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Subprime Lending Crisis: Strategies for Responding to Bank Enforcement Activity Brian C. McCormally March 18, 2008 The Subprime Crisis: A Perfect Storm Mortgage Market: Between 2003 and 2005, use of subprime and nontraditional mortgage products more than doubled By early 2006, nearly 80% of securitized subprime mortgage loans were ARMs (2/28s and 3/27s) Loans were underwritten without consideration of risk layering – – – – No doc/low doc loans Debt-to-income ratios based on teaser rates Increasing loan-to-value ratios Prepayment penalties Home prices stagnated (or fell) throughout the country Unable to refinance, delinquency rates on mortgage debt and foreclosures began to rise in 2006 and increased in 2007 Nearly 2 million subprime ARMs will reset by the end of 2008, with monthly payment increases of up to 30 percent 1 The Subprime Crisis: A Perfect Storm Political Oversight Changed: Democrats gained control of Congress and pressured Federal Banking Agencies Federal Banking Agency Oversight Increased: Banking Agencies issued restrictive guidance on non-traditional mortgage lending in October 2006 Banking Agencies issued more restrictive guidance on subprime lending in July 2007 OCC, FDIC and OTS updated exam manuals and took enforcement actions for the first time to address abusive mortgage lending practices State Attorneys General Oversight Increased: Enforcement actions taken against state mortgage lenders for abusive mortgage lending practices Civil actions commenced against banks and noteholders to enjoin foreclosure proceedings 2 Who Has Oversight for Consumer Lending Products and Practices? Federal and State Banking Agencies – Banks, Thrifts, Finance Companies, Operating Subsidiaries, Holding Company Subsidiaries, Service Providers Federal Trade Commission – Bank Subsidiaries and Holding Company Subsidiaries, Finance Companies, Loan Brokers, Service Providers Housing and Urban Development – Finance Companies, Loan Brokers State Attorneys General US Securities and Exchange Commission US Department of Justice 3 Federal Consumer Protection Statutes Federal Agencies Oversee and Enforce: – Federal Trade Commission Act (Section 5—declares unlawful any unfair or – – – – – – – deceptive act or practice) Truth in Lending Act (requires disclosures about terms and costs of credit) Equal Credit Opportunity Act (prohibits discrimination in any credit transaction) Fair Housing Act (prohibits discrimination in residential real estate trans.) Home Ownership and Equity Protection Act (provides protections in high cost mortgages) Real Estate Settlement Procedures Act (requires advance disclosure of settlement costs and prohibits kickbacks and unearned fees for settlements) Fair Credit Reporting Act (requires accurate information about credit reporting) Fair Debt Collection Practices Act (prohibits abusive collection practices) 4 Federal Banking Agencies’ Authority over Consumer Lending Banking agency oversight includes application and enforcement of: – Interagency guidelines establishing standards for residential – – – – – mortgage lending (1993) Interagency guidelines establishing standards for safety and soundness (1995) Interagency guidance on subprime lending (1999) Expanded guidance for subprime lending programs (2001) Interagency guidance on nontraditonal mortgage products (October 2006) Statement on subprime mortgage lending (July 2007) 5 Challenges Presented by Increasing Agency Reliance upon Guidance Documents While labeled guidelines, considered enforceable as agency rules when published in the Federal Register Broadens agency lending standards without formal rulemaking Permits agency enforcement actions for activity conducted in compliance with statutory parameters – Examples: • Loans in full compliance with HOEPA considered in violation of safety and • • soundness standards Broker fees charged in compliance with RESPA considered in violation of subprime lending guidance Disclosure documents in compliance with Federal statutes considered in violation of agency guidance on unfair or deceptive practices Exposes banking institutions, subsidiaries, and affiliates to potentially broader civil liability 6 Recent Trends in Mortgage Product and Practice Enforcement Actions Number and severity of federal and state banking agency enforcement actions are increasing Number and severity of state attorneys general enforcement actions are increasing Enhanced coordination between banking agencies and FTC is likely to increase number and severity of FTC enforcement actions against finance companies, subsidiaries, and service providers 7 Recent Banking Agency Actions 8 Banking Agency Examples Laredo National Bank, Laredo, Texas OCC Public Enforcement Action (November 2005) – Development of anti-predatory lending program, implementation of – compliance audit program, enhanced disclosures to borrowers, and remediation of all affected loans back to 2003 $14 million restitution reserve to be replenished as loans are remediated Mortgage Lending Deficiencies and Violations – Violation of Section 5 of FTC Act for loan flipping – Violation of RESPA for failure to provide accurate GFEs – Soliciting borrowers with “pre-approved” notices and then not approving loan applications – Failure to establish internal controls over lending operation – Failure to maintain adequate audit over lending operation 9 Banking Agency Examples (cont.) Fremont Investment and Loan, Brea, CA FDIC Public Enforcement Action (2007) – Development of anti-predatory lending program, implementation of – compliance audit program, enhanced disclosures to borrowers Remediate loans in an unspecified amount Cited Mortgage Lending Program Deficiencies – Lack of monitoring over brokered subprime loan activity – Inadequate risk management policies and procedures in brokered – – – subprime mortgage lending