Fifteen years ago, in mid-September, Lehman Brothers collapsed and the financial system crashed. Troubles in the U.S. mortgage market infected the entire globe, and American families and businesses lost trillions of dollars and experienced an incalculable level of pain. The subprime mortgage crisis represents one of the worst failures of regulators in modern history.
I want to first touch on a defunct mortgage giant that is well-known to you, but less known to the public: IndyMac. I then want to share a bit more details on the post-crisis reforms, including the establishment of the Consumer Financial Protection Bureau and the mortgage rules required by Congress. I’ll close by addressing some of the mortgage industry’s concerns about the legal validity of those rules.
Lessons from IndyMac
While there were other subprime mortgage giants that melted down, it’s easy to draw a lot of lessons from the one with a confusing name: IndyMac. Unlike Freddie Mac and Farmer Mac and the like, IndyMac wasn’t a government-sponsored entity.
IndyMac was like other banks. It took deposits and made loans. But unlike other lenders, it didn’t really engage in real underwriting. IndyMac’s mortgage business relied on Alt-A loans. These mortgages relied on risky features, such as stated or no income verification, interest-only or negative amortization, and no down payment requirement. While the borrowers might have had decent credit scores, common-sense underwriting was not part of the equation. Like others, IndyMac was able to jump on the securitization bandwagon and provide raw materials for mortgage-backed securities that were in high demand.
IndyMac also had another strategic advantage: a regulator that was completely in its pocket. Leadership of the Office of Thrift Supervision twisted itself into a pretzel to let IndyMac sidestep its obligations, including by backdating key financials.
In July 2008, IndyMac failed. At $32 billion, it was one of the largest ever bank failures managed by the FDIC. Because IndyMac relied on a lot of “uninsured” deposits, those depositors were not made whole.
There’s lots of lessons here, but three in particular are relevant today.
First, market forces can fail to provide a check on complex financial products and that’s why you need some basic rules. Homeowners naturally thought that if a lender was willing to offer the mortgage, that meant the lender thought they could pay it back. That was wrong. Investors in the mortgage-backed securities thought those Alt-A loans were safe. That was wrong.
Second, a handful of large players can lead to a market-wide race to the bottom as others seek to stay competitive. We are fortunate in the U.S. to have a competitive mortgage industry, particularly because we have so many independent players. But that can sometimes work against consumers, especially when there’s no consistent enforcement of rules.
Lastly, the regulator needs to be a watchdog, not a lapdog. The Office of Thrift Supervision relied on fees paid by its biggest institutions. Its leadership essentially marketed its charter to prospective institutions as a weak regulator. Protecting the public, especially consumers, was just not on their agenda.
Reforming the Mortgage Market and the Creation of the Consumer Financial Protection Bureau
So, let’s turn to what Congress did in response to the crisis. Here are some of the highlights.
Congress addressed a core market failure by essentially banning mortgages where the lender didn’t assess ability to repay. It also allowed for future rules that created a new category of loans that would be presumed to comply with their standard. It also tasked regulators with cleaning up the mortgage disclosures under the Truth in Lending Act and the Real Estate Settlement Procedures Act.
Congress also wanted to make sure lenders had more skin in the game by requiring them to hold on to some credit risk on loans they securitized, except for ones that met high standards. There were other requirements too, on mortgage data, mortgage servicing, and mortgage lender compensation.
Perhaps most importantly, Congress shook up the federal financial regulators. It shut down the Office of Thrift Supervision. It banned the Office of the Comptroller of the Currency from engaging in abusive preemption that halted commonsense state-level consumer protections. It stripped authorities from the Federal Reserve Board of Governors, the Office of the Comptroller of the Currency, and other regulators that also failed in the lead-up to the crisis. It transferred these authorities to a new agency within the Federal Reserve System, the Consumer Financial Protection Bureau.
Rather than allowing regulators to pass the buck or point fingers at one another, the CFPB would now be on the hook for examining banks and nonbanks across the mortgage industry and implementing and enforcing rules. And rather than being funded by fees from its regulated entities, the CFPB would be funded by the Federal Reserve Banks, just like the Federal Reserve Board of Governors is.
