Yesterday, The New York Times ran an editorial opposing a new Federal Reserve proposal to eliminate predatory lending penalties. The rule under consideration is the same obscure regulation I blogged about a couple of weeks back, and it’s very encouraging to see major publications paying close attention to the technical workings of regulatory policy. Usually even important rules like this slide right by under the media radar, but this particular rule is a major signal as to how policymakers will deal with the ever-escalating foreclosure fraud problem. Will the Fed and it’s allies stand up for homeowners and the rule of law, even if it means sticking it to the banks? Or will they continue to screw homeowners to preserve capital at too-big-to-fail behemoths?
The Times editorial makes essentially the same argument I did, and it’s totally correct, if I do say so myself. Right now, when a bank is found guilty of illegally withholding information about a mortgage from a borrower, the borrower can “rescind” the loan. They still have to pay off the principal balance, but all profits that the bank would have reaped from the loan—interest, fees, etc.—are nullified, and the bank loses its right to foreclose on the borrower.
This process is called “rescission,” and it reflects a standard feature of contract law that dates back several centuries. If a contract is fraudulent, the minimum proper remedy is to undo the contract. With mortgages, this means the bank gets its money back, but it doesn’t get to keep the profits it would have made from an illegal loan. Restricting borrower access to information is a key tactic in predatory lending, and as The Times notes, rescission is essentially the only federal remedy available to homeowners who have been defrauded.
The Fed is now attempting to eliminate this remedy due to “concern over banks’ compliance costs,” as The Times describes it. This is a rather generous description of the proposal, given the depth and severity of the foreclosure fraud outbreak currently sweeping the country. There are three key places that banks can commit fraud in the mortgage process—when the mortgage is pushed on a borrower, when the mortgage is sold to an investor, and when a bank is collecting payments or foreclosing. Much of the fraudulent activity we see among investors and in the foreclosure process helps cover-up fraud at the original sale of the mortgage to a borrower.
If borrowers cannot obtain relief through rescission, then they have little reason to press claims about fraud in other parts of the mortgage process. This is an enormous gift to the nation’s four largest banks, with major public policy implications that go beyond the very critical problem of rampant, illegal foreclosures. If borrowers don’t press claims about foreclosure fraud, investors will not be able to access key information for filing lawsuits.
The single gravest threat to bank balance sheets (and bonuses) is a slew of lawsuits from mortgage bond investors. Banks packaged lousy mortgages into bonds and sold them off to investors, often without making proper disclosures to the investors, who subsequently lost a ton of money. Investors are currently organizing to take action against the banks, and in many cases have obvious, open-and-shut fraud claims against Wall Street titans if their cases come to court. But the key is actually getting their case before a judge. To do that, 25 percent of the investors in any bond have to file a lawsuit together. For multi-billion-dollar bond issues, that requires coordination among dozens of different institutions, often from different countries. That’s a difficult technical feat, but investors will be much more likely to participate if they have lots of evidence of fraud before them. That evidence is produced by homeowners pressing their own individual cases. If homeowners don’t go to court because they can’t get anything out of it, the investors will have a harder time organizing.
So the Fed isn’t really concerned about “compliance costs.” This is, in fact, a rather absurd notion. Predatory lending is a form of theft. Imagine if the shoe were on the other foot, and the bank was being robbed. Can you imagine bank robbers complaining about the “compliance costs” of having to give back stolen cash? They would be laughed out of any courtroom. But the Fed is not only seriously considering such an argument from bankers, it is actively promoting it as official public policy.
The Fed’s proposal is itself illegal. Regulators like the Fed have the right to make rules that enforce laws passed by Congress. When Congress passed the Truth in Lending Act in 1968, it explicitly granted borrowers the right of rescission as a remedy for predatory lending. The Fed is now attempting to interpret that statute to mean that, actually, borrowers have no such right. If the Fed’s proposal is enacted, it will be a 180-degree reversal of the law on the books.
It’s hard to imagine a way for the Fed to disgrace itself any further than it did by failing to rein in the mortgage mess over the past decade. But if it proceeds with this effort to protect banks that engaged in predatory lending, it will not only be guilty of falling down on the job and looking the other way, but of actively encouraging illegal mortgage lending.
Whether the Fed withdraws its proposal or not, this is not what bank regulators are supposed to do, especially in the middle of a foreclosure fraud crisis. Elizabeth Warren and the Consumer Financial Protection Bureau will get formal jurisdiction over these issues in July 2011, and it won’t come a moment too soon. The Fed is proving, once again, that it cannot be trusted to protect the middle class from illegal abuses. Or even simply follow the law itself.