Inadequate underwriting and excessive risk in subprime lending activity Marketing and extending ARM products without considering borrower’s ability to repay at fully-indexed rate Originating subprime loans in violation of Interagency Expanded Guidance for Subprime Lending 10 Banking Agency Examples (cont.) AIG Federal Savings Bank, Wilmington, Delaware OTS Public Enforcement Action (June 2007) – Remediate an unspecified number of loans Mortgage Lending Program Deficiency, Supervisory Requirement and Estimated Costs – Insufficient supervision of affiliate’s subprime lending activity – Submission of Plan of Remediation to address: 1. borrowers whose creditworthiness not adequately considered; and 2. borrowers who incurred large broker and/or lender fees. – Estimated cost of remediation—$178 million reserve 11 Lessons Learned From Regulatory Investigations and Enforcement Actions 12 Lessons Learned from Regulatory Investigations and Enforcement Actions Get the Attorneys Involved at the Beginning The attorneys (internal or external) should be involved from the first day the bank or affiliated company is notified of an examination or investigation. But with Bank examinations, keep them out of sight! – Do not use attorneys as communicators of information to the bank examiners – Do not funnel documents requested by bank examiners through the attorneys – Do not give the impression that you are “lawyering up” 13 Lessons Learned (cont.) Conduct Your Own Inquiry Find out the facts on your own. – Independently and without the knowledge of the investigating agency Collect all past regulatory examinations and correspondence with the agency on the relevant issues. Obtain copies of all policies, procedures, reports, etc. requested by examiners/investigators to conduct an independent review, but do not require attorney review of records prior to delivery to bank examiners. – Interview personnel with relevant information about the focus of the examination/investigation • Do this before the examination/investigation commences, if possible • Determine whether personnel are aware of weaknesses or deficiencies in • bank policies, procedures, systems or controls at issue Assess the reliability and credibility of each source 14 Lessons Learned (cont.) Never Permit the Examination/Investigative Process to Become Confrontational Nothing positive can result from being confrontational. Remind personnel in contact with examiners/investigators to never say or imply that the government does not understand the business. Banks examiners are more likely to recommend sanctions against organizations that make the examination/investigative process difficult for them. “Contempt of Examiner” is the most common unstated basis for enforcement actions. While examiner retaliation is reviewable under the banking agencies’ appeal processes, it is rarely successful and often too late to be useful. 15 Lessons Learned (cont.) Track the Examination/Investigation Process Make an extra copy of everything that is requested by the agency. Index all documents by date, name of requestor and subject matter. But, DO NOT monitor the bank examiners’ daily activities or unnecessarily restrict their access to bank records or personnel. Interview/debrief every person who is interviewed by the examiners. – Assess the reliability of each person who is communicating with the examiners on a regular basis 16 Lessons Learned (cont.) Document Everything Make a record of all contacts with the examiners and the agency. – Faithfully employ transmittal and confirmation letters – Prepare memos to the file recording all examiner meetings Record all actions taken to address or correct any deficiencies identified during the examination. Provide written reports to the agency on all actions taken to address, respond to, or correct any deficiencies identified during the examination, preferably before the examination is finalized. 17 How Do You Get the Bank’s Views Heard and Avoid a Public Enforcement Action Communicate in writing how criticized practices, policies, procedures, systems, or internal controls complied with the agency’s regulations, guidance documents and public statements at the time. Be proactive by anticipating problems or criticisms and putting solutions in place to address examiner concerns. If the agency intends to criticize current or past practices, begin taking corrective action prior to delivery of the examination report. – Develop a corrective action plan to address recognized deficiencies and – – – present to the board of directors for consideration. Consider adopting a board resolution directing the plan’s implementation. Begin implementation of the plan as soon as possible (preferably before the examination is delivered in final). Make sure the company gets credit for being proactive by sharing the plan with examiners and requesting their input. 18 Always Remember, the Regulatory Agency isn’t Going Away Never forget that regular examinations are part of the cost of doing business in the banking industry. No matter how this examination comes out, the examiners will be back next year. Most seriously troubled banks began their downward spiral due to poisoned relations with the examiners that were never corrected or resolved. – Management cannot afford to forget that the examiners are not going away – Or that examiners have a long memory 19 Questions? 20 Brian C. McCormally Partner, Financial Services Practice Focuses on bank and thrift operations, corporate structures and activities, lending and marketing practices, regulatory practice and corporate governance, internal investigations, and regulatory enforcement actions. 20 years in senior legal positions at the Office of the Comptroller of the Currency and the Office of Thrift Supervision, including OCC Director of Enforcement & Compliance and OTS Senior Deputy Chief Counsel for Enforcement & Litigation. 21