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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
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
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
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
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
Fair Debt Collection Practices Act (prohibits abusive collection practices)
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)
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
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
Recent Banking Agency Actions
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
 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
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
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
Lessons Learned From
Regulatory Investigations and
Enforcement Actions
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”
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
– Interview personnel with relevant information about the focus of the
• 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
Lessons Learned (cont.)
Never Permit the Examination/Investigative Process to Become
 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.
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
Lessons Learned (cont.)
Document Everything
 Make a record of all contacts with the examiners and the
– 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.
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
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.
Always Remember, the Regulatory Agency isn’t Going
 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
– Management cannot afford to forget that the examiners are not going
– Or that examiners have a long memory
Brian C. McCormally
Partner, Financial Services
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.