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For Release Upon Delivery
12:00 pm., April 8, 2010
STATEMENT OF
JOHN C. DUGAN
COMPTROLLER OF THE CURRENCY
before the
FINANCIAL CRISIS INQUIRY COMMISSION
APRIL 8, 2010
Statement Required by 12 U.S.C. § 250:
The views expressed herein are those of the Office of the Comptroller of the Currency and do not
necessarily represent the views of the President.
INTRODUCTION
Chairman Angelides, Vice Chairman Thomas, and Commissioners, I appreciate the
opportunity to appear today before the Financial Crisis Inquiry Commission (“Commission”).
The Commission was created to examine the causes of both the financial crisis and the collapse
of each major financial institution that failed or was likely to fail if not for the receipt of
exceptional government assistance. In this context, the Commission’s letter of invitation asked
me to address several specific areas: the roles played in the crisis by federal preemption of state
mortgage lending laws and by the Community Reinvestment Act; the impact of the activities of
national banks related to subprime lending, both directly and indirectly; changes in laws and
regulations governing commercial banks’ authority to conduct asset-securitization activities; and
aspects of supervision of Citibank and Citigroup, by the Office of the Comptroller of the
Currency (OCC) and the Federal Reserve Board, respectively. My statement addresses each
topic, and is followed by separate appendices discussing each area in more detail, including
additional relevant material. It concludes with my thoughts regarding several key lessons
learned for the future.
CAUSES OF THE CRISIS
To address the specific topics the Commission has identified, it is essential to place them
in the context of key events that ignited the crisis. In particular, the Commission’s questions
focus on the problems caused by deep and widespread losses on residential mortgages, especially
subprime mortgages. That focus is appropriate given the record foreclosures, large financial
institution losses and failures, and market seizures that trace back to problem mortgages.
While the lack of adequate consumer protection contributed to the record levels of
mortgage losses, I believe there was a more fundamental problem: poor underwriting practices
that made credit too easy. Among the worst of these practices were the failure to verify borrower
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representations about income and financial assets; the failure to require meaningful borrower
equity in homes in the form of real down payments; the offering of “payment option” loans
where borrowers actually increased the amount of their principal owed with each monthly
payment; and the explicit or implicit reliance on future house price appreciation as the primary
source of loan repayment, either through refinancing or sale.
In short, at the beginning of the 21st century, the U.S. system for mortgage finance failed
fundamentally. The consequences were disastrous not just for borrowers and financial
institutions in the United States, but also for investors all over the world due to the transmission
mechanism of securitization.
I believe there are a number of reasons why this happened. One is that, for many years,
home ownership has been a policy priority. As a result, when times are good, we as a nation
have an unfortunate tendency to tolerate looser loan underwriting practices – sometimes even
turning a blind eye to them – if they make it easier for more people to buy their own homes.
Against that backdrop, an unhappy confluence of factors and market trends led to even greater
problems.
Around the world, low interest rates and excess liquidity spurred investors to chase
yields, and U.S. mortgage-backed securities offered higher yields on historically safe
investments. Hungry investors tolerated increased risk in order to obtain those higher yields,
especially from securities backed by subprime mortgages, where yields were highest. The
resulting strong investor demand for mortgages translated into weak underwriting standards to
increase supply.
Structured mortgage-backed securities, especially complex collateralized debt
obligations, were poorly understood. They gave credit rating agencies and investors a false sense
of security that, no matter how poor the underwriting of the underlying mortgages, the risk could
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be adequately mitigated through geographic and product diversification, sufficient credit
tranching, and other financial engineering.
Cheap credit and easy underwriting helped qualify more consumers for mortgages, which
increased demand for houses, which increased house prices. That in turn made it easier for
lenders and investors to rely more on house price appreciation and less on consumer
creditworthiness as the ultimate source of repayment for the underlying loans – so long as house
prices kept rising.
In addition, many mortgage brokers and originators sold mortgages directly to
securitizers. They therefore had no economic risk when considering the loan applications of
even very risky borrowers. Without any “skin in the game,” brokers and originators had every
incentive to apply the weakest underwriting standards that would produce the most mortgages
that could be sold. And unlike banks, most mortgage brokers in the United States were virtually
unregulated, so there was no regulatory or supervisory check on imprudent underwriting
practices.
The rapid increase in market share by these unregulated brokers and originators put
pressure on regulated banks to lower their underwriting standards, which they did, though not to
the same extent as was true for unregulated mortgage lenders. Indeed, the OCC took a number
of steps to keep the national banks we supervise from engaging in the same risky underwriting
practices as their nonbank competitors. That made a difference, but not enough for the whole
mortgage system.
The combination of all the factors I have just described produced, on a nationwide scale,
the worst underwritten mortgages in our history. When house prices finally stopped rising,
borrowers could not refinance their way out of financial difficulty. And not long after, we began
to see the record levels of delinquency, default, foreclosures, and declining house prices that
3
have plagued the United States for the last two years – both directly and through the spillover
effects to financial institutions, financial markets, and the real economy.
REGULATORY FRAMEWORK FOR MORTGAGE ORIGINATORS
With that context, let me also briefly describe the regulatory framework governing the
different types of institutions that originate residential mortgages, which is important for
addressing the Commission’s questions relating to both subprime lending and the role played by
federal preemption.
Chart 1 shows a regulated bank holding company, a regulated thrift holding company,
and the entities within those holding companies that originate mortgages. It also shows
mortgage originators that are not affiliated with a bank or thrift. In addition, the chart indicates
the federal regulatory agency and/or the state that has supervisory responsibility for each
mortgage originator. The OCC supervises national banks and their operating subsidiaries (the
green boxes); these are the only entities over which the OCC exercises supervisory authority.
Only the national banks and their operating subsidiaries, and the federal thrifts and their
operating subsidiaries (the yellow boxes) are subject to exclusive federal supervision and federal
preemption. The red boxes indicate entities that are subject to state supervision, either solely by
the state, or jointly by the state and federal agencies; these entities are not subject to federal
preemption. That is, state-chartered banks and thrifts and non-bank affiliates of bank and thrift
holding companies are subject to both federal and state supervision, while mortgage lenders that
are not affiliated with banks or thrifts are subject only to state supervision.
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CHART 1: Regulators of Mortgage Originators
Bank
Holding Company
(FRB/State)**
National
Bank
(OCC)
State
Bank
(State /
FRB or FDIC)
Operating
Subsidiary
(OCC)
Operating
Subsidiary
(State /
FRB or FDIC)
Thrift
Holding Company
(OTS/State)**
Non Bank
Mortgage
Affiliate
(FRB/State)
Federal
Thrift
(OTS)
State
Thrift
(OTS/State)
Non Thrift
Mortgage
Affiliate
(OTS/State)
Non Bank
Mortgage
Originator
and
Broker
(State Only)
Operating
Subsidiary
(OTS)
Subject to Supervision By:
OCC
OTS
State*
* As noted, some mortgage originators are regulated by both state and federal regulators.
** Some (mostly smaller) banks and thrifts are not part of holding companies and are not represented separately here.
FEDERAL PREEMPTION OF STATE LAW AND THE CAUSES OF THE CRISIS
As discussed above, the root cause of the mortgage crisis was exceptionally weak
underwriting standards. But these weak standards were not caused by federal preemption of
state mortgage lending laws.
Basic elements of national bank preemption are described in Appendix A. These
principles apply to national banks and their subsidiaries. Preemption is not applicable to state
regulated mortgage originators, whether they are state-chartered banks or thrifts, holding
company affiliates of banks or thrifts, or lenders or brokers that are unaffiliated with depository
institutions (the red boxes in Chart 1). As a result, preemption has done nothing to impede the
ability of states to establish and enforce sound mortgage underwriting standards for these
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mortgage originators, which, as described below, were collectively the source of the
overwhelming majority of subprime loans that are now performing so badly.
Indeed, if it were true that federal preemption caused the subprime mortgage crisis by
preventing states from applying more rigorous lending standards to national banks, one would
expect that most subprime lending would have migrated from state regulated lenders to national
banks. One would also expect that all bank holding companies engaging in these activities that
owned national banks would carry out the business through their national bank subsidiaries
subject to federal preemption, rather than their nonbank subsidiaries that were subject to state
law. But, as described below, neither of these conjectures is accurate: the overwhelming
majority of subprime lending was done outside of national banks in entities that were subject to
state law, and several large bank holding companies conducted all or most of their subprime
mortgage lending in nonbank subsidiaries rather than their national bank subsidiaries.
The essence of federal preemption as applied to national banks is that their banking
activities are governed by uniform federal standards, and a federal supervisor, the OCC,
regulates national banks to ensure their compliance with these federal standards. Conversely, by
express Congressional design, national banks’ banking activities are not subject to multiple sets
of state banking standards and multiple state regulators. The fundamental concept is that a
uniform set of banking standards should apply to national banks wherever they operate in the
country.
National banks are subject, however, to various state laws that govern their day-to-day
operations and do not restrict their federally authorized banking powers, such as laws governing
fraud, contracts, torts, etc. Notably, state anti-discrimination laws and state laws governing the
foreclosure process are not preempted.
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The lending activities of national banks and their subsidiaries are subject to extensive
federal standards and supervision by the OCC. This has been true, for example, in the area of
predatory lending, or the set of unscrupulous, unfair, and deceptive lending practices by which
lenders exploit borrowers. In the mortgage area, these include such practices as loan flipping,
equity stripping, and lending based solely on the liquidation value of the houses underlying the
mortgages. Such predatory lending is usually a subset of subprime lending, but it is different
from the type of subprime lending that was lawful but involved exceptionally weak underwriting
standards.
The OCC has been clear that predatory lending – unfair, deceptive, and abusive lending
practices – has no place in the national banking system. We have taken enforcement actions to
address such unacceptable credit practices; alone among the federal banking agencies issued
detailed guidance to national banks on avoidance of abusive mortgage lending practices; and
alone among the federal banking agencies issued enforceable guidelines on abusive, predatory,
unfair or deceptive residential mortgage lending practices. Predatory lending practices of the
type targeted by many state mortgage lending laws simply did not take root in the national
banking system.
More broadly, OCC-supervised national banks have not been especially receptive to even
the lawful type of subprime mortgage lending where underwriting standards declined so
significantly in the last ten years. This may have been the result of more rigorous credit
supervision and reserving practices required in national banks (and indeed, all banks), as
evidenced by the fact that a number of large bank holding companies owning national banks
often used nonbanks for their subprime lending. For example, HSBC, Citigroup, Wells Fargo,
and Countrywide (when it owned a national bank) conducted most of their subprime mortgage
lending in holding company affiliates of national banks that were not subject to OCC
supervision, but were subject to Federal Reserve and state supervision. It may also have been the
7
result of the lead the OCC took on an interagency basis to promulgate standards for sound
underwriting and consumer protection for nontraditional mortgage products, particularly
negatively amortizing “payment option” mortgages, which were rarely provided by national
banks.
Whatever the reasons, the result was that national banks and their operating subsidiaries
accounted for a disproportionately small share of the subprime mortgage market during the
period when the worst subprime mortgages were provided to consumers. The same was true for
the market for so-called Alt-A mortgages, the credit quality of which was better than subprime
mortgages but worse than prime mortgages. In both cases, overwhelmingly, these non-prime
mortgage loans were originated by nonbank lenders that were unaffected by preemption.
More specifically, as described in detail in Appendix B, national banks and their
operating subsidiaries accounted for only a small portion of non-prime loans originated in the
key years 2005-2007, the peak years for non-prime lending: national banks originated 10.6
percent of subprime loans, and 12.1 percent of non-prime loans overall. Moreover, this figure
overstates the portion of non-prime loans originated by national banks where preemption of state
law could even have been an issue. The non-prime figure includes originations of both home
purchase mortgages and refinance mortgages. Yet many state mortgage lending laws only
covered home refinance mortgages and not home purchase mortgages; therefore, preemption
could not have been a factor for a significant share of mortgage originations – the home purchase
mortgages – in those states.
As discussed in detail in Appendix B, the vast majority of non-prime loans originated
during this period were made by entities clearly subject to the jurisdiction of state authorities –
lenders for which preemption was not an issue. During the crucial period 2005-2007, for
example, analysis of non-prime loan data and HMDA data indicates that 72 percent of non-prime
loans were made by lenders subject to state authority (the red boxes in Chart 1).
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Moreover, the non-prime loans originated by national banks and their subsidiaries
generally have performed better than non-prime lending as a whole: 22 percent of the loans
originated by national banks and their subsidiaries subsequently entered the foreclosure process
at some time after origination, compared to the market average of 25.7 percent of loans. Apart
from credit unions, which were not significant originators, that percentage was the lowest of any
other federal regulator and was below the percentage of non-prime loans originated by entities
subject to state jurisdiction. The lower foreclosure rates generally indicate that the non-prime
loans originated by national banks were of relatively higher credit quality. Analysis of
delinquency rates on non-prime mortgage loans also supports that conclusion.
The relatively smaller share of non-prime mortgage originations made by national banks
and their subsidiaries, and the relatively better performance of these loans, are hard facts that
belie the argument that national banks’ federal preemption caused the mortgage crisis. Objective
analysis of the data reveals that the overwhelming majority of subprime and Alt-A loans, and the
worst of these loans, were made outside the national banking system.
This is not to suggest that national banks had no involvement in the subprime lending
crisis. Some national banks did originate poor quality non-prime mortgage loans and have
suffered substantial losses as those loans defaulted. Some national banks, like other investors,
acquired securitized interests in poorly underwritten subprime mortgages, unduly relying on the
investment grade ratings accorded those investments. And some national banks, as discussed
below, ended up holding mortgage-related risks that they had not anticipated. Nevertheless, the
relatively smaller role that national banks played in originating and purchasing these mortgages
is direct evidence that federal preemption was not a principal cause of the subprime mortgage
crisis.
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OTHER ACTIVITIES OF NATIONAL BANKS RELATED TO SUBPRIME LENDING
The Commission’s letter of invitation also asked me to address the nature and scope of
the activities of national banks and their operating subsidiaries to indirectly support subprime
mortgage lending. This could include activities such as providing warehouse lines of credit to
subprime originators and purchasing subprime loans and interests in residential mortgage-backed
securities or other structured products. Using the best information available, as discussed in
Appendix B, Parts II-IV, it is clear that national banks played a relatively limited role in
indirectly supporting independent subprime lenders.
Many of the state supervised subprime mortgage originators that sold mortgages directly
to securitizers relied on warehouse lines of credit to finance their lending operations. Warehouse
lines of credit are used to finance loans held for sale from origination to delivery into the
secondary market. Relative to the overall size of the warehousing market, the warehouse lines of
credit provided by national banks to subprime lenders were small. For example, as described in
Appendix B, Part III, as of the fourth quarter 2006, large national banks provided approximately
$33 billion of warehouse lines to 60 subprime lenders, compared with a total warehousing
market in excess of over $200 billion in 2006. By the third quarter of 2007, the volume of such
facilities at large national banks decreased to $14.6 billion, compared to a total warehousing
market of over $200 billion in 2007.
Once originated, many of these subprime loans were bundled into residential mortgagebacked securities (“RMBS”), and these RMBS were sold to a broad range of investors, including
national banks. As detailed in Appendix B, Part IV, national banks held more than $700 billion
in RMBS during 2005 - 2007, but much of this consisted of securities issued by the governmentsponsored enterprises (“GSEs”). National bank holdings of private-label RMBS peaked at $193
billion in 2007, representing less than 9 percent of the private-label market. But even that
percentage is overstated as it relates to nonprime RMBS, because about one fourth of
10
outstanding private-label RMBS were backed by prime mortgages rather than subprime or Alt-A
mortgages.
Another form of national bank involvement with subprime loans is through mortgage
servicing. National banks service a sizeable volume of subprime mortgages. The OCC and the
Office of Thrift Supervision collect data on first-lien residential mortgages serviced by most of
the industry’s largest mortgage servicers, the loans of which make up approximately 65 percent
of all mortgages outstanding in the United States. At year-end 2009, the largest national bank
servicers combined to service approximately $378 billion in subprime first mortgage loans, yet
this represented only approximately 8 percent of the total servicing portfolio. Moreover,
servicing of loans does not drive the origination of loans, and the servicing function is distinct
from the activities and funding associated with making the loan. Once a loan is originated, it
must be serviced, regardless of whether the loan was prime or subprime.
DATA DOES NOT SUPPORT ASSERTIONS THAT CRA WAS A CAUSE OF THE CRISIS
Questions also have been raised about whether the Community Reinvestment Act
(“CRA”) was a cause of the subprime mortgage crisis. As described in more detail in Appendix
C, available data does not support that claim. The federal banking agencies have considered this
question and, based on available studies, all have concluded that the mortgage crisis cannot be
traced to the CRA responsibilities of insured depository institutions. Moreover, based on
independent studies of comprehensive home lending data sets, the volume of subprime
originations in CRA assessment areas was simply too small relative to the overall mortgage
market to be a cause of the crisis.
Of course, not all single-family CRA mortgages performed well, because these loans
have experienced the same stresses as most other types of consumer credit. But CRA-related
loans appear to perform comparably to or better than other types of subprime loans. For
11
example, a study by the Federal Reserve Bank of San Francisco concluded that loans made by a
CRA-covered lender within its assessment area were markedly less likely to enter foreclosure
than loans made in the same area by lenders not subject to CRA. A second Federal Reserve
study concluded that single-family CRA-related mortgages originated and held in portfolio under
the affordable lending programs operated across the country by partners of NeighborWorks (the
Congressionally chartered organization dedicated to neighborhood reinvestment and
rehabilitation) have, by any measure of delinquency or foreclosure, performed better than
subprime and FHA-insured loans, and they have had a lower foreclosure rate than prime loans.
CHANGES IN REGULATION AND LAWS RELATING TO ASSET-SECURITIZATION ACTIVITIES
The Commission’s letter of invitation also asked about the impact of changes in
regulations and laws over the last 25 years that have allowed commercial banking organizations
to engage in the issuance and sale of asset-backed and structured investments.
Actually, national banks (and bank holding company affiliates) have long been permitted
to sell evidences of debt, including mortgages, to third parties, and no significant change in law
or regulation was necessary for them to use asset securitizations as a means of selling interests in
pools of mortgage loans (although there were important legal interpretations that clarified this
authority). National banks engaged in the first securitization of residential mortgage loans in the
1970s pursuant to statutory language unaltered since the enactment of the National Bank Act in
1864. The same statutes permit national banks to securitize their assets today.
Appendix D provides a detailed summary of the evolution of securitization activities of
national banks and companies affiliated with banks. This evolution has been gradual and has
taken place against the backdrop of the maturing secondary market for mortgage assets. Over
the years, as securitization practices have evolved, Congress and the courts have recognized the
authority of national banks to engage directly in these activities. For example, the courts have
12
upheld, as part of the business of banking, national banks’ authority to issue and sell interests in
a pool of mortgages as a mechanism for selling loans. Congress, in provisions enacted in the
Gramm-Leach-Bliley Act (“GLBA”), expressly recognized and preserved this authority for
national banks to engage directly in asset-backed securitization activities. GLBA also repealed
key provisions of the Glass-Steagall Act to allow banks to affiliate with full service investment
banks that engage extensively in, among other securities activities, asset securitizations.
The result of this evolution in law, regulation, and legal interpretation is that banking
organizations, especially larger ones, have become full participants in securitization activities
and securitization markets. In practice, most securitizations and structured credit activities have
been conducted outside of banking subsidiaries in holding company affiliates registered as
broker-dealers and regulated by the SEC and the Federal Reserve. National banks have
continued to participate in these activities, however, in various ways, including through credit
and liquidity support facilities, as well as through derivatives activities that are often conducted
in the bank.
It is plainly true that problems in securitization markets played a key role in the crisis,
including, as described above, the negative effect that the “originate to distribute” model had on
loan underwriting practices; the severe liquidity problems caused by the seizure in
securitizations; and the spread of severe and unanticipated losses to investors around the world.
It is also true that banking organizations, as full participants in securitization markets,
participated in these securitization problems. And it is certainly true, as described below, that
securitization activities caused very substantial losses for some banking organizations, including
for some national banks.
Nevertheless, I do not think that the increasing participation by banking organizations in
securitization markets over time was a singular cause of the securitization problems described
13
above. These problems were not unique to bank participants, and indeed appear to have been
more severe for the investment banking organizations that were unaffiliated with banks, e.g.,
Merrill Lynch, Lehman Brothers, and Bear Stearns. The same was true of the incidence of large
securitization losses.
Moreover, I do not believe that restricting or curtailing bank participation in
securitization activities or bank affiliation with securities companies is the right policy or
regulatory response to securitization problems. Indeed, had GLBA not repealed key provisions
of the Glass-Steagall Act to allow such affiliations, it would have been impossible to handle the
market confidence problems associated with Bear Stearns and Merrill Lynch, where mergers
with banks restored confidence and stability, and Morgan Stanley and Goldman Sachs, where
conversions to regulated bank holding companies did the same.
Instead, I believe that other measures have been and continue to be necessary to address
abuses in securitization markets, while preserving their benefits. These include accounting and
regulatory capital changes, which have already been implemented, to address the problem of offbalance sheet assets and vehicles presenting the same risks as on-balance sheet assets. They also
include changes to credit rating agency rating methodology and required disclosures to investors.
And they include changes to the incentives to weaken loan underwriting, which I have argued
should be addressed in the case of mortgages by the government establishing across-the-board
minimum mortgage underwriting standards.
SUPERVISION OF CITIBANK AND CITIGROUP BY THE OCC AND THE FEDERAL RESERVE
Finally, the Commission asked about aspects of the supervision of Citibank and Citigroup by
the OCC and the Federal Reserve. As an initial matter, it is important to be clear, as the chart below
depicts, that the OCC’s jurisdiction extends only to the national banks within Citigroup, and the
subsidiaries of those national banks (the green boxes). The remainder of the company – including
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the holding company affiliates in the chart that are referenced in the discussion below – is subject to
the jurisdiction of the Federal Reserve, various other federal functional regulators, and state
regulators.
Citigroup Inc.
(FRB)
Citibank, N.A.
(OCC)
Operating
Subsidiaries
(OCC)
Citigroup
Financial
Products, Inc
(FRB)
Citigroup Global
Markets, Inc
(SEC)
Citigroup North
America, Inc.
(FRB)
CitiFiancial
(FRB/States)
Citibank (West),
FSB
(OTS)
Merged into Citibank,
N.A., Oct. 2006
Citigroup
Global Markets
Limited
(UKFSA)
As described in detail in Appendix E, some of Citigroup’s exposures to subprime
mortgages and securities backed by subprime mortgages arose from the bank’s direct activities.
However, a significant part of that exposure resulted from activities of holding company
affiliates that, due to extraordinary market events, caused losses in the bank.
For example, through its broker-dealer affiliate, Citigroup warehoused and packaged
subprime mortgage loans purchased from third parties (not the national bank) into collateralized
debt obligations (“CDOs”) that were funded through off-balance sheet special purpose vehicles
(“SPVs”). The national bank provided a liquidity backstop for a segment of this business by
means of a “liquidity put.” If a liquidity event caused investors in short-term commercial paper
issued by the CDO/SPV to refuse to renew their investments at maturity, and no replacement
investors could be found, the liquidity put required the bank to step in with replacement funding.
Management viewed the likelihood of such an event as extremely remote. However, long before
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credit deterioration in the CDOs was officially evidenced through credit rating agency
downgrades, the subprime mortgage market meltdown triggered just such a liquidity event as
commercial paper investors chose not to roll commercial paper funding. As a result of the
liquidity put, and as explained in Appendix E, the bank ultimately assumed a significant amount
of “super-senior” credit exposure to CDOs backed ultimately by subprime mortgages. Even
though such exposures had received the very highest credit agency ratings, they were
subsequently downgraded and produced very large mark-to-market losses.
Citibank also assumed synthetic subprime CDO exposure through its London office.
This synthetic exposure was created using credit derivatives on either asset-backed securities or
related indices that were based on RMBS. When a structured synthetic CDO was packaged, the
highest risk tranches were sold, and the bank retained the super senior position. As with the
super-senior exposure to cash CDOs from the liquidity puts, the super senior exposures from the
synthetic CDOs ultimately produced substantial losses.
Additional subprime mortgage losses resulted from a major corporate restructuring
completed in October 2006. In this action, Citigroup reduced the number of insured depository
institutions from twelve to five as it consolidated approximately $200 billion of assets into
Citibank. Approximately 10 percent of this total consisted of subprime mortgages originated
primarily by Citigroup’s consumer finance company, CitiFinancial. Many of these mortgages
were originated in 2005 and 2006, when underwriting standards were weakest, and Citibank has
taken large losses and made substantial loan loss provisions as a result. Subprime mortgages
subsequently issued by Citibank in 2007 have also produced losses.
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Despite these losses, and other significant losses arising from other lending activities,
Citibank and the other national banks owned by Citigroup have repeatedly performed as well or
better than the remainder of the corporate family, as indicated in the chart below.
Net Income $B
National Banks
Non-Banks
2006
$13.1
$8.5
2007
$5.1
-$1.5
2008
- $6.3
-$21.4
2009
-$3.0
$1.4
The national banks reported a net income of $5.1 billion in 2007, and a loss of $6.3 billion in
2008, compared to losses of $1.5 billion in 2007 and $21.4 billion in 2008 for Citigroup,
excluding its national bank subsidiaries. As a result of its performance, as well as its better
funding base, Citibank has consistently maintained a stronger position than Citigroup as a whole.
LESSONS FOR THE FUTURE
There are many lessons to be learned from the crisis to prevent a recurrence of similar
events in the future. Financial reform legislation and changes to regulation and supervisory
practices, both here and in countries around the world, are intended to do just that, with many
sweeping changes proposed in such areas as capital and liquidity requirements, consumer
protection, derivatives regulation, resolution regimes for systemically important companies,
systemic risk regulation, loan loss provisioning practices, and many others. I have previously
testified on these issues in the context of U.S. financial reform, and strongly support moving
forward with legislative and regulatory changes.
In the context of the particular questions raised by the Commission for this hearing on
mortgage lending, securitization, and the problems at Citigroup, let me close with several
thoughts on lessons learned and proposed changes to address them.
First, we need to do more to ensure strong minimum underwriting standards for
residential mortgages that are applied across the board to all mortgage originators. I support the
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current proposals to empower a federal agency to write strong consumer protection rules that
apply uniformly to all providers of financial products and services. But these proposals do not
address minimum mortgage underwriting standards, which is a core safety and soundness
function for prudential regulators (although it certainly has a bearing on consumer protection as
well). I believe the bank regulators, the regulator of government sponsored enterprises, and the
Federal Housing Administration should coordinate the adoption of minimum, common sense
rules in such areas as required income and financial asset verification, real cash down payments
and limits on home equity extraction, and the qualification of borrowers for “teaser rate” loans.
In so doing, it is critical that the new rules apply effectively to all mortgage originators and
purchasers of mortgages, not just those subject to federal regulation.
Second, steps need to be taken to address differential regulation both among banking
regulators and, critically, between regulated sectors and the “shadow financial system” of
unregulated sectors. In the area of mortgages, for example, it should not be the case that
regulation should differ substantially depending on whether activities are conducted in a bank,
where they are most regulated today; in a holding company affiliate, where they are less
regulated; or in a mortgage lender or broker unaffiliated with a bank, where they are virtually
unregulated. Current proposals to consolidate bank and thrift regulation would help, as would
the proposal in the current Senate legislation to ensure unified regulation and supervision of
banking activities in a bank holding company, regardless of whether the activities are conducted
in the bank or a holding company affiliate of the bank. But we have still not solved the problem
of effectively extending comparable standards and supervision to such shadow banking entities
as nonbank mortgage lenders and brokers. These unregulated originators simply cannot be
allowed to “end run” federal standards to put pressure on regulated lenders to follow suit, which
was the very dynamic that caused so much damage during the crisis.
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Third, important steps have been taken and need to be taken in the area of securitization.
Accounting and regulatory capital standards have already been changed to address the problem
off-balance sheet securitization vehicles that never should have been treated as off-balance sheet.
Consensus proposals are moving forward, worldwide, to increase required capital for securitized
assets, especially re-securitized assets such as CDOs, and to prevent banking organizations from
over-relying on credit rating agency ratings in managing the risk of these exposures. The
Securities and Exchange Commission will soon propose enhanced disclosure rules for assetbacked securities that will allow investors to do more due diligence on the credit quality of
underlying assets, instead of relying exclusively on credit ratings. Other proposals are also
moving forward on mandatory risk retention for securitizers, often referred to as “skin in the
game” requirements, to improve the incentives for purchasers of loans to insist that the loans are
well underwritten. While I support the goal of these skin-in-the-game proposals, which is to
improve underwriting quality, there are legitimate concerns with unintended accounting
consequences that could make it considerably more difficult to securitize assets subject to such
rules. If these concerns cannot be addressed, then I have argued that, at least in the area of
mortgages, a better approach to improving underwriting quality would be for the government to
directly establish minimum underwriting standards, as discussed above.
Fourth, banking and financial organizations need to substantially improve their ability to
aggregate and manage similar risk exposures that take different forms in different parts of their
businesses. The crisis showed that risk concentrations can accumulate across product, business
lines, and legal entities within a firm, and that complex products containing the same types of
risks under different labels can obfuscate aggregate exposures. It also revealed weaknesses in
banking companies’ risk identification systems, which failed to capture and aggregate these
risks, and in their risk measurement models, which relied on historical correlations that did not
19
adequately address the risks presented by new forms of structured securities. Banking
companies, and their regulators, also failed to appreciate the ramifications of different lending
standards and risk tolerances in different segments of large companies, and how banks could end
up bearing risks that they would not otherwise directly accept. For example, the losses on
subprime CDOs proved in several cases to be a surprise to management that had consciously
reduced exposure to direct subprime lending risk. In light of this issue, the OCC, working with
other federal regulators, has directed bank management to take a number of steps to significantly
upgrade reporting systems and risk management to address this risk aggregation issue.
*
*
*
I appreciate this opportunity to appear before the Commission, and would be pleased to
answer questions.
20
LIST OF APPENDICIES
APPENDIX A: Federal Preemption of State and Local Fair Lending and
Mortgage Lending Laws
APPENDIX B: Activities of National Banks Related to Subprime Lending
APPENDIX C: Impact of the Community Reinvestment Act on Losses
Incurred by National Banks
APPENDIX D: Changes in Laws and Regulations Impacting National Banks
Engaging in the Issuance and Sale of Asset-Backed and
Structured Investments
APPENDIX E: OCC Supervision of Citibank, N.A.
21
APPENDIX A: FEDERAL PREEMPTION OF STATE AND LOCAL FAIR LENDING
AND MORTGAGE LENDING LAWS
I. Background of National Bank Preemption
Since its establishment in 1863 and 1864, the national banking system, operating under
uniform federal standards across state lines, has fostered an open financial marketplace, the
growth of national products and services in national and multi-state markets, sound operating
practices and efficient product delivery to bank customers. At the core of the national banking
system is the principle that national banks, in carrying on the business of banking under a
Federal authorization, should be subject to uniform national standards and uniform federal
supervision. 1 The legal principle that produces such a result is the “preemption” of state law.
In the years following the National Bank Act’s enactment, the Supreme Court recognized
the clear intent on the part of Congress to limit the authority of states over national banks
precisely so that the nationwide system of banking that was created in the National Bank Act
could develop and flourish. This point was highlighted by the Supreme Court in 1903 in Easton
v. Iowa. 2 The Court stressed that the application of multiple states’ standards would undermine
the uniform, national character of the powers of national banks, which operate in–
a system extending throughout the country, and independent, so far as powers conferred
are concerned, of state legislation which, if permitted to be applicable, might impose
limitations and restrictions as various and as numerous as the states…. If [ the states ] had
such power it would have to be exercised and limited by their own discretion, and
confusion would necessarily result from control possessed and exercised by two
independent authorities. 3
The Supreme Court strongly reaffirmed this point in 2007 in Watters v. Wachovia, 4
stating:
Diverse and duplicative superintendence [by the states] of national banks’ engagement in
the business of banking, we observed over a century ago, is precisely what the [ National
Bank Act ] was designed to prevent. 5
The Supreme Court and lower Federal courts have repeatedly made clear that state laws
that conflict, impede, or interfere with national banks’ powers and activities are preempted. For
1
In discussing the impact of the National Currency Act and National Bank Act, Senator Sumner stated that,
“[c]learly, the [national] bank must not be subjected to any local government, State or municipal; it must be kept
absolutely and exclusively under that Government from which it derives its functions.” Cong. Globe, 38th Cong., 1st
Sess., at 1893 (April 27, 1864).
2
188 U.S. 220 (1903).
3
Id. at 229, 230-31. A similar point was made by the Court in Talbott v. Bd. of County Commissioners of
Silver Bow County, in which the court stressed that the entire body of the Statute respecting national banks,
emphasize that which the character of the system implies - an intent to create a national banking system co-extensive
with the territorial limits of the United States, and with uniform operation within those limits. 139 U.S. 438, 443
(1891).
4
550 U.S. 1 (2007).
5
Id. at 14.
Appendix A
Page 2
example, in Davis v. Elmira Savings Bank, 6 the Supreme Court stated: “National banks are
instrumentalities of the Federal Government, … It follows that an attempt, by a state, to define
their duties or control the conduct of their affairs, is absolutely void.” In Franklin National Bank
v. New York, 7 the Supreme Court held that a state could not prohibit a national bank from using
the word “savings” in its advertising, since the state law conflicts with the power of national
banks to accept savings deposits. More recently, in Barnett Bank v. Nelson, 8 the Supreme Court
affirmed the preemptive effect of Federal banking law under the Supremacy Clause and held that
a state statute prohibiting banks from engaging in most insurance agency activities was
preempted by Federal law that permitted national banks to engage in insurance agency activities.
In reaching its conclusion, the Court explained that the history of the National Bank Act “is one
of interpreting grants of both enumerated and incidental ‘powers’ to national banks as grants of
authority not normally limited by, but rather ordinarily pre-empting, contrary state law.”
However, the Supreme Court also has recognized that many types of state commercial
and infrastructure laws do apply to national banks. The Supreme Court, only five years after the
enactment of the National Bank Act, recognized that national banks may be subject to some state
laws in the normal course of business if there is no conflict with Federal law. 9 In holding that
national banks’ contracts, their acquisition and transfer of property, their right to collect their
debts, and their liability to be sued for debts, are based on state law, the Court noted that national
banks “are subject to the laws of the State, and are governed in their daily course of business far
more by the laws of the State than of the nation.” 10 The OCC does not dispute this basic
proposition.
The courts have continued to recognize that national banks are subject to state laws,
unless those laws infringe upon the national banking laws or impose an undue burden on the
performance of the banks’ federally authorized activities. In McClellan v. Chipman, 11 the
Supreme Court held that the application to national banks of a state statute forbidding certain real
estate transfers by insolvent transferees was not preempted as the statute would not impede or
hamper national banks’ functions. In Wichita Royalty Co. v. City Nat. Bank of Wichita Falls, 12
the Court upheld the application of state tort law to a claim by a bank depositor against bank
directors. And in Anderson Nat. Bank v. Luckett, 13 the Supreme Court held that a state statute
administering abandoned deposit accounts did not unlawfully encroach on the rights and
privileges of national banks and, as a result, was not preempted.
As these cases demonstrate, there are numerous state laws to which national banks
remain subject because the laws do not significantly impede or interfere with powers granted
national banks under federal law. Yet, in reaching this conclusion, these cases serve to confirm
the fundamental principle of federal preemption as applied to national banks: that is, that the
6
161 U.S. 275, 283 (1896).
347 U.S. 373 (1954).
8
517 U.S. 25, 32 (1996).
9
National Bank v. Commonwealth, 76 U.S. (9 Wall.) 353 (1869).
10
Id. at 362 (1869).
11
164 U.S. 347 (1896).
12
306 U.S. 103 (1939).
13
321 U.S. 233 (1944).
7
Appendix A
Page 3
banking business of national banks is governed by federal standards. These uniform national
standards and the federal supervision under which national banks operate are the defining
attributes of the national bank component of our dual banking system.
II.
State Fair Lending Laws
The OCC does not take the position that state laws prohibiting discrimination in lending
(e.g., laws that prohibit lenders from discriminating on the basis of race, religion, ethnicity,
gender, sexual orientation, disability, or the like) are preempted. This position was explained in
a letter dated March 9, 2004, from then-Comptroller John D. Hawke, Jr., to the Honorable
Barney Frank. 14 Reflecting this, the OCC did not challenge the applicability to national banks of
the New York state fair lending law underlying the Supreme Court’s decision in Cuomo v.
Clearing House Ass’n, L.L.C. 15
In Cuomo, the OCC acknowledged that the state fair lending law was not preempted but
challenged the state attorney general’s authority to enforce it against national banks on the
grounds that the National Bank Act 16 prohibits the exercise of visitorial authority except by the
OCC or under other circumstances authorized by federal law. 17 The Supreme Court held that a
State attorney general could enforce non-preempted State law by bringing an action in court to
enforce the non-preempted state law, but that the type of administrative investigation initiated by
the state attorney general in this case was precluded by the National Bank Act.
There may be some misunderstanding of the OCC’s position with regard to state fair
lending laws, because some state laws imposing restrictions on mortgage lending terms have
“fair lending” in their titles, but do not actually address unlawful discrimination in lending. For
example, the Georgia Fair Lending Act (“GFLA”) 18 does not address lending discrimination but
rather prohibits certain mortgage loan products and terms and imposes special restrictions when
other loan terms or conditions are set. For this reason, the OCC concluded that various
provisions of the GFLA were preempted. 19
III.
State Mortgage Lending Laws
The OCC’s preemption rule issued in 2004 identifies and lists categories of state laws
that ordinarily are, and are not, preempted. 20 The lists were drawn from existing case law and
14
OCC Interpretive Letter No. 998 (March 9, 2004).
129 S. Ct. 2710 (June 29, 2009).
16
12 U.S.C. § 484.
17
The Cuomo case concerned the OCC’s visitorial powers rule rather than the OCC’s preemption rule. As
we explained in our brief, the visitorial powers “regulation does not declare the preemptive scope of the [ National
Bank Act], but identifies the circumstances under which state officials may act to enforce non-preempted state-law
provisions.” Brief for the Federal Respondent at 9 (filed March 25, 2009) (emphasis added).
18
Ga. Code. Ann. §§ 7-6A-1 et seq.
19
68 Fed. Reg. 46264 (Aug. 5. 2003).
20
69 Fed. Reg. 1904 (Jan. 13, 2004)(amending the OCC’s real estate lending rules at 12 C.F.R. Part 34). In
addition to real estate lending, the preemption rule also addressed deposit-taking, non-real estate lending, and,
generally, activities authorized to national banks by Federal law. Id.
15
Appendix A
Page 4
interpretations and are based on the preemption standards summarized in Barnett and developed
by the Supreme Court.
The rule affects state law restrictions on mortgage lending terms and conditions in several
respects. Examples of preempted laws include laws that restrict or prescribe the terms of credit,
amortization schedules, permissible security property, permissible rates of interest, escrow
accounts, disclosure and advertising, and laws that require a state license as a condition of
national banks’ ability to make loans. 21
On the other hand, the regulation also gives examples of the types of state laws that are
not preempted and would be applicable to national banks to the extent that they only incidentally
affect the real estate lending, other lending, deposit-taking, or other operations of national banks.
These include laws on contracts, rights to collect debts, acquisition and transfer of property,
taxation, zoning, crimes, and torts. In addition, any other law that the OCC determines to only
incidentally affect national banks' lending, deposit-taking, or other operations would not be
preempted under the preemption rule.
The OCC also included in the preemption rule two new provisions to ensure that the
federal standards under which national banks operate directly address abusive or predatory
lending practices. First, the preemption rule prohibits national banks from making a real estate
loan (or other consumer loan) based predominantly on the foreclosure or liquidation value of a
borrower’s collateral, rather than on the borrower’s ability to repay the loan according to its
terms. This underwriting standard applies uniformly to all consumer lending activities of
national banks, regardless of the location from which the bank conducts those activities or where
their customers live. It is comprehensive, it is nationwide, and it targets lending practices, such
as relying on future house price appreciation as the primary source of repayment that contributed
significantly to the mortgage meltdown that sparked the financial crisis.
Second, the preemption rule provides that national banks shall not engage in unfair and
deceptive practices within the meaning of Section 5 of the Federal Trade Commission Act in
connection with any type of lending. Section 5 prohibits “unfair or deceptive acts or practices”
in interstate commerce. This addition to our rule is particularly appropriate in light of the fact
that the OCC pioneered the use of Section 5 as a basis for enforcement actions against banks that
have engaged in such conduct. 22
21
In Watters v. Wachovia Bank, N.A., 550 U.S. 1 (2007), the Supreme Court noted that the state licensing
and registration requirements at issue in that case expressly exempted national banks from their application. As the
Supreme Court explained, that exemption for national banks was “not simply a matter of the [state] legislature’s
grace. . . . For, as the parties recognize, the [National Bank Act] would have preemptive force, i.e., it would spare a
national bank from state controls of the kind here involved.”
22
The OCC’s pioneering commitment to using the FTC Act to address consumer abuses is demonstrated by
a number of actions against national banks that have resulted in the payment of hundreds of millions of dollars in
restitution to consumers. For example, in 2000, the OCC required Providian National Bank to set aside not less than
$300 million for restitution to affected consumers; in 2005, the OCC required The Laredo National Bank and its
subsidiary, Homeowners Loan Corporation, to set aside at least $14 million for restitution to affected customers; and
in 2008, the OCC required Wachovia Bank, N.A., to set aside $125 million for restitution to affected consumers.
LISTING OF ATTACHMENTS TO APPENDIX A
69 Fed. Reg. 1904 (Jan. 13, 2004) (amending the OCC’s real estate lending rules at 12 C.F.R. Part
34 to clarify the extent to which state laws in general apply to national banks’ real-estate lending
activities).
Remarks by John C. Dugan, Comptroller of the Currency, before the Women in Housing and
Finance (“The Need to Preserve Uniform National Standards for National Banks”), Washington,
DC (September 24, 2009).
OCC White Paper, “The Importance of Preserving A System of National Standards For National
Banks” (October 2009).
1904
Federal Register / Vol. 69, No. 8 / Tuesday, January 13, 2004 / Rules and Regulations
shareholders and creditors of a national
bank);
(ii) Review, at reasonable times and
upon reasonable notice to a bank, the
bank’s records solely to ensure
compliance with applicable state
unclaimed property or escheat laws
upon reasonable cause to believe that
the bank has failed to comply with those
laws (12 U.S.C. 484(b));
(iii) Verify payroll records for
unemployment compensation purposes
(26 U.S.C. 3305(c));
(iv) Ascertain the correctness of
Federal tax returns (26 U.S.C. 7602);
(v) Enforce the Fair Labor Standards
Act (29 U.S.C. 211); and
(vi) Functionally regulate certain
activities, as provided under the
List of Subjects in 12 CFR Part 7
Gramm-Leach-Bliley Act, Pub. L. 106–
102, 113 Stat. 1338 (Nov. 12, 1999).
Credit, Insurance, Investments,
(2) Exception for courts of justice.
National banks, Reporting and
recordkeeping requirements, Securities, National banks are subject to such
visitorial powers as are vested in the
Surety bonds.
courts of justice. This exception pertains
Authority and Issuance
to the powers inherent in the judiciary
and does not grant state or other
■ For the reasons set forth in the
governmental authorities any right to
preamble, the OCC amends part 7 of
chapter I of title 12 of the Code of Federal inspect, superintend, direct, regulate or
compel compliance by a national bank
Regulations as follows:
with respect to any law, regarding the
content or conduct of activities
PART 7—BANK ACTIVITIES AND
authorized for national banks under
OPERATIONS
Federal law.
■ 1. The authority citation for part 7
(3) Exception for Congress. National
continues to read as follows:
banks are subject to such visitorial
Authority: 12 U.S.C. 1 et seq., 71, 71a, 92,
powers as shall be, or have been,
92a, 93, 93a, 481, 484, 1818.
exercised or directed by Congress or by
either House thereof or by any
Subpart D—Preemption
committee of Congress or of either
House duly authorized.
■ 2. In § 7.4000:
*
*
*
*
*
■ a. Add a new paragraph (a)(3); and
■ b. Revise paragraph (b) to read as
John D. Hawke, Jr.,
follows:
enforce/enf_search.htm. Indeed, as
recently observed by the Superior Court
of Arizona, Maricopa County, in an
action brought by Arizona against a
national bank, among others, the
restitution and remedial action ordered
by the OCC in that matter against the
bank was ‘‘comprehensive and
significantly broader in scope than that
available through [the] state court
proceedings.’’ State of Arizona v.
Hispanic Air Conditioning and Heating,
Inc., CV 2000–003625, Ruling at 27,
Conclusions of Law, paragraph 50 (Aug.
25, 2003). Thus, the OCC has ample
legal authority and resources to ensure
that consumers are adequately
protected.
§ 7.4000
Comptroller of the Currency.
[FR Doc. 04–585 Filed 1–12–04; 8:45 am]
Visitorial powers.
(a) * * *
(3) Unless otherwise provided by
Federal law, the OCC has exclusive
visitorial authority with respect to the
content and conduct of activities
authorized for national banks under
Federal law.
(b) Exceptions to the general rule.
Under 12 U.S.C. 484, the OCC’s
exclusive visitorial powers are subject to
the following exceptions:
(1) Exceptions authorized by Federal
law. National banks are subject to such
visitorial powers as are provided by
Federal law. Examples of laws vesting
visitorial power in other governmental
entities include laws authorizing state
or other Federal officials to:
(i) Inspect the list of shareholders,
provided that the official is authorized
to assess taxes under state authority (12
U.S.C. 62; this section also authorizes
inspection of the shareholder list by
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17:11 Jan 12, 2004
Jkt 203001
BILLING CODE 4810–33–P
DEPARTMENT OF THE TREASURY
Office of the Comptroller of the
Currency
12 CFR Parts 7 and 34
[Docket No. 04–04]
RIN 1557–AC73
Bank Activities and Operations; Real
Estate Lending and Appraisals
AGENCY: Office of the Comptroller of the
Currency, Treasury.
ACTION: Final rule.
SUMMARY: The Office of the Comptroller
of the Currency (OCC) is publishing a
final rule amending parts 7 and 34 of
our regulations to add provisions
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Sfmt 4700
clarifying the applicability of state law
to national banks’ operations. The
provisions concerning preemption
identify types of state laws that are
preempted, as well as the types of state
laws that generally are not preempted,
with respect to national banks’ lending,
deposit-taking, and other operations. In
tandem with these preemption
provisions, we are also adopting
supplemental anti-predatory lending
standards governing national banks’
lending activities.
EFFECTIVE DATE: February 12, 2004.
FOR FURTHER INFORMATION CONTACT: For
questions concerning the final rule,
contact Michele Meyer, Counsel, or
Mark Tenhundfeld, Assistant Director,
Legislative and Regulatory Activities
Division, (202) 874–5090.
SUPPLEMENTARY INFORMATION:
I. Introduction
The OCC is adopting this final rule to
specify the types of state laws that do
not apply to national banks’ lending and
deposit taking activities and the types of
state laws that generally do apply to
national banks. Other state laws not
specifically listed in this final rule also
would be preempted under principles of
preemption developed by the U.S.
Supreme Court, if they obstruct, impair,
or condition a national bank’s exercise
of its lending, deposit-taking, or other
powers granted to it under Federal law.
This final rule also contains a new
provision prohibiting the making of any
type of consumer loan based
predominantly on the bank’s realization
of the foreclosure value of the
borrower’s collateral, without regard to
the borrower’s ability to repay the loan
according to its terms. (A consumer loan
for this purpose is a loan made for
personal, family, or household
purposes). This anti-predatory lending
standard applies uniformly to all
consumer lending activities conducted
by national banks, wherever located. A
second anti-predatory lending standard
in the final rule further specifically
prohibits national banks from engaging
in practices that are unfair and
deceptive under the Federal Trade
Commission Act (FTC Act) 1 and
regulations issued thereunder, in
connection with all types of lending.
The provisions concerning
preemption of state laws are contained
in 12 CFR part 34, which governs
national banks’ real estate lending, and
in three new sections to part 7 added by
this final rule: § 7.4007 regarding
deposit-taking activities; § 7.4008
regarding non-real estate lending
1 15
E:\FR\FM\13JAR1.SGM
U.S.C. 45(a)(1).
13JAR1
Federal Register / Vol. 69, No. 8 / Tuesday, January 13, 2004 / Rules and Regulations
activities; and § 7.4009 regarding the
other Federally-authorized activities of
national banks. The first anti-predatory
lending standard appears both in part
34, where it applies with respect to real
estate consumer lending, and in part 7,
with respect to other consumer lending.
The provision prohibiting a national
bank from engaging in unfair or
deceptive practices within the meaning
of section 5 of the FTC Act and
regulations promulgated thereunder 2
similarly appears in both parts 34 and
7.
II. Description of Proposal
On August 5, 2003, the OCC
published a notice of proposed
rulemaking (NPRM or proposal) in the
Federal Register (68 FR 46119) to
amend parts 7 and 34 of our regulations
to add provisions clarifying the
applicability of state law to national
banks. These provisions identified the
types of state laws that are preempted,
as well as the types of state laws that
generally are not preempted, in the
context of national bank lending,
deposit-taking, and other Federallyauthorized activities.
A. Proposed Revisions to Part 34—Real
Estate Lending
Part 34 of our regulations implements
12 U.S.C. 371, which authorizes
national banks to engage in real estate
lending subject to ‘‘such restrictions and
requirements as the Comptroller of the
Currency may prescribe by regulation or
order.’’ Prior to the adoption of this final
rule, subpart A of part 34 explicitly
preempted state laws concerning five
enumerated areas with respect to
national banks and their operating
subsidiaries.3 Those are state laws
concerning the loan to value ratio; the
schedule for the repayment of principal
and interest; the term to maturity of the
loan; the aggregate amount of funds that
may be loaned upon the security of real
estate; and the covenants and
restrictions that must be contained in a
lease to qualify the leasehold as
acceptable security for a real estate loan.
Section 34.4(b) stated that the OCC
would apply recognized principles of
Federal preemption in considering
whether state laws apply to other
aspects of real estate lending by national
banks.
Pursuant to our authority under 12
U.S.C. 93a and 371, we proposed to
amend § 34.4(a) and (b) to provide a
more extensive enumeration of the types
of state law restrictions and
requirements that do, and do not, apply
2 12
CFR part 227.
12 CFR 34.1(b) and 34.4(a).
3 Prior
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17:11 Jan 12, 2004
Jkt 203001
to the real estate lending activities of
national banks. To the five types of state
laws already listed in the regulations,
proposed § 34.4(a) added a fuller, but
non-exhaustive, list of the types of state
laws that are preempted, many of which
have already been found to be
preempted by the Federal courts or OCC
opinions. As also explained in the
preamble to the NPRM, consistent with
the applicable Federal judicial
precedent, other types of state laws that
wholly or partially obstruct the ability
of national banks to fully exercise their
real estate lending powers might be
identified and, if so, preemption of
those laws would be addressed by the
OCC on a case-by-case basis.
We also noted in the preamble that
the nature and scope of the statutory
authority to set ‘‘requirements and
restrictions’’ on national banks’ real
estate lending may enable the OCC to
‘‘occupy the field’’ of the regulation of
those activities. We invited comment on
whether our regulations, like those of
the Office of Thrift Supervision (OTS),4
should state explicitly that Federal law
occupies the field of real estate lending.
We noted that such an occupation of the
field necessarily would be applied in a
manner consistent with other Federal
laws, such as the Truth-in-Lending Act
(TILA) 5 and the Equal Credit
Opportunity Act (ECOA).6
Under proposed § 34.4(b), certain
types of state laws are not preempted
and would apply to national banks to
the extent that they do not significantly
affect the real estate lending operations
of national banks or are otherwise
consistent with national banks’ Federal
authority to engage in real estate
lending.7 These types of laws generally
pertain to contracts, collection of debts,
acquisition and transfer of property,
taxation, zoning, crimes, torts, and
homestead rights. In addition, any other
law that the OCC determines to interfere
to only an insignificant extent with
national banks’ lending authority or is
otherwise consistent with national
banks’ authority to engage in real estate
lending would not be preempted.
The proposal retained the general rule
stated in § 34.3 that national banks may
‘‘make, arrange, purchase, or sell loans
or extensions of credit, or interests
CFR 560.2.
U.S.C. 1601 et seq.
6 15 U.S.C. 1691 et seq.
7 Federal law may explicitly resolve the question
of whether state laws apply to the activities of
national banks. There are instances where Federal
law specifically incorporates state law standards,
such as the fiduciary powers statute at 12 U.S.C.
92a(a). The language used in this final rule
‘‘[e]xcept where made applicable by Federal law’’
refers to this type of situation.
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5 15
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Sfmt 4700
1905
therein, that are secured by liens on, or
interests in, real estate, subject to terms,
conditions, and limitations prescribed
by the Comptroller of the Currency by
regulation or order.’’ That provision was
unchanged, other than by designating it
as paragraph (a).
The proposal added a new paragraph
(b), prescribing an explicit, safety and
soundness-based anti-predatory lending
standard to the general statement of
authority concerning lending. Proposed
§ 34.3(b) prohibited a national bank
from making a loan subject to 12 CFR
part 34 based predominantly on the
foreclosure value of the borrower’s
collateral, rather than on the borrower’s
repayment ability, including current
and expected income, current
obligations, employment status, and
other relevant financial resources.
This standard augments the other
standards that already apply to national
bank real estate lending under Federal
laws. These other standards include
those contained in the OCC’s Advisory
Letters on predatory lending; 8 section 5
of the FTC Act,9 which makes unlawful
‘‘unfair or deceptive acts or practices’’
in interstate commerce; and many other
Federal laws that impose standards on
lending practices.10 The NPRM invited
commenters to suggest other antipredatory lending standards that would
be appropriate to apply to national bank
real estate lending activities.
As a matter of Federal law, national
bank operating subsidiaries conduct
their activities subject to the same terms
and conditions as apply to the parent
banks, except where Federal law
provides otherwise. See 12 CFR
5.34(e)(3) and 7.4006. See also 12 CFR
34.1(b) (real estate lending activities
specifically). Thus, by virtue of
regulations in existence prior to the
proposal, the proposed changes to part
34, including the new anti-predatory
lending standard, applied to both
national banks and their operating
subsidiaries.
8 See OCC Advisory Letter 2003–2, ‘‘Guidelines
for National Banks to Guard Against Predatory and
Abusive Lending Practices’’ (Feb. 21, 2003) and
OCC Advisory Letter 2003–3, ‘‘Avoiding Predatory
and Abusive Lending Practices in Brokered and
Purchased Loans’’ (Feb. 21, 2003). These documents
are available on the OCC’s Web site at http://
www.occ.treas.gov/advlst03.htm.
9 15 U.S.C. 45(a)(1).
10 There is an existing network of Federal laws
applicable to national banks that protect consumers
in a variety of ways. In addition to TILA and ECOA,
national banks are also subject to the standards
contained in the Real Estate Settlement Procedures
Act, 12 U.S.C. 2601 et seq., the Fair Housing Act,
42 U.S.C. 3601 et seq., the Home Mortgage
Disclosure Act, 12 U.S.C. 2801 et seq., the Fair
Credit Reporting Act, 15 U.S.C. 1681 et seq., the
Truth in Savings Act, 12 U.S.C. 4301 et seq., the
Consumer Leasing Act, 15 U.S.C. 1667, and the Fair
Debt Collection Practices Act, 15 U.S.C. 1692 et seq.
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B. Proposed Amendments to Part 7—
Deposit-Taking, Other Lending, and
Bank Operations
The proposal also added three new
sections to part 7: § 7.4007 regarding
deposit-taking activities, § 7.4008
regarding non-real estate lending
activities, and § 7.4009 regarding other
national bank operations. The structure
of the proposed amendments was the
same for §§ 7.4007 and 7.4008 and was
similar for § 7.4009. For §§ 7.4007 and
7.4008, the proposal first set out a
statement of the authority to engage in
the activity. Second, the proposal stated
that state laws that obstruct, in whole or
in part, a national bank’s exercise of the
Federally-authorized power in question
are not applicable, and listed several
types of state laws that are preempted.
As with the list of preempted state laws
set forth in the proposed amendments to
part 34, this list reflects judicial
precedents and OCC interpretations
concerning the types of state laws that
can obstruct the exercise of national
banks’ deposit-taking and non-real
estate lending powers. Finally, the
proposal listed several types of state
laws that, as a general matter, are not
preempted.
As with the proposed amendments to
part 34, the proposed amendment to
part 7 governing non-real estate lending
included a safety and soundness-based
anti-predatory lending standard. As
proposed, § 7.4008(b) stated that a
national bank shall not make a loan
described in § 7.4008 based
predominantly on the foreclosure value
of the borrower’s collateral, rather than
on the borrower’s repayment ability,
including current and expected income,
current obligations, employment status,
and other relevant financial resources.
The preamble to the NPRM pointed out
that non-real estate lending also is
subject to section 5 of the FTC Act.
For proposed § 7.4009, as with
proposed §§ 7.4007 and 7.4008, the
NPRM first stated that a national bank
could exercise all powers authorized to
it under Federal law. To address
questions about the extent to which
state law may permissibly govern
powers or activities that have not been
addressed by Federal court precedents
or OCC opinions or orders, proposed
new § 7.4009(b) provided that state laws
do not apply to national banks if they
obstruct, in whole or in part, a national
bank’s exercise of powers granted to it
under Federal law. Next, proposed
§ 7.4009(c) noted that the provisions of
this section apply to any national bank
power or aspect of a national bank’s
operation that is not otherwise covered
by another OCC regulation that
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specifically addresses the applicability
of state law. Finally, the proposal listed
several types of state laws that, as a
general matter, are not preempted.
As with the proposed changes to part
34, and for the same reasons, the
proposal’s changes to part 7 would be
applicable to both national banks and
their operating subsidiaries by virtue of
an existing OCC regulation.
III. Overview of Comments
The OCC received approximately
2,600 comments, most of which came
from the following groups:
Realtors. The vast majority—
approximately 85%—of the opposing
comments came from realtors and others
representing the real estate industry,
who expressed identical concerns about
the possibility that national banks’
financial subsidiaries would be
permitted to engage in real estate
brokerage activities 11 and that, if that
power were authorized, the proposal
would permit them to do so without
complying with state real estate
brokerage licensing laws. This final rule
will not have that result because it does
not apply to the activities of national
bank financial subsidiaries. Thus,
should the Department of the Treasury
(Treasury) and the Board of Governors
of the Federal Reserve System (Board)
proposal to permit financial subsidiaries
and financial holding companies to
engage in real estate brokerage activities
go forward, this final rule would not
affect the application of state real estate
licensing requirements to national bank
financial subsidiaries.
Many realtor comments also raised
arguments concerning the impact of this
rulemaking on consumers and market
competition and some argued that
preemption of state licensing
requirements related to real estate
lending is inappropriate on the basis of
field or conflict preemption. These
issues also were raised by other
commenters and are addressed in
sections IV and VI of this preamble.
Community and consumer advocates.
In addition to the comments from
realtors, the OCC received opposing
comments from community and
consumer advocates. These commenters
argued that the OCC should not adopt
further regulations preempting state law
and, in particular, should not adopt in
11 Pursuant to procedures established by the
Gramm-Leach-Bliley Act, Pub. L. 106–102, 113 Stat.
1338 (Nov. 12, 1999), for determining that an
activity is ‘‘financial in nature,’’ and thus
permissible for financial holding companies and
financial subsidiaries, the Board and Treasury
jointly published a proposal to determine that real
estate brokerage is ‘‘financial in nature.’’ See 66 FR
307 (Jan. 3, 2001). No final action has been taken
on the proposal.
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the final rule an ‘‘occupation of the
field’’ preemption standard for national
banks’ real estate lending activities. The
community and consumer advocates
also asserted that the proposed
‘‘obstruct, in whole or in part’’
preemption standard is inconsistent
with, and a lowering of, the preemption
standards articulated by the U.S.
Supreme Court. Whatever the standard,
the community and consumer advocates
expressed concern that preemption
would allow national banks to escape
some state tort, contract, debt collection,
zoning, property transfer, and criminal
laws, and would expose consumers to
wide-spread predatory and abusive
practices by national banks. These
commenters asserted that the OCC’s
proposed anti-predatory lending
standard is insufficient and urged the
OCC to further strengthen consumer
protections in parts 7 and 34, including
prohibiting specific practices
characterized as unfair or deceptive.
These issues are addressed in sections
IV and VI of this preamble.
State officials and members of
Congress. State banking regulators, the
Conference of State Bank Supervisors
(CSBS), the National Conference of State
Legislators, individual state legislators,
the National Association of Attorneys
General (NAAG), and individual state
attorneys general questioned the legal
basis of the proposal and argued that the
OCC lacks authority to adopt it. These
commenters, like the community and
consumer advocates, also challenged the
OCC’s authority to adopt in the final
rule either a ‘‘field occupation’’
preemption standard or the proposed
‘‘obstruct, in whole or in part’’ standard.
These commenters raised concerns
about the effect of the proposal, if
adopted, on the dual banking system,
and its impact on what they assert is the
states’ authority to apply and enforce
consumer protection laws against
national banks, and particularly against
operating subsidiaries. Several members
of Congress submitted comments, or
forwarded letters from constituents and
state officials, that echoed these
concerns. The arguments concerning the
dual banking system are addressed in
the discussion of Executive Order 13132
later in this preamble.12 The remaining
issues raised by the state commenters
are addressed in sections IV and VI of
this preamble.13
12 See also OCC publication entitled National
Banks and the Dual Banking System (Sept. 2003).
13 See also Letter from John D. Hawke, Jr.,
Comptroller of the Currency, to Senator Paul S.
Sarbanes (Dec. 9, 2003), available on the OCC’s Web
site at http://www.occ.treas.gov/foia/
SarbanesPreemptionletter.pdf; and identical letters
sent to nine other Senators; and Letters from John
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National banks and banking industry
trade groups. National banks, other
financial institutions, and industry
groups supported the proposal. Many of
these commenters argued that Congress
has occupied the fields of deposit-taking
and lending in the context of national
banks and urged the OCC to adopt a
final rule reflecting an extensive
occupation of the field approach. These
commenters concluded that various
provisions of the National Bank Act
establish broad statutory authority for
the activities and regulation of national
banks, and that these provisions suggest
strongly that Congress did in fact intend
to occupy the fields in question. In
addition to these express grants of
authority, the commenters noted that
national banks may, under 12 U.S.C.
24(Seventh), ‘‘exercise * * * all such
incidental powers as shall be necessary
to carry on the business of banking,’’
and that this provision has been broadly
construed by the Supreme Court.14
These commenters concluded that this
broad grant of Federal powers, coupled
with equally broad grants of rulemaking
authority to the OCC,15 effectively
occupy the field of national bank
regulation.
Many of the supporting commenters
also urged the adoption of the proposal
for the reasons set forth in its preamble.
These commenters agreed with the
OCC’s assertion in the preamble that
banks with customers in more than one
state ‘‘face uncertain compliance risks
and substantial additional compliance
burdens and expense that, for practical
purposes, materially impact their ability
to offer particular products and
services.’’ 16 The commenters stated
that, in effect, a national bank must
often craft different products or services
(with associated procedures and
policies, and their attendant additional
costs) for each state in which it does
business, or elect not to provide all of
its products or services (to the detriment
of consumers) in one or more states.
These commenters believe that the
proposal, if adopted, would offer muchneeded clarification of when state law
does or does not apply to the activities
of a national bank and its operating
subsidiaries. Such clarity, these
commenters argued, is critical to
helping national banks maintain and
expand provision of financial services.
Without such clarity, these commenters
D. Hawke, Jr., Comptroller of the Currency, to
Representatives Sue Kelly, Peter King, Carolyn B.
Maloney, and Carolyn McCarthy (Dec. 23, 2003).
14 See, e.g., Nationsbank of North Carolina, N.A.
v. Variable Annuity Life Ins. Co., 513 U.S. 251, 258
n.2 (1995) (VALIC).
15 See, e.g., 12 U.S.C. 93a.
16 68 FR 46119, 46120.
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assert, the burdens and costs, and
uncertain liabilities arising under a
myriad of state and local laws, are a
significant diversion of the resources
that national banks otherwise can use to
provide services to customers
nationwide, and a significant deterrent
to their willingness and ability to offer
certain products and services in certain
markets. These issues are addressed in
sections IV and VI of this preamble.
IV. Reason and Authority for the
Regulations
A. The Regulations Are Issued in
Furtherance of the OCC’s Responsibility
To Ensure That the National Banking
System Is Able To Operate As
Authorized by Congress
As the courts have recognized,
Federal law authorizes the OCC to issue
rules that preempt state law in
furtherance of our responsibility to
ensure that national banks are able to
operate to the full extent authorized
under Federal law, notwithstanding
inconsistent state restrictions, and in
furtherance of their safe and sound
operations.
Federal law is the exclusive source of
all of national banks’ powers and
authorities. Key to these powers is the
clause set forth at 12 U.S.C. 24(Seventh)
that permits national banks to exercise
‘‘all such incidental powers as shall be
necessary to carry on the business of
banking.’’ This flexible grant of
authority furthers Congress’s long-range
goals in establishing the national
banking system, including financing
commerce, establishing private
depositories, and generally supporting
economic growth and development
nationwide. 17 The achievement of these
goals required national banks that are
safe and sound and whose powers are
dynamic and capable of evolving so that
they can perform their intended roles.
The broad grant of authority provided
by 12 U.S.C. 24(Seventh), as well as the
more targeted grants of authority
provided by other statutes,18 enable
national banks to evolve their
operations in order to meet the changing
needs of our economy and individual
consumers.19
17 For a more detailed discussion of Congress’s
purposes in establishing a national banking system
that would operate to achieve these goals distinctly
and separately from the existing system of state
banks, see the preamble to the proposal, 68 FR
46119, 46120, and National Banks and the Dual
Banking System, supra note 12.
18 See, e.g., 12 U.S.C. 92a (authorizing national
banks to engage in fiduciary activities) and 371
(authorizing national banks to engage in real estate
lending activities).
19 The Supreme Court expressly affirmed the
dynamic, evolutionary character of national bank
powers in VALIC, in which it held that the
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The OCC is charged with the
fundamental responsibility of ensuring
that national banks operate on a safe
and sound basis, and that they are able
to do so, if they choose, to the full
extent of their powers under Federal
law. This responsibility includes
enabling the national banking system to
operate as authorized by Congress,
consistent with the essential character
of a national banking system and
without undue confinement of their
powers. Federal law gives the OCC
broad rulemaking authority in order to
fulfill these responsibilities. Under 12
U.S.C. 93a, the OCC is authorized ‘‘to
prescribe rules and regulations to carry
out the responsibilities of the office’’ 20
and, under 12 U.S.C. 371, to ‘‘prescribe
by regulation or order’’ the ‘‘restrictions
and requirements’’ on national banks’’
real estate lending power without stateimposed conditions.21
In recent years, the financial services
marketplace has undergone profound
changes. Markets for credit (both
consumer and commercial), deposits,
and many other financial products and
services are now national, if not
international, in scope. These changes
are the result of a combination of
factors, including technological
innovations, the erosion of legal
barriers, and an increasingly mobile
society.
Technology has expanded the
potential availability of credit and made
possible virtually instantaneous credit
decisions. Mortgage financing that once
took weeks, for example, now can take
only hours. Consumer credit can be
obtained at the point of sale at retailers
and even when buying a major item
such as a car. Consumers can shop for
investment products and deposits online. With respect to deposits, they can
compare rates and duration of a variety
of deposit products offered by financial
institutions located far from where the
consumer resides.
Changes in applicable law also have
contributed to the expansion of markets
for national banks and their operating
subsidiaries. These changes have
affected both the type of products that
may be offered and the geographic
region in which banks—large and
small—may conduct business. As a
result of these changes, banks may
branch across state lines and offer a
broader array of products than ever
before. An even wider range of
‘‘business of banking’’ is not limited to the powers
enumerated in 12 U.S.C. 24(Seventh) and that the
OCC has the discretion to authorize activities
beyond those specifically enumerated in the statute.
See 513 U.S. at 258 n.2.
20 12 U.S.C. 93a.
21 12 U.S.C. 371(a).
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customers can be reached through the
use of technology, including the
Internet. Community national banks, as
well as the largest national banks, use
new technologies to expand their reach
and service to customers.
Our modern society is also highly
mobile. Forty million Americans move
annually, according to a recent
Congressional report issued in
connection with enactment of the Fair
and Accurate Credit Transactions Act of
2003.22 And when they move, they often
have the desire, if not the expectation,
that the financial relationships and
status they have established will be
portable and will remain consistent.
These developments highlight the
significance of being able to conduct a
banking business pursuant to consistent,
national standards, regardless of the
location of a customer when he or she
first becomes a bank customer or the
location to which the customer may
move after becoming a bank customer.
They also accentuate the costs and
interference that diverse and potentially
conflicting state and local laws have on
the ability of national banks to operate
under the powers of their Federal
charter. For national banks, moreover,
the ability to operate under uniform
standards of operation and supervision
is fundamental to the character of their
national charter.23 When national banks
are unable to operate under national
standards, it also implicates the role and
responsibilities of the OCC.
These concerns have been
exacerbated recently, by increasing
efforts by states and localities to apply
state and local laws to bank activities.
As we have learned from our experience
supervising national banks, from the
inquiries received by the OCC’s Law
Department, by the extent of litigation
in recent years over these state efforts,
and by the comments we received on
the proposal, national banks’ ability to
conduct operations to the full extent
authorized by Federal law has been
curtailed as a result.
Commenters noted that the variety of
state and local laws that have been
enacted in recent years—including laws
regulating fees, disclosures, conditions
on lending, and licensing—have created
higher costs and increased operational
22 See S. Rep. No. 108–166, at 10 (2003) (quoting
the hearing testimony of Secretary of the Treasury
Snow).
23 As we explained last year in the preamble to
our amendments to part 7 concerning national
banks’ electronic activities, ‘‘freedom from State
control over a national bank’s powers protects
national banks from conflicting local laws unrelated
to the purpose of providing the uniform,
nationwide banking system that Congress
intended.’’ 67 FR 34992, 34997 (May 17, 2002).
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challenges.24 Other commenters noted
the proliferation of state and local antipredatory lending laws and the impact
that those laws are having on lending in
the affected jurisdictions. As a result,
national banks must either absorb the
costs, pass the costs on to consumers, or
eliminate various products from
jurisdictions where the costs are
prohibitive. Commenters noted that this
result is reached even in situations
where a bank concludes that a law is
preempted, simply so that the bank may
avoid litigation costs or anticipated
reputational injury.
As previously noted, the elimination
of legal and other barriers to interstate
banking and interstate financial service
operations has led a number of banking
organizations to operate, in multi-state
metropolitan statistical areas, and on a
multi-state or nationwide basis,
exacerbating the impact of the overlay of
state and local standards and
requirements on top of the Federal
standards and OCC supervisory
requirements already applicable to
national bank operations. When these
multi-jurisdictional banking
organizations are subject to regulation
by each individual state or municipality
in which they conduct operations, the
problems noted earlier are compounded.
Even the efforts of a single state to
regulate the operations of a national
bank operating only within that state
can have a detrimental effect on that
bank’s operations and consumers. As we
explained in our recent preemption
determination and order responding to
National City Bank’s inquiry concerning
the Georgia Fair Lending Act (GFLA),25
the GFLA caused secondary market
participants to cease purchasing certain
Georgia mortgages and many mortgage
lenders to stop making mortgage loans
in Georgia. National banks have also
been forced to withdraw from some
products and markets in other states as
a result of the impact of state and local
restrictions on their activities.
When national banks are unable to
operate under uniform, consistent, and
predictable standards, their business
suffers, which negatively affects their
24 Illustrative of comments along these lines were
those of banks who noted that various state laws
would result in the following costs: (a)
Approximately $44 million in start-up costs
incurred by 6 banks as a result of a recently-enacted
California law mandating a minimum payment
warning; (b) 250 programming days required to
change one of several computer systems that
needed to be changed to comply with antipredatory lending laws enacted in three states and
the District of Columbia; and (c) $7.1 million in
costs a bank would incur as a result of complying
with mandated annual statements to credit card
customers.
25 See 68 FR 46264 (Aug. 5, 2003).
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safety and soundness. The application
of multiple, often unpredictable,
different state or local restrictions and
requirements prevents them from
operating in the manner authorized
under Federal law, is costly and
burdensome, interferes with their ability
to plan their business and manage their
risks, and subjects them to uncertain
liabilities and potential exposure. In
some cases, this deters them from
making certain products available in
certain jurisdictions.26
The OCC therefore is issuing this final
rule in furtherance of its responsibility
to enable national banks to operate to
the full extent of their powers under
Federal law, without interference from
inconsistent state laws, consistent with
the national character of the national
banking system, and in furtherance of
their safe and sound operations. The
final rule does not entail any new
powers for national banks or any
expansion of their existing powers.
Rather, we intend only to ensure the
soundness and efficiency of national
banks’ operations by making clear the
standards under which they do
business.
B. Pursuant to 12 U.S.C. 93a and 371,
the OCC May Adopt Regulations That
Preempt State Law
The OCC has ample authority to
provide, by regulation, that types of
state laws are not applicable to national
banks. As mentioned earlier, 12 U.S.C.
93a grants the OCC comprehensive
rulemaking authority to further its
responsibilities, stating that—
Except to the extent that authority to
issue such rules and regulations has
been expressly and exclusively granted
to another regulatory agency, the
Comptroller of the Currency is
authorized to prescribe rules and
regulations to carry out the
responsibilities of the office * * *.27
This language is significantly broader
than that customarily used to convey
rulemaking authority to an agency,
which is typically focused on a
particular statute. This was recognized,
some 20 years ago, by the United States
Court of Appeals for the D.C. Circuit in
26 As was recently observed by Federal Reserve
Board Chairman Alan Greenspan (in the context of
amendments to the Fair Credit Reporting Act),
‘‘[l]imits on the flow of information among financial
market participants, or increased costs resulting
from restrictions that differ based on geography,
may lead to an increase in the price or a reduction
in the availability of credit, as well as a reduction
in the optimal sharing of risk and reward.’’ Letter
of February 28, 2003, from Alan Greenspan,
Chairman, Board of Governors of the Federal
Reserve System, to The Honorable Ruben Hinojosa
(emphasis added).
27 12 U.S.C. 93a.
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its decision confirming that 12 U.S.C.
93a authorizes the OCC to issue
regulations preempting state law. In
Conference of State Bank Supervisors v.
Conover,28 the Conference of State Bank
Supervisors (CSBS) sought to overturn a
district court decision upholding OCC
regulations that provided flexibility
regarding the terms on which national
banks may make or purchase adjustable
rate mortgages (ARMs) and that
preempted inconsistent state laws. The
regulations provided generally that
national banks may make or purchase
ARMs without regard to state law
limitations. The district court granted
the OCC’s motion for summary
judgment on the ground that the
regulations were within the scope of the
OCC’s rulemaking powers granted by
Congress.
On appeal, the CSBS asserted that 12
U.S.C. 93a grants the OCC authority to
issue only ‘‘housekeeping’’ procedural
regulations. In support of this argument,
the CSBS cited a remark from the
legislative history of 12 U.S.C. 93a by
Senator Proxmire that 12 U.S.C. 93a
‘‘carries with it no new authority to
confer on national banks powers which
they do not have under existing law.’’
CSBS also cited a statement in the
conference report that 12 U.S.C. 93a
‘‘carries no authority [enabling the
Comptroller] to permit otherwise
impermissible activities of national
banks with specific reference to the
provisions of the McFadden Act and the
Glass-Steagall Act.’’ 29
The Court of Appeals rejected the
CSBS’s contentions concerning the
proper interpretation of 12 U.S.C. 93a.
The Court of Appeals explained first
that the challenged regulations (like this
final rule) did not confer any new
powers on national banks. Moreover,
[t]hat the Comptroller also saw fit to preempt
those state laws that conflict with his
responsibility to ensure the safety and
soundness of the national banking system,
see 12 U.S.C. § 481, does not constitute an
expansion of the powers of national banks.30
Nor did the Court of Appeals find
support for the CSBS’s position in the
conference report:
As the ‘‘specific reference’’ to the
McFadden and Glass-Steagall Acts indicates,
the ‘‘impermissible activities’’ which the
Comptroller is not empowered to permit are
activities that are impermissible under
federal, not state, law.31
The court summarized its rationale for
holding that 12 U.S.C. 93a authorized
28 710
F.2d 878 (D.C. Cir. 1983).
at 885 (emphasis in original).
30 Id. (emphasis in original).
31 Id.
29 Id.
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the OCC to issue the challenged
regulations by saying:
It bears repeating that the entire legislative
scheme is one that contemplates the
operation of state law only in the absence of
federal law and where such state law does
not conflict with the policies of the National
Banking Act. So long as he does not
authorize activities that run afoul of federal
laws governing the activities of the national
banks, therefore, the Comptroller has the
power to preempt inconsistent state laws.32
The authority under 12 U.S.C. 93a
described by the court in CSBS v.
Conover thus amply supports the
adoption of regulations providing that
specified types of state laws purporting
to govern as applied to national banks’
lending and deposit-taking activities are
preempted.
