crisis, these tried and true agencies may be the last ones standing when rules are finalized.
So when the debate is all finished and we have a clearer idea of the changes that have been made, can we look on the bright side?
“If there is a silver lining to this situation for banks, it will be the movement toward a national, uniform standard of regulation for all players in the mortgage market,” said Michael Smith. “Currently, there are many other types of lending firms out there who are not subject to nearly the level of regulation and scrutiny as are banks and thrifts.”
Hopefully borrowers will recognize the need to educate themselves on the products and the lender before committing to a mortgage that they might regret later. “They should be vigilant and knowledgeable when they are shopping for a mortgage or financial product of any kind,” added Smith.
The Bomb in the Basement
This brings us to the concept of structure versus standard. “If you let an industry run wild without any individual supervision or ramification for one’s action, this is the end result,” said Calimopulos. “Why is it that something has to go drastically wrong before anyone takes action?
“Structure is good,” he concluded. “But it has to be developed… by the men and women that work on the front lines of the industry themselves… the actual people that go into making a mortgage loan.”
Cornell’s Hockett said it’s no mystery why structural impositions are the most often used in financial markets. The least strict measures “are almost completely futile,” while the second sort only apply to problems after the fact.
He said the least strict regulation would be enunciated “good practice” standards meant to influence behavior, but which are not enforced. The second step would be enforcement of standards with fines and penalties for those who disregard them. The third are structural impositions such as firewall arrangements, portfolio-shaping rules such as lending limits, capital regulation, and so on.
Because financial markets are systematically linked to one another – as has been rediscovered – “the counterparties to the transactions are very often far from the only victims,” he says. “You build a plutonium bomb in your basement, and no one is going to wait till you set it off before they arrest you.” The consequences of financial crime “are widely appreciated to be such as to warrant careful prevention, not simply punitive after-the-fact cure.”
Editor’s Note: At press time, the Federal Reserve Board, the OCC, the OTS and the National Credit Union Administration sent a jointly-signed letter to OFHEO urging that the Home Valuation Code of Conduct be withdrawn or modified to exempt federally regulated lenders.
Lon S. Cohen is a freelance writer based in New York. He has over seven years’ experience working in and writing about the banking industry. You can reach him at firstname.lastname@example.org