Report from FRB Staff Highlights Risks of Nonbank Mortgage Lending

Staff members of the Board of Governors of the Federal Reserve System (“FRB”) issued a report warning that nonbank mortgage lending has increased within the mortgage market to historically high levels, a potentially dangerous development given the short-term lending that nonbank mortgage lenders rely on and the liquidity pressures that could emerge as a result. According to the report, as of 2016, almost half of all mortgages in the U.S. originated with nonbanks (up from around 20% in 2007). These loans represent 75% of the loan originations sold to Ginnie Mae in 2016, indicating that weaknesses in the sector could lead to taxpayer losses. The authors argued that liquidity issues in the nonbank mortgage sector played a significant role in the financial crisis, and questioned the viability of concentrating so much risk in such a vulnerable sector.

The report further describes:

  • why the funding and operational structure of the nonbank mortgage sector remains a significant channel for systemic liquidity risk in U.S. capital markets;
  • why these risks could lead to dislocations in mortgage markets, especially for minority and low-income borrowers;
  • how liquidity pressures played out during and after the 2007-2008 financial crisis;
  • the appeals that nonbank mortgage industry made to U.S. government for assistance; and
  • the ways nonbanks are still exposed to significant liquidity risks in their funding or mortgage originations and in their servicing portfolios.

As noted, the analysis and conclusions set forth in staff working papers “do not indicate concurrence” by the Board of Governors. The report was authored by You Suk Kim, Steven M. Laufer, Karen Pence, Richard Stanton and Nancy Wallace.

Lofchie Comment: Is this an example of a situation where over-regulation of small banks ended up chasing business away from the regulated sector?  Or was the move from regulated bank lenders to non-regulated lenders inevitable given the costs of regulation at any level?

CFTC Commissioner Calls for Creation of Cryptocurrency SRO

CFTC Commissioner Brian Quintenz advocated for the creation of a self-regulatory organization (“SRO”) focused on the oversight of cryptocurrency platforms.

In remarks delivered at the DC Blockchain Summit, Mr. Quintenz addressed the issue of the proliferation of cryptocurrencies and initial coin offerings. He described various oversight and regulatory challenges including jurisdictional limitations that restrict CFTC authority over spot markets.

Mr. Quintenz advocated for the creation of a private, independent organization aimed at developing standards and policing cryptocurrency platforms. Citing the success of SROs such as FINRA, the NFA and the MSRB, Mr. Quintenz suggested that a similar organization could be established in order to (i) set best practices and industry standards for cryptocurrency platforms and (ii) eventually enforce rules and supervise members for compliance. He pointed to independent bodies that had been established in other countries, and said that creating such an organization could help to “create uniform standards for these trading platforms, reduce the possibility of regulatory arbitrage, and avoid duplicative regulation.”

Mr. Quintenz also highlighted what he sees as several advantages over federal regulators, including that SROs: (i) do not require new legislation in order to quickly establish oversight, (ii) are funded by members as opposed to the federal government, and (iii) have the ability to expediently create or amend rules. He said that the IOSCO Principles for Self-Regulation could be used as a framework to establish a self-regulatory group for cryptocurrency. While SROs must be subject to the oversight of a government regulator, Mr. Quintenz said, an “SRO-like” entity could begin to establish a framework for standard-setting as Congress considers potential federal action.

Lofchie Comment: While there is a growing consensus that there should be a federal system of regulation of cryptocurrencies and ICOs, it seems unlikely that the development of such a system can be accelerated by reliance on a system of “self-regulation.” Such systems succeed because members interact extensively with each other and share a mutual interest in the development of the industry and the product as a whole.

These are not the characteristics of the crypto industry. To a good extent, one may even question whether crypto firms are issuing a common product. Further, Mr. Quintenz may overestimate the degree to which the U.S. self-regulatory organizations are genuinely self-regulatory; in fact, at least on the securities side, SROs are very much under the authority of the SEC, and function less as “self-regulatory” organizations than as extensions of the government.