Under 12 U.S.C. 371, the OCC has the
additional and specific authority to
provide that the specified types of laws
relating to national banks’ real estate
lending activities are preempted. As we
have described and as recognized in
CSBS v. Conover,33 12 U.S.C. 371 grants
the OCC unique rulemaking authority
with regard to national banks’ real estate
lending activities. That section states:
[a]ny national banking association
may make, arrange, purchase or sell
loans or extensions of credit secured by
liens on interests in real estate, subject
to section 1828(o) of this title and such
restrictions and requirements as the
Comptroller of the Currency may
prescribe by regulation or order.34
The language and history of 12 U.S.C.
371 confirm the real estate lending
powers of national banks and that only
the OCC ‘‘subject to other applicable
Federal law ‘‘and not the states may
impose restrictions or requirements on
national banks’ exercise of those
powers. The Federal powers conferred
by 12 U.S.C. 371 are subject only ‘‘to
section 1828(o) of this title and such
restrictions and requirements as the
Comptroller of the Currency may
prescribe by regulation or order.’’ 35
at 878 (emphasis added).
CSBS v. Conover, the court also held that the
authority conferred by 12 U.S.C. 371, as the statute
read at the time relevant to the court’s decision,
conferred authority upon the OCC to issue the
preemptive regulations challenged in that case. The
version of section 371 considered by the court
authorized national banks to make real estate loans
‘‘subject to such terms, conditions, and limitations’’
as prescribed by the Comptroller by order, rule or
regulations. The court said that the ‘‘restrictions
and requirements’’ language contained in the
statute today was ‘‘not substantially different’’ from
the language that it was considering in that case. Id.
at 884.
34 12 U.S.C. 371(a).
35 Id. As noted supra at note 7, Federal legislation
occasionally provides that national banks shall
conduct certain activities subject to state law
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33 In
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Thus, the exercise of the powers granted
by 12 U.S.C. 371 is not conditioned on
compliance with any state requirement,
and state laws that attempt to confine or
restrain national banks’ real estate
lending activities are inconsistent with
national banks’ real estate lending
powers under 12 U.S.C. 371.
This conclusion is consistent with the
fact that national bank real estate
lending authority has been extensively
regulated at the Federal level since the
power first was codified. Beginning
with the enactment of the Federal
Reserve Act of 1913,36 national banks’
real estate lending authority has been
governed by the express terms of 12
U.S.C. 371. As originally enacted in
1913, section 371 contained a limited
grant of authority to national banks to
lend on the security of ‘‘improved and
unencumbered farm land, situated
within its Federal reserve district.’’ 37 In
addition to the geographic limits
inherent in this authorization, the
Federal Reserve Act also imposed limits
on the term and amount of each loan as
well as an aggregate lending limit. Over
the years, 12 U.S.C. 371 was repeatedly
amended to broaden the types of real
estate loans national banks were
permitted to make, to expand
geographic limits, and to modify loan
term limits and per-loan and aggregate
lending limits.
In 1982, Congress removed these
‘‘rigid statutory limitations’’ 38 in favor
of a broad provision that is very similar
to the current law and that authorized
national banks to ‘‘make, arrange,
purchase or sell loans or extensions of
credit secured by liens on interests in
real estate, subject to such terms,
conditions, and limitations as may be
prescribed by the Comptroller of the
Currency by order, rule, or
regulation.’’ 39 The purpose of the 1982
amendment was ‘‘to provide national
banks with the ability to engage in more
creative and flexible financing, and to
become stronger participants in the
home financing market.’’ 40 In 1991,
Congress removed the term ‘‘rule’’ from
this phrase and enacted an additional
requirement, codified at 12 U.S.C.
standards. For example, national banks conduct
insurance sales, solicitation, and cross-marketing
activities subject to certain types of state restrictions
expressly set out in the Gramm-Leach-Bliley Act.
See 15 U.S.C. 6701(d)(2)(B). There is no similar
Federal legislation subjecting national banks’ real
estate lending activities to state law standards.
36 Federal Reserve Act, Dec. 23, 1913, ch. 6, 38
Stat. 251, as amended.
37 Id. section 24, 38 Stat. 273.
38 S. Rep. No. 97–536, at 27 (1982).
39 Garn-St Germain Depository Institutions Act of
1982, Pub. L. 97–320, section 403, 96 Stat. 1469,
1510–11 (1982).
40 S. Rep. No. 97–536, at 27 (1982).
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1828(o), that national banks (and other
insured depository institutions) conduct
real estate lending pursuant to uniform
standards adopted at the Federal level
by regulation of the OCC and the other
Federal banking agencies.41
Thus, the history of national banks’
real estate lending activities under 12
U.S.C. 371 is one of extensive
Congressional involvement gradually
giving way to a streamlined approach in
which Congress has delegated broad
rulemaking authority to the
Comptroller. The two versions of 12
U.S.C. 371—namely, the lengthy and
prescriptive approach prior to 1982 and
the more recent statement of broad
authority qualified only by reference to
Federal law —may be seen as evolving
articulations of the same idea.
C. The Preemption Standard Applied in
This Final Rule Is Entirely Consistent
With the Standards Articulated by the
Supreme Court
State laws are preempted by Federal
law, and thus rendered invalid with
respect to national banks, by operation
of the Supremacy Clause of the U.S.
Constitution.42 The Supreme Court has
identified three ways in which this may
occur. First, Congress can adopt express
language setting forth the existence and
scope of preemption.43 Second,
Congress can adopt a framework for
regulation that ‘‘occupies the field’’ and
leaves no room for states to adopt
supplemental laws.44 Third, preemption
may be found when state law actually
conflicts with Federal law. Conflict will
be found when either: (i) compliance
with both laws is a ‘‘physical
impossibility;’’ 45 or (ii) when the state
law stands ‘‘as an obstacle to the
accomplishment and execution of the
full purposes and objectives of
Congress.’’ 46
In Barnett Bank of Marion County v.
Nelson,47 the Supreme Court articulated
preemption standards used by the
41 See section 304 of the Federal Deposit
Insurance Corporation Improvement Act, codified
at 12 U.S.C. 1828(o). These standards governing
national banks’ real estate lending are set forth in
Subpart D of 12 CFR part 34.
42 ‘‘This Constitution, and the Laws of the United
States which shall be made in Pursuance thereof
* * * shall be the supreme Law of the Land; and
the Judges in every State shall be bound thereby,
any Thing in the Constitution or Laws of any State
to the Contrary notwithstanding.’’ U.S. Const. art.
VI, cl. 2.
43 See Jones v. Rath Packing Co., 430 U.S. 519,
525 (1977).
44 See Rice v. Santa Fe Elevator Corp., 331 U.S.
218, 230 (1947).
45 Florida Lime & Avocado Growers, Inc. v. Paul,
373 U.S. 132, 143 (1963).
46 Hines v. Davidowitz, 312 U.S. 52, 67 (1941);
Barnett Bank of Marion County, N.A. v. Nelson, 517
U.S. 25, 31 (1996) (quoting Hines).
47 517 U.S. 25 (1996).
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Supreme Court in the national bank
context to determine, under the
Supremacy Clause of the U.S.
Constitution, whether Federal law
conflicts with state law such that the
state law is preempted. As observed by
the Supreme Court in Barnett, a state
law will be preempted if it conflicts
with the exercise of a national bank’s
Federally authorized powers.
The Supreme Court noted in Barnett
the many formulations of the conflicts
standard. The Court stated:
In defining the pre-emptive scope of
statutes and regulations granting a
power to national banks, these cases
take the view that normally Congress
would not want States to forbid, or
impair significantly, the exercise of a
power that Congress explicitly granted.
To say this is not to deprive States of the
power to regulate national banks, where
(unlike here) doing so does not prevent
or significantly interfere with the
national bank’s exercise of its powers.
See, e.g., Anderson Nat. Bank v. Luckett,
321 U.S. 233, 247–252 (1944) (state
statute administering abandoned
deposit accounts did not ‘‘unlawful[ly]
encroac[h] on the rights and privileges
of national banks’’); McClellan v.
Chipman, 164 U.S. 347, 358 (1896)
(application to national banks of state
statute forbidding certain real estate
transfers by insolvent transferees would
not ‘‘destro[y] or hampe[r]’’ national
banks’’ functions); National Bank v.
Commonwealth, 76 U.S. (9 Wall.) 353,
362 (1869) (national banks subject to
state law that does not ‘‘interfere with,
or impair [national banks’] efficiency in
performing the functions by which they
are designed to serve [the Federal]
Government’’).48
The variety of formulations quoted by
the Court—‘‘unlawfully encroach,’’
‘‘hamper,’’ ‘‘interfere with or impair
national banks’ efficiency’’—defeats any
suggestion that any one phrase
constitutes the exclusive standard for
preemption. As the Supreme Court
explained in Hines v. Davidowitz: 49
There is not—and from the very
nature of the problem there cannot be—
any rigid formula or rule which can be
used as a universal pattern to determine
the meaning and purpose of every act of
Congress. This Court, in considering the
validity of state laws in the light of
48 Id. at 33–34. Certain commenters cite Nat’l
Bank v. Commonwealth for the proposition that
national banks are subject to state law. These
commenters, however, omit the important caveat,
quoted by the Barnett Court, that state law applies
only where it does not ‘‘interfere with, or impair
[national banks’] efficiency in performing the
functions by which they are designed to serve [the
Federal] Government.’’
49 312 U.S. 52 (1941).
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treaties or federal laws touching the
same subject, has made use of the
following expressions: conflicting;
contrary to; occupying the field;
repugnance; difference;
irreconcilability; inconsistency;
violation; curtailment; and interference.
But none of these expressions provides
an infallible constitutional test or an
exclusive constitutional yardstick. In the
final analysis, there can be no one
crystal clear distinctly marked formula.
Our primary function is to determine
whether, under the circumstances of
this particular case, [the state law at
issue] stands as an obstacle to the
accomplishment and execution of the
full purposes and objectives of
Congress.50
Thus, in Hines, the Court recognized
that the Supremacy Clause principles of
preemption can be articulated in a wide
variety of formulations that do not yield
substantively different legal results. The
variation among formulations that carry
different linguistic connotations does
not produce different legal outcomes.
We have adopted in this final rule a
statement of preemption principles that
is consistent with the various
formulations noted earlier. The phrasing
used in the final rule—obstruct,51
impair,52 or condition 53’’—differs
somewhat from what we proposed. This
standard conveys the same substantive
point as the proposed standard,
however; that is, that state laws do not
apply to national banks if they
impermissibly contain a bank’s exercise
of a federally authorized power. The
words of the final rule, which are drawn
directly from applicable Supreme Court
precedents, better convey the range of
effects on national bank powers that the
Court has found to be impermissible.
The OCC intends this phrase as the
distillation of the various preemption
constructs articulated by the Supreme
Court, as recognized in Hines and
Barnett, and not as a replacement
construct that is in any way inconsistent
with those standards.
In describing the proposal, we invited
comment on whether it would be
appropriate to assert occupation of the
entire field of real estate lending. Some
commenters strongly urged that we do
so, and that we go beyond real estate
lending to cover other lending and
deposit-taking activities as well. Upon
further consideration of this issue and
50 Id.
at 67 (emphasis added) (citations omitted).
Hines, 312 U.S. at 76.
52 See Nat’l Bank v. Commonwealth, 76 U.S. at
362; Davis v. Elmira Savings Bank, 161 U.S. 275,
283 (1896); McClellan, 164 U.S. at 357.
53 See Barnett, 517 U.S. at 34; Franklin Nat’l Bank
of Franklin Square v. New York, 347 U.S. 373, 375–
79 (1954).
51 See
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careful review of comments submitted
pertaining to this point, we have
concluded, as the Supreme Court
recognized in Hines and reaffirmed in
Barnett, that the effect of labeling of this
nature is largely immaterial in the
present circumstances. Thus, we decline
to adopt the suggestion of these
commenters that we declare that these
regulations ‘‘occupy the field’’ of
national banks’ real estate lending, other
lending, and deposit-taking activities.
We rely on our authority under both 12
U.S.C. 93a and 371, and to the extent
that an issue arises concerning the
application of a state law not
specifically addressed in the final
regulation, we retain the ability to
address those questions through
interpretation of the regulation, issuance
of orders pursuant to our authority
under 12 U.S.C. 371, or, if warranted by
the significance of the issue, by
rulemaking to amend the regulation.
V. Description of the Final Rule
A. Amendments to Part 34
1. Section 34.3(a). The final rule
retains the statement of national banks’
real estate lending authority, now
designated as § 34.3(a), that national
banks may ‘‘make, arrange, purchase, or
sell loans or extensions of credit, or
interests therein, that are secured by
liens on, or interests in, real estate (real
estate loans), subject to 12 U.S.C.
1828(o) and such restrictions and
requirements as the Comptroller of the
Currency may prescribe by regulation or
order.’’
2. Section 34.3(b). New § 34.3(b) adds
an explicit safety and soundnessderived anti-predatory lending standard
to the general statement of authority
concerning lending. Many bank
commenters voiced concern that the
proposed anti-predatory lending
standard, by prohibiting a national bank
from making a loan based
predominantly on the foreclosure value
of a borrower’s collateral without regard
to the borrower’s repayment ability,
would also prohibit a national bank
from engaging in legitimate, nonpredatory lending activities. These
commenters noted that reverse
mortgage, small business, and high net
worth loans are often made based on the
value of the collateral.
We have revised the anti-predatory
lending standard in the final rule to
clarify that it applies to consumer loans
only, (i.e., loans for personal, family, or
household purposes), and to clarify that
it is intended to prevent borrowers from
being unwittingly placed in a situation
where repayment is unlikely without
the lender seizing the collateral. Where
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the bargain agreed to by a borrower and
a lender involves an understanding by
the borrower that it is likely or expected
that the collateral will be used to repay
the debt, such as with a reverse
mortgage, it clearly is not objectionable
that the collateral will then be used in
such a manner. Moreover, the final
rule’s anti-predatory lending standard is
not intended to apply to business
lending or to situations where a
borrower’s net worth would support the
loan under customary underwriting
standards.
Thus, we have revised the antipredatory lending standard so that it
focuses on consumer loans and permits
a national bank to use a variety of
reasonable methods to determine a
borrower’s ability to repay, including,
for example, the borrower’s current and
expected income, current and expected
cash flows, net worth, other relevant
financial resources, current financial
obligations, employment status, credit
history, or other relevant factors.
Several commenters urged the OCC to
expressly affirm that a national bank’s
lending practices must be conducted in
conformance with section 5 of the FTC
Act, which makes unlawful ‘‘unfair or
deceptive acts or practices’’ in interstate
commerce,54 and regulations
promulgated thereunder. As discussed
in more detail in section VI of this
preamble, the OCC has taken actions
against national banks under the FTC
Act where the OCC believed they were
engaged in unfair or deceptive practices.
As demonstrated by these actions, the
OCC recognizes the importance of
national banks and their operating
subsidiaries acting in conformance with
the standards contained in section 5 of
the FTC Act. We therefore agree that an
express reference to those standards in
our regulation would be appropriate and
have added it to the final rules.55
3. State laws that are preempted
(§ 34.4(a)). Pursuant to 12 U.S.C. 93a
and 371, the final rule amends § 34.4(a)
to add to the existing regulatory list of
types of state law restrictions and
requirements that are not applicable to
national banks. This list, promulgated
under our authority ‘‘to prescribe rules
and regulations to carry out the
responsibilities of the office’’ and to
U.S.C. 45(a)(1).
is important to note here that we lack the
authority to do what some commenters essentially
urged, namely, to specify by regulation that
particular practices, such as loan ‘‘flipping’’ or
‘‘equity stripping,’’ are unfair or deceptive. While
we have the ability to take enforcement actions
against national banks if they engage in unfair or
deceptive practices under section 5 of the FTC Act,
the OCC does not have rulemaking authority to
define specific practices as unfair or deceptive
under section 5. See 15 U.S.C. 57a(f).
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55 It
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prescribe the types of restrictions and
requirements to which national banks’
real estate lending activities shall be
subject, reflects our experience with
types of state laws that can materially
affect and confine—and thus are
inconsistent with—the exercise of
national banks’ real estate lending
powers.56
The final rule revises slightly the
introductory clause used in proposed
§ 34.4(a) in order to conform this section
more closely to the amended sections of
part 7 discussed later in this preamble.
Thus, the final rule provides: ‘‘Except
where made applicable by Federal law,
state laws that obstruct, impair, or
condition a national bank’s ability to
fully exercise its Federally authorized
real estate lending powers do not apply
to national banks.’’ The final rule then
expands the current list of the types of
state law restrictions and requirements
that are not applicable to national
banks.
Many of the supporting commenters
requested that the final rule clarify the
extent to which particular state or local
laws that were not included in the
proposal are preempted. For example,
these commenters suggested that the
final rule address particular state laws
imposing various limitations on
mortgage underwriting and servicing.
We decline to address most of these
suggestions with the level of specificity
requested by the commenters.
Identifying state laws in a more generic
way avoids the impression that the
regulations only cover state laws that
appear on the list. The list of the types
of preempted state laws is not intended
to be exhaustive, and we retain the
ability to address other types of state
laws by order on a case-by-case basis, as
appropriate, to make determinations
whether they are preempted under the
applicable standards.57
4. State laws that are not preempted
(§ 34.4(b)). Section 34.4(b) also provides
that certain types of state laws are not
preempted and would apply to national
banks to the extent that they are
consistent with national banks’ Federal
authority to engage in real estate lending
because their effect on the real estate
56 As we noted in our discussion of this list in
the preamble to the proposal, the ‘‘OCC and Federal
courts have thus far concluded that a wide variety
of state laws are preempted, either because the state
laws fit within the express preemption provisions
of an OCC regulation or because the laws conflict
with a Federal power vested in national banks.’’ See
68 FR 46119, 46122–46123. The list is also
substantially identical to the types of laws specified
in a comparable regulation of the OTS. See 12 CFR
560.2(b).
57 See, e.g., OCC Determination and Order
concerning the Georgia Fair Lending Act, supra
footnote 25.
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lending operations of national banks is
only incidental. These types of laws
generally pertain to contracts, rights to
collect debts, acquisition and transfer of
property, taxation, zoning, crimes,
torts,58 and homestead rights. In
addition, any other law the effect of
which is incidental to national banks’
lending authority or otherwise
consistent with national banks’
authority to engage in real estate lending
would not be preempted.59 In general,
these would be laws that do not attempt
to regulate the manner or content of
national banks’ real estate lending, but
that instead form the legal infrastructure
that makes it practicable to exercise a
permissible Federal power.
One category of state law included in
the proposed list of state laws generally
not preempted was ‘‘debt collection.’’
Consistent with Supreme Court
precedents addressing this type of state
law,60 we have revised the language of
the final rule to refer to national banks’
‘‘right to collect debts.’’
B. Amendments to Part 7—DepositTaking, Other Consumer Lending, and
National Bank Operations
The final rule adds three new sections
to part 7: § 7.4007 regarding deposittaking activities, § 7.4008 regarding nonreal estate lending activities, and
§ 7.4009 regarding national bank
operations. The structure of the
amendments is the same for §§ 7.4007
and 7.4008 and is similar for § 7.4009.
For § 7.4007, the final rule first sets
out a statement of the authority to
engage in the activity. Second, the final
58 See Bank of America v. City & County of San
Francisco, 309 F.3d 551, 559 (9th Cir. 2002).
59 The label a state attaches to its laws will not
affect the analysis of whether that law is preempted.
For instance, laws related to the transfer of real
property may contain provisions that give
borrowers the right to ‘‘cure’’ a default upon
acceleration of a loan if the lender has not
foreclosed on the property securing the loan.
Viewed one way, this could be seen as part of the
state laws governing foreclosure, which historically
have been within a state’s purview. However, as we
concluded in the OCC Determination and Order
concerning the GFLA, to the extent that this type
of law limits the ability of a national bank to adjust
the terms of a particular class of loans once there
has been a default, it would be a state law limitation
‘‘concerning * * * (2) The schedule for the
repayment of principal and interest; [or] (3) The
term to maturity of the loan * * *’’ 12 CFR 34.4(a).
In such a situation, we would be governed by the
effect of the state statute.
60 See, e.g., Nat’l Bank v. Commonwealth, 76 U.S.
at 362 (national banks ‘‘are subject to the laws of
the State, and are governed in their daily course of
business far more by the laws of the State than of
the nation. All their contracts are governed and
construed by State laws. Their acquisition and
transfer of property, their right to collect their debts,
and their liability to be sued for debts, are all based
on State law.’’) (emphasis added); see also
McClellan, 164 U.S. at 356–57 (quoting Nat’l Bank
v. Commonwealth).
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rule notes that state laws that obstruct,
impair, or condition a national bank’s
ability to fully exercise the power in
question are not applicable, and lists
several types of state laws that are
preempted. Types of state laws that are
generally preempted under § 7.4007
include state requirements concerning
abandoned and dormant accounts,
checking accounts, disclosure
requirements, funds availability, savings
account orders of withdrawal, state
licensing or registration requirements,
and special purpose savings services.
Finally, the final rule lists types of state
laws that, as a general matter, are not
preempted. Examples of these laws
include state laws concerning contract,
rights to collect debt, tort, zoning, and
property transfers. These lists are not
intended to be exhaustive, and the OCC
retains the ability to address other types
of state laws on a case-by-case basis to
make preemption determinations under
the applicable standards.
For § 7.4008, the final rule also sets
out a statement of the authority to
engage in the activity (non-real estate
lending), notes that state laws that
obstruct, impair, or condition a national
bank’s ability to fully exercise this
power are not applicable, and lists
several types of state laws that are, or
are not, preempted. Section 7.4008 also
includes a safety and soundness-based
anti-predatory lending standard. Final
§ 7.4008(b) states that ‘‘[a] national bank
shall not make a consumer loan subject
to this § 7.4008 based predominantly on
the bank’s realization of the foreclosure
or liquidation value of the borrower’s
collateral, without regard to the
borrower’s ability to repay the loan
according to its terms. A bank may use
any reasonable method to determine a
borrower’s ability to repay, including,
for example, the borrower’s current and
expected income, current and expected
cash flows, net worth, other relevant
financial resources, current financial
obligations, employment status, credit
history, or other relevant factors.’’
Separately, § 7.4008(c) also includes a
statement that a national bank shall not
engage in unfair or deceptive practices
within the meaning of section 5 of the
FTC Act and regulations promulgated
thereunder in connection with making
non-real estate related loans. The
standards set forth in § 7.4008(b) and
(c), plus an array of Federal consumer
protection standards,61 ensure that
national banks are subject to consistent
and uniform Federal standards,
administered and enforced by the OCC,
that provide strong and extensive
customer protections and appropriate
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supra note 10.
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safety and soundness-based criteria for
their lending activities.
In § 7.4009, the final rule first states
that national banks may exercise all
powers authorized to them under
Federal law.62 Second, the final rule
states that except as otherwise made
applicable by Federal law, state laws
that obstruct, impair, or condition a
national bank’s ability to fully exercise
its authorized powers do not apply to
the national bank.63 Finally, the final
rule lists several types of state laws that,
as a general matter, are not preempted.
For the reasons outlined earlier in the
discussion of the amendments to 12
CFR part 34, the reference to debt
collection laws has been revised to refer
to state laws concerning national banks’
‘‘rights to collect debts.’’
The OCC’s regulations adopted in this
final rule address the applicability of
state law with respect to a number of
specific types of activities. The question
may persist, however, about the extent
to which state law may permissibly
govern powers or activities that have not
been addressed by Federal court
precedents or OCC opinions or orders.
Accordingly, as noted earlier, new
§ 7.4009 provides that state laws do not
apply to national banks if they obstruct,
impair, or condition a national bank’s
ability to fully exercise the powers
authorized to it under Federal law,
including the content of those activities
and the manner in which and standards
whereby they are conducted.
As explained previously, in some
circumstances, of course, Federal law
directs the application of state standards
to a national bank. The wording of
§ 7.4009 reflects that a Federal statute
may require the application of state
62 As noted in the proposal, the OTS has issued
a regulation providing generally that state laws
purporting to address the operations of Federal
savings associations are preempted. See 12 CFR
545.2. The extent of Federal regulation and
supervision of Federal savings associations under
the Home Owners’ Loan Act is substantially the
same as for national banks under the national
banking laws, a fact that warrants similar
conclusions about the applicability of state laws to
the conduct of the Federally authorized activities of
both types of entities. Compare, e.g., 12 U.S.C.
1464(a) (OTS authorities with respect to the
organization, incorporation, examination,
operation, regulation, and chartering of Federal
savings associations) with 12 U.S.C. 21
(organization and formation of national banking
associations), 12 U.S.C. 481 (OCC authority to
examine national banks and their affiliates), 12
U.S.C. 484 (OCC’s exclusive visitorial authority),
and 12 U.S.C. 93a (OCC authority to issue
regulations).
63 As noted previously, the final rule makes
changes to the introductory clause concerning the
applicability of state law in 12 CFR 34.4(a),
7.4007(b), 7.4008(d), and 7.4009(b) to make the
language of these sections more consistent with
each other.
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law,64 or it may incorporate—or
‘‘Federalize’’—state standards.65 In
those circumstances, the state standard
obviously applies. State law may also
apply if it only incidentally affects a
national bank’s Federally authorized
powers or if it is otherwise consistent
with national banks’ uniquely Federal
status. Like the other provisions of this
final rule, § 7.4009 recognizes the
potential applicability of state law in
these circumstances. This approach is
consistent with the Supreme Court’s
observation that national banks ‘‘are
governed in their daily course of
business far more by the laws of the
state than of the nation.’’ 66 However, as
noted previously, these types of laws
typically do not regulate the manner or
content of the business of banking
authorized for national banks, but rather
establish the legal infrastructure that
makes practicable the conduct of that
business.
C. Application of Amendments to
Operating Subsidiaries
As a matter of Federal law, national
bank operating subsidiaries conduct
their activities under a Federal license,
subject to the same terms and
conditions as apply to the parent banks,
except where Federal law provides
otherwise. See 12 CFR 5.34 and 7.4006.
See also 12 CFR 34.1(b)(real estate
activities specifically).67 Thus, by virtue
of preexisting OCC regulations, the
changes to parts 7 and 34, including the
new anti-predatory lending standards
applicable to lending activities, apply to
both national banks and their operating
subsidiaries. The final rule makes no
change to these existing provisions.
VI. The OCC’s Commitment to Fair
Treatment of National Bank Customers
and High Standards of National Bank
Operations
The OCC shares the view of the
commenters that predatory and abusive
lending practices are inconsistent with
national objectives of encouraging home
ownership and community
revitalization, and can be devastating to
individuals, families, and communities.
64 See, e.g., 15 U.S.C. 6711 (insurance activities of
national banks are ‘‘functionally regulated’’ by the
states, subject to the provisions on the operation of
state law contained in section 104 of the GrammLeach-Bliley Act).
65 See, e.g., 12 U.S.C. 92a (permissible fiduciary
activities for national banks determined by
reference to state law).
66 Nat’l Bank v. Commonwealth, 76 U.S. at 362
(holding that shares held by shareholders of a
national bank were lawfully subject to state
taxation).
67 For a detailed discussion of this issue, see the
OCC’s visitorial powers rulemaking also published
today in the Federal Register.
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We will not tolerate such practices by
national banks and their operating
subsidiaries. Our Advisory Letters on
predatory lending,68 our pioneering
enforcement positions resulting in
substantial restitution to affected
consumers, and the anti-predatory
lending standards adopted in this final
rule reflect our commitment that
national banks operate pursuant to high
standards of integrity in all respects.
The provisions of this final rule,
clarifying that certain state laws are not
applicable to national banks’ operations,
do not undermine the application of
these standards to all national banks, for
the protection of all national bank
customers—wherever they are located.
Advisory Letters 2003–2, which
addresses loan originations, and 2003–
3, which addresses loan purchases and
the use of third party loan brokers,
contain the most comprehensive
supervisory standards ever published by
any Federal financial regulatory agency
to address predatory and abusive
lending practices and detail steps for
national banks to take to ensure that
they do not engage in such practices. As
explained in the Advisory Letters, if the
OCC has evidence that a national bank
has engaged in abusive lending
practices, we will review those practices
not only to determine whether they
violate specific provisions of law such
as the Homeowners Equity Protection
Act of 1994 (HOEPA), the Fair Housing
Act, or the Equal Credit Opportunity
Act, but also to determine whether they
involve unfair or deceptive practices
that violate the FTC Act. Indeed, several
practices that we identify as abusive in
our Advisory Letters—such as equity
stripping, loan flipping, and the
refinancing of special subsidized
mortgage loans that originally contained
terms favorable to the borrower—
generally can be found to be unfair or
deceptive practices that violate the FTC
Act.
Moreover, our enforcement record,
including the OCC’s pioneering actions
using the FTC Act to address consumer
abuses that were not specifically
prohibited by regulation, demonstrates
our commitment to keeping abusive
practices out of the national banking
system. For example, In the Matter of
Providian Nat’l Bank, Tilton, New
Hampshire,69 pursuant to the FTC Act,
the OCC required payment by a national
bank to consumers in excess of $300
million and imposed numerous
supra note 8.
Action 2000–53 (June 28, 2000),
available at the OCC’s Web site in the ‘‘Popular
FOIA Requests’’ section at http://
www.occ.treas.gov/foia/foiadocs.htm.
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69 Enforcement
Frm 00021
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1913
conditions on the conduct of future
business. Since the Providian settlement
in 2000, the OCC has taken action under
the FTC Act to address unfair or
deceptive practices and consumer harm
involving five other national banks.70
Most recently, on November 7, 2003,
the OCC entered into a consent order
with Clear Lake National Bank that
requires the bank to reimburse fees and
interest charged to consumers in a series
of abusive home equity loans. More than
$100,000 will be paid to 30 or more
borrowers. This is the first case brought
by a Federal regulator under the FTC
Act that cites the unfair nature of the
terms of the loan. The OCC also found
that the loans violated HOEPA, the
Truth in Lending Act, and Real Estate
Settlement Procedures Act.71
The OCC also has moved aggressively
against national banks engaged in
payday lending programs that involved
consumer abuses. Specifically, we
concluded four enforcement actions
against national banks that had entered
into contracts with payday lenders for
loan originations, and in each case
ordered the bank to terminate the
relationship with the payday lender.72
70 See In the Matter of First Consumers National
Bank, Beaverton, Oregon, Enforcement Action
2003–100 (required restitution of annual fees and
overlimit fees for credit cards); In the Matter of
Household Bank (SB), N.A., Las Vegas, Nevada,
Enforcement Action 2003–17 (required restitution
regarding private label credit cards); In the Matter
of First National Bank in Brookings, Brookings,
South Dakota, Enforcement Action 2003–1
(required restitution regarding credit cards); In the
Matter of First National Bank of Marin, Las Vegas,
Nevada, Enforcement Action 2001–97 (restitution
regarding credit cards); and In the Matter of Direct
Merchants Credit Card Bank, N.A., Scottsdale,
Arizona, Enforcement Action 2001–24 (restitution
regarding credit cards). These orders can be found
on the OCC’s Web site within the ‘‘Popular FOIA
Requests’’ section at http://www.occ.treas.gov/foia/
foiadocs.htm.
71 See In the Matter of Clear Lake National Bank,
San Antonio, Texas, Enforcement Action 2003–135
(Nov. 7, 2003), available at http://
www.occ.treas.gov/FTP/EAs/ea2003–135.pdf. We
believe these enforcement actions, which have
generated hundreds of millions of dollars for
consumers in restitution, also demonstrate that the
OCC has the resources to enforce applicable laws.
Indeed, as recently observed by the Superior Court
of Arizona, Maricopa County, in an action brought
by Arizona against a national bank, among others,
the restitution and remedial action ordered by the
OCC in that matter against the bank was
‘‘comprehensive and significantly broader in scope
that that available through [the] state court
proceedings.’’ State of Arizona v. Hispanic Air
Conditioning and Heating, Inc., CV 2000–003625,
Ruling at 27, Conclusions of Law, paragraph 50
(Aug. 25, 2003).
72 See In the Matter of Peoples National Bank,
Paris, Texas, Enforcement Action 2003–2; In the
Matter of First National Bank in Brookings,
Brookings, South Dakota, Enforcement Action
2003–1; In the Matter of Goleta National Bank,
Goleta, California, Enforcement Action 2002–93;
and In the Matter of Eagle National Bank, Upper
Darby, Pennsylvania, Enforcement Action 2001–
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Other than these isolated incidences
of abusive practices that have triggered
the OCC’s aggressive supervisory
response, evidence that national banks
are engaged in predatory lending
practices is scant. Based on the absence
of such information—from third parties,
our consumer complaint database, and
our supervisory process—we have no
reason to believe that such practices are
occurring in the national banking
system to any significant degree.
Although several of the commenters
suggested this conclusion is implausible
given the significant share of the
lending market occupied by national
banks, this observation is consistent
with an extensive study of predatory
lending conducted by the Department of
Housing and Urban Development (HUD)
and the Treasury Department,73 and
even with comments submitted in
connection with an OTS rulemaking
concerning preemption of state lending
standards by 46 State Attorneys General.
Less than one year ago, nearly two
dozen State Attorneys General signed a
brief in litigation that reached the same
conclusion. That case involved a revised
regulation issued by the Office of Thrift
Supervision to implement the
Alternative Mortgage Transaction Parity
Act (AMTPA). The revised regulation
seeks to distinguish between Federally
supervised thrift institutions and nonbank mortgage lenders and makes nonbank mortgage lenders subject to state
law restrictions on prepayment
penalties and late fees. In supporting the
OTS’s decision to retain preemption of
state laws for supervised depository
104. These orders can also be found on the OCC’s
Web site within the ‘‘Popular FOIA Requests’’
section at http://www.occ.treas.gov/foia/
foiadocs.htm.
73 A Treasury-HUD joint report issued in 2000
found that predatory lending practices in the
subprime market are less likely to occur in lending
by—
banks, thrifts, and credit unions that are subject
to extensive oversight and regulation * * *. The
subprime mortgage and finance companies that
dominate mortgage lending in many low-income
and minority communities, while subject to the
same consumer protection laws, are not subject to
as much federal oversight as their prime market
counterparts—who are largely federally-supervised
banks, thrifts, and credit unions. The absence of
such accountability may create an environment
where predatory practices flourish because they are
unlikely to be detected.
Departments of Housing and Urban Development
and the Treasury, ‘‘Curbing Predatory Home
Mortgage Lending: A Joint Report’’ 17–18 (June
2000), available at http://www.treas.gov/press/
releases/report3076.htm.
In addition, the report found that a significant
source of abusive lending practices is non-regulated
mortgage brokers and similar intermediaries who,
because they ‘‘do not actually take on the credit risk
of making the loan, * * * may be less concerned
about the loan’s ultimate repayment, and more
concerned with the fee income they earn from the
transaction.’’ Id. at 40.
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institutions and their subsidiaries but
not for unsupervised housing creditors,
the State Attorneys General stated:
Based on consumer complaints
received, as well as investigations and
enforcement actions undertaken by the
Attorneys General, predatory lending
abuses are largely confined to the
subprime mortgage lending market and
to non-depository institutions. Almost
all of the leading subprime lenders are
mortgage companies and finance
companies, not banks or direct bank
subsidiaries.74
It is relevant for purposes of this final
rule that the preemption regulations
adopted by the OCC are substantially
identical to the preemption regulations
of the OTS that have been applicable to
Federal thrifts for a number of years. It
does not appear from public
commentary—nor have the state
officials indicated—that OTS
preemption regulations have
undermined the protection of customers
of Federal thrifts. In their brief in the
OTS litigation described above, the
State Attorneys General referenced ‘‘the
burdens of federal supervision,’’ in
concluding that there ‘‘clearly is a
substantial basis for OTS’s
distinction’’ 75 between its supervised
institutions and state housing creditors.
These considerations are equally
applicable in the context of national
banks, and were recognized, again, by
all 50 State Attorneys General, in their
comment letter to the OCC on this very
regulation, which stated:
It is true that most complaints and
state enforcement actions involving
mortgage lending practices have not
been directed at banks. However, most
major subprime mortgage lenders are
now subsidiaries of bank holding
companies, (although not direct bank
operating subsidiaries).76
The OCC is firmly committed to
assuring that abusive practices—
whether in connection with mortgage
lending or other national bank
activities—continue to have no place in
the national banking system.
VII. Regulatory Analysis
CDRI Act Delayed Effective Date
This final rule takes effect 30 days
after the date of its publication in the
Federal Register, consistent with the
delayed effective date requirement of
the Administrative Procedure Act. See
74 Brief for Amicus Curiae State Attorneys
General, Nat’l Home Equity Mortgage Ass’n v. OTS,
Civil Action No. 02–2506 (GK) (D.D.C.) at 10–11
(emphasis added).
75 Id. at 10.
76 National Association of Attorneys General
comment letter on the proposal at 10 (Oct. 6, 2003)
(emphasis added).
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5. U.S.C. 553(d). Section 302 of the
Riegle Community Development and
Regulatory Improvement Act of 1994
(CDRI Act), 12 U.S.C. 4802(b), provides
that regulations that impose additional
reporting, disclosure, or other
requirements on insured depository
institutions may not take effect before
the first day of the quarter following
publication unless the agency finds that
there is good cause to make the rule
effective at an earlier date. The
regulations in this final rule require
national banks to adhere to explicit
safety and soundness-based antipredatory lending standards. These
standards prohibit national banks from
engaging in certain harmful lending
practices, thereby benefiting consumers.
The final rule imposes no additional
reporting, disclosure, or other
requirements on national banks.
Accordingly, in order for the benefits to
become available as soon as possible,
the OCC finds that there is good cause
to dispense with the requirements of the
CDRI Act.
Regulatory Flexibility Act
Pursuant to section 605(b) of the
Regulatory Flexibility Act, 5 U.S.C.
605(b) (RFA), the regulatory flexibility
analysis otherwise required under
section 604 of the RFA is not required
if the agency certifies that the rule will
not have a significant economic impact
on a substantial number of small entities
and publishes its certification and a
short, explanatory statement in the
Federal Register along with its rule.
Pursuant to section 605(b) of the RFA,
the OCC hereby certifies that this final
rule will not have a significant
economic impact on a substantial
number of small entities. Accordingly, a
regulatory flexibility analysis is not
needed. The amendments to the
regulations identify the types of state
laws that are preempted, as well as the
types of state laws that generally are not
preempted, in the context of national
bank lending, deposit-taking, and other
activities. These amendments simply
provide the OCC’s analysis and do not
impose any new requirements or
burdens. As such, they will not result in
any adverse economic impact.
Executive Order 12866
The OCC has determined that this
final rule is not a significant regulatory
action under Executive Order 12866.
Unfunded Mandates Reform Act of 1995
Section 202 of the Unfunded
Mandates Reform Act of 1995, Pub. L.
104–4 (2 U.S.C. 1532) (Unfunded
Mandates Act), requires that an agency
prepare a budgetary impact statement
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before promulgating any rule likely to
result in a Federal mandate that may
result in the expenditure by State, local,
and tribal governments, in the aggregate,
or by the private sector of $100 million
or more in any one year. If a budgetary
impact statement is required, section
205 of the Unfunded Mandates Act also
requires an agency to identify and
consider a reasonable number of
regulatory alternatives before
promulgating a rule. The OCC has
determined that this final rule will not
result in expenditures by State, local,
and tribal governments, or by the
private sector, of $100 million or more
in any one year. Accordingly, this
rulemaking is not subject to section 202
of the Unfunded Mandates Act.
Executive Order 13132
Executive Order 13132, entitled
‘‘Federalism’’ (Order), requires Federal
agencies, including the OCC, to certify
their compliance with that Order when
they transmit to the Office of
Management and Budget any draft final
regulation that has Federalism
implications. Under the Order, a
regulation has Federalism implications
if it has ‘‘substantial direct effects on the
States, on the relationship between the
national government and the States, or
on the distribution of power and
responsibilities among the various
levels of government.’’ In the case of a
regulation that has Federalism
implications and that preempts state
law, the Order imposes certain
consultation requirements with state
and local officials; requires publication
in the preamble of a Federalism
summary impact statement; and
requires the OCC to make available to
the Director of the Office of
Management and Budget any written
communications submitted by state and
local officials. By the terms of the Order,
these requirements apply to the extent
that they are practicable and permitted
by law and, to that extent, must be
satisfied before the OCC promulgates a
final regulation.
In the proposal, we noted that the
regulation may have Federalism
implications. Therefore, in formulating
the proposal and the final rule, the OCC
has adhered to the fundamental
Federalism principles and the
Federalism policymaking criteria.
Moreover, the OCC has satisfied the
requirements set forth in the Order for
regulations that have Federalism
implications and preempt state law. The
steps taken to comply with these
requirements are set forth below.
Consultation. The Order requires that,
to the extent practicable and permitted
by law, no agency shall promulgate any
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regulation that has Federalism
implications and that preempts state
law unless, prior to the formal
promulgation of the regulation, the
agency consults with state and local
officials early in the process of
developing the proposal. We have
consulted with state and local officials
on the issues addressed herein through
the rulemaking process. Following the
publication of the proposal,
representatives from the Conference of
State Bank Supervisors (CSBS) met with
the OCC to clarify their understanding
of the proposal and, subsequently, the
CSBS submitted a detailed comment
letter regarding the proposal. As
mentioned previously, additional
comments were also submitted on the
proposal by other state and local
officials and state banking regulators.
Pursuant to the Order, we will make
these comments available to the Director
of the OMB. Subsequent, public
statements by representatives of the
CSBS have restated their concerns, and
CSBS representatives have further
discussed these concerns with the OCC
on several additional occasions.
In addition to consultation, the Order
requires a Federalism summary impact
statement that addresses the following:
Nature of concerns expressed. The
Order requires a summary of the nature
of the concerns of the state and local
officials and the agency’s position
supporting the need to issue the
regulation. The nature of the state and
local official commenters’ concerns and
the OCC’s position supporting the need
to issue the regulation are set forth in
the preamble, but may be summarized
as follows. Broadly speaking, the states
disagree with our interpretation of the
applicable law, they are concerned
about the impact the rule will have on
the dual banking system, and they are
concerned about the ability of the OCC
to protect consumers adequately.
Extent to which the concerns have
been addressed. The Order requires a
statement of the extent to which the
concerns of state and local officials have
been met.
a. There is fundamental disagreement
between state and local officials and the
OCC regarding preemption in the
national bank context. For the reasons
set forth in the materials that precede
this Federalism impact statement, we
believe that this final rule is necessary
to enable national banks to operate to
the full extent of their powers under
Federal law, and without interference
from inconsistent state laws; consistent
with the national character of the
national banks; and in furtherance of
their safe and sound operations. We also
believe that this final rule has ample
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1915
support in statute and judicial
precedent. The concerns of the state and
local officials could only be fully met if
the OCC were to take a position that is
contrary to Federal law and judicial
precedent. Nevertheless, to respond to
some of the issues raised, the language
in this final regulation has been refined,
and this preamble further explains the
standards used to determine when
preemption occurs and the criteria for
when state laws generally would not be
preempted.
b. Similarly, we fundamentally
disagree with the state and local
officials about whether this final rule
will undermine the dual banking
system. As discussed in the OCC’s
visitorial powers rulemaking also
published today in the Federal Register,
differences in national and state bank
powers and in the supervision and
regulation of national and state banks
are not inconsistent with the dual
banking system; rather, they are the
defining characteristics of it. The dual
banking system is universally
understood to refer to the chartering and
supervision of state-chartered banks by
state authorities and the chartering and
supervision of national banks by Federal
authority, the OCC. Thus, we believe
that the final rule preserves, rather than
undermines, the dual banking system.
c. Finally, we stand ready to work
with the states in the enforcement of
applicable laws. The OCC has extended
invitations to state Attorneys General
and state banking departments to enter
into discussions that would lead to a
memorandum of understanding about
the handling of consumer complaints
and the pursuit of remedies, and we
remain eager to do so. Moreover, as
discussed in the preamble, we believe
the OCC has the resources to enforce
applicable laws, as is evidenced by the
enforcement actions that have generated
hundreds of millions of dollars for
consumers in restitution, that have
required national banks to disassociate
themselves from payday lenders, and
that have ordered national banks to stop
abusive practices. Thus, the OCC has
ample legal authority and resources to
ensure that consumers are adequately
protected.
List of Subjects
12 CFR Part 7
Credit, Insurance, Investments,
National banks, Reporting and
recordkeeping requirements, Securities,
Surety bonds.
12 CFR Part 34
Mortgages, National banks, Real estate
appraisals, Real estate lending
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Authority: 12 U.S.C. 1 et seq., 71, 71a, 92,
92a, 93, 93a, 481, 484, and 1818.
(1) Contracts;
(2) Torts;
(3) Criminal law; 5
(4) Rights to collect debts;
(5) Acquisition and transfer of
property;
(6) Taxation;
(7) Zoning; and
(8) Any other law the effect of which
the OCC determines to be incidental to
the deposit-taking operations of national
banks or otherwise consistent with the
powers set out in paragraph (a) of this
section.
■ 3. A new § 7.4008 is added to read as
follows:
Subpart D—Preemption
§ 7.4008
standards, Reporting and recordkeeping
requirements.
Authority and Issuance
For the reasons set forth in the
preamble, parts 7 and 34 of chapter I of
title 12 of the Code of Federal
Regulations are amended as follows:
■
PART 7—BANK ACTIVITIES AND
OPERATIONS
1. The authority citation for part 7 is
revised to read as follows:
■
■ 2. A new § 7.4007 is added to read as
follows:
§ 7.4007
Deposit-taking.
(a) Authority of national banks. A
national bank may receive deposits and
engage in any activity incidental to
receiving deposits, including issuing
evidence of accounts, subject to such
terms, conditions, and limitations
prescribed by the Comptroller of the
Currency and any other applicable
Federal law.
(b) Applicability of state law. (1)
Except where made applicable by
Federal law, state laws that obstruct,
impair, or condition a national bank’s
ability to fully exercise its Federally
authorized deposit-taking powers are
not applicable to national banks.
(2) A national bank may exercise its
deposit-taking powers without regard to
state law limitations concerning:
(i) Abandoned and dormant
accounts;3
(ii) Checking accounts;
(iii) Disclosure requirements;
(iv) Funds availability;
(v) Savings account orders of
withdrawal;
(vi) State licensing or registration
requirements (except for purposes of
service of process); and
(vii) Special purpose savings
services; 4
(c) State laws that are not preempted.
State laws on the following subjects are
not inconsistent with the deposit-taking
powers of national banks and apply to
national banks to the extent that they
only incidentally affect the exercise of
national banks’ deposit-taking powers:
3 This does not apply to state laws of the type
upheld by the United States Supreme Court in
Anderson Nat’l Bank v. Luckett, 321 U.S. 233
(1944), which obligate a national bank to ‘‘pay
[deposits] to the persons entitled to demand
payment according to the law of the state where it
does business.’’ Id. at 248–249.
4 State laws purporting to regulate national bank
fees and charges are addressed in 12 CFR 7.4002.
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Lending.
(a) Authority of national banks. A
national bank may make, sell, purchase,
participate in, or otherwise deal in loans
and interests in loans that are not
secured by liens on, or interests in, real
estate, subject to such terms, conditions,
and limitations prescribed by the
Comptroller of the Currency and any
other applicable Federal law.
(b) Standards for loans. A national
bank shall not make a consumer loan
subject to this § 7.4008 based
predominantly on the bank’s realization
of the foreclosure or liquidation value of
the borrower’s collateral, without regard
to the borrower’s ability to repay the
loan according to its terms. A bank may
use any reasonable method to determine
a borrower’s ability to repay, including,
for example, the borrower’s current and
expected income, current and expected
cash flows, net worth, other relevant
financial resources, current financial
obligations, employment status, credit
history, or other relevant factors.
(c) Unfair and deceptive practices. A
national bank shall not engage in unfair
or deceptive practices within the
meaning of section 5 of the Federal
Trade Commission Act, 15 U.S.C.
45(a)(1), and regulations promulgated
thereunder in connection with loans
made under this § 7.4008.
(d) Applicability of state law. (1)
Except where made applicable by
Federal law, state laws that obstruct,
impair, or condition a national bank’s
5 But see the distinction drawn by the Supreme
Court in Easton v. Iowa, 188 U.S. 220, 238 (1903)
between ‘‘crimes defined and punishable at
common law or by the general statutes of a state and
crimes and offences cognizable under the authority
of the United States.’’ The Court stated that
‘‘[u]ndoubtedly a state has the legitimate power to
define and punish crimes by general laws
applicable to all persons within its jurisdiction
* * *. But it is without lawful power to make such
special laws applicable to banks organized and
operating under the laws of the United States.’’ Id.
at 239 (holding that Federal law governing the
operations of national banks preempted a state
criminal law prohibiting insolvent banks from
accepting deposits).
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ability to fully exercise its Federally
authorized non-real estate lending
powers are not applicable to national
banks.
(2) A national bank may make nonreal estate loans without regard to state
law limitations concerning:
(i) Licensing, registration (except for
purposes of service of process), filings,
or reports by creditors;
(ii) The ability of a creditor to require
or obtain insurance for collateral or
other credit enhancements or risk
mitigants, in furtherance of safe and
sound banking practices;
(iii) Loan-to-value ratios;
(iv) The terms of credit, including the
schedule for repayment of principal and
interest, amortization of loans, balance,
payments due, minimum payments, or
term to maturity of the loan, including
the circumstances under which a loan
may be called due and payable upon the
passage of time or a specified event
external to the loan;
(v) Escrow accounts, impound
accounts, and similar accounts;
(vi) Security property, including
leaseholds;
(vii) Access to, and use of, credit
reports;
(viii) Disclosure and advertising,
including laws requiring specific
statements, information, or other
content to be included in credit
application forms, credit solicitations,
billing statements, credit contracts, or
other credit-related documents;
(ix) Disbursements and repayments;
and
(x) Rates of interest on loans.6
(e) State laws that are not preempted.
State laws on the following subjects are
not inconsistent with the non-real estate
lending powers of national banks and
apply to national banks to the extent
that they only incidentally affect the
exercise of national banks’ non-real
estate lending powers:
(1) Contracts;
(2) Torts;
(3) Criminal law;7
(4) Rights to collect debts;
(5) Acquisition and transfer of
property;
(6) Taxation;
(7) Zoning; and
6 The limitations on charges that comprise rates
of interest on loans by national banks are
determined under Federal law. See 12 U.S.C. 85; 12
CFR 7.4001. State laws purporting to regulate
national bank fees and charges that do not
constitute interest are addressed in 12 CFR 7.4002.
7 See supra note 5 regarding the distinction
drawn by the Supreme Court in Easton v. Iowa, 188
U.S. 220, 238 (1903) between ‘‘crimes defined and
punishable at common law or by the general
statutes of a state and crimes and offences
cognizable under the authority of the United
States.’’
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(8) Any other law the effect of which
the OCC determines to be incidental to
the non-real estate lending operations of
national banks or otherwise consistent
with the powers set out in paragraph (a)
of this section.
■ 4. A new § 7.4009 is added to read as
follows:
§ 7.4009 Applicability of state law to
national bank operations.
(a) Authority of national banks. A
national bank may exercise all powers
authorized to it under Federal law,
including conducting any activity that is
part of, or incidental to, the business of
banking, subject to such terms,
conditions, and limitations prescribed
by the Comptroller of the Currency and
any applicable Federal law.
(b) Applicability of state law. Except
where made applicable by Federal law,
state laws that obstruct, impair, or
condition a national bank’s ability to
fully exercise its powers to conduct
activities authorized under Federal law
do not apply to national banks.
(c) Applicability of state law to
particular national bank activities. (1)
The provisions of this section govern
with respect to any national bank power
or aspect of a national bank’s operations
that is not covered by another OCC
regulation specifically addressing the
applicability of state law.
(2) State laws on the following
subjects are not inconsistent with the
powers of national banks and apply to
national banks to the extent that they
only incidentally affect the exercise of
national bank powers:
(i) Contracts;
(ii) Torts;
(iii) Criminal law 8
(iv) Rights to collect debts;
(v) Acquisition and transfer of
property;
(vi) Taxation;
(vii) Zoning; and
(viii) Any other law the effect of
which the OCC determines to be
incidental to the exercise of national
bank powers or otherwise consistent
with the powers set out in paragraph (a)
of this section.
PART 34—REAL ESTATE LENDING
AND APPRAISALS
Subpart A—General
5. The authority citation for part 34
continues to read as follows:
■
Authority: 12 U.S.C. 1 et seq., 29, 93a, 371,
1701j–3, 1828(o), and 3331 et seq.
■ 6. In § 34.3, the existing text is
designated as paragraph (a), and new
88
Id.
VerDate jul<14>2003
17:11 Jan 12, 2004
Jkt 203001
paragraphs (b) and (c) are added to read
as follows:
§ 34.3
General rule.
*
*
*
*
*
(b) A national bank shall not make a
consumer loan subject to this subpart
based predominantly on the bank’s
realization of the foreclosure or
liquidation value of the borrower’s
collateral, without regard to the
borrower’s ability to repay the loan
according to its terms. A bank may use
any reasonable method to determine a
borrower’s ability to repay, including,
for example, the borrower’s current and
expected income, current and expected
cash flows, net worth, other relevant
financial resources, current financial
obligations, employment status, credit
history, or other relevant factors.
(c) A national bank shall not engage
in unfair or deceptive practices within
the meaning of section 5 of the Federal
Trade Commission Act, 15 U.S.C.
45(a)(1), and regulations promulgated
thereunder in connection with loans
made under this part.
■ 7. Section 34.4 is revised to read as
follows:
§ 34.4
Applicability of state law.
(a) Except where made applicable by
Federal law, state laws that obstruct,
impair, or condition a national bank’s
ability to fully exercise its Federally
authorized real estate lending powers do
not apply to national banks.
Specifically, a national bank may make
real estate loans under 12 U.S.C. 371
and § 34.3, without regard to state law
limitations concerning:
(1) Licensing, registration (except for
purposes of service of process), filings,
or reports by creditors;
(2) The ability of a creditor to require
or obtain private mortgage insurance,
insurance for other collateral, or other
credit enhancements or risk mitigants,
in furtherance of safe and sound
banking practices;
(3) Loan-to-value ratios;
(4) The terms of credit, including
schedule for repayment of principal and
interest, amortization of loans, balance,
payments due, minimum payments, or
term to maturity of the loan, including
the circumstances under which a loan
may be called due and payable upon the
passage of time or a specified event
external to the loan;
(5) The aggregate amount of funds that
may be loaned upon the security of real
estate;
(6) Escrow accounts, impound
accounts, and similar accounts;
(7) Security property, including
leaseholds;
PO 00000
Frm 00025
Fmt 4700
Sfmt 4700
1917
(8) Access to, and use of, credit
reports;
(9) Disclosure and advertising,
including laws requiring specific
statements, information, or other
content to be included in credit
application forms, credit solicitations,
billing statements, credit contracts, or
other credit-related documents;
(10) Processing, origination, servicing,
sale or purchase of, or investment or
participation in, mortgages;
(11) Disbursements and repayments;
(12) Rates of interest on loans;1
(13) Due-on-sale clauses except to the
extent provided in 12 U.S.C. 1701j–3
and 12 CFR part 591; and
(14) Covenants and restrictions that
must be contained in a lease to qualify
the leasehold as acceptable security for
a real estate loan.
(b) State laws on the following
subjects are not inconsistent with the
real estate lending powers of national
banks and apply to national banks to the
extent that they only incidentally affect
the exercise of national banks’ real
estate lending powers:
(1) Contracts;
(2) Torts;
(3) Criminal law; 2
(4) Homestead laws specified in 12
U.S.C. 1462a(f);
(5) Rights to collect debts;
(6) Acquisition and transfer of real
property;
(7) Taxation;
(8) Zoning; and
(9) Any other law the effect of which
the OCC determines to be incidental to
the real estate lending operations of
national banks or otherwise consistent
with the powers and purposes set out in
§ 34.3(a).
Dated: January 6, 2004.
John D. Hawke, Jr.,
Comptroller of the Currency.
[FR Doc. 04–586 Filed 1–12–04; 8:45 am]
BILLING CODE 4810–33–P
1 The limitations on charges that comprise rates
of interest on loans by national banks are
determined under Federal law. See 12 U.S.C. 85
and 1735f–7a; 12 CFR 7.4001. State laws purporting
to regulate national bank fees and charges that do
not constitute interest are addressed in 12 CFR
7.4002.
2 But see the distinction drawn by the Supreme
Court in Easton v. Iowa, 188 U.S. 220, 238 (1903)
between ‘‘crimes defined and punishable at
common law or by the general statutes of a state and
crimes and offences cognizable under the authority
of the United States.’’ The Court stated that
‘‘[u]ndoubtedly a state has the legitimate power to
define and punish crimes by general laws
applicable to all persons within its jurisdiction
* * *. But it is without lawful power to make such
special laws applicable to banks organized and
operating under the laws of the United States.’’ Id.
at 239 (holding that Federal law governing the
operations of national banks preempted a state
criminal law prohibiting insolvent banks from
accepting deposits).
E:\FR\FM\13JAR1.SGM
13JAR1
Remarks by
John C. Dugan
Comptroller of the Currency
Before
Women in Housing and Finance
Washington, DC
September 24, 2009
The Need to Preserve
Uniform National Standards for National Banks
I welcome this opportunity for a return engagement before Women in Housing
and Finance at this very critical time. We are, of course, in the middle of an important
national debate about how best to address the gaps and weaknesses in financial regulation
that were exposed by the financial events of the last two years. In this context, the
Treasury Department’s plan to strengthen our regulatory framework is both thoughtful
and comprehensive, and I support many of its core elements.
Among these are certain parts of the plan that would enhance consumer
protection. One is the establishment of a strong federal rulewriter – which Treasury
proposes as a new Consumer Financial Protection Agency or “CFPA” – to issue uniform
national rules for consumer protection. These rules would apply equally not just to
federally regulated banks, but also – and this is critically important – to the literally
hundreds of thousands of nonbank financial providers, such as finance companies and
mortgage brokers, that have been unregulated or lightly regulated by the states. It is well
established that this “shadow banking system” of unregulated financial providers has
been the source of the worst consumer protection and underwriting abuses, especially in
the area of subprime mortgages.
For the same reason, I support providing the CFPA with supervisory and
enforcement authority over these nonbank financial providers, which is crucial to ensure
their compliance with CFPA rules to the same extent as banks. However, for reasons that
have received a great deal of attention in congressional hearings and media accounts, I
think the plan should not strip such authority from bank regulators, where I believe the
current system has worked well.
Today I would like to focus my remarks on a different part of the consumer
protection plan that has received less attention than I think it deserves, given its critical
importance. That is the sweeping proposal to eliminate uniform national consumer
protection standards by repealing key parts of the National Bank Act’s preemption of
state laws, which unfortunately I cannot support. This radical change is fundamentally at
odds with the concept of efficient national standards for national products and services
offered across state lines in national markets – a concept that has been central to the
economic prosperity of the United States since the adoption of our Constitution, and one
that has been critical to the flourishing of our national banking system since 1863. More
importantly – and especially with the strong federal consumer protection rules envisioned
by the new CFPA – truly uniform national standards that provide real benefits to
consumers would be undermined by the repeal of national bank preemption.
Importance of National Standards in US History
Let me explain my strong concerns, beginning, if you will indulge me, with a
brief history of the important role that national standards have played in our economic
-2
history. After the Revolutionary War, the critical and well recognized weakness in the
Articles of Confederation was that it permitted individual states to erect commercial
barriers to trade with neighboring states and foreign powers.1 The ensuing problems
precipitated the adoption of our national Constitution in 1789, because the framers
understood that fragmentation via differing state laws was incompatible with economic
growth, efficiency, and innovation by the nation as a whole. Indeed, one of the most
critical changes the Constitution made was to grant Congress plenary authority over
commerce in Article I, Section 8. Aptly referred to as the “Interstate Commerce clause,”
this provision empowered Congress to establish uniform national standards to govern
economic activities that span state boundaries, clearing the way for the emergence of a
truly national economy.2
How these principles should apply to banking, and whether the national interest
was served by a federal role in the banking system, was one of the earliest policy debates
addressed by the new government. Creation of the First Bank of the United States in
1791 and the Second Bank of the United States in 1816 substantially benefited the
nation’s finances, but proved hugely controversial. Beyond attracting charges of
excessive concentration of power, these federal banks were seen as threats to statechartered institutions. Maryland’s attempt to prevent effective operation of the Second
Bank through state taxation resulted in a landmark Supreme Court decision – McCulloch
v. Maryland – that confirmed the national government’s power to establish a bank and
the supremacy of federal over state law.
1
For example, some states with ports exacted a price from producers in landlocked states to move goods
to market; states adopted bankruptcy laws that advantaged local creditors and debtors at the expense of
others; and states sought to tax and regulate the United States mails.
2
“To regulate Commerce with foreign Nations, and among the Several States, and with the Indian
Tribes[.]”
-3
The controversy came to a head in 1836, when Andrew Jackson vetoed the
renewal of the Second Bank. His principal political opponent, Henry Clay, articulated a
very different vision, rooted in the ideas of Alexander Hamilton, of a truly American
system based on national standards and institutions. Clay proposed to extend the life of
the national bank, protect American industry, and establish a national network of roads
and rails. And it was one of Clay’s most enthusiastic followers, Abraham Lincoln, who
was to ensure that Clay’s national vision ultimately prevailed.
In 1861, the departure of secessionist legislators from Washington marked a
critical step on the path to Civil War. But it also ushered in a period of unprecedented
legislative productivity that advanced national economic goals. This included the
construction of a transcontinental railroad, expansion of the national telegraph network,
improvements in roads and canals, and of course, establishment of our national banking
system through the National Currency Act of 1863 and the National Bank Act of 1864,
which Lincoln helped shape into law.
In adopting these measures, Congress did not abolish state banking. But it did
include explicit protections in the new framework so that national banks would be
governed by federal standards administered by a new federal agency – the Office of the
Comptroller of the Currency. The OCC has successfully carried out those duties for
nearly 150 years, and over that same period, a series of Supreme Court decisions have
confirmed the fundamental principle of federal preemption as applied to national banks:
that is, that the banking activities of national banks are governed by national standards
established by Congress, subject to supervision and oversight by the OCC.
-4
With this design, the state and national banking systems have grown up around
one another, creating the “dual banking system” we know today. Encompassing both
large institutions that market products and services nationally and very small institutions
that do business exclusively in their immediate communities, it is a diverse system with
complex linkages and interdependencies. In this context and over time, a crucial benefit
has been clear: the “national” part of the dual banking system, the part that has allowed
large and small national banks to operate under uniform national rules across state lines,
has strongly fostered the growth of national products and services in national and multistate markets.
Repeal of National Bank Preemption
Returning to the Treasury plan, it’s important to recognize that key parts of it
promote and endorse the concept of uniform national standards. Indeed, as previously
discussed, one of its critical intended benefits is that strong federal rules issued by the
new CFPA would apply equally to all financial providers, whether bank or nonbank.
Another of its goals is to raise the level of compliance with such rules by nonbanks,
which today are unregulated or very lightly regulated, to the same level as currently
applies to federally regulated banks. Both of these aspects of the plan are fully consistent
with the principle of uniform national standards, uniformly applied – as are other aspects
of the plan.3
3
See, e.g., Proposal, supra note 1, at 69 (discussing the proposed CFPA, observing that “[f]airness,
effective competition, and efficient markets require consistent regulatory treatment for similar products,”
and noting that consistent regulation facilitates consumers’ comparison shopping); and at 39 (discussing
the history of insurance regulation by the states, which “has led to a lack of uniformity and reduced
competition across state and international boundaries, resulting in inefficiency, reduced product innovation,
and higher costs to consumers.”).
-5
Unfortunately, however, the very principle of uniform national standards is
expressly undermined by the plan’s specific grant of authority to individual states to
adopt different rules; by the repeal of uniform standards for national banks; and by the
empowerment of individual states, with their very differing points of view, to enforce
federal consumer protection rules – under all federal statutes – in ways that might vary
from state to state. In effect, the resulting patchwork of federal-plus-differing-state
standards would distort and displace the CFPA’s federal rulemaking. This is true even
though the CFPA’s federal rules would be the product of an open public comment
process and the behavioral research and evaluative functions that the plan highlights.
In particular, for the first time in the 146-year history of the national banking
system, federally chartered banks would be subject to multiple state operating standards,
because the plan would sweepingly repeal the ability of national banks to conduct retail
banking business under uniform national standards. This rejection and reversal of such
standards is an extreme change that is, in my view, both unwise and unjustified.
Given the CFPA’s enhanced authority and mandate to write stronger consumer
protection rules, and the thorough and expert processes described as integral to its
rulemaking, there should no longer be any issue as to whether sufficiently strong federal
consumer protection standards would be in place and apply to national banks. In this
context there is no need to authorize states to adopt different standards for such banks.
Likewise, there is no need to authorize states to enforce federal rules against national
banks – which would inevitably result in differing state interpretations of federal rules –
because federal regulators already have broad enforcement authority over such
institutions and the resources to exercise that authority fully.
-6
More fundamentally, we live in an era where the market for financial products
and services is often national in scope. Advances in technology, including the Internet
and the increased functionality of phones, enable banks to do business with customers in
many states. Our population is increasingly mobile, and many people live in one state
and work in another – as is true for many of us in the Washington, D.C. area.
In this context, regressing to a regulatory regime that fails to recognize the way
retail financial services are now provided, and the need for a single set of rules for banks
with customers in multiple states, would discard many of the benefits consumers reap
from our modern financial product delivery system. Such a balkanized approach could
give rise to significant uncertainty about which sets of standards apply to institutions
conducting a multistate business. That in turn would generate major legal and
compliance costs, and major impediments to interstate product delivery.
Moreover, this issue is very real for all banks operating across state lines – not
just national banks. Recognizing the importance of preserving uniform interstate
standards for all banks operating in multiple states, Congress expressly provided in the
“Riegle-Neal II” Act enacted in 1997 that state banks operating through interstate
branches in multiple states should enjoy the same federal preemption and ability to
operate with uniform standards as national banks.4
Accordingly, repealing uniform national standards for national banks would
create fundamental, practical problems for all banks operating across state lines, large or
small. For example, there are a number of areas in which complying with different
standards set by individual states would require a bank to determine which state’s law
governs – the law of the state where a person provides a product or service; the law of the
4
12 U.S.C. § 1831a(j); see also id. at 1831d (interest rates; parity for state banks).
-7
home state of the bank; or the law of the state where the customer is located. It is far
from clear how a bank could do this based on objective analysis, and any conflicts could
result in penalties and litigation in multiple jurisdictions.
And think about some of the practical problems that could arise from different
grace periods for credit cards; different internet advertising rules; different solicitation
standards for telephone sales, with different duties for sales personnel; different employee
compensation limits; and different licensing requirements for new products.
Or consider a more detailed example involving terms for a checking account.
Today a bank can offer customers checking accounts with uniform terms and uniform
disclosures through branches in multiple states, over the Internet, and through various
forms of media. Under the plan, individual states could adopt particular required or
prohibited terms for different aspects of these checking accounts, as well as additional
disclosure and advertising requirements. For example, there could be state-by-state
differences in rules on the number and amount of withdrawals or deposits, permissible
minimum balance requirements, and ATM screen disclosures. States could assert that
those requirements apply according to the law of the state in which the branch offering
the account is located, the home state of the bank, the state where the customer resides, or
someplace else. States could have different standards for exerting jurisdiction over the
terms and disclosures, creating the potential for the laws of two or more states to apply to
the same transaction. How would a bank advertise in the newspaper or on the radio to
promote its checking accounts if it were located in a multistate region – such as the
Washington D.C. area – if different states imposed different requirements regarding
terms and disclosures? Even if the bank figured all this out for a particular customer, that
-8
could all change if the customer moved, or if the bank merged with another bank located
in a different state. Would that mean the customer would have to open a new account to
incorporate the state’s required terms? And even if Congress added language to address
some of the questions we can think of today, there would only be more uncertainties
tomorrow – and no realistic possibility of writing a fix into national law each time a new
issue arose.
Such uncertainties have the real potential to confuse consumers, subject providers
to major new liabilities, and significantly increase the cost of doing business in ways that
will be passed on to consumers. It could also cause providers to pull back where
increased costs erase an already thin profit margin – for example, with “indirect” auto
lending across state lines – or where they see unacceptable levels of uncertainty and risk.
Moreover, a bank with multistate operations might well decide that the only
sensible way to conduct a national business would be to operate to the most stringent
standard prevailing in its most significant state market. It should not be the case that a
decision by one state legislature about how products should be designed, marketed, or
sold should effectively replace a national regulatory standard established by the federal
government based on thorough research and an open and nationwide public comment
process, as would be the case with the new CFPA.
Finally, subjecting national banks to state laws and state enforcement of federal
laws is a potentially crippling change to the national bank charter and a rejection of core
principles that form the bedrock of the dual banking system. For nearly 150 years,
national banks have been subject to a uniform set of federal rules enforced by the OCC,
and state banks have generally been subject to their own states’ rules. This dual banking
-9
system has worked well, as it has allowed a state to serve as a “laboratory” for new
regulation – without compelling adoption of a particular regulation as a national standard.
That is, the dual banking system is built on individual states experimenting with
different kinds of laws, including new consumer protection laws, that apply to a state’s
own banks, but not to state banks in all states and not to national banks. Some of these
individual state laws have proven to be good ideas, while others have not. When
Congress has believed that a particular state’s experiment is worthwhile, it has enacted
that approach to apply throughout the country, not only to national banks, but to state
banks operating in other states that have not yet adopted such laws. As a result, national
banks operate under an evolving set of federal rules that are at any one time the same,
regardless of the state in which the banks are headquartered, or the number of different
states in which they operate. This reliable set of uniform federal rules is a defining
characteristic of the national bank charter. It has helped banks provide a broader range of
products at lower cost, with savings that can be passed along to the consumer.
Preemption Has Not Harmed Consumers
In short, there are many good reasons to oppose the plan’s rejection of uniform
national standards for national banks, especially given the strong rulewriting role
envisioned for the CFPA. But are there good reasons for supporting this aspect of the
proposal? I think not. The argument I’ve heard most often is that repealing national
bank preemption is necessary to stop national banks from engaging in activities that
caused the financial crisis, like predatory subprime lending, which critics say state
consumer protection laws would have prevented.
- 10
That argument is just plain wrong. Its premise is that national banks were the
source of predatory and unsafe mortgage loans, while state-regulated institutions were
not. That’s exactly backwards. It is widely recognized that the worst subprime loans that
have caused the most foreclosures were originated by nonbank lenders and brokers
regulated exclusively by the states. Although the OCC has little rulewriting authority in
this area, we have closely supervised national bank subprime lending practices. As a
result, national banks originated a relatively smaller share of subprime loans and applied
better standards, resulting in significantly fewer foreclosures – as demonstrated in an
attachment to this speech prepared last year by OCC staff. Meanwhile, nothing in federal
law precluded states from effectively regulating their own nonbank mortgage lenders and
brokers. Indeed, that’s why the plan’s grant of strong rulewriting and enforcement
authority at the federal level over the shadow banking system of unregulated financial
providers, through the CFPA, is such a good idea – and why granting the states new
authority over national banks is not.
Another argument I hear focuses on enforcement, asserting that the new law
should empower state officials to enforce consumer protection rules against national
banks – including federal consumer protection rules issued by the new CFPA – because
there supposedly can never be “too many cops on the beat.” But this assertion is simply
not true in a world that has only a limited number of “cops.” State resources are finite,
and there are hundreds of thousands of nonbank financial providers, including subprime
lenders and brokers, that have been the disproportionate source of financial consumer
protection problems. These are the firms most in need of supervisory and enforcement
attention, by both the states and the new CFPA. That’s where state enforcement
- 11
resources should be devoted, rather than diluting them on national banks that are already
extensively supervised by the OCC. And if state officials have information that national
banks appear to be violating applicable law or otherwise engaging in inappropriate
practices, we want to hear about it, we will follow up on it, and we will be open with
those officials about what we find and what we propose to do about it. All of us want
consumers to be treated fairly and honestly; by collaborating rather than duplicating, we
can better help achieve that result.
Conclusion
In sum, throughout our history, uniform national standards have proved to be a
powerful engine for prosperity and growth. Such standards for national banks have been
very much a part of this history, and have produced real benefits for consumers. As
Congress moves forward with legislation on financial consumer protection, its goals
should be to strengthen federal rules and apply them more uniformly to all providers of
the same financial products – goals shared by the Treasury Plan. It should not be to
undermine those goals by inviting every state to adopt its own rules for national banks – a
course of action likely to produce far greater costs than benefits.
*
*
*
- 12
*
O
Comptroller of the Currency
Administrator of National Banks
Washington, DC 2021
The Importance of
Preserving a System of
National Standards
For
National Banks
January 2010
The Importance of Preserving a System of
National Standards for National Banks
I.
Introduction
Since the establishment of the national banking system in 1863 and 1864, banks and their
consumers have benefitted from the dynamic of the dual banking system. State banking systems
can serve as laboratories of regulatory innovation, exploring new products and regulatory
approaches to issues that, if successful, may be adopted at the federal level. The national banking
system, operating under uniform federal standards across state lines, strongly fosters an open
financial marketplace, the growth of national products and services in national and multi-state
markets, and reduced costs.
The legal principle that supports uniform federal standards for national banks is the
doctrine of federal “preemption,” which flows directly from the Supremacy Clause of the U.S.
Constitution. The Supreme Court has long held that, under the doctrine of federal preemption,
any state law that conflicts, impedes, or interferes with national banks’ federally-granted powers
may not be applied to national banks – the state law is “preempted” by federal power.
Preservation of the uniform federal standards has benefitted consumers of financial products by
making a wider range of banking products and services available to more consumers and, overall,
lowering the costs of credit and other banking products and services. In turn, the banking system
benefits from greater economies of scale and improved risk management.
Critics of federal preemption have argued that it undermines the dual banking system.
This argument, however, dismisses the clear benefits the system produces for consumers and
banks alike, and shortchanges the state banking systems and the vital role they play in the dual
banking system.
Other critics contend that federal preemption is contrary to consumers’ interests and assert
that preemption was one of the leading causes of the subprime mortgage lending crisis. The facts
-3simply do not bear this out. National banks and their subsidiaries originated only 12 to 14 percent
of all subprime mortgages between 2005 and 2007. The vast majority of the subprime mortgages
originated during these years were made by state licensed and supervised entities. The limited
role that national banks and their subsidiaries played in the subprime mortgage lending crises
strongly suggests that federal preemption had little to do with the crisis. This conclusion is
bolstered by the track record of performance of subprime loans originated by national banks,
which is better than the performance of subprime lending done by nonbanks in recent years.
II.
The National Banking System and Federal Preemption
Congress enacted the National Currency Act of 1863 and the National Bank Act of 1864
to establish a national banking system to operate distinctly and separately from the existing
system of private state banks. In adopting these measures, Congress did not abolish state
banking, but was concerned about state legislation hostile to banks that the states did not create
and control. To shield the national banks from such legislation, Congress included explicit
protections in the new framework to ensure that national banks would be governed by Federal
standards administered exclusively by a new federal agency – the Office of the Comptroller of the
Currency. With the establishment of the national banks, Congress created the “dual banking
system,” in which both the states and the federal government have the power to charter banks and
the power to supervise and regulate independently the banks they have chartered. The dual
banking system remains in place today.
A.
Doctrine of Federal Preemption Flows Directly from the Supremacy Clause of
the United States Constitution
At the core of the national banking system is the principle that national banks, in carrying
on the business of banking under a federal authorization, should be subject to uniform national
-4standards and uniform federal supervision.1 The legal principle that produces such a result is the
“preemption” of state law. The doctrine of preemption flows directly from the Supremacy Clause
of the U.S. Constitution,2 and provides that the Constitution and laws of the United States are the
“Supreme Law” of the land, notwithstanding anything in the Constitution of laws of the States to
the contrary. The Supremacy Clause was the basis for the landmark 1819 Supreme Court
decision, McCulloch v. Maryland,3 which established the bedrock principle that state law cannot
stand as an obstacle to the accomplishment of federal legislative goals.
B.
For Over 140 Years, the Supreme Court Has Held That State Laws Which
Conflict, Impede, or Interfere with National Banks’ Powers and Activities Are
Preempted
In the years following the National Bank Act’s enactment, the Supreme Court recognized
the clear intent on the part of Congress to limit the authority of states over national banks
precisely so that the nationwide system of banking that was created in the National Bank Act
could develop and flourish. This point was highlighted by the Supreme Court in 1903 in Easton
v. Iowa. 4 The Court stressed that the application of multiple states’ standards would undermine
the uniform, national character of the powers of national banks, which operate in –
a system extending throughout the country, and independent, so far as powers conferred
are concerned, of state legislation which, if permitted to be applicable, might impose
limitations and restrictions as various and as numerous as the states…. If [the states] had
such power it would have to be exercised and limited by their own discretion, and
confusion would necessarily result from control possessed and exercised by two
independent authorities. 5
1
In discussing the impact of the National Currency Act and National Bank Act, Senator Sumner stated that,
“[c]learly, the [national] bank must not be subjected to any local government, State or municipal; it must be kept
absolutely and exclusively under that Government from which it derives its functions.” Cong. Globe, 38th Cong., 1st
Sess., at 1893 (April 27, 1864).
