The final panel of the first public hearing of the Financial Crisis Inquiry Commission brought testimony from the state regulators as to how so many subprime loans were able to be issued given the current regulation, which is important as these issues are part of the motivation for a Consumer Financial Protection Agency. The testimony of Attorney General Lisa Madigan of Illinois and John Suthers of Colorado is useful here.
So what went wrong? The failure appeared to be in two directions. One is that ‘shadow banks’ of subprime lenders started to appear, often as subsidiaries of the largest banks, which offered complicated loan products designed to balloon, weighed down with fees, and with special perverse incentives to originators to jack up the interest rate. The second is ‘pre-emption’, which meant that the federal government was actively working to undermine reform taking place at the state level.
So what was so bad about these loans? The one that jumped out at me most strongly was the issue of “Yield Spread Premiums”: this is a form of broker compensation that has brokers paid more by the lenders for placing borrowers in riskier loans and with riskier features. A broker gets a piece of the interest rate as compensation; if the broker adds a prepayment penalty, often considered to be a trap to keep borrowers in loans that have gone sour, the broker gets more money. This gives him an incentive to find the craziest tricks and traps and get them into loans. The rest of the narrative follows accordingly. Lisa Madigan called for the banning of Yield Spread Premiums and similar forms of broker compensation, and it’s hard to think of a way to defend these things. These compensation schemes make brokers less into honest brokers and more into front line deception agents of lenders.
So why didn’t state regulators step up and fight predatory lending? One issue they had was pre-emption: federal regulators came in and tried to block efforts at the state’s regulating the biggest national banks. I’ve discussed why pre-emption is important for consumer finance here, and it is interesting to hear live testimony about how much of an effort the federal efforts of The Office of the Comptroller of the Currency and the Office of Thrift Supervision put in to derail efforts by states to regulate the largest banks.
And regulating national banks at the state level for consumer finance would have been crucial: National banks funded 21 of the 25 largest subprime issuers doing business in the lead-up to the crisis. If the Obama administration is able to create a Consumer Financial Protection Agency, co-ordinated action on both these efforts, banning the most egregious practices that create the conditions for all the others, and letting state regulators supplement the federal mission, is essential.
Mike Konczal is a Roosevelt fellow and blogs for Rortybomb.