The mortgage crisis points to the need for leveling the playing field between banks and nonbank providers for consumer lending. The lack of sensible, consistent mortgage lending standards and consumer protections in the run-up to the crisis ended up destabilizing housing markets and the entire financial system. This "race to the bottom" mentality imposed large losses on banks and nonbanks alike, and imposed long-term damage on household balance sheets and consumer confidence.
The CFPB provides a real opportunity to simplify consumer rules and make them work in the interest of consumers. It subjects nonbank financial providers to more rigorous rules and examinations while enhancing the competitive position of responsible lenders, including many community banks, who are trying to do the right thing by their customers.
The financial crisis also has exposed other critical flaws in how our financial system operated and was regulated. The reforms authorized under the Dodd-Frank Act include far-reaching changes to restore market discipline, internalize the costs of risk-taking, and make our regulatory process more attuned to systemic risks.
A key reform is the new resolution authority for large bank-holding companies and systemically important nonbank financial companies. This new authority directly addresses the dilemma we faced in the fall of 2008, when a number of these companies ran into serious trouble.
We all saw the result of the Lehman bankruptcy, which threw global financial markets into chaos. In contrast, the FDIC regularly carries out a prompt and orderly resolution process using its receivership authority for insured banks and thrifts. The Dodd-Frank Act for the first time gives the FDIC a similar set of receivership powers to close and liquidate systemically important financial firms that are failing.
Let me briefly describe to you the practical significance of this new resolution authority. In the old world of “too big to fail,” risk taking was subsidized. Systemically important companies took on too much risk because the gains were private while the losses are absorbed by the government.
Market discipline failed to rein in the excesses at these institutions because equity and debt holders—who should rightly be at risk if things go wrong—enjoy an implicit government backstop. This skewing of financial incentives inevitably leads to a misallocation of capital and credit flows.
During the boom, too much credit was directed to single-family housing, when it might have been put to better use in other sectors. And much of that credit was structured in ways that did not meet the long-term needs of household borrowers.
But implementing the new resolution authority and ending “too big to fail” is a game changer in terms of economic incentives. It is the key to restoring market discipline on the nation's largest financial institutions and better aligning their financial incentives to control risks. Capital and credit will be allocated more efficiently. And taxpayers will no longer be on the hook when these companies get it wrong.
Consumer protection does not take a back seat at the FDIC. While the FDIC does not have rulemaking authority for unfair or deceptive acts or practices and other consumer laws, we do have examination and enforcement authority which we aggressively pursue on a case-by-case basis.
For instance, since 2008, our enforcement actions involving UDAP violations resulted in more than $180 million in penalties and restitution. Over the past 10 years, we have taken over 1,500 formal and informal enforcement actions and have required more than 900 institutions to make restitution to consumers.
In addition, the FDIC uses public advocacy and the rulemaking comment process to raise alarms about consumer protection problems that affect both consumers and the economy as a whole.
We were early advocates for stronger underwriting standards for nontraditional and subprime mortgage products. We argued vigorously for banning yield-spread premiums, cracking down on prepayment penalties, and requiring full income documentation and underwriting based on the fully indexed rate.
One of the most urgent consumer protection issues that we see now involves serious weaknesses in mortgage servicing and foreclosure practices that have come to be associated with the practice of "robo-signing."
Some mortgage servicers have failed to properly assemble the paperwork needed to establish ownership of mortgages and the right to foreclose on delinquent loans. And some have pursued foreclosure and loan modification in an uncoordinated dual-track process. This has often led to needless confusion for borrowers, and can result in costly and unnecessary foreclosures.
These mortgage servicing weaknesses are a byproduct of both rapid growth in the number of problem loans and a compensation structure for servicers that is not well designed to support loss-mitigation measures.
In recent testimony before the Senate Banking Committee, I outlined what I see as steps that mortgage servicers can and should institute now as they seek agreements with major stakeholders that can help resolve servicing defects.
One such step is to establish a single point of contact for struggling homeowners. This will go a long way towards eliminating the conflicts and miscommunications between loan modifications and foreclosures, and will provide borrowers assurance that their application for modification is being considered in good faith.
Another is to dramatically simplify the private loan modification process, which remains far too complicated. Modifications need to be put in place at an early stage of delinquency, and should provide for a significant reduction in the borrower's monthly payment—practices that have been shown to raise the odds that the modification will succeed.
In exchange, mortgage servicers should have a "safe harbor" that would assure them that their claims will be recognized if foreclosure becomes unavoidable. Servicers also need to make certain that their staffing resources and quality control processes are appropriate to the scale and complexity of their business. And second-lien holders should be required to take a meaningful writedown if the first mortgage loan is modified or approved for a short sale.
All stakeholders must be willing to come to the table and compromise if we are to find solutions to the foreclosure problem and set the stage for recovery in our housing markets.
The FDIC has been working on a number of fronts, in concert with other regulatory agencies, to institute reforms in loan securitization that can get this market moving again by better aligning the financial incentives of issuers and servicers with those of investors and borrowers.
First, we have updated our rules for safe harbor protection with regard to the sale treatment of securitized assets in failed bank receiverships. Our final rule, approved in September, establishes standards for disclosure, loan quality, loan documentation, and the oversight of servicers.
Importantly, the new rule requires that the issue of servicer incentives be addressed in order to obtain safe-harbor status. Servicing agreements must provide servicers with the authority to act to mitigate losses in a timely manner and modify loans in order to address reasonably foreseeable defaults to avoid the perverse incentives created when loans must be delinquent before they can be restructured. The agreements must require the servicer to act for the benefit of all investors, not for any particular class of investors.
The rule also addresses a recurring problem in servicing: the obligation for servicers to continue funding payments missed by borrowers. Under most current servicing agreements, this obligation has the effect of accelerating foreclosures as servicers seek to recover these payments by selling the home. Our new rule strictly limits advances to just three payments unless there is a way to repay the servicer that does not rely on foreclosure.
While the FDIC's new rule will help create positive incentives for servicing, it is, by the nature of our authority, limited to banks. The Dodd-Frank financial reform law now provides a chance to improve incentives across the market, whether the securitization is issued by a bank or not. Dodd-Frank requires regulations governing the risk retained by any issuer of asset-backed securities. Those regulations may reduce the standard 5% risk-retention for qualifying residential mortgages that pose a reduced risk of default.
Given the important role that quality servicing plays in mitigating the incidence of default, I believe that the new regulations—like our safe harbor—should address the need for reform of the servicing process.
Shelia Bair is the chairman of the Federal Deposit Insurance Corp.