2
U.S. Constitution Article VI, cl. 2.
3
McCulloch v. Maryland, 17 U.S. (4 Wheat) 316 (1819).
4
188 U.S. 220 (1903).
5
Id. at 229, 230-31. A similar point was made by the Court in Talbott v. Bd. of County Commissioners of
Silver Bow County, in which the court stressed that the entire body of the Statute respecting national banks,
emphasize that which the character of the system implies - an intent to create a national banking system co-extensive
with the territorial limits of the United States, and with uniform operation within those limits. 139 U.S. 438, 443
(1891).
-5The Supreme Court strongly reaffirmed this point in 2007 in Watters v. Wachovia,6 stating:
Diverse and duplicative superintendence [by the states ] of national banks’ engagement in
the business of banking, we observed over a century ago, is precisely what the [ National
Bank Act ] was designed to prevent.7
The Supreme Court and lower federal courts have repeatedly made clear that state laws that
conflict, impede, or interfere with national banks’ powers and activities are preempted. For
example, in Davis v. Elmira Savings Bank,8 the Supreme Court stated: “National banks are
instrumentalities of the Federal Government, … It follows that an attempt, by a state, to define
their duties or control the conduct of their affairs, is absolutely void.” In Franklin National Bank
v. New York,9 the Supreme Court held that a state could not prohibit a national bank from using
the word “savings” in its advertising, since the state law conflicts with the power of national
banks to accept savings deposits. More recently, in Barnett Bank v. Nelson,10 the Supreme Court
affirmed the preemptive effective of federal banking law under the Supremacy Clause and held
that a state statute prohibiting banks from engaging in most insurance agency activities was
preempted by Federal law that permitted national banks to engage in insurance agency activities.
In reaching its conclusion, the Court explained that the history of the National Bank Act “is one
of interpreting grants of both enumerated and incidental ‘powers’ to national banks as grants of
authority not normally limited by, but rather ordinarily pre-empting, contrary state law.”
C.
However, the Supreme Court Also Has Recognized That Many Types of State
Commercial and Infrastructure Laws Do Apply to National Banks
The common thread running through these cases recited above is the preemption of a state
law that impedes or interferes with national banks’ powers. On the other hand, states are
6
550 U.S. 1 (2007).
Id. at 14.
8
161 U.S. 275, 283 (1896).
9
347 U.S. 373 (1954).
10
517 U.S. 25, 32 (1996).
7
-6permitted to regulate the activities of national banks where doing so does not impair, encroach
upon, significantly interfere with, or prevent the exercise of these powers.11 Thus, many types of
state commercial and business “infrastructure” laws are not preempted, and national banks remain
subject to significant state statutory schemes, including contracts, torts, criminal justice, zoning,
right to collect debt, and many other generally applicable commercial and business standards.
The OCC has recognized that such laws are not preempted.12
The Supreme Court, only five years after the enactment of the National Bank Act,
recognized that national banks may be subject to some state laws in the normal course of business
if there is no conflict with Federal law.13 In holding that national banks’ contracts, their
acquisition and transfer of property, their right to collect their debts, and their liability to be sued
for debts, are based on State law, the Court noted that national banks “are subject to the laws of
the State, and are governed in their daily course of business far more by the laws of the State than
of the nation.”14 The OCC does not dispute this basic proposition.
The courts have continued to recognize that national banks are subject to state laws, unless
those laws infringe upon the national banking laws or impose an undue burden on the
performance of the banks’ federally-authorized activities. In McClellan v. Chipman,15 the
Supreme Court held that the application to national banks of a state statute forbidding certain real
estate transfers by insolvent transferees was not preempted as the statute would not impede or
hamper national banks’ functions. In Wichita Royalty Co. v. City Nat. Bank of Wichita Falls,16
the Court upheld the application of state tort law to a claim by a bank depositor against bank
11
Barnett Bank, 517 U.S. at 33 (1996).
12 C.F.R. § 7.4009(c) (2009). The OCC adopted this rule in 2004, noting that these laws do not attempt to
regulate national banks’ activities, but rather form the legal infrastructure that makes it practicable to exercise a
permissible Federal power. 69 Fed.Reg. 1904, 1912 (Jan. 13, 2004).
13
National Bank v. Commonwealth, 76 U.S. (9 Wall.) 353 (1869).
14
Id. at 362 (1869).
15
164 U.S. 347 (1896).
16
306 U.S. 103 (1939).
12
-7directors. And in Anderson Nat. Bank v. Luckett,17 the Supreme Court held that a state statute
administering abandoned deposit accounts did not unlawfully encroach on the rights and
privileges of national banks and, as a result, was not preempted.
As these cases demonstrate, there are numerous state laws to which national banks remain
subject because the laws do not significantly impede or interfere with powers granted national
banks under Federal Law. Yet, in reaching this conclusion, these cases serve to confirm the
fundamental principle of federal preemption as applied to national banks: that is, that the banking
business of national banks is governed by federal standards. These uniform national standards
and the federal supervision under which national banks operate are the defining attributes of the
national bank component of our dual banking system.
III.
The Dual Banking System and Uniform Federal Standards for National Banks
In establishing the national banking system, Congress opted not to abolish existing private
state banks, but rather to adopt a new framework in which national banks would be governed by
uniform federal standards.18 With this design, the state and national banking systems have grown
up around one another, creating the “dual banking system” we know today.
A.
Benefits of the Dual Banking System
Encompassing both large institutions that market products and services nationally and
very small institutions that do business exclusively in their immediate communities, the dual
banking system provides both banks and consumers with significant benefits. These benefits flow
from the competitive dynamic between the national and state systems when each component
system is allowed to function in accordance with its distinctive attributes.
17
321 U.S. 233 (1944).
The “very core of the dual banking system is the simultaneous existence of different regulatory options
that are not alike in terms of statutory provisions, regulatory implementation and administrative policy.” Kenneth E.
Scott, The Dual Banking System: A Model of Competition in Regulation, 20 Stan. L. Rev. 1, 41 (1977).
18
-81.
States may serve as laboratories for innovative and new approaches
One of the well-understood benefits of the dual banking systems is that, by having a
separate system of state banks, states may serve as laboratories for innovation and for new
approaches to an issue, without compelling adoption of a particular approach by all states or as a
national standard. That is, the dual banking system is built on the ability of individual states
experimenting with different kinds of laws, including new consumer protection laws that apply to
state banks in a given state, but not to state banks in all states and not to national banks. Over
time, some of these individual state laws have proven to be good ideas, while others have not.
When Congress has believed that a particular state’s experiment is worthwhile, it has enacted that
approach to apply throughout the country, not only to all national banks, but to state banks
operating in other states that have not yet adopted such laws.
The national banking system, on the other hand, is the venue for efficiencies and benefits
that flow from uniform national standards. This role is increasingly important as the market for
financial products and services has evolved, as advances in technology have enabled banks to do
business with consumers in many states, and as consumer financial products have become
commoditized and marketed nationally. In other words, the national banking system is a
laboratory, too, but what it demonstrates is the value of applying uniform national standards to
activities and products that, today, have national markets.
2.
Promotion of a diverse and flexible financial marketplace
In large part attributable to the competitive dynamic between its national and state banking
components, the dual banking system has produced a remarkably diverse and innovative financial
marketplace. Bankers can make choices between state and national bank charters on the basis of
their business needs and particular circumstances. Businesses and consumers have a wide range
of options in the marketplace, as financial institutions are encouraged to respond dynamically to
-9the changing needs of borrowers and depositors and to provide services and products in an
efficient and cost-effective manner. In short, the dual banking system has been critical in
producing a banking system that is able to finance growth and meet customer needs through
innovation, responsiveness, and flexibility.19
Each component of the dual banking system makes different, positive contributions to the
overall strength of the U.S. banking system. Efforts to dilute – or eliminate – the unique
characteristics of one component of the system undermine the collective strength that comes from
the diverse contributions of the two systems. The U.S. banking system as a whole, including the
state banking component, benefits from the national banking system’s contributions, which flow
from the efficiencies and benefits of operating under uniform national standards and a strong and
uniform federal supervisory system.
B.
The Existence of Federal Preemption as an Essential Characteristic of the Dual
Banking System Established by Congress Does Not Disadvantage State Banks
and the State Banking Charter
Notwithstanding the role that both the state and national banking components play in the
collective strength of the dual banking system, some argue that federal preemption of state laws
which interfere or impede with national banks’ activities – that is, the application of the
Supremacy Clause of the U.S. Constitution – is somehow unfair to the state banking system.
This argument profoundly short-changes the State banking systems and the crucial role
they play in the modern financial services marketplace. More fundamentally, however, the
argument is backwards. National and State charters each have their own distinct advantages.
Indeed, State banking supervisors vigorously assert that the State charter is superior. Numerous
State banking department websites provide lists of the advantages of the State charter, often
including a side-by-side comparison of fees and assessments to demonstrate the lower costs of a
19
See Susan S. Bies, Governor, Board of Governors of the Federal Reserve System, Remarks Before the
Conference of State Bank Supervisors (May 30, 2003).
- 10 State charter.20 One state banking department, after a listing of ten advantages of the State
charter, concludes that the “state banking charter the charter of choice” for banks in that state.21
Some states have actively marketed the State bank charter, sending unsolicited letters, and even
videos, touting the benefits of a State bank charter to national banks.
When all factors are considered, the number of national and state-chartered banks simply
does not suggest that the principle of preemption has eroded the dual banking system.22 As of
June 30, 2009, there were 5,490 FDIC-insured, state-chartered commercial banks, and 1,505
FDIC-insured, OCC-chartered national banks.23 Far from signaling that state-chartered
institutions are disadvantaged, these figures amply demonstrate the important role played by the
state banking systems and the vitality of the dual banking system.24
C.
Benefits of the National Banking System and Uniform Standards of Operation
and Supervision
From its establishment, the national banking system has been governed by uniform federal
standards of operation and supervision. When a state law has impeded or significantly interfered
with powers granted national banks under Federal law, the courts have held that under the
Supremacy Clause the state law is preempted. Over the years, preemption of state laws that
20
See, e.g., Texas Department of Banking, http://www.banking.state.tx.us/corp/charter/benefits.htm; California
Department of Financial Institutions, http://www.dfi.ca.gov/cacharter/advantages.asp; South Dakota Division of
Banking, http://www.state.sd.us/drr2/reg/bank/banktrust/State%20Charter%20Comparison.pdf;
21
Tennessee Department of Financial Institutions, http://www.state.tn.us/tdfi/banking/charter.html.
22
See “The Benefits of Charter Choice: The Dual Banking System As A Case Study,” prepared by the
Conference of State Bank Supervisors and the American Bankers Association (June 24, 2005) (concluding the dual
banking system “works,” fostering innovation, making products and services more widely available, and lowering
costs). See also Testimony of Joseph A. Smith, Jr., North Carolina Commissioner of Banks, on behalf of the
Conference of State Bank Supervisors, before the Committee on Financial Services of the U.S. House of
Representatives (Sept. 23, 2009) (arguing that creation of a single federal financial regulator would undermine the
dual banking system; state-chartered institutions and the financial system itself have benefited from the debate among
state and federal regulators); Testimony of Jospeh A. Smith, Jr., North Carolina Commissioner of Banks, on behalf of
the Conference of State Bank Supervisors, before the Committee on Financial Services of the U.S. House of
Representatives (July 24, 2009) (stating that the dual banking system has produced a diverse, dynamic, and durable
banking industry and broad access to affordable credit).
23
FDIC Quarterly Banking Profile (June 30, 2009).
24
Jeffery C. Vogel, Conference of State Bank Supervisors Chairman, 2007-08, “CSBS Year in Review,”
(May 21, 2008) (stating that “the state banking system is a significant and vital force in our local and national
economies”).
- 11 impede or interfere with national banks’ activities has fostered the creation of a set of predictable
rules for national banks, which has lowered the costs of interstate banking and opened the
financial marketplace. Such openness benefits both consumers and banks alike.25
The banking system benefits from (1) greater economies of scale, as consumer products
become commoditized and marketed in larger geographic areas; (2) improved risk management,
as banks diversify across product offerings and across geographic markets; and (3) increased
competition in the bank sector, a crucial factor in the continued vitality of the dual banking
system. While these benefits accrue to all banks, they are especially important for smaller
banking companies with customers in more than one state, where economies of scale and costeffective risk management are critical if they are to operate efficiently.
D.
Preemption and the Practical Impact of Applying State Laws to National Banks
As demonstrated above, important benefits flow from the ability of national banks to
conduct their banking business under uniform national standards. Federal preemption of state
laws that impede or interfere with national banks’ activities preserves these uniform standards.
Repeal or removal of federal preemption would create the potential for national banks to be
subject to myriad state and local regulations and restrictions with significant practical impact on
their banking activities. Such a balkanized approach would give rise to considerable uncertainty
about which sets of standards apply to institutions conducting a multistate business. That, in turn,
would generate major legal and compliance costs and impediments to product delivery for all
banks, large or small.
For example, there are a number of areas in which complying with different standards set
by individual states would require a bank to determine which state’s law governs – the law of the
25
Cf. Jith Jayaratne & Philip E. Strahan, “The Benefits of Branching Deregulation,” FRBNY Econ. Pol’y
Rev. 13 (1997) (finding that, as geographic restrictions on interstate branching were removed between 1978 and
1992, bank efficiency improved greatly, with reduction in operating costs passed along to consumers in the form of
lower loan rates).
- 12 state where a person provides a product or service; the law of the home state of the bank; or the
law of the state where the customer is located. It is far from clear how a bank could do this based
on objective analysis, and any conflicts could result in penalties and litigation in multiple
jurisdictions. Practical problems could arise from different grace periods for credit cards;
different internet advertising rules; different solicitation standards for telephone sales, with
different duties for sales personnel; different employee compensation limits; and different
licensing requirements for new products.
On this basis alone, the maintenance of uniform national standards is compelling. But on
at a more granular level – at the level of potential types of state regulation of national banks’
activities – the case in favor of preemption is forceful. In practical terms, there are generally three
categories of state laws involved: 1) laws that prevent or impede the ability of a national bank to
operate or offer a particular product or service; 2) laws that impose controls on pricing of
particular products or indirectly affecting pricing by prohibiting specified terms; and 3) laws
regulating the manner and means by which consumers are provided information about the bank’s
financial products and services.
1.
Preventing or impeding the ability of a national bank to operate or
offer a particular product or service
The banking business of national banks is controlled by Federal law, specifically the
National Bank Act (“NBA”), 12 U.S.C. § 1 et seq., and federal regulations. The NBA authorizes
national banks to engage in activities that are part of, or incidental to, the business of banking,
plus other specified activities set forth in the NBA. When a state attempts to regulate a national
bank’s activities by precluding national banks from operating within the state – where they are
authorized to operate under Federal law – or to bar national banks from offering products or
services – which they are authorized to offer under Federal law, the state is directly interfering
with powers granted under Federal law. Such interference is fundamentally at odds with
- 13 Constitutional principles embodied in the Supremacy Clause. Examples of this type of state law
include the following:
•
Different states could impose licensing or product clearance requirements that could
simply prevent national banks from providing certain products and services, or subject
certain or new products and services to a state-by-state level pre-clearance.
•
Different states could impose different capital or net worth requirements or security deposit
requirements as preconditions for product providers operating in the state, such as net worth
requirements for mortgage originators based on size or volume of business conducted in a
state.
•
Different states could specify requirements regarding the structures through which a bank
must operate in order to provide certain products, based on a view that certain corporate
structures or reporting lines are needed to effectively implement consumer protection
objectives.
2.
Imposing controls on pricing of particular products or indirectly
affecting pricing by prohibiting specified terms
A second type of state law may attempt to impose controls on the pricing of particular
products or indirectly affect pricing by prohibiting specified terms. A state could seek to impose
direct price controls, by dictating how much a bank may charge for a product or service or when
fees or other charges may be imposed, or may indirectly control prices, by prohibiting or
conditioning the use of certain product features. Whether implemented directly or indirectly, such
price controls represent the state telling a federally-chartered bank how much it can charge for
particular products and services when no such pricing restriction exists under Federal law.
A national bank’s authority to provide products or services to its customers necessarily
encompasses the ability to charge a fee for the product or service.26 This ability to charge a fee
for the bank’s products and services is expressly reaffirmed in OCC regulations.27 As a result,
state efforts to limit or otherwise control, directly or indirectly, the price a national bank may
26
Bank of America v. City and County of San Francisco, 309 F.3d 551 (9th Cir. 2002), cert. denied, 538
U.S. 1069 (2003).
27
12 C.F.R. Section 7.4002(a) provides that “[a] national bank may charge its customers non-interest
charges and fees, including deposit account service charges.”
- 14 charge for its products and services are preempted and invalid under the Supremacy Clause.
Examples of these types of restrictions are:
•
Different states could impose different limits on the rates of interest that may be charged
to consumers in their states, and could prescribe different definitions of what types of
charges constitute “interest” for purposes of each state’s “interest” rate cap.
•
Different states could impose other limits or directives on particular terms and conditions
of any consumer financial product offered by the bank. Banks could be required to offer
specified products and services that conform to specified terms. States also could dictate
particular product features, such as minimum payment requirements, grace periods,
minimum periods for loan repayment, and early termination of mortgage insurance.
3.
Regulating the manner and means by which consumers are provided
information about financial products and services
A third type of state law may attempt to regulate how national banks conduct business by
dictating the manner and means by which consumers are provided information about financial
products and services.28 For example, states could impose different disclosure requirements in
connection with sales and solicitations of products or even requirements dictating the presentation
and format of such disclosures. Examples of this type of state law requirement include the
following:
•
Different states could impose different disclosure requirements in connection with sales
and solicitations of particular products.
•
Disclosure requirements could dictate not just substantive content, but also presentation
and placement of disclosures, further impeding the ability of consumers to comparison
shop.
•
Different states could impose different standards concerning manner of negotiation, sales
and solicitation of particular financial products and services with respect to consumers in
each state.
In recent years, the federal government and agencies have developed a much-expanded
rulewriting process for developing standards for consumer disclosures, and other
28
This type of law does not include a state law that embodies a business conduct standard, such as a prohibition on
offering products and services in a manner that is unfair or deceptive, comparable to the standards in section 5 of the
Federal Trade Commission Act.
- 15 communications, which convey important financial information to consumers. The process
incorporates nationwide public comment process and extensive consumer testing to identify the
information most meaningful to consumers and the most effective way to convey it to them. In
the absence of preemption, a state could require – on any basis – that disclosures or
communications take a form other than that required by the federal standards produced by this
robust federal process. There is no basis to assume that the disclosure requirements imposed by
any state – which would not be based on the comment process and testing used to develop a
federal rule – would be better than the federal rule. For a national bank that operates interstate,
the least costly option may be to cede to the requirements of the state with the apparently most
extensive disclosure requirements, if doing so would satisfy the remaining states’ requirements.
The practical result would then be that a single state’s requirements displace the standards
promulgated in the federal rulemaking process, not just in one state, but in multiple states.
Permitting the states to adopt different disclosure requirements also has real downsides for
consumers. As compliance costs increase, some portion of these costs is passed on to consumers
of financial products and services. Yet, at the same time, consumers’ ability to look out for
themselves and comparison shop for the best deal is undermined if differences in disclosure and
communication requirements undermine their ability to compare products.
E.
Preemption Incentivizes Robust Federal Standards
A key to the benefits of preemption described above is strong consumer protection
standards at the federal level – a position the OCC agrees with.29 In fact, preemption, when
coupled with robust federal standards for national banks, operates as an incentive for the
application of robust standards at the federal level that will apply to all participants in the
29
See Testimony of John C. Dugan, Comptroller of the Currency, before the Committee on Financial
Services of the U.S. House of Representatives, (Jun. 13, 2007) (setting forth in detail the OCC’s comprehensive
approach to consumer protection regulation).
- 16 financial marketplace. With comprehensive robust federal standards in place to identify and
resolve problems before they explode, there is no need for state “first responders” to arrive at the
scene of a disaster, assess the damage and treat the wounded. Strong federal standards should
prevent the disaster. Prevention, and not response, should be the first goal.
IV.
Preemption Did Not Cause the Subprime Mortgage Lending Crisis
Some critics of preemption allege that it was a primary cause of the subprime mortgage
crisis. This argument crumbles when facts and hard numbers are analyzed. The vast majority of
subprime loans were originated by state licensed and supervised lenders and mortgage brokers,
not federally-regulated banks. National banks had a limited share of subprime lending during
crucial recent years, and those loans have a better performance record than nonbank subprime
lending. Indeed, a portion of national banks’ loans labeled “subprime” was to low- and moderateincome borrowers in furtherance of banks’ CRA obligations. Community advocates and Federal
Reserve researchers agree that these loans are of higher quality and have performed better than
mortgages made by lenders not covered by CRA.
A.
National Banks Did Limited Subprime Lending, and when National Banks
Originated Subprime Mortgage Loans, Those Loans Have Performed Better
than Subprime Lending as a Whole
On a nationwide basis, national banks and their subsidiaries accounted for approximately
12 to 14 percent of all non-prime originations, in the years 2005-2007, the peak years for nonprime lending.30 The overwhelming majority of non-prime loans originated during this period
were made by entities licensed and supervised by the states.31
30
Letter from John C. Dugan, Comptroller of the Currency, to Elizabeth Warren, Chair, Congressional
Oversight Panel (Feb. 12, 2009) (analyzing data from Loan Performance Corporation and Home Mortgage Disclosure
Act data).
31
Id. See also Report and Recommendations by the Majority Staff of the Joint Economic Committee, “The
Subprime Lending Crisis: The Economic Impact on Wealth, Property Values and Tax Revenues, and How We Got
Here,” at p. 17 (Oct. 2007) (“The mortgages underwritten by subprime lenders come from many sources, but the
overwhelming majority is originated through mortgage brokers.”)
- 17 The subprime loans originated by national banks and their subsidiaries generally have
performed better than subprime lending as a whole, with lower foreclosure rates.32 The OCC
identified the ten mortgage orginators with the highest rate of subprime and Alt-A mortgage
foreclosures in the ten metropolitan statistical areas (“MSAs”) experiencing the highest
foreclosure rates for the years 2005-2007. Of the 21 firms comprising the “worst 10” in those 10
MSAs, 12 firms – accounting for nearly 60 percent of non-prime mortgage loans and foreclosures
– were exclusively supervised by the states. See Attachment A. The lower foreclosure rates
generally indicate that the subprime loans originated by national banks were relatively higher
quality and better underwritten mortgages.
B.
A Portion of National Banks’ Subprime Lending Was Made to Low- and
Moderate-Income Borrowers in Furtherance of CRA Obligations
A portion of the non-prime mortgage loan origination by national banks is traceable to
efforts by national banks to fulfill their obligations to help meet the credit needs of their local
communities, including low- and moderate-income (“LMI”) areas, under the Community
Reinvestment Act (“CRA”). Potential borrowers in LMI areas tend to have lower credit scores –
average credit scores in LMI census tracts are about 90 points less than average scores in other
census tracts – placing many of them in the “subprime” category. National banks can and do lend
to borrowers with lower credit scores, but to do so prudently the banks generally price the loans to
cover the higher risk associated with lower credit scores. The annual Home Mortgage Disclosure
Act (“HMDA”) data indicates that nearly 30 percent of mortgage loans with higher interest rates,
so-called “rate spread loans,”33 originated by national banks and their operating subsidiaries
tended to be in LMI census tracts, even though those tracts account for only approximately 15
32
Testimony of John C. Dugan, Comptroller of the Currency, before the Committee on Financial Services of
the U.S. House of Representatives, supra note 29; Letter from John C. Dugan, Comptroller of the Currency, to
Elizabeth Warren, Chair, Congressional Oversight Panel, supra note 30.
33
Rate spread loans and subprime loans are not exactly the same thing, but the HMDA data are more
comprehensive and of higher quality than other data sources that focus narrowly on subprime loans, and the results
likely are a good indication of overall tendencies in the market.
- 18 percent of national banks’ mortgage lending overall. These numbers suggest a discernible share
of subprime lending done by banks was done for CRA purposes.34
This portion of subprime lending was not, as some have suggested, the cause of the
subprime crisis. Where CRA-covered banking institutions made subprime loans in their
assessment areas, in aggregate these subprime loans have performed better than subprime loans
made by other types of lenders. For example, a study by the Federal Reserve Bank of San
Francisco concluded that subprime origination volume by CRA-covered lenders within CRA
assessment areas was relatively small, and that loans made by a CRA-covered lender within its
assessment area are markedly less likely to go into foreclosure than loans made in the same area
by lenders not subject to CRA.35 A second Federal Reserve study found that mortgages
originated and held in portfolio under the affordable lending programs operated by the
NeighborWorks partners36 across the country have, along any measure of delinquency or
foreclosure, performed better than subprime and FHA-insured loans and have a lower foreclosure
rate than prime loans.37
In summary, a portion of national banks’ non-prime loans were made to fill their
obligations under CRA, but these loans did not cause the mortgage crisis. Subprime origination
in CRA assessment areas was too small relative to the overall mortgage market to be a primary
cause of the crisis, and subprime lending by CRA-covered lenders has been shown to outperform
mortgages made by lenders not covered by CRA.
34
These figures were derived through analysis of FFIEC data on credit scores and HMDA data on 1-4
family first lien mortgage origination.
35
Elizabeth Laderman and Carolina Reid, Federal Reserve Bank of San Francisco, “Lending in Low- and
Moderate-Income Neighborhoods in California: The Performance of CRA Lending During the Subprime Meltdown”
(Nov. 14, 2008), at pp. 14-16.
36
Many loans originated through NeighborWorks programs are done in connection with CRA-covered
institutions.
37
Glenn Canner and Neil Bhutta, Board of Governors of the Federal Reserve System, Division of Research
and Statistics, “Staff Analysis of the Relationship between the CRA and the Subprime Crisis,” p. 3 and p. 8 table 3
(Nov. 21, 2008), at p.5 and table 9, p. 10.
- 19 VI.
Conclusion
From its establishment, the national banking system has been governed by uniform federal
standards of operation and supervision. These characteristics are fundamental to the distinctions
that are the essence of the “dual banking system.” These uniform federal standards have fostered
the creation of a set of predictable rules and consistent federal oversight for national banks, which
has lowered the costs of interstate banking and opened the financial marketplace. The banking
system benefits from greater economies of scale, improved risk management, and increased
competition in the bank sector. In turn, consumers have benefitted from nationally uniform
standards of consumer protection, the availability of a wider range of banking products and
services and, overall, lowering the costs of credit and other banking products and services.
Attachment A
Worst Ten in the Worst Ten: Supervisory Status of Mortgage Originators
Originator
New Century Mortgage Corp.
Long Beach Mortgage Co.
Argent Mortgage Co.
WMC Mortgage Corp.
Supervisor
State supervised. Subsidiary of publicly-traded
REIT, filed for bankruptcy in early 2007.
State and OTS supervised. Affiliate of WAMU,
became a subsidiary of thrift in early 2006; closed in
late 2007 / early 2008.
State supervised until Citigroup acquired certain
assets of Argent in 08/07. Held by Citigroup, new
lending curtailed and merged into CitiMortgage (NB
opsub) shortly thereafter.
State supervised. Subsidiary of General Electric,
closed in late 2007.
Foreclosures in Worst 10
Metro Areas, based on
2005-07 Originations
14,120
11,736
10,728
10,283
Fremont Investment & Loan
FDIC supervised. California state chartered
industrial bank. Liquidated, terminated deposit
insurance, and surrendered charter in 2008.
8,635
Option One Mortgage Corp.
State supervised. Subsidiary of H&R Block, closed
in late 2007.
8,344
First Franklin Corp.
Countrywide
Ameriquest Mortgage Co.
ResMae Mortgage Corp.
American Home Mortgage
Corp.
IndyMac Bank, FSB
Greenpoint Mortgage Funding
Wells Fargo
Ownit Mortgage Solutions,
Inc.
Aegis Funding Corp.
People's Choice Financial
Corp.
BNC Mortgage
Fieldstone Mortgage Co.
OCC supervised. Subsidiary of National City Bank.
Sold to Merrill Lynch 12/06. Closed in 2008.
Data includes loans originated by (1) Countrywide
Home Loans, an FRB and state-supervised holding
company affiliate until 03/07, and an OTS and statesupervised entity after 03/07; and (2) Countrywide
Bank, an OCC supervised entity until 03/07, and an
OTS supervised entity after 03/07.
State supervised. Citigroup acquired certain assets
of Ameriquest in 08/07. Merged into CitiMortgage
(NB opsub) shortly thereafter.
8,037
4,736
4,126
State supervised. Filed for bankruptcy in late 2007.
3,558
State supervised. Filed for bankruptcy in 2007.
2,954
OTS supervised thrift. Closed in July 2008.
FDIC supervised. Acquired by Capital One, NA, in
mid 2007 as part of conversion and merger with
North Fork, a state bank. Closed immediately
thereafter in 08/07.
Data includes loans originated by (1) Wells Fargo
Financial, Inc., an FRB and state-supervised entity,
and (2) Wells Fargo Bank, an OCC supervised
entity.
2,882
2,815
2,697
State supervised. Closed in late 2006.
2,533
State supervised. Filed for bankruptcy in late 2007.
State supervised. Filed for bankruptcy in early
2008.
State and OTS supervised. Subsidiary of Lehman
Brothers (S&L holding company), closed in August
2007.
State supervised. Filed for bankruptcy in late 2007.
2,058
Decision One Mortgage
State and FRB supervised. Subsidiary of HSBC
Finance Corp. Closed in late 2007.
Delta Funding Corp.
State supervised. Filed for bankruptcy in late 2007.
1,783
1,769
1,561
1,267
598
- 21 -
APPENDIX B: ACTIVITIES OF NATIONAL BANKS RELATED TO SUBPRIME LENDING
National banks and their operating subsidiaries can be engaged in several different types
of activities that are related to nonprime residential mortgage lending, including direct loan
origination, loan servicing, providing warehouse lines of credit to subprime originators,
purchasing loan for securitization, or acquiring various types of securities that are backed by
subprime loans.
I.
Direct Origination
OCC analysis has found that national bank subprime origination during the period
preceding the financial crisis was small relative to the total subprime market. However, some
analyses by others have reached conflicting conclusions, finding significantly higher percentages
of overall subprime mortgage lending. To some extent the existence of conflicting estimates is
not surprising. Developing precise estimates of subprime lending activity is difficult because
comprehensive data for the market simply do not exist, from either private or public sources.
Statements about subprime activity also suffer from lack of agreement at a more basic level
regarding how to define “subprime” or other variants of nonprime mortgage loans. Some of the
potential approaches to measuring or approximating the size of the subprime market and banks’
shares of that market are reasonable, others less so. As described below, the OCC has taken a
rigorous approach that produces estimates of subprime activity that are more accurate than other,
conflicting estimates.
Estimates of subprime activity often accompany discussions of which supervisors were
responsible for subprime mortgages lenders. This requires careful identification of both lenders
and their associated supervisor; a common source of confusion stems from failure to recognize
important distinctions between banks, subsidiaries of banks, and affiliates of banks within bank
holding companies, and how those distinctions determine the responsible regulator. Chart 1
illustrates the differences:
Chart 1
Bank
Holding Company
(FRB/State)**
National
Bank
(OCC)
State
Bank
(State /
FRB or FDIC)
Operating
Subsidiary
(OCC)
Operating
Subsidiary
(State /
FRB or FDIC)
Thrift
Holding Company
(OTS/State)**
Non Bank
Mortgage
Affiliate
(FRB/State)
Federal
Thrift
(OTS)
State
Thrift
(OTS/State)
Non Thrift
Mortgage
Affiliate
(OTS/State)
Non Bank
Mortgage
Originator
and
Broker
(State Only)
Operating
Subsidiary
(OTS)
Subject to Supervision By:
OCC
OTS
State*
* As noted, some mortgage originators are regulated by both state and federal regulators.
** Some (mostly smaller) banks and thrifts are not part of holding companies and are not represented separately here.
Appendix B
Page 2
Banks may make subprime loans, and may have operating subsidiaries that also make
loans; however, other non-bank subsidiaries owned by parent holding companies can and do
originate loans as well. In addition, many mortgage lenders, including independent mortgage
companies and brokers, are not affiliated with banking or thrift companies at all. Only national
banks, federal thrifts, and their operating subsidiaries (the green and yellow boxes in the chart)
are subject to exclusive federal regulation; state-chartered banks and thrifts and nonbank
subsidiaries of bank and thrift holding companies are subject to both federal and state regulation,
and lenders that are not affiliated with banks or thrifts are not subject to regulation by the federal
banking agencies.
Using the most reliable data available on nonprime mortgage lending, and accurately
accounting for corporate organization and regulatory responsibilities, national banks and their
subsidiaries subject to OCC supervision accounted for less than 15 percent of nonprime activity.
This percentage is strikingly and disproportionately low, given the central role of national banks
in the U.S. mortgage markets; according to the comprehensive data collected under the Home
Mortgage Disclosure Act, national banks and their operating subsidiaries originated nearly 30
percent of all mortgages during the corresponding period. In contrast, lenders supervised solely
by the states accounted for well over half of nonprime lending; combining originations by those
lenders with the totals for state-chartered banks reveals that nearly three quarters of nonprime
mortgages originated at lenders that were wholly or partly the responsibility of state authorities.
Other, higher estimates of the share of national banks are based on less reliable data or fail to
accurately account for the corporate structure of holding companies and the regulators
responsible for different entities within those holding companies, e.g., often combining a bank’s
holding company affiliates with the bank. Moreover, the data show that subprime mortgages
originated by OCC-supervised lenders have performed better than other subprime loans, with
lower rates of foreclosure.
A.
OCC Estimates of Subprime Activity
1.
Early estimates
In early 2007, OCC staff estimated that national banks accounted for about 10 percent of
subprime (so-called “B/C”) mortgage originations during 2006. This estimate was a rough
approximation done on a best-efforts basis using the best information available at the time.
Specifically, in the absence of any formal reporting of subprime activity, OCC
supervisory staff collected information on the dollar volume of subprime lending from major
mortgage originators in the national bank population; this yielded an estimate of national bank
subprime lending, although it was only an approximation since it reflected definitions of
“subprime” that varied across banks. That supervisory estimate of national bank volume
corresponded to about 10 percent of overall subprime market originations for 2006, estimated at
$600 billion based on data published in the March 23, 2007, edition of the industry publication
Inside Mortgage Finance. 1
Using Inside Mortgage Finance to estimate the overall size of the market for the analysis
was expedient, since it was one of the few sources of information on what had recently become a
1
March 23, 2007.
Appendix B
Page 3
prominent part of the mortgage market. However, the figures presented in Inside Mortgage
Finance were compiled by that publication from various sources (including analyst reports and
self-reported figures from staff at the originating institutions), and may not be reliable; in some
cases institutions chose to report figures using varying definitions and methods to create
particular market perceptions. Market share figures computed from Inside Mortgage Finance
may be particularly misleading, because the methods did not encompass the entire market, and
the overall size of the market can only be very roughly approximated from the published tables
of data.
2.
Later estimates
To refine estimates of national bank activity in non-prime residential mortgage markets,
the OCC acquired a database developed and marketed by Loan Performance Corp. (or “LPC,”
now a unit of First American CoreLogic Inc). This is the premier data source on nonprime (that
is, both subprime or B/C and Alt-A) mortgage activity. LPC covers virtually all securitized B/C
and Alt-A mortgages; the database covers the market fairly well because most such mortgages
have been securitized since they were originated.
A 2008 OCC analysis focused on loans in LPC originated during the years 2005, 2006,
and 2007, the peak years of subprime mortgage activity. One challenge with using LPC is that
originator name information – that is, the identity of the bank or mortgage company that actually
made the loan in the first place – is captured and presented inconsistently in the database. Many
loans (about 43 percent) have no originator information, others have ambiguous names, and still
others do not adequately distinguish among affiliated entities with similar names. OCC staff
used a variety of automated and manual methods to identify the originators of as many loans in
LPC as possible.
The result was a large dataset consisting of roughly five million nonprime loans for
which the originator was known. For each originator in LPC, the OCC then identified the
primary supervisor, taking into account dates at which the primary supervisor changed during the
time period considered (for example, one major subprime originator, First Franklin, shifted from
OCC to OTS supervision in late 2006), and wherever possible distinguishing between depository
institutions and their holding company affiliates.
Some significant subprime originators had a large number of loans in LPC for which it
was difficult to determine whether the loans were originated by the bank or by an affiliate within
the larger holding company. Referring to Chart 1, it was clear that the loans originated
somewhere within the holding company structure, but not from which specific box on the chart;
without that, estimates of the sources of subprime (for example, OCC-supervised versus others)
would remain imprecise. In those cases, other information available to the OCC in its
supervisory role – including confidential information from resident examiners at banks – was
used to determine realistic allocations of the loans in the database. However, the OCC also
conducted sensitivity analysis to determine the impact of alternative allocations and how much
the results might change. Estimates of the nonprime mortgage share of national banks varied
from about 11 percent to about 15 percent, but the most likely allocations of originations
suggested that the national bank share of nonprime loans in the LPC data originated during 2005,
2006, or 2007 was 14 percent or less.
Appendix B
Page 4
3.
Most recent estimates
More recently, the OCC has updated and refined the analysis of the LPC nonprime data.
One obvious development since the 2008 analysis is that more loans have entered foreclosure.
Summary results are presented in the tables below. Of the roughly 5 million nonprime loans
from 2005-2007 in the LPC data for which the originator could be reliably identified, OCCsupervised institutions accounted for 10.6 percent of subprime loans (B/C), and 12.1 percent of
nonprime loans including both B/C and Alt-A. Lenders supervised only by the states originated
63.6 percent of subprime loans during these years, and 57.1 percent of combined nonprime;
including loans originated by state-chartered banks, 72 percent of all nonprime mortgages came
from lenders subject to state authority. 2
Nonprime (B/C and Alt-A) Originations, 2005-2007
Supervisor
Originations
State
2,818,126
FDIC
436,981
Federal Reserve
295,343
Subtotal*
3,550,450
OCC
595,304
OTS
783,719
NCUA
3,024
Total
4,932,497
*Subtotal reflects institutions subject to state supervision
Subprime (B/C) Originations, 2005-2007
Supervisor
Originations
State
2,423,355
FDIC
318,796
Federal Reserve
224,882
Subtotal*
2,967,033
OCC
403,958
OTS
439,488
NCUA
233
Total
3,810,712
Share
57.1%
8.9%
6.0%
72.0%
12.1%
15.9%
0.1%
100.0%
Share
63.6%
8.4%
5.9%
77.9%
10.6%
11.5%
0.0%
100.0%
Source: LPC data and OCC calculations
B.
Other Estimates of Subprime Activity
Analyses conducted by others have produced different estimates of subprime activity and
its allocation among institutions and regulators. After reviewing many of these analyses, the
OCC has concluded that most have shortcomings that raise significant questions about their
accuracy and relevance compared to results based on a careful analysis of the LPC data.
2
The figure understates the actual extent of state authority, because loans made by affiliates of federal
thrifts are included in the OCC/OTS total but actually are subject to state authority.
Appendix B
Page 5
1.
HMDA data
Some discussions of residential mortgage problems are based on the annual reporting
required of mortgage lenders under the Home Mortgage Disclosure Act (“HMDA”). However,
HMDA data cannot be relied upon directly to evaluate subprime lending by financial institutions,
because rate-spread loans and subprime loans are not necessarily the same.
The HMDA data have the advantage of providing a fairly comprehensive picture of
mortgage applications and originations, as well as identifying the originators and their associated
regulators. But the HMDA data do not include any designation for subprime loans, nor do they
include information such as credit scores (which might be used to infer subprime status). What
HMDA does contain, which makes the data potentially relevant to subprime activity, is
information on higher-priced or “rate-spread” loans. Under HMDA, a loan is deemed to have a
high “rate spread” that must be reported if the loan has an APR at least 3 percentage points
higher than the yield on a Treasury security of comparable maturity, for first-lien mortgages.
Since subprime loans might be expected to have higher interest rates than otherwise similar
loans, the HMDA rate-spread loan data may be useful as a supplement to other estimates of
subprime activity, given the generally poor quality of information on subprime.
In view of this, it is not surprising that the rate-spread data are sometimes used in the
context of subprime mortgage discussions. A notable example is the 2009 Senate testimony of
Professor Patricia McCoy. 3 In that testimony, Professor McCoy observed “In 2006, depository
institutions and their affiliates, which were regulated by federal banking regulators, originated
about 54% of all higher-priced home loans. In 2007, that percentage rose to 79.6%.” Professor
McCoy’s testimony accurately characterizes the figures on rate-spread loans.
However, the percentages quoted by Professor McCoy include a large number of loans
made not by banks, but rather by other lenders owned by the banks’ parent holding companies;
as described above in the discussion of Chart 1, such lenders are subject to regulatory oversight
that is different in nature and degree than the oversight of depository institutions. Excluding
holding company affiliates, the corresponding percentages of rate-spread lending for depository
institutions – banks and thrifts together – were 41 percent in 2006 and 62 percent in 2007. In
fact, depository institutions actually account for a disproportionately low share of rate-spread
loans in the HMDA data, considering their central role in providing mortgage credit in the
United States; for example, in 2006 when their share of rate-spread loans was 41 percent, they
accounted for 59 percent of all originations.
Moreover, the only reason the bank and thrift share of rate-spread loans rose between
2006 and 2007 was because a very large number of independent mortgage companies either
disappeared or dramatically reduced originations, leaving banks and thrifts as the main providers
of home loans of all types. The number of “higher-priced” originations by depository
institutions and their affiliates actually fell in 2007, but since these institutions were the primary
lenders remaining in the market for home loans, their share of lending increased.
3
Prepared statement of Patricia A. McCoy, Hearing on “Consumer Protections in Financial Services: Past
Problems, Future Solutions” before the Senate Committee on Banking, Housing, and Urban Affairs, March 3, 2009,
available at http://banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=40666635-bc764d59-9c25-76daf0784239.
Appendix B
Page 6
But rate-spread loans are not necessarily subprime, and subprime loans may not
necessarily have high rate spreads. Using data from LPC and from the OCC’s own Mortgage
Metrics 4 database, the OCC has been able to assess the extent of overlap between HMDA ratespread loans and the nonprime loans from the other data sources. This again requires a careful
and complex process of matching loans from different data sources, to ensure that a particular
loan reported under HMDA is in fact the same loan as one appearing in one of the other
databases. The OCC has devoted significant resources to creating an accurate mapping of this
type, because the matched data are valuable for supervision, analysis, policy development, and
other uses.
For the peak subprime year of 2006, the OCC found that 64 percent of rate-spread loans
were subprime, and another 11 percent were Alt-A; the remaining 25 percent of rate-spread loans
were prime mortgages. However, not all subprime and Alt-A loans have rate spreads that cause
them to be captured in the rate-spread reporting; again for 2006, the OCC found that 37 percent
of the loans in Mortgage Metrics designated as “subprime” were not reported as rate-spread
loans under HMDA, and the non-rate-spread percentage for Alt-A was much higher, at 82
percent. These percentages vary over time due to market conditions; in 2007 a higher percentage
of prime loans were rate-spread loans and more rate-spread loans were prime compared to 2006,
whereas the opposite was true in 2005.
Although data from HMDA are valuable for some purposes, the limited overlap between
HMDA rate-spread loans and the nonprime loan population makes HMDA a potentially
misleading source of information on subprime mortgage lending.
2.
Inside Mortgage Finance
Some other discussions of subprime activity continue to rely on data from Inside
Mortgage Finance, despite the clear drawbacks discussed above of using information from that
source to make inferences about subprime market shares.
A notable recent example is a paper prepared by the National Consumer Law Center
(“NCLC”). That report uses data from Inside Mortgage Finance to argue that a group of eight
federally supervised institutions accounted for 31.5 percent of subprime originations, as shown in
the table reproduced from that report 5 below:
4
These data are the basis for the Mortgage Metrics Report, a joint publication of the OCC and the Office of
Thrift Supervision that provides performance and other data on approximately 34 million first mortgage loans
serviced by national banks and federal thrifts.
5
Preemption and Regulatory Reform: Restore the States’ Traditional Role as ‘First Responder’, National
Consumer Law Center White Paper (September 2009).
Appendix B
Page 7
From NCLC White Paper:
NCLC incorrectly characterizes Equifirst as a national bank when in fact it was a
subsidiary of state-chartered Regions Bank, and the figures given for some lenders (most notably
WMC Mortgage) differ somewhat from the original source numbers provided by Inside
Mortgage Finance. Removing Equifirst and correcting other data errors reduces the total
“market share” of these federally supervised institutions to 26 percent. 6 However, as noted
above, little confidence should be placed even in this corrected figure, due to the unreliable
estimate of the overall size of the subprime market used as its denominator.
C.
OCC Analysis of Subprime and Alt-A Loan Performance
National banks and their operating subsidiaries engaged in subprime mortgage lending to
a relatively modest extent, as demonstrated above. However, not all subprime loans have
subsequently caused problems for borrowers, lenders, and others. Subprime and Alt-A loans
may be appropriate for some borrowers in some situations. The quality of the underwriting
process – that is, determining through analysis of the borrower and market conditions that a
borrower is highly likely to be able to repay the loan as promised – is a major determinant of
subsequent loan performance. The quality of underwriting varies across lenders, a factor that is
evident through comparisons of rates of delinquency, foreclosure, or other loan performance
measures across loan originators. Through analysis of the available data, the OCC has
determined that subprime loans originated by OCC-supervised institutions have generally
performed better than similar loans originated by other lenders.
The subprime data from LPC used for the analysis of market share above also contains
information on how loans have performed since they were originated. In analysis done in 2008,
the OCC used that information to analyze the foreclosure experience in the ten metropolitan
areas hardest hit by foreclosures, and to identify the ten originators with the largest number of
non-prime loans that went into foreclosure in those markets. The results are described in the
6
The correct figure for BNC Mortgage is $14 billion, and for WMC Mortgage $11 billion.
Appendix B
Page 8
attached note on the “Worst 10 in the Worst 10” analysis. As noted there, nearly 60 percent of
non-prime mortgage loans and foreclosures in the “Worst 10” markets were from originators not
supervised by any federal banking agency. See Attachment 1.
The OCC recently updated the “Worst 10” analysis using the most recently available data
from LPC. Market conditions have continued to deteriorate, and the identity of the hardest hits
markets has evolved, with metropolitan areas in California and Florida now dominating the list.
However, the list of originators is largely unchanged, as are the overall conclusions. The
updated “Worst 10” tables are included as Attachment 2.
In addition to the Worst 10 analysis, the OCC also analyzed the performance of the
broader nonprime mortgage market using LPC. That work, shown in Tables 1 and 2, below,
found that nonprime loans originated by national banks and their subsidiaries have generally
presented fewer problems than loans made by other lenders under two measures of distress. In
the column headed “Foreclosure Start Rate,” Table 1 shows the percentage of nonprime loans
that entered foreclosure at any time after origination (even if they did not go all the way through
to eventual foreclosure). Those results indicate that 22 percent of nonprime loans originated by
national banks from 2005 through 2007 experienced a foreclosure start as of November 2009,
compared to a market average of 25.7 percent. Aside from credit unions, which were not
significant originators, that percentage was the lowest of any federal regulator. State-chartered
banks, supervised by state regulators and either the FDIC or Federal Reserve, and other lenders
subject solely to state authority were the source of 73 percent of the nonprime mortgages that
experienced a foreclosure start.
The OCC conducted a similar analysis of the LPC data using a broader indicator of loan
deterioration: whether a loan ever became 60 days or more delinquent. The results of that
analysis, shown in Table 2, below, mirror those for foreclosures. Of the nonprime loans
originated by national banks and their subsidiaries, 37.1 percent became delinquent by 60 days or
more at some time after origination, compared to a market average of 45.5 percent. National
banks originated 9.8 percent of those nonprime loans. State-chartered banks, supervised by state
regulators and either the FDIC or Federal Reserve, and other lenders subject solely to state
authority were the source of 73.9 percent of those loans, with the vast majority originated by
non-bank lenders subject exclusively to state authority.
Appendix B
Page 9
Table 1: Nonprime Loans that Experienced a Foreclosure Start
NONPRIME (COMBINED SUBPRIME AND ALT‐A) LOANS
Agency
Originations
OTS
STATE*
FDIC
FED
OCC
NCUA
Total
783,719
2,818,126
436,981
295,343
595,304
3,024
4,932,497
Market
Share
15.9%
57.1%
8.9%
6.0%
12.1%
0.1%
100.0%
Foreclosure Starts
210,943
741,068
110,976
74,169
130,806
364
1,268,326
Foreclosure Start
Rate
26.9%
26.3%
25.4%
25.1%
22.0%
12.0%
25.7%
Share of
Foreclosure
Starts
16.6%
58.4%
8.7%
5.8%
10.3%
0.0%
100.0%
ALT‐A LOANS
Agency
FDIC
STATE*
FED
OTS
OCC
NCUA
Total
Originations
118,185
394,771
70,461
344,231
191,346
2,791
1,121,785
Market
Share
10.5%
35.2%
6.3%
30.7%
17.1%
0.2%
100.0%
Foreclosure Starts
33,241
98,437
17,082
74,028
26,045
351
249,184
Foreclosure
Start Rate
28.1%
24.9%
24.2%
21.5%
13.6%
12.6%
22.2%
Share of
Foreclosure
Starts
13.3%
39.5%
6.9%
29.7%
10.5%
0.1%
100.0%
SUBPRIME LOANS
Agency
OTS
STATE*
OCC
FED
FDIC
NCUA
Total
Originations
439,488
2,423,355
403,958
224,882
318,796
233
3,810,712
Market
Share
11.5%
63.6%
10.6%
5.9%
8.4%
0.0%
100.0%
Foreclosure Starts
136,915
642,631
104,761
57,087
77,735
13
1,019,142
Foreclosure
Start Rate
31.2%
26.5%
25.9%
25.4%
24.4%
5.6%
26.7%
Share of
Foreclosure
Starts
13.4%
63.1%
10.3%
5.6%
7.6%
0.0%
100.0%
* Denotes entities not subject to supervision by any federal banking agency (reporting to HUD under HMDA).
“Originations” include all subprime and Alt‐A loans in LPC originated during 2005‐2007 for which the originator could be identified reliably.
“Foreclosure Starts” counts the number of loans that entered foreclosure at any time between origination and November 2009.
Appendix B
Page 10
Table 2: Loans That Became 60 Days or More Delinquent at Any Time after Origination
NONPRIME (COMBINED SUBPRIME AND ALT‐A) LOANS
Agency
Originations
OTS
STATE*
FDIC
FED
OCC
NCUA
Total
783,719
2,818,126
436,981
295,343
595,304
3,024
4,932,497
Market
Share
15.9%
57.1%
8.9%
6.0%
12.1%
0.1%
100.0%
Number of Loans
Ever 60 Days or
More Delinquent
783,719
1,323,178
212,332
124,026
220,895
538
2,246,092
60 Days or More
Delinquency
Rate
46.6%
47.0%
48.6%
42.0%
37.1%
17.8%
45.5%
Share of Loans
Ever 60 Days
or More
Delinquent
16.3%
58.9%
9.5%
5.5%
9.8%
0.1%
100.0%
ALT‐A LOANS
Agency
Originations
FDIC
STATE*
FED
OTS
OCC
NCUA
Total
118,185
394,771
70,461
344,231
191,346
2,791
1,121,785
Market
Share
10.5%
35.2%
6.3%
30.7%
17.1%
0.2%
100.0%
Number of Loans
Ever 60 Days or
More Delinquent
46,632
143,402
24,255
119,001
40,221
455
373,726
60 Days or More
Delinquency
Rate
39.3%
36.3%
34.4%
34.6%
21.0%
16.3%
33.3%
Share of Loans
Ever 60 Days
or More
Delinquent
12.4%
38.4%
6.5%
31.8%
10.8%
0.1%
100.0%
SUBPRIME LOANS
Agency
OTS
STATE*
OCC
FED
FDIC
NCUA
Total
Originations
439,488
2,423,355
403,958
224,882
318,796
233
3,810,712
Market
Share
11.5%
63.6%
10.6%
5.9%
8.4%
0.0%
100.0%
Number of Loans
Ever 60 Days or
More Delinquent
246,102
1,179,776
180,674
99,791
165,940
83
1,872,366
60 Days or More
Delinquency
Rate
56.0%
48.7%
44.7%
44.4%
52.1%
35.6%
49.1%
Share of Loans
Ever 60 Days
or More
Delinquent
13.1%
63.0%
9.6%
5.3%
8.9%
0.0%
100.0%
* Denotes entities not subject to supervision by any federal banking agency (reporting to HUD under HMDA).
“Originations” include all subprime and Alt‐A loans in LPC originated during 2005‐2007 for which the originator could be identified reliably.
“Foreclosure Starts” counts the number of loans that entered foreclosure at any time between origination and November 2009.
Appendix B
D.
Page 11
Other Analyses of Mortgage Loan Performance
Other analysts have presented findings that appear to contradict these general results,
finding worse performance for subprime mortgage (or other mortgage) loans from OCCsupervised originators. For example, a recent paper by Ding, Quercia, Reid, and White
(“DQRW”) released by the Center for Community Capitalism at the University of North Carolina
examines the performance of mortgages originated by lenders subject to different regulators in
states with and without anti-predatory lending laws. 7
The study uses loan-level performance data for subprime and Alt-A loans matched to
HMDA to compare delinquency rates for loans originated by OCC-regulated institutions in states
with anti-predatory lending laws (APL states), before and after finalization of the OCC’s 2004
preemption rules. DQRW state at the onset of the study that they expect to find that loans
originated by national banks after preemption have higher delinquency rates than loans
originated prior to 2004. To control for changes in market conditions before and after adoption
of the preemption rules, the changes in OCC delinquency rates over time are compared to
changes in delinquency rates for loans originated by independent mortgage companies (HUDregulated).
DQRW find that delinquency rates increased for OCC loans originated after the
preemption rules were issued (2005-2006) in states with anti-predatory lending laws - using
HUD loans as a control group – in only one of the four categories of loans (refinance fixed-rate
loans). DQRW interpret this result as indicating that the OCC’s 2004 preemption regulation led
“both to a deterioration in the quality of and an increase in the default risk for mortgages
originated by OCC-regulated (or OCC-preempted) (sic) lenders in states with anti-predatory
lending laws.”
It is doubtful that the results from DQRW are relevant for the broad mortgage market.
The unique sample used in the study has some advantages, but a significant disadvantage is that
the sample is relatively small, and the mortgage loans contained in that unique dataset do not
appear to be generally representative of the mortgage market. Loans from lenders regulated by
the Federal Reserve, FDIC and NCUA are limited. Loans originated in California represent 25
percent of the sample (as compared to a 16 percent share in the HMDA data). In addition,
although the analysis uses loans originated during the years 2002-2006, the data contain only the
subsample of those originations that were active as of December 2006. Thus, loans originated
early in the data period that had prepaid or already foreclosed (likely a large percentage) were
excluded from the analysis.
But beyond that concern, the reported results do not support the authors’ primary
conclusion; if anything, the results tend to point in the other direction. For example, the authors
find only one type of loan (fixed rate refinances) for which their delinquency measure increased
more for OCC-supervised lenders than for other lenders, and emphasize that as their conclusion
– ignoring the fact that the other loan types do not show that effect. Their own results show that
the delinquency measure for adjustable-rate purchase loans – which are a much more important
part of the market – increased by 30 percent less at national banks than at the lenders not subject
7
Ding, Quercia, Reid, and White, “The Preemption Effect: the Impact of Federal Preemption of State AntiPredatory Lending Laws on the Foreclosure Crisis”, Research Report, Center for Community Capital University of
North Carolina, Chapel Hill (March 23, 2010).
Appendix B
Page 12
to federal preemption in their sample. They also find that loans from OCC-supervised
institutions were less risky across the board than loans from other lenders, consistent with the
OCC analysis of loan performance summarized above.
Table 6 in DQRW (reproduced below) provides their results from applying the wellaccepted method of logit regression to the sample of loans to measure the risk of delinquency
and to try to isolate the impact of being regulated by the OCC or by the states (the “IND
lenders”). Odds ratios are used to measure how likely a loan is to become delinquent compared
to a comparable or “reference” loan used as a neutral standard of comparison. The authors use as
their neutral reference point the group of otherwise similar mortgage loans made by OCCsupervised banks in states that did not have anti-predatory lending laws (APLs) that could be
preempted in 2004.
The odds ratios are uniformly lower for the national banks than for the state lenders; that
is, loans of all types in all periods made by national banks had lower delinquencies. As an
extreme example, fixed-rate home purchase loans in 2005-2006 were 28.4 percent less risky for
national banks in these states than for the reference group, while the same type of loan from a
state lender has an odds ratio of 1.399 for that vintage, making it about 40 percent riskier than the
comparison group. The difference between 40 percent riskier for state lenders and 28 percent
less risky for OCC lenders is a big difference.
Then the authors estimate the same odds-ratio risk measures after the preemption rule
was issued, to see how they changed, and then compare the relative changes in risk for OCCregulated lenders versus state-regulated lenders. The authors focus on the results for “refi_frm”,
that is for fixed-rate refinancings; those loans became more risky at OCC lenders after
preemption, by about 20 percent, whether one looks at the 2004 loans or the 2005-2006 loans.
But the other results in Table 6 are either very close to 1.0, suggesting no material difference, or
less than 1.0 showing that risk actually fell at OCC-supervised lenders compared to statesupervised lenders. For example, the 2005-2006 adjustable-rate purchase loans made by national
banks became more than 30 percent less risky than the same loans made by state-regulated IND
lenders. Thus the reported results for the “Preemption Effect” do not strongly support the
authors’ main conclusion, and a larger number of the results actually go the other way.
Appendix B
II.
Page 13
Servicing
The quarterly OCC and OTS Mortgage Metrics Report (“MMR”) provides extensive data
on the extent to which major national banks and thrifts service first-lien residential mortgages of
all types, including subprime loans. The OCC and OTS collect data on first-lien residential
mortgages from the nine national banks and three thrifts with the largest mortgage-servicing
portfolios among national banks and thrifts. 8 These 12 depository institutions are owned by
nine holding companies, 9 and represent most of the industry’s largest mortgage servicers,
covering approximately 65 percent of all mortgages outstanding in the United States.
More than 90 percent of the mortgages in the portfolio were serviced for third parties
because of loan sales and securitization. At the end of December 2009, the reporting institutions
serviced almost 34 million first-lien mortgage loans, totaling nearly $6 trillion in outstanding
balances.
MMR uses standardized definitions for three categories of mortgage creditworthiness
based on the following ranges of borrowers’ credit scores at the time of origination: “Prime”
with scores of 660 and above, “Alt-A” with scores from 620 to 659, and “Subprime” with scores
below 620. 10 Approximately 13 percent of loans in the data are not accompanied by credit
scores and are classified as “other.” This group includes a mix of prime, Alt-A, and subprime
loans. In large part, the lack of credit scores results from acquisitions of loan portfolios from
third parties for which borrower credit scores at the origination of the loans were not available.
As of December 31, 2009, these institutions serviced 2,758,613 loans in the Subprime
score range, accounting for 8% of all loans serviced. The number of Subprime loans has
declined by 9 percent over the past year, whereas the total portfolio declined 2 percent as
origination of new Subprime loans has not kept pace with foreclosures, loan payoffs, and sales
and transfers.
Table 3 displays the composition of the servicing portfolio covered by MMR. At yearend 2007, national bank servicers combined to service more than $267 billion in Subprime first
mortgage loans; the volume of Serviced subprime loans increased to $283 billion at the end of
2008 and $378 billion at the end of 2009.
8
The nine banks are Bank of America, JPMorgan Chase, Citibank, First Tennessee (formerly referred to as
First Horizon), HSBC, National City, USBank, Wachovia, and Wells Fargo. The thrifts are OneWestBank
(formerly IndyMac), Merrill Lynch, and Wachovia FSB. Wachovia FSB was merged into Wells Fargo National
Bank in November 2009.
9
The holding companies are Bank of America Corp., JPMorgan Chase, Citigroup, First Horizon, HSBC,
OneWest (formerly IndyMac), PNC, US Bancorp, and Wells Fargo Corp.
10
Note that the definition of “subprime” used in MMR is based entirely on credit score in order to create a
definition that is standardized across firms; this definition of subprime may not match definitions use in other
contexts. In particular, this definition of subprime does not directly correspond to criteria used by institutions to
self-identify loans considered subprime, which generally reflect a combination of credit scores, LTV, loan structure,
and the institution’s business focus.
Appendix B
Page 14
Table 3
Overall Mortgage Portfolio in Mortgage Metrics Report
12/31/08
3/31/09
6/30/09
9/30/09
12/31/09
Total Servicing
$6,106,764 $6,014,455
$5,969,246
$5,998,986
$5,952,423
(Millions)
Total Servicing
34,551,061 34,096,603
33,832,014
34,024,602
33,824,889
(Number of Loans)
Composition (Percent of All Mortgages in the Portfolio)*
Prime
66%
67%
68%
68%
68%
Alt-A
10%
10%
10%
10%
11%
Subprime
9%
8%
8%
8%
8%
Other
14%
14%
13%
14%
13%
Composition (Number of Loans in Each Risk Category of the Portfolio)
Prime 22,963,965 22,867,059
22,929,113
23,064,371
23,136,115
Alt-A
3,567,323
3,519,821
3,528,840
3,524,305
3,560,656
Subprime
3,034,620
2,888,029
2,847,412
2,774,028
2,758,613
Other
4,985,153
4,821,694
4,526,649
4,661,898
4,369,505
* Percentages may not total 100 percent due to rounding.
III.
Warehouse lines of credit to independent subprime originators
In the fourth quarter of 2006, large national banks had warehouse lines to subprime
companies totaling $32.9 billion, although only approximately $12.4 billion had been advanced
on those lines. The volume of such warehouse facilities decreased to $14.6 billion as of the third
quarter of 2007, with approximately $6 billion advanced on the lines. These warehouse lines
compare with the total market warehouse lending capacity, per National Mortgage News, of over
$200 billion in 2006 and 2007. Total market capacity declined dramatically to approximately
$20 to $25 billion in 2008. 11
IV.
Purchasing subprime loans for securitizations and purchasing interests in MBS
As previously discussed, in 2006 and 2007, subprime mortgages, mostly originated by
nonbanks, were a very important share of the total market. Additionally, many subprime
mortgages were bundled into residential mortgage-backed securities (“RMBS”), and many of
these RMBS were then repackaged into collateralized debt obligations (“CDOs”). Both
subprime RMBS and CDOs backed by subprime RMBS were sold to a broad range of investors.
A few large national banks also were involved in structuring products to be sold that included
subprime mortgages.
The Federal Reserve’s Flow of Funds data presented in Table 4 below show that RMBS
issued by or guaranteed by housing government sponsored enterprises (“GSEs”) accounted for
the largest share of outstanding RMBS during the subprime boom. Private-label RMBS were a
much smaller component of the market, even during the peak subprime years, and of course not
all of those securities were subprime. For example, credible estimates indicate that only one third
11
National Mortgage News, October 20, 2008; March 23, 2009; and April 1, 2009.
Appendix B
Page 15
of the outstanding dollar volume of private-label RMBS at the end of 2007 was subprime,
although an additional 43 percent was Alt-A, with the remainder consisting largely of prime
jumbo MBS. 12 Commercial banking firms as a group hold only a small share of the outstanding
private-label RMBS, and national bank holdings are even smaller; as shown in Table 4, national
banks hold between 5 and 10 percent of outstanding private RMBS.
Table 4: Residential Mortgage-Backed Securities Outstanding
Flow of Funds Data ($ bil)
2005
2006
2007
2008
Issued or guaranteed by GSEs
3,420
3,711
4,319
4,801
Private label RMBS
1,622
2,140
2,172
1,859
170
192
272
246
1,452
1,948
1,900
1,613
5,042
5,851
6,491
6,660
Held by commercial banking firms
Held by other investors
Total RMBS
Call Report Data ($ bil)
National bank holdings of GSE RMBS
505
594
542
640
National bank holdings of private RMBS
87
114
193
155
Total national bank holdings of RMBS
592
709
735
795
National bank share of private RMBS
5.4%
5.3%
8.9%
8.4%
12
Deutsche Bank “Projecting Mortgage Losses” MBS Special Report, May 5, 2008.
Attachment 1
Worst Ten in the Worst Ten: Supervisory Status of Mortgage Originators
Originator
Supervisor
Foreclosures in Worst 10
Metro Areas, based on
2005-07 Originations
New Century Mortgage Corp.
State supervised. Subsidiary of publicly-traded REIT, filed
for bankruptcy in early 2007.
14,120
Long Beach Mortgage Co.
State and OTS supervised. Affiliate of WAMU, became a
subsidiary of thrift in early 2006; closed in late 2007 / early
2008.
11,736
Argent Mortgage Co.
State supervised until Citigroup acquired certain assets of
Argent in 08/07. Merged into CitiMortgage (NB opsub)
shortly thereafter.
10,728
WMC Mortgage Corp.
OTS supervised. Subsidiary of GE Money Bank, FSB,
closed in late 2007.
10,283
Fremont Investment & Loan
FDIC and State supervised. California state chartered
industrial bank. Liquidated, terminated deposit insurance,
and surrendered charter in 2008.
8,635
Option One Mortgage Corp.
State supervised. Subsidiary of H&R Block, closed in late
2007.
8,344
First Franklin Corp.
Data includes loans originated by (1) OCC supervised
subsidiary of National City Bank until 12/06; and (2) OTS
supervised subsidiary of Merrill Lynch Bank & Trust Co.,
FSB, after 12/06. Closed in 2008.
8,037
Countrywide
Data includes loans originated by (1) Countrywide Home
Loans, an FRB/State supervised entity until 03/07, and an
OTS/State supervised entity after 03/07; and (2)
Countrywide Bank, an OCC supervised entity until 03/07,
and an OTS supervised entity after 03/07.
4,736
Ameriquest Mortgage Co.
State supervised. Citigroup acquired certain assets of
Ameriquest in 08/07. Merged into CitiMortgage (NB
opsub) shortly thereafter.
4,126
ResMae Mortgage Corp.
State supervised. Filed for bankruptcy in late 2007.
3,558
American Home Mortgage Corp.
State supervised. Filed for bankruptcy in 2007.
2,954
IndyMac Bank, FSB
OTS supervised thrift. Closed in July 2008.
2,882
Greenpoint Mortgage Funding
FDIC and State supervised. Acquired by Capital One, NA,
in mid 2007 as part of conversion and merger with North
Fork, a state bank. Closed immediately thereafter in
08/07.
2,815
Wells Fargo
Data includes loans originated by (1) Wells Fargo
Financial, Inc., an FRB and State supervised entity, and (2)
Wells Fargo Bank, an OCC supervised entity.
2,697
Ownit Mortgage Solutions, Inc.
State supervised. Closed in late 2006.
2,533
Aegis Funding Corp.
State supervised. Filed for bankruptcy in late 2007.
2,058
People's Choice Financial Corp.
State supervised. Filed for bankruptcy in early 2008.
1,783
BNC Mortgage
OTS supervised. Subsidiary of Lehman Brothers, FSB,
closed in August 2007.
1,769
Fieldstone Mortgage Co.
State supervised. Filed for bankruptcy in late 2007.
1,561
Decision One Mortgage
State and FRB supervised. Subsidiary of HSBC Finance
Corp. Closed in late 2007.
1,267
Delta Funding Corp.
State supervised. Filed for bankruptcy in late 2007.
Monday, March 22, 2010
598
Attachment 2
Worst Ten in the Worst Ten: Update
•
This attachment updates the OCC’s November 2008 analysis of subprime
origination and performance in the markets hit hardest by foreclosures, using the
most recently available LPC data (November 2009).
•
An updated list of the ten metropolitan areas experiencing the highest rates of
foreclosure (the “Worst Ten” MSAs) was developed from data reported by
RealtyTrac. The ten worst metropolitan areas were distributed across seven states
in 2008, but now are concentrated in only three: California, Florida, and Nevada. Six
of the ten are in California.
Worst 10 Markets (from RealtyTrac data)
Rank
•
MSA/PMSA
Non-prime Mortgage
Foreclosure Rate
1
Fort Myers-Cape Coral, FL MSA
43.3%
2
Merced, CA MSA
40.5%
3
Fort Pierce-Port St Lucie, FL MSA
40.1%
4
Stockton-Lodi, CA MSA
38.1%
5
Modesto, CA MSA
37.9%
6
Las Vegas, NV MSA
32.9%
7
Riverside-San Bernardino, CA PMSA
31.7%
8
Vallejo-Fairfield-Napa, CA PMSA
30.6%
9
Bakersfield, CA MSA
29.4%
10
Reno, NV MSA
27.5%
As in the original analysis, the ten originators in each market with the most
foreclosures were identified. (See the next page for lists of individual markets.)
•
The number of “worst” originators on the list decreased from 21 companies in
November 2008 to 16 in November 2009.
•
In 2009, as in 2008, only three firms on the list were subject to OCC supervision
at any time during 2005 through 2007. However, those three firms now account
for a larger share of foreclosure starts (20 percent in 2009, compared to 12
percent in 2008).
•
The fraction of companies supervised exclusively by the states remained at
roughly 56 percent, while their share of originations fell from 60 to 54 percent.
Worst Ten in the Worst Ten: Supervisory Status of Mortgage Originators
Originator
Supervisor
Foreclosures in Worst 10
Metro Areas, based on
2005-07 Originations
New Century Mortgage Corp.
State supervised. Subsidiary of publicly-traded REIT, filed
for bankruptcy in early 2007.
17,229
WMC Mortgage Corp.
OTS supervised. Subidiary of GE Money Bank, FSB,
closed in late 2007.
13,433
Long Beach Mortgage Co.
State and OTS supervised. Affiliate of WAMU, became a
subsidiary of thrift in early 2006; closed in late 2007 / early
2008.
10,997
Countrywide
Data includes loans originated by (1) Countrywide Home
Loans, an FRB/State supervised entity until 03/07, and an
OTS/State supervised entity after 03/07; and (2)
Countrywide Bank, an OCC supervised entity until 03/07,
and an OTS supervised entity after 03/07.
10,254
First Franklin Corp.
Data includes loans originated by (1) OCC supervised
subsidiary of National City Bank until 12/06; and (2) OTS
supervised subsidiary of Merrill Lynch Bank & Trust Co.,
FSB, after 12/06. Closed in 2008.
9,353
Fremont Investment & Loan
FDIC and State supervised. California state chartered
industrial bank. Liquidated, terminated deposit insurance,
and surrendered charter in 2008.
8,829
Option One Mortgage Corp.
State supervised. Subsidiary of H&R Block, closed in late
2007.
8,686
Argent Mortgage Co.
State supervised until Citigroup acquired certain assets of
Argent in 08/07. Merged into CitiMortgage (NB opsub)
shortly thereafter.
7,633
Greenpoint Mortgage Funding
FDIC and State supervised. Acquired by Capital One, NA,
in mid 2007 as part of conversion and merger with North
Fork, a state bank. Closed immediately thereafter in
08/07.
6,485
American Home Mortgage Corp.
State supervised. Filed for bankruptcy in 2007.
5,721
IndyMac Bank, FSB
OTS supervised thrift. Closed in July 2008.
5,508
ResMae Mortgage Corp.
State supervised. Filed for bankruptcy in late 2007.
4,019
Wells Fargo
Data includes loans originated by (1) Wells Fargo
Financial, Inc., an FRB and State supervised entity, and (2)
Wells Fargo Bank, an OCC supervised entity.
3,982
Ameriquest Mortgage Co.
State supervised. Citigroup acquired certain assets of
Ameriquest in 08/07. Merged into CitiMortgage (NB
opsub) shortly thereafter.
3,516
Ownit Mortgage Solutions, Inc.
State supervised. Closed in late 2006.
2,468
Lenders Direct Capital Corp.
State supervised. Closed in early 2007.
1,127
March 29, 2009 (Foreclosures in Worst 10 Metro Areas as of Nov. 2009, based on 2005-07 Originations)
APPENDIX C: IMPACT OF THE COMMUNITY REINVESTMENT ACT ON
LOSSES INCURRED BY NATIONAL BANKS
All the federal banking regulatory agencies have considered the impact of the
Community Reinvestment Act (“CRA”) on the losses incurred by depository institutions during
the current crisis. Based on all available research, each has concluded that the CRA did not
contribute in any material way to the mortgage crisis or the broader credit quality issues in the
marketplace. 1 Attached to this Appendix are several key documents and studies related to these
findings.
Studies Assessing the Impact of the CRA on the Economic and Financial Crisis
There has been much public discussion concerning whether CRA may have contributed
to the current financial and economic crisis. This discussion has focused on the connection
between CRA-related home mortgage lending to low- and moderate-income borrowers and what
some allege to be a disproportionate representation in failing loans.
As described below, both independent and agency studies and the quantitative analysis of
comprehensive home lending data sets lead to the conclusion that only a small portion of
subprime loan originations (loans identified as “higher cost” under the Home Mortgage
Disclosure Act (“HMDA”)) are related to the CRA. In addition, these studies indicate that CRArelated loans appear to perform better than subprime loans generally.
For example, single-family CRA-related mortgages offered in conjunction with
NeighborWorks organizations were found to perform on par with standard conventional
mortgages. 2 Foreclosure rates within the NeighborWorks network were just 0.21 percent in the
second quarter of 2008, 3 compared to 4.26 percent of subprime loans and 0.61 percent for
conventional conforming mortgages. 4
The Federal Reserve Board (“FRB”) has reported extensively on these findings for all
CRA loans. Using higher priced loans listed in the HMDA disclosures as a rough proxy for
1
See Remarks by John C. Dugan Comptroller of the Currency Before the Enterprise Annual Network
Conference November 19, 2008, available at http://www.occ.treas.gov/ftp/release/2008-136a.pdf ; Speech
entitled “CRA: A Framework for the Future,” Governor Elizabeth A. Duke, February 24, 2009, available at
http://www.federalreserve.gov/newsevents/speech/duke20090224a.htm; Remarks by FDIC Chairman Sheila C. Bair
Before the Consumer Federation of America, December 4, 2008, available at http://www.fdic.gov/news/news/
speeches/archives/2008/chairman/spdec0408_2.html; Speech entitled “The Community Reinvestment Act and the
Recent Mortgage Crisis,” Governor Randall S. Kroszner, December 3, 2008, available at
http://www.federalreserve.gov/newsevents/speech/kroszner20081203a.htm#f6; John M. Reich, Director of the
Office of Thrift Supervision (OTS) in response to question posed at the OTS Housing Summit, Washington DC,
December 8, 2009.
2
See “Low-Income Mortgage Borrowers with the Benefit of Homeownership Counseling Do Substantially
Better than General Market, According to New Foreclosure Analysis,” NeighborWorks America, News Release,
September 25, 2008.
3
Latest date for which data is available.
4
A study by the University of North Carolina’s Center for Community Capital also indicates that high-cost
subprime mortgage borrowers default at much higher rates than those who take out loans made for CRA purposes.
See Lei Ding, Roberto G. Quercia, Janneke Ratcliffe, Wei Li, “Risky Borrowers or Risky Mortgages:
Disaggregating Effects Using Propensity Score Models,” University of North Carolina, Center for Community
Capital, October 2008.
Appendix C
Page 2
subprime loans, a FRB study of 2005 - 2006 HMDA data showed that banks subject to CRA and
their affiliates originated or purchased only six percent of the reported higher-priced loans made
to lower-income borrowers within their CRA assessment areas. 5 The FRB also found that less
than 2 percent of the higher-priced and CRA credit-eligible mortgage originations sold by
independent mortgage companies in 2006 were purchased by CRA-covered institutions. FRB
loan data analysis also found that 60 percent of higher-priced loan originations went to middleor higher-income borrowers or neighborhoods and, further, that more than 20 percent of the
higher-priced loans extended to lower-income borrowers or borrowers in lower-income areas
were made by independent non-bank institutions that are not covered by CRA. 6
Federal Reserve Governor Randall S. Krozner affirmed these findings in a 2008
presentation, 7 and Governor Elizabeth Duke concurred in 2009. 8 A report issued in September
2009 by the United States Commission on Civil Rights concludes, “data reflect that the subprime
loans made by banking institutions or their affiliates in their CRA assessment areas remained a
marginal segment of the overall market.” 9
Additional reports by FRB economists comport with these findings that only a small
percentage of higher priced loans were originated by CRA-regulated lenders to either lowerincome borrowers or in neighborhoods in bank CRA assessment areas. 10 Similarly, they have
concluded that banks purchased only a small percentage of higher-priced, CRA-eligible loans
originated by independent mortgage companies. 11
Finally, the performance of higher-cost loans originated by federally regulated banks and
thrifts has proven markedly better than loans originated by non-bank institutions. One study
found that even after controlling for a wide range of borrower, neighborhood, and loan
characteristics, higher cost loans made by lenders regulated under the CRA were significantly
less likely to go into foreclosure than those made by independent mortgage companies, i.e., those
mortgage originators that fall outside the regulatory reach of the CRA. “This provides
5
See Neil Bhutta and Glenn B. Canner, “Did the CRA cause the mortgage market meltdown?”, Community
Dividend (Federal Reserve Bank of Minneapolis: March 2009), available at http://www.minneapolisfed.org/
publications_papers/issue.cfm?id=293. Most subprime and Alt-A loans fall within the definition of high-cost
(higher-priced). Although the definition of high-cost (higher-priced) loans under Regulation Z (which implements
the Truth in Lending Act) was recently changed, for loans originated during the years covered by this study, the
previous definition of high-cost applied, which covered loans where the spread between the annual percentage rate
and the yield on Treasury securities of comparable maturity was 3 percentage points or more for first-lien loans and
5 percentage points or more for subordinate lien loans.
