Special Advisor to the Secretary of the Treasury for the
Consumer Financial Protection Bureau
American Banker’s Regulatory Symposium
September 20, 2011
Thank you to the American Banker and National Mortgage News for inviting me here to speak today. I looked over the list of attendees, and I have to say it is a real privilege to engage with a group that is so relevant to our work at the Consumer Financial Protection Bureau.
It’s also an honor to be the warm-up act for Congressman Frank. I have heard Congressman Frank speak on many occasions, and given the breadth of his knowledge, the magnitude of his impact, and the sharpness of his wit, I can assure you that I am relieved to be speaking before him, and not after. He’s a tough act to follow.
We are here today to discuss the Dodd-Frank Act and its implications for consumers, businesses, and the economy. From my, admittedly biased, perspective, the consumer bureau is one of the Dodd-Frank Act’s most significant reforms.
The Bureau is a great fit for me because I’ve seen firsthand the important role of consumer protection in financial services. I grew up in consumer finance. And like most of the people that I know in the business, or indeed in any business, I believe in markets where the prices are clear, and where ethical business people can compete fairly to get ahead.
I know that I am not unique. I know that there are literally millions of financial services professionals who view doing right by their customers as very much a core part of their business.
I’m a real believer in the power of free markets. But free markets need rules. If those rules aren’t sensible or if they go unenforced, then markets don’t work well.
Free markets also need oversight. Government oversight, though, should hold itself to a high standard. Regulators ought to be able to answer the question: How do our actions improve the functioning of the market?
And that, of course, presumes a notion of what a properly functioning market looks like. Let me suggest an answer. In a well-functioning market, you should find at least three things.
Number one: Transparency. Both parties should know what they’re getting.
Number two: Aligned incentives. In consumer credit, people should get paid to take good risks, not to take bad ones.
Number three: Fair competition. The rules should be consistently applied and enforced for everyone. Cheaters should not prosper.
Transparency. Aligned incentives. Fair competition.
Today, I’d like to spend time relating each of these three basic principles to the breakdowns in the mortgage market before the crisis. Through that lens, it’s clear that the mortgage market was quite profoundly broken.
Let’s start with transparency.
The foundation of an efficient market is the notion that the buyer and the seller each understand the terms of a deal, so that they can engage in deals that each party thinks is in his or her own self-interest. But in the years leading up to the financial crisis, that foundation collapsed.
During the housing bubble, the fastest-growing product lines in mortgages were also some of the most complicated. Hybrid and payment-option adjustable-rate mortgages and interest-only loans are arcane by their nature. To properly calculate the costs and risks of any of these exotic products, borrowers needed to understand the dynamics of rate spreads and rate caps, predict future interest-rate movements, and then factor in the effect of any teaser rates and prepayment penalties. I know plenty of bond traders who have difficulty making those kinds of predictions; imagine what it’s like for ordinary borrowers. Topping it off, there weren’t clear disclosures of these risks or the potential costs that borrowers might face.
So it’s not surprising that borrowers often found it impossible to compare one loan to another. And it’s not surprising that borrowers often walked away from the closing table without an accurate understanding of their mortgage. For example, data from the Survey of Consumer Finances – the government’s best source for household finance data – indicates that 35 percent of adjustable-rate mortgage borrowers said they did not know the maximum amount their interest rate could change in an adjustment period. And 41 percent of these borrowers did not know their own lifetime interest cap.
Now, no one denies that borrowers have to be responsible for their financial decisions. In fact, that is a bedrock premise of the Bureau’s approach to markets. But when risks and costs are obscured, it becomes very difficult for borrowers to make responsible decisions. And just layering on page after page of additional disclosures doesn’t necessarily make the choices any more clear.
The Bureau is actively working to address the transparency problem at a critical step in the mortgage process – at the time of application. We’re taking the required mortgage disclosure forms and streamlining them into a single form. And to mirror the same transparency we encourage in the market, we launched an initiative called Know Before You Owe.
Through Know Before You Owe, we have elicited public feedback on the prototype forms on our website, ConsumerFinance.gov. By making our process transparent and considering comments from a wide range of sources, we believe the final product will be more useful to consumers, and simultaneously reduce costs for lenders.
But we’re not kidding ourselves. Disclosure alone doesn’t solve every problem. The alignment, or misalignment, of incentives also has a significant impact on what consumers and firms do, and what market outcomes result.
It’s useful to step back a bit. In most lending markets, a lender traditionally has an incentive to care about a borrower’s ability to repay. That should seem obvious. If I lend you money, I will be more than a little curious about whether you have the means to pay me back.
But when you look closely at the mortgage market prior to the crisis, you see that almost everyone involved – mortgage brokers, lenders, appraisers, investment bankers, even rating agencies – earned rewards that were front-loaded and insufficiently connected to the performance of the loans over time. Indeed, in mortgages, unlike, say, in credit cards, it was even possible for a loan originator to sell all of the credit risk in a loan.
You could sell everything. Residual credit risk? Sold. Rate risk? Sold. Servicing rights? Sold. All of it could be sold for cash, and all of it sold before anyone could know how the loan would actually perform over time. As a result, originators lost much of their incentive to ensure that credit risks were being mitigated. If loans went bad; it was often, quite literally, somebody else’s problem.