FRB Vice Chairman Says Regulators Considering Volcker Rule Changes

Board of Governors of the Federal Reserve System (“FRB”) Vice Chairman for Supervision Randal K. Quarles reported that federal regulators are collaborating on a proposal to make “material changes to the Volcker Rule.” Speaking at the Institute of International Bankers Annual Washington Conference, Mr. Quarles asserted that certain Dodd-Frank regulations have caused compliance challenges and imposed unnecessary burdens on foreign banking organizations (“FBOs”).

Mr. Quarles argued that prior to the financial crisis, there was rapid growth of FBOs in the United States and insufficient regulation. He stated that certain post-Dodd-Frank regulatory requirements, particularly regarding the use of intermediate holding companies, had materially improved the quality of U.S. oversight. That said, Mr. Quarles characterized the Volcker Rule as an “example of a complex regulation that is not working well.”

Mr. Quarles said it was now possible to identify areas for improvement of the statute and the regulations. Mr. Quarles is seeking regulatory flexibility with regard to enhanced prudential standards for FBOs. He stressed the importance of tailoring standards to consider a firm’s actual risk profile, and vowed that the FRB will consider exceptions from certain requirements depending on a bank’s particular circumstances. He also committed to exploring solutions to tailor the rule and reduce burdens, particularly for firms that do not engage in proprietary trading and do not have large trading operations. Absent a statutory remedy, Mr. Quarles asserted, regulators will seek to make improvements by clarifying key terminology (such as “market making-related activity,” “proprietary trading” and “covered fund”). He shared that he expects regulators to explore solutions that will make exemptions more accessible for FBOs and foreign funds.

Lofchie Comment: In many respects, the tone of Vice Chair Quarles’ remarks is similar to previous remarks by CFTC Chair Giancarlo. Each has committed to a careful review of what is working and what is not, and to make improvements that are possible, while minimizing the likelihood of divisive political fights that are not worth the effort. That should provide wide latitude, given how much low-hanging fruit there is in improving on the existing Dodd-Frank regulations.

Congressional Republicans File Amicus Brief Supporting President Trump in Fight over CFPB Appointment

Republican members of Congress filed an amicus brief supporting President Donald Trump and Acting Consumer Financial Protection Bureau (“CFPB”) Director Mick Mulvaney in a lawsuit challenging the President’s authority to appoint Mr. Mulvaney as acting head of the CFPB. The lawsuit was filed by CFPB Deputy Director Leandra English.

As previously covered, the dispute arose after former CFPB Director Richard Cordray left the agency and asserted Ms. English’s authority to serve as Acting Director until a permanent replacement was selected and confirmed by the Senate. President Trump then named Mr. Mulvaney as Acting Director, and Ms. English has since pursued legal action to overturn the appointment. Her challenge was rejected by the U.S. District Court for the District of Columbia and is now being heard by the D.C. Circuit Court of Appeals.

In the amicus brief, the Republican Congress members assert that President Trump appointed Mr. Mulvaney in a manner consistent with his authority under the Federal Vacancies Reform Act (“FVRA”). Ms. English argued that a Dodd-Frank provision supersedes the President’s FVRA authority, prohibits his appointment of Mr. Mulvaney, and allows the Deputy Director to serve as Acting Director until a new Director is confirmed by the Senate.

Lofchie Comment: There is, or at least there should be, a distinction between the question of whether Mick Mulvaney is the right person to head the CFPB and the question of whether there is anyone who believes it is good government, or in any way rational, to empower the departing heads of major U.S. government regulatory agencies to name their successors. If Congressional supporters of Ms. English think this is a good way to run a government, perhaps they should introduce legislation to amend the FVRA and so make it general practice. To do so would make plain that Ms. English’s position is nonsense and works only for the most short-term political advantage. Those who support it should be mindful that it will simply be used against them should Democrats win the next Presidential election.

FRB Secure Payments Task Force to Disband

The Board of Governors of the Federal Reserve (“FRB”) Secure Payments Task Force (“Task Force”) will disband in March 2018 and its members will transition into a newly formed FRB FedPayments Improvement Community (“Community”). The Community provides a forum for payments industry stakeholders to participate in market efforts based on their “interest, expertise and availability.” The Task Force is scheduled to release a final report this month describing current primary payment methods.