6
See “The Community Reinvestment Act and the Recent Mortgage Crisis,” Governor Randall S. Kroszner,
supra at n. 1.
7
Id. at p. 3 (“I can state very definitively from the research that we have done, that the Community
Reinvestment Act is not one of the causes of the current crisis.”).
8
See “CRA: A Framework for the Future,” Governor Elizabeth A. Duke, supra at n. 1 (An “analysis of
foreclosure rates in that study found that loans originated by CRA-covered lenders were significantly less likely to
be in foreclosure than those originated by independent mortgage companies. Clearly, claims that CRA caused the
subprime crisis are not supported by the facts.”).
9
United States Commission on Civil Rights, “Civil Rights and the Mortgage Crisis,” September 2009, p. 69.
10
Bhutta and Canner, “Did the CRA Cause the Mortgage Market Meltdown?”, supra n. 5, at p. 2.
11
Robert Avery et al, “The 2007 HMDA Data,” Federal Reserve Bulletin, December 2008.
Appendix C
Page 3
compelling evidence that the performance of [higher cost] loans made by CRA-regulated
institutions has been significantly stronger than those by [independent mortgage companies].” 12
Another researcher states, “Our research finds that after controlling for loan vintage,
origination date, borrower, credit, and loan characteristics, the estimated cumulative default rate
for a comparable group of subprime borrowers was about 3.5 times higher than that experienced
for borrowers in our CRA portfolio. In outperforming other types of mortgage investments,
CRA portfolios may have served as a stabilizing factor for many covered institution.” 13
From such evaluations, the OCC and the other federal bank regulators have concluded
that rather than causing losses to national banks, the Community Reinvestment Act has made a
positive contribution to community revitalization across the country and has generally
encouraged sound community development lending initiatives by regulated banking
organizations.
12
Elizabeth Laderman and Carolina Reid, “CRA Lending During the Subprime Meltdown,” Revisiting the
CRA: Perspectives on the Future of the Community Reinvestment Act, a joint publication of the Federal Reserve
Banks of Boston and San Francisco, February 2009, p. 122.
13
Michael A. Stegman, testimony before the House Financial Services Committee on the subject of
“Proposals to Enhance the Community Reinvestment Act,” September 16, 2009, p. 2.
LISTING OF ATTACHMENTS TO APPENDIX C
Comptroller John C. Dugan, speech before the Enterprise Annual Network Conference,
November 19, 2008.
Elizabeth Laderman and Carolina Reid, “CRA Lending During the Subprime Meltdown,”
Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act, a joint
publication of the Federal Reserve Banks of Boston and San Francisco, February 2009.
Lei Ding, Roberto G. Quercia, et al, “Risky Borrowers or Risky Mortgages: Disaggregating
Effects Using Propensity Score Models,” Working Paper, Center for Community Capital,
December 2008.
Neil Bhutta and Glenn B. Canner, “Did the CRA Cause the Mortgage Market Meltdown?”
Community Dividend, March 2009.
United States Commission on Civil Rights, “Civil Rights and the Mortgage Crisis,” September
2009, pages 66-83.
Remarks by
John C. Dugan
Comptroller of the Currency
Before the
Enterprise Annual Network Conference
November 19, 2008
Thank you Mayor Rice. It’s a real pleasure to have this opportunity to be here
with you today at the Enterprise Annual Network Conference.
Growing up in Washington, D.C., I followed the work of Jim Rouse first-hand.
He captivated us all with his festival marketplaces and his inspiring vision for America’s
cities. Baltimore, with its Inner Harbor and diverse neighborhoods, is one of the many
places where his vision and the work of the Enterprise Foundation came alive and
flourished.
Today, Enterprise brings that same spirit of innovation to projects benefiting lowand moderate-income households and green communities around the country. In the
capable hands of Doris Koo and the Enterprise Board, Enterprise continues to be a
respected intermediary that has raised and invested over $8 billion to support the creation
of affordable homes. It is also currently investing in communities at a rate of $1 billion
annually.
I would like to spend my time with you today discussing the current credit
environment and the important contribution that community reinvestment makes – to
individual communities and to our economy as a whole.
We continue to face an extraordinary market situation and unprecedented
challenges to the flow of credit. These circumstances have put considerable pressure on
borrowers and lenders alike. As so many people in this audience have witnessed, helping
low- and moderate-income individuals and families that Enterprise serves has become
even more challenging with disruptions in the financial markets.
The good news is that although we have many challenges ahead, important steps
have been taken to assure financial stability, and the financial system is definitely in
better shape than it was six weeks ago. Our focus is now on continuing to reinforce that
stability; enhancing the availability of sound credit; and moving forward with strategies
to reduce the number of homes lost to foreclosure.
On this last point, I recognize that there is considerable discussion about the need
for the government to provide direct funding to reduce foreclosures, and I think it’s safe
to assume that this debate will continue into the next Administration. In the meantime,
however, I do think it’s important to recognize the concerted and considerable efforts of
the public, private, and nonprofit sectors to make meaningful progress. As many of you
may know, the OCC has spearheaded an effort to collect reliable, validated, loan level
data on the performance of individual mortgages throughout the country that are serviced
by the large national banks that we supervise. The Office of Thrift Supervision has
joined us in this effort, and together we have begun producing a quarterly Mortgage
Metrics report that provides the best available information on more than 60 percent of all
mortgages outstanding in the United States. The Mortgage Metrics report covering the
second quarter of 2008 shows that new loan modifications – and I don’t mean payment
plans – increased by 50 percent from the previous quarter, with modifications accounting
for nearly 45 percent of all workouts.1 Our preliminary analysis of third quarter data
shows that this trend is continuing, and we expect soon to have more data about the types
of modifications being employed. Moreover, major lenders that we supervise have
2
recently announced comprehensive, proactive, and streamlined mortgage loan
modification and loss mitigation programs. And a number of mortgages are being
restructured and refinanced through Fannie Mae, Freddie Mac, and HUD’s FHA Secure
programs. While these actions and programs may not prove fully adequate to address the
problem, they do constitute meaningful steps in the right direction.
Turning back to financial stability, I believe that all banks have benefited from the
stabilizing effect of recent aggressive actions by the government to inject capital, to
provide guarantees on bank deposit accounts and certain liabilities, and to ensure the
availability of backup liquidity to our nation’s banking organizations. At the same time,
we recognize that banks must continue to perform their essential function of extending
credit – in a safe and sound manner – to meet the needs of creditworthy borrowers.
In an interagency statement issued just last week, the federal banking agencies
emphasized this – stressing both the importance of banks fulfilling their fundamental
roles as credit intermediaries through prudent lending practices, and the need to work
with existing borrowers to avoid preventable foreclosures. We support recent efforts by
banking organizations to implement systematic loan modification protocols, and the
objective of attaining modifications that borrowers are able to sustain. The OCC and the
other federal banking supervisors are committed to fully supporting their regulated
banking organizations as they work to implement effective and sound loan modification
programs.
Indeed, all of these efforts are fully in keeping with the OCC’s mission and the
way that we approach our regulatory and supervisory responsibilities, including those
under the Community Reinvestment Act. CRA supports banks doing what they do best
3
and what they should want to do well – making viable lending and investment decisions,
with acceptable rates of return, consistent with their business plans, in their own
communities.
Given recent public discussion, it is appropriate to ask about the role that CRA
plays in the credit challenges we face on so many fronts. In my view, it plays a very
positive role. Unfortunately, however, current market disruptions have clouded the
accomplishments that CRA has generated, many of which we recognized last year during
its 30th anniversary. There are even some who suggest that CRA is responsible for the
binge of irresponsible subprime lending that ignited the credit crisis we now face.
Let me squarely respond to this suggestion: I categorically disagree. While not
perfect, CRA has made a positive contribution to community revitalization across the
country and has generally encouraged sound community development lending,
investment, and service initiatives by regulated banking organizations.
CRA is not the culprit behind the subprime mortgage lending abuses, or the
broader credit quality issues in the marketplace. Indeed, the lenders most prominently
associated with subprime mortgage lending abuses and high rates of foreclosure are
lenders not subject to CRA. A recent study of 2006 Home Mortgage Disclosure Act data
showed that banks subject to CRA and their affiliates originated or purchased only six
percent of the reported high cost loans made to lower-income borrowers within their
CRA assessment areas. 2
Over the last ten years, CRA has helped spur the doubling of lending by banking
institutions to small businesses and farms, to more than $2.6 trillion. During this period,
those lenders more than tripled community development lending to $371 billion.3
4
Overwhelmingly, this lending has been safe and sound. For example, single family
CRA-related mortgages offered in conjunction with NeighborWorks organizations have
performed on a par with standard conventional mortgages.4 Foreclosure rates within the
NeighborWorks network were just 0.21 percent in the second quarter of this year,
compared to 4.26 percent of subprime loans and 0.61 percent for conventional
conforming mortgages.5 Similar conclusions were reached in a study by the University
of North Carolina’s Center for Community Capital, which indicates that high-cost
subprime mortgage borrowers default at much higher rates than those who take out loans
made for CRA purposes.6
Of course, not all single-family CRA mortgages performed this well, because
these loans have experienced the same stresses as most other types of consumer credit.
Nevertheless, a number of studies have shown that when these loans are made in
conjunction with a structured homebuyer counseling program, mortgage performance is
substantially improved.7 Affordable CRA multi-family projects utilizing low-income
housing tax credits have also performed well, with an average foreclosure rate through
2006 of 0.08 percent on the underlying mortgages.8
During the community tours I have taken over the past three years, I personally
witnessed the positive impact that CRA partnerships have had in transforming
communities, expanding homeownership, and promoting job creation and economic
development. These partnerships between communities and financial institutions have
also helped house senior citizens and people with special needs, built community
facilities, and assisted small businesses serving low-income areas.
5
In the Anacostia community of D.C., an area of economic resurgence that I have
toured on several occasions, Enterprise’s Wheeler Creek project was a critical link in
stabilizing a neighborhood that had been plagued by a troubled public housing project.
Wheeler Creek involved development of for-sale homes in conjunction with a bank
community development corporation, as well as a bank’s purchase of low-income
housing tax credits for rental housing.
CRA projects also act as catalysts for other investments, job creation, and housing
development. Such infusion of capital into these markets leverages public subsidies,
perhaps as much as 10 to 25 times, by attracting additional private capital. Many of these
CRA equity investments can be made under national banks’ public welfare investment
authority. These bank investments have grown significantly over the years – totaling
more than $25 billion over the past decade. Indeed, the OCC recently held its Managers
Conference at the Grand Masonic Lodge on North Charles Street here in Baltimore, a
public welfare investment funded by a national bank. To meet the demand to invest in
similar types of projects, OCC successfully sought legislation last year to raise the cap on
public welfare investments from 10 to 15 percent of a bank’s capital and surplus. This
rise will enable the amount of such investments to increase by as much as $30 billion.
Interpreting national bank public welfare investment authority, OCC recently
issued an approval related to energy conservation that may be of interest to Enterprise.
This approval clarifies that such authority extends to bank investments in renewable
energy tax credits primarily benefiting low- and moderate-income individuals and areas,
government revitalization areas, rural underserved and distressed middle-income areas,
and designated disaster areas. The investing bank can claim the credits and, in some
6
instances, receive positive CRA consideration under the investment or community
development tests.
Your Green Communities initiative, and others like it, may be able to take
advantage of these tools to obtain additional resources under the public welfare
investment authority, CRA, and other available incentives to build many more
sustainable homes and communities across the country. The research and examples
described on your Web site demonstrate that moving to a green economy can generate a
significant number of jobs, stimulate economic growth, and create a healthy environment
in communities that Enterprise serves.
As the credit market stabilizes, CRA-driven initiatives can also help us tackle
challenges such as the preservation of homeownership opportunities and rental housing
development. Opportunities also lie ahead for bank partnerships with Enterprise affiliates
and other nonprofits to help mitigate the impact of foreclosures in communities across the
country.
The National Community Stabilization Trust, which Enterprise and other national
housing intermediaries recently formed, is an important new initiative to help coordinate
the transfer of foreclosed properties from financial institutions, servicers, investors, and
government-sponsored enterprises to local housing organizations funded by the
Neighborhood Stabilization Program. The Trust has developed standardized transaction
formats and valuation and pricing models to assist local programs in making acquisition
decisions and sales efficiently.
For our part at the OCC, we have sought to clarify how banks might receive CRA
consideration for the donation and discounted sales of foreclosed properties in
7
conjunction with these initiatives. We co-hosted a conference earlier this summer that
highlighted many effective strategies employed by nonprofits and public agencies for
coping with the rising number of foreclosures. We now have a Neighborhood
Stabilization page on the OCC’s Web site, which will serve as a resource to nonprofits
and public agencies seeking to purchase foreclosed properties in your communities.
We have also hired a Community Affairs Officer, Vonda Eanes, to specialize in
working with nonprofits and public agencies across the country to focus on neighborhood
stabilization and serve as a resource for banks and communities developing initiatives
regarding foreclosed property.
Vonda joins the OCC’s Community Affairs department, headed by Barry Wides.
The responsibilities of this department include sharing best practices, providing guidance
on regulatory issues, and explaining to bankers how these initiatives can help their CRA
performance. I encourage you to introduce yourself to Vonda, Barry, and the other OCC
representatives attending this conference. They hope to learn more about how the OCC
might assist your efforts.
Our nation has accomplished much since CRA’s passage. Perhaps even Jim
Rouse could not imagine how much the flow of CRA-related capital and credit has
contributed to affordable homeownership, jobs and business development, and healthy
neighborhoods. In today’s challenging economy, the need for the positive results that
CRA has generated are even greater, and the same is true for organizations like
Enterprise.
Thank you very much.
8
1
“OCC and OTS Mortgage Metrics Report: Disclosure of National Bank and Federal Thrift Mortgage
Loan Data,” January-June 2008. View the report at http://www.occ.gov/ftp/release/2008-105a.pdf.
2
Glenn B. Canner, Senior Advisor, Federal Reserve Board, “2007 HMDA Data: Identifying Trends and
Potential Regulatory Concerns,” presentation at the Consumer Bankers Association’s 2008 CRA and Fair
Lending Colloquium, October 27, 2008.
3
“Findings from Analysis of Nationwide Summary Statistics for Community Reinvestment Act Data,”
FFIEC Fact Sheets, July 1999 – July 2008.
4
“Low-Income Mortgage Borrowers with the Benefit of Homeownership Counseling Do Substantially
Better than General Market, According to New Foreclosure Analysis,” NeighborWorks America, News
Release, September 25, 2008.
5
Ibid.
6
Lei Ding, Roberto G. Quercia, Janneke Ratcliffe, Wei Li, “Risky Borrowers or Risky Mortgages:
Disaggregating Effects Using Propensity Score Models,” University of North Carolina, Center for
Community Capital, October 2008.
7
“Measuring the Delivery Costs of Prepurchase Homeownership Education and Counseling,”
NeighborWorks America, May 2005, pp. 11-15.
8
Ernst and Young LLP, “Understanding the Dynamics IV: Housing Tax Credit Investment Performance,”
2007.
9
Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act
CRA Lending During the Subprime Meltdown
Elizabeth Laderman and Carolina Reid*
Federal Reserve Bank of San Francisco
T
he current scale of mortgage delinquencies
and foreclosures, particularly in the subprime
market, has sparked a renewed debate over the
Community Reinvestment Act (CRA) and the
regulations governing home mortgage lending. On one
side, detractors argue that the CRA helped to precipitate
the current crisis by encouraging lending in low- and
moderate-income neighborhoods.1 Economist Thomas
DiLorenzo, for instance, wrote that the current housing
crisis is "the direct result of thirty years of government
policy that has forced banks to make bad loans to uncreditworthy borrowers."2 Robert Litan of the Brookings
Institution similarly suggested that the 1990s enhancement of the CRA may have contributed to the current
crisis. "If the CRA had not been so aggressively pushed,"
Litan said, "it is conceivable things would not be quite
as bad. People have to be honest about that."3
On the other side, advocates of the CRA point to a
number of reasons why the regulation should not be
blamed for the current subprime crisis. Ellen Seidman,
formerly the director of the Office of Thrift Supervision,
points out that the surge in subprime lending occurred
long after the enactment of the CRA, and that in 1999
regulators specifically issued guidance to banks imposing restraints on the riskiest forms of subprime lending.4
In addition, researchers at the Federal Reserve Board of
Governors have reported that the majority of subprime
loans were made by independent mortgage lending
companies, which are not covered by the CRA and
receive less regulatory scrutiny overall.5 In addition to being excluded from CRA obligations, independent mortgage companies are not regularly evaluated for “safety
and soundness” (a key component of the regulatory
oversight of banks) nor for their compliance with consumer protections such as the Truth in Lending Act and
the Equal Credit Opportunity Act.6 This has created what
the late Federal Reserve Board Governor Ned Gramlich
aptly termed, a “giant hole in the supervisory safety net.”7
What has been missing in this debate has been an
empirical examination of the performance of loans made
by institutions regulated under the CRA, versus those
made by independent mortgage banks. The ability to
conduct this research has been limited by the lack of a
dataset that links information on loan origination with
information on loan performance. In this study, we use
a unique dataset that joins lender and origination
*
This article is based on a longer working paper that is part of a Federal Reserve Bank of San Francisco’s Working Paper Series, available at
http://www.frbsf.org/publications/community/wpapers/2008/wp08-05.pdf.
1
Walker, David. Interview with Larry Kudlow. Lessons from Subprime. CNBC, April 4, 2008, and Steve Moore. Interview with Larry Kudlow.
Kudlow & Company. CNBC, March 26, 2008.
2
DiLorenzo, Thomas J. “The Government-Created Subprime Mortgage Meltdown.” September 2007, available at http://www.lewrockwell.com/
dilorenzo/dilorenzo125.html.
3
Weisman, Jonathan (2008). “Economic Slump Underlines Concerns About McCain Advisers.” Washington Post, April 2, 2008, A01.
4
Seidman, Ellen. “It’s Still Not CRA,” September 2008, available at http://www.newamerica.net/blog/asset-building/2008/its-still-not-cra-7222.
5
Avery, Robert B., Raphael W. Bostic, Paul S. Calem, and Glenn B. Canner (2007). “The 2006 HMDA Data.” Federal Reserve Bulletin 94:
A73–A109. See also: Kroszner, Randall S. (2008). “The Community Reinvestment Act and the Recent Mortgage Crisis.” Speech given at the
Confronting Concentrated Poverty Policy Forum, Board of Governors of the Federal Reserve System, Washington, DC, December 3, 2008.
6
The federal laws that govern home mortgage lending, including the Equal Credit Opportunity Act, the Home Mortgage Disclosure Act, and
the Truth in Lending Act, apply to both depository institutions and nonbank independent mortgage companies. However, the enforcement of
these laws and the regulations that implement them differ greatly between banks and nonbanks. Banks are subject to ongoing supervision and
examination by their primary federal supervisor. In contrast, the Federal Trade Commission is the primary enforcer of these laws for nonbanks
and only conducts targeted investigations based on consumer complaints.
7
Gramlich, Edward M. (2007). “Booms and Busts: The Case of Subprime Mortgages.” Paper presented in Jackson Hole, Wyoming, August 31,
2007, available at http://www.urban.org/UploadedPDF/411542_Gramlich_final.pdf.
115
Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act
information from the Home Mortgage Disclosure Act
(HMDA) reports with data on loan performance from
Lender Processing Services, Inc. Applied Analytics
(LPS).8 We thus have access to information on borrower characteristics (including race, income, and credit
score), loan characteristics (including its loan-to-value
ratio, whether it was a fixed or adjustable-rate mortgage,
and the existence of a prepayment penalty), institutional
characteristics (whether the lending institution was
regulated under the CRA and the loan source), and loan
performance (delinquency and foreclosure).
In this article, we use these data to examine several
interrelated questions:
presents the results of our models. We conclude with the
policy implications of this study and present suggestions
for further research.
The Community Reinvestment Act
In 1977, concerned about the denial of credit to
lower-income communities—both minority and white—
Congress enacted the Community Reinvestment Act.
The CRA encourages federally insured banks and thrifts
to meet the credit needs of the communities they serve,
including low- and moderate-income areas, consistent with safe-and-sound banking practices. Regulators
consider a bank’s CRA record in determining whether
to approve that institution’s application for mergers
with, or acquisitions of, other depository institutions. A
key component of the CRA is the Lending Test (which
accounts for 50 percent of a Large Bank’s CRA rating),
which evaluates the bank’s home mortgage, small-business, small-farm, and community-development lending
activity. In assigning the rating for mortgage lending,
examiners consider the number and amount of loans
to low- and moderate-income borrowers and areas and
whether or not they demonstrate “innovative or flexible
lending practices.”9
The CRA has generated significant changes in how
banks and thrifts view and serve low- and moderateincome communities and consumers. Researchers who
have studied the impact of the CRA find, on balance,
that the regulations have reduced information costs and
fostered competition among banks serving low-income
areas, thereby generating larger volumes of lending from
diverse sources and adding liquidity to the market.10 In
a detailed review, William Apgar and Mark Duda of the
Joint Center for Housing Studies at Harvard University
• What is the neighborhood income distribution of
loans made by independent mortgage companies
versus those made by institutions regulated under
the CRA?
• After controlling for borrower credit risk, is there a
difference in the foreclosure rates for loans made
by independent mortgage companies versus those
made by institutions regulated under the CRA?
• How do other factors, such as loan terms and loan
source, influence the likelihood of foreclosure?
• How do the factors that influence foreclosure differ in low- and moderate-income neighborhoods
compared with the factors in middle- and upperincome neighborhoods?
The article is organized into four sections. In the first
section, we provide background information on the CRA
and review the existing literature on the relationship
between the CRA and mortgage lending in low- and
moderate-income communities. In the second section,
we describe our data and methodology. The third section
8
Formerly known as McDash Analytics.
9
As part of their CRA exam, large banks are also evaluated on their investments and services. Under the Investment Test, which accounts for
25 percent of the bank’s CRA grade, the agency evaluates the amount of the bank’s investments, its innovation, and its responsiveness to community needs. Under the Service Test, which makes up the remaining 25 percent of the bank’s evaluation, the agency analyzes “the availability
and effectiveness of a bank’s systems for delivering retail banking services and the extent and innovativeness of its community development
services.” Different rules apply for Small and Intermediate Small institutions. For more complete details on the CRA regulations, visit http://
www.ffiec.gov/cra/default.htm for text of the regulations and Interagency Q&A.
10 Avery, Robert B., Raphael W. Bostic, Paul S. Calem, and Glenn B. Canner (1996). “Credit Risk, Credit Scoring, and the Performance of Home
Mortgages.” Federal Reserve Bulletin 82: 621–48. See also: Avery, Robert B., Raphael W. Bostic, Paul S. Calem, and Glenn B. Canner (1999).
“Trends in Home Purchase Lending: Consolidation and the Community Reinvestment Act.” Federal Reserve Bulletin 85: 81–102; Michael S.
Barr (2005). “Credit Where It Counts: The Community Reinvestment Act and Its Critics.” New York University Law Review 80(2): 513–652;
Belsky, Eric, Michael Schill, and Anthony Yezer (2001). The Effect of the Community Reinvestment Act on Bank and Thrift Home Purchase
Mortgage Lending (Cambridge, MA: Harvard University Joint Center for Housing Studies); Evanoff, Douglas D., and Lewis M. Siegal (1996).
“CRA and Fair Lending Regulations: Resulting Trends in Mortgage Lending.” Economic Perspectives 20(6): 19–46; and Litan, Robert E., et
al. (2001). The Community Reinvestment Act After Financial Modernization: A Final Report (Washington, DC: U.S. Treasury Department).
116
Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act
concluded that the CRA has had a positive impact on
low- and moderate-income communities. In particular,
the study notes that “CRA-regulated lenders originate a
higher proportion of loans to lower-income people and
communities than they would if the CRA did not exist.”11
Since the passage of the CRA, however, the landscape
of financial institutions serving low- and moderateincome communities has changed considerably. Most
notably, innovations in credit scoring, coupled with
the expansion of the secondary market, have led to an
explosion of subprime lending, especially in the last few
years. According to one source, the subprime market
accounted for fully 20 percent of all mortgage originations in 2005, with a value of over $600 billion.12 Many
of these loans were not made by regulated financial
institutions; indeed, more than half of subprime loans
were made by independent mortgage companies, and
another 30 percent were made by affiliates of banks or
thrifts, which also are not subject to routine examination
or supervision.13
Given the large role played by independent mortgage
companies and brokers in originating subprime loans,
there has been growing interest in extending the reach
of the CRA to encompass these changes in the financial
landscape. Yet to date, there has been little research that
has empirically assessed individual loan performance at
CRA-regulated institutions versus loan performance at
independent mortgage companies, particularly within
low- and moderate-income areas. Instead, most of the
existing literature has focused on determining the share
of subprime lending in low-income communities and
among different racial groups.14 These studies, however, cannot assess whether loans made by institutions
regulated by the CRA have performed better than those
made by independent mortgage companies. Answering
this question has been difficult given the lack of a single
dataset that captures details on loan origination as well
as details on loan performance.
A few recent studies attempt to match data from different sources to shed light on pieces of this puzzle. Researchers at Case Western’s Center on Urban Poverty and
Community Development used a probabilistic matching
technique to link mortgage records from the HMDA data
with locally recorded mortgage documents and foreclosure filings.15 They found that the risk of foreclosure for
higher-priced loans, as reported in the HMDA data, was
8.16 times higher than for loans that were not higher
priced. They also found that loans originated by financial institutions without a local branch had foreclosure
rates of 19.08 percent compared to only 2.43 percent for
loans originated by local banks.
Another recent study released by the Center for
Community Capital at the University of North Carolina
uses a propensity score matching technique to compare
the performance of loans made through a LMI-targeted
community lending program (the Community Advantage Program [CAP] developed by Self-Help, a Community Development Financial Institution) to a sample of
subprime loans in the McDash database.16 They found
that for borrowers with similar income and risk profiles,
the estimated default risk was much lower for borrowers with a prime loan made through the community
lending program than with a subprime loan. In addition, they found that broker-origination, adjustable-rate
mortgages and prepayment penalties all increased the
likelihood of default.
Both of these studies provide important insights
into the relationship between subprime lending and
foreclosure risk, and conclude that lending to low- and
moderate-income communities is viable when those
11 Apgar, William, and Mark Duda (2003). “The Twenty-Fifth Anniversary of the Community Reinvestment Act: Past Accomplishments and
Future Regulatory Challenges.” Federal Reserve Bank of New York Economic Policy Review (June): 176.
12 Inside Mortgage Finance (2007). Mortgage Market Statistical Annual (Bethesda, MD: Inside Mortgage Finance Publications).
13 Avery, Brevoort, and Canner (2007). “The 2006 HMDA Data.” See also: Kroszner (2008). “The Community Reinvestment Act.”
14 See, for example: Avery, Robert B., Glenn B. Canner, and Robert E. Cook (2005). “New Information Reported Under HMDA and Its Application in Fair Lending Enforcement.” Federal Reserve Bulletin (Summer 2005): 344–94; Gruenstein Bocian, Debbie, Keith Ernst, and Wei Li
(2008). “Race, Ethnicity, and Bubprime Home Loan Pricing.” Journal of Economics and Business 60: 110–24; and Calem, Paul S. Jonathan
E. Hershaff, and Susan M. Wachter (2004). “Neighborhood Patterns of Subprime Lending: Evidence from Disparate Cities.” Housing Policy
Debate 15(3): 603–22.
15 Coulton, Claudia, Tsui Chan, Michael Schramm, and Kristen Mikelbank (2008). “Pathways to Foreclosure: A Longitudinal Study of Mortgage
Loans, Cleveland and Cuyahoga County.” Center on Urban Poverty and Community Development, Case Western University, Cleveland, Ohio.
16 Ding, Lei, Roberto G. Quercia, Janneke Ratcliffe, and Wei Li (2008). “Risky Borrowers or Risky Mortgages: Disaggregating Effects Using
Propensity Score Models.” Center for Community Capital, University of North Carolina, Chapel Hill.
117
Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act
loans are made responsibly. However, both studies
are limited in certain important ways. Coulton and her
colleagues do not examine the regulatory oversight
of the banks that made the loans, and are only able
to control for a limited number of borrower and loan
characteristics. Ding and his colleagues are constrained
by having access only to a relatively narrow subset of
loans securitized by the CAP program. Because the
sample of CAP mortgages may not be representative of a
national sample of mortgage borrowers, and especially
since being part of the CAP demonstration may influence
the lender’s behavior and the quality of the loans
they sell to Self-Help, the study’s findings may not be
applicable to lending in low- and moderate-income
areas more generally.
In this study, we attempt to build on these research
contributions by: (a) examining the performance of a
sample of all loans (prime and subprime, and not limited
to a specific demonstration program) made in California
during the height of the housing boom; and (b) controlling for a wider range of variables, examining not only
borrower characteristics, but assessing the influence of
loan and lender variables on the probability of foreclosure as well.
ing procedure, we compared the sample statistics from
the matched sample with the same sample statistics from
the unmatched sample and found them to be similar.
The LPS database provides loan information collected
from approximately 15 mortgage servicers, including
nine of the top ten, and covers roughly 60 percent of the
mortgage market. Because the LPS includes both prime
and subprime loans, the sample of loans tends to perform better than the sample in other databases such as
Loan Performance First American’s subprime database.
However, we believe that for this paper it is important to
consider both prime and subprime loans in evaluating
the performance of loans made by institutions regulated
under the CRA, since presumably the original intent of
the CRA was to extend “responsible” credit to low- and
moderate-income communities.
For this paper, we limit our analysis to a sample of
conventional, first-lien, owner-occupied loans originated
in metropolitan areas in California between January
2004 and December 2006. This time period represents
the height of the subprime lending boom in California. We also limit our analysis in this instance to home
purchase loans, although other studies have noted that
much of the demand for mortgages during this period
was driven by refinance loans and this will certainly be
an area for further study. This leaves us with 239,101
matched observations for our analysis.
Methodology
The quantitative analysis we use relies on a unique
dataset that joins loan-level data submitted by financial
institutions under the Home Mortgage Disclosure Act
(HMDA) of 197517 and a proprietary data set on loan
performance collected by Lender Processing Services,
Inc. Applied Analytics (LPS). Using a geographic crosswalk file that provided corresponding zip codes to
census tracts (weighted by the number of housing units),
data were matched using a probabilistic matching
method that accounted for the date of origination, the
amount of the loan, the lien status, the type of loan, and
the loan purpose. To check the robustness of the match-
Borrower and Housing Market Characteristics
For borrower characteristics, we include information
from the HMDA data on borrower race and/or ethnicity. Most of the existing research on subprime lending
has shown that race has an independent effect on the
likelihood of obtaining a higher-priced loan.18 HMDA
reporting requirements allow borrowers to report both
an ethnicity designation (either “Hispanic or Latino” or
“Not Hispanic or Latino”) and up to five racial designations (including “white” and “African American” or
“black”). We code and refer to borrowers who were
17 Enacted by Congress in 1975, the Home Mortgage Disclosure Act (HMDA) requires banks, savings and loan associations, and other financial
institutions to publicly report detailed data on their mortgage lending activity. A depository institution (bank, savings and loan, thrift, and credit
union) must report HMDA data if it has a home office or branch in a metropolitan statistical area (MSA) and has assets above a threshold level
that is adjusted upward every year by the rate of inflation. For the year 2006, the asset level for exemption was $35 million. A nondepository
institution must report HMDA data if it has more than $10 million in assets and it originated 100 or more home purchase loans (including
refinances of home purchase loans) during the previous calendar year. Beginning in 2004, lenders were required to report pricing information
related to the annual percentage rate of “higher-priced” loans, defined as a first-lien loan with a spread equal to or greater than three percentage points over the yield on a U.S. Treasury security of comparable maturity.
18 Avery, Canner, and Cook (2005). “New Information Reported Under HMDA.”
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Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act
median year houses in the census tract were built.21 We
also include the tract’s capitalization rate, defined as a
ratio of the tract’s annualized median rent divided by
the median house value. A larger value for this measure
is consistent with lower expected price appreciation or
more uncertain future house prices.22 We would expect
this variable to be positively associated with the relative
likelihood of foreclosure.
In addition to neighborhood-level variables, we also
include a variable on the performance of the local housing market. Economic research conducted at the Federal
Reserve Bank of San Francisco and the Federal Reserve
Bank of Boston has shown that house price dynamics are
an important predictor of foreclosure.23 Because current
house values may be endogenously related to foreclosure rates, we include an OFHEO variable that captures
house price changes in the MSA/metropolitan division in
the two years prior to the loan origination.24 We assume
that loans originated during a time of significant house
price appreciation will be more likely to be in foreclosure, since it is areas that saw prices rising rapidly relative to fundamentals that have seen the most dramatic
realignment of prices.
identified as “Hispanic or Latino” and “white” as Latino,
borrowers who were identified as “African American or
black” as black, and borrowers who were identified as
“Asian” as Asian. We code borrowers and refer to them
as “white” if they are “Not Hispanic or Latino” and only
identified as “white” in the race field.
We use two other borrower-level variables in the
analyses that follow. From the HMDA data, we include
the borrower income, scaled in $1,000 increments.
From the LPS data, we include the FICO credit score
of the borrower at origination.19 Because FICO scores
are generally grouped into “risk categories” rather than
treated as a continuous variable, we distinguish between
“low” (FICO < 640), “middle” (640 >= FICO < 720) and
“high” (FICO >= 720) credit scores.20 We assume that
lower credit scores would lead to a higher probability of
delinquency and, subsequently, foreclosure.
At the neighborhood level, we include the FFIEC
income designation for each census tract, the same
measure that is used in evaluating a bank’s CRA performance. Low-income census tracts are those that have
a median family income less than 50 percent of the
area median income; moderate-income census tracts
are those that have a median family income at least 50
percent and less than 80 percent of the area median
income; middle-income census tracts are those that have
a median family income at least 80 percent and less than
120 percent of the area median income; and upperincome are those with a median family income above
120 percent of the area median income. In addition to
tract income, we also include variables from the 2000
Census that attempt to capture the local housing stock,
including the percent of owner-occupied units and the
Loan Characteristics
In the models that follow, we also include various
loan characteristics that may affect the probability of
foreclosure. From HMDA, we include whether or not
the loan was a “higher-priced” loan. Researchers have
shown a strong correlation between higher-priced loans
and delinquency and foreclosure.25 Since higher-priced
loans are presumably originated to respond to the cost
of lending to a higher risk borrower (such as those with
19 Although there are several credit scoring methods, most lenders use the FICO method from Fair Isaac Corporation.
20 In running the models with FICO treated as a continuous variable, foreclosure risk increased monotonically with FICO score declines, and did
not significantly affect the other variables in the model.
21 In some models we tested, we also controlled for neighborhood-level variables such as the race distribution and educational level of the census
tract, but these proved not to be significant in many of the model specifications, and tended to be highly correlated with the FFIEC neighborhood income categories. In addition, we were concerned about including too many 2000 census variables that may not reflect the demographic
changes that occurred in neighborhoods in California between 2000 and 2006, years of rapid housing construction and price appreciation.
22 Calem, Hershaff, and Wachter (2004). “Neighborhood Patterns of Subprime Lending.”
23 Doms, Mark, Frederick Furlong, and John Krainer (2007). “Subprime Mortgage Delinquency Rates.” Working Paper 2007-33, Federal
Reserve Bank of San Francisco. See also: Gerardi, Kristopher, Adam Hale Shapiro, and Paul S. Willen (2007). “Subprime Outcomes: Risky
Mortgages, Homeownership Experiences, and Foreclosures.” Working Paper 07-15, Federal Reserve Bank of Boston.
24 We use OFHEO instead of Case Shiller because Case Shiller is available only for Los Angeles and San Francisco and we wanted to capture
changes in house-price appreciation across a greater number of communities, particularly those in California’s Central Valley.
25 Pennington-Cross, Anthony (2003). “Performance of Prime and Nonprime Mortgages.” Journal of Real Estate Finance and Economics 27(3):
279–301. See also: Gerardi, Shapiro, and Willen (2007). “Subprime Outcomes;” and Immergluck, Dan (2008). “From the Subprime to the
Exotic: Excessive Mortgage Market Risk and Foreclosures.” Journal of the American Planning Association 74(1): 59–76.
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Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act
to protect the “safety and soundness” of the lender.29
In contrast to CRA-regulated institutions, independent
mortgage companies are subject to state licensing and
monitoring requirements and do not undergo routine
examination.
We further distinguish between loans made by a
CRA-regulated lender outside its assessment area and
those made by a CRA-regulated lender within its assessment area. Mortgages made by banks and thrifts in their
assessment areas are subject to the most detailed CRA
review, including on-site reviews and file checks. The
assessment-area distinction also correlates with differences in the way mortgages are marketed and sold.30 For
example, loans made to borrowers living inside the assessment area are likely to come through the institution’s
retail channel. In contrast, loans made to borrowers
living outside the organization’s CRA-defined assessment
area are more likely to be originated by loan correspondents or mortgage brokers. We assume that if a lending
entity subject to the CRA has a branch office in a metropolitan statistical area (MSA), then that MSA is part of the
entity’s assessment area. Loans made in MSAs where the
lending entity does not have a branch office are assumed
to be originated outside the entity’s assessment area.31
Building on recent research suggesting the importance of mortgage brokers during the subprime lending
boom,32 we also include a loan-source variable that
captures the entity responsible for the loan origination,
even if the loan eventually was financed by a CRAregulated lender or independent mortgage company.
We control for whether the loan was made by a retail
institution, a correspondent bank, or a wholesale lender.
Wholesale lenders are third-party originators, generally
mortgage brokers, that market and process the mortgage
application. One important methodological note is that
our models that include the loan-source variable are
run on a smaller sample of loans. In these models, we
impaired credit scores), it is not surprising that this relationship exists. However, the current crisis has also shed
light on the fact that many loans originated during the
height of the subprime lending boom included additional features that can also influence default risk, such
as adjustable mortgage rates, prepayment penalties, and
the level of documentation associated with the loan.26
For this reason, we include a wide range of variables
in the LPS data on the terms of the loan, including the
loan-to-value ratio, whether or not the loan has a fixed
interest rate, whether or not it included a prepayment
penalty at origination, and whether or not it was a fully
documented loan. We also include data on the value
of the monthly payment, scaled at $500 increments.
While standard guidelines for underwriting suggest that
monthly costs should not exceed 30 percent of a household’s income, recent field research suggests that many
loans were underwritten at a much higher percent.
Lender Characteristics
To determine whether or not a loan was originated
by a CRA-regulated institution, we attach data on lender
characteristics from the HMDA Lender File, following
the insights of Apgar, Bendimerad, and Essene (2007)27
on how to use HMDA data to understand mortgage market channels and the role of the CRA. We focus on two
variables: whether or not the lender is regulated under
the CRA, and whether or not the loan was originated
within the lender’s CRA-defined assessment area, generally defined as a community where the bank or thrift
maintains a branch location.28
As was described above, CRA regulations apply only
to the lending activity of deposit-taking organizations
and their subsidiaries (and, in some instances, their
affiliates). Independent mortgage companies not only
fall outside the regulatory reach of the CRA but also a
broader set of federal regulations and guidance designed
26 Crews Cutts, Amy, and Robert Van Order (2005). “On the Economics of Subprime Lending.” Journal of Real Estate Finance and Economics
30(2): 167–97. See also: Immergluck (2008). “From the Subprime to the Exotic.”
27 Apgar, William, Amal Bendimerad, and Ren Essene (2007). Mortgage Market Channels and Fair Lending: An Analysis of HMDA Data (Cambridge, MA: Harvard University, Joint Center for Housing Studies).
28 We exclude loans originated by credit unions from this analysis; credit unions are not examined under the CRA and comprise a relatively small
proportion of the home-purchase mortgage market.
29 Apgar, Bendimerad, and Essene (2007). Mortgage Market Channels and Fair Lending.
30 Ibid.
31 Our methodology is consistent with that of Apgar, Bendimerad, and Essene (2007), who assume that if a lending entity subject to the CRA has
a branch office in a particular county, then that county is part of the entity’s assessment area.
32 Ernst, Keith, D. Bocia, and Wei Li (2008). Steered Wrong: Brokers, Borrowers, and Subprime Loans (Durham, NC: Center for Responsible Lending).
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Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act
exclude loans where loan source is equal to “servicing
right” due to endogeneity concerns.33 Some financial
institutions specialize in servicing “scratch and dent”
mortgages, which, by their nature, would be more likely
to foreclose.34 Indeed, in early models we found loans
obtained through a servicing right were significantly
more likely to be in foreclosure than loans originated by
any other loan source.
in part to the high cost of housing in California, yet it
also suggests that on the whole, lending in low- and
moderate-income communities remained a relatively
small share of the lending market for regulated financial
institutions, despite the incentive of the CRA.
These descriptive statistics, however, do not control
for the wide range of borrower and loan characteristics
that may influence the likelihood of foreclosure. For
example, might the higher rates of foreclosure among
IMC-originated loans be due to different risk profiles of
the borrowers themselves? In the following tables, we
present a series of binomial logistic regression models
that predict the likelihood of a loan being in foreclosure,
controlling for various borrower and loan characteristics. In all the models, we cluster the standard errors
by census tract because standard errors are likely not
independent across time within tracts. We also examined
the correlation among the independent variables in each
of the models and found that although many of the factors we include are interrelated, the models perform well
and the coefficients and standard errors do not change
erratically across different model specifications. We present the findings as odds ratios to assist in interpreting the
coefficients.
In Table 2, we present the full model, including all
variables with the exception of loan source. Several findings stand out. First, metropolitan house-price changes
do have a significant effect on the likelihood of foreclosure. Rapid house-price appreciation in the two years
preceding origination significantly increases the likelihood of foreclosure (odds ratio 1.26). This is consistent
with previous research that has linked foreclosures and
delinquencies to local housing market conditions, particularly in California, where house prices rose quickly
in relation to fundamentals and where subsequent corrections have been quite dramatic.35 A higher percent
of owner-occupied housing in a tract and more recent
construction both also seem to increase the likelihood
of foreclosure, but only slightly. The tract’s capitalization
rate is not significant.
Second, and not surprisingly, FICO scores matter. A
borrower with a FICO score of less than 640 is 4.1 times
Findings
In Table 1 (at the end of this article), we present
simple descriptive statistics that show the distribution
of loan originations made by CRA-regulated institutions
(CRA lenders) versus independent mortgage companies
(IMCs), stratified by neighborhood income level. The
table demonstrates the important role that IMCs have
played in low- and moderate-income communities in
California during the subprime boom. While CRA lenders originated more loans in low- and moderate-income
tracts than did IMCs, IMCs originated a much greater
share of higher-priced loans in these communities.
Indeed, more than half of the loans originated by IMCs
in low-income communities were higher priced (52.4
percent), compared with 29 percent of loans made by
CRA lenders; in moderate-income communities, 46.1
percent of loans originated by IMC lenders were higher
priced, compared with 27.3 percent for CRA lenders.
In addition, 12 percent of the loans made by IMCs in
low-income census tracts and 10.3 percent of loans in
moderate-income census tracts are in foreclosure, compared with 7.2 percent of loans made by CRA lenders in
low-income census tracts and 5.6 percent in moderateincome census tracts.
It is also worth noting the relatively small share of
loans that were originated in low- and moderate-income
communities; only 16 percent of loans made by CRA
lenders were located in low- and moderate-income
census tracts. IMCs made a slightly greater share of their
total loans (20.5 percent) in low- and moderate-income
communities. The relatively limited share of lending in
low- and moderate-income communities may be due
33 “Servicing right” as the loan source means that only the servicing rights were purchased, not the whole loan. The lender was likely not
involved in the credit decision or in determining the credit criteria. In some cases, the loan itself may not be salable or may be damaged
(“scratch & dent”). Damaged loans are usually impaired in some way, such as missing collateral or an imperfect note/lien.
34 Pennington-Cross, Anthony and Giang Ho (2006). “Loan Servicer Heterogeneity and the Termination of Subprime Mortgages.” Working
Paper 2006-024A, Federal Reserve Bank of St. Louis.
35 Doms, Furlong, and Krainer (2007). “Subprime Mortgage Delinquency Rates.”
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Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act
more likely to be in foreclosure than a borrower with a
FICO score of more than 720; for borrowers with a FICO
score between 640 and 720, the odds ratio is 2.68. We
also find that race has an independent effect on foreclosure even after controlling for borrower income and
credit score. In particular, African American borrowers
were 1.8 times as likely as white borrowers to be in
foreclosure, whereas Latino and Asian borrowers were,
respectively, 1.4 and 1.3 times more likely to be in foreclosure as white borrowers.36 The income of the neighborhood also seems to have some effect on the foreclosure rate. Loans located in low-income tracts were
1.8 times more likely to be in foreclosure than those in
upper-income tracts, with the risk declining monotonically as the income of the neighborhood increases.
Yet the model shows that even with controls for
borrower characteristics included, the terms of the loan
matter. Consistent with previous research, we find that
higher-priced loans are significantly more likely (odds
ratio 3.2) to be in foreclosure than those not designated as higher priced in the HMDA data. But we also
find that other loan features—such as the presence of
a prepayment penalty at origination, a fixed rate interest loan, a high loan-to-value ratio, a large monthly
payment in relation to income, and the loan’s level of
documentation—all have a significant effect on the likelihood of foreclosure, even after controlling for whether
the loan was a higher-priced loan or not. A fixed interest
rate significantly and strongly reduces the likelihood of
foreclosure (odds ratio 0.35), as does the presence of
full documentation (odds ratio 0.61). An increase of ten
percentage points in the loan-to-value ratio—for example, from 80 to 90 percent loan-to-value—increases the
likelihood of foreclosure by a factor of 3.0.
What is interesting, however, is that even after controlling for this wide range of borrower, neighborhood,
and loan characteristics, loans made by lenders regulated under the CRA were significantly less likely to go into
foreclosure than those made by IMCs (odds ratio 0.703).
This provides compelling evidence that the performance
of loans made by CRA-regulated institutions has been
significantly stronger than those made by IMCs.
Even more striking is what we find when we present
the same model with the CRA lender status broken down
by loans made within the CRA lenders’ assessment area
and loans made outside the CRA lenders’ assessment
area (with the omitted category being loans originated by
IMCs). Presented in the second column of the table, we
find that loans made by CRA lenders in their assessment
areas were half as likely to be in foreclosure as loans
made by IMCs (odds ratio 0.53). For loans made by a
CRA lender outside its assessment area, the odds ratio is
0.87. In other words, loans made by CRA lenders within
their assessment areas, which receive the greatest regulatory scrutiny under the CRA, are significantly less likely
to be in foreclosure than those made by independent
mortgage companies that do not receive the same regulatory oversight.
In Table 3, we add information about the source of
the loan. As discussed earlier, we omit observations
where the loan source is indicated as “servicing right.” 37
The model demonstrates the importance of the originating mortgage-market channel in the performance of the
loan. While the findings for other variables remained
similar to those in models presented above, we find
significant differences in the loan performance among
loans originated at the retail branch, by a correspondent
lender, or by a wholesale lender/mortgage broker. In
particular, loans originated by a wholesale lender were
twice as likely to be in foreclosure as those originated
by a retail branch. This is a significant finding, and it
supports other research that has shown that there were
significant differences between broker and lender pricing
on home loans, primarily on mortgages originated for
borrowers with weaker credit histories.38 Interestingly,
the inclusion of loan source also weakens the effect of
the CRA variables. While loans made by CRA lenders
within their assessment area are still less likely to go into
foreclosure than those made by IMCs (an odds ratio of
0.743), the coefficient for CRA loans made outside the
assessment area is no longer significant. This suggests
that the origination channel is a critical factor in determining the likelihood of foreclosure, even for CRA-regulated institutions.
36 In some additional preliminary analysis, we interacted the race variables with income and found some variation among the coefficients. For
example, while African American borrowers at all income levels were more likely to be in foreclosure, for Asian borrowers, as income went up,
the risk of foreclosure decreased compared to white borrowers. The story for Latino borrowers was more mixed and warrants further research.
However, these interaction terms did not meaningfully alter the other coefficients, and we do not include the interaction terms here.
37 This decreases our sample size from 239,101 to 195,698.
38 Ernst, Bocia, and Li (2008). Steered Wrong.
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Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act
The Performance of CRA Lending in Low- and
Moderate-Income Census Tracts
While the models above control for the income
category of the neighborhood, they do not explore
the relative performance of loans from CRA-regulated
institutions within low- and moderate-income census
tracts. In other words, on average, the loan performance
of CRA lenders may be better than that of IMCs, but does
this hold true within low- and moderate-income census
tracts, the areas that are intended to benefit the most
from the presence of the CRA? In Tables 4–7, we replicate our analysis above by looking specifically at what
happens when we stratify the models by neighborhood
income level. For each neighborhood classification (low,
moderate, middle, and upper), we present two models:
the first including borrower and loan characteristics, and
the second adding the loan source. Some interesting
differences emerge, both in comparison to the full model
and among the models for the different neighborhood
income categories.
Regarding the restriction of the sample to low-income
neighborhoods, it is interesting to see that the effect of
being a CRA lender loses much of its strength as well as
its statistical significance. With no loan-source control,
the point estimate indicates that CRA loans made outside
the assessment area were only slightly less likely to be in
foreclosure than loans made by IMCs (an odds ratio of
0.95). However, loans made by a CRA lender within its
assessment area remain quite a bit less likely (odds ratio
of 0.73) to be in foreclosure than loans made by IMCs in
the same neighborhoods, and the effect remains statistically significant. In moderate-income communities,
loans made by CRA lenders, both outside and within
their assessment areas, are significantly less likely to be
in foreclosure. In moderate-income communities, loans
made by CRA-regulated institutions within their assessment areas were 1.7 times less likely (an odds ratio of
0.58) to be in foreclosure than those made by IMCs.
Yet, when we include the loan-source variable, the
statistical significance of the effect of CRA lending in
low- and moderate-income neighborhoods disappears.
It is possible that, in these neighborhoods, the explanatory variables other than the CRA-related variables fully
capture the practical application of the prudent lending
requirements of the CRA and other regulations. If this
were the case, then regulations, working through those
factors, would be significant underlying determinants of
loan performance without the coefficients on the CRA123
related variables themselves showing up as statistically
significant. That said, the estimation results do demonstrate the importance of the terms of the loan and the
origination source in predicting foreclosure, in particular,
whether or not the loan was originated by a wholesale
lender. Indeed, in low-income neighborhoods, wholesale loans were 2.8 times as likely to be in foreclosure
as are those originated by the retail arm of the financial
institution; in moderate-income neighborhoods, wholesale loans were two times as likely to be in foreclosure.
Given that these regressions control for a wide range of
both borrower and loan characteristics, it suggests that
more attention be paid to the origination channel in
ensuring responsible lending moving forward.
In the following tables, we present the same analysis for middle- and upper-income census tracts. Here
the results are more in line with the full sample. Loans
made by CRA lenders within their assessment area are
significantly less likely to be in foreclosure than those
made by IMCs, even after controlling for the loan source.
Although at first glance this may be counterintuitive—
why would the CRA have an effect in middle- and upperincome areas?—we believe that this finding reflects
much broader differences in market practices between
regulated depository institutions and IMCs. Specifically,
while the CRA may have provided regulated financial
institutions with some incentive to lend in low- and
moderate-income communities, the CRA is really only
a small part of a much broader regulatory structure. This
regulatory structure, as well as the very different business
models of regulated financial institutions compared with
IMCs, has significant implications for loan performance,
only some aspects of which we have controlled for in
our regressions.
Although not our focus here, an interesting difference that emerges across neighborhood income classifications is the role of the loan-to-value ratio as well
as the variable on previous house-price appreciation. In
middle- and upper-income neighborhoods, these seem
to carry more weight than in low- and moderate-income
neighborhoods, suggesting that in higher income areas,
investment and economic decisions may be more important in predicting the likelihood that a borrower enters
foreclosure. In contrast, in low- and moderate-income
neighborhoods, fixed rate and monthly payment seem to
have relatively more importance in predicting the likelihood of foreclosure, indicating that in these communities it may be more of an issue of short-term affordability.
Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act
current crisis.39 Third, the continued importance of race
as a variable deserves further exploration. In all of the
models, African Americans were significantly more likely
to be in foreclosure than whites. While some of this is
likely due to differences in assets and wealth (which
we cannot control for), additional research that can
tease out the underlying reasons for this disparity may
have important implications for fair-lending regulations.
Fourth, we focus this analysis on lending for home purchases, yet an examination of refinance loans may yield
different results. Finally, it may be valuable to specify this
model as a two-step process, where the choice of lender
is modeled separately from loan outcomes, particularly if
the decision to borrow from an IMC versus a CRA-regulated institution is correlated with unobservable characteristics that affect the likelihood of foreclosure.
Despite these caveats, we believe that this research
should help to quell if not fully lay to rest the arguments
that the CRA caused the current subprime lending boom
by requiring banks to lend irresponsibly in low- and
moderate-income areas. First, the data show that overall,
lending to low- and moderate-income communities comprised only a small share of total lending by CRA lenders,
even during the height of subprime lending in California.
Second, we find loans originated by lenders regulated
under the CRA in general were significantly less likely
to be in foreclosure than those originated by IMCs. This
held true even after controlling for a wide variety of borrower and loan characteristics, including credit score,
income, and whether or not the loan was higher priced.
More important, we find that whether or not a loan was
originated by a CRA lender within its assessment area is
an even more important predictor of foreclosure. In general, loans made by CRA lenders within their assessment
areas were half as likely to go into foreclosure as those
made by IMCs (Table 2). While certainly not conclusive,
this suggests that the CRA, and particularly its emphasis
on loans made within a lender’s assessment area, helped
to ensure responsible lending, even during a period of
overall declines in underwriting standards.40
The exception to this general finding is the significance of the CRA variables in the models that focused
While these findings are very preliminary and deserve
further exploration, they do suggest that there may be
important differences among communities regarding the
factors that influence the sustainability of a loan.
Conclusions and Policy Implications
This article presents the first empirical examination
of the loan performance of institutions regulated under
the CRA relative to that of IMCs using a large sample of
loans originated in California during the subprime lending boom. Importantly, by matching data on mortgage
originations from the HMDA with data on loan performance from LPS, we are able to control for a wide range
of factors that can influence the likelihood of foreclosure, including borrower and neighborhood characteristics, loan characteristics, lender characteristics, and the
mortgage origination channel.
Before turning to our conclusions and the policy
implications of our research, we would like to emphasize that these findings are preliminary, and additional
research is needed to understand more fully the relationship between borrowers, lending institutions, loan
characteristics, and loan performance. We see several
important gaps in the literature that still need to be
addressed. First, it is unclear whether or not our findings for California are applicable to other housing and
mortgage markets. The size and diversity of California
lend it weight as a valid case study for the performance
of CRA lending more generally. However, the high cost
of housing in California may influence the nature of the
findings, and it would be valuable to replicate this analysis in other markets. Second, we focused our analysis on
loans made in low- and moderate-income census tracts,
given the CRA’s original “spatial” emphasis on the link
between a bank’s retail deposit-gathering activities in
a neighborhood and its obligation to meet local credit
needs. A yet-unanswered question is the performance
of CRA lending for low- and moderate- income borrowers. In addition, we focus solely on mortgage lending
activities and do not examine the impact that the CRA
investment or service components may have had on the
39 For example, regulated financial institutions may have increased their exposure to mortgage-backed securities to satisfy their requirements for
the CRA Investment Test. However, analysis conducted by the Federal Reserve Board suggests that banks purchased only a very small percentage of higher-priced loans (Kroszner 2008),1.
40 For an analysis of the quality of loans between 2001 and 2006 see Demyanyk Yuliya, and Otto van Hemert (2008). “Understanding the Subprime Mortgage Crisis.” Working Paper, Federal Reserve Bank of St. Louis, February 4, 2008.
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Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act
on loans made in low- and moderate-income neighborhoods. In these regressions, when loan source was
not included as an explanatory variable, loans from
CRA-regulated institutions within their assessment areas
performed significantly better than loans from IMCs.
But, when we included loan source, the significance
of the CRA variables disappeared. Even so, loans from
CRA-regulated institutions certainly performed no
worse than loans from IMCs. Moreover, as mentioned
earlier, the practical application of the prudent lending
requirements of the CRA (as well as other regulations)
may have been captured in the other explanatory variables in the model without the coefficients on the CRArelated variables themselves showing up as statistically
significant. For example, 28 percent of loans made by
CRA lenders in low-income areas within their assessment area were fixed-rate loans; in comparison, 18.2
percent of loans made by IMCs in low-income areas
were fixed-rate. And only 12 percent of loans made by
CRA lenders in low-income areas within their assessment areas were higher priced, compared with 29
percent in low-income areas outside their assessment
areas and with 52.4 percent of loans made by IMCs in
low-income areas.
Yet the finding that the origination source of the
loan—retail, correspondent, or wholesale originated—
is an important predictor of foreclosure, particularly in
low- and moderate-income neighborhoods, should not
be ignored. This builds on evidence from other research
that suggests that mortgage brokers are disproportionately associated with the origination of higher-priced
loans, particularly outside depository institutions’ CRA
assessment areas41 and that mortgage brokers may be
extracting materially higher payments from borrowers
with lower credit scores and/or less knowledge of mortgage products.42
The study also emphasizes the importance of responsible underwriting in predicting the sustainability of a
loan. Loan characteristics matter: a higher-priced loan,
the presence of a prepayment penalty at origination, a
high loan-to-value ratio, and a large monthly payment in
relation to income all significantly increase the likelihood of foreclosure, while a fixed interest rate and full
documentation both decrease the likelihood of foreclosure. For example, in low- and moderate-income communities, higher-priced loans were 2.3 and 2.1 times,
respectively, more likely to be in foreclosure than those
that were not higher priced, even after controlling for
other variables including loan source.
In that sense, our paper supports the need to reevaluate the regulatory landscape to ensure that low- and
moderate-income communities have adequate access to
“responsible” credit. Many of the loans analyzed in this
paper were made outside the direct purview of supervision under the CRA, either because the loan was made
outside a CRA lender’s assessment area or because it was
made by an IMC. Proposals to “modernize” the CRA, either by expanding the scope of the CRA assessment area
and/or by extending regulatory oversight to IMCs and
other nonbank lenders, certainly deserve further consideration.43 In addition, the study’s findings also lend
weight to efforts to rethink the regulations and incentives
that influence the practice of mortgage brokers.44
In conclusion, we believe that one of the more interesting findings of our research is the evidence that some
aspect of “local” presence seems to matter in predicting
the sustainability of a loan: once a lender is removed
from the community (outside their assessment area)
or from the origination decision (wholesale loan), the
likelihood of foreclosure increases significantly. For lowand moderate-income borrowers and communities, a
return to localized lending may be even more important.
Research on lending behavior has suggested that “social
relationships and networks affect who gets capital and
at what cost.”45 Particularly in communities that have
traditionally been denied credit, and where intergenera-
41 Kenneth P. Brevoort, and Glenn B. Canner (2006). “Higher-Priced Home Lending and the 2005 HMDA Data.” Federal Reserve Bulletin
(September 8): A123–A166.
42 Ernst, Bocia, and Li (2008). Steered Wrong.
43 Apgar and Duda (2003). “The Twenty-Fifth Anniversary of the Community Reinvestment Act.”
44 Ernst, Bocia, and Li (2008). Steered Wrong.
45 Uzzi, Brian (1999). “Embeddedness in the Making of Financial Capital: How Social Relations and Networks Benefit Firms Seeking
Financing.” American Sociological Review 64(4): 481–505. See also: Holmes, Jessica, Jonathan Isham, Ryan Petersen, and Paul Sommers
(2007). “Does Relationship Lending Still Matter in the Consumer Banking Sector? Evidence from the Automobile Loan Market.” Social
Science Quarterly 88(2): 585–97.
125
Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act
Economics from the University of California at Berkeley.
Her research interests include bank market structure,
small business lending, and financial market issues
related to low-income communities. She has written
many articles on banking for the Federal Reserve and
other publications.
tional wealth and knowledge transfers integral to the
home-ownership experience may be missing, social
networks and local presence may be a vital component
of responsible lending (see Moulton 2008 for an excellent overview of how these localized social networks
may influence mortgage outcomes, for example, by filling information gaps for both lenders and borrowers).46
Indeed, the relatively strong performance of loans
originated as part of statewide affordable lending
programs,47 Self-Help’s Community Action Program,48
and loans originated as part of Individual Development
Account programs49 all suggest that lending to low- and
moderate-income communities can be sustainable.
Going forward, increasing the scale of these types of
targeted lending activities—all of which are encouraged
under the CRA—is likely to do a better job of meeting
the credit needs of all communities and promoting sustainable homeownership than flooding the market with
poorly underwritten, higher-priced loans.
Carolina Reid joined the Community Affairs Department in March of 2005, where she conducts community
development research and policy analysis, with a special
focus on asset building and housing issues. Carolina
earned her PhD in 2004 from the University of Washington, Seattle. Her dissertation focused on the benefits of
homeownership for low-income and minority families,
using quantitative longitudinal analysis and interviews
to assess the impacts of homeownership on a family’s
financial well-being over time. Other work experience
includes policy research and program evaluation at the
Environmental Health and Social Policy Center in Seattle,
where she worked on issues of public housing and
welfare reform, and at World Resources Institute, where
she focused on issues of urban environmental health and
environmental justice.
Elizabeth Laderman is a banking economist in the
Economic Research Department at the Federal Reserve
Bank of San Francisco. She received her PhD in
See Tables 1 – 7 on the following pages
46 Moulton, Stephanie (2008). “Marketing and Education Strategies of Originating Mortgage Lenders: Borrower Effects and Policy Implications.” Paper presented at the Association for Public Policy Analysis and Management 30th Annual Research Conference, Los Angeles, November 6, 2008.
47 Ibid.
48 Ding, Quercia, Ratcliffe, and Li (2008). “Risky Borrowers or Risky Mortgages.”
49 CFED (2008). “IDA Program Survey on Homeownership and Foreclosure,” available at http://www.cfed.org/focus.m?parentid=31&siteid=37
4&id=2663.
126
Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act
Table 1: Distribution of Lending Activity: CRA Lenders vs. Independent Mortgage Companies
CRA Lenders
Independent Mortgage
Companies
Total Loans
Low-Income Neighborhood
3,843
1,487
Moderate-Income Neighborhood
24,795
10,609
Middle-Income Neighborhood
67,766
24,606
Upper-Income Neighborhood
83,563
22,432
179,967
59,134
Low-Income Neighborhood
1,116
779
Moderate-Income Neighborhood
6,765
4,892
Middle-Income Neighborhood
10,573
8,068
Upper-Income Neighborhood
5,307
4,338
23,761
18,077
275
177
Moderate-Income Neighborhood
1,379
1,092
Middle-Income Neighborhood
2,517
1,945
Upper-Income Neighborhood
1,613
1,211
All Neighborhoods
5,784
4,425
All Neighborhoods
Total High-Priced Loans
All Neighborhoods
Total Foreclosures
Low-Income Neighborhood
127
Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act
Table 2: Model Predicting the Likelihood of Loan Foreclosure
CRA with
Assessment Area
CRA
Odds Ratio
Standard
Odds Ratio
Error
Standard
Error
NEIGHBORHOOD VARIABLES
Neighborhood Income Level (omitted: Upper-Income)
Low-Income
Moderate-Income
Middle-Income
1.79 ***
1.32 ***
1.21 ***
0.149
0.067
0.045
1.73 ***
1.28 ***
1.18 ***
0.142
0.064
0.044
Percent Owner-Occupied
1.00 ***
8.69x10-4
1.00 ***
8.68x10-4
Median Year Housing Built
1.01 ***
0.001
1.01 ***
0.001
Capitalization Rate
0.85
0.515
0.75
0.451
House Price Appreciation (2 years prior to origination)
1.26 ***
0.019
1.22 ***
0.019
African American
Latino
Asian
1.78 ***
1.36 ***
1.29 ***
0.084
0.044
0.052
1.79 ***
1.36 ***
1.29 ***
0.084
0.044
0.052
Borrower Income
1.00 **
Borrower FICO Score (omitted: High - Above 720)
Low FICO - Below 640
Mid-level FICO - 640-720
4.09 ***
2.68 ***
0.166
0.087
4.07 ***
2.65 ***
0.165
0.086
LOAN VARIABLES
Higher-Priced Loan (yes=1)
Fixed Interest Rate (yes=1)
Prepayment Penalty (yes=1)
Full Documentation (yes=1)
Monthly Payment
Loan-to-Value Ratio
3.23 ***
0.35 ***
1.30 ***
0.61 ***
1.06 ***
3.00 ***
0.004
0.017
0.036
0.021
0.110
0.080
3.05
0.35
1.31
0.63
1.05
3.02
***
***
***
***
***
***
0.104
0.017
0.036
0.022
0.004
0.081
0.70 ***
0.018
CRA in Assessment Area
0.53 ***
0.017
CRA outside Assessment Area
0.87 ***
0.024
BORROWER VARIABLES
Borrower Race (omitted: Non-Hispanic White)
7.17x10-5
1.00 **
7.26x10-5
LENDER VARIABLES
CRA (omitted: Independent Mortgage Company)
Observations
236,536
*(**)(***) Statistically significant at 10(5)(1) level.
128
Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act
Table 3: Model Predicting the Likelihood of Loan Foreclosure, includes Loan Source
CRA with
Assessment Area
Odds Ratio
Standard
Error
NEIGHBORHOOD VARIABLES
Neighborhood Income Level (omitted: Upper-Income)
Low-Income
Moderate-Income
Middle-Income
2.11 ***
1.35 ***
1.24 ***
0.232
0.096
0.063
Percent Owner-Occupied
1.00 ***
0.001
Median Year Housing Built
1.01 ***
0.002
Capitalization Rate
0.85
0.680
House Price Appreciation (2 years prior to origination)
1.20 ***
0.026
African American
Latino
Asian
1.77 ***
1.38 ***
1.24 ***
0.127
0.066
0.067
Borrower Income
1.00 **
8.91x10-5
Borrower FICO Score (omitted: High - Above 720)
Low FICO - Below 640
Mid-level FICO - 640-720
4.58 ***
2.73 ***
0.266
0.124
LOAN VARIABLES
Higher-Priced Loan (yes=1)
Fixed Interest Rate (yes=1)
Prepayment Penalty (yes=1)
Full Documentation (yes=1)
Monthly Payment
Loan-to-Value Ratio
2.47
0.39
1.55
0.63
1.05
2.53
***
***
***
***
***
***
0.119
0.025
0.072
0.027
0.005
0.078
CRA (omitted: Independent Mortgage Company)
0.70 ***
0.018
CRA in Assessment Area
0.743***
0.043
BORROWER VARIABLES
Borrower Race (omitted: Non-Hispanic White)
LENDER VARIABLES
CRA outside Assessment Area
0.995
Loan Source (omitted: retail branch)
0.057
Correspondent Loan
Wholesale Loan
1.45 ***
2.03 ***
0.092
0.099
Observations
195,698
*(**)(***) Statistically significant at 10(5)(1) level.
129
Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act
Table 4: Model Predicting the Likelihood of Loan Foreclosure in Low-Income Neighborhoods
CRA
Assessment Area
Odds Ratio
NEIGHBORHOOD VARIABLES
CRA with Assessment
Area and Loan Source
Standard
Odds Ratio
Error
Standard
Error
Percent Owner-Occupied
1.01 ***
0.005
1.01
0.008
Median Year Housing Built
1.00
0.006
1.00
0.008
Capitalization Rate
0.64
0.742
0.35
0.685
House Price Appreciation (2 years prior to origination)
1.16 *
0.092
1.17
0.125
African American
Latino
Asian
1.75 **
0.95
1.25
0.393
0.121
0.280
1.96 *
1.09
1.43
0.728
0.291
0.396
Borrower Income
1.00
4.43x10-4
1.00
6.97x10-4
Borrower FICO Score (omitted: High - Above 720)
Low FICO - Below 640
Mid-level FICO - 640-720
4.10 ***
2.41 ***
0.783
0.434
4.00 ***
2.48 ***
1.130
0.632
LOAN VARIABLES
Higher-Priced Loan (yes=1)
Fixed Interest Rate (yes=1)
Prepayment Penalty (yes=1)
Full Documentation (yes=1)
Monthly Payment
Loan-to-Value Ratio
3.12 ***
0.29 ***
1.28 *
0.71 **
1.10 ***
2.35 ***
0.559
0.081
0.180
0.114
0.031
0.220
2.31 ***
0.27 ***
1.42
0.84
1.15 ***
1.81 ***
0.591
0.104
0.361
0.150
0.037
0.262
BORROWER VARIABLES
Borrower Race (omitted: Non-Hispanic White)
LENDER VARIABLES
CRA (omitted: Independent Mortgage Company)
CRA in Assessment Area
0.73 **
0.115
0.89
0.264
CRA outside Assessment Area
0.95
0.121
0.86
0.244
Correspondent Loan
Wholesale Loan
1.58
2.79 ***
0.536
0.702
Observations
3,981
Loan Source (omitted: retail branch)
5,271
*(**)(***) Statistically significant at 10(5)(1) level.
130
Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act
Table 5: Model Predicting the Likelihood of Loan Foreclosure in Moderate-Income Neighborhoods
CRA
Assessment Area
Odds Ratio
NEIGHBORHOOD VARIABLES
CRA with Assessment
Area and Loan Source
Standard
Odds Ratio
Error
Standard
Error
Percent Owner-Occupied
1.00 **
0.002
1.00 **
0.002
Median Year Housing Built
1.00
0.002
1.00
0.003
Capitalization Rate
1.21
1.160
0.58
0.806
House Price Appreciation (2 years prior to origination)
1.10 ***
0.033
1.10 **
0.048
African American
Latino
Asian
2.13 ***
1.32 ***
1.27 ***
0.202
0.089
0.115
1.88 ***
1.17
1.15
0.269
0.117
0.145
Borrower Income
1.00
Borrower FICO Score (omitted: High - Above 720)
Low FICO - Below 640
Mid-level FICO - 640-720
3.69 ***
2.29 ***
0.310
0.162
3.72 ***
2.38 ***
0.475
0.242
LOAN VARIABLES
Higher-Priced Loan (yes=1)
Fixed Interest Rate (yes=1)
Prepayment Penalty (yes=1)
Full Documentation (yes=1)
Monthly Payment
Loan-to-Value Ratio
2.64 ***
0.30 ***
1.14 ***
0.73 ***
1.09 ***
2.49 ***
0.181
0.032
0.057
0.505
0.011
0.106
2.07
0.37
1.55
0.73
1.10
2.04
0.207
0.053
0.148
0.062
0.015
0.125
BORROWER VARIABLES
Borrower Race (omitted: Non-Hispanic White)
1.37x10-4
1.00
***
***
***
***
***
***
1.14x10-4
LENDER VARIABLES
CRA (omitted: Independent Mortgage Company)
CRA in Assessment Area
0.58 ***
0.04
0.96
0.119
CRA outside Assessment Area
0.84 ***
0.048
1.17
0.143
Correspondent Loan
Wholesale Loan
1.62 ***
1.96 ***
0.221
0.212
Observations
26,248
Loan Source (omitted: retail branch)
34,933
*(**)(***) Statistically significant at 10(5)(1) level.
131
Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act
Table 6: Model Predicting the Likelihood of Loan Foreclosure in Middle-Income Neighborhoods
CRA
Assessment Area
Odds Ratio
NEIGHBORHOOD VARIABLES
CRA with Assessment
Area and Loan Source
Standard
Odds Ratio
Error
Standard
Error
Percent Owner-Occupied
1.01 ***
0.001
1.01 ***
0.002
Median Year Housing Built
1.01 ***
0.002
1.00
0.002
Capitalization Rate
0.69
0.636
2.27
2.920
House Price Appreciation (2 years prior to origination)
1.27 ***
0.030
1.23 ***
0.041
African American
Latino
Asian
1.53 ***
1.33 ***
1.17 ***
0.113
0.063
0.073
1.52 ***
1.31 ***
1.09
0.176
0.091
0.093
Borrower Income
1.00 ***
1.14x10-4
1.00 ***
1.42x10-4
Borrower FICO Score (omitted: High - Above 720)
Low FICO - Below 640
Mid-level FICO - 640-720
4.22 ***
2.68 ***
0.261
0.130
5.13 ***
2.82 ***
0.454
0.201
LOAN VARIABLES
Higher-Priced Loan (yes=1)
Fixed Interest Rate (yes=1)
Prepayment Penalty (yes=1)
Full Documentation (yes=1)
Monthly Payment
Loan-to-Value Ratio
2.93 ***
0.34 ***
1.30 ***
0.61 ***
1.06 ***
3.10 ***
0.142
0.025
0.055
0.034
0.008
0.159
2.34
0.35
1.51
0.59
1.06
2.67
***
***
***
***
***
***
0.172
0.035
0.111
0.040
0.010
0.127
BORROWER VARIABLES
Borrower Race (omitted: Non-Hispanic White)
LENDER VARIABLES
CRA (omitted: Independent Mortgage Company)
CRA in Assessment Area
0.56 ***
0.028
0.80 ***
0.072
CRA outside Assessment Area
0.92 ***
0.038
1.06
0.091
Correspondent Loan
Wholesale Loan
1.39 ***
1.97 ***
0.129
0.147
Observations
73,603
Loan Source (omitted: retail branch)
91,400
*(**)(***) Statistically significant at 10(5)(1) level.
132
Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act
Table 7: Model Predicting the Likelihood of Loan Foreclosure in Upper-Income Neighborhoods
CRA
Assessment Area
Odds Ratio
NEIGHBORHOOD VARIABLES
CRA with Assessment
Area and Loan Source
Standard
Odds Ratio
Error
Standard
Error
Percent Owner-Occupied
1.01 ***
0.002
1.00 ***
0.002
Median Year Housing Built
1.01 ***
0.002
1.01 ***
0.003
Capitalization Rate
2.79
4.720
3.93
8.280
House Price Appreciation (2 years prior to origination)
1.27 ***
0.039
1.26 ***
0.051
African American
Latino
Asian
1.67 ***
1.47 ***
1.38 ***
0.148
0.088
0.096
1.69 ***
1.65 ***
1.33 ***
0.218
0.141
0.117
Borrower Income
1.00 ***
1.09x10-4
1.00 ***
1.68x10-4
Borrower FICO Score (omitted: High - Above 720)
Low FICO - Below 640
Mid-level FICO - 640-720
3.99 ***
2.83 ***
0.301
0.162
4.64 ***
2.83 ***
0.498
0.213
LOAN VARIABLES
Higher-Priced Loan (yes=1)
Fixed Interest Rate (yes=1)
Prepayment Penalty (yes=1)
Full Documentation (yes=1)
Monthly Payment
Loan-to-Value Ratio
3.44 ***
0.41 ***
1.40 ***
0.57 ***
1.04 ***
3.52 ***
0.225
0.032
0.074
0.036
0.006
0.127
2.96
0.45
1.50
0.59
1.05
2.89
***
***
***
***
***
***
0.248
0.045
0.119
0.048
0.007
0.152
BORROWER VARIABLES
Borrower Race (omitted: Non-Hispanic White)
LENDER VARIABLES
CRA (omitted: Independent Mortgage Company)
CRA in Assessment Area
0.49 ***
0.028
0.64 ***
0.067
CRA outside Assessment Area
0.84 ***
0.046
0.93
0.096
Correspondent Loan
Wholesale Loan
1.37 ***
2.12 ***
0.164
0.180
Observations
91,866
Loan Source (omitted: retail branch)
104,932
*(**)(***) Statistically significant at 10(5)(1) level.
133
Risky Borrowers or Risky Mortgages
Disaggregating Effects Using Propensity Score Models
Lei Ding, a * Roberto G. Quercia, b Wei Li, c Janneke Ratcliffe b
Draft on November 30, 2009
a
Department of Urban Studies and Planning, Wayne State University, Detroit, MI
b
Center for Community Capital, University of North Carolina, Chapel Hill, NC
c
Center for Responsible Lending, Durham, NC
* Contact author: Telephone: 313-577-0543, E-mail: lei_ding@wayne.edu
Risky Borrowers or Risky Mortgages
Disaggregating Effects Using Propensity Score Models
Abstract:
In this research, we examine the relative risk of subprime mortgages and community
reinvestment loans. Using the propensity score matching method, we construct a
sample of comparable borrowers with similar risk characteristics but holding the two
different loan products. We find that community reinvestment loans have a lower
default risk than subprime loans, very likely because they are not originated by
brokers and lack risky features such as adjustable rates and prepayment penalties.
Our results suggest that similar borrowers holding community reinvestment loans
exhibit significantly lower default risks.