It’s no wonder, then, that originators embraced more risk. From 1990 to 2005, subprime loans, as reported by Inside Mortgage Finance, rose from 8 percent to roughly 23 percent of total mortgage production. Alt-A loans, which include for example reduced-documentation mortgages to prime borrowers, added another 15 percent in 2006. Together, in 2006, subprime and Alt-A loans totaled roughly $1 trillion in originations, or nearly 40 percent of the origination market.
So originators embraced more risks and those risks have turned out badly. And we shouldn’t be surprised by that. When risk is separated from reward, underwriting and pricing standards are more likely to loosen or to loosen more than is otherwise typical.
The Dodd-Frank Act addresses many of these incentive problems. First, there is the risk retention provision, which requires sponsors of asset-backed securitizations to retain at least 5 percent of the credit risk. This is meant to align the interests of those who take risk, the investors, with those who make the underwriting decisions in the first place. The CFPB is not one of the agencies responsible for writing the risk retention regulations.
But on the origination front, the CFPB acquired the Federal Reserve’s proposed rule addressing lenders’ duty to determine that consumers have a reasonable ability to repay mortgages. We’re in the process of carefully reviewing the comments that have been received on the proposal. And we plan to issue a final rule early next year in order to provide clarity to the market as quickly as we can, without sacrificing the quality of our analysis.
Incentive problems weren’t just confined to origination and securitization, though. We can also see the pernicious effect of misaligned incentives in mortgage servicing.
With some $10.4 trillion in unpaid principal balances outstanding, mortgage servicing is an enormous component of the overall market. But it’s a market that has been plagued by pervasive and profound consumer protection issues, as documented by recent reports by a number of other government agencies.
Mortgage servicing is marked by two structural features that make it especially prone to consumer harm. First, in the vast majority of cases, consumers do not choose their mortgage servicer. Mortgage servicing rights can be, and frequently are, bought and sold among servicers. So a servicer can, in a sense, “fire” a borrower; but a borrower can’t fire a servicer. That reduces the incentive for servicers to treat borrowers properly.
There’s a second incentive problem in servicing. The current structure of servicing fees creates a strong incentive to under-invest in adequate technology, people, and processes to handle unusual spikes in delinquency. Servicing revenues are mostly fixed. Servicing a delinquent loan costs more – dramatically more – than servicing a performing loan. It takes one-on-one contact with borrowers, costly collection efforts, and specialized staff to compare the relative value of workouts or foreclosures.
So servicers, when taking on a pool of loans, were effectively making a bet on the loans’ performance and taking on risk that those loans might go bad. And many of those loans – far more than expected – did go bad. But instead of investing in the necessary resources to properly service delinquent loans, many servicers cut corners, loosened operating protocols, and at times, violated the law.
In reviews of 14 major servicers this spring, the Office of the Comptroller of the Currency, the Federal Reserve, and the Office of Thrift Supervision determined that the weaknesses in servicers’ foreclosure processes were so severe that they had “an adverse effect on the functioning of the mortgage markets” and posed “significant risk to the safety and soundness of mortgage activities.” Poor servicing practices have inflicted hardships on borrowers, investors, and the economy as a whole.
A comprehensive approach to servicing that protects consumers, investors, the financial sector, and the housing market requires the coordinated action of many federal regulators. With that in mind, the Bureau is working with other federal agencies to develop common-sense national servicing standards.
Even the best of rules designed to assure transparency and align incentives will mean little if they don’t apply equally to all the players in a market.
During the housing bubble, our fragmented system of mortgage regulation, supervision, and enforcement produced an unlevel playing field that encouraged irresponsible lenders to shop for the most permissive legal regime. The opportunity for regulatory arbitrage accelerated a race to the bottom in lending standards.
Fortunately, the Bureau has been charged with making consumer financial markets work better for all consumers, regardless of who they do business with. For the first time, non-depository institutions will be federally supervised alongside their depository counterparts. This is true at every consumer touch point – on both the origination side and the servicing side.
This is a profoundly important change. Supervision is an effective, subtle, and nuanced tool for promoting reasonable conduct and sound markets. It doesn’t make sense to use that tool with some players, but not with others. When it comes to consumer protection, at least, it shouldn’t matter if you’re a bank, a thrift, a credit union, a finance company, a broker, or an investment bank. A mortgage is a mortgage. And the rules are the rules. With consistent supervision and smart enforcement, cheaters will not prosper.
A vibrant economy depends on a vibrant housing market. And a vibrant housing market depends on a well-functioning private mortgage market that works for, and commands the confidence of, all participants – from the consumers who take out the loans to the lenders and investors who hold the risk.
We need to put the problems of the past behind us and move to creating that kind of market as quickly and as thoughtfully as we can. It’s the kind of market that produces products that consumers want to pay for. It’s the kind of market where risk and return will go hand in hand. Products with higher levels of risk will be presumably priced to reflect that risk. Clear loan terms will help consumers see what those products are and make the choices that are right for them.
This is good for consumers. It’s good for responsible lenders. And it’s good for our economy.