GAO Identifies Deficiencies in Rule Reviews by Financial Regulators

In testimony before the House Committee on Small Business, U.S. Government Accountability Office (“GAO”) Director of Financial Markets and Community Investment Michael Clements shared the results of a new study identifying deficiencies in reviews conducted by financial regulators.

The reviews were conducted pursuant to the Regulatory Flexibility Act (“RFA”) and the Economic Growth and Regulatory Paperwork Reduction Act (“EGRPRA”). RFA requires federal agencies to analyze the impact of proposed and final rules on small entities and consider potential alternatives to rules that would have a significant economic impact. The EGRPRA requires financial regulators to conduct periodic retrospective rule reviews.

The GAO identified three areas in which rules were particularly burdensome for small entities:

  • Data-reporting requirements related to loan applicants and loan terms;
  • Transaction reporting and customer due diligence requirements under anti-money laundering regulations; and
  • Disclosures of mortgage loan fees and terms to consumers.

The GAO found that the regulators should improve their RFA reviews. Specifically, the GAO identified deficiencies in (i) the sufficiency of certifications concerning the economic impact of rules, (ii) consideration of potential compliance costs, (iii) the disclosure of data sources and methodologies for estimating economic effects, and (iv) the adequacy of policies and procedures for RFA analyses. Among the regulators requiring improvement were the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the FDIC, the SEC, the CFTC, and the Consumer Financial Protection Bureau (“CFPB”).

As to EGRPRA reviews, the GAO observed that since the CFPB is not included in the statute mandating the review process, many important mortgage regulations were not assessed. The GAO determined that several regulators failed to (i) conduct or report on quantitative analyses relevant to reviewed rules, and (ii) consider the cumulative effects of regulations (i.e., overlapping or duplicative burdens).

Lofchie Comment: The findings contained in this GAO study are unsurprising. Generally, regulators do an insufficient job of evaluating the costs of the rules that they impose. Regulators have little incentive to find that their rules are costly or provide limited benefit. Further, political concerns produce more pressure to adopt new rules than to evaluate and remove unnecessary or deficient ones. The CFPB may be viewed as the poster child for that. The question is whether this type of behavior can be changed over the long term. It would seem unlikely that periodic GAO reviews are sufficient in this regard, particularly in the absence of any enforcement mechanism.

SEC Investor Advocate Objects to Mandatory Arbitration of Shareholder Class Actions

SEC Investor Advocate Rick Fleming expressed disapproval of mandatory arbitration provisions that prohibit shareholders from pursuing class actions. These provisions generally require shareholders to pursue claims on an individual basis through arbitration.

In an SEC Speaks program sponsored by the Practising Law Institute, Mr. Fleming responded to several commentators who recommended that U.S. public companies adopt mandatory arbitration provisions in their articles of incorporation or bylaws to avoid the high costs of class action litigation. Mr. Fleming argued that such a view neglects the negative side effects of limiting shareholders’ class actions.

Mr. Fleming asserted that the class action mechanism serves a number of beneficial purposes. These include (i) encouraging private enforcement of the securities laws where the SEC’s resources are limited, (ii) providing a means of redress for all investors, regardless of their holding size, (iii) avoiding collective action problems resulting from the high costs of pursuing securities claims, and (iv) serving as the basis for an extensive body of case law interpreting the federal securities laws. Mr. Fleming stated that arbitration does not offer comparable benefits because it does not effectively handle multiple plaintiffs, avoids public disclosure, does not require written decisions or opinions, renders appeals difficult to pursue, and does not incentivize investors with small holdings.

Mr. Fleming urged the SEC to continue its objection to U.S. IPO issuers that impose mandatory arbitration provisions on the basis of Securities Act Section 14, and Exchange Act Section 29(a), which provide that any condition that forces a person to waive compliance with those laws is void. Mr. Fleming also urged public companies to consider the downside risks of mandatory arbitration provisions.

Lofchie Comment: Notwithstanding Mr. Fleming’s arguments that the market would disfavor mandatory arbitration clauses, it seems quite plausible that the reverse would be true. In any case, academics can see how the stock markets react to the adoption of such provisions by individual companies. The hard question, then, becomes whether there is any public policy reason to disfavor such clauses even if securities holders as a group prefer them.