Introduction
Explanations for the current foreclosure crisis abound. There are the obvious culprits:
overextended borrowers, risky mortgages, reckless originators, and investors and
other secondary market participants who failed to act with due diligence (e.g. Mian
and Sufi, 2008; Quercia and Ratcliffe, 2008). Moreover, there are some who blame
government regulation, such as the Community Reinvestment Act (CRA), designed to
increase the credit supply to traditionally underserved, but creditworthy, population
(Cravatts, 2008; Krauthammer, 2008). From this perspective, the CRA and similar
regulation are said to have put pressure on lenders and the government sponsored
enterprises (GSEs) to extent mortgages to over-leveraged, uncreditworthy, and/or
irresponsible low-income and minority borrowers.
The debate over what caused the mortgage mess and how best to fix it has important
policy implications. What is missing in the debate is an empirical examination of the
relative performance of similar borrowers holding either a typical CRA loan or a
subprime product. Such an analysis will help inform policy by answering the question
of whether high default rates represent just the higher risk profile of borrowers
holding subprime loans or the risky characteristics of subprime loans. Although
borrowers holding subprime loans generally are weaker across key underwriting
criteria, many borrowers holding subprime products actually qualify for a prime
mortgage (Hudson and Reckard, 2005; Brooks and Simon, 2007). Some products or
features that are more prevalent among subprime loans, such as prepayment penalties,
adjustable rates, and balloon payments, have been found to be associated with
elevated default risk (e.g. Ambrose, LaCour-Little and Huszar, 2005; PenningtonCross and Ho, 2006; Quercia, Stegman and Davis, 2007). Are the higher default rates
reported in the subprime sector mainly the result of risky loan products?
1
We address this issue by comparing the performance of subprime loans and CRA
loans in a special lending program called Community Advantage Program (CAP). To
solve the problem of selection bias since performance differences may be due to
differences in the borrowers who receive each product type, we rely on propensity
score matching methods to construct a sample of comparable borrowers. We find that
for borrowers with similar risk characteristics, the estimated default risk is about 70
percent lower with a CRA loan than with a subprime mortgage. Broker-origination
channel, adjustable rates, and prepayment penalties all contribute substantially to the
elevated risk of default among subprime loans. When broker origination is combined
with both adjustable rates and prepayment penalties, the borrower’s default risk is
four to five times higher than that of a comparable borrower with a prime-term CRA
mortgage. Though CAP has some program specific characteristics, the results of this
study clearly suggest that mortgage default risk cannot be attributed solely to
borrower credit risk; the high default risk is significantly associated with the
characteristics of loan products. Thus, the results are not consistent with the concerns
of those blaming the borrowers likely to benefit from CRA and similar regulations.
Done responsibly, targeted lending programs stimulated by the CRA can do a much
better job in providing sustainable homeownership for the low- to moderate-income
(LMI) population than subprime lending. The results have important policy
implications on how to respond to the current housing crisis and how to meet the
credit needs of all communities, especially the LMI borrowers, in the long run.
Compared with prior work, this study is characterized by several important
differences. First, while most early studies focused on the performance of mortgages
within different markets, the focus here is on similar LMI borrowers with different
mortgages, allowing us to compare the relative risk of different mortgage products.
Second, because of data constraints, research on the performance of CRA loans is
scarce. With a unique dataset, this study examines the long term viability of the
homeownership opportunities that CRA-type products provide, relative to that of
subprime alternatives. Third, there have been few discussions and applications of the
propensity score matching method in real estate research. This study uses propensity
score models to explicitly address the selection bias issue and constructs a
comparison group based on observational data. This method allows us to isolate the
impact of loan product features and origination channel on the performance of
mortgages. Finally, while the propensity score model cannot capture all the
information for estimating the propensity of taking out a subprime loan, this study
makes full use of the loan interest rate information to shed some light on the impact
of the unobservable heterogeneity on the mortgage performance.
Literature Review
Risk of Subprime Mortgages
Subprime mortgages were originally designed as refinancing tools to help borrowers
with impaired credit consolidate debt. With the reformed lending laws, the adoption
of automated underwriting, risk-based pricing, as well as the persistent growth in
2
house prices nationwide, the subprime lending channel soon expanded its credit to
borrowers on other margins. The subprime surge was rapid and wide: between 1994
and 2006, the subprime share of all mortgage originations more than quadrupled,
from 4.5 percent to 20.1 percent; and subprime loan originations increased more than
seventeen fold, from $35 billion to about $600 billion. The surge was largely fueled
by securitization (private Wall Street issuances) over the same period, the volume of
securitized subprime mortgage loans increased over forty-four-fold, from $11 billion
to more than $483 billion in 2006, accounting for more than 80 percent of all
subprime lending (Inside Mortgage Finance, 2008).
Beginning in late 2006, a rapid rise in subprime mortgage delinquency and
foreclosure caused a so-called meltdown of the subprime market. The Mortgage
Bankers Association (MBA) reports that the serious delinquency rate for subprime
loans in the second quarter of 2008 was 7.6 times higher than that for prime loans
(17.9 percent versus 2.35 percent). Although subprime mortgages represented about
12 percent of the outstanding loans, they represented 48 percent of the foreclosures
started during the same quarter (MBA, 2008). Delinquency and default rates for
subprime loans typically are six times to more than 10 times higher than those of
prime mortgages (Pennington-Cross, 2003; Gerardi, Shapiro and Willen, 2007;
Immergluck, 2008).
It may be true that borrowers holding subprime loans are generally weaker across key
underwriting criteria. A subprime borrower used to refer to an individual who had any
of the following characteristics: 1) a FICO score below 620, 2) a delinquent debt
repayment in the previous two years, 3) a bankruptcy filing in the previous five years
(Gerardi et al. 2007). Recent subprime home-purchase loans became available to
borrowers who may have had impaired credit history or were perceived to have
elevated credit risks, such as ―low-doc‖ or ―no doc‖ borrowers, ―low-down‖ or ―zerodown‖ payment borrowers, or borrowers with high debt-to-income ratios (DTIs). All
these risk characteristics are usually significantly associated with a higher default risk
of the mortgages these borrowers hold.
At this point, it is important to make a distinction between borrowers and mortgage
products. It can be said that there are two types of borrowers and two types of
mortgage products: prime and subprime. Not all prime borrowers get prime
mortgages and not all subprime borrowers get subprime mortgages. Borrowers who
do not meet all the traditional underwriting guidelines can be considered subprime but
these borrowers can receive prime-type mortgages as they may through CRA efforts.
Similarly, borrowers with good credit can receive subprime products characterized by
high debt to income and loan to value ratios, no or low documentation, teaser and
adjustable rates and other such risky characteristics (the so called Alt-A market).
Some loan features and loan terms are more prevalent in the subprime sector than in
other markets and are also associated with higher default risk. As summarized by
Cutts and Van Order (2005) and Immergluck (2008), characteristics of subprime
loans relative to prime loans include: 1) high interest rates, points, and fees, 2)
3
prevalence of prepayment penalties, 3) prevalence of balloon payments, 4) prevalence
of adjustable-rate mortgages (ARMs), 5) popularity of broker originations. After
2004, some ―innovative‖ mortgage products, such as interest-only, payment option,
negative amortization, hybrid ARMs, and piggy-back loans became more popular in
the subprime sector (Immergluck, 2008). In the literature, Calhoun and Deng (2002)
and Quercia et al. (2007) find that subprime ARMs have a higher risk of foreclosure
because of the interest-rate risk. At the aggregate level, the share of ARMs appears to
be positively associated with market risk as measured by the probability of the
property value to decline in the next two years (Immergluck, 2008). Subprime hybrid
ARMs, which usually have prepayment penalties, bear particularly high risk of
default at the time the interest rate is reset (Ambrose et al. 2005; Pennington-Cross
and Ho, 2006).
As to the feature of prepayment penalties and balloons, Quercia et al. (2007) find that
refinanced loans with prepayment penalties are 20 percent more likely than loans
without to experience a foreclosure while loans with balloon payments are about 50
percent more likely to experience a foreclosure than those without. Prepayment
penalties also tend to reduce prepayments and increase the likelihood of delinquency
and default among subprime loans (Danis and Pennington-Cross, 2005).
Recently, mortgage brokers have played a greater role in the subprime sector. In 2003
brokers originated about 48 percent of all subprime loans; in 2006 the share was
estimated between 63 percent and 80 percent (Ernst et al. 2008), higher than the share
of about 30 percent of broker-originated loans among all mortgages in recent years
(Inside Mortgage Finance, 2008). Empirical evidence on the behavior of brokeroriginated mortgages is scarce. LaCour-Little and Chun (1999) find that for the four
types of mortgages analyzed, loans originated by a third party (including broker and
correspondence) were more likely to prepay than loans originated by a lender.
Alexander, Grimshaw, McQueen and Slade (2002) find that third-party originated
loans do not necessarily prepay faster but they default with greater frequency than
similar retail loans, based on a sample of subprime loans originated from 1996 to
1998. They suggest that third-party originated mortgages have higher default risk than
similar retail loans because brokers are rewarded for originating a loan but not held
accountable for the loan’s subsequent performance.
Thus, the higher default rates reported in subprime lending may be because of risky
borrowers, risky loan products, or a combination of both.
CRA Lending
The Community Reinvestment Act (CRA) of 1977 was created in response to charges
that financial institutions were engaging in redlining and discrimination. The Act
mandates that federally insured depository institutions help meet the credit needs of
communities in which they operate in a manner consistent with safe and sound
operation (Bernanke, 2007). Regulators assess each bank’s CRA record when
evaluating these institutions’ applications for mergers, acquisitions, and branch
4
openings. The performance of large institutions is measured under three categories of
bank activities: lending, services, and investment, with the lending test carrying the
most weight (at least 50 percent).1 For the lending test, it examines the amount and
proportion of lending activities made within an institution’s assessment area.2
Usually, loans are regarded as ―CRA-related‖ if they are made by CRA-regulated
institutions within their assessment areas to low-income borrowers (those with less
than 80% area median income (AMI), regardless of neighborhood income) or in a
low- income neighborhood (with less than 80% AMI, regardless of borrower income)
(Avery, Bostic and Canner, 2000).
The CRA lending test also examines the use of innovative or flexible lending
practices to address the credit needs of LMI households and community. In response,
many banks have developed ―CRA Special Lending Programs‖ or have introduced
mortgage products characterized by more flexible underwriting standards. Survey
results suggest that most financial institutions offer these special programs, and that
most of the programs relate to home mortgage lending, which typically feature some
combination of special outreach, counseling and education, and underwriting
flexibility (especially in terms of reduced cash to close, alternative credit verification
and higher debt-to-income thresholds) (Avery et al. 2000). A review article by Apgar
and Duda (2003) suggests the CRA has had a positive impact on underserved
population by originating a higher proportion of loans to low-income borrowers and
communities than they would have without CRA. At the same time, one study
suggests that there is no evidence that CRA-affected lenders cut interest rates to
CRA-eligible borrowers or that there is a regulation-driven subsidy for CRA loans
(Canner, Laderman, Lehnert and Passmore, 2002).
CRA-type mortgages are different from subprime loans in that CRA products usually
have prime-term characteristics. In general, they are believed to carry a higher risk
because they are originated by liberalizing one or two underwriting criteria.
Moreover, CRA products are originated by federally insured depository institutions
covered by CRA while two out of three subprime lenders are independent mortgage
companies not covered by CRA (Bernanke, 2007). A few studies investigating the
delinquency behaviors among CRA borrowers suggest the delinquency rate of CRA
mortgages is comparable to that of FHA loans after excluding loans with low loan-tovalue ratios (LTV) (e.g., Quercia, Stegman, Davis and Stein, 2002). Because of data
constraints, little is known about the long term viability of the homeownership
opportunities that these products provide.
Why Different Markets Coexist
To increase the flow of funds into low-income population and neighborhoods, the
CRA encourages lenders to meet credit needs within their service or catchment area,
taking into account safety and soundness considerations. Liberalizing one or two
traditional mortgage underwriting standards allows lenders to make loans to those
who would otherwise not qualify for a prime mortgage (for instance, not requiring
5
mortgage insurance when the downpayment is less than 20 percent makes loans more
affordable for some borrowers).
In this sense, both CRA and subprime products may target many of the same
borrowers. In fact, recent studies suggest there is a significant overlap between
borrowers holding subprime mortgages and those holding prime loans, FHA loans,
and other loan products, particularly among LMI borrowers with marginal credit
quality. Freddie Mac, for example, finds that about 20 percent of subprime borrowers
could have qualified for a prime rate mortgage (Hudson and Reckard, 2005). A Wall
Street Journal report suggests 61 percent of subprime mortgages went to borrowers
with credit that would have qualified them for conventional loans by 2006 (Brooks
and Simon, 2007). Bocian, Ernst and Li (2007) suggest that a significant portion of
subprime borrowers (estimates range from 10 percent to almost 40 percent) could
have qualified for low-priced prime loans.
Why would many people who could qualify for low-cost prime-type loans take out
subprime products? First of all, many borrowers, especially those with impaired
credit history, are usually financially unsophisticated and may feel they have limited
options. Courchane, Surette and Zorn (2004) indicate that subprime borrowers ―are
less knowledgeable about the mortgage process, are less likely to search for the best
rates, and are less likely to be offered a choice among alternative mortgage terms and
instruments‖ (p.365). Especially, for some nontraditional mortgages, including
interest-only mortgages, negative amortization mortgages, and mortgages with teaser
rates, they were apparently not well understood by many borrowers. When borrowers
do not know the best price and are less likely to search for the best rates, it is likely
that they cannot make the right decision when they shop for mortgage products. In
fact, Courchane et al. (2004) find that search behavior as well as adverse life events,
age, and Hispanic ethnicity contribute to explaining the choice of a subprime
mortgage.
Second, predatory lending or abusive lending practices are concentrated in the
subprime sector which may explain why some borrowers end up with certain loans.
Unscrupulous lenders, or brokers as their agents, may take advantage of uninformed
borrowers by charging fees and rates not reflected of the risk, by not informing
borrowers of lower cost loan alternatives, and by offering products and services
without full disclosure of terms and options. Renuart (2004) highlights the role of
loan steering and abusive push-marketing of subprime lending practices, in which
lenders steer borrowers to subprime products instead of low-cost prime alternatives.
A major reason for this is that there are higher incentives from originating subprime
mortgages than from low-cost alternatives. Compared to traditional prime mortgages,
subprime mortgages generated much higher profit for originators before the bust – 3.6
percent versus 0.93 percent for Countrywide alone in 2004 (Morganson, 2008). For
brokers, in addition to the standard origination fees, they are compensated by a yieldspread premium (YSM), which is an extra payment that brokers receive from lenders
for delivering a mortgage with a higher interest rate than that for which the borrower
may qualify (Ernst et al. 2008). Thus, brokers are usually more concerned about
6
mortgage volume and features that generate fees and points from borrowers and
commissions and premiums from lenders, instead of the loan’s subsequent
performance. Because the subprime market is characterized by complicated pricing
tiers and product types that are not easy to understand, the steering problem is likely
to be more pronounced in the subprime sector than in other markets in which products
are generally standardized. Furthermore, the originators usually do not have to be
held accountable for the loan’s long term performance as most of subprime loans
originated in recent years were securitized (80 percent in 2006). For brokers, broker
fees and the yield spread premiums are paid upon settlement of the loan, at which
point the broker would have no further stake in the performance of that loan. Of
course, banks and investors, as well as brokers and banks, are involved in repeated
relationships, reputation concerns may somewhat prevent the moral hazard of lenders.
But the not well-designed compensation mechanism and the lack of responsibility for
the long-term sustainability of mortgages provide the incentive for many lenders and
brokers to originate subprime loans than other less profitable products to maximize
their own profit.
In the literature, similar behaviors have been examined with the information
asymmetry theory, moral hazard theory, and agency cost theory. For an originator to
provide an efficient level of such services as marketing and underwriting mortgage
products, it must be given the proper incentives to do so. But Alexander et al. (2002)
suggest that third-party originators have the incentive to game with lenders and
investors either passively or actively in the credit underwriting process: intentionally
lacking rigor in the screening process, exaggerating measures of credit worthiness or
property value, or targeting and putting borrowers with marginal quality to high-cost
subprime with risky loan terms instead of lower cost alternatives.3 Mian and Sufi
(2008) blame the moral hazard on behalf of originators selling risky mortgages is the
primary cause of the loose underwriting and the subsequent mortgage foreclosure
crisis. Keys, Mukherjee, Seru and Vig (2008) also suggest that securitization leads to
lax screening by adversely affecting the screening incentives of lenders.
In short, borrowers generally sort to prime/CRA, subprime or other mortgage markets
based on their risk profile. However, the lack of financial sophistication of some
borrowers, the poor alignment of incentives, and moral hazard considerations are
some of the many reasons borrowers—especially marginally qualified borrowers—
may receive less desirable mortgage products than they can be qualified for.
7
Data
Data for this study come from one LMI-targeted lending program, the Community
Advantage Program (CAP), developed by Self-Help in partnership with a group of
lenders, Fannie Mae, and the Ford Foundation. Participating lenders establish their
own guidelines. The most common variants from typical conventional, prime
standards are: reduced cash required to close (through lower down payment and/or
lower cash reserve requirements);4 alternative measures or lower standards of credit
quality;5 and flexibility in assessing repayment ability (through higher debt ratios
and/or flexible requirements for employment history).6 These guidelines variants
could be combined or used to offset each other.7 Nearly 90 percent of the programs
feature exceptions in at least two of these areas, and more than half feature exceptions
in all three. The majority of programs combine neighborhood and borrower targeting.
Under the LMI-targeted CAP lending program, participating lenders are able to sell
these nonconforming mortgages to Self-Help, which then securitizes and sells them to
Fannie Mae or other investors. Participating lenders originate and service the loans
under contract with Self-Help. It should be emphasized that, while many of the
borrowers are somewhat credit impaired, the program cannot be characterized as
subprime. The vast majority of CAP loans are retail originated (in contrast to broker
originated) and feature terms associated with the prime market: thirty-year fixed-rate
loans amortizing with prime-level interest rates, no prepayment penalties, no
balloons, with escrows for taxes and insurance, documented income, and standard
prime-level fees. As a LMI-targeting program, CAP has some program-specific
characteristics such as income and geographic limitations.8
The data of subprime loans come from a proprietary database from Lender Processing
Services, Inc. (LPS, formerly McDash Analytics), which provides loan information
collected from approximately 15 mortgage servicers. LPS’ coverage in the subprime
market by volume increased from 14 percent in 2004 to over 30 percent in 2006,
based on our estimation using data from Inside Mortgage Finance. There is no
universally accepted definition of subprime mortgage; the three most commonly used
definitions are 1) those categorized as such by the secondary market, 2) those
originated by a subprime lender as identified by HUD’s annual list, and 3) those that
meet HUD’s definition of a ―high-cost‖ mortgage (Gerardi et al. 2007). For the
purposes of this paper we primarily follow the first definition, since we can identify
those B&C loans in LPS but could not identify lenders’ information and mortgages’
APR. We further consider high-cost ARMs as subprime in this analysis. Less than
20% of loans in our LPS study sample are included solely because they are
considered high-cost, defined as having a margin greater than 300 basis points (Poole,
2007). In addition, we appended to our data selected census and aggregated HMDA
variables at a zip code level, including the Herfindahl-Hirschman Index (―HHI‖)
calculated from HMDA, racial and educational distribution from census data, and
area average FICO scores calculated from the LPS data.
8
We started from a sample of 9,221 CAP loans originated from 2003 to 2006. All are
first-lien, owner-occupied, fixed-rate conforming home purchase loans with full or
alternative documentation. National in scope, these loans were originated in 41 states,
with about two-thirds concentrated in Ohio, North Carolina, Illinois, Georgia and
Oklahoma. To make sure subprime loans are roughly comparable to CAP loans, as
Exhibit 1 shows, we limited our analysis to subprime mortgages also characterized as
first-lien, single-family, purchase-money, and conforming loans with full or
alternative documentation that originated during the same period. We further
excluded loans with missing values for some key underwriting variables (FICO score,
LTV, DTI, and documentation status) and loans without complete payment history.
Finally, because we want to compare CAP and subprime loans in the same market,
we excluded those subprime loans in areas without CAP lending activities. This gave
us a sample of 42,065 subprime loans. Table 2 summarizes some important
characteristics of both CAP loans and subprime loans in this analysis. Significance
tests show that almost all variables across the two groups differ significantly before
matching, indicating that the covariate distributions are different between CAP and
subprime loans in the original sample.
Though drawn from similar markets, the CAP borrowers (including all active loans
originated as early as 1990s) are not experiencing the same mortgage woes as
subprime borrowers. As Exhibit 2 shows, 3.21 percent of our sample of community
lending borrowers were 90-days’ delinquent or in foreclosure process in the second
quarter of 2008. This was slightly higher than the 2.35 percent delinquency rate on
prime loans but well below the 17.8 percent on subprime loans nationwide.
Especially, over 27 percent of subprime ARMs were in foreclosure or serious
delinquency, which was almost nine times that of community lending loans.
In summary, the CAP and subprime samples have identical characteristics for the
following important underwriting variables: lien status, amortization period, loan
purpose, occupancy status, and documentation type. They were originated during the
same time period and roughly in the same geographic areas. But the two samples
differ in other underwriting factors, including DTI, LTV, and FICO score, and in loan
amount and some loan features that are more common only for subprime loans. In the
next section, we use the propensity score matching (PSM) method to develop a new
sample by matching CAP loans with comparable subprime loans.
Methodology
The PSM method has been widely used to reduce selection biases in recent program
evaluation studies. PSM was first developed by Rosenbaum and Rubin (1983) as an
effort to more rigorously estimate causal effects from observational data. Basically,
PSM accounts for observable heterogeneity by pairing participants with
nonparticipants on the basis of the conditional probability of participation, given the
observable characteristics. The PSM approach has gained increasing popularity
among researchers from a variety of disciplines, including biomedical research,
epidemiology, education, sociology, psychology, and social welfare (see review in
9
Guo, et al., 2006). There is some evidence that nonparametric PSM methods can
produce impact estimates that are closer to the experimental benchmark than the
parametric approach (Essama-Nssah, 2006).
There are three basic steps involved in implementing PSM. First, a set of covariates is
used to estimate the propensity scores using probit or logit, and the predicted values
are retrieved. Then each participant is paired with a comparable nonparticipant based
on propensity scores. In the last step, regression models or other methods can be
applied to the matched group to compare the outcomes of participants and
nonparticipants. Here we describe these steps in our analysis in more details.
In this case, because receiving a subprime is a choice/assignment process rather than
randomly assigned we used the PSM method to adjust this selection bias. In the first
step, we employed logistic regression models to predict the propensity (e(xi)) for
borrower i (i= 1,…,N) of receiving subprime loans (Si= 1) using a set of conditioning
variables (xi).
e(xi)=pr(Si=1|Xi= xi)
(1)
In the second step, we used the nearest-neighbor with caliper method to match CAP
borrowers with borrowers holding subprime loans based on the estimated propensity
scores from the first step. The method of nearest-neighbor with caliper is a
combination of two approaches: traditional nearest-neighbor matching and caliper
matching. 9 This method begins with a randomly sort of the participants and
nonparticipants, then selecting the first participant and finding the nonparticipant
subject with the closest propensity score within a predetermined common-support
region called caliper (δ). The approach imposes a tolerance level on the distance
between the propensity score of participant i and that of nonparticipant j. Formally,
assuming c(pi) as the set of the neighbors of i in the comparison group, the
corresponding neighborhood can be stated as follows.
c( pi )
j
pi
pj
(2)
If there is no member of the comparison group within the caliper for the treated unit i,
then the participant is left unmatched and dropped from the analysis. Thus, caliper is
a way of imposing a common support restriction. Naturally, there is uncertainty about
the choice of a tolerance level since a wider caliper can increase the matching rate but
it also increase the likelihood of producing inexact matching. A more restrictive
caliper increases the accuracy but may significantly reduce the size of the matched
sample.
In the third step, we employed a multinomial regression model (MNL) to further
control factors that may influence the performance of the new sample after loan
origination, many of which are time-varying. In each month the loan can be in only
one state or outcome (active, default, or prepaid). Since the sum of the probabilities of
each outcome must equal to one, the increase in the probability of one outcome
10
necessitates a decrease in the probability of at least one competing outcome. Thus the
multinomial logit model is a competing risk model.
We can think of mortgage borrowers as having three options each month:
DEFAULT: This study treats the incidence of the first 90-day delinquency as
a proxy of default.
PREPAID: If a loan was prepaid before it is seriously delinquent, it is
considered a prepayment.
ACTIVE: Active and not default (not seriously delinquent in some models)
The probability of observing a particular loan outcome is given by:
Pr( yit
e
j)
jZit
j Si
for j 1,2
2
1
e
kZit
k Si
k 1
Pr( yit
1
j)
for j 0
2
1
e
kZit
(3)
k Si
k 1
T
N
2
ln L
d ijt ln(Pr( y it
j ))
t 1 i 1 j 0
where j=0,1,2 represents the three possible outcomes of a loan and the omitted
category (j=0) remains active and not seriously delinquent (ACTIVE). dijt is an
indicator variable taking on the value 1 if outcome j occurs to loan i at time t, and
zero otherwise. Z contains a set of explanatory variables and is the coefficient. To
identify the difference between the performance of CAP loans and subprime loans, S
contains a subprime dummy variable or indicators of subprime loan characteristics.
Specifically, we considered the impact one origination channel and two loan
characteristics: the prepayment penalty, the adjustable rate, and the broker origination
channel. We constructed six mutually exclusive dummy variables for the
combinations of these three characteristics,10 such as sub_bro&arm&ppp for ―brokeroriginated subprime loans with adjustable rates and prepayment penalties‖ and
sub_arm for ―retail-originated subprime loans with adjustable interest rates and no
prepayment penalties.‖ None of the CAP loans have these features, and they are set as
the reference group in both models.
In the context of observational studies, the PSM methods seek to mimic conditions
similar to an experiment so that the assessment of the impact of the program can be
based on a comparison of outcomes for a group of participants (i.e. those with Si = 1)
with those drawn from a comparison group of non-participants (Si = 0). We need to
check whether our observational data meet the two primary assumptions underlying
the PSM methods: the conditional independence assumption and the overlap
assumption.
11
Conditional Independence Assumption: 11
To yield consistent estimates of program impact, matching methods rely on a
fundamental assumption known as ―conditional independence,‖ which can be
formally stated as:
( y0 , y1 )
wx
(4)
This expression states that potential outcomes are orthogonal to treatment status,
given the observable covariates. In other words, conditional on observable
characteristics, participation is independent of potential outcomes and unobservable
heterogeneity is assumed to play no role in participation (Dehejia and Wahba, 2002).
Assuming that there are no unobservable differences between the two groups after
conditioning on xi, any systematic differences in outcomes between participants and
nonparticipants are due to participation. So the plausibility of an evaluation method
depends largely on the correctness of the propensity score model underlying program
design and implementation.
Our first strategy is to use a well specified logit regression to estimate the probability
of taking out a subprime mortgage for each cohort, grounded on a sound
understanding of the subprime market. We determined the conditional variables that
are associated with the use of subprime loans based on a review of subprime lending
and mortgage choice literature, as discussed in the next section. Second, it is possible
that lenders have access to more information about the borrower and local market
than the information in our dataset and the unobservable lender information would
influence the estimation results. Our strategy is to rerun the multinomial regression
model by including the unobservable borrower heterogeneity as an independent
variable, which is proxied by interest rate variables if the mortgage note rate can be
assumed to an effective predictor of the level of credit risk.
Overlap assumption:
For matching to be feasible, there must be individuals in the comparison group with
the same or similar propensity as the participant of interest. This requires an overlap
in the distribution of observables between the treated and the comparison groups.
The overlap assumption is usually stated as:
0
pr(w 1 x) 1
(5)
This implies the possible existence of a nonparticipant analogue for each participant.
When this condition is not met, then it would be impossible to find matches for a
fraction of program participants.
12
In this case, as we discussed in the literature review, it is highly likely that there is
significant overlap between the CRA-type CAP loans and the subprime sample since
both of them focus on households with marginal credit quality and have identical loan
characteristics such as lien status, loan purpose, occupancy status, and documentation
type. As shown in Exhibit 3, the distribution of credit scores for the CAP and
subprime borrowers, subprime borrowers tend to have lower FICO scores than CAP
borrowers, but there is a significant overlap in these distributions. This overlap allows
us to conduct a meaningful analysis of the performance of different loan products.
Empirical Analysis
Propensity Score Matching
Recent empirical studies suggest that borrowers take out subprime mortgages based
on their credit score, income, payment history, level of down payment, debt ratios,
and loan size limits; there is mixed evidence on the effect of demographics
(Courchane et al. 2004; Cutts and Van Order, 2005; Chomsisengphet and PenningtonCross, 2006; LaCour-Little, 2007). Based on the literature review, we included the
key underwriting factors of FICO score and DTI in our analysis. These variables are
assumed to directly affect credit risk and therefore affect mortgage
choice/assignment, since higher credit risk is hypothesized to be associated with a
greater probability of taking out a subprime mortgage. For example, lower FICO
scores are assumed to be associated with higher credit risk, so we expect subprime
loans to capture the majority of the borrowers with lower FICO scores. LTV, another
important underwriting variable, is also generally considered to raise endogeniety
concerns (LaCour-Little, 2007). In this case, higher LTV is one distinct characteristic
of most CAP loans, with over 82 percent of CAP loans having an LTV equal to or
higher than 97 percent. By contrast, most subprime loans have an LTV of less than 90
percent. Courchane et al. (2004) also suggest that high LTV may be associated with
higher risk but is not necessarily associated with getting a subprime mortgage.
Because our focus is the impact of borrower and neighborhood characteristics on
borrowers’ choice/assignment of mortgages, we decided not to include LTV variables
in the model.12
In addition to the underwriting variables, we included loan amount as an explanatory
variable since fixed costs are usually a large component of loan originations. We
further included several factors measuring local market dynamics and credit risk. We
constructed a zip-code-level credit risk measure: the mean FICO score for mortgages
originated in the preceding year from the LPS data. Our hypothesis is that subprime
lenders tend to market in neighborhoods or areas with a larger share of potential
borrowers who have impaired credit history. The zip-code educational distribution
was included as a proxy of residents’ financial knowledge and literacy. Because some
literature suggests that subprime lending is more likely to be concentrated in minority
neighborhoods (Calem et al. 2004), we included the share of minority in the zip code
in the models. Furthermore, we constructed a zip-code-level HHI using HMDA data
to measure the extent of competition in the market in which borrowers’ properties are
13
located.13 The HHI measure also partially represents the volume of transactions in the
area, since more transactions in a hot market could, though not necessarily would,
attract more lenders to the market. In addition, we included quarterly calendar dummy
variables to account for fluctuations in the yield curve that could affect market
dynamics.
Exhibit 5 presents the results from logistic regression models for different vintages.
Across different years, credit risk measures are highly predictive: borrower FICO
score, coded into buckets with above 720 as the holdout category, is highly predictive
of the use of subprime loans; coefficients are relatively large and decrease
monotonically as credit score categories increase. In other words, as expected, the
higher the FICO score, the lower the probability of taking out a subprime mortgage.
Compared to those with very high DTI (>42 percent), borrowers with lower DTIs are
generally less likely to receive subprime loans; exceptions are the buckets with low
DTI (<28 percent) for the 2005 and 2006 samples. While it seems CAP borrowers
had very high DTIs in 2006, the results generally suggest that borrowers with very
high DTIs are more likely to receive subprime loans. In all the models, loan amount is
positive for the use of subprime loans, consistent with the hypothesis that subprime
borrowing involves higher costs, with costs being driven by large fixed components.
Further, zip-code-level average credit score is statistically significant and negatively
related to the probability of taking out a subprime mortgage, suggesting that
borrowers in areas with a higher share of low-score population are more likely to
receive subprime loans. Zip-code-level education performs about as expected, with
higher educational attainment roughly associated with a reduced probability of
receiving a subprime mortgage. Borrowers in areas with a higher share of minorities
are more likely to use subprime mortgages. Finally, higher HHIs are associated with a
lower probability of taking out a subprime mortgage—suggesting that, at least in the
period from 2003-2006, subprime loans were more likely to be in the markets with
more intensive competition and/or more transactions.
In this analysis, we defined the logit rather than the predicted probability as the
propensity score, because the logit is approximately normally distributed. For the
one-to-one nearest neighbor with caliper match, we selected the subprime loan with
the closest propensity score within a caliper for the first CAP loan after the subprime
and randomly ordered CAP loans. We then removed both cases from further
consideration and continued to select the subprime loan to match the next CAP loan.
For the one-to-many match, we matched subprime loans with CAP loans with the
closest propensity score within a caliper after all the loans were randomly sorted.
Instead of removing the matched cases after matching, as in the one-to-one match, we
kept the matched CAP loans in the sample and continued to find the matching CAP
loans for the next subprime loan. This allows us to match as many subprime loans as
possible for each CAP loan. We tried two different calipers, 0.1 and 0.25 times of
standard error as suggested by Rosenbaum and Rubin (1985). In other words, we tried
two matching algorithms, allowing us to match one CAP loan with one or multiple
subprime loans, and two caliper sizes, allowing us to test the sensitivity of the
14
findings to varying sizes. For the one-to-many matched sample, to ensure that our
analysis is representative of the matched set, we apply a system of weights, where the
weight is the inverse of the number of subprime loans that matched to one single CAP
loan.
Exhibit 6 describes the four matching schemes and numbers of loans for the
resamples: Match 1 and Match 2 are based on the one-to-one match; Match 3 and
Match 4 are based on the one-to-many match. Match 1 and Match 3 use nearest
neighbor matching within a more restrictive caliper of 0.1, while other matching
schemes employ a wider caliper (0.25 times of the standard deviation of the
propensity scores). The results show that the more restrictive caliper does not
dramatically reduce the sample size; we lost about 791 cases (12 percent) from Match
2 to Match 1 and only one CAP loan from Match 4 to Match 3. Because the
qualitative results do not change and a restrictive caliper can lower the likelihood of
producing inexact matching, we focused on the schemes using the more restrictive
caliper size of 0.1 (Matches 1 and 3) in our analysis of loan performance. For the oneto-one match (Match 1), we ended up with a sample of 5,558 CAP loans and 5,558
matching subprime loans. For the one-to-many match, the sample was 35,971
subprime loans matched to 3,943 CAP loans (Match 3).
We checked covariate distributions after matching. Both Match 1 and Match 3
remove all significant differences, except LTV variables, between groups. For the
matched groups, as Exhibit 7 shows, borrowers are remarkably similar across all
groups except for LTV ratios, and we got a reduced but more balanced sample of
CAP and subprime borrowers. Compared to CAP loans, which are usually fixed-rate
retail loans with no prepayment penalty, subprime loans have distinctive features and
terms. A vast majority (86 percent) of subprime loans are adjustable rate mortgages;
most (70 percent) were obtained through brokers; and many (41 percent) have
prepayment penalties.
Performance of the Matched Sample
We turn now to the comparison of CAP loans and subprime loans with similar
characteristics. For the matched sample, we observed the payment history during the
period from loan origination to March 2008. During this period, CAP loans had a
lower serious delinquency rate: only 9.0 percent had ever experienced 90-day
delinquencies before March 2008, compared to 19.8 percent of comparable subprime
loans (Exhibit 8). Subprime loans also had a higher prepayment rate, 38 percent
compared to about 18 percent for the matched CAP loans.
In addition to the subprime variables, we considered in the MNL model important
underwriting variables, including borrower DTI ratio, credit history, loan age, and
loan amount, as well as the put option. According to the option-based theory, home
equity plays a central role in determining the probability of foreclosure (Quercia and
Stegman 1992). The value of the put option is proxied by the ratio of negative equity
(unpaid mortgage balance minus estimated house price based on the house price
15
index of the Office of Federal Housing Enterprise Oversight) to the original house
price. We recognize that the inclusion of the put option may overestimate the risk of
subprime loans since, as suggested in Zelman, McGill, Speer and Ratner (2007),
some subprime loans may have second mortgages that were not captured here. We
tried the same models without the put option variable; although the estimated default
rate for the subprime loans is smaller, the qualitative results are fairly consistent with
those in Exhibit 9 and Exhibit 10.
Falling interest rates may lead to faster prepayments and drive down delinquency
rates as borrowers refinance their way out of potential problems. Rising interest rates
can cause payment shocks at the reset date for adjustable-rate mortgages and reduce
the ability of borrowers to afford a fixed-rate refinance. To capture the change in
interest rate environment, we used the difference between the prevailing interest rates,
which is proxied by the average interest rate of 30-year fixed-rate mortgages from the
Freddie Mac Primary Mortgage Market Survey (PMMS), and the temporal average of
the prevailing interest rates during the study period (Q1 2003 to Q1 2008).
Consistent with prior work, we further separated the matched sample into two cohorts
based on years of origination. Subprime loans that originated in 2003 and 2004 were
underwritten during a time of historically low interest rates and a strong economy,
leading to a relatively good performance with very low default rates (Cutts and
Merrill, 2008). Many borrowers were able to refinance their mortgages or sell their
houses because of lax underwriting and high house price appreciation before 2007,
which extinguished the default option. Instead, subprime loans that originated in 2005
and 2006, especially subprime ARMs, have not performed as well. These two cohorts
capture some unobservable heterogeneity characterizing mortgages that originated in
a booming housing market and those that originated in a softening housing market.
The results from the MNL regressions based on different matching samples are listed
in Exhibit 9 (one-to-one match) and Exhibit 10 (one-to-many match). Model 1
considers the subprime dummy variable only, while Model 2 helps us explain the
difference in performance between CAP and subprime loans. The results-based
samples using varying algorithms are quite consistent; estimated coefficients for the
explanatory variables are of the same sign and similar size, so Exhibit 10 only lists
results for the subprime variables. Except for a few insignificant coefficients for the
prepayment outcome, the subprime variables are significant and have expected signs.
It is not easy to interpret the results based on the coefficients from the MNL
regressions directly. We estimated the cumulative default and prepayment rates in the
first 24 months after origination for borrowers with impaired credit score (FICO score
580-620) and with mean value of other regressors, except loan age and loan
characteristics, based on the MNL regression results. The estimation results discussed
below are listed in Exhibit 11, where we consider a 90-day delinquency as
termination of a loan, although it may still be active after the delinquency.
Summary of Primary Findings
16
First of all, there is consistent evidence that subprime loans have a higher default risk
and a higher prepayment probability than CAP loans. The estimated cumulative
default rate for a 2004 subprime loan is 16.3 percent, about four times that of CAP
loans (4.1 percent). For a 2006 subprime loan, the cumulative default rate is over 47.0
percent, about 3.5 times that of comparable CAP loans (13.3 percent). In other words,
CAP loans are over 70 percent less likely to default than a comparable subprime loan
across different vintages. We also notice that the default rate of the 2005-2006 cohort
is significantly higher than that of the 2003-2004 cohort for loans with same loan
features. Very likely this is because of changes in the underwriting standard and in
economic conditions, as well as other unobservable heterogeneity.
We also found that subprime loans with adjustable rates have a significantly higher
default rate than comparable CAP loans. And when the adjustable rate term is
combined with the prepayment-penalty feature, the default risk of subprime loans
becomes even higher. For a 2004 sub_arm loan (retail-originated subprime ARM
without prepayment penalty), the estimated cumulative default rate would be 6.5
percent, slightly higher than that of CAP loans (4.1 percent). But if the adjustable rate
subprime mortgage has a prepayment penalty, the estimated default rate increases to
13.5 percent for a 2004 sub_arm&ppp loan (retail-originated subprime ARM with
prepayment penalty), over 100 percent higher than that of sub_arm. The same pattern
also holds for the 2006 originations.
Finally, we found that the broker-origination channel is significantly associated with
an increased level of default. For example, the estimated cumulative default rate for a
2004 sub_bro&arm loan (broker-originated adjustable-rate subprime loan without
prepayment penalty) is 17.3 percent, significantly higher than the 6.5 percent of the
sub_arm loans. For a 2006 sub_bro&arm loan, the estimated cumulative default rate
is as high as 51 percent, much higher than the 16.8 percent of the sub_arm loans. The
same pattern can also identified for adjustable-rate subprime loans with prepayment
penalties. When a broker-originated subprime ARM has the term of prepayment
penalty, the default risk for 2004 originations is 5.1 times as high as that of CAP
loans (21.8 percent vs. 4.1 percent) and for 2006 originations 4.0 times as high (53.8
percent vs. 13.3 percent).
The results suggest that, all other characteristics being equal, borrowers are three to
five times more likely to default if they obtained their mortgages through brokers.
When this feature is combined with the adjustable rate and/or prepayment penalty, the
default risk is even higher. One possible explanation is that, as suggested in Ernst et
al. (2008) and Woodward (2008), loans originated through brokers have significantly
higher closing costs and prices, which increases borrowers’ costs and can lead to
elevated default risk. It is also possible that borrowers obtaining loans through
brokers are more likely to receive products with features that may increase the default
risk. Finally, it is very likely that the broker-origination channel has a looser
underwriting standard that has not been fully captured by the model, which allows
unqualified borrowers to receive unsustainable risky products. All these contentions
17
are consistent with the results, and additional research is needed to examine this issue
in more detail.
As to the outcome of prepayment, we observed two obvious trends. The first is that
subprime loans, especially subprime ARMs, have a significantly higher prepayment
rate than CAP loans (Exhibit 11). Second, for recent originations (2005-2006),
subprime loans with prepayment penalties are less likely to prepay than loans with
similar terms but without prepayment penalties. But for early originations (20032004), the pattern is reversed: subprime loans with prepayment penalties have a
higher prepayment rate, probably because they are more likely to be prepaid after the
prepayment penalty period has expired. Although we were not able to determine the
prepayment penalty clauses for all subprime loans because of missing values, for
those loans with complete information prepayment penalties were most frequently
levied within the first two to three years of loan origination. As of March 2008, then,
most prepayment penalties for 2003-2004 originations have expired. But prepayment
may also be part of the problem if the borrower prepaid the loans by refinancing into
another subprime product.
The Impact of Unobservable Heterogeneity
To check how unobservable borrower risk characteristics impact the results, we
treated unobservable heterogeneity as an omitted variable, and solved this problem by
including a proxy of the omitted variable as a regressor in the outcome equation along
with the subprime dummy and other controls. Our first proxy of borrower
unobservable heterogeneity is the risk premium (rate_sp), which is the mortgage
interest rate minus the national average rate of 30-year fixed-rate mortgages from the
PMMS. Of course, the risk premium variable may be an endogenous variable here,
because if priced properly mortgage interest rates are determined by an assessment of
a borrower's risk profile and some mortgage characteristics. To address the
endogeneity issue, we used the residue of the risk premium (rate_resid) as a proxy of
the unobservable lender/borrower risk characteristics based on an OLS model using
observable information to predict mortgage risk premium.14
The qualitative results generally do not change when the proxies of unobservable
heterogeneity are considered (Model 3 and Model 4 in Exhibit 12). The inclusion of
the risk premium variables seems help explain the borrowers’ prepayment behavior
but not the default behavior. The coefficients of the subprime variables for the default
option vary only slightly and have the same significance in different models. The
noticeable difference is that for prepayment option once the risk premium variables
are controlled, the coefficients of the subprime variables become much smaller for the
2005-2006 cohort but the signs and significance are the same. The coefficients of the
risk premium variables (rate_sp and rate_resid) are generally insignificant for the
default option (with only one exception of the 2003-2004 cohort which is slightly
significant). As to the prepayment option, risk premium variables have a positive
impact on the probability of prepayment for the 2005-2006 cohort but have a negative
18
impact, though with a magnitude close to zero, for the 2003-2004 cohort, possibly
because of changes in some uncaptured market condition information.
In summary, we demonstrate that the results we obtained earlier are robust enough
even after controlling for proxies of the unobservable heterogeneity among
borrowers. As a result, we are more confident about the conclusions about the relative
risk of different loan products.
Empirical Results of Other Controls
Because the results for most of the variables are generally consistent across different
models, discussion of other control variables is based primarily on Model 1, as
summarized in Exhibit 9. For other controlled variables, the results suggest:
Other risk variables
Put option: Borrowers with less or negative equity in their homes (larger value
of put) are more likely to default and less likely to prepay. The results confirm
the common wisdom that the level of equity in a home is a strong predictor for
prepayment and default.
Credit history: As expected, there is consistent evidence that borrowers with
lower credit scores are more likely to experience serious delinquency.
Debt-to-income ratio: Higher debt-to-income ratios are associated with a
higher default risk for the 2003-2004 cohort, but the coefficients are
insignificant for the 2005-2006 sample.
Loan characteristics
Size of unpaid balance: Larger loan size is generally associated with lower
default risk. Larger loan size is also associated with higher prepayment
probability for the 2003-2004 cohort.
Area and neighborhood controls
Area credit risk: Average credit score in the zip code is significantly and
negatively associated with default risk. There is also some evidence that zip
code average credit score is positively associated with prepayment probability
(for the 2005-2006 vintage).
Interest rate dynamics: For different cohorts, the impact of interest rate
environment is different. For the 2003-2004 cohort, the increase in average
interest rate decreases the prepayment probability but for the recent cohort, the
increase in average interest rate increases the default risk and has no
significant impact on the prepayment probability.
County unemployment rate: Average county unemployment rate is generally
insignificant in explaining the default and prepayment behaviors across
different models.
Time dummies
19
Dummies of 2003 and 2005 originations: The 2005 originations are
significantly less likely to default, compared to the 2006 cohort.
Conclusions
As the current economic crisis worsens, the debate continues as to what cause the
initial foreclosure crisis in the mortgage markets. In this study, we examine the
relative default risk of two of the suspects: subprime mortgages and community
reinvestment loans. Using propensity matching methods, we constructed a sample of
comparable borrowers with similar risk characteristics but holding the two different
loan products. We found that, for comparable borrowers, the estimated default risk is
much lower with a CRA loan than with a subprime mortgage. More narrowly, we
found that the broker-origination channel, an adjustable rate, and a prepayment
penalty, all contribute substantially to the elevated risk of default among subprime
loans. In the worst scenario, when broker origination is combined with the features of
adjustable rate and prepayment penalty, the default risk of a borrower is four to five
times as high as that of a comparable borrower holding a CRA-type product. Though
CAP has some program-specific features, the results clearly suggest that the relative
higher default risk of subprime loans may not be solely attributed to borrower credit
risk, instead it is significantly associated with the characteristics of the products and
the origination channel in the subprime market. Thus, the results suggest that when
done right and responsibly, lending to LMI borrowers is viable proposition.
Borrowers and responsible CRA lending should not be blamed for the current housing
crisis.
Our results are consistent with recent regulatory action.15 Key features of subprime
loans—underwriting that ignores ability to pay, the inclusion of prepayment penalties,
escalating interest rates and hidden fees--make it difficult for families to stay current
on their mortgage payments. Federal Reserve rules issued in 2006 and recent
amendments to the Truth in Lending Act (Regulation Z) have banned negative
amortization for high-priced loans and most prepayment penalties. They have also
banned underwriting loans without regard to a borrower's ability to pay.
Unfortunately, broker origination also significantly increases default risk. However,
there is no Federal law and only a few states have sufficiently regulated the incentive
structure of the broker origination channel, especially the yield spread premium
which many have argued may lead brokers to originate loans that may not be in the
best interest of the borrower.16
In the current economic situation, many borrowers holding subprime mortgages with
risky loan features are having difficulty making their current payments and many
have already been seriously delinquent or in default. One proposed solution has been
to modify troubled owner-occupied subprime loans with FHA-insured loans or more
sustainable fixed-rate products at a significant discount (Inside B&C Lending, 2008).
This research demonstrates that if subprime-like borrowers receive loans with prime
rather than subprime terms and conditions, their default rate would be much lower.
20
Because the mortgage industry was originally criticized for failing to serve lowerincome and minority households and more recently for flooding the market with
unsustainable mortgages with risky features, our findings are important for
policymakers. This research suggests that loans with prime terms and conditions
offered through special CRA lending programs provide LMI and minority
households, even those with somewhat imperfect credit histories, more sustainable
homeownership options than subprime loans.
While our results are interesting for understanding the performance difference
between subprime and CRA loans, we would like to emphasize that CAP has some
program specific characteristics. Though national in scope, CAP is geographically
concentrated in certain markets. In addition, this analysis focuses solely on home
purchase lending activities and borrowers with full or alternative documentation only.
As such, it is unclear whether or not our findings for the CAP program are applicable
to national population of CRA loans and the entire subprime market. However, CAP
borrowers are matched with subprime borrowers with similar risk profiles, focusing
in this way on the less risky portion of the subprime market. We have also excluded
from the analysis investor loans and low- or no-doc subprime mortgages, all of which
are generally associated with a higher credit risk. Further, if borrowers are indeed
steered to low- and no-doc loans in the subprime market even when they could have
documented their income, as has been asserted by some observers, this would suggest
that the increased risk of having one’s mortgage originate in the subprime market is
even greater than captured in this paper. As such, this research provides more
convincing evidence of the relative risk of the CRA-type loans and the impact of loan
features and origination channels on loan performance.
Endnotes:
1
For more complete details of CRA regulations, see http://www.ffiec.gov/cra/default.html.
The CRA assessment area for a retail-oriented banking institution must include ―the areas in which
the institution operates branches and deposit-taking automated teller machines and any surrounding
areas in which it originated or purchased a substantial portion of its loans‖ (Avery et al. 2000, p. 712).
3
As Alexander et al. (2002) suggest that some practices of possible gaming of brokers with lenders
include at least reporting the highest FICO score from the three bureaus, pulling a FICO score after
challenging a derogatory, and shopping for cooperative appraisers.
4
Examples of guidelines that reduced cash required to close include: Lesser of $500 or 1percent from
borrower’s own funds; Maximum LTV of 98percent and maximum combined LTV (including soft
seconds) of 103percent; No reserves required.
5
Examples of guideline flexibility with respect to credit history include: Demonstrate 6-month
satisfactory payment history with four sources of credit, either traditional or non-traditional; FICO
scores thresholds below 620 accepted in certain programs.
6
Examples of underwriting flexibility in assessing the ability to repay include: Maximum total ratio of
debt payments to income ratio of 43 percent, or up to 45 percent if new housing payment is not more
than 25 percent higher than prior housing payment.
7
Examples of offsetting or combined guideline flexibilities include: Maximum total ratio of debt
payments to income varies from 38percent to 48percent with borrowers with higher credit scores
allowed higher ratios; Higher downpayments or reserve requirements for borrowers with FICO below
620.
2
21
8
To qualify for the CAP program, borrowers must meet one of three criteria: (1) have income under 80
percent of the area median income (AMI) for the metropolitan area; (2) be a minority with income
below 115 percent of AMI; (3) or purchase a home in a high-minority (>30%) or low-income (<80%
AMI) census tract and have an income below 115 percent AMI.
9
Other common matching algorithms include: nearest-neighbor matching, kernel matching, local
linear matching, Mahalanobis metric matching, Mahalanobis metric matching including the propensity
score, and difference in differences methods (see review in Guo et al. 2006 and Essama-Nssah, 2006).
10
Unfortunately, there are too few loans in the matched sample for retail-originated fixed-rate
mortgages (less than 20 for the one-to-one match for each category), which does not allow us to
conduct meaningful analysis, and so they were dropped from further analysis.
11
This assumption is also known as the exogeneity, or unconfoundedness, or ignorable treatment
assignment, or conditional homogeneity, or selection on observables assumption (Essama-Nssah,
2006).
12
To empirically test the impact on results of including/excluding LTV variables, we tried logistic
regression models with LTV variables. As expected, LTV ratio is highly significant in predicting the
use of subprime loans, with lower LTVs consistently and monotonically related to the use of subprime
loans. The match rate is lower than those reported in Exhibit 6, but the qualitative results on the
performance of mortgages do not change.
13
The HHI is constructed as the sum of squared market shares of firms in a zip code. Based on
HMDA data, we got the market share of firms in a census tract and then matched to corresponding zip
codes. When a census tract overlaps multiple zip codes, we assume the share of loans for the particular
firm is the same as the share of house units of the tract in this zip code. As such, the index ranges from
10,000 in the case of 100% market concentration to near zero in the case of many firms with equally
small market shares.
14
We assume mortgage risk premium is determined by a set of borrower, neighborhood characteristics
in the propensity score estimation and loan characteristics that may influence pricing including LTV,
adjustable rates, and prepayment penalties. We ran OLS regressions for different cohorts and the R
squares of the four regressions range from 0.4 for the 2004 cohort to 0.61 for the 2003 cohort. The
regression results are available upon request.
15
Home Ownership and Equity Protection Act bans balloon payments, negative amortization, most
prepayment penalties for high-rate/high-fee loans. The Revision of Regulation Z of Truth in Lending
Act in July 2008 further bans any prepayment penalties if the payment can change in the initial four
years and for high-priced loans prepayment penalties cannot last for more than two years.
16
Effective on October 1, the House Bill 2188 in North Carolina bans rate or yield spread premiums.
22
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25
Exhibit 1 Construction of Subprime Study Sample
# of Observations
Subprime
Step 1 Subprime Loans meeting the following criteria: home
purchase loans, first-lien; single family house, 30-year
amortization, conforming loans with a minimum loan amount of
$10,000 only
544,849
Step 2 Exclude loans with no or limited documentation or
missing information for the following variables: LTV, Fico
score, DTI, documentation
86,697
Step 3 Exclude loans not in zip codes with CAP activities
and loans without complete payment history
42,065
Note: based on authors’ calculation from LPS. Subprime loans here include B&C loans and high-cost
ARMs (with a margin greater than 300 basis points).
26
Exhibit 2 90-day Delinquency Rate by Loan Types
Source: Mortgage Banker Association (2008) and Self-Help
Exhibit 3 CAP and Subprime FICO Score Distribution (2003-2006)
Credit Score Distribution 2003-2006
0.06
CAP
subprime
0.05
Density
0.04
0.03
0.02
0.01
0
300
390
480
570
660
750
840
FICO Score
Source: Lender Processing Services, Inc. (LPS) and Self-Help
27
Exhibit 4 Descriptive Statistics (Mean or Percentage)
Variable
Debt-to-income ratio*
DTI<28%
DTI 28-36%
DTI 36-42%
DTI>42%
FICO score*
<580
580-620
620-660
660-720
>=720
LTV*
<80%
80-90%
90-97%
>=97%
Loan characteristics
Loan_amt*
ARMs*
Broker*
Prepayment penalty*
Note Rate*
Neighborhood/Local
characteristics
HHI index ( in 10,000, 2005)*
CAP
Subprime
0.126
0.278
0.315
0.281
0.163
0.158
0.178
0.501
0.031
0.109
0.224
0.324
0.312
0.213
0.263
0.225
0.192
0.107
0.037
0.050
0.090
0.823
0.369
0.381
0.167
0.083
100.86
6.66%
148.1
0.903
0.808
0.495
7.87%
0.051
0.036
688.6
0.293
685.2
0.482
0.199
0.318
0.272
0.211
0.239
0.283
0.292
0.186
OH (22.3%)
NC (14.6%)
IL (12.6%)
GA (11.4%)
OK (5.8%)
CA (19.2%)
TX (11.0%)
FL (10.1%)
IL (9.1%)
GA (5.3%)
2,670
2,581
2,251
1,719
9,221
4,680
18,380
11,703
7,302
42,065
Mean area FICO Score (2005)*
Share of minority *
Education distribution*
Share of less high school
Share of high school
Share of some college
Share of college and above
Geography: top 5 states
Origination Year
2003
2004
2005
2006
N
Note: * Bivariate
2
test or t test significant at the 0.01 level.
28
Exhibit 5 Logistic regression models predicting propensity scores
dti<28
dti 28-36
dti 36-42
dti>42
cscore<580
cscore 580-620
cscore 620-660
cscore 660-720
cscore >=720
loan_amt
qtr1
qtr2
qtr3
qtr4
HHI (in 10,000)
area credit
score
pctmin
pct_less_high
pct_high
pct_somecoll
pct_coll
_cons
Pseudo R2
2003
Coef.
-0.172
-1.369
-1.411
P-value
0.000
0.000
0.000
2006
Coef.
1.324
0.216
-0.160
P-value
0.000
0.018
0.060
4.182
2.846
1.438
0.632
0.000
0.000
0.000
0.000
1.900
1.245
1.021
0.483
0.000
0.000
0.000
0.000
0.000
0.000
0.407
0.342
0.011
0.606
0.315
0.073
0.000
0.000
0.000
0.372
0.010
1.137
0.891
0.601
0.000
0.000
0.000
0.000
-18.747
0.000
-21.058
0.000
-23.296
0.000
0.046
0.001
-0.004
0.006
0.053
0.001
-0.002
0.017
0.438
0.000
0.000
0.014
0.937
0.000
0.000
0.000
0.000
0.000
-0.077
0.049
-0.067
5.411
0.36
N=20,961
0.000
0.000
0.000
0.000
-0.057
0.054
-0.058
2.164
0.38
N=13,954
0.000
0.000
0.000
0.177
-0.144
0.015
-0.092
6.127
0.35
0.000
0.037
0.000
0.001
P-value
0.088
0.000
0.000
2004
Coef.
0.006
-1.252
-1.486
P-value
0.941
0.000
0.000
2005
Coef.
0.616
-0.603
-0.837
4.632
2.040
1.431
0.850
0.000
0.000
0.000
0.000
3.943
2.237
1.121
0.550
0.000
0.000
0.000
0.000
0.012
0.055
-0.019
-0.545
0.000
0.585
0.843
0.000
0.013
-0.553
-0.062
0.070
-14.763
0.000
-0.004
-0.007
-0.124
0.062
-0.082
6.015
0.42
N=7,350
N=9,021
Exhibit 6 Description of matching schemes and resample sizes
N of original
sample
N of the new sample
CAP
CAP
Subprime
Match1
Nearest 1-to-1 using caliper=0.1
9,221
5,558
5,558
Match2
9,221
6,349
6,349
Nearest 1-to-1 using caliper=0.25
Match3
Nearest 1-to-many using caliper=0.1
9,221
3,943
35,971
Match4
9,221
3,944
36,236
Nearest 1-to-many using caliper=0.25
Note: For the one-to-one nearest neighbor with caliper match, the subprime loan with the closest
propensity score within a caliper for the first CAP loan was selected after the sample was randomly
ordered. We then removed both cases from further consideration and continue to select the subprime
loan to match the next CAP loan. For the one-to-many match, subprime loans were matched with CAP
loans with the closest propensity score within a caliper after all the loans were randomly sorted.
Instead of removing the matched cases after matching as in the one-to-one match, we kept the matched
CAP loans in the sample and continued to find the matching CAP loan for the next subprime loan.
Scheme
Description of matching method
29
Exhibit 7 Significance tests of the resamples
Variable
Match 1
Match3
Debt-to-income ratio
CAP
Subprime
CAP
Subprime
DTI<28%
0.229
0.221
0.223
0.218
DTI 28-36%
0.261
0.249
0.242
0.233
DTI 36-42%
0.375
0.391
0.397
0.403
DTI>42%
0.135
0.139
0.138
0.146
FICO score
<580
0.047
0.049
0.165
0.164
580-620
0.15
0.155
0.251
0.241
620-660
0.256
0.241
0.296
0.292
660-720
0.305
0.305
0.165
0.164
>=720
0.242
0.25
0.123
0.139
LTV (* for match 1)
<80%
0.042
0.314
0.044
0.305
80-90%
0.062
0.276
0.066
0.282
90-97%
0.11
0.209
0.117
0.208
>=97%
0.786
0.201
0.773
0.204
Loan characteristics
loan_amt*
109.4
109.7
112.0
113.2
ARMs*
0.864
0.880
Broker*
0.696
0.682
Prepayment penalty*
0.413
0.422
Note Rate*
0.066
0.078
0.066
0.078
N
5,558
5,558
3,943
35,971**
Note: * Bivariate 2 test or t test significant at 0.01 level. **Statistics based on Match 3 are weighted
average and the weight is the inverse of number of subprime loans that matched to one CAP loan.
Exhibit 8 Performance measures of the new samples
Whole sample
CAP
2003-2004 Sample
2005-2006 Sample
% of 90day
% prepayment
% of 90-day
%
prepayment
8.98
18.46
7.64
12.97
25.73
50.06
% of 90-day
%
prepayme
nt
10.94
7.84
29.81
21.04
19.81
38.27
N
11,116
6,600
4,516
Note: Observation period is from origination to March 2008; if a loan was 90-day delinquent and then
prepaid, it is considered as a 90-day delinquency only.
Subprime
30
Exhibit 9 MNL regression results of default and prepayment (Match 1 in Exhibit 6)
2003-2004 Sample
2005-2006 Sample
Model 1
Variable
Default
Prepay
Coef.
Model 2
P>z
Coef.
Model 1
P>z
Coef.
Model 2
P>z
Coef.
P>z
put
0.041
0.000
0.044
0.000
0.050
0.000
0.052
0.000
dti 28-36
0.581
0.000
0.585
0.000
0.083
0.528
0.093
0.480
dti 36-42
0.632
0.000
0.599
0.000
0.025
0.847
0.018
0.890
dti>42
0.323
0.029
0.522
0.000
-0.241
0.065
0.015
0.907
cscore<580
2.414
0.000
2.196
0.000
1.682
0.000
1.477
0.000
cscore 580-620
1.991
0.000
1.790
0.000
1.278
0.000
1.057
0.000
cscore 620-660
1.471
0.000
1.286
0.000
1.033
0.000
0.907
0.000
cscore 660-720
0.634
0.000
0.512
0.001
0.448
0.004
0.388
0.011
unpaid balance (in log)
-0.357
0.000
-0.266
0.008
-0.163
0.079
-0.066
0.482
loan age (in log mon)
1.007
0.000
1.084
0.000
1.043
0.000
1.093
0.000
area credit score
-0.010
0.000
-0.009
0.000
-0.012
0.000
-0.010
0.000
average interest rate
-0.128
0.346
-0.142
0.299
0.522
0.000
0.507
0.000
area unemp rate
0.044
0.120
0.045
0.106
0.045
0.120
0.025
0.393
y2003 (y2005)
-0.078
0.389
-0.153
0.097
-0.607
0.000
-0.491
0.000
subprime
1.592
0.000
1.596
0.000
sub_arm
0.540
0.004
0.361
0.033
sub_arm&ppp
1.546
0.028
1.898
0.000
sub_bro
1.945
0.000
1.446
0.000
sub_bro&ppp
1.985
0.000
1.527
0.000
sub_bro&arm
1.661
0.000
1.898
0.000
sub_bro&arm&ppp
1.987
0.000
1.818
0.000
cons
0.818
0.544
-0.963
0.482
1.291
0.347
-1.241
0.371
put
-0.015
0.000
-0.013
0.000
-0.007
0.061
-0.006
0.185
dti 28-36
0.289
0.000
0.301
0.000
-0.045
0.760
0.015
0.920
dti 36-42
0.348
0.000
0.354
0.000
0.058
0.683
0.149
0.311
dti>42
0.015
0.825
0.119
0.088
-0.300
0.030
-0.175
0.248
cscore<580
0.142
0.322
-0.001
0.996
-0.090
0.663
-0.012
0.956
cscore 580-620
0.080
0.321
-0.006
0.945
0.237
0.069
0.274
0.045
cscore 620-660
0.323
0.000
0.262
0.000
-0.193
0.131
-0.140
0.285
cscore 660-720
0.149
0.005
0.139
0.008
-0.076
0.521
-0.114
0.344
unpaid balance (in log)
0.329
0.000
0.298
0.000
-0.055
0.537
-0.117
0.201
loan age (in log mon)
0.459
0.000
0.512
0.000
0.697
0.000
0.699
0.000
area credit score
0.001
0.381
0.002
0.091
0.007
0.001
0.008
0.001
average interest rate
-0.197
0.007
-0.187
0.011
0.200
0.203
0.188
0.237
area unemp rate
-0.016
0.338
-0.022
0.185
-0.029
0.409
-0.031
0.375
y2003 (y2005)
-0.021
0.640
0.029
0.519
0.278
0.003
0.317
0.002
subprime
0.922
0.000
1.238
0.000
sub_arm
0.611
0.000
1.132
0.000
sub_arm&ppp
1.685
0.000
2.289
0.000
sub_bro
0.437
0.000
1.207
0.001
sub_bro&ppp
0.979
0.000
-0.241
0.510
sub_bro&arm
1.080
0.000
1.660
0.000
sub_bro&arm&ppp
1.340
0.000
0.947
0.000
-11.612
0.000
cons
Log likelihood
N
-11.241
0.000
-16790.3
N=192,179 of 6,600 loans
-16683.1
-11.908
0.000
-11.495
-8262.9
0.000
-8157.0
N=93,646 of 4,516 loans
Note: sub_arm represents subprime retail originated ARMs without prepayment penalty;
sub_ arm&ppp represents subprime retail originated ARMs with prepayment penalties;
sub_bro represents subprime broker originated fixed-rate mortgages without prepayment penalties; sub_bro&ppp represents
subprime broker originated fixed-rate mortgages with prepayment penalties;
sub_bro&arm represents subprime broker originated ARMs without prepayment penalties; sub_bro&arm&ppp represents
subprime broker originated ARMs with prepayment penalties.
31
Exhibit 10 MNL regression results of default and prepayment (Match 3 in Exhibit 6)
2003-2004 Sample
Model 1
Variable
Default
subprime
2005-2006 Sample
Model 2
Coef.
P>z
1.448
Coef.
Model 1
P>z
0.000
Coef.
1.616
Model 2
P>z
Coef.
P>z
0.000
sub_arm
0.482
0.003
0.189
0.208
sub_arm&ppp
1.658
0.000
2.073
0.000
sub_bro
1.721
0.000
1.418
0.000
sub_bro&ppp
1.770
0.000
1.581
0.000
sub_bro&arm
1.638
0.000
1.906
0.000
sub_bro&arm&ppp
1.843
0.000
1.833
0.000
cap
Prepay
subprime
0.940
0.000
1.308
0.000
sub_arm
0.666
0.000
1.192
0.000
sub_arm&ppp
1.544
0.000
2.220
0.000
sub_bro
0.510
0.000
1.235
0.000
sub_bro&ppp
0.901
0.000
-0.451
0.111
sub_bro&arm
1.052
0.000
1.751
0.000
sub_bro&arm&ppp
1.385
0.000
1.073
0.000
cap
N
N=341,367 of 16,604 loans
N= 528,292 of 23,310 loans
Note: see note in Exhibit 9 for the definition of different loan products.
There should be 8 dummies for different combinations of loan features but the sample sizes of the
buckets of retail-originated fixed-rate subprime with and without prepayments are too small, which
does not allow us conduct meaningful analysis.
Exhibit 11 Estimated cumulative default and prepayment rate
(24 months after origination for a borrower with impaired credit score of 580-620)
2004 Origination
2006 Origination
Default
prepayment
Default
prepayment
CAP
4.08%
10.34%
13.32%
7.47%
Subprime
16.28%
22.81%
47.04%
17.69%
sub_arm
6.53%
17.93%
16.82%
20.82%
sub_arm&ppp
13.48%
41.43%
43.30%
39.42%
sub_bro
24.15%
13.92%
40.61%
18.76%
sub_bro&ppp
23.33%
22.48%
47.84%
4.74%
sub_bro&arm
17.30%
25.37%
51.00%
24.27%
sub_bro&arm&ppp
21.82%
30.40%
53.78%
13.36%
Note: see note in Exhibit 9 for the definition of different loan products. The predicted cumulative
default and prepayment rate is as of 24 months after origination for a borrower with a FICO score
between 580-620 and holding a mortgage originated in 2004 or 2006, with the mean value of other
regressors. The estimation is based on regression results in Exhibit 9.
32
Exhibit 12 MNL Regression Results of Default and Prepayment
(with proxy of unobservable heterogeneity)
2003-2004 Sample
Model 1
Variable
Default
Coef.
Model 3
P>z
put
0.041
0.000
dti 28-36
0.581
0.000
dti 36-42
0.632
0.000
dti>42
0.323
0.029
cscore<580
2.414
0.000
cscore 580-620
1.991
0.000
cscore 620-660
1.471
0.000
cscore 660-720
unpaid balance (in
log)
loan age (in log mon)
0.634
0.000
-0.357
0.000
1.007
0.000
area credit score
-0.010
0.000
average interest rate
-0.128
0.346
area unemp rate
0.044
0.120
y2003 (y2005)
-0.078
0.389
1.592
0.000
cons
0.818
0.544
put
-0.015
0.000
dti 28-36
0.289
0.000
dti 36-42
0.348
0.000
dti>42
0.015
0.825
cscore<580
0.142
0.322
cscore 580-620
0.080
0.321
cscore 620-660
0.323
0.000
cscore 660-720
unpaid balance (in
log)
loan age (in log mon)
0.149
0.005
0.329
0.000
0.459
0.000
area credit score
0.001
0.381
average interest rate
-0.197
0.007
area unemp rate
-0.016
0.338
y2003 (y2005)
-0.021
0.640
subprime
0.922
0.000
cons
-11.24
0.00
rate_sp
Coef.
P>z
0.041
0.571
0.606
0.349
2.271
1.921
1.422
0.614
-0.308
0.996
-0.010
-0.143
0.038
-0.097
0.075
0.000
0.000
0.000
0.019
0.000
0.000
0.000
0.000
0.002
0.000
0.000
0.297
0.186
0.289
0.033
1.446
0.268
-0.014
0.291
0.356
-0.008
0.264
0.136
0.361
0.158
0.309
0.466
0.000
-0.184
-0.014
-0.023
-0.068
0.000
0.846
0.000
0.000
0.000
0.906
0.068
0.099
0.000
0.003
0.000
0.000
0.626
0.012
0.408
0.613
0.000
rate_resid
subprime
Prepay
rate_sp
rate_resid
Log likelihood
-16790.3
2005-2006 Sample
Model 4
1.004
0.000
-10.74
0.00
-16780.3
Coef.
Model 1
P>z
0.041
0.582
0.632
0.323
2.413
1.990
1.471
0.634
-0.357
1.007
-0.010
-0.128
0.044
-0.077
0.000
0.000
0.000
0.030
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.348
0.121
0.393
-0.002
1.594
0.814
-0.014
0.297
0.360
0.002
0.117
0.072
0.324
0.143
0.335
0.464
0.001
-0.186
-0.014
-0.019
0.961
0.000
0.546
0.000
0.000
0.000
0.975
0.405
0.376
0.000
0.007
0.000
0.000
0.350
0.011
0.385
0.675
-0.059
0.002
0.977
0.000
-11.39
0.00
-16785.1
Coef.
Model 3
P>z
0.050
0.000
0.083
0.528
0.025
0.847
-0.241
0.065
1.682
0.000
1.278
0.000
1.033
0.000
0.448
0.004
-0.163
0.079
1.043
0.000
-0.012
0.000
0.522
0.000
0.045
0.120
-0.607
0.000
1.596
0.000
1.291
0.347
-0.007
0.061
-0.045
0.760
0.058
0.683
-0.300
0.030
-0.090
0.663
0.237
0.069
-0.193
0.131
-0.076
0.521
-0.055
0.537
0.697
0.000
0.007
0.001
0.200
0.203
-0.029
0.409
0.278
0.003
1.238
0.000
-11.91
0.00
-8262.9
Coef.
Model 4
P>z
0.049
0.081
0.024
-0.232
1.628
1.237
1.015
0.441
-0.122
1.040
-0.012
0.518
0.044
-0.602
0.038
0.000
0.543
0.859
0.077
0.000
0.000
0.000
0.004
0.240
0.000
0.000
0.000
0.121
0.000
0.274
1.515
0.719
-0.018
-0.062
0.082
-0.123
-0.734
-0.184
-0.373
-0.159
0.338
0.679
0.008
0.163
-0.022
0.273
0.399
0.000
0.629
0.000
0.686
0.579
0.386
0.001
0.187
0.004
0.181
0.002
0.000
0.000
0.304
0.528
0.003
0.000
0.505
0.000
-17.37
0.00
-8211.7
0.049
0.078
0.018
-0.243
1.690
1.274
1.032
0.448
-0.152
1.042
-0.012
0.522
0.045
-0.608
0.000
0.560
0.893
0.063
0.000
0.000
0.000
0.004
0.114
0.000
0.000
0.000
0.120
0.000
0.020
1.559
1.237
-0.018
-0.139
-0.049
-0.299
-0.022
0.139
-0.211
-0.080
0.129
0.688
0.006
0.186
-0.022
0.239
0.573
0.000
0.371
0.000
0.356
0.739
0.031
0.916
0.298
0.102
0.497
0.157
0.000
0.012
0.241
0.527
0.010
0.367
0.000
0.601
0.000
-12.46
0.00
-8219.2
Note: Model 1 is the same as the one in Exhibit 9. rate_sp represents the difference between the
mortgage note rate and the average interest rate of 30-year fixed-rate mortgages from the Freddie Mac
Primary Mortgage Market Survey in the same month. rate_resid represents the residue of the risk
premium variable from OLS models of risk premium.
33
Did the CRA cause the mortgage market meltdown? - Community Dividend - Publication... Page 1 of 5
Did the CRA cause the mortgage market meltdown?
Two Federal Reserve economists examine whether available data support critics' claims that the
Community Reinvestment Act spawned the subprime mortgage crisis.
Neil Bhutta - Economist
Glenn B. Canner - Economist
March 2009
As the current financial crisis has unfolded, an argument that the Community Reinvestment Act (CRA)
is at its root has gained a foothold. This argument draws on the fact that the CRA encourages
commercial banks and savings institutions (collectively known as banking institutions) to help meet the
credit needs of lower-income borrowers and borrowers in lower-income neighborhoods.1/ Critics of the
CRA contend that the law pushed banking institutions to undertake high-risk mortgage lending.
This article discusses key features of the CRA and presents results from our analysis of several data
sources regarding the volume and performance of CRA-related mortgage lending. On balance, the
evidence runs counter to the contention that the CRA lies at the root of the current mortgage crisis.
Assessing banks in context
The CRA directs federal banking regulatory agencies, including the Federal Reserve, to use their
supervisory authority to encourage banking institutions to help meet the credit needs of all segments of
their local communities. These communities, referred to hereafter as CRA assessment areas, are defined
as the areas where banking institutions have a physical branch office presence and take deposits,
including low- and moderate-income areas. The banking agencies periodically assess the performance of
banking institutions in serving their local communities, including their patterns of lending to lowerincome households and neighborhoods, and take the assessments into consideration when reviewing the
institutions' applications for mergers, acquisitions, and branches.
The CRA emphasizes that banking institutions fulfill their CRA obligations within the framework of
safe and sound operation. CRA performance evaluations have become more quantitative since 1995,
when regulatory changes were enacted that stress actual performance rather than documented efforts to
serve a community's credit needs. However, the CRA does not stipulate minimum targets or even goals
for the volume of loans, services, or investments banking institutions must provide. While it is fair to
say that the primary focus of CRA evaluations is the number and dollar amount of loans to lowerincome borrowers or areas, the agencies instruct examiners to judge banks' performance in light of 1)
each institution's capacity to extend credit to lower-income groups and 2) the local economic and market
conditions that might affect the income and geographic distribution of lending.
Timing and originations
Before we turn to our analysis of CRA lending data, we have two important points to note regarding the
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CRA and its possible connection to the current mortgage crisis.
The first point is a matter of timing. The current crisis is rooted in the poor performance of mortgage
loans made between 2005 and 2007. If the CRA did indeed spur the recent expansion of the subprime
mortgage market and subsequent turmoil, it would be reasonable to assume that some change in the
enforcement regime in 2004 or 2005 triggered a relaxation of underwriting standards by CRA-covered
lenders for loans originated in the past few years. However, the CRA rules and enforcement process
have not changed substantively since 1995.2/ This fact weakens the potential link between the CRA and
the current mortgage crisis.
Our second point is a matter of the originating entity. When considering the potential role of the CRA in
the current mortgage crisis, it is important to account for the originating party. In particular, independent
nonbank lenders, such as mortgage and finance companies and credit unions, originate a substantial
share of subprime mortgages, but they are not subject to CRA regulation and, hence, are not directly
influenced by CRA obligations. (We explore subprime mortgage originations in further detail below.)
The CRA may directly affect nonbank subsidiaries or affiliates of banking institutions. Banking
institutions can elect to have their subsidiary or affiliate lending activity counted in CRA performance
evaluations. If the banking institution elects to include affiliate activity, it cannot be done selectively.
For example, the institution cannot "cherry pick" loans that would be favorably considered under the law
while ignoring loans to middle- or higher-income borrowers.
In the next section, we discuss the data analysis we undertook to assess the merits of the claims that the
CRA was a principal cause of the current mortgage market difficulties. The analysis focuses on two
basic questions. First, what share of subprime mortgage originations is related to the CRA? Second, how
have CRA-related subprime loans performed relative to other loans? We believe the answers to these
two questions will shed light on the role of the CRA in the subprime crisis.
CRA-related lending volume and distribution
In analyzing the available data, we consider two distinct metrics of lending activity: loan origination
activity and loan performance. With respect to the first question posed above concerning loan
originations, we determine which types of lending institutions made higher-priced loans, to whom those
loans were made, and in what types of neighborhoods the loans were extended.3/ This analysis therefore
depicts the fraction of subprime mortgage lending that could be related to the CRA.
Using loan origination data obtained pursuant to the Home Mortgage Disclosure Act (HMDA), we find
that in 2005 and 2006, independent nonbank institutions—institutions not covered by the CRA—
accounted for about half of all subprime originations. (See Table 1.) Also, about 60 percent of higherpriced loan originations went to middle- or higher-income borrowers or neighborhoods, populations not
targeted by the CRA. (See Table 2.) In addition, independent nonbank institutions originated nearly half
of the higher-priced loans extended to lower-income borrowers or borrowers in lower-income areas
(share derived from Table 2).
