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What Big Banks Fear More Than the CFPA

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At stake in the financial reform debate is an issue that has received far less attention than the Consumer Financial Protection Agency, but is at least as important: whether Congress will restore the authority of states to oversee national banks.

If you don't believe me, then take it from U.S. Bancorp CEO Richard Davis, who chairs the powerful big bank lobbying group, the Financial Services Roundtable. In an interview with the Minneapolis Star Tribune editorial board two weeks ago, Davis revealed that the industry's "number one concern" about financial reform is not the CFPA, but rather the power of states to regulate the activities of national banks.

"If we had one thing to fight for, it would be to protect [federal] preemption [of state law]," Davis said.

Much has been said about the failure of federal banking regulators in the years leading up to the collapse. But that is only half the story. The other half has to do with how state regulators reacted. Unlike their federal counterparts, state regulators were onto abuses in the mortgage industry more than a decade ago. As early as 1998, states were taking predatory lenders to court, connecting the dots to Wall Street, and passing laws that limited risky, high-cost mortgage terms.

But the states were stopped in their tracks by a powerful federal agency that operates deep inside the Treasury Department: the Office of the Comptroller of the Currency (OCC). Relying on a dubious legal justification, the OCC declared many of these state laws preempted by federal law and told national banks to ignore them. Then, in 2004, the OCC issued a sweeping preemption order that basically nullified all state laws governing consumer lending.

That 2004 order remains the law of the land and Davis and other big bankers want to keep it that way. In the House, they managed to significantly weaken a provision in the financial reform bill that would have restored state authority. Now, in the Senate, big bank allies are hoping to cut a deal in which they'd support other aspects of Dodd's bill, perhaps even the CFPA, in exchange for broad federal preemption of state banking laws.

We'd be fools to accept that deal.

For 150 years, the U.S. had a system of dual oversight of banks. Banks had to follow both federal law as well as the laws of the states in which they operated. This system worked remarkably well. States served as first-responders, spotting new problems well ahead of federal regulators and experimenting with solutions. Bad policies generally came and went without affecting more than one state. Good ideas spread. In fact, many of the consumer protections that have been written into federal banking law -- rules on fair lending, credit card disclosures, identity theft, and more -- were pioneered by the states.

In the late 1990s, this system was working just as designed. Alarmed by the sudden proliferation of risky, high-cost mortgages, state lawmakers and regulators swung into action, gathering data, initiating investigations, and debating policy approaches.

"I remember when my consumer people came to me and said, we are going to have a tidal wave of foreclosures on our hands in a few years," recalls Illinois Attorney General Lisa Madigan, who, in 1998, together with attorneys general in Minnesota and Massachusetts, filed one of the first lawsuits against a predatory lender, a company called First Alliance Mortgage, which was pushing people into bad mortgages and selling the loans to Lehman Brothers.

In 1999, North Carolina became the first state to adopt an anti-predatory lending law. In all, more than 30 states would enact some form of legislation. Based on decades of judicial precedent, states assumed that their laws were valid so long as they did not conflict directly with federal law.

But by then the OCC had developed a much more expansive view of its preemption powers. A few years earlier, the agency had started knocking down state consumer protection laws that were not in conflict with federal law, but simply constrained the activities and profits of banks -- things like caps on ATM fees and rules about what credit card issuers had to disclose to customers.

As states tried to address the explosion of risky mortgages, the OCC stepped up its preemption activities and began running an aggressive interference on behalf of big banks. When Michigan tried to enforce a state lending law against a Wachovia subsidiary that dealt in mortgages, the OCC stepped in and gave Wachovia carte blanche to ignore the law.

When New York Attorney General Eliot Spitzer launched an investigation into whether Citigroup, JPMorgan Chase, and Wells Fargo had been pushing minorities into expensive subprime loans even when they qualified for better loans, the OCC went to court on behalf of the banks to block Spitzer's case. (Spitzer appealed and the Supreme Court eventually ruled in New York's favor, but not until June 2009, when the damage had long since been done.)

But the state law that perhaps best illustrates our lost opportunity to avert the financial crisis was enacted in Georgia in 2002. This prescient law extended what is known as "assignee liability" to Wall Street investors. Normally, if a lender misrepresents the terms of a mortgage or otherwise tries to defraud you, you can take them to court to stop foreclosure on your house and even win damages. But this liability disappears when the mortgage is sold. Georgia decided that the liability should stay with the loan, making Wall Street banks and investors dealing in mortgage-backed securities accountable for the loans they were buying.