The CFPB and the Mortgage Market
After the law passed, the Secretary of the Treasury set up a team to open the agency, and in July 2011, the CFPB joined the Federal Reserve System, and opened its doors.
Much of the mortgage industry was eager for us to get going. While Congress set the broad outlines for new protections and standards, the details would be implemented through the CFPB’s rulemaking. Without rules, many of the thorny issues written in the statute would need to get litigated in court. Responsible players in the mortgage industry were eager to turn the page on the past.
The CFPB got it done. It implemented the new standards for ensuring borrowers have the ability to repay through the qualified mortgage rule. If lenders meet certain conditions, they can even get legal immunity. Other regulators responsible for the skin-in-the-game standards for mortgage securitization largely duplicated the standards in the CFPB’s rule.
The CFPB also implemented other mortgage rules mandated by Congress. And whether you agree with the details or not, the details of those rules are now built into the entire fabric of our country’s mortgage system, including marketing, origination, securitization, and servicing.
The rules haven’t just provided clarity – they’ve also helped to restore trust in the mortgage system. Products with non-traditional features, like ones with adjustable rates, are much safer than their pre-crisis predecessors. When bad actors are emerging, the CFPB is taking action to stop systemic abuse from spreading. Mortgage servicers can’t send borrowers on a wild goose chase when they ask for help.
There’s lots of data that show these results. According to CFPB research, in the first three years the rules were in effect, they saved at least 26,000 families from foreclosure and allowed at least 127,000 more borrowers to recover from delinquency and resume payments. If these rules had been in place during the 2008 crisis, I believe families would have been able to stay in their homes and that what became the Great Recession would have had a different outcome.
Challenges to the Stability of the Mortgage Regulatory Framework
Mortgage lenders across the country are dealing with new challenges, especially the interest rate environment, housing supply shortages, and the restart of student loan payments. This is requiring many independent mortgage lenders to make shifts so that they can continue to help homeowners.
As many of you are aware, CFPB rules are facing a number of court challenges contesting their validity. The payday loan lobby has argued that the CFPB’s funding through the Federal Reserve System is unconstitutional because Congress provided the CFPB its funding through a law other than annual appropriations bills. We and the Solicitor General of the United States disagree, and the Supreme Court is scheduled to review this issue in the coming weeks.
As a new agency, the CFPB is no stranger to these challenges and has continued its important work through them. Nonetheless, the case involving the CFPB has significant implications for the entire housing finance and financial regulatory system. The CFPB is just one part of that structure, and we are not the only agency funded this way. Any doubt about the legitimacy of the CFPB could be destabilizing.
The Mortgage Bankers Association recently filed a brief with the Supreme Court warning that calling into question CFPB rules could have “potentially catastrophic consequences on the mortgage and real-estate markets.” Their brief also notes that “virtually all financial transactions for residential real estate in the United States depend upon compliance with the CFPB’s rules, and consumers rely on the rights and protections provided by those rules.” And that “lenders, servicers, and consumers have operated by the CFPB’s guideposts for more than ten years, and without those rules substantial uncertainty would arise as to how to undertake mortgage transactions in accordance with federal law.”
Similarly, the Solicitor General of the United States noted in her brief that the CFPB “has issued more than 200 final rules [that] govern important aspects of countless transactions involving both regulated entities and individual consumers every day, affecting the way homes are mortgaged, cars are purchased, credit cards are administered, loans are made, debts are collected, and banks are run.”
Reverting to a system without these regulations would create uncertainty for the mortgage industry and the economy. And even putting aside the questions about existing rules, moving to a world where the future of housing finance oversight is uncertain and unknown, including the number of years we would be living under such mystery, should raise serious shared trepidations among market participants, financial markets, and consumers alike.
Questions about those rules and the ability of the system to adapt to immediate and future challenges would raise significant concerns for the stability of the housing market and the financial system more broadly.
Rohit Chopra is the director of the Consumer Financial Protection Bureau. This article is adapted from a speech he delivered before the Mortgage Collaborative National Conference on Sept. 11.