In total, of all the higher-priced loans, only 6 percent were extended by CRA-regulated lenders (and
their affiliates) to either lower-income borrowers or neighborhoods in the lenders' CRA assessment
areas, which are the local geographies that are the primary focus for CRA evaluation purposes. The
small share of subprime lending in 2005 and 2006 that can be linked to the CRA suggests it is very
unlikely the CRA could have played a substantial role in the subprime crisis.
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To the extent that banking institutions chose not to include their affiliates' lending in their CRA
examinations, the 6 percent share overstates the volume of higher-priced, lower-income lending that
CRA examiners would have counted.4/ It is possible, however, the examiners might have considered at
least some of the lower-income lending outside of CRA assessment areas if institutions asked that it be
considered in their CRA performance evaluations. No data are available to assess this possibility;
however, the majority of the higher-priced loans made outside of assessment areas were to middle- or
higher-income borrowers. In our view, this suggests it is unlikely that the CRA was a motivating factor
for such higher-priced lending. Rather, it is likely that higher-priced lending was primarily motivated by
its apparent profitability.
It is also possible that the remaining share of higher-priced, lower-income lending may be indirectly
attributable to the CRA due to the incentives under the CRA investment test. Specifically, examiners
may have given banks "CRA credit" for their purchases of lower-income loans or mortgage-backed
securities containing loans to lower-income populations, which could subsequently affect the supply of
mortgage credit.
Although we lack definitive information on banks' CRA-induced secondary market activity, the HMDA
data provide information on the types of institutions to which mortgages are sold. The data suggest that
the link between independent mortgage companies and banks through direct secondary market
transactions is weak, especially for lower-income loans. (See Table 3.) In 2006, only about 9 percent of
independent mortgage company loan sales were to banking institutions. (Figure not shown in table.)
And among these transactions, only 15 percent involved higher-priced loans to lower-income borrowers
or neighborhoods. In other words, less than 2 percent of the mortgage originations sold by independent
mortgage companies in 2006 were higher-priced, CRA-credit-eligible, and purchased by CRA-covered
banking institutions.
Analyzing loan performance
To assess the relative performance of CRA-related, higher-priced loans, we use data from First
American LoanPerformance (LP) on subprime and alt-A mortgage securitizations to compare
delinquency rates for subprime and alt-A loans in lower-income neighborhoods relative to those in
middle- and higher-income neighborhoods. The LP data do not provide information on borrower income
or the type of originating institution, but do indicate the ZIP Code of the property, which we use to
group loans into neighborhood income categories.5/ The results indicate that the 90-days-or-more
delinquency rate as of August 2008 for subprime and alt-A loans originated between January 2006 and
April 2008 is high regardless of neighborhood income, with delinquency rates comparable across
neighborhood income categories. (See Table 4.)6/
In order to gauge more precisely the possible effects of the CRA, we use the LP data again and focus
attention on the subset of ZIP Codes that are similar, in principle, except for their relationship to the
CRA. Specifically, we focus only on ZIP Codes right above and right below the CRA eligibility
threshold. (A neighborhood meets the CRA threshold if it has a median family income equivalent to 80
percent or less of the median family income of the broader area.) As such, the only major difference
between these two sets of neighborhoods should be that the CRA focuses on one group and not the
other. This analysis indicates that subprime loans in ZIP Codes that are the focus of the CRA (those just
below the threshold) have performed virtually the same as loans in the areas right above the threshold.7/
(See Table 5.)
To gain further insight into the risks of lending to lower-income borrowers or areas, we also compared
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the performance of first mortgages originated and held in portfolio under the nationwide affordable
lending programs operated by the NeighborWorks® America (NWA) partners to the performance of
loans of various types as reported by the Mortgage Bankers Association of America. Many loans
originated through NWA programs are done in conjunction with banking institutions subject to the
CRA, so the performance of these loans provides another basis to address the relationship between the
CRA and the subprime crisis. Along any measure of the severity of loan delinquency or the incidence of
foreclosure, the loans originated under the NWA program have performed better than subprime loans.8/
(See Table 6.) Although the performance of loans in the NWA portfolio provides one benchmark to
compare the performance of CRA-related loans with other loans, it is only one portfolio of such loans;
further research of this type could provide a stronger base from which to draw conclusions.
Another way to measure the relationship between the CRA and the subprime crisis is to examine
foreclosure activity across neighborhoods that are classified by income. Data made available by
RealtyTrac on foreclosure filings from January 2006 through August 2008 indicate that most foreclosure
filings (e.g., about 70 percent in 2006) have taken place in middle- or higher-income neighborhoods.
More important, foreclosure filings have increased at a faster pace in middle- or higher-income areas
than in lower-income areas that are the focus of the CRA.9/ (See Table 7.)
Two basic points emerge from our analysis of the available data. First, only a small portion of subprime
mortgage originations is related to the CRA. Second, CRA-related loans appear to perform comparably
to other types of subprime loans. Taken together, the available evidence seems to run counter to the
contention that the CRA contributed in any substantive way to the current mortgage crisis.
Neil Bhutta and Glenn B. Canner are economists in the Division of Research and Statistics at the Board
of Governors of the Federal Reserve System. The views expressed are those of the authors and do not
necessarily reflect those of the Board of Governors or members of its staff.
1/ Lower-income households are determined by comparing the income of the household to the median
family income of the metropolitan statistical area (MSA) or statewide non-MSA in which the property
being purchased or refinanced is located. "Lower" is less than 80 percent of the median, "middle" is 80
to 119 percent, and "higher" is 120 percent or more. Lower-income neighborhoods are determined by
comparing the median family income of the census tract where the property being purchased or
refinanced is located to the MSA or statewide non-MSA median family income. Income categories for
census tract classification have the same numerical thresholds as those applied for households.
2/ The change in the CRA rules in 2005 focused primarily on reducing burden for smaller lenders and
expanding the focus of the CRA to include some middle-income census tracts in distressed rural areas.
No changes were made that encouraged lenders to relax their underwriting standards.
3/ A higher-priced loan is defined as a loan where the spread between the annual percentage rate on the
loan and the rate on Treasury securities of comparable maturity is above designated thresholds. For firstlien loans, the focus of attention in this article, the designated threshold is 3 percentage points. For
junior-lien loans, the threshold is 5 percentage points. The definition was adopted as part of Regulation
C (the regulation that implements the Home Mortgage Disclosure Act) and was intended to identify
loans that fell in the subprime portion of the mortgage market.
4/ About one-fifth of the higher-priced loans extended in the banking institutions' local communities
were extended by their affiliates.
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5/ We classify ZIP Code-based delinquency data by relative income in two different ways. First, we use
information published by the U.S. Census Bureau on income at the ZIP Code Tabulation Area (ZCTA)
level of geography. Because the ZCTA data provide an income estimate for each ZIP Code, delinquency
rates can be calculated directly from the LP data based on the ZIP Code location of the properties
securing the loans (see www.census.gov/geo/ZCTA/zcta.html). Second, we calculate delinquency rates
for each relative income group (lower, middle, and higher) as the weighted sum of delinquencies divided
by the weighted sum of mortgages, where the weights equal each ZIP Code's share of population in
census tracts of the particular relative income group. Relative income is based on the 2000 census and is
calculated as the median family income of the census tract divided by the median family income of its
MSA or a nonmetropolitan portion of the state. The two approaches yield virtually identical results.
6/ A virtually identical relationship across neighborhood income groups is found if the pool of loans
evaluated is expanded to cover those originated between January 2004 and April 2008. The only
material difference is that the levels of delinquency are lower for both subprime and alt-A loans for the
larger sample of loans. Such a relationship is expected, since loans that are relatively long-lived tend to
perform well over time.
7/ See footnote 6.
8/ No information was available on the geographic distribution of the NWA loans. The geographic
pattern of lending can matter, as certain areas of the country are experiencing much more difficult
housing conditions than other areas. Also, no information was available on the age of the loans, which
can have an important effect on performance.
9/ These data are reported at the ZIP Code level. We calculate the statistics by relative income group in
Table 7 as before; see footnote 6. Foreclosure filings have been consolidated at the property level, so
separate filings on first- and subordinate-lien loans on the same property are counted as a single filing.
Data Tables
Table 1: Higher-Priced Lending by Institution Type, 2005–2006
Table 2: Profile of All Higher-Priced Loans, 2005–2006
Table 3: Loans Originated by Independent Mortgage Companies and Sold to Depositories:
Distribution by Loan Price and Neighborhood Income Group
Table 4: 90-Days-Plus Delinquency Rates by Relative ZIP Code Income
Table 5: 90-Days-Plus Delinquency Rates for ZIP Codes Just Above and Below the CRA Threshold
Table 6: Comparative Data on Single-Family First Mortgage Home Loans, as of June 30, 2008
Table 7: Foreclosure Filing Activity by Relative Neighborhood Income Group
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september 2009
Civil Rights and the Mortgage Crisis
Washington, DC 20425
Visit us on the web: www.usccr.gov
united states commission on civil rights
U . S . C o m m i ss i o n o n C i v i l R i g h t s
United State s Commi ssion on Civil Right s
September 2009
U . S . C o m m i ss i o n o n C i v i l R i g h t s
M e m b e rs o f t h e C o m m i ss i o n
The U.S. Commission on Civil Rights is an independent,
bipartisan agency established by Congress in 1957. It is
directed to:
Gerald A. Reynolds, Chairman
• Investigate complaints alleging that citizens are
being deprived of their right to vote by reason of their
race, color, religion, sex, age, disability, or national
origin, or by reason of fraudulent practices.
Gail Heriot
• Study and collect information relating to
discrimination or a denial of equal protection of
the laws under the Constitution because of race,
color, religion, sex, age, disability, or national
origin, or in the administration of justice.
Michael Yaki
• Appraise federal laws and policies with respect to
discrimination or denial of equal protection of the laws
because of race, color, religion, sex, age, disability, or
national origin, or in the administration of justice.
• Serve as a national clearinghouse for information
in respect to discrimination or denial of equal
protection of the laws because of race, color,
religion, sex, age, disability, or national origin.
Abigail Thernstrom, Vice Chair
Todd Gaziano
Peter N. Kirsanow
Arlan D. Melendez
Ashley L. Taylor, Jr.
Martin Dannenfelser, Staff Director
U.S. Commission on Civil Rights
624 Ninth Street, NW
Washington, DC 20425
(202) 376-8128 voice
(202) 376-8116 TTY
www.usccr.gov
• Submit reports, findings, and recommendations
to the President and Congress.
• Issue public service announcements to discourage
discrimination or denial of equal protection of the laws.
This report is available on disk in ASCII Text and Microsoft Word 2003 for persons with visual impairments. Please call (202) 376-8110.
Cover photo: “Suburban American Flag.” David Gilder, 2006. Photo: istockphoto.com.
CIVIL RIGHTS
a n d
t h e
Mortgage Crisis
U n i t e d S t a t e s C o m m i ss i o n o n C i v i l R i g h t s
September 2009
LETTER OF TRANSMITTAL
The President
The President of the Senate
The Speaker of the House
Sirs and Madam:
The United States Commission on Civil Rights transmits this report, An Examination of Civil Rights
Issues With Respect to the Mortgage Crisis, pursuant to Public Law 103-419. The purpose of the report
is to examine whether federal efforts to increase homeownership rates among minority and low-income
individuals may have unintentionally weakened underwriting standards and lending policies to the point
that too many borrowers were vulnerable to financial distress and heightened risk of default, thereby
setting conditions for the current mortgage crisis. It also examines the policies of federal agencies in
enforcing prohibitions against mortgage fraud and lending discrimination.
To that end, the Commission studied federal policies aimed at increasing low-income and minority
homeownership, including the Community Reinvestment Act and the Department of Housing and
Urban Development’s lending goals for government-sponsored enterprises (GSEs) Fannie Mae and
Freddie Mac, and the critiques regarding the relationship of such policies to the mortgage crisis. As
part of its analysis, the Commission also considered the impact of the growth of securitization on
lending practices, including the availability of subprime mortgages and other kinds of credit, as well as
the manner in which such credit was made available on the secondary market. This analysis involved
gathering information from the GSEs and some eleven federal agencies with various levels of regulatory
responsibility over the housing market and lending standards.
The Commission also looked at issues of predatory lending, mortgage fraud, and lending discrimination
and assessed the efforts of eight federal agencies with responsibility for enforcing the Fair Housing and
Equal Credit Opportunity Acts to combat such practices. The result, we hope, will contribute to the
growing body of literature for consideration by policy makers as they examine whether existing lending
policies require revision, modification, or elimination to avoid a future similar crisis while enhancing the
possibility that the American dream of homeownership remains an attainable goal for low and middleincome Americans.
On August 7, 2009, the Commission approved this report. The vote was as follows: Chapters 1-5 and
the appendix were approved by Commissioners Reynolds, Thernstrom, Kirsanow and Taylor, with
Commissioners Yaki, Melendez, Heriot and Gaziano abstaining. The Commission declined to adopt
findings and recommendations to this report with six Commissioners voting against adoption, and with
Vice Chair Thernstrom and Commissioner Melendez abstaining. The report includes a joint statement
and separate rebuttal statements submitted by Commissioners Melendez and Yaki, a separate statement
by Vice Chair Thernstrom, and a joint rebuttal statement by Commissioners Gaziano, Reynolds,
Kirsanow, and Taylor.
For the Commissioners,
Gerald A. Reynolds
Chairman
Table of Contents
v
TABLE OF CONTENTS
LETTER OF TRANSMITTAL.................................................................................................................. iii
TABLE OF CONTENTS............................................................................................................................ v
INTRODUCTION AND OVERVIEW ...................................................................................................... 1
Overview .......................................................................................................................................... 1
Scope and Methodology ................................................................................................................... 2
PART I: MINORITY HOMEOWNERSHIP .............................................................................................. 5
CHAPTER 1: OVERVIEW OF FEDERAL POLICIES TO INCREASE MINORITY HOMEOWNERSHIP AND CRITIQUES REGARDING THEIR RELATIONSHIP TO THE MORTGAGE CRISIS ..... 7
I. Bipartisan Effort........................................................................................................................ 7
II. The Community Reinvestment Act ........................................................................................ 11
A. Evolution of the CRA....................................................................................................................................11
B. Agencies and Their Evaluation Authority .....................................................................................................13
III. Fannie Mae and Freddie Mac ................................................................................................. 16
A.
B.
C.
D.
HUD Goals ....................................................................................................................................................16
Legal and Regulatory History of HUD Goals ...............................................................................................16
Setting and Meeting the Goals ......................................................................................................................18
Broad, Continued Legislative Response to the Mortgage Crisis ...................................................................22
CHAPTER 2: HOMEOWNERSHIP POLICIES: CRITIQUES AND RESPONSE ................................ 25
I. Response to the Alleged Role of the CRA and HUD Lending Goals in the Mortgage Crisis 29
II. Other Causes ........................................................................................................................... 35
CHAPTER 3: ANALYSIS OF THE EFFECTS OF FEDERAL POLICIES TO INCREASE MINORITY
HOMEOWNERSHIP ............................................................................................................................... 47
I. Policies to Increase Minority and Low- and Moderate-Income Homeownership .................. 47
A. Homeownership Patterns...............................................................................................................................47
B. Racial and Ethnic Disparities in Homeownership Over Time.......................................................................47
II. Review and Analysis of Mortgage Lending Statistics and Changes in Lending Standards ... 51
A. Disparities in Conventional Mortgage Loans by Race Over Time................................................................51
B. Disparities in Refinance Loans by Race Over Time .....................................................................................55
III. Prime and Subprime Lending ................................................................................................. 59
A. Prime vs. Subprime Lending by Race Over Time .........................................................................................61
IV. Foreclosure Rates by Type of Loan Over Time...................................................................... 64
V. Community Reinvestment Act ................................................................................................ 66
A. Number and Monetary Value of Prime v. Subprime Loans ..........................................................................67
vi
Civil Rights and the Mortgage Crisis
B.
C.
D.
E.
F.
Mortgage Lending Within CRA Assessment Areas 1993-2006....................................................................69
Distribution of Subprime Loans 2004-2007 ..................................................................................................70
Distribution of Prime Loans 2004-2007 ........................................................................................................74
Mortgage Lending by Neighborhood Income, 2006 .....................................................................................79
Mortgage Lending By Race ..........................................................................................................................81
VI. HUD’s Lending Goals ............................................................................................................ 83
A.
B.
C.
D.
E.
GSEs’ Performance Against the HUD Goals ................................................................................................86
GSEs’ Efforts to Increase Minority Homeownership....................................................................................88
GSEs’ Share of the Lending Market Over Time ...........................................................................................97
GSEs’ Volume of Purchasing Subprime Lending Over Time..................................................................... 101
Fannie Mae and Freddie Mac’s Purchasing of Private-Label Securities Over Time................................... 104
PART II: PREDATORY LENDING, MORTGAGE FRAUD, AND MORTGAGE LENDING
DISCRIMINATION ............................................................................................................................... 111
CHAPTER 4: PREDATORY LENDING, Mortgage FRAUD, AND MORTGAGE Lending
DISCRIMINATION ............................................................................................................................... 113
I. Predatory Lending ................................................................................................................. 117
II. Mortgage Fraud ..................................................................................................................... 120
A. Mortgage Fraud Generally .......................................................................................................................... 120
B. Federal Enforcement Against Mortgage Fraud ........................................................................................... 123
III. Mortgage Lending Discrimination ........................................................................................ 129
A. Statutory Efforts to Protect Mortgage Applicants and Borrowers............................................................... 131
B. Federal Enforcement of FHA and ECOA ................................................................................................... 141
PART III: CREDIT SCORING .............................................................................................................. 169
CHAPTER 5: CREDIT SCORING AND OTHER FACTORS RELATED TO THE GRANTING AND
PRICING OF LOANS ............................................................................................................................ 171
I. Background: The Boston Fed Study ..................................................................................... 171
II. Methods Lenders Use to Quantify Credit Risk of Prospective Borrowers ........................... 174
A. Effects of Credit Scoring Methods on Minority and Other Populations. .................................................... 177
III. Factors Other than Credit Score that Relate to Differences in Lending for Minorities and
Whites ................................................................................................................................... 187
METHODOLOGY USED IN REPORT ................................................................................................ 190
STATEMENT OF VICE-CHAIR THERNSTROM .............................................................................. 195
JOINT STATEMENT OF COMMISSIONERS MELENDEZ AND YAKI ........................................ 201
REBUTTAL STATEMENT OF COMMISSIONER MELENDEZ....................................................... 207
REBUTTAL STATEMENT OF COMMISSIONER YAKI .................................................................. 211
JOINT REBUTTAL STATEMENT OF COMMISSIONERS GAZIANO, REYNOLDS, KIRSANOW,
AND TAYLOR....................................................................................................................................... 215
Table of Contents
vii
FIGURES
Figure 2.1 New Privately-Owned Housing Units Started, 2000–2006 ..................................................... 41
Figure 2.2 The Federal Funds Rate: The Interest Rate at Which Depository Institutions Lend
Balances at the Federal Reserve to Other Depository Institutions Overnight, 2000–2006 ...................... 42
Figure 3.1 Homeownership Rate by Race and Ethnicity, 1994–2008 ...................................................... 49
Figure 3.2 Net Gain in Homeownership Rate by Race and Ethnicity, 1994–2008 .................................. 51
Figure 3.3 Conventional Loans Made to Applicants by Race and Ethnicity, 1999–2007 ........................ 52
Figure 3.4 Conventional Mortgage Applications Denied by Race and Ethnicity, 1999-2007 ................. 53
Figure 3.5 Denial of Conventional Mortgage Applications Based on Credit History by Race and
Ethnicity, 1999-2007................................................................................................................................. 54
Figure 3.6 Refinance Loans Granted to Applicants by Race and Ethnicity, 1999–2007 ......................... 56
Figure 3.7 Refinance Loan Applications Denied by Race and Ethnicity, 1999–2007 ............................. 57
Figure 3.8 Denial of Refinance Loan Applications Based on Credit History by Race and Ethnicity,
1999–2007................................................................................................................................................. 58
Figure 3.9 Subprime (Higher-Priced) Conventional Loans as a Percentage of Total Loans by
Race and Ethnicity, 2004–2007 ................................................................................................................ 61
Figure 3.10 Subprime (Higher-Priced) Conventional Refinance Loans as a Percentage of Total
Conventional Refinance Loans by Race and Ethnicity, 2004–2007......................................................... 63
Figure 3.11 Mortgage Foreclosure Rates by Type of Loan, 1998–2008 .................................................. 64
Figure 3.12 Conventional Foreclosure Rates by Type of Loan, 1998–2008 ............................................ 65
Figure 3.13 Subprime (Higher-Priced) and All Home Mortgage Loans (Loan Counts) Originated,
2004–2007................................................................................................................................................. 67
Figure 3.14 Subprime (Higher-Priced) and All Home Mortgage Loans (Billions of Dollars),
2004–2007................................................................................................................................................. 68
Figure 3.15 Mortgage Lending Within CRA Assessment Areas, 1993–2006......................................... 69
Figure 3.16 Distribution of Subprime (Higher-Priced) Mortgage Loans (Loan Counts) by Income
of Borrowers and/or Neighborhood, 2004–2007 ...................................................................................... 71
Figure 3.17 Distribution of Subprime (Higher-Priced) Mortgage Loan Volume (Billions of Dollars)
by Income of Borrowers and/or Neighborhood Income, 2004–2007 ....................................................... 72
Figure 3.18 Percent Distribution of Subprime (Higher-Priced) Mortgage Loans (Loan Counts) to
Lower-Income of Borrowers and/or Neighborhoods by Lender Type, 2004–2007 ................................. 73
Figure 3.19 Distribution of Prime (Lower-Priced) and All Home Mortgage Loans (Loan Counts)
Originated, 2004–2007 ............................................................................................................................. 74
Figure 3.20 Distribution of Prime (Lower-Priced) and All Home Mortgage Loans (Billions of
Dollars), 2004–2007 ................................................................................................................................. 75
viii
Civil Rights and the Mortgage Crisis
Figure 3.21 Distribution of Prime Mortgage Loans (Loan Counts) by Income of Borrowers and/
or Neighborhood, 2004–2007 .................................................................................................................. 76
Figure 3.22 Prime Mortgage Loan Volume (Billions of Dollars) by Income of Borrowers and/or
Neighborhood Income, 2004–2007 .......................................................................................................... 77
Figure 3.23 Percent Distribution of Prime (Lower-Priced) Mortgage Loans (Loan Counts) to Lowand Moderate-Income Borrowers and/or Neighborhoods by Lender Type, 2004–2007 .......................... 78
Figure 3.24 Home Purchase Mortgage Loans by Type of Neighborhood Income, 2006 ......................... 79
Figure 3.25 Refinance Mortgage Loans by Type of Neighborhood Income, 2006 .................................. 80
Figure 3.26 Home Purchase Loans by Race, 2006 ................................................................................... 82
Figure 3.27 Home Refinance Loans by Race/Ethnicity, 2006.................................................................. 83
Figure 3.28 Fannie Mae and Freddie Mac’s Performance Against the Department of Housing and
Urban Development’s Lending Goals and Subgoals, 1993–2007 ............................................................ 87
Figure 3.28 (continued) Fannie Mae and Freddie Mac’s Performance Against the Department of
Housing and Urban Development’s Lending Goals and Subgoals, 1993–2007 ....................................... 88
Figure 3.29 GSEs’ Purchased Loans (of Institutions’ Originations and Purchased Ones)
Apportioned by Race/Ethnicity of Minority Borrowers, 1999–2007 ....................................................... 91
Figure 3.30 Counts of GSEs’ Loans (of Institutions’ Originations and Purchased Ones) Involving
Minority Borrowers, 1999–2007 .............................................................................................................. 93
Figure 3.31 Counts of GSEs’ Purchased Loans (of Institutions’ Originations or Purchased Ones)
Involving Minority or White Borrowers, 1999–2007 ............................................................................... 96
Figure 3.32 Counts of GSEs’ Loans Purchased (of Financial Institutions’ Originations and
Purchased Loans), 1999–2007 ................................................................................................................. 98
Figure 3.33 The Number of Loans Purchased (of Financial Institutions’ Originations and
Purchased Loans), 1999–2007 ................................................................................................................. 99
Figure 3.34 GSEs’ Purchased Loans’ (of Financial Institutions’ Originations and Purchased
Loans) Percent of the Market, 1999–2007.............................................................................................. 100
Figure 3.35 Percent of the Number of Loans by Type of Purchaser (Originations and Purchased
Loans), 1999–2007 ................................................................................................................................. 101
Figure 3.36 Number of Subprime (Higher-Priced) Loans (Both First and Junior Liens)
(Originations Only) By Type of Purchaser, 2004–2007 ......................................................................... 102
Figure 3.37 Value of Subprime (Higher-Priced) Loans (Both First and Junior Liens)
(Originations Only) By Type of Purchaser, 2004–2007 ......................................................................... 103
Figure 3.38 Fannie Mae and Freddie Mac Purchases of Private-Label Mortgage-Related
Securities, 1990–2007 ............................................................................................................................. 105
Figure 3.39 Proportion of Fannie Mae’s and Freddie Mac’s Purchases of Private-Label
Mortgage-Related Securities that Were Single-Family Subprime or Alt-A, 2002–2007 ....................... 107
Figure 4.1 Financial Institutions’ Mortgage Fraud-Related Suspicious Activity Reports, Fiscal
Years 2003–2008 .................................................................................................................................... 121
Table of Contents
ix
Figure 4.2 FBI’s Pending Investigations of Mortgage Fraud, Fiscal Years 2003–2008 ........................ 125
Figure 4.3 Total Number of Closed HUD and FHAP Lending Complaints, 1990–2008 ....................... 143
Figure 4.4 ECOA Referrals DOJ Received from Each of Seven Federal Regulatory Agencies,
1999–2007............................................................................................................................................... 146
Figure 4.5 Dispositions of the Year’s ECOA Referrals from Regulatory Agencies at Year’s End,
1999–2007............................................................................................................................................... 147
Figure 4.6 Consumer Complaints to FDIC, 2003–2008 ......................................................................... 159
Figure 4.7 Mortgage Discrimination (Race/National Origin) and Predatory Lending Complaints
Received by OCC, 1998–2008 ............................................................................................................... 163
Figure 4.8 Mortgage Lending Complaints Referred to HUD, 1999–2008 ............................................. 164
Figure 4.9 Home Mortgage Lending Complaints Received by OTS, 1999–2008.................................. 166
Figure 5.1 Average Credit Score (on a Scale of 0 to 100) by Racial Group, June 30, 2003 .................. 179
Figure 5.2 Distribution of Credit Scores by Racial Group, June 30, 2003 ............................................. 181
Figure 5.3 Bad Performance on Any Account by Credit Score and Racial Group ................................ 183
Figure 5.4 Probability of Getting a New Loan by Credit Score and Racial Group ................................ 184
TABLES
Table 1.1 Levels of the Department of Housing and Urban Development’s Lending Goals and
Subgoals for Government-Sponsored Enterprises, 1996–2007 ................................................................ 18
Table 1.2 Fannie Mae and Freddie Mac Revised Goals and Subgoals, 2009 ........................................... 22
Table 3.1 Levels of the Department of Housing and Urban Development’s Lending Goals and
Subgoals for Government-Sponsored Enterprises Since 1996 by Year ................................................... 85
Table 5.1 Default Rate on New Loans for the Two Years (October 2000 to October 2002) after
Origination, by FICO Credit Score ......................................................................................................... 175
Table 5.2 Average Interest Rate on Fixed-Rate, Thirty-Year Home Loan by FICO Credit Score,
July 14, 2009 ........................................................................................................................................... 176
Table 5.3 Incidence of Credit Record Item by Demographic Group ...................................................... 178
Table 5.4 Percent of Racial and Ethnic Groups With No Credit History on Which to Base Credit
Scores ...................................................................................................................................................... 185
66
Civil Rights and the Mortgage Crisis
By far the highest rate of foreclosure is attributable to subprime ARMs. While the rate of foreclosure for
such loans declined from 2001 to 2005, it began to rise dramatically thereafter. By 2006, the rate of
foreclosure for such loans had risen to 5.6 percent, and had increased to 13.4 percent by 2007. The rate
of foreclosure in 2008 was 22.2 percent. By that point, the gap in foreclosure rates between prime ARMs
and subprime ARMs, which had been at 2.9 percentage points in 2005, had increased to 16.5 percentage
points.
V.
Community Reinvestment Act
This section seeks to determine to what extent the requirements of the CRA may have affected
residential mortgage lending practices and the existing mortgage crisis.
The mortgage lending data presented in this section are restricted to conventional first liens on home
purchase and refinance loans for owner-occupied properties.26 Conventional mortgage loans exclude
those made by the Federal Housing Administration (FHA loans) and those guaranteed by the Veterans
Administration (VA loans) and the Rural Housing Service of the U.S. Department of Agriculture (RHS
Loan Programs). 27
In order to analyze the effect of the CRA, this section examines practices of banking institutions and
their affiliates and independent mortgage companies. This analysis compares and contrasts Performance
with regard to a variety of factors in order to determine to what extent the CRA has played a role over
approximately the last decade.
In this regard, section A compares the number and monetary value of (i) prime loans; (ii) subprime
loans; and (iii) subprime loans by banking institutions and affiliates within their CRA assessment areas.
Section B then examines the decreasing amount of mortgage lending within CRA assessment areas.
Section C then examines the distribution of subprime loans from 2004 to 2007 by examining differences
between loans made to low- and moderate-income individuals as compared to middle- and upperincome individuals. This section looks not only at loan counts and the monetary value of such loans, but
the percent distributed by year and by lender type. Section D undertakes a similar analysis with regard to
prime loans.
Sections E and F then analyze the race and types of neighborhoods that receive different types of loans.
Section E examines mortgage lending by neighborhood income for the year 2006, while Section F
examines mortgage lending by race for the same year.
26
Neighborhood income level in the context of the CRA is defined in relation to a designated geographic area’s median
family income; “lower income” is defined as less than 50 percent of the area’s median family income; “moderate income,”
from 50 percent to less than 80 percent; “middle income,” 80 percent to less than 120 percent; and “upper income,” greater
than or equal to 120 percent. Lower income neighborhoods include low- and moderate-incomes ones, the focus of the CRA.
Non-lower income neighborhoods include middle and higher income ones. See The Federal Reserve, Briefing on CRA and
Credit Scoring Issues to the U.S. Commission on Civil Rights, January 7, 2009 (“definition” and “the CRA”). Glenn B.
Canner, senior advisor, The Federal Reserve, e-mail to Sock-Foon C. MacDougall, social scientist, U.S. Commission on Civil
Rights, Apr. 29, 2009.
27
Mortgage-X Mortgage Information Service, Types of Mortgage Loans, <http://mortgage-x.com/library.loans.htm> (last
accessed Feb. 24, 2009).
Chapter 3: Analysis of the Effects of Federal Policies
A.
67
Number and Monetary Value of Prime v. Subprime Loans
Figure 3.13 contrasts (i) the number of all loans (subprime and prime) originated, with (ii) all subprime
loans originated, and (iii) all subprime loans originated by banking institutions and their affiliates within
their CRA assessment areas to low- and moderate-income borrowers/neighborhoods.
Figure 3.13
Subprime (Higher-Priced) and All Home Mortgage Loans (Loan Counts) Originated, 2004–2007
12,000,000
Number of loans
10,000,000
9,657,932
9,917,222
8,556,213
8,000,000
6,481,494
6,000,000
4,000,000
2,000,000
0
1,410,608
2,602,519
2,393,492
162,275
150,464
1,237,352
103,913
2004
2005
2006
138,087
2007
Year
Total subprime and prime loans (counts)
Total subprime loans (counts)
Total subprime loans to LMI by banking institut. & affiliates within their CRA assess. area (counts)
Note: Restricted to conventional first liens on home purchase and refinance loans for owner-occupied properties.
Source: “Statistics on Mortgage Lending from HMDA Data,” EXCEL spreadsheet, Glenn B. Canner, senior advisor, The
Federal Reserve, to Sock-Foon C. MacDougall, social scientist, U.S. Commission on Civil Rights, Feb. 19, 2009.
Caption: During this period, the number of subprime loans compared to all loans originated was no more
than 30.4 percent at its peak in 2005. At the same time, during its peak in 2007 the number of subprime
loans made to low and moderate income borrowers/neighborhoods was no more than 11 percent of all
such loans originated.
Figure 3.13 shows that, from 2004–2007, the total number of subprime loans made up just 14.6 percent
of the total market in 2004, but that the number of such loans rose to 30.4 percent of the total market in
2005 as the market peaked. The share then fell to 24.1 percent in 2006, and by 2007 had decreased to
19.1 percent. 28
28
The figure for each year is obtained by calculating the percentage that the total number of subprime loans constituted of the
total number of subprime and prime loans originated.
68
Civil Rights and the Mortgage Crisis
The total number of subprime loans that banking institutions and their affiliates made in their CRA
assessment areas to low- and moderate-income borrowers/neighborhoods represented an even smaller
fraction of the total number of subprime loans originated. Specifically, such loans constituted a mere 7
percent of all subprime loans in 2004, 6 percent in 2005 and 2006, and 11.0 percent in 2007. 29
Figure 3.14 presents the same three categories, measured by the monetary value of the loans.
Figure 3.14
Subprime (Higher-Priced) and All Home Mortgage Loans (Billions of Dollars), 2004–2007
$2,500.0
Billions of dollars
$2,000.0
$1,921.7
$1,876.9
$2,225.1
$1,520.3
$1,500.0
$1,000.0
$470.9
$500.0
$0.0
$485.1
$194.6
$240.1
$8.4
2004
$17.3
$19.0
2005
2006
$17.5
2007
Year
Total subprime and prime loan volume ($)
Total subprime loan volume ($)
Total subprime loan volume to LMI by banking institut. & affiliates within their CRA assess. area ($)
Note: Restricted to conventional first liens on home purchase and refinance loans for owner-occupied properties.
Source: “Statistics on Mortgage Lending from HMDA Data,” EXCEL spreadsheet, Glenn B. Canner, senior advisor, The
Federal Reserve, to Sock-Foon C. MacDougall, social scientist, U.S. Commission on Civil Rights, Feb. 19, 2009.
Caption: During this period, the monetary value of subprime loans compared to all loans originated was
no more than 24.5 percent at its peak in 2005. Meanwhile, at its peak in 2007, the monetary value of
subprime loans made to low and moderate income borrowers/neighborhoods was no more than 7 percent
of all such loans originated.
29
The figure for each year is obtained by calculating the percentage that the total number of subprime loans banking
institutions and their affiliates originated to low- and moderate-income borrowers/neighborhoods within their CRA
assessment areas constituted of the total number of subprime loans originated.
Chapter 3: Analysis of the Effects of Federal Policies
69
HMDA data show that the monetary value of subprime loans constituted 10.4 percent of overall volume
in 2004, a percentage that climbed to 24.5 percent in 2005, decreased to 21.8 percent in 2006 and fell to
15.8 percent in 2007. 30
Most notably, the monetary volume of subprime loans made by banking institutions and their affiliates
to lower-income borrowers/neighborhoods within their CRA assessment areas comprised a very small
segment of all subprime loans originated. Specifically, such loans accounted for only 4 percent of
overall volume from 2004 to 2006. By 2007, the figure had risen to only 7 percent. 31
Based on Figures 3.13 and 3.14, the data indicate that, whether measured by number of loans, or
monetary value of loans, subprime loans reached their peak in 2005 and never exceeded more than 30.4
percent of the number of loans or 24.5 percent of the value of loans. In addition, said data reflect that
subprime loans made by banking institutions or their affiliates in their CRA assessment areas remained a
marginal segment of the overall market.
B.
Mortgage Lending Within CRA Assessment Areas 1993-2006
Figure 3.15 documents home purchase and refinance mortgage lending within CRA assessment areas,
irrespective of neighborhood income.
Figure 3.15
Mortgage Lending Within CRA Assessment Areas, 1993–2006
50.0
45.0
Percent
40.0
35.0
30.0
25.0
20.0
15.0
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Home Purchase 36.0 38.6 35.5 32.2 32.0 30.6 31.1 29.6 28.1 27.5 25.8 24.1 21.4 24.9
Refinance
43.6 45.8 42.7 41.3 35.9 37.0 36.8 31.6 33.1 32.7 32.8 28.1 24.5 26.6
Year
30
The figure for each year is obtained by calculating the percentage that the total volume subprime loans constituted of the
total volume of subprime and prime loans originated.
31
The figure for each year is obtained by calculating the percentage that the total volume of subprime loans banking
institutions and their affiliates originated to low- and moderate-income borrowers/neighborhoods within their CRA
assessment areas constituted of the total volume of subprime loans originated.
70
Civil Rights and the Mortgage Crisis
Note: The Figure shows the percentage of mortgage loans originated by deposit-taking organizations within their assessment
th
areas. This graph was presented by Ren S. Essene and William C. Apgar, “The 30 Anniversary of the CRA: Restructuring the
CRA to Address the Mortgage Finance Revolution in Revisiting the CRA: Perspectives on the Future of the Community
Reinvestment Act, A Joint Publication of the Federal Reserve Banks of Boston and San Francisco, February 2009, p. 22,
exhibit 1: Assessment Area Lending Has Fallen Steadily. The source of the raw data for the graph is the JCHS enhanced
HMDA database.
Source: Ren Essene, policy analyst, Federal Reserve Bank of Boston, PowerPoint file “Exhibit 1: Assessment Area Lending
has Fallen” to Sock-Foon C. MacDougall, social scientist, U.S. Commission on Civil Rights, Mar. 25, 2009, 11.01 p.m.
Caption: Within CRA assessment areas, home mortgage lending and home refinancing particularly had
been decreasing steadily from 1993 to 2006.
As reflected in Figure 3.15, mortgage lending within CRA assessment areas has decreased steadily over
time. From 1993 to 2006, home purchase mortgage lending in CRA assessment areas, as a percent of all
home purchase loans, decreased from 36.0 percent to 24.9 percent, a drop of 11.1 percentage points. 32
In the same period, mortgage lending in CRA assessment areas for home refinancing decreased at a
higher rate, falling from 43.6 percent to 26.6 percent, a drop of 17.0 percentage points. This decrease, at
a time when overall mortgage lending was increasing, indicates that persons in lower-income
neighborhoods were increasingly using banking institutions and their affiliates outside the CRA areas, as
well as to independent mortgage companies. 33
C.
Distribution of Subprime Loans 2004-2007
Subprime loans traditionally have been made to those of low or moderate incomes. People of lower
income often have lower levels of creditworthiness and, thus, are charged higher rates of interest on
loans. The next set of Figures examines how such loans were distributed between low- and moderateincome borrowers/neighborhoods and middle- and upper-income borrowers/neighborhoods, for the
period 2004-2007. Noticeably, as housing prices increased, even those with higher levels of income
began obtaining subprime loans.
32
See Ren S. Essene and William C. Apgar, “The 30th Anniversary of the CRA: Restructuring the CRA to Address the
Mortgage Finance Revolution,” Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act, A Joint
Publication of the Federal Reserve Banks of Boston and San Francisco, February 2009, p. 22. See also KEVIN PARK,
“SUBPRIME LENDING AND THE COMMUNITY REINVESTMENT ACT,” JOINT CTR. FOR HOUSING STUDIES OF HARV. U.
33
One possible explanation for this phenomenon was as follows:
I don’t want to say it’s in the cultural DNA, but a lot of us who are older than 30 have some memory of
disappointment or humiliation related to banks,” Mr. Grannum said. “The white guy in the suit with the same
income gets a loan and you don’t?” “So you turn to local brokers, even if they don’t offer the best rates.” This may
help explain an unusual phenomenon: Upper-income black borrowers in the region are more likely to hold subprime
mortgages than even blacks with lower incomes, who often benefit from homeownership classes and lending
assistance offered by government and nonprofits.
Michael Powell and Janet Roberts, Minorities Affected Most as New York Foreclosures Rise, N.Y. TIMES, May 16, 2009, at
A1.
Chapter 3: Analysis of the Effects of Federal Policies
71
Figure 3.16
Distribution of Subprime (Higher-Priced) Mortgage Loans (Loan Counts) by Income of Borrowers and/or
Neighborhood, 2004–2007
Number of subprime loan counts
1,600,000
1,385,164
1,400,000
1,345,502
1,217,355
1,200,000
1,047,990
1,000,000
800,000
684,064 726,544
700,282
537,070
600,000
400,000
200,000
0
2004
2005
2006
2007
Year
Middle and Upper Income
Lower and Moderate Income
Note: Restricted to conventional first liens on home purchase and refinance loans for owner-occupied properties.
Source: “Statistics on Mortgage Lending from HMDA Data,” EXCEL spreadsheet, Glenn B. Canner, senior advisor, The
Federal Reserve, to Sock-Foon C. MacDougall, social scientist, U.S. Commission on Civil Rights, Feb. 19, 2009.
Caption: For three of the four years of this period, a smaller number of subprime loans were originated to
low- and moderate-income borrowers/neighborhoods than to middle- and upper-income ones, with most
being made in 2005.
Figure 3.16 shows that, except in 2004, the number of subprime loans made to low- and moderateincome borrowers/neighborhoods by financial institutions was smaller than that to middle- and upperincome ones. The number of such loans to low and moderate borrowers was among the highest in 2005
and 2006 and evidenced considerable variation over time. Rising from about 726,000 in 2004, such
loans peaked at 1.2 million in 2005, an increase of 67.6 percent. In 2006, the number of such loans
decreased somewhat, by 13.9 percentage points, but remained above a million. By 2007, they had fallen
precipitously, bottoming out at about 537,000, a decrease of 48.8 percentage points over the previous
year.
For every year, other than 2004, the number of middle- and upper-income subprime loans exceeded
those for low- and moderate-income groups.
Figure 3.17 shows the distribution of subprime loans broken down by volume.
72
Civil Rights and the Mortgage Crisis
Figure 3.17
Distribution of Subprime (Higher-Priced) Mortgage Loan Volume (Billions of Dollars) by Income of
Borrowers and/or Neighborhood Income, 2004–2007
$330.7
Billions of dollars
$350
$305.9
$300
$250
$200
$150
$100
$165.0
$117.9
$154.4
$168.3
$71.8
$76.8
$50
$0
2004
2005
2006
2007
Year
Middle and Upper Income
Lower and Moderate Income
Note: Restricted to conventional first liens on home purchase and refinance loans for owner-occupied properties.
Source: The Reserve Board, “Statistics on Mortgage Lending from HMDA Data,” EXCEL spreadsheet, Glenn B. Canner,
senior advisor, to Sock-Foon C. MacDougall, social scientist, U.S. Commission on Civil Rights, Feb. 19, 2009.
Caption: The monetary value of subprime loans to low- and moderate-income borrowers/neighborhoods
is consistently lower than that to middle- and upper-ones and evidenced decline. Meanwhile, the overall
monetary value of subprime loans had grown substantially since 2004, noticeably in 2005 and 2006.
Figure 3.17 reflects that, during this period, the monetary volume of subprime loans to middle- and
upper-income borrowers/neighborhoods consistently exceeded those made to lower- and moderateincome groups. Indeed, during the critical years of 2005, 2006, and 2007, subprime loans to lower- and
moderate-income borrowers/neighborhoods were often less than half the dollar value of subprime loans
made to middle- and upper-income borrowers/neighborhoods.
In addition, Figure 3.17 reflects the growth of subprime loans generally over this period. For example,
the total value of subprime loans reflected in Figure 3.17 for 2004 was 194.7 billion. By 2005 that figure
had risen to 470.9 billion, and by 2006 the figure had reached 485.1 billion.
The next set of Figures seeks to examine to what extent subprime loans were made within CRA
assessment areas. For that purpose, Figure 3.18 presents the number of subprime loans originated by
different lender types, including independent mortgage companies.
Chapter 3: Analysis of the Effects of Federal Policies
73
Percent subprime loan count
to lower income
Figure 3.18
Percent Distribution of Subprime (Higher-Priced) Mortgage Loans (Loan Counts) to Lower-Income of
Borrowers and/or Neighborhoods by Lender Type, 2004–2007
60.0
51.2
51.3
51.1
50.0
45.0
40.6
40.0
35.6
34.5
30.0
20.0
25.7
14.3
23.0
14.4
13.3
10.0
0.0
2004
2005
2006
2007
Year
Bankng institutions and affiliates- loans made within their CRA assessment area
Banking institutions and affiliates- loans made outside their CRA assessment area
Independent Mortgage Company
Note: Restricted to conventional first liens on home purchase and refinance loans for owner-occupied properties.
Source: “Statistics on Mortgage Lending from HMDA Data,” EXCEL spreadsheet, Glenn B. Canner, senior advisor, The
Federal Reserve, to Sock-Foon C. MacDougall, social scientist, U.S. Commission on Civil Rights, Feb. 19, 2009.
Caption: Independent mortgage companies dominated the market for subprime loans to low and
moderate borrowers/neighborhoods from 2004 through 2006. Banking institutions and their affiliates
made the smallest percentage of subprime loans within their assessment areas but growth of such loans
outside these areas was discernable, particularly in 2006 and 2007.
As reflected above, independent mortgage companies made the highest percentage of such loans for
three of the four years, with their market share falling precipitously in 2007. 34 In the first two years, they
consistently claimed a majority of subprime loans. By 2006, however, that share had decreased to 45
percent and, by 2007, their market share fell further to 23.0 percent.
Of the subprime loans made by banking institutions and their affiliates, the smallest percentages were
originated within an institution’s CRA assessment area. From 2004 to 2006, for example, the figures
were consistently low, 14.3, 13.3, and 14.4 percent, respectively. Only in 2007 did this share in the
market increase rising to 25.7 percent.
34
The rather dramatic increase and decrease in market shares in 2007 on the part of the banking institutions and their
affiliates and the independent mortgages, respectively, might be explained by a reduction in the number of lenders. In 2007,
169 lenders that reported data for 2006 ceased operations and did not report in 2007. With the exception of two lenders, all
were independent mortgage companies. The Federal Reserve, Briefing on the 2007 HMDA Data to the U.S. Commission on
Civil Rights, Jan. 28, 2009.
74
Civil Rights and the Mortgage Crisis
At the same time, progressively higher percentages were originated outside CRA assessment areas. Such
loans initially increased modestly, rising from 34.5 percent in 2004 to 35.6 percent in 2005. They then
increased to 40.6 in 2006, and finally to 51.3 percent in 2007. Between 2004 and 2007, there was an
increase of 16.8 percentage points.
Based on Figures 3.16-3.18, two major points can be discerned. First, during the time period in question,
middle- and upper-income borrowers/neighborhoods were the largest consumers of subprime loans. This
is so whether measured by number of loans or monetary volume. Second, as reflected in Figure 3.18, the
largest percent of subprime loans, by a substantial margin, was made by either independent mortgage
companies or banking institutions outside their CRA assessment areas.
Both of these findings call into question not only the argument that the CRA played a major role in the
current mortgage crisis, but also the CRA’s continued relevance as a means to ensure sound lending to
low- and moderate-income borrowers/neighborhoods.
D.
Distribution of Prime Loans 2004-2007
The focus of the next examination is on the extent of prime loans originated within CRA assessment
areas. To that end, Figure 3.19 examines the number of such loans, while Figure 3.20 examines their
monetary value.
Figure 3.19
Distribution of Prime (Lower-Priced) and All Home Mortgage Loans (Loan Counts) Originated, 2004–2007
12,000,000
Number of Loans
10,000,000
8,000,000
9,657,932
9,917,222
8,556,213
8,247,324
5,953,694
7,523,730
6,481,494
6,000,000
5,244,142
4,000,000
2,000,000
898,801
663,276
787,492
0
2004
2005
2006
644,978
2007
Year
Total subprime and prime loans (counts)
Total prime loans (counts)
Total prime loan volume to LMI by banking institut. & affiliates within their CRA assess. area (counts)
Note: Restricted to conventional first liens on home purchase and refinance loans for owner-occupied properties.
Source: “Statistics on Mortgage Lending from HMDA Data,” EXCEL spreadsheet, Glenn B. Canner, The Federal Reserve,
senior advisor, to Sock-Foon C. MacDougall, social scientist, U.S. Commission on Civil Rights, Feb. 19, 2009.
Chapter 3: Analysis of the Effects of Federal Policies
75
Caption: During this period, prime loans constituted a substantial percentage of all loans originated, no
less than 69.6 percent in 2005. In contrast, at its peak in 2007 prime loans to low- and moderate-income
borrowers/neighborhoods comprised no more than 12 percent of all prime loans originated.
As reflected in Figure 3.19, the total number of prime loans constituted a substantial proportion of all
loans originated (prime and subprime), particularly in 2004 and 2007. In percentage terms, prime loans
constituted 85.4 percent of the total in 2004, 69.6 percent in 2005, 75.9 percent in 2006, and 80.9
percent in 2007. 35
At the same time, the number of prime loans that banking institutions and their affiliates originated to
low- and moderate-income borrowers/neighborhoods within their CRA assessment areas was
consistently a very small portion of all prime loans originated. In percentage terms, such loans
represented only 11 percent of the total in 2004 and 2005, 10 percent in 2006, and 12 percent in 2007. 36
Figure 3.20
Distribution of Prime (Lower-Priced) and All Home Mortgage Loans (Billions of Dollars), 2004–2007
$2,500.0
$2,225.1
Billions of dollars
$2,000.0
$1,876.9
$1,682.2
$1,500.0
$1,921.7
$1,740.0
$1,450.8
$1,520.3
$1,280.2
$1,000.0
$500.0
$113.8
$111.0
$98.8
$0.0
2004
2005
2006
$101.5
2007
Year
Total subprime and prime loan volume ($)
Total prime loan volume ($)
Total prime loan volume to LMI by banking institut. & affiliates within their CRA assess. area ($)
Note: Restricted to conventional first liens on home purchase and refinance loans for owner-occupied properties.
Source: “Statistics on Mortgage Lending from HMDA Data,” EXCEL spreadsheet, Glenn B. Canner, senior advisor, The
Federal Reserve, to Sock-Foon C. MacDougall, social scientist, U.S. Commission on Civil Rights, Feb. 19, 2009.
35
The figure for each year is obtained by calculating the percentage that the total number of prime loans constituted of the
total number of subprime and prime loans originated.
36
The figure for each year is obtained by calculating the percentage that the total number of prime loans banking institutions
and their affiliates originated to low- and moderate-income borrowers/neighborhoods within their CRA assessment areas
constituted of the total number of prime loans originated.
76
Civil Rights and the Mortgage Crisis
Caption: During this period, the monetary value of prime loans constituted a substantial percentage of all
loans originated, no less than 75.5 percent in 2005. In contrast, the monetary value of prime loans to lowand moderate-income borrowers/neighborhoods constituted a significantly lower percentage of all prime
loans originated, no more than 8 percent in 2007.
Figure 3.20 presents similar results by examining the monetary value of such loans. HMDA data show
that, during the period in question, the volume of prime loans made up a substantial portion of the total
of all loans (subprime and prime) originated, particularly in 2004 and 2007. From a high of 89.6 percent
in 2004, the monetary share of prime loans bottomed out in 2005 to 75.5 percent, but rose to 78.2
percent in 2006 and climbed to 84.2 percent in 2007. 37
Most notably, the volume of prime loans that banking institutions and their affiliates originated to lowand moderate-income borrowers/neighborhoods within their CRA assessment areas is consistently a
very small portion of all prime loan volume originated, a finding similar to that relating to prime loan
counts. Such loans represented only 7 percent of the total in 2004 and 2005, 6 percent in 2006, and 8
percent in 2007. 38
The next set of Figures examines the distribution of prime mortgages between middle- and upperincome and low- and moderate-income borrowers/neighborhoods. The evidence indicates that middleand upper-income individuals were the primary recipients of prime mortgage loans.
Number of prime loan counts
Figure 3.21
Distribution of Prime Mortgage Loans (Loan Counts) by Income of Borrowers and/or
Neighborhood, 2004–2007
6,000,000
5,611,507
5,272,868
5,000,000
4,142,025
3,640,077
4,000,000
3,000,000
2,635,817
1,811,669
2,000,000
2,250,862
1,604,065
1,000,000
0
2004
2005
2006
2007
Year
Middle and Upper Income
Lower and Moderate Income
Note: Restricted to conventional first liens on home purchase and refinance loans for owner-occupied properties.
37
The figure for each year is obtained by calculating the percentage that the total volume prime loans constituted of the total
volume of subprime and prime loans originated.
38
The figure for each year is obtained by calculating the percentage that the total volume of prime loans banking institutions
and their affiliates originated to low- and moderate-income borrowers/neighborhoods within their CRA assessment areas
constituted of the total volume of prime loans originated.
Chapter 3: Analysis of the Effects of Federal Policies
77
Source: “Statistics on Mortgage Lending from HMDA Data,” EXCEL spreadsheet, Glenn B. Canner, The Federal Reserve,
senior advisor, to Sock-Foon C. MacDougall, social scientist, U.S. Commission on Civil Rights, Feb. 19, 2009, 1:33 pm.
Caption: During this period, more than twice the number of prime loans was made to middle- and upperincome borrowers/neighborhoods than to low and moderate ones.
As reflected in Figure 3.21, financial institutions consistently originated a higher number of prime loans
to middle- and upper-income borrowers. During each of the four years examined, the number of prime
mortgage loans made to middle- and upper-income borrowers/neighborhoods was more than twice that
to low- and moderate-income borrowers/neighborhoods.
Figure 3.22 examines similar information with regard to the volume of such loans. While Figure 3.21
indicated that middle- and upper-income borrowers/neighborhoods received the largest number of prime
loans, Figure 3.22 reflects that the monetary value of such loans is even greater, with the monetary value
of loans to middle- and upper-income borrowers/neighborhoods often exceeding three times the value of
such loans to low- and moderate-income borrowers/neighborhoods.
Figure 3.22
Prime Mortgage Loan Volume (Billions of Dollars) by Income of Borrowers and/or
Neighborhood Income, 2004–2007
1,600
Billions of Dollars
1,400
1,398.1
1,320.4
1,163.4
1,200
1,023.1
1,000
800
600
400
361.9
341.9
287.4
257.1
200
0
2004
2005
2006
2007
Year
Middle and Upper Income
Lower and Moderate Income
Note: Restricted to conventional first liens on home purchase and refinance loans for owner-occupied properties.
Source: “Statistics on Mortgage Lending from HMDA Data,” EXCEL spreadsheet, Glenn B. Canner, senior advisor, The
Federal Reserve, to Sock-Foon C. MacDougall, social scientist, U.S. Commission on Civil Rights, Feb. 19, 2009.
Caption: For this period, the monetary value of prime loans to middle and upper income
borrowers/neighborhood exceeds that to low and moderate ones by more than three times.
In sum, as was the case with subprime lending, CRA-related prime loans made up only a minor part of
the market, and the largest number and value of prime loans went to middle- and upper-income
borrowers/neighborhoods.
78
Civil Rights and the Mortgage Crisis
The next series of Figures examines the extent to which prime loans made to low- and moderate-income
borrowers/neighborhoods occur within CRA assessment areas. As reflected in Figure 3.23, and in this
case unlike the situation with subprime loans, 39 the percentage of prime loans made within a CRA
assessment area is very similar to those made outside the CRA assessment area.
Percent prime loan count to
lower income
Figure 3.23
Percent Distribution of Prime (Lower-Priced) Mortgage Loans (Loan Counts) to Low- and ModerateIncome Borrowers and/or Neighborhoods by Lender Type, 2004–2007
45.0
40.0
35.0
30.0
25.0
20.0
15.0
10.0
5.0
0.0
39.7
36.6
40.2
35.0
34.1
26.2
40.2
40.1
37.1
26.3
24.9
19.6
2004
2005
2006
2007
Year
Bankng institutions and affiliates- loans made within their CRA assessment area
Banking institutions and affiliates- loans made outside their CRA assessment area
Independent Mortgage Company
Note: Restricted to conventional first liens on home purchase and refinance loans for owner-occupied properties.
Source: “Statistics on Mortgage Lending from HMDA Data,” EXCEL spreadsheet, Glenn B. Canner, senior advisor, The
Federal Reserve, to Sock-Foon C. MacDougall, social scientist, U.S. Commission on Civil Rights, Feb. 19, 2009.
Caption: Banking institutions and their affiliates made similar percentages of prime loans within and
outside their CRA assessment areas while independent mortgage companies made the least, no more
than 26.3 percent.
In the case of prime loans, the percentages originated to low- and moderate-income
borrowers/neighborhoods within and outside the CRA assessment areas were generally similar. Loans
made within CRA assessment areas ranged from 34.1 to 40.2 percent of the total, while loans made
outside the areas ranges from 37.1 to 40.2 percent. In contrast, the independent mortgage companies,
which focused primarily on subprime lending, originated the lowest percentages of prime loans, which
decreased steadily over time from 26.2 percent in 2004 to 19.6 percent in 2007.
39
See Figure 3.18.
Chapter 3: Analysis of the Effects of Federal Policies
E.
79
Mortgage Lending by Neighborhood Income, 2006
Figures 3.24 to 3.25 take a snapshot of mortgage lending in neighborhoods with different mixes of
racial/ethnic populations and income levels for the year 2006. Figure 3.24 reviews home purchase
lending.
100.0
90.0
80.0
43.8
37.1
32.6
45.0
38.6
29.9
42.2
36.5
29.7
70.0
60.0
50.0
40.0
33.0
38.3
40.4
33.2
37.3
40.8
33.8
35.0
39.6
30.0
20.0
10.0
23.2
24.5
27.0
21.9
24.1
29.3
24.1
28.4
30.7
0.0
High-income
white
neighborhood
High-income
minority
neigborhood
Moderateincome mixed
Neighborhood
Low-income
white
neighborhood
Low-income
minority
neigborhood
Home purchase mortgage loans in
percent
Figure 3.24
Home Purchase Mortgage Loans by Type of Neighborhood Income, 2006
Neighborhood Type
Inside CRA assessment areas
Outside CRA assessment areas
Independent mortgage companies
Note: First-lien loans for owner occupied properties only. The small share of loans originated by credit unions is included in
"outside assessment area" totals.
Source: Ren S. Essene and William C. Apgar, “The 30th Anniversary of the CRA: Restructuring the CRA to Address the
Mortgage Finance Revolution,” Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act, A Joint
Publication of the Federal Reserve Banks of Boston and San Francisco, February 2009, p. 23 exhibit 2: Assessment Area
Lending Lags in Low-income and Minority Areas. The source of the raw data for Exhibit 2 is the JCHS enhanced HMDA
database, 2006.
Caption: In 2006, banking institutions and their affiliates were less likely to make home purchase
mortgage loans within CRA assessment areas irrespective of the racial/ethnic composition and income
level of the neighborhoods. Independent mortgage companies were more likely to make the highest
percentage of home purchase mortgage loans in minority neighborhoods regardless of income level.
As reflected in Figure 3.24, in 2006, irrespective of the racial composition and income level of
neighborhoods, banking institutions and their affiliates were still less likely to make home purchase
loans within their CRA assessment areas than outside them. For example, of the total number of loans
made in low-income minority neighborhoods, banking institutions and their affiliates originated 23.2
percent within their assessment areas compared to 33.0 percent outside of them. Among the loans made
in moderate-income White neighborhoods, banking institutions and their affiliates originated 29.3
percent within their CRA assessment areas compared to 40.8 percent outside of them. Across the nine
types of racial/ethnic income neighborhoods, the proportions of home purchase loans within CRA
80
Civil Rights and the Mortgage Crisis
assessment areas were narrowly bounded, between 21.9 and 30.7 percent, a range of just 8.8 percentage
points.
Of greatest significance, the percentages of home purchase loans originated by banking institutions and
their affiliates within their CRA assessment areas to minority neighborhoods were the lowest compared
to other types of racial/ethnic neighborhoods irrespective of income level. For example, in low-income
neighborhoods, the percentage of loans to minorities was 23.2 percent compared to 24.5 percent and
27.0 percent to mixed neighborhoods and White neighborhoods, respectively. In moderate-income
neighborhoods, the comparable figures were 21.9 percent in minority neighborhoods matched against
24.1 percent and 29.3 percent in mixed and White neighborhoods respectively. Similarly, in high income
neighborhoods, the percentage of loans to minority neighborhoods was 24.1 percent compared to 28.4
percent and 30.7 in mixed and White neighborhoods, respectively.
Tellingly, independent mortgage companies are most likely to make the highest percentage of house
purchase loans in minority neighborhoods, regardless of income level.
Figure 3.25 reviews similar information with regard to refinance mortgage lending. Again, the figures
only relate to a single year, 2006.
43.1
33.8
36.9
41.5
23.2
26.5
27.8
28.5
28.6
High-income mixed
neighborhood
High-income white
neighborhood
21.5
29.9
High-income minority
neigborhood
22.7
34.6
Moderare-income white
neighborhood
41.0
38.4
Moderate-income mixed
Neighborhood
35.2
31.5
41.8
36.8
34.5
39.9
25.3
23.8
Moderate-income minority
neigborhood
37.5
Low-income white
neighborhood
42.0
Low-income mixed
neighborhood
100.0
90.0
80.0
70.0
60.0
50.0
40.0
30.0
20.0
10.0
0.0
Low-income minority
neigborhood
Refinance mortgage loans in percent
Figure 3.25
Refinance Mortgage Loans by Type of Neighborhood Income, 2006
43.1
30.4
Neighborhood type
Banking organization Independent mortgage companies
Banking organization Outside CRA assessment areas
Banking organization Inside CRA assessment areas
Note: First-lien loans for owner occupied properties only. The small share of loans originated by credit unions is included in
"outside assessment area" totals.
Chapter 3: Analysis of the Effects of Federal Policies
81
Source: Ren S. Essene and William C. Apgar, “The 30th Anniversary of the CRA: Restructuring the CRA to Address the
Mortgage Finance Revolution, Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act, A Joint
Publication of the Federal Reserve Banks of Boston and San Francisco, February 2009, p. 23 exhibit 2: Assessment Area
Lending Lags in Low-income and Minority Areas. The source of the raw data for Exhibit 2 is the JCHS enhanced HMDA
database, 2006.
Caption: In 2006, banking institutions and their affiliates were less likely to make refinance mortgage
loans within CRA assessment areas regardless of the racial/ethnic composition and income level of the
neighborhoods. Independent mortgage companies were most likely to make the highest percentages of
refinance mortgage loans to minority neighborhoods irrespective of income level.
As was the case of home purchase loans, irrespective of the racial composition and income levels of
neighborhoods, banking institutions and their affiliates were less likely to originate refinance loans
within their CRA assessment areas than outside them. However, unlike with home purchase loans, the
percentages of refinance loans banking institutions and their affiliates made within their assessment
areas was lowest for minority neighborhoods only in high income areas, 27.8 percent. In low- and
moderate-income areas, it was racially mixed neighborhoods that received the lowest share, 21.5 percent
and 23.2 percent, respectively.
Across the nine types of racial/ethnic income neighborhoods, the proportions of refinance purchase
loans within CRA assessment areas are clustered closely together, between 21.5 and 28.6 percent, a
range of only 7.1 percentage points.
Again independent mortgage companies continued to be most likely to make the highest percentage of
refinance loans in minority neighborhoods, regardless of income.
F.
Mortgage Lending By Race
Figures 3.26 to 3.27 shift the focus to borrower race and ethnicity in examining home purchase and
refinance lending. This analysis is particularly informative in determining the degree to which CRA
loans are ultimately obtained by various racial and/or ethnic groups.
Figure 3.26 documents home purchase lending practices for the year 2006.
82
Civil Rights and the Mortgage Crisis
Figure 3.26
Home Purchase Loans by Race, 2006
Home purchase mortgage loans in percent
100.0
80.0
36.7
32.5
34.0
44.7
44.3
45.5
60.0
40.0
38.5
38.4
36.1
35.7
33.5
19.6
22.3
34.1
20.0
24.8
29.9
29.1
20.4
0.0
American
Asian
Black
Native
Non-Hispanic
Indian
Hawaiian
White
Independent mortgage companies
Borrower race/ethnicity
Outside CRA assessment areas
Inside CRA assessment areas
Hispanic
Note: First-lien loans for owner occupied properties only. The small share of loans originated by credit unions is included in
"outside assessment area" totals.
Source: Ren S. Essene and William C. Apgar, “The 30th Anniversary of the CRA: Restructuring the CRA to Address the
Mortgage Finance Revolution, Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act, A Joint
Publication of the Federal Reserve Banks of Boston and San Francisco, February 2009, p. 23 exhibit 2: Assessment Area
Lending Lags in Low-income and Minority Areas. The source of the raw data for Exhibit 2 is the JCHS enhanced HMDA
database, 2006.
Caption: Banking institutions and their affiliates were less likely to make home purchase loans within
their assessment areas regardless of the race or ethnicity of the borrowers.
The data in Figure 3.26 indicate that, in 2006, banking institutions and their affiliates were less likely to
make home purchase loans within their assessment areas, irrespective of the race or ethnicity of the
borrowers. For example, home purchase loans made to Blacks within CRA assessment areas equaled
19.6 percent. Such loans made outside the CRA areas, however, equaled 35.7 percent. Similar
percentages apply with equal force to other groups. For Hispanics, the respective figures were 20.4
percent versus 34.1 percent; for Whites, 29.1 percent versus 38.4 percent; and for Asians/Pacific
Islanders, 29.9 percent versus 36.1 percent.
While a single year is hardly determinative, for 2006, the minorities who were to most benefit from the
CRA, were more likely to obtain loans from other sources.
Chapter 3: Analysis of the Effects of Federal Policies
83
Figure 3.27 examines the same information with regard to home refinance lending practices. Again, the
figures only apply to 2006.
Refinance mortgage loans in
percent
Figure 3.27
Home Refinance Loans by Race/Ethnicity, 2006
100.0
90.0
80.0
70.0
60.0
50.0
40.0
30.0
20.0
10.0
0.0
31.4
32.3
42.3
35.6
26.4
American
Indian
32.1
Asian
32.5
39.6
43.0
42.4
33.9
18.0
23.2
27.4
Native
Hawaiian
NonHispanic
White
Black
40.2
41.5
33.6
24.9
Hispanic
Borrower race/ethnicity
Inside CRA assessment areas
Independent mortgage companies
Outside CRA assessment areas
Note: First-lien loans for owner-occupied properties only. The small share of loans originated by credit unions are included in
"outside assessment area" totals.
Source: Ren S. Essene and William C. Apgar, “The 30th Anniversary of the CRA: Restructuring the CRA to Address the
Mortgage Finance Revolution,” Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act, A Joint
Publication of the Federal Reserve Banks of Boston and San Francisco, February 2009, p. 23 exhibit 2: Assessment Area
Lending Lags in Low-income and Minority Areas, p. 23. The source of the raw data for Exhibit 2 is the JCHS enhanced HMDA
database, 2006.
Caption: Banking institutions and their affiliates were less likely to make home refinance loans within
their assessment areas regardless of the race or ethnicity of the borrowers.
Figures for refinance loans mirror those in Figure 3.26, regarding home purchase loans. In both cases,
banking institutions and their affiliates were less likely to make loans within their CRA assessment
areas, regardless of the race or ethnicity of borrowers. For example, the percentage of refinance loans to
Black borrowers within CRA assessment areas was 18 percent, while the percentage of such loans
outside the area was 42.4 percent. The respective figures for Hispanics were 24.9 percent and 33.6
percent, while the percentages for Whites were 27.4 percent and 40.2 percent.
VI.
HUD’s Lending Goals
This next section examines the performance of GSEs generally, and Fannie Mae and Freddie Mac in
particular, with regard to HUD’s lending goals. First, this section examines performance of Fannie Mae
and Freddie Mac against the HUD lending goals. These reflect that, until the market began to collapse,
the goals were being met.
APPENDIX D: CHANGES IN LAWS AND REGULATIONS IMPACTING NATIONAL BANKS
ENGAGING IN THE ISSUANCE AND SALE OF ASSET-BACKED AND STRUCTURED INVESTMENTS
The roles of banks in mortgage asset securitization in recent years is the product of an
evolution in recognition by agencies, courts and Congress of the authority and desirability of
permitting asset securitization as a means of selling or borrowing against loan assets. 1 National
banks engaged in the first securitizations of residential mortgage loans as far back as the 1970s
under the same laws that permit national banks to securitize their assets today. Since that time,
there has been significant growth in the number and complexity of asset-backed securitizations. 2
Congress encouraged some of this growth in the 1980s and 1990s by expanding the authority of
national banks and other financial institutions to purchase certain mortgage-related and small
business-related securitized assets.
But many other factors, beyond legal authority, have driven the tremendous growth of the
securitization market by creating incentives for market participants to use securitizations. These
factors, as described below, include reallocating risks such as credit and interest rate risk among
originators and investors, providing new sources of funding and liquidity and achieving
favorable accounting and capital treatment. Market events, along with recent changes in
regulatory capital requirements and accounting rules have altered some of these incentives.
Nevertheless, the securitization market is expected to continue to be an important source of
credit for the economy in the future. 3
I.
Evolution and Growth of Asset-Backed Securitization
The origin of securitization activities in the United States is generally attributed to the
evolution and developments in the secondary markets for residential mortgages. 4 In 1938, the
Federal National Mortgage Association (Fannie Mae’s ancestor) was created to encourage the
maintenance of an active secondary market for mortgages. 5 The first pass-through mortgage
securities were introduced by the Government National Mortgage Association (“GNMA”) in
1970. 6 Until that time, lenders that wanted to reduce their exposure to rising interest rates had to
buy and sell whole loans. But the market for whole loans was relatively illiquid and buying and
selling individual whole loans was costly and inefficient. By combining mortgage loans into
pools, GNMA was able to pass the mortgage payments through to the certificate holders or
investors. Although this innovation provided lenders and investors with a more liquid market, it
left investors exposed to prepayment risk (the unexpected return of principal).
1
National banks may play a number of different roles in securitization transactions, including lender,
investor, originator, servicer and sponsor.
2
Asset-backed securitization is a financing technique in which loans or other financial assets are pooled
and converted into instruments that may be offered and sold in the capital markets. Asset-backed commercial paper
conduits fit within this broad definition and specifically involve the financing of assets through the continuous rollover of short-term liabilities, typically commercial paper. See generally Comptroller’s Handbook, Asset
Securitization (Nov. 1997) (“Comptroller’s Handbook”); Securities and Exchange Commission (SEC), AssetBacked Securities, 70 Fed. Reg. 1506, 1511-12 (Jan. 7, 2005).
3
The securitization market accounted for about 30 percent of credit provision in the United States by the
end of 2008.
4
See Christine A. Pavel, Securitization: The Analysis and Development of the Loan-Based/Asset-Backed
Securities Markets (Probus Publishing) (1989).
5
Frank J. Fabozzi, editor, Advances & Innovations in the Bond and Mortgage Markets, p. 175 (Probus
Publishing) (1989) (“Fabozzi”).
6
Id. at 262.
Appendix D
Page 2
In response to investor demand, in 1983, Freddie Mac issued the first collateralized
mortgage obligation (CMO), which allowed payments to be directed to certain classes of debt
securities in a specified order, allowing for different interest rates, payment schedules, and
maturity dates. 7
The securitization market continued its exponential growth through the 1990s and into
the 2000s. 8 In particular, the last decade has witnessed tremendous growth in the use of special
purpose entities (SPEs) to securitize assets. 9 To appreciate the reason for this growth, it is
important to understand the motivations of originators and investors in using these structures.
For example, one of the primary purposes of SPEs is reallocating credit risk by legally isolating
the assets held by the SPE from the originating institution. For the originator, this has the
advantage of potentially limiting its legal obligation to perform on the debts issued by the SPE. 10
For the investor, investing in a bankruptcy remote entity allows the investor to focus on the risks
associated with certain assets rather than having to assess the entire business of the originator
and its creditworthiness.
Another key motivation for originators to use SPEs is to access additional sources of
funding and liquidity and to reduce funding costs. One of the primary functions that SPEs serve
is to allow the originating institution to transform less liquid, non-rated exposures into more
liquid, rated securities. This can provide the issuing institution enhanced liquidity through an
expanded funding base and lower funding costs. This enhanced liquidity is also a benefit to
investors because these securities can be more easily traded in the secondary market or used as
collateral in securities funding transactions. 11
Originators have also used SPEs to achieve off-balance sheet accounting treatment.
Recent changes in accounting standards have significantly reduced the ability of sponsors to use
SPEs to achieve off-balance sheet treatment, however. These new standards, FAS 166 and FAS
7
Creating different classes of debt securities, known as “tranched” securitization, was later applied to other
asset classes, such as equipment leases and auto loans, starting in 1985. Fabozzi, supra at 527.
8
In the early 2000s, there was significant growth in the issuance of private-label securitizations. This
period also witnessed a rapid growth in the unregulated financial industry – resulting from the use of SPEs to raise
money in the capital markets for lending and investing, rather than through the use of bank balance sheets. This
discussion focuses on asset securitizations involving regulated financial institutions.
9
An SPE is a legal entity created at the direction of a sponsoring firm. An SPE can take the form of a
corporation, trust, partnership, or limited liability company. SPEs are generally structured to be bankruptcy remote
from the sponsoring firm. As discussed below, SPEs are used for a variety of business purposes. See also Basel
Committee on Bank Supervision, The Joint Forum Report on Special Purpose Entities (Sept. 2009) (Joint Forum
Report).
10
The originator is the entity that generates receivables by means that include selling loans, selling goods
and services on credit, and providing financing for the acquisition of goods and services, and then transfers those
receivables (as Transferor), directly or indirectly, to an asset backed security issuing special purpose vehicle.
Originators create and often service the assets that are sold or used as collateral for asset-backed securities.
Originators include commercial banks, thrift institutions, captive finance companies of the major automakers,
insurance companies, securities firms, and others.
11
See Joint Forum Report at 18.
-2-
Appendix D
Page 3
167, determine the extent to which a securitization transaction is on or off the financial
statements of originators, servicers, and investors. 12
Regulatory capital considerations also have played a significant role in the use of SPEs.
The U.S. federal banking agencies have used generally accepted accounting principles (GAAP)
as the initial basis for determining whether an exposure is treated as on- or off-balance sheet for
risk-based and leverage capital purposes. 13 Since many securitization transactions were
accorded sales treatment under prior accounting standards, significant capital benefits were
derived from securitization of bank assets. Recent capital regulatory changes fundamentally
changed the capital consequences of securitizations. That is, because capital rules will generally
continue to follow GAAP as the basis for determining whether an asset is on- or off-balance
sheet, the fact that fewer SPEs will be treated as off-balance sheet for accounting purposes means
that the same will be true for regulatory capital purposes.
Other recent changes to regulatory capital requirements also have significantly altered the
incentives associated with securitization and other similar structures. For example, the
development of the Basel II Framework has materially lessened the capital benefits associated
with securitization. Under Basel I, banks could realize regulatory capital benefits from
securitizations that transferred assets through SPEs. Due to its risk invariant capital
requirements, Basel I created an incentive to remove assets from the balance sheet of a bank that
had high regulatory capital requirements relative to the market’s assessment of the assets’
economic risk. 14
Recently the Basel Committee on Banking Supervision announced additional
enhancements to the Basel II Framework that materially affect securitization activities and the
capital requirements for the largest U.S. banking companies. These enhancements will result in
significant increases in the capital requirements for re-securitizations, such as collateralized debt
obligations or CDOs. 15 Bank regulators hope to implement these changes by rules that would
take effect at the beginning of 2011.
12
FAS 166 addresses whether securitizations and other transfers of financial assets are treated as sales or
financings. See Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets
(FAS 166). FAS 167 addresses whether certain legal entities often used in securitization and other structured
finance transactions should be included in the consolidated financial statements of any particular interested party.
See Statement of Financial Accounting Standards No. 167 (FAS 167).
13
While GAAP does not dictate regulatory capital requirements, bank regulators believe GAAP is the most
effective starting point for the development of regulatory capital requirements because GAAP is a consistent
standard that can be used to compare bank performance, and financial reports under GAAP are subject to external
audit. In addition, Federal statute requires the use of GAAP for financial reporting purposes. See 12 U.S.C. §
1831n.
14
Differences between Basel I and Basel II’s treatment of retained securitization exposures also provided
incentives to securitize. The increased risk sensitivity of Basel II in measuring capital requirements for
securitization-related exposures has reduced both of these incentives.
15
These enhancements will result in increased capital requirements for securitization positions held in the
trading book and the banking book as well as liquidity facilities for asset-backed commercial paper programs and
securitizations where the bank failed to do its own due diligence on external credit quality, relying instead
exclusively on credit ratings. See “Basel II Capital Framework Enhancements Announced by the Basel Committee”
(July 13, 2009).
-3-
Appendix D
Page 4
In sum, a number of factors have influenced the growth of securitizations and the use of
SPEs in particular. Although the recent disruption in the securitization market has stalled this
growth, some of the factors that influenced originators and investors to use securitizations in the
past are still relevant today. For example, asset securitization will continue to provide an
additional source of funding and liquidity even if SPEs are consolidated on the bank’s balance
sheet for regulatory capital purposes. 16
II.
Legal Authority for National Banks to Issue and Securitize Assets
A.