Wall Street freaked out. The ratings agencies declared that they wouldn't touch any loans coming out of Georgia -- a pretty clear indication that they knew mortgage fraud and deception was widespread.

"[Georgia's law] could have been a game-changer," says John Ryan of the Conference of State Bank Supervisors. "If the secondary market had to think a little more seriously about what it was funding, that could have made a real difference."

But Wall Street was let off the hook by the OCC. Shortly after Georgia's law took effect, the OCC preempted the law at the request of National City Bank, whose subsidiary, First Franklin, was a major subprime lender in Georgia.

Five months later, in January 2004, the OCC issued a sweeping order that essentially nullified all state consumer lending laws. The order says that states may not "impair" or even "condition" a national bank's ability to exercise its powers. The only state laws still valid are those that only "incidentally affect" a bank's activities.

In an unprecedented show of unity, all 50 state attorneys general opposed the OCC's action. Many legal scholars argued the OCC was acting well outside the bounds of its Congressionally defined authority, but neither the Bush Administration nor the Republican-controlled Congress were inclined to rein in this rogue agency.

A House subcommittee did manage to hold hearings, in which some lawmakers pressed OCC Chief Counsel Julie Williams to justify the agency's actions. She told the subcommittee to consider the plight of national banks, which were facing "uncertain exposure" and "additional costs." Worse, she said, "the secondary market [i.e., Wall Street] was being impacted."

Clearing the way for big banks to do whatever they want was a disaster for American families. A study just released by the University of North Carolina found that, in states with strong anti-predatory lending laws, the effect of the OCC's 2004 order was an immediate and significant increase in the share of mortgages issued with risky, high-cost terms. Predictably, defaults also shot up after 2004.

Another immediate effect of the 2004 order was that many nonbank mortgage companies, which had been subject to state law, sold themselves to national banks in order to take advantage of federal preemption. Big banks were quite happy to swallow these highly profitable subprime subsidiaries, which, a few years later, turned into poison pills that would bring down many of them, including Merrill Lynch, Wachovia, and National City.

Meanwhile, some banks that had operated under state charters -- notably the giants JP Morgan Chase and HSBC -- switched to federal charters and thereby gained immunity from state laws and state attorneys general. By 2005, the share of all bank assets held by banks overseen by the OCC had shot up to 67 percent. This in turn boosted the OCC's funding, which is derived almost entirely from fees levied on the banks it oversees.

The OCC is a perfect example of an agency that has been "captured" by the industry it regulates. After disabling the states -- which in 2003 initiated more than 20,000 investigations of abusive lending and took more than 4,000 enforcement actions -- the OCC undertook just three public enforcement actions involving consumer mortgage lending between 2004 and 2007.

The hope is that a CFPA would be different and actually put consumers first, but we would be unwise to take fifty states off the beat in order to get it. The CFPA ought to work hand-in-hand with the states, setting minimum consumer protection standards that states are free to exceed. "The only way it works is when both the states and the federal government are involved," contends Iowa Attorney General Tom Miller, who has been lobbying Congress for both the CFPA and state authority.

This dual oversight is essential, because the reality is that it's much easier for an industry to influence, game, or capture a single federal agency. "It's much harder to capture the states, because there's fifty of them," notes Arthur Wilmarth, an expert on banking law and a professor at George Washington University. "It's particularly hard to capture the attorneys general, because they are elected. Many of them want to become governors, so they have a real reason to have consumers think well of them. None of the federal agencies have that viewpoint."

Big banks understand this, which is why, in the House, they put the lion's share of their energy into fighting state authority, not the CFPA. Both President Obama's proposal and the original bill would have repealed the 2004 preemption order and fully restored state authority. But a coalition of New Democrats led by Rep. Melissa Bean, who ranks 9th in the House in contributions from the financial industry, held up the bill and managed to substantially weaken the language.

The bill the House passed says states can adopt consumer protection laws so long as they do not "materially impair" national banks. Courts will have to decide what that means, but to my ears it sure sounds like any state law that inhibits maximum profits will be thrown out.

Meanwhile, in the Senate, Dodd's bill as currently written restores at least some degree of state authority, but people privy to the discussions have told me that he does not seem all that committed to it and, unless there's more public attention and pressure, he may well bargain it away to win support on other aspects of the bill.

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Stacy Mitchell, author of Big-Box Swindle, is a senior researcher with the New Rules Project and its Community Banking Initiative.