12 U.S.C. § 24(Seventh)
National banks and other U.S.-regulated financial institutions have long been permitted to
use asset securitization as a means of selling or borrowing against loan assets. In language
unaltered since the enactment of the National Bank Act in 1864, national banks are granted
express authority to “carry on the business of banking; by discounting and negotiating
promissory notes . . . and other evidences of debt. 17 The Courts have held that the right to
discount and negotiate includes the right to buy and sell evidences of debt, including securitized
assets. 18 In a leading case, the Second Circuit Court of Appeals held that Security Pacific
National Bank could issue and sell interests in a pool of mortgages as a mechanism for selling
loans. 19 The court recognized that the “pass-through certificate mechanism permits the bank to
offer purchasers an interest in a pool of mortgage loans, rather than just single mortgage loans. . .
With the increased marketability that pass-through certificates make possible comes increased
liquidity, an important benefit as banks face the task of funding long term mortgage loans with
short term deposits.” 20
16
See Joint Forum Report at 19.
12 U.S.C. § 24(Seventh). While 12 U.S.C. § 24(Seventh) on its own provides sufficient authority for
these activities, 12 U.S.C. § 371(a) also permits the sale of mortgage-related assets. Section 371(a) authorizes a
national bank to make and sell loans or extensions of credit secured by liens on interests in real estate, subject to any
conditions or limitations set forth by the OCC.
18
See First Nat’l Bank of Hartford v. City of Hartford, 273 U.S. 548, 559-60 (1927) (the Supreme Court
determined that the sale of mortgages and other evidences of debt acquired through a national bank’s exercise of its
express power to lend money on the security of real estate, and to discount and negotiate other evidences of debt,
was authorized as part of the business of banking under 12 U.S.C. § 24 (Seventh)). The courts have long held that
the term “discount” includes the purchases of notes and other evidences of debt. See, e.g., Danforth v. Nat’l State
Bank, 48 F. 271, 273-74 (3rd. Cir. 1891).
19
See Securities Industry Ass’n v. Clarke, 885 F.2d 1034, 1050 (2d Cir. 1989), cert. denied, 439 U.S. 1070
(1990) (“Security Pacific”). The Second Circuit’s decision upheld the OCC’s interpretation under 12 U.S.C.
§ 24(Seventh) in Interpretive Letter No. 388, (June 16, 1987). The court also indicated that it had no difficulty
concluding that the section 371(a) supported the OCC’s conclusion that the bank had the express power to sell its
mortgage loans. 885 F.2d. at 1048. In Interpretive Letter No. 388, the OCC explained the mortgage-backed passthrough certificates evidencing ownership interests in the banks’ mortgage assets represented nothing more than the
negotiation of evidences of debt and sale of real estate loans, under the express authority of 12 U.S.C. § 24(Seventh)
and § 371(a). More generally, the OCC opined the transaction involved a sale of bank assets, which is fully
permitted under the national banking laws.
20
Security Pacific, 885 F.2d at 1049.
17
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The Second Circuit held that the bank’s activities were authorized as part of the business
of banking and thus, were not prohibited by Section 16 of the Glass-Steagall Act.21 The court
recognized that the fact that the negotiation and sale may be accomplished through the creation
and sale by a bank of asset-backed securities does not alter in any respect the substance of the
transaction, nor its permissibility under the national banking laws. 22 Indeed, Courts have
recognized that section 24(Seventh)’s grant of authority extends beyond the label given a certain
activity and permits activities that are fundamentally banking in nature. 23
B.
Congress Has Repeatedly Reaffirmed the Authority of National Banks to
Securitize Assets
Congress has recognized and enhanced the authority of national banks to engage in
securitization activities under 12 U.S.C. § 24(Seventh). In an effort to encourage private
investment in the housing and small business markets, Congress removed the investment limits
for certain types of mortgage and small business-related securities with the passage of the
Secondary Mortgage Market Enhancement Act of 1984 (“SMMEA”) and the Riegle Community
Development and Regulatory Improvement Act of 1994 (“CDRI”). Prior to enactment of
SMMEA and CDRI, national banks generally could not invest more than 10 percent of
unimpaired capital and stock and surplus in the investment securities of any one issuer, with
certain exceptions. 24 More recently, Congress recognized and preserved the ability of banks to
engage in asset-backed transactions through the provisions enacted in the Gramm-Leach Bliley
Act (“GLBA”).
1.
SMMEA
SMMEA amended 12 U.S.C. § 24(Seventh) to permit national banks to purchase without
limitation certain residential and commercial mortgage-related securities offered and sold
pursuant to section 4(5) of the Securities Act of 1933, 15 U.S.C. § 77d(5), or residential
mortgage related securities as defined in section 3(a)(41) of the Exchange Act, 15 U.S.C. §
78c(a)(41). 25 The stated intent of Congress was to increase the flow of funds to the housing
21
Section 16 of the Glass-Steagall Act generally prohibits banks from underwriting or dealing in securities.
The Second Circuit concluded that an activity that “falls within the business of banking is not subject to the
restrictions [that] … section 16 places on a bank’s ‘business of dealing in securities and stocks.’” Id. at 1048. See
also, Securities Industry Ass’n v. Board of Governors of the Federal Reserve System, 468 U.S. 137, 158 n.11 (1984).
OCC decisions also recognized that the Glass-Steagall Act did not restrict the means by which national banks could
sell or transfer interests in their assets. See e.g., OCC Interpretive Letter No. 388, supra (pass-through certificates
representing undivided interests in pooled bank assets are legally transparent for purposes of the Glass-Steagall
analysis).
22
See OCC Interpretive Letter No. 388 (June 16, 1987).
23
See American Ins. Ass’n v. Clarke, 656 F. Supp. 404, 408-10 (D.D.C. 1987), aff’d, 856 F.2d 278 (D.C.
1988); M&M Leasing Corp. v. Seattle First Nat’l Bank, 563 F.2d 1377, 1382-83 (9th Cir. 1977); see also OCC
Interpretive Letter No. 494 (Dec. 20, 1989); No-Objection Letter No. 87-9 (Dec. 16, 1987).
24
Section 24 (Seventh) imposed no investment limitations on housing revenue bonds issued by
municipalities and states and obligations of the Federal housing agencies, Ginnie Mae, Fannie Mae and Freddie
Mac.
25
SMMEA required that a “mortgage related security” be rated in one of the two highest rating categories.
See 15 U.S.C. 78c(a)(41).
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market by facilitating the participation of the private sector in the secondary mortgage market. 26
To accomplish this, SMMEA amended the Securities Exchange Act of 1934 to facilitate the
development of a forward trading market in “mortgage related securities” and designate such
securities as “legal investments” for state and federally regulated financial institutions.
2.
CDRI
CDRI amended 12 U.S.C. § 24(Seventh) by removing limitations on purchases by
national banks of certain small business-related and commercial mortgage-related securities.27
The stated intent of Congress was to increase small business access to capital by removing
impediments in existing law to the securitizations of small business loans. 28 CDRI built on the
framework for securitizations established by SMMEA to create a similar framework for these
securities with the goal of stimulating the flow of funds to small businesses.
CDRI also removed certain impediments to trading and investing in commercial
mortgage related securities, including easing margin requirements under the federal securities
laws and authorizing depository institutions to purchase these securities under conditions
established by their regulators. At the same time, the CDRI preserved the existing authority of
federal bank regulators to regulate bank purchases of commercial mortgage related securities.
3.
GLBA Exemption for Bank Securitization Activities
GLBA amended the Securities Exchange Act of 1934, 15 U.S.C. § 78c(a)(5), to eliminate
the complete exemption of banks from the definition of “dealer” for purposes of the securities
laws. 29 In so doing, however, Congress specifically provided certain exemptions for banks from
the definition of dealer including a specific provision on asset-backed transactions. Section
78c(a)(5) provides:
Exception for certain bank activities. A bank shall not be considered to be a
dealer because the bank engages in any of the following activities under the
conditions described: . . .
26
Senate Report (Banking, Housing and Urban Affairs Committee) No. 98-293 to accompany S. 2040
(Secondary Mortgage Market Enhancement Act of 1984), Vol. 130 Cong. Record 2809, 2814 (Sept. 26, 1984).
27
CDRI defined a new type of “small business-related security” in section 3(a)(53)(A) of the Exchange
Act, 15 U.S.C. § 78c(a)(53(A), and added a class of commercial mortgage related securities to section 3(a)(41) of
the Exchange Act., 15 U.S.C. § 78c(a)(41). CDRI also provided that eligible residential and commercial mortgagerelated securities must receive a rating from an NRSRO in one of the top two rating categories. Small businessrelated securities were required to receive a rating in one of the top four rating categories.
28
See Conference Report on the CDRI, Vol. 140 Cong. Record, pp. H6685, H6690 (Aug. 2, 1994). See
also Remarks of Sen. Domenici, Vol. 140 Cong. Record, p. S11039, S11043-43 (Aug. 2, 1994) (discussing national
banks’ authority to purchase commercial mortgage related securities under conditions established by the OCC).
29
In adopting rules under this provision, the SEC noted that the question of whether a bank acts as a
“dealer” under the securities laws is entirely separate from the banking law considerations. It is possible for a bank
to be a “dealer” under the securities laws and not under the banking laws. See 68 Fed. Reg. 8686, 8689 (Feb. 24,
2003). Likewise, in the securitization context, it is important to recognize important distinctions in the applicable
terminology to the parties involved in each transaction.
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Asset-backed transactions. The bank engages in the issuance or sale to qualified
investors, through a grantor trust or other separate entity, of securities backed by
or representing an interest in notes, drafts, acceptances, loans, leases, receivables,
other obligations (other than securities of which the bank is not the issuer), or
pools of any such obligations predominantly originated by-- the bank;
- an affiliate of any such bank other than a broker or dealer; or
- a syndicate of banks of which the bank is a member, if the obligations or
pool of obligations consists of mortgage obligations or consumer related
receivables.
The exception recognized and preserved the ability of banks to engage directly in these
types of securitization activities, rather than conduct them in separate SEC-registered brokerdealer subsidiaries or affiliates.
C.
The Impact of GLBA’s Repeal of Certain Glass-Steagall Act Restrictions
In 1999, as part of the GLBA, Congress repealed restrictions in the Glass-Steagall Act on
affiliations between member banks and firms principally engaged in securities underwriting,
distribution, and dealing activities that were not permissible for national banks. While GLBA
repealed these restrictions, the repeal was not a marked change in the types of mortgage asset
securitizations activities that could be conducted by banking organizations, since a wide range of
mortgage asset securitization activities already were recognized as permissible for banks and had
been specifically authorized by Congress and therefore were not within the scope of GlassSteagall prohibitions.
Yet, the GLBA changes to the Glass-Steagall Act did have several notable results. The
changes permitted affiliations between banks and firms engaged in more extensive investment
banking business than had been permitted for affiliates of commercial banks. On the one hand,
this introduced more of the investment banking culture into certain banking holding companies
and a level of risk tolerance not typical for traditional bank risk managers. The manifestations of
this culture shift presented new challenges for banking supervisors. On the other hand, the
changes GLBA made to the framework for regulated bank holding companies ultimately were
essential to enable large bank holding companies to rescue major securities firms that had been
operating under less rigorous prudential standards than bank holding companies, and which were
threatened by the financial turmoil. These acquisitions and the ability of major securities firms
to fit into the bank holding company framework provided crucial support and market reassurance
that was part of the process of restoring confidence in the stability of the financial system as a
whole.
D.
OCC Interpretive Letters and Regulations
1.
OCC Interpretive Letters
On the basis of banks’ 12 U.S.C. § 24(Seventh) and 12 U.S.C. § 371(a) authorities, the
OCC through the years has approved various structures and issuances of mortgage-backed
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securities (“MBS”), ABS, and other similar instruments. 30 For example, in 1988, in Interpretive
Letter No. 418, the OCC approved a bank’s operating subsidiary securitizing and issuing
mortgage-related instruments based on assets held by its affiliates. As the OCC explained:
[T]he activity of selling mortgages into the secondary market, or alternatively
raising lendable funds by borrowing in the market secured by mortgages, may be
accomplished by the use of the securitized formats which the market has
developed in the last decades as well as by direct methods. The securitized
formats are tools used to effect the selling, purchasing, borrowing, and lending
functions of the secondary market. They were developed so that these market
functions could be accomplished more efficiently, but they are mere tools, another
means of performing the same functions. 31
2.
12 C.F.R. Part 1
In 1996, the OCC codified at 12 C.F.R. § 1.3(g) its long-standing position, as affirmed by
case law, that a national bank may securitize and sell assets that it originates or has acquired
from others. 32 Section 1.3(g) today remains the same as in 1996 and provides:
A national bank may securitize and sell assets that it holds, as a part of its banking
business. The amount of securitized loans and obligations that a bank may sell is not
limited to a specified percentage of the bank’s capital and surplus.
In addition, the OCC’s 1996 amendments to Part 1 added two new types of securities to
effect the changes made by SMMEA and CDRI, as discussed above, and developments in
30
See, e.g., Letter from Robert L. Clarke, Comptroller of the Currency, to the Honorable Alfonse M.
D’Amato, United States Senate (Jun. 18, 1986); Letter from Robert Bloom, Acting Comptroller of the Currency, to
Bank of America (Mar. 29, 1977). In addition, earlier letters addressed the application of 12 U.S.C. § 82, now
repealed, which limited the borrowings of a national bank, and the language of 12 U.S.C. § 378 (section 21of the
Glass-Steagall Act), which was viewed originally as providing certain authorizing language (subsequently amended
by the Secondary Mortgage Market Enhancement Act of 1983). See, e.g., OCC Interpretive Letter No. 257 (Apr.
12, 1983).
31
OCC Interpretive Letter No. 418 (Feb. 17, 1988). It has long been recognized that national banks have
the power to borrow funds. Borrowing is an incidental bank power—a traditional power, “necessary to carry on the
business of banking.” See Securities Industry Association v. Board of Governors of the Federal Reserve System, 468
U.S. 137, 158 n.11 (1984). Moreover, the power to sell or transfer interests in one’s assets is simply an incident of
ownership. Ownership is defined in Black’s Law Dictionary 997 (rev. 5th ed. 1979) as the “collection of rights to
use and enjoy property, including [the] right to transmit it to others.” As with any other corporation, in order to
operate effectively, a bank must be able to sell its assets, or interests therein, as economic conditions or safety and
soundness considerations warrant. The OCC has recognized that a bank’s ability to sell interests in its long term
mortgage-related portfolio serves specific banking purposes. The ability to sell mortgages which would otherwise be
held for twenty or thirty years provides needed liquidity to the mortgage portfolio, resulting in the generation of
additional funds for new lending and other purposes. The ability to sell mortgage assets on a regular basis also
facilitates management of the maturity mismatch problems inherent in funding long term mortgages with shorter
term deposits.
32
Comptroller of the Currency, Investment Securities, 61 Fed. Reg. 63972, 63977 (Dec. 2, 1996) (adopting
final rule and providing long list of OCC precedents). See, e.g., OCC Interpretive Letter No. 585 (Jun. 8, 1992)
(securitized motor vehicle retail installment sales contracts); OCC Interpretive Letter No. 540 (Dec. 12, 1990)
(securitized credit card receivables); Interpretive OCC Letter No. 514 (May 5, 1990) (securitized mortgages).
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national banks’ treatment of their assets. 33 Thus, besides recognizing the ability of a national
bank to securitize and sell its assets, Part 1 also recognizes a national bank’s ability to purchase
securitized assets as investment securities.
Specifically, the OCC amended 12 C.F.R. Part 1 to add “Type IV” securities, which are
defined as certain types of asset-backed securities identified in SMMEA and CDRI, and which
are exempt from the 10 percent investment limitation of 12 U.S.C. § 24(Seventh). Distinct from
the Type IV securities, the 1996 rule also added “Type V” securities to address “investment
grade” securities representing interests in assets a bank may invest in directly. 34 The rule defines
a Type V security as a security rated investment grade, marketable, not a Type IV, and fully
secured by interests in a pool of loans to numerous obligors and in which a national bank could
invest in directly. 35 The OCC reiterated that “this definition reflect[s] the OCC's long-standing
interpretations that, in addition to investments described in 12 U.S.C. § 24(Seventh), a national
bank may hold securitized forms of assets in which it may invest directly.” 36 The rule limits a
bank's purchase of Type V securities from any one issuer (or certain related issuers) to 25% of
the bank's capital and surplus. 37
Separate from a national bank’s ability to purchase and hold assets under the investment
authority of 12 U.S.C. § 24(Seventh) and 12 C.F.R. Part 1, the OCC also has long recognized the
ability of a national bank to acquire asset-backed securities representing participation interests in
loan pools under a bank’s general lending authority, subject to safety and soundness
requirements. 38 The purchase of interests as loan participations merely constitutes another way
for a bank to engage in permissible lending activities. 39 Under this analysis, the OCC views the
purchase of the interests as a purchase of a share of the assets they represent. Significantly,
33
Part 1 prescribes standards for national banks engaged in purchasing, selling, dealing in, underwriting,
and holding securities, consistent with the authority contained in 12 U.S.C. § 24(Seventh) and safe and sound
banking practices. See 12 C.F.R. § 1.1.
34
The rule defines the term “investment grade” to mean a security that is rated in one of the four highest
rating categories by either (1) two or more nationally recognized statistical rating organization (“NRSROs”); or (2)
one NRSRO if the security has been rated by only one NRSRO. 12 C.F.R. § 1.2(d). By definition, an “investment
security” is a marketable debt obligation that is not predominantly speculative in nature. A security is not
predominantly speculative in nature if it is rated investment grade. When a security is not rated, the security must be
the credit equivalent of a security rated investment grade. 12 C.F.R. § 1.2(e).
35
12 C.F.R. § 1.2(n). In this context, “obligor” means the borrowers on the underlying loans backing the
security. In contrast, in applying the investment limits to Type V securities, the limit applies to the “issuer” of the
security and not each underlying “obligor” on the underlying loans.
36
61 Fed. Reg. at 63976.
37
See 12 C.F.R. § 1.3(f). The rule states that in calculating the limits for Type V securities a bank must
take into account the Type V securities the bank is legally committed to purchase or sell in addition to the bank’s
“existing holdings.” Section 1.4(d) clarifies that aggregation requirements apply separately to Type III and Type V
securities. However, in the rule’s preamble the OCC cautions that credit concentrations in excess of 25% from one
issuer, but representing different “types” of securities, may raise potential safety and soundness concerns. Similarly,
the OCC notes credit concentration standards would be applicable to curtail the amount of a bank’s holdings of an
issuer’s debt obligations that rely on two different sources of authority. See 61 Fed. Register at 63979.
38
Twelve U.S.C. § 24(Seventh) specifically authorizes national banks to discount and negotiate evidences
of debt. This authority has long included a national bank’s power, using their lending authority, to purchase and
hold a variety of debt and debt-like instruments, including certain instruments denominated as securities. See, e.g.,
OCC Interpretive Letter No. 600 (July 31, 1992).
39
See OCC Interpretive Letter No. 911 (June 4, 2001).
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however, bank purchasers relying on their lending authority must adhere to the legal lending
limits, the prudential requirements of the OCC as set forth in Banking Circular 181, and other
relevant guidance. 40
3.
12 C.F.R. Part 3
The minimum capital adequacy requirements for national bank are codified at 12 C.F.R.
Part 3. These rules were first adopted by the OCC in 1985 pursuant to the OCC's general
rulemaking authority (12 U.S.C. § 93a) and the International Lending Supervision Act of
1983. 41 These rules contain the requirements and calculations of the minimum regulatory capital
requirements for national banks, including the capital treatment of securitization exposures held
by national banks. The national bank capital requirements have evolved over the past 25 years
reflecting the efforts of the OCC, in conjunction with the other Federal bank supervisory
agencies, to make the capital requirements more risk sensitive to activities and risks held by
national banks. 42
Primary and Secondary Capital Requirement. The initial capital requirements adopted in
1985 required banks to maintain two minimum capital ratios: (1) 6 percent total
capital (consisting of “primary” and “secondary” capital) to adjusted balance sheet asset and (2)
5.5 percent primary capital to adjusted balance sheet assets. 43 These rules contained no specific
provision relating to securitizations.
Risk-Based Capital Guidelines. In 1989, the primary and secondary capital
requirements 44 were supplemented with the addition of the Risk-Based Capital Guidelines issued
by the OCC and the other Federal banking supervisory agencies. 45 The Risk-Based Capital
Guidelines implemented in the U.S. the first international Basel agreement on bank capital, often
40
See 12 U.S.C. § 84 and 12 C.F.R. § 32 (statutory and regulatory lending limits for national banks); OCC
Banking Circular No. 181 (Rev.), Purchases of Loans In Whole or In Part-Participations (Aug. 2, 1984). See, e.g.,
Interpretive Letter No. 930 (Mar. 11, 2002) (Apr. 2002) (the OCC requires banks to implement “satisfactory
controls” over loans, including: [1] written lending policies and procedures governing those transactions; [2] an
independent analysis of credit quality by the purchasing bank; [3] agreement by the obligor to make full credit
information available to the selling bank; [4] agreement by the selling bank to provide available information on the
obligor to the purchaser; and [5] written documentation of recourse arrangements outlining the rights and obligations
of each party); see also OCC Bulletin 2002-19, Unsafe and Unsound Investment Portfolio Practices (May 22, 2002)
(recognizing use of lending authority to acquire securities, but emphasizing the need to measure, manage, and
control investment risks).
41
See 50 Fed. Reg. 10207 (Mar. 14, 1985).
42
This section summarizes the OCC rules relating to the capital treatment of securitization exposures where
the bank acts as originator or sponsor of the securitization (as opposed to investor). This summary only includes
final rulemakings.
43
See 50 Fed. Reg. 10207 (Mar. 14, 1985).
44
Specifically, the Risk-Based Capital Guidelines provided that mortgage backed securities (MBSs) issued
by the government or government-sponsored agency would be risk-weighted according to the risk-weight of the
issuer (zero percent for government issuer; 20 percent for government-sponsored agency). Privately issued MBSs
would be risk weighted according to the highest risk weight asset in the pool (typically 50 percent for qualifying
mortgages). Any subordinated interest (non pro-rata) to a MBS and interest-only or principle-only strips would be
risk weighted at 100 percent.
45
See 54 Fed. Reg. 4168 (Jan. 27, 1989).
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referred to as Basel I. 46 Under the Risk-Based Capital Guidelines, a bank is required to maintain
a minimum capital ratio of total capital (consisting of Tier 1 and Tier 2 capital) to risk-weighted
assets of 8 percent.
The Risk-Based Capital Guidelines represented a significant change in the capital
requirements for national banks in that, among other things, regulatory capital would
be required to be held against off-balance sheet exposures. While recourse and securitization
exposures generally would be captured by the Risk-Based Capital Guidelines as either an onbalance sheet asset or an off-balance sheet item, specific provision addressing securitization
exposures were limited to mortgage backed securities 47 held by the bank and the treatment of
assets sold with recourse. Under the Risk-Based Capital Guidelines, the full amount of an asset
or a pool of assets sold with recourse remained on the balance sheet of the bank and was subject
to the capital charge as if the asset were not sold (essentially a 100 percent credit conversion
factor for off-balance sheet items and a credit risk weight based on the type of asset).
Insignificant Recourse Rule. In 1992, the OCC revised the capital treatment of assets
sold with recourse to provide an exception for insignificant recourse. Specifically, the
amendment provided that an exception to the recourse treatment for certain sales of mortgage
loan pools with less than significant risk of loss, provided that the bank has not retained any
significant risk of loss, the maximum contractual exposure is less than the amount of probable
loss, and the bank creates a special reserve to cover the maximum contractual exposure. 48
Low Level Recourse Rule. In 1995, the OCC amended the Risk-Based Capital
Guidelines to adopt the Low Level Recourse Rule as required by the Riegle Community
Development and Regulatory Improvement Act of 1994. Generally, under the Low Level
Recourse Rule, where the amount of recourse liability retained by a bank is less than the capital
requirement for the credit exposure, the amount capital that a bank must hold is limited to the
amount of the bank's maximum contractual exposure under the recourse obligation. 49
46
See International Convergence of Capital Measurement and Capital Standards (July 1988).
The primary and secondary capital ratio was subsequently replace in 1990 with the now current Tier 1
Leverage Capital Ratio which essentially requires a bank to maintain a Tier 1 capital to adjusted total assets of 4
percent (or alternatively, 3 percent for banks with a composite CAMELS rating of 1). See 55 Fed. Reg. 38797 (Sept.
21, 1990).
48
See 57 Fed. Reg. 44078 (Sept. 24, 1992). The OCC rule represented a clarification, and not a change, of
the existing treatment of recourse arrangements under the risk-based capital guidelines. See discussion at 57 Fed.
Reg. 44078, 44083 (Sept. 24, 1992). The rule was generally consistent with the Federal Reserve’s treatment of
recourse exposures. See 56 Fed. Reg. 51151 (Oct. 10, 1991).
49
See 60 Fed. Reg. 17986 (April 10, 1995). As required by CDRI, the Low Level Recourse Rule was also
adopted by the other Federal bank supervisory agencies in separate rulemakings. See 60 Fed. Reg. 8177 (Feb. 13,
1995) (Board); 60 Fed. Reg. 15858 (March 28, 1995) (FDIC). The OTS's rules already contain a low level recourse
provisions so no rulemaking was necessary. See 66 Fed. Reg. 59614, 59615 (November 29, 2001). The Federal
bank supervisory agencies’ low-level recourse rules appeared at: 12 CFR 3, appendix A, section 3(d) (OCC); 12
CFR 208, appendix A, section III.D.1.g and 225, appendix A, section III.D.1.g (FRB); 12 CFR 325, appendix A,
section II.D.1 (FDIC); and 12 CFR 567.6(a)(2)(i)(C) (OTS). See discussion at 65 Fed. Reg. 57993, 57996 (Note 10)
(Sept. 27, 2000). These provisions were later incorporated into the Federal bank supervisory agencies' joint
rulemaking on recourse and direct credit substitutes. See 66 Fed. Reg. at 59617.
47
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Small Business Loan Recourse Rule. In 1995, the OCC and the other Federal bank
supervisory agencies issued an interim rule to amend the Risk-Based Capital Guidelines to adopt
the Small Business Loan Recourse Rule as required by the Community Development and
Regulatory Improvements Act of 1994. Specifically, the Small Business Loan Recourse Rule
generally provided an alternative capital charge based on the amount of the retained recourse for
small business obligations transferred with recourse for certain well capital banks that establishes
a non-capital reserve sufficient to cover the estimated liability under the recourse arrangement up
to an aggregate limit of 15 percent of the bank's total capital. 50
Recourse Rule In 2001, the OCC and the other Federal bank supervisory agencies issued
the “recourse” rule, which amended the Risk-Based Capital Guidelines to add provisions
specifically on the treatment of securitization exposures retained in connection with a bank’s
securitization activities. As part of the securitization process, banks often retain subordinate
securities which act as credit enhancement to the senior securities sold to investors. Under the
Recourse Rule, banks may apply the “ratings based approach” specified in the rule to qualifying
retained securitization exposures. The ratings-based approach assigns risk weights ranging from
20 percent (for triple-A ratings) to 200 percent (for double-B ratings), depending on the rating. A
securitization exposure rated below double-B does not qualify for the ratings-based approach and
is assigned a dollar-for-dollar capital charge that approximates a 1,250 percent risk weight. 51
The adoption of the Recourse Rule represented a significant increase in the risk
sensitivity of the current Risk-Based Capital Guidelines (which reflected the Basel I international
capital framework) with respect to securitization exposures. The principles developed in the US
capital treatment for securitization exposures in the Recourse Rule would later serve as the basis,
with some enhancement, for the securitization framework in the Basel II international capital
framework.
Asset-Backed Commercial Paper (“ABCP”) Rule. In 2003, the OCC and the other
Federal bank supervisory agencies issued an interim final rule that addressed the consolidation of
ABCP program assets and liquidity facilities to ABCP conduits. Specifically, the ABCP rule
allowed sponsoring banks to remove consolidated ABCP program assets from their riskweighted assets for the purpose of calculating their risk-based capital ratios. Under the ABCP
Rule, sponsoring banks were required to hold capital against all other risk exposures arising in
connection with ABCP programs. 52 The exception to consolidation of ABCP program assets
was eliminated in 2010. 53 Consequently, following a transition period, the consolidated assets of
an ABCP program will be reflected in a bank’s risk-based capital ratios.
Under the Risk-Based Capital Guidelines, long-term liquidity facilities with an original
maturity of over one year were converted to an on-balance sheet credit equivalent amount using
the 50 percent credit conversion factor. Short-term liquidity facilities with an original maturity
of one year or less were converted to an on-balance sheet credit equivalent amount utilizing the
zero percent credit conversion factor, which result in no capital charge. In the final ABCP Rule,
50
See 60 Fed. Reg. 47455 (Sept. 13, 1995); 62 Fed. Reg. 55490 (Oct. 24, 1997).
See 66 Fed. Reg. 59614 (Nov. 29, 2001).
52
See 68 Fed. Reg. 56530 (Oct. 1, 2003); 69 Fed. Reg. 44908 (July 28, 2004) (Final Rule).
53
See 75 Fed. Reg. 4636 (Jan. 28, 2010).
51
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Appendix D
Page 13
the OCC and other Federal bank supervisory agencies revised the capital treatment of liquidity
facilities. Specifically, under the ABCP Rule, subject to an asset quality test, long-term facilities
receive a credit conversion factor of 50 percent, and short term facilities receive a credit
conversion factor of 10 percent. If the asset quality test is not met, the liquidity facility is subject
to a 100 percent credit conversion factor.
Basel II Advanced Approaches Rule. In 2007, the OCC and the other Federal bank
supervisory agencies supplemented the current capital rules with the addition of the Basel II
Advanced Approaches Rule, which implemented in the U.S. the Basel revised capital
framework, often referred to as Basel II. 54 The Basel II Advanced Approaches Rule represented
a significant change in the capital requirements for certain internationally active banks in
that regulatory capital requirement for these banks generally is based on an advanced internal
ratings-based approach for credit risk and an advanced measurement approach for operational
risk. With respect to securitization exposures, under the Basel II Advanced Approaches Rule,
gain-on-sale and credit enhancing interest only strips, which are often recognized or retained by
an issuing bank, are deducted from capital. Banks must apply a ratings-based approach to
qualifying retained securitization exposures that are not already deducted that is similar to the
capital treatment under the Recourse Rule provided in the Risk-Based Capital Guidelines. Under
the Risk-Based Capital Guidelines, the capital treatment for retained exposures that are not
eligible for the ratings-based approach may be modeled if there is sufficient information.
However, generally, the modeling alternatives are equal to or harsher than the treatment provided
under the ratings-based approach. If a bank does not use any of the treatments described above,
it must deduct the exposure from capital. 55
54
See International Convergence of Capital Measurement and Capital Standards: A Revised Framework
(June 2006).
55
See 72 Fed. Reg. 69288 (Dec. 7, 2007).
- 13 -
LISTING OF ATTACHMENTS TO APPENDIX D
Select OCC Interpretive Letters
Letter from Robert Bloom, Acting Comptroller of the Currency, to Bank of America (Mar.
29, 1977)
Letter from Robert L. Clarke, Comptroller of the Currency, to the Honorable Alfonse M.
D’Amato, United States Senate (June 18, 1986)
OCC Interpretive Letter No. 388 (June 16, 1987)
OCC Interpretive Letter No. 418 (Feb. 17, 1988)
Select OCC Supervisory Guidance
OCC Comptroller’s Handbook, Asset Securitization (Nov. 1997)
OCC Bulletin 99-46 (December 1999), Interagency Guidance on Asset Securitization
Activities
OCC Bulletin 2007-1 (January 2007), Interagency Statement on Sound Practices Concerning
Elevated Risk Complex Structured Finance Activities
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/(3910
Comptroller of the Currency
Washington, DC 20219
Release Date: March 1988
Interpretive Letter No. 418
1988 OCC Ltr. LEXIS 16; Fed. Banking L. Rep. (CCH) P85,642
February 17, 1988
[*1]
Re: BancBoston Mortgage Securities, Inc.
Douglas A. Bacon, Esq.
Senior Counsel
The First National Bank of Boston
Boston, Massachusetts 02106
Dear Mr. Bacon:
This letter responds to the notification by The First National Bank of Boston ("Bank") of its intent
to establish a new operating subsidiary, BancBoston Mortgage Securities, Inc. ("Mortgage Securities"). Mortgage Securities will be a wholly owned subsidiary of an existing wholly owned operating subsidiary of the Bank, BancBoston Mortgage Companies, Inc. ("Mortgage Companies").
Mortgage Securities is being organized to facilitate the securitization of mortgage assets held by
Mortgage Companies and its other mortgage subsidiaries in the course of their mortgage banking
business. The Office previously has found similar proposals permissible for national banks. Accordingly, the Office approves the Bank's establishment of Mortgage Securities.
The Bank's Proposal
Our understanding of the Bank's proposal is based upon the Bank's operating subsidiary notification
letter, dated March 9, 1987, the Bank's supplemental letter, dated June 18, 1987, and your telephone
conversations with Richard H. Cleva, a senior [*2] attorney in the Legal Advisory Services Division
of this Office.
Mortgage Companies is an existing subsidiary of the Bank which engages in the mortgage banking
business both directly and through three wholly owned second-tier subsidiaries. Mortgage Securities will be a wholly owned subsidiary of Mortgage Companies and is being organized to facilitate
the sale, in securitized forms, of mortgage assets held by Mortgage Companies, its three other subsidiaries, the Bank, or affiliates of the Bank. Mortgage Securities will conduct its business from an
office located in Jacksonville, Florida, which is neither the main office nor a branch of the Bank.
Mortgage Securities is being organized to issue mortgage-related instruments based upon mortgage
assets held by its affiliates. In so doing, Mortgage Securities will engage in the following activities.
First, it will acquire, own, hold, sell, transfer, assign, pledge, finance, refinance, and/or otherwise
deal in (a) fully modified pass-through certificates ("GNMA Certificates") guaranteed as to the
timely payment of principal and interest by the Government National Mortgage Association
("GNMA"), (b) mortgage pass-through certificates [*3] ("FNMA Certificates") guaranteed as to the
timely payment of principal and interest by the Federal National Mortgage Association ("FNMA"),
(c) mortgage participation certificates ("FHLMC Certificates", and, together with the GNMA Certificates and the FNMA Certificates, "Agency Certificates") guaranteed as to the ultimate payment
of principal and the timely payment of interest by the Federal Home Loan Mortgage Corporation
("FHLMC"), and (d) conventional residential mortgage loans.
Second, it will authorize, issue, and deliver bonds or other evidences of indebtedness (in single or
multi-class form) either directly or through grantor trusts established by Mortgage Securities, which
bonds or other evidences of indebtedness would be collateralized by a pool of Agency Certificates
and/or conventional residential mortgage loans (each such bond or other evidence of indebtedness a
"Collateralized Mortgage Obligation" or "CMO"). Third, it will authorize, issue, and deliver certificates or other evidences of an ownership interest (in single or multi-class form) in a pool of
Agency Certificates and/or conventional residential mortgage loans (each such certificate or other
evidence of an ownership [*4] interest a "Pass-Through Certificate"). Fourth, it will authorize, issue, and deliver any other similar instruments, bonds, certificates, evidences of indebtedness or
ownership, or securities as may by law be permitted. Fifth, it will engage in other activities incidental to accomplishing the foregoing.
The CMOs or Pass-Throughs issued by Mortgage Securities may be backed by either Agency Certificates or mortgage loans. The Agency Certificates are intended primarily to be Agency Certificates issued by GNMA, FNMA, or FHLMC in exchange for mortgage loans originated by Mortgage Companies or other affiliates of Mortgage Securities. However, it is also intended that Mortgage Securities will supplement such Agency Certificates with other Agency Certificates purchased
in the open market.
Of the mortgage loans used to back CMOs or Pass-Throughs issued by Mortgage Securities, approximately fifty percent of the mortgages in Mortgage Securities portfolio will have been originated by parties unrelated to Mortgage Securities, i.e., correspondent institutions, and approximately fifty percent will have been originated by Mortgage Companies, its subsidiaries, the Bank,
and its other [*5] subsidiaries and affiliates. Mortgage Companies and its mortgage banking subsidiaries regularly sell and purchase mortgages from other institutions in the secondary mortgage
market as a routine part of their mortgage banking business. They purchase only mortgages which
comply with Mortgage Companies' own underwriting standards used on direct originations. Those
underwriting standards are FNMA/FHLMC standards for conventional loans and FHA/VA standards for FHA and VA loans, as applicable. Any mortgages purchased by Mortgage Companies or
its subsidiaries are reviewed to ensure that they meet or exceed these standards. Whether originated
by Mortgage Companies and its affiliates or purchased, it is expected that substantially all of the
conventional residential mortgage loans acquired by Mortgage Securities and used to collateralize
CMOs or underlie Pass-Through Certificates issued by Mortgage Securities will be loans serviced
by Mortgage Companies, its subsidiaries, or other affiliates of the Bank.
Transactions would be structured as follows: Mortgage Securities would purchase the mortgage
loans or Agency Certificates from the affiliates referred to above and would then issue [*6] and sell
the CMOs or Pass-Through Certificates to the underwriter, securing them with a pledge of the
mortgages or Agency Certificates to a trustee. The proceeds of each issuance of CMOs or PassThrough Certificates will be used to purchase the collateral necessary to secure the CMOs or to purchase the mortgage interests underlying the Pass-Through Certificates. It is presently contemplated
that the CMOs or Pass-Through Certificates proposed to be issued by Mortgage Securities would be
issued in a number of series under a pooling agreement, indenture, or similar document between
Mortgage Securities or a trust established by Mortgage Securities and an unaffiliated trustee, and
would bear interest at rates to be determined for each series. Mortgage Securities may elect to treat
certain of the CMOs or Pass-Through Certificates issued as regular or residual interests in a real estate mortgage investment conduit ("REMIC") under the Internal Revenue Code of 1986.
The CMOs or Pass-Through Certificates issued by Mortgage Securities would be registered with the
Securities and Exchange Commission under the Securities Act of 1933. The holders of any CMOs
or Pass-Through Certificates issued [*7] by Mortgage Securities would not have any recourse
against the Bank, Mortgage Companies, its mortgage subsidiaries, or any other affiliate of the Bank
(except against Mortgage Securities in the case of a CMO issued by Mortgage Securities directly).
The only recourse of the holders of any CMOs (other than those issued by Mortgage Securities directly) or Pass-Through Certificates would be to exercise their rights with respect to such collateral
or such underlying mortgage interests, as the case may be, and to enforce the guaranty of any third
party, such as GNMA. This fact would be brought prominently to the attention of prospective investors, who would also be specifically informed that the CMOs or Pass-Through Certificates do
not represent bank deposits and are not insured by the Federal Deposit Insurance Corporation.
The Bank has engaged the services of an independent, unrelated investment banking firm to act as
underwriter for the initial offering by Mortgage Securities. The Bank, Mortgage Securities, and
other affiliates do not intend to engage in activities which would cause them to be treated as underwriters of Mortgage Securities' issuances under the federal securities [*8] laws.
In addition, the Bank will not finance any purchaser's acquisition of the CMOs or Pass-Through
Certificates, will not purchase any of the CMOs or Pass-Through Certificates for any trust or
agency account as to which it has investment discretion or for the Bank's pension accounts, will not
promote the CMOs or Pass-Through Certificates, and will not lend money to Mortgage Securities.
Discussion
These activities -- i.e., participation in the mortgage banking business including the buying and selling of mortgage assets (and lending or borrowing collateralized by mortgage assets) in both direct
and securitized formats -- are permissible activities for national banks and their subsidiaries and
have been previously approved by this Office. Accordingly, we believe the proposed activities of
Mortgage Securities are permissible and approve the Bank's proposal.
The origination and making of real estate loans on the part of the bank; the purchase and sale of real
estate loans and participations therein; and the originating, warehousing, and servicing of loans on
behalf of other investors are centrally traditional banking activities. See, e.g., 12 U.S.C. §§ 24(7)
[*9] & 371(a); 12 C.F.R. § 34.1; 12 C.F.R. § 7.7379; First National Bank of Hartford v. City of
Hartford, 273 U.S. 548, 559-60 (1927).
This mortgage banking business includes making loans and holding them in portfolio, making loans
and selling them on to other lenders, purchasing loans from other loan-originators and holding
them, purchasing loans and selling them on, and servicing loans. The mix of activities in any given
bank's mortgage banking business at any particular time depends on such factors as local lending
opportunities, secondary market lending opportunities, local funding opportunities, secondary market funding opportunities, and so on.
The Office also believes that the activity of selling mortgages into the secondary market, or alternatively raising lendable funds by borrowing in the market secured by mortgages, may be accomplished by the use of the securitized formats which the market has developed in the last decades as
well as by direct methods. The securitized formats are tools used to effect the selling, purchasing,
borrowing, and lending functions of the secondary market. They were developed so that these market functions could be accomplished more efficiently; [*10] but they are mere tools, another means
of performing the same functions.
In keeping with this view, the Office, at least as far back as 1977, has approved of national banks'
use of pass-through certificates, collateralized mortgage obligations, or similar instruments as vehicles for selling, or borrowing against, mortgage assets. See, e.g., Letter of Robert L. Clarke, Comptroller of the Currency (June 18, 1986) (unpublished) (surveying prior letters and elaborating Office's legal analysis); OCC No-action Letter No. 86-9 (May 22, 1986), reprinted in Fed. Banking L.
Rep (CCH) P84,015 (bank issuance and sale of CMOs based on pools of agency mortgage certificates and/or mortgage loans); OCC Interpretive Letter No. 257 (April 12, 1983), reprinted in Fed.
Banking L. Rep. (CCH) P85,421 (bank selling and dealing in pass-through certificates where pool
of loans consists of obligations expressly eligible under section 24(7)); OCC Interpretive Letter No.
92 (April 20, 1979), reprinted in Fed. Banking L. Rep. (CCH) P85,167 (pool of conventional mortgage loans, bank sale through issuance of pass-through certificates in two classes); OCC Interpretive Letter No. 41 (May 18, 1978), [*11] reprinted in Fed. Banking L. Rep. (CCH) P85,116 (pool
of conventional mortgage loans, bank sale through issuance of pass-through certificates); OCC Interpretive Letter No. 25 (February 14, 1978), reprinted in Fed. Banking L. Rep. (CCH) P85,100
(pool of conventional mortgages, bank sale through issuance of pass-through certificates, and bank
employees marketing the certificates in private placements); Letter of Robert Bloom, Acting Comptroller of the Currency (March 29, 1977), reprinted in Fed. Banking L. Rep. (CCH) P97,093 (pool of
conventional mortgage loans, bank sale through issuance of pass-through certificates).
In addition, on two more recent occasions, the Office has reiterated its views on national banks' use
of pass-through certificates and CMO vehicles. In one letter, in addition to the Office's traditional
analysis of the bank's power to use these vehicles, various operational legal, accounting, and reporting questions in the use of CMOs were discussed. See OCC Interpretive Letter No. 378 (March 24,
1987), reprinted in Fed. Banking L. Rep. (CCH) P85,602. In another letter, the Office considered
the additional factual element that the bank participated [*12] in the public selling efforts for its
pass-through certificates, in addition to using an independent investment bank for sales efforts, and
concluded this activity was also permissible for banks. See OCC Interpretive Letter No. 388 (June
16, 1987), reprinted in Fed. Banking L. Rep. (CCH) P85,612, suit pending, Securities Industry Association v. Clarke, No. 87-4504 (S.D.N.Y. filed June 25, 1987).
As can be seen from the foregoing list of prior letters, the activities involved in the Bank's proposal
are within the scope of these contemplated in the Office's various prior authorizations from 1977
forward. Indeed, since the Bank intends to use an independent investment bank and will not itself
participate in the selling efforts, the Bank's proposal is within the Office's pre-1987 letters and does
not involve a factual setting similar to Letter No. 388 of June 16, 1987. Inasmuch as the Office has
previously determined these activities to be permissible for national banks, we find the Bank's proposed activities in Mortgage Securities similarly permissible.
Mortgage Securities will conduct its activities from an office which is neither the head office nor a
branch [*13] of the Bank. However, in our opinion the proposed activities of Mortgage Securities
do not include the types of business for which a branch license is required under 12 U.S.C. § 36(f),
because its activities do not involve the three types of banking business enumerated in section 36(f)
-- i.e., making loans, receiving deposits, or paying checks. See Clarke v. Securities Industry Association, 479 U.S. , 93 L. Ed. 2d 757, 772-75 (1987). Thus, Mortgage Securities' activities may be
performed at locations other than branches, and the Bank's proposal is accordingly consistent with
12 U.S.C. § 36.
Finally, the Bank's proposal is not affected by the recently enacted Competitive Equality Banking
Act of 1987, Pub. L. No. 100-86, 101 Stat. 552. In section 201(b) of the Act, Congress passed a
temporary moratorium on approvals of certain securities activities of banking organizations. Under
section 201(b)(2)(B), a federal banking agency may not authorize a bank to engage "in any securities activity not legally authorized in writing prior to March 5, 1987." Assuming without deciding
that the Bank's proposal would involve a "securities activity" within the meaning of the [*14] Act,
it is nevertheless not covered by the moratorium since the activities in the Bank's proposal are like
those authorized in the Office's prior letters from 1977 onward, such as those discussed earlier.
Moreover, the Act also does not affect "activities which had been lawfully engaged in prior to
March 5, 1987." Because banks have previously engaged in the activities involved in the Bank's
proposal (as shown, for example, in the transactions which were the subjects of the Office's prior
letters), the Bank's proposal is not affected by the moratorium also under this provision.
Conclusion
As set forth above, the proposed activities of Mortgage Securities are within the scope of activities
previously determined to be permissible for national banks and their operating subsidiaries. Thus, in
light of the above precedents and based upon our review of your description of Mortgage Securities'
activities and your legal analysis, we believe the proposed activities are permissible. Accordingly,
the Bank may proceed with its proposal under 12 C.F.R. § 5.34.
Very truly yours,
J. Michael Shepherd
Senior Deputy Comptroller for Corporate and Economic Programs
L-Sec
Comptroller of the Currency
Administrator of National Banks
Asset Securitization
Comptroller’s Handbook
November 1997
L
Liquidity and Funds Management
Asset Securitization
Table of Contents
Introduction
1
Background
Definition
A Brief History
Market Evolution
Benefits of Securitization
1
2
2
3
4
Securitization Process
6
Basic Structures of Asset-Backed Securities
Parties to the Transaction
Structuring the Transaction
Segregating the Assets
Creating Securitization Vehicles
Providing Credit Enhancement
Issuing Interests in the Asset Pool
The Mechanics of Cash Flow
Cash Flow Allocations
6
7
12
13
15
19
23
25
25
Risk Management
30
Impact of Securitization on Bank Issuers
Process Management
Risks and Controls
Reputation Risk
Strategic Risk
Credit Risk
Transaction Risk
Liquidity Risk
Compliance Risk
Other Issues
Risk-Based Capital
Comptroller’s Handbook
i
30
30
33
34
35
37
43
47
49
49
56
Asset Securitization
Examination Objectives
61
Examination Procedures
62
Overview
Management Oversight
Risk Management
Management Information Systems
Accounting and Risk-Based Capital
Functions
Originations
Servicing
Other Roles
Overall Conclusions
References
62
64
68
71
73
77
77
80
83
86
89
ii
Asset Securitization
Introduction
Background
Asset securitization is helping to shape the future of traditional commercial
banking. By using the securities markets to fund portions of the loan
portfolio, banks can allocate capital more efficiently, access diverse and costeffective funding sources, and better manage business risks.
But securitization markets offer challenges as well as opportunity. Indeed,
the successes of nonbank securitizers are forcing banks to adopt some of their
practices. Competition from commercial paper underwriters and captive
finance companies has taken a toll on banks’ market share and profitability in
the prime credit and consumer loan businesses. And the growing
competition within the banking industry from specialized firms that rely on
securitization puts pressure on more traditional banks to use securitization to
streamline as much of their credit and originations business as possible.
Because securitization may have such a fundamental impact on banks and
the financial services industry, bankers and examiners should have a clear
understanding of its benefits and inherent risks.
This booklet begins with an overview of the securitization markets, followed
by a discussion of the mechanics of securitization. The discussion evolves to
the risks of securitization and how, at each stage of the process, banks are
able to manage those risks.
A central theme of this booklet is the bank’s use of asset securitization as a
means of funding, managing the balance sheet, and generating fee income.
The discussion of risk focuses on banks’ roles as financial intermediaries, that
is, as loan originators and servicers rather than as investors in asset-backed
securities. Although purchasing asset-backed securities as investments clearly
helps to diversify assets and manage credit quality, these benefits are
discussed in other OCC publications, such as the “Investment Securities”
section of the Comptroller’s Handbook.
Comptroller’s Handbook
1
Asset Securitization
Definition
Asset securitization is the structured process whereby interests in loans and
other receivables are packaged, underwritten, and sold in the form of “assetbacked” securities. From the perspective of credit originators, this market
enables them to transfer some of the risks of ownership to parties more
willing or able to manage them. By doing so, originators can access the
funding markets at debt ratings higher than their overall corporate ratings,
which generally gives them access to broader funding sources at more
favorable rates. By removing the assets and supporting debt from their
balance sheets, they are able to save some of the costs of on-balance-sheet
financing and manage potential asset-liability mismatches and credit
concentrations.
Brief History
Asset securitization began with the structured financing of mortgage pools in
the 1970s. For decades before that, banks were essentially portfolio lenders;
they held loans until they matured or were paid off. These loans were funded
principally by deposits, and sometimes by debt, which was a direct
obligation of the bank (rather than a claim on specific assets).
But after World War II, depository institutions simply could not keep pace
with the rising demand for housing credit. Banks, as well as other financial
intermediaries sensing a market opportunity, sought ways of increasing the
sources of mortgage funding. To attract investors, investment bankers
eventually developed an investment vehicle that isolated defined mortgage
pools, segmented the credit risk, and structured the cash flows from the
underlying loans. Although it took several years to develop efficient
mortgage securitization structures, loan originators quickly realized the
process was readily transferable to other types of loans as well.
Since the mid 1980s, better technology and more sophisticated investors
have combined to make asset securitization one of the fastest growing
activities in the capital markets. The growth rate of nearly every type of
securitized asset has been remarkable, as have been the increase in the types
of companies using securitization and the expansion of the investor base.
The business of a credit intermediary has so changed that few banks, thrifts,
Asset Securitization
2
Comptroller’s Handbook
or finance companies can afford to view themselves exclusively as portfolio
lenders.
Market Evolution
The market for mortgage-backed securities was boosted by the government
agencies that stood behind these securities. To facilitate the securitization of
nonmortgage assets, businesses substituted private credit enhancements.
First, they overcollateralized pools of assets; shortly thereafter, they
improved third-party and structural enhancements. In 1985, securitization
techniques that had been developed in the mortgage market were applied for
the first time to a class of nonmortgage assets — automobile loans. A pool of
assets second only to mortgages, auto loans were a good match for structured
finance; their maturities, considerably shorter than those of mortgages, made
the timing of cash flows more predictable, and their long statistical histories
of performance gave investors confidence.
The first significant bank credit card sale came to market in 1986 with a
private placement of $50 million of bank card outstandings. This transaction
demonstrated to investors that, if the yields were high enough, loan pools
could support asset sales with higher expected losses and administrative costs
than was true within the mortgage market. Sales of this type — with no
contractual obligation by the seller to provide recourse — allowed banks to
receive sales treatment for accounting and regulatory purposes (easing
balance sheet and capital constraints), while at the same time allowing them
to retain origination and servicing fees. After the success of this initial
transaction, investors grew to accept credit card receivables as collateral, and
banks developed structures to normalize the cash flows.
The next growth phase of securitization will likely involve nonconsumer
assets. Most retail lending is readily “securitizable” because cash flows are
predictable. Today, formula-driven credit scoring and credit monitoring
techniques are widely used for such loans, and most retail programs produce
fairly homogeneous loan portfolios. Commercial financing presents a greater
challenge. Because a portfolio of commercial loans is typically less
homogeneous than a retail portfolio, someone seeking to invest in them must
often know much more about each individual credit, and the simpler tools for
Comptroller’s Handbook
3
Asset Securitization
measuring and managing portfolio risk are less effective. Nonetheless,
investment bankers and asset originators have proven extremely innovative at
structuring cash flows and credit enhancements. Evidence of this can be seen
in the market for securitized commercial real estate mortgages. Commercial
real estate is one of the fastest-growing types of nonconsumer assets in the
securitization markets, which fund approximately 10 percent of commercial
mortgage debt.
Benefits of Asset Securitization
The evolution of securitization is not surprising given the benefits that it offers
to each of the major parties in the transaction.
For Originators
Securitization improves returns on capital by converting an on-balance-sheet
lending business into an off-balance-sheet fee income stream that is less
capital intensive. Depending on the type of structure used, securitization
may also lower borrowing costs, release additional capital for expansion or
reinvestment purposes, and improve asset/liability and credit risk
management.
For Investors
Securitized assets offer a combination of attractive yields (compared with
other instruments of similar quality), increasing secondary market liquidity,
and generally more protection by way of collateral overages and/or
guarantees by entities with high and stable credit ratings. They also offer a
measure of flexibility because their payment streams can be structured to
meet investors’ particular requirements. Most important, structural credit
enhancements and diversified asset pools free investors of the need to obtain
a detailed understanding of the underlying loans. This has been the single
largest factor in the growth of the structured finance market.
For Borrowers
Borrowers benefit from the increasing availability of credit on terms that
lenders may not have provided had they kept the loans on their balance
Asset Securitization
4
Comptroller’s Handbook
sheets. For example, because a market exists for mortgage-backed securities,
lenders can now extend fixed rate debt, which many consumers prefer over
variable rate debt, without overexposing themselves to interest rate risk.
Credit card lenders can originate very large loan pools for a diverse customer
base at lower rates than if they had to fund the loans on their balance sheet.
Nationwide competition among credit originators, coupled with strong
investor appetite for the securities, has significantly expanded both the
availability of credit and the pool of cardholders over the past decade.
Comptroller’s Handbook
5
Asset Securitization
Asset Securitization
Securitization Process
Before evaluating how a bank manages the risks of securitization, an
examiner should have a fundamental understanding of asset-backed securities
and how they are structured. This section characterizes asset-backed
securities, briefly discusses the roles of the major parties, and describes the
mechanics of their cash flow, or how funds are distributed.
Basic Structures of Asset-Backed Securities
A security’s structure is often dictated by the kind of collateral supporting it.
Installment loans dictate a quite different structure from revolving lines of
credit. Installment loans, such as those made for the purchase of
automobiles, trucks, recreational vehicles, and boats, have defined
amortization schedules and fixed final maturity dates. Revolving loans, such
as those extended to credit card holders and some home equity borrowers,
have no specific amortization schedule or final maturity date. Revolving
loans can be extended and repaid repeatedly over time, more or less at the
discretion of the borrower.
Installment Contract Asset-Backed Securities
Typical installment contract asset-backed securities, which bear a close
structural resemblance to mortgage pass-through securities, provide investors
with an undivided interest in a specific pool of assets owned by a trust. The
trust is established by pooling installment loan contracts on automobiles,
boats, or other assets purchased from a loan originator, often a bank.
The repayment terms for most installment contract asset-backed securities call
for investors to receive a pro rata portion of all of the interest and principal
received by the trust each month. Investors receive monthly interest on the
outstanding balance of their certificates, including a full month’s interest on
any prepayments. The amount of principal included in each payment
depends on the amortization and prepayment rate of the underlying
collateral. Faster prepayments shorten the average life of the issue.
Asset Securitization
6
Comptroller’s Handbook
Revolving Asset Transactions
The typically short lives of receivables associated with revolving loan
products (credit cards, home equity lines, etc.) require issuers to modify the
structures used to securitize the assets. For example, a static portfolio of
credit card receivables typically has a life of between five months and ten
months. Because such a life is far too short for efficient security issuance,
securities backed by revolving loans are structured in a manner to facilitate
management of the cash flows. Rather than distributing principal and interest
to investors as received, the securities distribute cash flow in stages — a
revolving phase followed by an amortization phase. During the revolving
period, only interest is paid and principal payments are reinvested in
additional receivables as, for example, customers use their credit cards or
take additional draws on their home equity lines. At the end of the revolving
period an amortization phase begins, and principal payments are made to
investors along with interest payments. Because the principal balances are
repaid over a short time, the life of the security is largely determined by the
length of the revolving period.
Parties to the Transaction
The securitization process redistributes risk by breaking up the traditional role
of a bank into a number of specialized roles: originator, servicer, credit
enhancer, underwriter, trustee, and investor. Banks may be involved in
several of the roles and often specialize in a particular role or roles to take
advantage of expertise or economies of scale. The types and levels of risk to
which a particular bank is exposed will depend on the organization’s role in
the securitization process.
With sufficient controls and the necessary infrastructure in place,
securitization offers several advantages over the traditional bank lending
model. These benefits, which may increase the soundness and efficiency of
the credit extension process, can include a more efficient origination process,
better risk diversification, and improved liquidity. A look at the roles played
by the primary participants in the securitization process will help to illustrate
the benefits.
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Asset Securitization
Exhibit 1: Parties Involved in Structuring Asset-Backed Securities
Borrower. The borrower is responsible for payment on the underlying loans
and therefore the ultimate performance of the asset-backed security. Because
borrowers often do not realize that their loans have been sold, the originating
bank is often able to maintain the customer relationship.
From a credit risk perspective, securitization has made popular the practice of
grouping borrowers by letter or categories. At the top of the rating scale, ’A’quality borrowers have relatively pristine credit histories. At the bottom, ’D’quality borrowers usually have severely blemished credit histories. The
categories are by no means rigid; in fact, credit evaluation problems exist
because one originator’s ’A’ borrower may be another’s ’A-’ or ’B’ borrower.
Nevertheless, the terms ’A’ paper and ’B/C’ paper are becoming more and
more popular.
Exhibit 2 is an example of generic borrower descriptions used by Duff and
Phelps Credit Rating Corporation in rating mortgage borrowers. The
borrowers’ characteristics in the exhibit are generalizations of each category’s
standards and fluctuate over time; however, the table does provide an
illustration of general standards in use today. For example, an ‘A’ quality
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Exhibit 2: Borrower Credit Quality Categories
Generic Borrower
Credit Quality
Description
Mortgage Credit
Other Credit
Recency of
Bankruptcy
Debt to
Income Ratio
Loan-to-Value
Guidelines
A: Standard agency quality
1 x 30 last 12 months
No derogatories
5 yrs.
36%
97%
A-: Very minor credit
problems
1 x 30 last 12 months
2 x 30 last 24 months
Minor derogatories 5 yrs.
explained
42%
90%
B: Minor to moderate
credit problems
4 x 30 last 12 months
1 x 60 last 24 months
Some prior defaults 3 yrs.
50%
75%
C: Moderate to serious
credit problems
6 x 30 last 12 months
1 x 60 & 1 x 90 last
12 months
Significant credit
problems
18 months
55%
70%
Severe credit
problems
12 months
60%
65%
D: Demonstrated unwillingness 30-60 constant
or inability to pay
delinquent, 2 x 90
last 12 months
(Source: Duff & Phelps)
borrower will typically have an extensive credit history with few if any
delinquencies, and a fairly strong capacity to service debt. In contrast, a ‘C’
quality borrower has a poor or limited credit history, numerous instances of
delinquency, and may even have had a fairly recent bankruptcy. Segmenting
borrowers by grade allows outside parties such as rating agencies to compare
performance of a specific company or underwriter more readily with that of
its peer group.
Originator. Originators create and often service the assets that are sold or
used as collateral for asset-backed securities. Originators include captive
finance companies of the major auto makers, other finance companies,
commercial banks, thrift institutions, computer companies, airlines,
manufacturers, insurance companies, and securities firms. The auto finance
companies dominate the securitization market for automobile loans. Thrifts
securitize primarily residential mortgages through pass-throughs, paythroughs, or mortgage-backed bonds. Commercial banks regularly originate
and securitize auto loans, credit card receivables, trade receivables, mortgage
loans, and more recently small business loans. Computer companies,
airlines, and other commercial companies often use securitization to finance
receivables generated from sales of their primary products in the normal
course of business.
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Asset Securitization
Servicer. The originator/lender of a pool of securitized assets usually
continues to service the securitized portfolio. (The only assets with an active
secondary market for servicing contracts are mortgages.) Servicing includes
customer service and payment processing for the borrowers in the securitized
pool and collection actions in accordance with the pooling and servicing
agreement. Servicing can also include default management and collateral
liquidation. The servicer is typically compensated with a fixed normal
servicing fee.
Servicing a securitized portfolio also includes providing administrative
support for the benefit of the trustee (who is duty-bound to protect the
interests of the investors). For example, a servicer prepares monthly
informational reports, remits collections of payments to the trust, and
provides the trustee with monthly instructions for the disposition of the trust’s
assets. Servicing reports are usually prepared monthly, with specific format
requirements for each performance and administrative report. Reports are
distributed to the investors, the trustee, the rating agencies, and the credit
enhancer.
Trustee. The trustee is a third party retained for a fee to administer the trust
that holds the underlying assets supporting an asset-backed security. Acting
in a fiduciary capacity, the trustee is primarily concerned with preserving the
rights of the investor. The responsibilities of the trustee will vary from issue
to issue and are delineated in a separate trust agreement. Generally, the
trustee oversees the disbursement of cash flows as prescribed by the
indenture or pooling and servicing agreement, and monitors compliance with
appropriate covenants by other parties to the agreement.
If problems develop in the transaction, the trustee focuses particular attention
on the obligations and performance of all parties associated with the security,
particularly the servicer and the credit enhancer. Throughout the life of the
transaction the trustee receives periodic financial information from the
originator/servicer delineating amounts collected, amounts charged off,
collateral values, etc. The trustee is responsible for reviewing this
information to ensure that the underlying assets produce adequate cash flow
to service the securities. The trustee also is responsible for declaring an event
of default or an amortization event, as well as replacing the servicer if it fails
to perform in accordance with the required terms.
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Credit Enhancer. Credit enhancement is a method of protecting investors in
the event that cash flows from the underlying assets are insufficient to pay the
interest and principal due for the security in a timely manner. Credit
enhancement is used to improve the credit rating, and therefore the pricing
and marketability of the security.
As a general rule, third-party credit enhancers must have a credit rating at
least as high as the rating sought for the security. Third-party credit support is
often provided through a letter of credit or surety bond from a highly rated
bank or insurance company. Because there are currently few available highly
rated third-party credit enhancers, internal enhancements such as the
senior/subordinated structure have become popular for many asset-backed
deals. In this latter structure, the assets themselves and cash collateral
accounts provide the credit support. These cash collateral accounts and
separate, junior classes of securities protect the senior classes by absorbing
defaults before the senior position’s cash flows are interrupted.
Rating Agencies. The rating agencies perform a critical role in structured
finance — evaluating the credit quality of the transactions. Such agencies are
considered credible because they possess the expertise to evaluate various
underlying asset types, and because they do not have a financial interest in a
security’s cost or yield. Ratings are important because investors generally
accept ratings by the major public rating agencies in lieu of conducting a due
diligence investigation of the underlying assets and the servicer.
Most nonmortgage asset-backed securities are rated. The large public issues
are rated because the investment policies of many corporate investors require
ratings. Private placements are typically rated because insurance companies
are a significant investor group, and they use ratings to assess capital reserves
against their investments. Many regulated investors, such as life insurance
companies, pension funds, and to some extent commercial banks can
purchase only limited amounts of securities rated below investment grade.
The rating agencies review four major areas:
•
•
Quality of the assets being sold,
Abilities and strength of the originator/servicer of the assets,
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Asset Securitization
•
•
Soundness of the transaction’s overall structure, and
Quality of the credit support.
From this review, the agencies assess the likelihood that the security will pay
interest and principal according to the terms of the trust agreement. The
rating agencies focus solely on the credit risk of an asset-backed security.
They do not express an opinion on market value risks arising from interest
rate fluctuations or prepayments, or on the suitability of an investment for a
particular investor.
Underwriter. The asset-backed securities underwriter is responsible for
advising the seller on how to structure the security, and for pricing and
marketing it to investors. Underwriters are often selected because of their
relationships with institutional investors and for their advice on the terms and
pricing required by the market. They are also generally familiar with the
legal and structural requirements of regulated institutional investors.
Investors. The largest purchasers of securitized assets are typically pension
funds, insurance companies, fund managers, and, to a lesser degree,
commercial banks. The most compelling reason for investing in asset-backed
securities has been their high rate of return relative to other assets of
comparable credit risk. The OCC’s investment securities regulations at 12
CFR 1 allow national banks to invest up to 25 percent of their capital in
“Type V” securities. By definition, a Type V security:
C
C
C
C
Is marketable,
Is rated investment grade,
Is fully secured by interests in a pool of loans to numerous obligors and
in which a national bank could invest directly, and
Is not rated as a mortgage-related or Type IV security.
Structuring the Transaction
The primary difference between whole loan sales or participations and
securitized credit pools is the structuring process. Before most loan pools can
be converted into securities, they must be structured to modify the nature of
the risks and returns to the final investors. Structuring includes the isolation
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Comptroller’s Handbook
and distribution of credit risk, usually through credit enhancement
techniques, and the use of trusts and special purpose entities to address tax
issues and the management of cash flows.
Examiners performing a comprehensive review of a specific securitization
process should read through the pooling and servicing agreement and/or a
specific series supplement for explicit detail on the structure and design of the
particular asset-backed security and the responsibilities of each involved
party. For purposes of this booklet, the following is an overview of the
structuring process and a description of what the documents usually contain.
Generally, the structure of a transaction is governed by the terms of the
pooling and servicing agreement and, for master trusts, each series
supplement. The pooling and servicing agreement is the primary contractual
document between the seller/servicer and the trustee. This agreement
documents the terms of the sale and the responsibilities of the seller/servicer.
For master trusts, the pooling and servicing agreement, including the related
series supplement, document the terms of the sale and responsibilities of the
seller/servicer for a specific issuance. The following section describes the
four major stages of the structuring process:
C
C
C
C
Segregating the assets from the seller/originator.
Creating a special-purpose vehicle to hold the assets and protect
the various parties’ interests.
Adding credit enhancement to improve salability.
Issuing interests in the asset pool.
Segregating the Assets
Securitization allows investors to evaluate the quality of a security on its own
(apart from the credit quality of the originator/seller). To accomplish this, the
seller conveys receivables to a trust for the benefit of certificate holders. For
revolving-type assets, this conveyance includes the amount of receivables in
certain designated accounts on a specific cutoff date, plus the option for the
trust to purchase any new receivables that arise from those designated
accounts subsequent to the cutoff date. The accounts and receivables are
subject to eligibility criteria and specific representations and warranties of the
seller.
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Asset Securitization
Choosing Accounts — Initial Pool Selection
The seller designates which accounts’ receivables will be sold to a trust. The
selection is carried out with an eye to creating a portfolio whose performance
is not only predictable but also consistent with the target quality of the
desired security. Step one is determining which accounts will be
“designated” as those from which receivables may be included in the trust.
For example, past-due receivables may be left in the eligible pool, but
accounts that have had a default or write-off may be excluded. Some issuers
include written-off receivables, allowing the revenue from recoveries to
become part of the cash flow of the trust. Other selection criteria might
include data elements such as geographic location, maturity date, size of the
credit line, or age of the account relationship.
Step two, asset selection, can either be random, in order to create selections
that are representative of the total portfolio, or inclusive, so that all qualifying
receivables are sold. In random selection, the issuer determines how many
accounts are needed to meet the target value of the security; then the
accounts are selected randomly (for example, every sixth account is selected
from the eligible universe).
Account Additions and Removals
For trusts with a revolving feature, such as credit cards or home equity lines
of credit, the seller may be required to designate additional accounts that will
be assimilated by the trust. This may be required for a variety of reasons, for
example, when the seller’s interest (the interest in the receivables pool
retained by the seller subsequent to transfer into the trust) falls below a level
specified in the pooling and servicing agreement. The seller also typically
reserves the ability to withdraw some accounts previously designated for the
trust.1 Rating agencies must often be notified when account additions or
removals reach certain thresholds. For example, the terms of the rating may
1
The issue of whether provisions for the removal of accounts are in-substance call options
retained by the seller (which may compromise sales treatment) is under consideration by FASB
at the time of this writing. A formal FASB interpretation is expected to be issued in exposure
draft form. Until then, the guidance under Emerging Issues Task Force (EITF) Issue 90-18
remains in effect.
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Comptroller’s Handbook
require rating agency confirmation that account additions or removals do not
lower outstanding ratings when additions or removals exceed 15 percent of
the balance at the beginning of the previous quarter.
Creating Securitization Vehicles
Banks usually structure asset-backed securities using “grantor trusts,” “owner
trusts,” or other “revolving asset trusts,” each of which customarily issues
different types of securities. In choosing a trust structure, banks seek to ensure
that the transaction insulates the assets from the reach of the issuer’s creditors
and that the issuer, securitization vehicle, and investors receive favorable tax
treatment.
In a grantor trust, the certificate holders (investors) are treated as beneficial
owners of the assets sold. The net income from the trust is taxed on a passthrough basis as if the certificate holders directly owned the receivables. To
qualify as a grantor trust, the structure of the deal must be passive — that is,
the trust cannot engage in profitable activities for the investors, and there
cannot be “multiple classes” of interest. Grantor trusts are commonly used
when the underlying assets are installment loans whose interest and principal
payments are reasonably predictable and fit the desired security structure.
In an owner trust, the assets are usually subject to a lien of indenture through
which notes are issued. The beneficial ownership of the owner trust’s assets
(subject to the lien) is represented by certificates, which may be sold or
retained by the bank. An owner trust, properly structured, will be treated as a
partnership under the Internal Revenue Code of 1986. A partnership, like a
grantor trust, is effectively a pass-through entity under the Internal Revenue
Code and therefore does not pay federal income tax. Instead, each certificate
holder (including the special-purpose corporation) must separately take into
account its allocated share of income, gains, losses, deductions, and credits of
the trust. Like the grantor trust, the owner trust is expressly limited in its
activities by its charter, although owner trusts are typically used when the
cash flows of the assets must be “managed” to create “bond-like” securities.
Unlike a grantor trust, the owner trust can issue securities in multiple series
with different maturities, interest rates, and cash flow priorities.
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Asset Securitization
Revolving asset trusts may be either stand-alone or master trust structures.
The stand-alone trust is simply a single group of accounts whose receivables
are sold to a trust and used as collateral for a single security, although there
may be several classes within that security. When the issuer intends to issue
another security, it simply designates a new group of accounts and sells their
receivables to a separate trust. As the desire for additional flexibility,
efficiency, and uniformity of collateral performance for various series issued
by the same originator has increased over time, the stand-alone structure
evolved into the master trust structure.
Master trusts allow an issuer to sell a number of securities (and series) at
different times from the same trust. All of the securities rely on the same pool
of receivables as collateral. In a master trust, each certificate of each series
represents an undivided interest in all of the receivables in the trust. This
structure provides the issuer with much more flexibility, since issuing a new
series from a master trust costs less and requires less effort than creating a
new trust for every issue. In addition, credit evaluation of each series in a
master trust is much easier since the pool of receivables will be larger and
less susceptible to seasonal or demographic concentrations. Credit cards,
home equity lines of credit, and other revolving assets are usually best
packaged in these structures. A revolving asset trust is treated as a “security
arrangement” and is ignored for tax purposes. (See following discussion
under “Tax Issues.”)
Legal Issues
When banks are sellers of assets, they have two primary legal concerns. They
seek to ensure that:
•
•
A security interest in the assets securitized is perfected.
The security is structured so as to preclude the FDIC’s voiding of the
perfected security interest.
By perfecting security interests, a lender protects the trustee’s property rights
from third parties who may have retained rights that impair the timely
payment of debt service on the securities. Typically, a trustee requires a legal
opinion to the effect that the trust has a first-priority perfected security interest
in the pledged receivables. In general, filing Uniform Commercial Code
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Comptroller’s Handbook
documents (UCC-1) is sufficient for unsecured consumer loan receivables
such as credit cards. For other types of receivables whose collateral is a
reliable fall-back repayment source (such as automobile loans and home
equity lines of credit), additional steps may be required (title amendments,
mortgage liens, etc.) to perfect the trustee’s security interest in the receivables
and the underlying collateral.
If the seller/originator is a bank, the provisions of the U.S. Bankruptcy Code
(11 USC 1 et seq.) do not apply to its insolvency proceedings. In the case of
a bank insolvency, the FDIC would act as receiver or conservator of the
financial institution.2 Although the Federal Deposit Insurance Act does not
contain an automatic stay provision that would stop the payout of securities
(as does the bankruptcy code), the FDIC has the power to ask for a judicial
stay of all payments or the repudiation of any contract. In order to avoid
inhibiting securitization, however, the FDIC has stated3 that it would not seek
to void an otherwise legally enforceable and perfected security interest
provided:
•
•
•
•
•
The agreement was undertaken in the ordinary course of business, not
in contemplation of insolvency, and with no intent to hinder, delay, or
defraud the bank or its creditors;
The secured obligation represents a bona fide and arm’s length
transaction;
The secured party or parties are not insiders or affiliates of the bank;
The grant of the security interest was made for adequate consideration;
and
The security agreement evidencing the security interest is in writing,
was duly approved by the board of directors of the bank or its loan
committee, and remains an official record of the bank.
2
A national bank may not be a “debtor” under the bankruptcy code. See USC 109(b)(2). The
FDIC may act as receiver or conservator of a failed institution, subject to appointment by the
appropriate federal banking agency. See 12 USC 1821.
3
“Statement of Policy regarding Treatment of Security Interests after Appointment of the FDIC as
Conservator or Receiver.” March 31, 1993, 58 FR 16833.
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Asset Securitization
Tax Issues
Issuers ordinarily choose a structure that will minimize the impact of taxes on
the security. Federal income tax can be minimized in two principal ways —
by choosing a vehicle that is not subject to tax or by having the vehicle issue
“debt” the interest on which is tax deductible (for the vehicle or its owners).
In a grantor trust, each certificate holder is treated as the owner of a pro rata
share of the trust’s assets and the trust is ignored for tax purposes. To receive
the favorable tax treatment, each month the grantor trust must distribute all
principal and interest received on the assets held by the trust. A grantor trust
is not an “entity” for federal tax purposes; rather, its beneficiaries are treated
as holders of a ratable share of its assets (in contrast to partnerships, which
are treated as entities, even though their income is allocated to the holders of
the partnership interests). The requirement that the trust be “passive”
generally makes the grantor trust best suited for longer-term assets such as
mortgages or automobile receivables.
An owner trust generally qualifies as a partnership for tax purposes. Because
the issuer usually retains an interest in the assets or a reserve account, it is
usually a partner; if so, the transfer of assets to the trust is governed by tax
provisions on transfers to partnerships. Although the partnership itself would
generally not be subject to tax, its income (net of deductions for interest paid
to note holders) would be reportable by the partner certificate holders and the
issuer. Partnership owner trusts are commonly used in fixed pool
transactions involving the same kinds of assets that are securitized through
grantor trusts; assets in owner trusts typically require more management or
will be issued as more than one class of security.
The cash flows for shorter-term assets, such as credit cards, require too much
management for a grantor trust. Although owner trusts are theoretically the
appropriate vehicle for issuing such assets, in practice revolving asset trusts
are usually used when the parties structure the transaction for tax purposes as
a secured loan from the investors to the seller of the receivables. The trust is
simply a means of securing financing and is ignored for tax purposes. (Such
treatment — as a “security arrangement” — is like that accorded a grantor
trust, which is also ignored for tax purposes, except that a grantor trust must
file a tax report and a “security arrangement” does not.)
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Assets requiring managed cash flows can also be structured as a specialpurpose corporation (SPC), in which the asset-backed securities are debt of
the issuer rather than ownership interests in the receivables. In this structure
an SPC typically owns the receivables and sells debt that is backed by the
assets, thus allowing the SPC to restructure the cash flows from the
receivables into several debt tranches with varying maturities. The interest
income from the receivables is taxable to the corporation, and this taxable
income is largely offset by the tax deduction from the interest expense on the
debt it issues.
Other securitization vehicles, such as real estate mortgage investment
conduits (REMICs) and, more recently (effective September 1, 1997), financial
asset securitization investment trusts (FASITs), are essentially statutory
structures modeled after the “common law” structures described in the
foregoing examples. In any event, the overriding objective remains the same:
to receive the equivalent of “flow-through” treatment that minimizes the tax
consequences for the cash flows. Because interpretations concerning tax
treatment may change as structures evolve, banks are encouraged to consult
with tax counsel on taxation issues arising from securitization.
Providing Credit Enhancement
Securitization typically splits the credit risk into several tranches, placing it
with parties that are willing or best able to absorb it. The first loss tranche is
usually capped at levels approximate to the “expected” or “normal” rate of
portfolio credit loss. All credit losses up to this point are effectively absorbed
by the credit originator, since it typically receives portfolio cash flow after
expenses (which include expected losses) in the form of excess spread.
The second tranche typically covers losses that exceed the originator’s cap.
This second level of exposure is usually capped at some multiple of the
pool’s expected losses (customarily between three times and five times these
losses), depending on the desired credit ratings for the senior positions. This
risk is often absorbed by a high-grade, well-capitalized credit enhancer that is
able to diversify the risk (exhibit 3). The third tranche of credit risk is
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Asset Securitization
undertaken by the investors that buy the asset-backed securities themselves.
Although investors are exposed to other types of risk, such as prepayment or
interest rate risk, senior-level classes of asset-backed securities typically have
little exposure to credit loss.
Aside from the coupon rate paid to investors, the largest expense in
structuring an asset-backed security is the cost of credit enhancement. Issuers
are constantly attempting to minimize the costs associated with providing
credit protection to the ultimate investors. Credit enhancement comes in
several different forms, although it can generally be divided into two main
types: external (third-party or seller’s guarantee) or internal (structural or cashflow-driven). Common types of credit enhancements in use today include:
Credit Enhancement Provided by External Parties
•
Third-party letter of credit. For issuers with credit ratings below the
level sought for the security issued, a third party may provide a letter of
credit to cover a certain amount of loss or percentage of losses. Draws
on the letter of credit protection are often repaid (if possible) from
excess cash flows from the securitized portfolio.
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•
Recourse to seller. Principally used by nonbank issuers, this method
uses a limited guaranty of the seller covering a specified maximum
amount of losses on the pool.
•
Surety bonds. Guarantees issued by third parties, usually AAA-rated
mono-line insurance companies. Surety bond providers generally
guarantee (or wrap) the principal and interest payments of 100 percent
of a transaction.
Although the ratings of third-party credit enhancers are rarely lowered, such
an event could lower the rating of a security. As a result, issuers are relying
less and less on third-party enhancement.
Credit Enhancement Provided by Internal Structure
Loss Position
Structural features can be created to raise the credit quality of an asset-backed
security. For example, a highly rated senior class of securities can be
supported by one or more subordinate security classes and a cash collateral
account. Senior/subordinate
Last
structures are layered so that each
position benefits from the credit
protection of all the positions
Class A
subordinate to it. The junior
‘AAA’
Receivables
positions are subordinate in the
payment of both principal and
Class B - ‘A’
interest to the senior positions in
the securities.
CIA - ‘BBB’
A typical security structure may
contain any of the following
internal enhancements (which are
presented in order from junior to
senior, that is, from the first to
absorb losses to the last):
1.
CCA
Cash
Spread Account
First
Excess Spread
Excess spread. The portfolio yield for a given month on the receivables
supporting an asset-backed security is generally greater than the
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Asset Securitization
coupon, servicing costs, and expected losses for the issued securities.
Any remaining finance charges after funding, servicing costs, and losses
is called “excess spread.” (See the cash flow waterfall discussion in the
“Mechanics of Cash Flow” section, which follows, for an illustration of
how excess spread is determined.) This residual amount normally
reverts to the seller as additional profit. However, it is also commonly
available to the trust to cover unexpected losses.
2.
Spread account. Monthly finance charges from the underlying pool of
receivables are available to cover unexpected losses in any given
month. If not needed, this “excess spread” generally reverts to the
seller. Many trusts provide that, if portfolio yield declines or losses
increase, the monthly excess spread is captured, or “trapped,” in a
spread account (a form of cash collateral account) to provide future
credit enhancement.
3.
Cash collateral accounts. A cash collateral account is a segregated trust
account, funded at the outset of the deal, that can be drawn on to cover
shortfalls in interest, principal, or servicing expense for a particular
series if excess spread is reduced to zero. The account can be funded
by the issuer, but is often funded by a loan from a third-party bank,
which will be repaid only after holders of all classes of certificates of
that series have been repaid in full.
4.
Collateral invested amount (CIA). The CIA is an uncertificated, privately
placed ownership interest in the trust, subordinate in payment rights to
all investor certificates. Like a layer of subordination, the CIA serves the
same purpose as a cash collateral account: it makes up for shortfalls if
excess spread is negative. The CIA is itself often protected by a cash
collateral account and available monthly excess spread. If the CIA
absorbs losses, it can be reimbursed from future excess spread if
available.
5.
Subordinate security classes. Subordinate classes are junior in claim to
other debt — that is, they are repayable only after other classes of the
security with a higher claim have been satisfied. Some securities
contain more than one class of subordinate debt, and one subordinate
class may have a higher claim than other such positions.
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Most structures contain a combination of one or more of the enhancement
techniques described above. For example, some issuers combine surety
bond protection with senior/subordinate structures, creating “super senior”
classes that are insulated from third-party risk and have higher rated
subordinated classes because of the credit-wrap. The objective from an
issuer’s viewpoint is to find the most practical and cost-effective method of
providing the credit protection necessary for the desired credit rating and
pricing of the security.
Most securities also contain performance-related features designed to protect
investors (and credit enhancers) against portfolio deterioration. These
“performance triggers” are designed to increase the spread account available
to absorb losses, to accelerate repayment of principal before pool
performance would likely result in losses to investors, or both. The first (most
sensitive) triggers typically capture excess spread within the trust (either
additions to existing spread accounts or a separate reserve fund) to provide
additional credit protection when a portfolio begins to show signs of
deterioration. If delinquencies and loss levels continue to deteriorate, early
amortization events may occur. Early amortization triggers are usually based
on a three-month rolling average to ensure that amortization is accelerated
only when performance is consistently weak.
The originator or pool sponsor will often negotiate with the rating agencies
about the type and size of the internal and external credit enhancement. The
size of the enhancement is dictated by the credit rating desired. For the
highest triple-A rating, the rating agencies are likely to insist that the level of
protection be sufficient to shield cash flows against circumstances as severe
as those experienced during the Great Depression of the 1930s.
Issuing Interests in the Asset Pool
On the closing date of the transaction, the receivables are transferred, directly
or indirectly, from the seller to the special-purpose vehicle (trust). The trust
issues certificates representing beneficial interests in the trust, investor
certificates, and, in the case of revolving asset structures, a transferor (seller)
certificate.
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Investors’ Certificate
The investor certificates are sold in either public offerings or private
placements, and the proceeds, net of issuance expenses, are remitted to the
seller. There are two main types of investor interests in securitized assets — a
discrete interest in specific assets and an undivided interest in a pool of
assets. The first type of ownership interest is used for asset pools that match
the maturity and cash flow characteristics of the security issued. The second
type of interest is used for relatively short-term assets such as credit card
receivables or advances against home equity lines of credit. For the shorterterm assets, new receivables are generated and added to the pool as the
receivables liquidate, and the investor’s undivided interest automatically
applies to the new receivables in the pool.
Seller’s Interest
When receivables backing securities are short-term or turn over rapidly, as do
trade receivables or credit cards, the cash flows associated with the
receivables must be actively managed. One objective is to keep the
outstanding principal balance of the investor’s interest equal to the certificate
amounts. To facilitate this equalization, an interest in trust structures, known
as the “seller’s” or “transferor’s” interest, is not allocated to investors. The
seller’s interest serves two primary purposes: to provide a cash-flow buffer
when account payments fall short of account purchases and to absorb
reductions in the receivable balance attributable to dilution and
noncomplying receivables.
To calculate the size of the seller’s interest, subtract the amount of securities
issued by the trust (liabilities) from the balance of principal receivables in the
trust (assets). The seller’s interest is generally not a form of credit
enhancement for the investor interests.
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The Mechanics of Cash Flow
Cash Flow Allocations
Pass-Through Securities
The payment distribution for securities backed by installment loans is closely
tied to the loans’ payment flows. Interest is customarily paid monthly, and
the principal included in each payment will depend on the amortization
schedule and prepayment rate of the underlying collateral.
Pay-Through Securities
For revolving asset types such as credit cards, trade receivables, and home
equity lines, the cash flow has two phases:
•
•
The revolving period; and
The principal pay-down period (amortization phase).
During the revolving period, investors receive their pro rata share of the gross
portfolio yield (see below) based on the principal amount of their certificates
and the coupon rate. The remaining portion of their share of the finance
charges above the coupon rate is available to pay the servicing fees and to
cover any charge-offs, with residual amounts generally retained by the seller
or credit enhancement provider as excess spread. This distribution of cash is
often referred to as the “cash flow waterfall.”
The cash flow waterfall for credit card securities may look like this
(percentages based on investor’s pro rata share of outstanding receivables):
Revenue
Finance Charges
Annual Fees
Late Fees and Other Fees
Interchange
16.5%*
1.5%
0.7%
1.8%
Gross Portfolio Yield (finance charges)
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20.5%
Asset Securitization
Expenses
Investor Coupon
Servicing Expense
Charge-offs
7.0%*
2.5%
5.0%
Total Expenses
14.5%
Excess Spread
6.0%
During the revolving period, monthly principal collections are used to
purchase new receivables generated in the designated accounts or to
purchase a portion of the seller’s participation if there are no new receivables.
If the percentage of the seller’s interest falls below a prescribed level of
principal outstanding because of a lack of new borrowings from the
designated accounts, new accounts may be added.
After this revolving period comes the amortization period. During this phase,
the investors’ share of principal collections are no longer used to purchase
replacement receivables. These proceeds are returned to investors as
received. This is the simplest form of principal repayment. However,
because over time investors have preferred more stable returns of principal,
some issuers have created structures to accumulate principal payments in a
trust account (“accumulation account”) rather than simply passing principal
payments through to investors as received. The trust then pays principal on a
specific, or “bullet,” maturity date. Bullet maturities are typically either
“hard” or “soft,” depending on how the structure compensates when funds in
the accumulation account are not sufficient to pay investors in full on the
scheduled maturity date. Under a hard bullet structure, a third-party maturity
guaranty covers the shortfall. Under a soft bullet structure, the entire
accumulation account is distributed to the investors and further funds are
paid as received. Soft bullet structures usually include an expected maturity
date and a final maturity date.
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Early Amortization Protection
In addition to the previously discussed credit enhancement types, revolving
asset-backed securities typically use early amortization triggers to protect
investors from credit risk. These triggers, or payout events, accelerate the
repayment of investor principal if cash flow from the pool declines or the
condition of the pooled assets deteriorates. This accelerated repayment
method requires that the investors’ share of all principal collections be
returned immediately as it is received by the trust. The payout events are
defined in the pooling and servicing agreement and series supplement of
each securitization, and are intended to protect investors from prolonged
exposure to deteriorating performance of the underlying assets or the default
of a servicer.
To monitor the asset-backed security’s performance, the trustee, the rating
agencies, and investors focus on several indicators of pool performance:
portfolio yield, the loss rate, the monthly payment rate, and the purchase rate.
•
Portfolio yield generally consists of three types of payments: finance
charges, fees, and interchange. Finance charges are the periodic
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interest costs associated with an unpaid balance at the end of a grace
period. Fees include annual membership fees, late payment fees, cash
advance transaction fees, and over-limit fees. Interchange is the fee
paid by merchants and passed to the card-issuing bank for completing
the transaction.
•
Loss rates are evaluated relative to the seasoning of the pool and the
marketing and underwriting strategies of the originator. Rating agencies
pay particular attention to estimated and actual loss rates when settling
on credit enhancement levels and monitoring securities for potential
ratings actions.
•
The monthly payment rate includes monthly collections of principal,
finance charges, and fees paid by the borrower. Payment rate
monitoring is focused on principal collections since it is principal
repayments that will be used to pay down the investor’s outstanding
principal.
•
The purchase rate is the amount of new charges transferred to the trust
each month from the designated accounts as a percent of the
receivables outstanding. New purchases keep the amount of principal
receivables in the trust from falling. If the pool balance falls below a
minimum, the seller is usually required to assign additional accounts to
the pool.
Other items of interest are finance charge and principal allocations among the
various interests in the trust and, for floating rate issues, coupon rates. Should
any of the aforementioned indicators show prolonged signs of deterioration
by tripping a preset trigger, early amortization would begin.
Common early amortization triggers include:
•
•
A reduction in the portfolio yield (net of defaults) below a base rate
(investor coupon plus the servicing fee) averaged over a three-month
period.
A reduction in the seller’s interest below a fixed percentage of the total
principal receivables outstanding.
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•
A failure of the seller, servicer, or the credit enhancement provider to
perform as required by the terms of the pooling and servicing
agreement.
An early return of principal is not always welcomed by investors, so a wellstructured agreement should balance the need for predictable repayment with
the need to maintain satisfactory credit quality.
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Asset Securitization
Risk Management
Impact of Securitization on Bank Issuers
Properly managed, securitization enables a bank to originate a higher volume
of assets while managing deposit insurance and reserve requirement costs;
reducing credit risk, liquidity risk, and interest rate risk; diversifying funding
sources and tenors; and maintaining (and expanding) customer relationships.
The net effects of these benefits can be improved return-on-asset and returnon-equity ratios, enhanced customer service, and reduced exposure to
concentration risks.
Examiners should be aware, however, that management at some banks may
overestimate the risk transfer of securitization or may underestimate the
commitment and resources required to effectively manage the process. Such
mistakes may lead to highly visible problems during the life of the transaction
that could impair future access to the securitization markets as a funding
source. The risks faced by a bank will largely be a function of the roles they
play in the transaction and the quality of the underlying assets they originate
and/or service. The objective of the risk management evaluation performed
by examiners should be to assess the impact of all aspects of securitization on
the overall financial condition and performance of the institution.
Process Management
Banks that have been able to exploit the full range of benefits offered by
securitization typically view the process as a broad-based strategic initiative.
As part of this approach they have integrated their risk management systems
into all facets of the securitization process.
New Product Evaluation
First-time securitizers should ensure that the proposed process has been
thoroughly reviewed before the first transaction. The business plan for
securitization (or for introducing any new product) should detail the business
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rationale, how existing policies should be modified, a performance
measurement process, a list of potential counterparties (credit enhancers,
underwriters, trustees, etc.), and assurances that the bank has adequate
controls and procedures, systems, and risk analysis techniques. The business
proposal should at least provide a description of:
•
•
•
•
•
•
The proposed products, markets, and business strategy;
The risk management implications;
The methods to measure, monitor, and control risk;
The accounting, tax, and regulatory implications;
Any legal implications; and
Any necessary system enhancements or modifications.
All relevant departments should review and approve the proposal. Key
parties normally include the risk oversight function, operations, information
technology, finance/accounting, legal, audit, and senior line management. A
rigorous approval process for new products or activities lessens the risk that
bank management may underestimate the level of due diligence required for
risk management or the ongoing resources required for process management.
Responsibility and Accountability
While ad hoc committees often form the initial steering group for a
securitization transaction, proficient issuers usually assign responsibility for
managing securitization to a dedicated individual or department. This
manager (or group) should have the experience and skills to understand the
various components of securitization and the authority to communicate and
act across product and department lines. The manager should consider the
effects that proposed changes in policies or procedures on origination or
servicing may have on outstanding or future securitization issues. He or she
should communicate observations and conclusions to senior management.
Oversight
All risk management programs should be independently monitored and
evaluated, usually by an internal audit unit or another risk control unit. The
control group determines whether internal control practices are in
accordance with risk management policies, whether controls are adequate,
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whether risk levels are accurately estimated, and whether such levels are
appropriate.
To facilitate the development of internal controls, risk managers should be
informed about the securitization process at the earliest possible stage.
During the initial due diligence for a securitization transaction, the
underwriter (often an investment banker), the rating agencies, and the
independent outside accountants thoroughly review the bank’s securitization
process. Their review, however, takes place primarily in the early stages of
the process; they do little direct review after the initial transaction is
complete. At that point, the bank’s internal oversight takes on vast
importance.
The bank’s risk control unit should report directly to a senior executive to
ensure the integrity of the process. The unit, which should evaluate every
role the bank has in securitization, should pay special attention to the
origination and servicing operations. In the origination area, the unit should
take significant samples of credit decisions, verify information sources, and
track the approval process. In the servicing area, the unit should track
payment processing, collections, and reporting from the credit approval
decision through the management and third-party reporting process. The
purpose of these reviews is to ensure that activities are consistent with policy
and trust agreements and to detect operational weaknesses that leave the
bank open to fraud or other problems. Risk managers often suggest policies
or procedures to prevent problems, such as documenting exceptions to bank
policies. Any irregularities discovered in the audits should be followed up
and discussed with senior management.
Monitoring of Securitization Transactions
Management reports should monitor the performance of the underlying asset
pools for all outstanding deals. Although the bank may have sold the
ownership rights and control of the assets, the bank’s reputation as an
underwriter or servicer remains exposed. To control the impact of
deterioration in pools originated or serviced by the bank, a systematic
reporting process allows management to track pool quality and performance
throughout the life of the transactions.
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Reports on revolving transactions (credit cards, home equity lines, etc.)
should monitor:
•
•
•
•
•
•
•
The portfolio’s gross yield;
Delinquencies;
The charge-off rate;
The base rate (investor coupon plus servicing fees);
Monthly excess spread;
The rolling three-month average excess spread; and
The monthly payment rate.
Reports on securities backed by installment loans (automobiles, equipment
leases, etc.) should monitor:
•
•
•
•
•
The charge-off rate;
The net portfolio yield (portfolio yield minus charge-offs);
Delinquencies (aged);
Principal prepayment speeds; and
Outstanding principal compared to original security size.
Communication with Outside Parties
To maintain market confidence, reputation, and the liquidity of securities,
issuers and servicers should be able to supply accurate and timely
information about the performance of underlying assets to investors, rating
agencies, and investment bankers. The bank’s cost of accessing the capital
markets can depend on this ability. The securitization manager or
management unit should regularly verify information on performance.
Risks and Controls
Although it is common for securitization transactions to receive substantial
attention early in their lives, the level of scrutiny generally declines over time.
Many of the problems that institutions have experienced, such as rising
delinquencies and charge-offs, inaccurate investor reporting, and bad
publicity, have occurred in the later stages of the transaction. The bank
should supervise and monitor a transaction for the duration of the institution’s
involvement.
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Examiners assess banking risk relative to its impact on earnings and capital.
From a supervisory perspective, risk is the potential that events, expected or
unanticipated, will have an adverse impact on the bank’s earnings or capital.
The primary risks associated with securitization activities are reputation,
strategic, credit, transaction, liquidity, and compliance. The types and levels
of risk to which a particular banking organization is exposed will depend
upon the organization’s role or roles in the securitized transactions. The
definitions of these risks and their pertinence to securitization are discussed
below. For more complete definitions, see the “Bank Supervision Process”
booklet of the Comptroller’s Handbook.
Reputation Risk
Reputation risk is the risk to earnings or capital arising from negative public
opinion. This affects the institution’s ability to establish new relationships or
services or continue servicing existing relationships. This risk can expose the
institution to litigation, financial loss, or damage to its reputation. Reputation
risk is present throughout the organization and includes the responsibility to
exercise an abundance of caution in dealing with its customers and
community.
Nature of Reputation Risk
Exposure to reputation risk is essentially a function of how well the internal
risk management process is working in each of the other risk categories and
the manner and efficiency with which management responds to external
influences on bank-related transactions. Reputation risk has a “qualitative”
nature, reflecting the strength of an organization’s franchise value and how it
is perceived by other market participants. This perception is usually tied to
performance over time. Although each role a bank plays in securitization
places its reputation on the line, it stakes its reputation most heavily on the
quality of the underlying receivables and the efficiency of its servicing or
other fiduciary operations.
Asset performance that falls short of expectations will reflect poorly on the
underwriting and risk assessment capabilities of the originator. Because the
asset performance of securitized pools is publicly disclosed and monitored by
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market participants, securitization can highlight problems that were less
obvious when reported as a smaller component of overall portfolio
performance.
The best evidence of positive or negative perception is how the market
accepts and prices newly issued asset-backed securities. Poorly performing
assets or servicing errors on existing transactions can increase the costs and
decrease the profitability of future deals. Reputation as an underwriter or
servicer is particularly important to issuers that intend to securitize regularly.
For some issuers, negative publicity from securitization transactions may
cause the market to avoid other liability as well as equity issuances.
Managing Reputation Risk
The most effective method of controlling reputation risk is a sound business
plan and a comprehensive, effective risk management and control framework
that covers all aspects of securitization activities. Up-front effort will
minimize the potential for unexpected errors and surprises, most of which are
quite visible to public market participants.
Management of reputation risk often involves business decisions that extend
beyond the technical, legal, or contractual responsibilities of the bank. For
securitization activities, problems are most often associated with revolving
assets. Although the bank has transferred legal liability for performance of
such receivables, it is nevertheless closely associated with the assets through
servicing, through replacement receivables sales, or simply by name.
Decisions to protect franchise value by providing additional financial support
should be made with full recognition of the potential long-term market,
accounting, legal, and regulatory impacts and costs.
Strategic Risk
Strategic risk is the risk to earnings and capital arising from adverse business
decisions or improper implementation of those decisions. This risk is a
function of the compatibility of an organization’s strategic goals, the business
strategies developed to achieve those goals, the resources deployed against
those goals, and the quality of implementation. The resources needed to
carry out business strategies are both tangible and intangible. They include
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communication channels, operating systems, delivery networks, and
managerial capacities and capabilities.
Nature of Strategic Risk
To assess a bank’s strategic risk exposure, one must recognize the long-term
impacts of securitization on operations, profitability, and asset/liability
management. Such exposure increases if transactions are undertaken without
considering the long-term internal resource requirements. For example,
while the existing systems in the credit and collections department may be
adequate for normal operations, securitization transactions are often
accompanied by rapid growth in the volume of transactions and more timely
and precise reporting requirements. At a minimum this may require
improved computer systems and software and dedicated operational and
treasury personnel. Business and strategic plans should delineate the longterm resources needed to handle the projected volume of securitization.
Decisions on credit quality and origination also expose a bank to strategic
risk. The availability of funding, the opportunity to leverage systems and
technology, and the ability to substantially increase fee income through
securitization should not lure issuers into a business line about which they
don’t have sufficient knowledge. For example, banks that are successful at
underwriting and servicing ’A’ quality paper may not be as successful with
’B/C’ paper, because different skills are needed to service higher risk loans.
Banks that have been successful in entering new product lines are those that
have first acquired the necessary expertise.
Competition is a prime source of strategic risk. Securitization provides
economical funding to a far greater pool of credit originators than banks have
traditionally had to compete against. The long-term effects of this greater
competition may be to erode profit margins and force banks to seek further
efficiencies and economies of scale. Tighter profitability margins diminish
the room for error, increasing the importance of strategy. Many market
participants (including banks) will be forced to find where their competitive
advantages lie and what new or additional skills they need to compete.
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Managing Strategic Risk
Before initiating a securitization transaction, management should compare
the strategic and financial objectives of proposed securitization activities with
the risk exposures and resource requirements. A thorough analysis would
include the costs of the initial transaction and any systems or technology
upgrades necessary to fulfill servicing obligations. Because securitization
affects several different areas in a bank, the assessment should describe the
responsibilities of each key person or department. Each manager responsible
for an area involved in the securitization process should review the
assessment.
Credit Risk
Credit risk is the risk to earnings or capital arising from an obligor’s failure to
meet the terms of any contract with the bank or otherwise to perform as
agreed. Credit risk is found in all activities where success depends upon
counterparty, issuer, or borrower performance. It arises any time bank funds
are extended, committed, invested, or otherwise exposed through actual or
implied contractual agreements, whether on or off the balance sheet.
One of the primary benefits of securitization is its usefulness in managing
credit risk exposure. For example, overall portfolio quality may improve
because of the opportunity to diversify exposure to a particular industry (e.g.,
oil and gas, real estate, retail credit, etc.) or geographic area. Securitization
structures reduce the credit exposure of the assets sold by transferring the
unexpected portion of the default risk to credit enhancement providers and
investors. Effective risk management requires recognizing the extent and
limits of this risk transfer and planning for the capital and other resource
requirements necessary to support the remaining risk levels.
Nature of Credit Risk
Although financial reporting and regulatory risk-based capital practices are
useful indicators of the credit impact of securitization on a bank, these
guidelines do not fully capture the economic dimensions of the originator’s
exposure to credit risk from a sale of securitized assets. Although important,
an examiner’s inquiry should extend beyond whether the sale of assets is
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accounted for on or off the balance sheet. It should assess the fundamental
residual credit risks left with the bank after the transaction. In addition, the
assessment should be made in the context of a total return standard rather
than focusing solely on absolute loss and delinquency levels. For example,
some pools, such as sub-prime automobile loans, are expected to have
relatively high loss and delinquency rates. These pools, if properly
underwritten, can be economically successful as long as the pricing and
structure of the loans reflects the inherent risks.
A bank that sells assets in a securitization transaction confronts three main
forms of credit risk:
•
•
•
Residual exposure to default.
Credit quality of the remaining on-balance-sheet portfolio.
Possibility that it will have to provide moral recourse.
Default Exposure. Securitizing banks must evaluate how much default risk
remains with them after a sale. Quantifying the residual default risk or
contingent liability requires an in-depth review of the cash flow structure of
the transaction and its third-party support. In most structures, credit risk is
allocated so that the originator bears default losses up to a certain point,
typically based on historic losses and projected performance. The first loss
exposure assumed by the originator is a function of its acceptance of excess
portfolio yield as a residual interest, that is, after the coupon and servicing
expense are paid and loan losses are calculated. As pool performance
deteriorates and charge-offs increase, excess spread (which could eventually
return to the bank) declines.
Subject to certain structural provisions, excess spread may be diverted to fund
or supplement cash collateral accounts for the benefit of investors and credit
enhancers. Once excess spread is exhausted, the risks of credit default
customarily shift to credit enhancers up to some additional multiple of
projected losses. Only defaults above these multiples are borne by investors.
As previously discussed, other protective measures, such as early
amortization provisions, insulate investors and, to some extent, credit
enhancers. Since losses of the magnitude required to trigger early
amortization are infrequent, originators effectively absorb a substantial
portion of realized losses in most securitized pools.
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Remaining Asset Quality. Securitization readily lends itself to high-quality
assets that provide a predictable, steady cash flow stream. Higher and more
predictable net cash flows translate into lower credit enhancement fees and
higher excess spread income. This may tempt banks to securitize the betterquality assets while keeping lower quality assets on the balance sheet.
Because a bank new to the securitization markets does not have a track
record with investors, it may be especially inclined to do so. If this approach
becomes a habit, the bank will be required to hold more capital and loan loss
reserves for the assets that remain on the books. Such an approach can
compromise the integrity of loan loss reserve analyses that are based on
historical performance.
Moral Recourse. Most prospectuses on asset-backed securities issued by
banks clearly state that the offering is not an obligation of the originating
bank. Despite this lack of legal obligation, in certain circumstances an
originator may feel compelled to protect its name in the marketplace by
providing support to poorly performing asset pools. Because there is some
precedent in the market for preventing ratings downgrades or early
amortization, many investors expect sponsors to aid distressed transactions.
Deciding to provide financial support for sold assets is difficult for banks. In
addition to the immediate costs associated with steps to improve the yield on
the asset pool, there may be other accounting, legal, and regulatory costs.
For example, actions taken to support previously sold assets may compromise
both the transaction’s legal standing as a sale and the ability to treat the assets
as off-balance-sheet items for GAAP and regulatory capital purposes. If this
occurs, performance ratios, regulatory capital charges, and perhaps the tax
treatment of the transaction may be affected.
Prudent business practice dictates that management consider all of the
potential costs of providing additional enhancement to poorly performing
asset pools. Not only would the bank supply direct financial support but it
may also be obliged by its assumption of greater risk to meet a higher capital
requirement. From a practical viewpoint, examiners should recognize that
banks may decide to support outstanding securitization transactions to retain
access to the funding source, even though doing so may require them to hold
additional capital. For example, if bankers were to allow early amortization,
they might need to obtain both new funding for the assets returning to the
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balance sheet and additional risk-based capital. Although such a decision is
for management to make, examiners should ensure appropriate risk-based
capital levels are maintained for the risks assumed. (See the risk-based capital
discussion under “Other Issues” for additional guidance.)
Other Credit Quality Issues. Banks can also assume credit risk exposure from
securitized asset pools by becoming a credit enhancer for assets originated by
a third party. Doing so exposes a bank to credit risk from a pool of loans it
had no part in originating. So credit-enhancing banks must understand the
transaction structure and perform adequate due diligence, especially when
exceptions to underwriting policies and overrides are involved.
Managing Credit Risk
Because originating banks absorb most of the expected losses from both onbalance-sheet and securitized pools, sound underwriting standards and
practices remain the best overall protection against excessive credit exposure.
These banks should include experienced credit personnel in the strategic and
operating decision-making process. Investment-banker, marketing, or other
volume-oriented parties should not drive the process. Often, sustained
periods of dramatic growth, aggressive teaser rates, and liberal balance
transfer strategies are indications of an easing of underwriting standards. No
matter how competitive the market, decisions on credit quality should be
careful ones. In effective risk management systems, audit or credit review
functions regularly test the lenders’ compliance with underwriting standards
for both on- and off-balance-sheet credits.
Most banks recognize the broad effects of securitization on credit risk and
strategically attempt to ensure that sold and retained loans are of the same
general quality. To protect against the tendency to loosen underwriting
standards for pools that lenders believe may be sold, many banks require that
all loans be subject to the same loan policy and approval process. To
minimize the potential that the quality of securitized and retained loans
differ, many banks employ a random selection process to ensure that every
pool of assets reflects the overall quality of the portfolio and underwriting
standards. If a business decision is made to choose a specific quality of loans
for sale, special precautions are warranted.
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If the sold loans are of higher quality than retained loans, then management
should acknowledge the increased level of on-balance-sheet risk by ensuring
that the bank’s capital level and allowance for loan and lease losses are
maintained at appropriate levels. If sold loans are to be lower quality than
retained loans, the business and/or capital plans should acknowledge the
increased vulnerability to moral recourse.
Other Credit Issues
Automated Underwriting Systems. Because securitization rewards
economies of scale and allows a bank to originate a greater volume of
receivables, many originators now use automated underwriting systems such
as credit scoring and the electronic services of ratings companies such as Dun
& Bradstreet. The objective is to speed credit approvals by allowing
computers to accept (or reject) the large number of applications that are well
within (or outside) the underwriting guidelines. Marginal applications are
then processed individually. Use of these systems also improves the ability to
predict and model pool performance, which in turn can lower the cost of
credit enhancement and security coupon rates.
In addition to loan quality problems, poorly designed automated
underwriting and scoring systems can adversely affect some borrowers or
groups of borrowers. The bank’s CRA policy, or loan policy, should address
the needs of low- to moderate-income members of the trade area. The bank
should be aware of the possibility of economic redlining, which could be
caused, in part, by its desire to conform to the criteria handed down by the
secondary market. Compliance reviews should include originations for
securitization to ensure compliance with CRA. Automated scoring systems
should be managed like other risk management models. For example, they
should be tested periodically for continued relevance and validity.
Stress Testing of Securitized Pools. Many banks use cash flow models to
simulate the structure and performance of their securitized asset pools. These
models trace funds through the proposed transaction structure, accounting for
the source and distribution of cash flows under many possible scenarios.
Because the cash flows from any pool of assets can vary significantly
depending on economic and market events, banks often subject proposed
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structures to severe stress-testing to predict the loss exposures of investors and
credit enhancers under most-likely and worst-case scenarios.
The effectiveness of models used to predict the performance of loan pools
depends on disciplined adherence to clear underwriting standards for
individual loans. Although a potentially powerful tool, models can be
misused, become outdated, or skew results because of inaccurate or
incomplete information. Any of these factors may cause projections to vary
from the actual performance of the asset pool. To control potential
weaknesses, management should back-test model results regularly, revalidate
the logic and algorithms, and ensure the integrity of data entry/capture and
assumptions.
Vintage Analysis. Another technique used to monitor loan quality and
estimate future portfolio performance is vintage analysis. This type of
analysis tracks delinquency, foreclosure, and loss ratios for similar products
over comparable time periods. The objective is to identify sources of credit
quality problems (such as weak or inappropriate underwriting standards) early
so that corrective measures can be taken. Because loan receivables often do
not reach peak delinquency levels until they have seasoned for several
months, tracking the payment performance of seasoned loans over time
allows the bank to evaluate the quality of newer receivables over comparable
time periods and to forecast the impact that aging will have on portfolio
performance.
Disclosure vs. Confidentiality. Most commercial loan files contain a
substantial amount of nonpublic information. Much of this information is
confidential. Although banks want to honor this confidence, they also feel
obligated to disclose all the material information that a prospective investor
should know. The problem is less daunting with homogeneous consumer
loan products that lend themselves to aggregate performance analysis than it
is in the growing markets for small business loans and other commercial loan
products.
Bank policy on securitization of commercial loans should address the
disclosure of confidential information provided by borrowers that are
privately owned companies. The bank should obtain legal advice concerning
what information should be disclosed or not disclosed about an issue of
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securitized loans. Bank counsel should also sign off on decisions whether to
inform borrowers of the disclosure of nonpublic information. To avoid
problems with large commercial borrowers, bank management may wish to
routinely obtain an acknowledgment or release from customers.
Transaction Risk
Transaction risk is the risk to earnings or capital arising from problems with
service or product delivery. This risk is a function of internal controls,
information systems, employee integrity, and operating processes.
Transaction risk exists in all products and services.
For most securitized asset sales, the responsibility for servicing the assets is
retained by the originator. This obligation usually extends throughout the life
of the issued securities. Since the fee associated with servicing the portfolio
is typically fixed, the risk of inefficiency from an operational point of view is
retained by the originator. The length of the obligation and the volumedriven nature of these activities increase the possibility that banks, especially
those with limited securitization experience, will overestimate their capacity
to meet obligations, will underestimate the associated costs, or both.
Nature of Transaction Risk
The pooling and servicing agreement is the primary document defining the
servicers’ responsibilities for most securitization transactions. Transaction risk
exposure increases when servicers do not fully understand or fulfill their
responsibilities under the terms of this agreement. Servicing difficulties, such
as incorrect loan and payment processing, inefficient collection of delinquent
payments, or inaccurate investor reporting, expose the servicer to transaction
risk. Effective servicing helps to ensure that receivables’ credit quality is
maintained. The main obligations assumed by the servicing bank are
transaction processing, performance reporting, and collections.
Transaction Processing. Processing problems can occur when existing bank
systems, which were designed to service volumes and types of loans that met
certain portfolio objectives and constraints, are now subject to larger volumes
or unanticipated loan types. Excessive volume may overextend systems and
contribute to human error.
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For most deals, the servicer agrees to service and administer the receivables
in accordance with its customary practices and guidelines. The servicer also
has the responsibility and authority to make payments to and withdrawals
from deposit accounts that are governed by the documents. Servicers are
typically paid a fixed percentage of the invested amount for their obligation
to service the receivables (often between 1.5 percent and 2.5 percent for
consumer products such as credit cards). Many bank servicers are highly
rated and are able, under the pooling and servicing agreement, to commingle
funds until one business day before the distribution date. Those lacking
short-term, unsecured ratings of ’A-1’ or better must customarily deposit
collections in an eligible deposit account at another institution within one or
two business days of receipt.
Reporting. Bank management, investors, and rating agencies all require that
the performance of security pools be reported accurately and in a timely
manner. Such reporting can be an especially difficult challenge for first-time
issuers or for banks without integrated systems. For example, reporting
difficulties have occurred when lead banks or holding companies have
attempted to pool loans from various affiliates with different processing and
reporting systems, or when bank-sponsored conduits have pooled receivables
from various third-party originators. Servicing agreements are usually specific
about the timing of payment processing and the types and structures of
required reports, and trustees and investors have little tolerance for errors or
delays.
Collections. A bank may also be exposed to transaction risk when its systems
or personnel are not compatible with new types of borrowers or new
products. Although securitization often provides incentives to expand
activity beyond traditional markets and products, the staff members of some
banks have done business only with certain customer types or are used to
considerable flexibility in dealing with customers, particularly in workout
situations. These bankers may have difficulties adjusting to the restrictions or
specific requirements of securitization agreements. For example, the decision
to compete for market share by expanding into markets for borrowers with
poor credit histories may require a change in collection methods. Front-line
relationship managers may be uncomfortable with the labor-intensive
methods necessary for long-term success in this market segment, and pool
performance may suffer.
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The increased transaction volumes and risk transfers associated with
securitization have, in some ways, depersonalized the lending and
collections process. For example, limiting bankers’ ability to work out
problems with customers may pose special problems. In order to maintain
strong relationships with customers, some bankers may wish to ignore the
limits of typical pool requirements in renegotiating repayment terms and
collateral positions. If longstanding customer relationships are valuable
enough, some bankers may decide to repurchase securitized loans and draw
up more flexible workout terms. Management should recognize that
decisions to repurchase loans may compromise “sales treatment” for some
transactions.
Liquidity Enhancement. As part of the servicing agreement, seller/servicers
are sometimes obligated to enhance the liquidity of receivables securitized.
The purpose of doing so is not to protect against deterioration in the credit
quality of the underlying receivables but rather to ensure that the security
issuer (the trust) will have sufficient funds to pay obligations as scheduled.
Funding becomes necessary when the due date of payments to investors
arrives before sufficient collections accrue. This liquidity enhancement
requires a servicer to make cash advances to the trustee on behalf of obligors
who may not pay as scheduled or estimated. However, a servicer can usually
exempt itself from making such advances by formally determining that the
funds would not be recoverable. In many cases the accuracy of a servicer’s
“recovery determination” is reviewable by the trustee. If the servicer does
advance funds against receivables that later default for credit quality
purposes, the liquidity provider obtains the investor’s rights to use proceeds
from the credit enhancement to repay any advances it has made.
Managing Transaction Risk
The effective management of servicing obligations requires a thorough
understanding of the securitization process and especially the associated
information and technology requirements. To reduce the bank’s exposure to
transaction risk, management should evaluate staffing, skill levels, and the
capacity of systems to handle the projected type and volume of transactions.
The largest hurdle is typically the development of system enhancements that
provide timely and accurate information on both the securitized loan pools
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and the bank’s remaining portfolio. Reports should be designed and
modified as necessary to allow servicing managers to evaluate the
performance of specific loan types and to monitor continuing performance.
Quality control of the servicing operation may require periodic reports and
an analysis of borrowers’ complaints, which are usually about servicing
problems or loan quality. The servicer should also have adequate insurance
against errors and omissions. The volume and types of loans serviced by the
bank will dictate the amount of insurance.
To mitigate transaction risk exposure, pooling and servicing agreements
usually require independent accounting reviews of the servicer at least
annually. These reviews result in written opinions on the servicer’s
compliance with the documents and on the adequacy of its operating policies
and procedures. Efficient servicers supplement this annual external review of
operations with periodic internal reviews.
Servicing capabilities, which should be a subject of long-range technology
planning, should keep pace with projected volumes. Plans for servicing
should prepare the company to resolve possible incompatibilities of loan
systems within the company, as well as incompatibilities of internal systems
with pools purchased from third parties. Every bank should have a back-up
system, which should be tested at least annually. At a minimum, the
guidelines provided in Banking Circular 177, “Corporate Contingency
Planning,” must be followed.
Liquidity Enhancement. In view of the responsibilities and liabilities that may
accrue to the servicer as a liquidity provider, a formal policy should be
developed that determines how the bank will respond to situations that
require funds to be advanced. Servicers who provide back-up liquidity will
often protect against exposure to deteriorating asset quality by defining a
borrowing base of eligible (performing) assets against which they will
advance. They may require that there be no existing breach of covenants or
warranties on the loans, and that neither borrowers nor seller have initiated
bankruptcy proceedings. Liquidity providers will often have senior liens on
the eligible assets, or will otherwise be senior to credit enhancement facilities
or other obligations of the issuer.
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Liquidity Risk
Liquidity risk is the risk to earnings or capital arising from a bank’s inability to
meet its obligations when they come due, without incurring unacceptable
losses. Liquidity risk includes the inability to manage unplanned decreases or
changes in funding sources. Liquidity risk also arises from the bank’s failure
to recognize or address changes in market conditions that affect the ability to
liquidate assets quickly and with minimal loss in value.
Given adequate planning and an efficient process structure, securitization can
provide liquidity for balance sheet assets, as well as funding for leveraging
origination capacity. This not only provides banks with a ready source of
managed liquidity, but it increases their access to, and presence in, the
capital markets.
Nature of Liquidity Risk
The securitization of assets has significantly broadened the base of funds
providers available to banks and created a more liquid balance sheet. Too
much reliance on a single funding vehicle, however, increases liquidity risk.
Banks must prepare for the possible return of revolving-credit receivable
balances to the balance sheet as a result of either scheduled or early
amortization. The primary risk is the potential that large asset pools could
require balance sheet funding at unexpected or inopportune times. This risk
threatens banks that do not correlate maturities of individual securitized
transactions with overall planned balance sheet growth. This exposure is
heightened at banks that seek to minimize securitization costs by structuring
each transaction at the maturity offering the lowest cost, without regard to
maturity concentrations or potential long-term funding requirements.
A second concern is unmitigated dependence on securitization markets to
absorb new asset-backed security issues — a mistake that banks originating
assets specifically for securitization are more likely to make. Such a bank
may allocate only enough capital to support a “flow” of assets to the
securitization market. This strategy could cause funding difficulties if
circumstances in the markets or at the bank were to force the institution to
hold assets on its books.
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Managing Liquidity Risk
The implications of securitization for liquidity should be factored into a
bank’s day-to-day liquidity management and its contingency planning for
liquidity. Each contemplated asset sale should be analyzed for its impact on
liquidity both as an individual transaction and as it affects the aggregate funds
position.
Liquidity management issues include:
•
•
•
•
•
The volume of securities scheduled to amortize during any particular
period;
The plans for meeting future funding requirements (including when
such requirements are expected);
The existence of early amortization triggers;
An analysis of alternatives for obtaining substantial amounts of liquidity
quickly; and
Operational concerns associated with reissuing securities.
The bank should monitor all outstanding transactions as part of day-to-day
liquidity management. The bank should develop systems to ensure that
management is forewarned of impending early amortization triggers, which
are often set off by three successive months of negative cash flow (excess
spread) on the receivables pool. Management should be alerted well in
advance of an approaching trigger so that preventive actions can be
considered. Thus forewarned, management should also factor the maturity
and potential funding needs of the receivables into shorter-term liquidity
planning.
Contingency planning should anticipate potential problems and be thorough
enough to assume that, during a security’s amortization phase, management
will be required to find replacement funding for the full amount of the
receivables. Plans should outline various funding alternatives, recognizing
that a complete withdrawal from the securitization market or a cutback in
lending could affect the bank’s reputation with investors and borrowers.
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Compliance Risk
Compliance risk is the risk to earnings or capital arising from violations or
nonconformance with laws, rules, regulations, prescribed practices, or ethical
standards. Compliance risk also arises in situations where the laws or rules
governing certain bank products or activities of the bank’s clients may be
ambiguous or untested. Compliance risk also exposes the institution to fines,
civil money penalties, payment of damages, and the voiding of contracts.
Compliance risk can lead to a diminished reputation, reduced franchise
value, limited business opportunities, lessened expansion potential, and lack
of contract enforceability.
Consumer laws and regulations, including fair lending and other antidiscrimination laws, affect the underwriting and servicing practices of banks
even if they originate loans with the intent to securitize them. Management
should ensure that staff involved in the underwriting and servicing functions
(including collections) comply fully with these laws and regulations.
Examiner’s should refer to the Comptroller’s Handbook for Compliance for
detailed guidance on identifying and assessing compliance risk in the lending
process.
Other Issues
There are two significant events, effective January 1, 1997, that affect the
capital and financial reporting requirements for sales of assets associated with
securitization transactions. First, the Federal Financial Institutions
Examination Council (FFIEC) decided that banks should follow generally
accepted accounting principles (GAAP) for their quarterly reports of condition
and income (call reports). Second, The Financial Accounting Standards
Board (FASB) adopted Financial Accounting Standard 125, “Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”
(FAS 125). Both of these changes affect how banks must recognize revenue
and maintain capital for securitization transactions.
Accounting
Under GAAP, the applicable accounting guidance for asset transfers in a
securitization transaction is FAS 125. Although primarily concerned with
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differentiating sales from financing treatment, FAS 125 also describes how to
properly account for servicing assets and other liabilities in securitization
transactions. FAS 125 applies to all types of securitized assets, including auto
loans, mortgages, credit card loans, and small business loans. FAS 125
replaced previous accounting guidance including FAS 77, “Reporting by
Transferor for Transfers of Receivables with Recourse,” FAS 122, “Accounting
for Mortgage Servicing Rights,” and various guidance issued by FASB’s
Emerging Issues Task Force.
Generally, the accounting treatment for an asset transfer under FAS 125 is
determined by whether legal control over the financial assets changes.
Specifically, a securitization transaction will qualify for “sales” treatment (i.e.,
removal from the seller’s reported financial statements) if the transaction
meets the following conditions:
•
The transferred assets are isolated from the seller (that is, they are
beyond the reach of the seller and its creditors, even in bankruptcy or
other receivership);
•
The buyer can pledge or exchange the transferred assets, or the buyer is
a qualifying special-purpose entity and the holders of the beneficial
interests in that entity have the right to pledge or exchange those
interests; and
•
The seller does not retain effective control over the transferred assets
through an agreement that
-
Both entitles and obligates it to repurchase the assets before
maturity, or
Entitles it to repurchase transferred assets that are not readily
obtainable in the market.
If the securitization transaction meets the FAS 125 criteria, the seller:
•
•
•
Removes all transferred assets from the balance sheet;
Recognizes all assets obtained and liabilities incurred in the transaction
at fair value; and
Recognizes in earnings any gain or loss on the sale.
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Any recourse obligation in a transaction qualifying for sales treatment should
be recorded as a liability, at fair value, and subtracted from the cash received
to determine the gain or loss on the transaction. If the “sales treatment”
criteria are not met, the transferred assets remain on the balance sheet and
the transaction is accounted for as a secured borrowing (and no gain or loss is
recognized).
A Sample Transaction. The adoption of GAAP for regulatory reporting
purposes and FAS 125 change the accounting for asset sales associated with
securitization transactions. Certain gains or losses that were deferred under
previous regulatory accounting practices are now recognized on the sale
date.
The following is an example of the accounting entries a seller might make
when transferring credit card receivables to a master trust:
The initial sales transaction:
Principal amount of initial receivables pool:
Carrying amount net of specifically allocated
loss reserve
Servicing fee (based on outstanding receivables balance)
Up-front transaction costs:
Seller’s interest:
Value of servicing asset
Transaction structure
$120,000
$117,000
2%
$
600
$ 20,000
$ 1,500
Fair Value*
Allocated
% of total
Fair Value
Carrying
Amount
Portion
Sold
Class A
$ 100,000
(117/124.5)
$ 93,976
$ 93,976
Seller’s Interest
$ 20,000
(117/124.5)
$ 18,795
$ 18,795
IO Strip**
$
3,000
(117/124.5)
$ 2,819
$ 2,819
Servicing
$
1,500
(117/124.5)
$ 1,410
$ 1,410
Total
$124,500
$117,000
Portion
Retained
$ 93,796
$ 23,024
*Must be estimated. See guidance under “Estimating Fair Value.”
**An IO (interest-only) strip is a contractual right to receive some or all of the interest due on an
interest bearing financial instrument. In a securitization transaction, it refers to the present value of the
expected future excess spread from the underlying asset pool.
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The journal entries to record the initial transaction on the books of the bank
are:
Entry #1.
Cash
IO Strip
Servicing Asset
Seller’s Certificate
Debits
$99,400
2,819
1,410
18,795
Net Carrying Amount of Loans
Pretax Gain
($100,000 - 600)
Credits
$117,000
5,424
(To record securitization transaction by recognizing assets retained and by removing assets
sold.)
FAS 125 requires the seller to record the IO strip at its allocated cost.
However, since the IO strip is treated like a marketable equity security, it
must be carried at fair market value throughout its life. Therefore, adjusting
entries are necessary if the asset’s estimated value changes. The following
journal entry represents the recognition of an increase in the fair value of the
asset. (The reverse of this entry would occur if the periodic estimate found
that the value had declined or been impaired.)
Entry #2.
IO Strip
$181
Equity
$181
(To measure an IO strip categorized as an available-for-sale security at its fair market value as
required under FAS 115).
As the bank receives cash associated with excess spread from the trust, the
effect of the journal entries is to increase cash and reduce the amount of the
IO strip. In effect, the entry would be:
Entry #3.
Cash
$10
IO Strip
$10
(To recognize cash “excess spread” from the trust.)
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If the transaction meets the FAS 125 sales criteria, a selling bank should
recognize the servicing obligation (asset or liability) and any residual interests
in the securitized loans retained (such as the IO strip and the seller’s
certificate). The bank should also recognize as assets or liabilities any written
or purchased options (such as recourse obligations), forward commitments, or
other derivatives (e.g., commitments to deliver additional receivables during
the revolving period of a securitization), or any other rights or obligations
resulting from the transaction.
Estimating Fair Value. FAS 125 guidance states that the fair value of an asset
(or liability) is the amount for which it could be bought or sold in a current
transaction between willing parties — that is, in other than a forced
liquidation sale. Quoted market prices in active markets are the best
evidence of fair value and, if available, shall be used as the basis for the
pricing.
Unfortunately, it is unlikely that a securitizer will find quoted market prices
for most of the financial assets and liabilities that arise in a securitization
transaction. Accordingly, estimation is necessary. FAS 125 says that if
quoted market prices are not available, the estimate of fair value shall be
based on the best information available. Such information includes prices for
similar assets and liabilities and the results of valuation techniques such as:
•
•
•
•
•
The present value of estimated expected future cash flows using a
discount rate commensurate with the risks involved;
Option-pricing models;
Matrix pricing;
Option-adjusted spread models; and
Fundamental analysis.
These techniques should include the assumptions about interest rates, default
rates, prepayment rates, and volatility that other market participants employ
in estimating value. Estimates of expected future cash flows should be based
on reasonable and supportable assumptions and projections. All available
evidence should be considered in developing estimates of expected future
cash flows. The weight given to the evidence should be commensurate with
the extent to which the evidence can be verified objectively. If a range is
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estimated for either the amount or timing of future cash flows, the likelihood
of possible outcomes should be considered to determine the best estimate.
Recognition of Servicing. A servicing asset should be recorded if the
contractual servicing fee more than adequately compensates the servicer.
(Adequate compensation is the amount of income that would fairly
compensate a substitute servicer, and includes the profit that would be
required in the market place.) The value of servicing assets includes the
contractually specified servicing fees, late charges, and other related fees and
income, including float.
A servicing liability should be recorded when the estimated future revenues
from stated servicing fees, late charges, and other ancillary revenues are not
expected to adequately compensate the servicer for performing the servicing.
The recorded value of servicing rights is initially based on the fair value of the
servicing asset relative to the total fair value of the transferred assets.
Servicing assets must be amortized in proportion to estimated net servicing
income and over the period that such income is received. In addition,
servicing assets must be periodically evaluated and measured for impairment.
Any impairment losses should be recognized in current period income.
According to FAS 125, servicing assets should be subsequently measured and
evaluated for impairment as follows:
1.
Stratify servicing assets based on one or more of their predominant risk
characteristics. The risk characteristics may include financial asset type,
size, interest rate, date of origination, term, and geographic location.
2.
Recognize impairment through a valuation allowance for each
individual stratum. Impairment should be recognized as the amount by
which the carrying amount of a category of servicing assets exceeds its
fair value. The fair value of servicing assets that have not been
recognized should not be used in this evaluation.
3.
Periodically adjust the valuation allowance to reflect changes in
impairment. However, appreciation in the fair value of a stratum of
servicing assets over its carrying amount should not be recognized.
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Treatment of Excess Cash Flows. The right to future income in excess of
contractually stated servicing fees should be accounted for separately from
the servicing asset. The right to these cash flows is treated as an interest-only
strip and accounted for under FAS 115 as either an available-for-sale or
trading security.
If IO strips or other receivables or retained interests in securitizations can be
contractually prepaid or settled in a way that the holder might not
substantially recover its recorded investment, FAS 125 requires that they be
measured at fair value and that the treatment be similar to that given
available-for-sale and trading securities under FAS 115. Accordingly, these
items are initially recorded at allocated fair value. (Allocating fair value
refers to apportioning the previous carrying amount of the transferred assets
between the assets sold and the interests retained by the seller based on their
relative fair values at the date of transfer. See example entry #1.) These items
are periodically adjusted to their estimated fair value (example entry #2)
based on their expected cash flows.
Recognition of Fees. The accounting treatment of fees associated with loans
that will be securitized should be in accordance with FAS 91, “Accounting
for Nonrefundable Fees and Costs Associated with Originating or Acquiring
Loans and Initial Direct Costs of Leases” and FAS 65, “Accounting for Certain
Mortgage Banking Enterprises.” In accordance with these statements’
standards for pools of loans that are held for sale, the loan origination fees
and direct loan origination costs should be deferred and recognized in
income when the loans are sold.
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Risk-Based Capital4
Asset Sales without Recourse
Securitization can have important implications for a bank’s risk-based capital
requirement. (For a more complete discussion of OCC risk-based capital
requirements, see the “Capital and Dividends” section of the Comptroller’s
Handbook.) If asset sales meet the “sale” requirements of FAS 125 and the
assets are sold without recourse, the risk-based capital standards do not
require the seller to maintain capital for the assets securitized. The primary
attraction of securitization for bank issuers (notwithstanding the wealth of
liquidity inherent in selling loans quickly and efficiently for cash) is the ability
to avoid capital requirements while realizing considerable financial benefits
(e.g., servicing fees, excess servicing income, and origination fees). Several
of the “pure play” or monoline banks have off-balance-sheet, securitized
assets that are several times larger than their on-balance-sheet loan amounts.
Although the risk-based capital standards are heavily weighted toward credit
risk, a bank’s capital base must also be available to absorb losses from other
types of risk, such as funding source concentrations, operations, and liquidity
risk. For this reason, it is prudent for banks to evaluate all of the exposures
associated with securitizing assets, especially revolving assets such as credit
cards and home equity lines of credit for which the bank retains a close
association with the borrower even after a specific receivable balance has
been sold.
Using models or other methods of analysis, a bank should allocate the
appropriate amount of capital to support these risks. At least two major offbalance-sheet risk areas pertinent to securitization are not specifically
discussed in the minimum capital requirements of risk-based capital:
•
•
4
Servicing obligations.
Liquidity risk associated with revolving asset pools.
At the time of this writing there are a number of pending regulations that affect capital
(servicing assets, recourse, small business recourse, etc.). The reader should refer to 12 CFR 3
and “Instructions for the Consolidated Reports of Condition and Income” for definitive capital
regulations and guidance.
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Servicing Obligations. Securitization is a volume business that rewards
economies of scale. The amount of capital support should be commensurate
with the expected transaction volumes, the nature of the transactions
(revolving or amortizing), the technology requirements, and the complexity of
the collections process. A bank should consider increasing capital for
servicing if bank personnel are not experienced with the asset and borrower
types anticipated, the bank is offering a new product or entering a new
business line, or the complexity of the servicing is growing.
Liquidity Risks. Securitization transactions involving revolving assets (for
example, credit cards and home equity lines of credit) pose more liquidity
risk than amortizing assets such as automobile loans. When a revolving-asset
securitization matures, the bank must either roll any new receivables into
another securitization or find another way to fund the assets. While most
banks will not find it difficult to access the securitization markets in normal
times, the risk of overall market disruption does exist. In addition, if a bank’s
financial condition or capacity to provide servicing deteriorates, access to the
markets may be limited or using them may not be cost effective. These
possibilities should be reflected in determining capital adequacy.
Other Factors. Other factors not related to credit may expose a bank to
additional risk, such as representations and warranties provided by the seller,
and some kinds of obligations associated with acting as a trustee or advisor
for a transaction. These may vary with specific transactions and should be
included in any analysis of capital adequacy.
Capital Reserves. When an issuer securitizes receivables, it usually reverses
the bad debt reserves previously held against the receivables and takes that
amount into income. Often, at the time of sale, issuers will use these freedup reserves to set up new capital reserves for potential exposures associated
with securitization transactions. While these new reserves are a healthy
recognition that all risk exposures are not eliminated when assets are
securitized, the capital allocation for exposures to off-balance-sheet
securitization transactions should specifically reflect the nature and volume of
the remaining exposures. These transaction, liquidity, and other risks may
not be identical to the credit risk that has been transferred, and the capital
analysis and resulting reserve decisions should focus on actual risk exposure.
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Asset Sales with Recourse
Generally, the risk-based capital requirements for assets transferred with
recourse were not changed by the adoption of GAAP for regulatory reporting
purposes on January 1, 1997. Guidance for the accounting and risk-based
capital treatment of asset sales with recourse can be found in 12 CFR 3,
appendix A, section 3(b)(1)(B)(iii), with accompanying footnote; in the
instructions for the preparation of the consolidated reports of condition and
income (the call reports); and in periodic interpretive letters issued by the
regulatory agencies. These guidelines address the determination of recourse
in an asset sale, the associated risk-based capital requirements, and the
treatment of limited, or “low-level,” recourse transactions.
Recourse Determination. In securitization activities, “recourse” typically
refers to the risk of loss that a bank retains when it sells assets to a trust or
other special-purpose entity established to issue asset-backed securities. The
general rule is that a transfer that qualifies for sales treatment under GAAP
does not require risk-based capital support provided the transferring bank:
1.
Does not retain risk of loss on the transferred assets from any source,
and
2.
Is not obligated to any party for the payment of principal or interest on
the assets transferred resulting from:
a.
Default on principal or interest by the obligor of the underlying
instrument or from any other deficiencies in the obligor’s
performance.
b.
Changes in the market value of the assets after they have been
transferred.
c.
Any contractual relationship between the seller and purchaser
incident to the transfer that, by its term, could continue after final
payment, default, or other termination of the assets transferred.
d.
Any other cause.
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If risk or obligation for payment of principal or interest is retained by, or may
revert to, the seller in an asset transfer that qualifies for sale treatment under
GAAP, the transaction must be considered an “asset sale with recourse” for
risk-based capital purposes.
Two exceptions to the general recourse rule do not by themselves cause a
transaction to be treated as a sale with recourse. These exceptions are
contractual provisions that:
•
Provide for the return of the assets to the seller in instances of
incomplete documentation or fraud.
•
Allow the purchaser a specific period of time to determine that the
assets transferred are as represented by the seller and to return deficient
paper to the seller.
Assets transferred in transactions that do not qualify as sales under GAAP
should continue to be reported as assets on the call report balance sheet and
are subject to regulatory capital requirements.
Most transactions that involve recourse are governed by contracts written at
the time of sale. These contracts set forth the terms and conditions under
which the purchaser may compel payment from the seller. In some instances
of recourse a bank assumes risk of loss without an explicit contractual
agreement or in amounts exceeding a specified contractual limit. A bank
suggests that it may have granted implicit recourse by taking certain actions
subsequent to the sale. Such actions include: a) providing voluntary support
for a securitization by selling assets to a trust at a discount from book value;
b) exchanging performing for nonperforming assets; c) infusing additional
cash into a spread account or other collateral account; or d) supporting an
asset sale in other ways that impair the bank’s capital. Proving the existence
of implicit recourse is often a complex and fact-specific process. Therefore,
the OCC expects that the general test of loss retention and capital
impairment, supplemented by periodic interpretations as structures and assettypes evolve, will be the most effective method of determining the existence
of recourse in securitization transactions.
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Risk-Based Capital Treatment. Asset sales with recourse are reported on the
call report in Schedule RC-L, “Off-Balance-Sheet Items,” and Schedule RC-R,
“Regulatory Capital.” Under the risk-based capital standards, assets sold with
recourse are risk-weighted using two steps. First, the full outstanding amount
of assets sold with recourse is converted to an on-balance-sheet credit
equivalent amount using a 100 percent credit conversion factor, except for
certain low-level recourse transactions (described below) and small business
obligations transferred with recourse. Second, the credit equivalent amount
is assigned to the appropriate risk-weight category according to the obligor
or, if relevant, the guarantor or the nature of the collateral.
Low-Level Recourse Transactions. According to the risk-based capital
standards, the amount of risk-based capital that must be maintained for assets
transferred with recourse should not exceed the maximum amount of
recourse for which a bank is contractually liable under the recourse
agreement. This rule applies to transactions in which a bank contractually
limits its risk of loss or recourse exposure to less than the full effective
minimum risk-based capital requirement for the assets transferred. The lowlevel recourse provisions may apply to securitization transactions that use
contractual cash flows (e.g., interest-only strips receivable and spread
accounts), retained subordinated interests, or retained securities (e.g.,
collateral invested amounts and cash collateral accounts) as credit
enhancements. If the low-level recourse rule applies to these credit
enhancements, the maximum contractual dollar amount of the bank’s
recourse exposure, and therefore that amount of risk-based capital that must
be maintained, is generally limited to the amount carried as an asset on the
balance sheet in accordance with GAAP. The call report instructions for
Schedule RC-R provide specific guidance for the reporting and capital
requirements for low-level recourse transactions.
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Asset Securitization
Examination Objectives
1.
To determine the quantity of risk and the quality of risk management by
assessing whether the bank is properly identifying, measuring,
monitoring, and controlling the risks associated with its securitization
activities.
2.
To determine whether the bank’s strategic or business plan for asset
securitization adequately addresses resource needs, capital
requirements, and profitability objectives.
3.
To determine whether asset securitization policies, practices,
procedures, objectives, internal controls, and audit functions are
adequate.
4.
To determine that securitization activities are properly managed within
the context of the bank’s overall risk management process.
5.
To determine the quality of operations and the adequacy of MIS.
6.
To determine compliance with applicable laws, rulings, regulations,
and accounting practices.
7.
To determine the level of risk exposure presented by asset securitization
activities and evaluate that exposure’s impact on the overall financial
condition of the bank, including the impact on capital requirements and
financial performance.
8.
To initiate corrective action when policies, practices, procedures,
objectives, or internal controls are deficient, or when violations of law,
rulings, or regulations have been noted.
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Asset Securitization
Examination Procedures
Many of the steps in these procedures require examiners to gather
information from or review information with examiners in other areas,
particularly those responsible for originating assets used in securitized pools
(e.g., retail lending, mortgage banking, credit card lending). To avoid
duplicating examination procedures already being performed in these areas,
examiners should discuss and share examination data related to asset
securitization with examiners from these other areas before beginning these
procedures.
Examiners should cross-reference information obtained from other areas in
their examination work papers. When information is not available from other
examiners, it should be requested directly from the bank. The final decision
on the scope of the examination and the most appropriate way to obtain
information rests with the examiner-in-charge (EIC).
The examination procedures in the first section (“Overview”) will help the
examiner determine how the bank securitizes and the general level of
management and board oversight. The procedures in the second section
(“Functions”) supplement the “Overview” section and will typically be used
for more in-depth reviews of operational areas. The procedures in “Overall
Conclusions” (#s 67-71) should be completed for each examination.
Overview
1.
Obtain and review the following documents:
G
G
G
G
G
Asset Securitization
Previous examination findings related to asset securitization and
management’s response to those findings.
Most recent risk assessment profile of the bank.
Most recent internal/external audits addressing asset securitization
and management’s response to significant deficiencies.
Supervisory Monitoring System (SMS) reports.
Scope memorandum issued by the bank EIC.
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G
G
G
G
G
G
G
G
G
Strategic or business plan for asset securitization.
All written policies or procedures related to asset securitization.
A description of the risk measurement and monitoring system for
securitization activities and a copy of all related MIS reports.
(Measurement systems may include tracking reports, exposure
reports, valuation reports, and profitability analyses. See the
examination procedures under “Management Information Systems”
for additional details.)
A summary or outline of all outstanding asset-backed issuances.
Document for the permanent work paper file information for each
outstanding security including:
C
The origination date, original deal amount, current
outstanding balance, legal maturity, expected maturity,
maturity type (hard bullet, soft bullet, controlled
`amortization, etc.), revolving period dates, current
coupon rates, gross yield, loss rate, base rate, excess
spread amounts (one month and three month), monthly
payment rates, and the existence of any interest rate caps.
C
The amount and form of credit enhancements (overcollateralization, cash collateral accounts, spread
accounts, etc.).
C
Performance triggers relating to early amortization events
or credit enhancement levels.
Copies of pooling and servicing agreements and/or series
supplements for major asset types securitized or those targeted at
this exam.
Information detailing the potential contractual or contingent
liability from guarantees, underwriting, and servicing of securitized
assets.
Copies of compensation programs, including incentive plans,
for personnel involved in securitization activities.
Current organizational chart for the asset securitization unit of
the bank.
A list of board and executive or senior management committees
that supervise the asset securitization function, including a list of
members and meeting schedules. Also, minutes documenting
meetings held since the last examination should be available for
review.
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2.
Determine whether any material changes have occurred since the last
review regarding originations and purchases, servicing, or managing
securitized portfolios.
3.
Based on results from the previous steps and discussions with the bank
EIC and other appropriate supervisors, determine the scope and
objectives of the examination.
Select from among the following examination procedures the steps
necessary to meet examination objectives. Examiners should tailor the
procedures to the specific activities and risks faced by the bank.
Note: Examinations will seldom require completion of all steps.
4.
As examination procedures are performed, test for compliance with
established policies and confirm the existence of appropriate internal
controls. Identify any area that has inadequate supervision or poses
undue risk, and discuss the need to perform additional or expanded
procedures with the EIC.
Management Oversight
5.
Review the bank’s securitization business plan. Determine that it has
been reviewed by all significant affected parties and approved by the
bank’s board of directors. At a minimum, the plan should address the
following:
a.
The integration of the securitization program into the bank’s
corporate strategic plan.
b.
The integration of the securitization program into the bank’s
asset/liability, contingency funding, and capital plans.
c.
The integration of the securitization program into the bank’s
compliance review, loan review, and audit program.
d.
The specific capacities in which the bank will engage (servicer,
trustee, credit enhancer, etc.).
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6.
7.
e.
The establishment of a risk identification process.
f.
The type(s) and volume of business to be done in total (aggregate
of deals in process as well as completed deals that are still
outstanding).
g.
Profitability objectives.
Evaluate the quality of the business plan. Consider whether:
a.
The plan is reasonable and achievable in light of the bank’s capital
position, physical facilities, data processing systems capabilities,
size and expertise of staff, market conditions, competition, and
current economic forecasts.
b.
The feasibility analysis considers tax, legal, and resource
implications.
c.
The goals and objectives of the securitization program are
compatible with the overall business plan of the bank, the holding
company, or both.
Determine whether the bank has and is following adequate policies and
operating procedures for securitization activities. At a minimum,
policies should address:
a.
Permissible securitization activities including individual
responsibilities, limits, and segregation of duties.
b.
Authority levels and responsibility designations covering:
•
•
•
•
•
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Transaction approvals and cancellations;
Counterparty approvals for all outside entities the bank is
doing business with (originators, servicers, packagers,
trustees, credit enhancers, underwriters, and investors);
Systemic and individual transaction monitoring;
Pricing approvals;
Hedging and other pre-sale decisions;
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Asset Securitization
•
•
c.
Exposure limits by:
•
•
•
•
•
•
8.
Quality standard approvals; and
Supervisory responsibilities over personnel.
Type of transaction;
Individual transaction dollar size;
Aggregate transactions outstanding (because of the moral
recourse implicit in the bank’s name on the securities);
Geographic concentrations of transactions (individually
and in aggregate);
Maturities of transactions (particularly important in
evergreen deals, i.e., credit cards and home equity lines);
and
Originators (for purchased assets), credit enhancers,
trustees, and servicers.
d.
Quality standards for all transactions in which the bank plans to
participate. Standards should extend to all counterparties
conducting business with the bank.
e.
Minimum MIS reports to be presented to senior management and
the board or appropriate committees. (During reviews of
applicable meeting minutes, ascertain which reports are presented
and the depth of discussions held).
Review the organizational structure and determine who is responsible
for coordinating securitization activities.
a.
Determine whether the board of directors or appropriate
committee and management have a separate securitization steering
committee. If so, review committee minutes for significant
information.
b.
Determine whether decision making is centralized or delegated.
c.
Determine which individuals are responsible for major decisions
and where final decisions are made.
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9.
Determine whether, before approving a new securitization transaction,
the bank requires sign-off from the following departments:
•
•
•
•
•
•
•
•
10.
11.
Appropriate credit division
Treasury or capital markets
Audit
Asset and liability management
Capital planning committee
Legal
Liquidity management
Operations
Assess the expertise and experience of management responsible for
securitization activities.
a.
Conduct interviews and review personnel files and resumes to
determine whether management and other key staff members
possess appropriate experience or technical training to perform
their assigned functions.
b.
Review management succession plans and determine whether
designated successors have the necessary background and
experience.
Review incentive plans covering personnel involved in the
securitization process. Determine whether plans are oriented toward
quality execution and long-run profitability rather than high-volume,
short-term asset production and sales.
a.
Ensure that such plans have been approved by the board of
directors or an appropriate committee.
b.
Determine that senior management and the board of directors are
aware of any substantial payments or bonuses made under these
plans.
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Asset Securitization
12.
Evaluate the pricing system used in all aspects of securitization.
a.
Determine that the bank has a system for quantifying costs and
risks (liquidity, credit, transaction, etc.) and for making incremental
adjustments to compensate for the less readily quantifiable costs
and risks.
b.
Determine whether decision makers use an effective pricing
system to determine whether prospective transactions will be
profitable.
Risk Management
13.
14.
Determine whether the risk management process is effective and based
on timely and accurate information. Evaluate its adequacy in managing
significant risks in each area of the securitization process.
a.
Ascertain whether management has identified all significant risks in
each of the bank’s planned roles.
b.
Determine how these risks are monitored and controlled.
c.
Evaluate how controls are integrated into overall bank systems.
d.
Evaluate management’s method of allocating capital or reserves to
various business units in recognition of securitization risks.
Determine that the bank’s obligations from securitization activities have
been reviewed by appropriate legal counsel.
a.
Ensure that legal counsel has reviewed and approved any
standardized documents used in the securitization process.
Counsel should also review any transactions that deviate
significantly from standardized documents.
b.
If the bank is involved in issuing prospectuses or private placement
memoranda, ensure that legal counsel has reviewed them. Also,
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ensure that operating practices require a party independent of the
securitization process to check the financial and statistical information in the
prospectus for accuracy.
15.
Determine that the scope of credit and compliance reviews includes
loans originated for securitization or purchased for that purpose.
a.
Ascertain appropriateness of scope, frequency, independence, and
competency of reviews in view of the bank’s activity volume and
risk exposure.
b.
Credit and compliance reviews should include:
•
•
•
Loans on the bank’s books and not yet securitized;
Loans in process of being securitized; and
Completed deals that bear the bank’s name or in which
the bank has ongoing responsibilities (servicer, trustee,
etc.).
Portfolio Management
16.
Determine whether management’s assessment of the quality of loan
origination and credit risk management includes all managed assets
(receivables in securitization programs and on-balance-sheet assets). At
a minimum, the assessment should include:
a.
A review of the number and dollar volume of existing past-due
loans, early payment defaults, and repurchased loans from
securitized asset pools. The review should also compare the
bank’s performance to industry, peer group averages, or both.
b.
An analysis of the cause of delinquencies and repurchases.
c.
The impact on delinquencies and losses of altered underwriting
practices, new origination sources, and new products.
d.
Determination of whether repurchases or other workout actions
compromised the sales status of problem credits or related assets.
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Asset Securitization
17.
Determine whether the bank performs periodic stress tests of securitized
asset pools. Determine whether these tests:
a.
Consider the appropriate variables affecting performance according
to asset or pool type.
b.
Are conducted well in advance of approaching designated early
amortization triggers.
c.
Are adequately documented.
18.
If third parties provide credit or liquidity enhancements for banksponsored asset-backed securities, determine whether their credit rating
has been downgraded recently or whether their credit quality has
deteriorated. If so, determine what actions the bank has taken to
mitigate the impact of these events.
19.
Assess whether securitization activities have been adequately integrated
into liquidity planning. Consider whether:
a.
The cash flows from scheduled maturities of revolving asset-backed
securities are coordinated to minimize potential liquidity concerns.
b.
The impact of unexpected funding requirements due to early
amortization events are factored into contingency funding plans for
liquidity.
Internal and External Audit
20.
Review the bank’s internal audit program for securitization activities.
Determine whether it includes objectives, written procedures, an audit
schedule, and reporting systems that are appropriate in view of the
bank’s volume of activity and risk exposure.
a.
Asset Securitization
Review the education, experience, and ongoing training of the
internal audit staff and evaluate its expertise in auditing
securitization activities.
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b.
Determine whether comprehensive audits of all securitization
areas are conducted in a timely manner. Ensure that the scope of
internal audit includes:
•
•
c.
21.
An evaluation of compliance with pooling and servicing
agreement requirements; and
Periodic verification of the accuracy of both internal and
external portfolio performance reports.
Review management’s responses to audit reports for timeliness and
implementation of corrective action when appropriate.
If the external auditors review the major operational areas involved in
securitization activities, review the most recent engagement letter,
external audit report, and management letter. Determine:
a.
To what extent the external auditors rely on the internal audit staff
and the internal audit report.
b.
Whether the external auditors rendered an opinion on the
effectiveness of internal controls for the major products or services
related to securitization.
c.
Whether management promptly and effectively responds to the
external auditor’s concerns and recommendations. Assess whether
management makes changes to operating and administrative
procedures that are appropriate responses to report findings.
Management Information Systems
22.
Review management information systems to determine whether they
provide appropriate information for monitoring securitization activities.
a.
Evaluate reports produced for each capacity in which the bank is
involved. At a minimum, the following should be produced:
•
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Tracking reports to monitor overall securitization activity.
Reports should include:
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Asset Securitization
-
•
Inventory reports to monitor available transaction
collateral. Reports should include summaries by:
-
•
-
Asset Securitization
Product type, including outstanding and committed
receivable amounts;
Geographic or other types of concentrations; and
Sale status (for transactions in process).
Performance reports by portfolio and specific product
type. Reports should reflect performance of both assets in
securitized pools and total managed assets. Reports
should include:
-
b.
Completed transactions, transactions in process,
and prospective transactions;
Exposure reports detailing exposures by specific
function (credit enhancer, servicer, trustee, etc.)
and by counterparties; and
Profitability analysis by product and functional
department (originations, servicing, trustees, etc.).
Profitability reports should include cost-center
balance sheet and earnings statements. The
balance sheets should reflect the amount of capital
and reserves set aside for risks within the various
functions.
Credit quality (delinquencies, losses, portfolio
aging, etc.);
Profitability (by individual transaction and product
type); and
Performance compared with expected performance
(portfolio yields, monthly principal payment rates,
purchase rates, charge-offs, etc.).
Determine whether MIS provides sufficient detail to permit reviews
for compliance with policy limits and to make appropriate
disclosures on regulatory reports and other required financial
statements. Evaluate whether:
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•
•
23.
The frequency of report generation is commensurate with
volume and risk exposure; and
Reports are distributed to, and reviewed by, appropriate
management, board committees, or both.
Determine whether investor reporting is accurate and timely. Choose a
sample of outstanding transactions and compare internal performance
reports with those provided to investors. Note: Examiners can
supplement this procedure by comparing internal reports with
information reported by external sources (such as Bloomberg, Fitch, and
Moody’s). Discrepancies should be brought to management’s attention
immediately.
Accounting and Risk-Based Capital
24.
25.
Determine whether the bank is classifying securitization transactions
appropriately as “sales” or “financings.”
a.
Determine that the bank has a system to ensure that independent
personnel review transactions and concur with accounting
treatment.
b.
Ensure that audit has tested for proper accounting treatment as part
of its normal reviews.
For transactions that qualify for sales treatment under FAS 125, review
the written policies and procedures to determine whether they:
a.
Allocate the previous book carrying amount between the assets
sold and the retained interests based on their fair market values on
the date of transfer.
b.
Adjust the net proceeds received in the exchange by recording, on
the balance sheet, the fair market value of any guarantees, recourse
obligations, or derivatives such as put options, forward
commitments, interest rate swaps, or currency swaps.
c.
Recognize gain or loss only on assets sold.
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d.
26.
Continue to carry on the balance sheet any retained interest in the
transferred assets. Such balance sheet items should include
servicing assets, beneficial debt or equity interests in the specialpurpose entity, or retained undivided interests.
Determine whether the asset values and periodic impairment analyses
for servicing assets and rights to future excess interest (IO strips) are
consistent with FAS 125 and regulatory accounting requirements.
a.
Determine whether the bank has a reasonable method for
determining fair market value of the assets.
b.
Determine whether recorded servicing and IO strip asset values are
reviewed in a timely manner and adjusted for changes in market
conditions.
For servicing assets, verify that:
•
•
•
•
•
Servicing assets are appropriately stratified by
predominant risk characteristics (e.g., asset type, interest
rate, date of origination, or geographic location);
Impairment is recognized by stratum;
Impairment is assessed frequently (e.g., at least quarterly);
Assumptions and calculations are documented; and
Servicing assets are not recorded at a value greater than
their original allocated cost.
For IO strip assets, verify that:
•
•
c.
Asset Securitization
Valuation considers changes in expected cash flows due
to current and projected volatility of interest rates, default
rates, and prepayment rates; and
IO strips are recorded at fair market value consistent with
available-for-sale or trading securities.
Determine that servicing assets and IO strips are accorded
appropriate risk-based capital treatment. Ensure that:
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•
•
27.
28.
Nonmortgage servicing assets are fully deducted from Tier
1 capital and risk-weighted assets. (Mortgage-related
servicing assets and purchased credit card relationships
may be included in Tier 1 capital; however, the total of all
mortgage related servicing assets and purchased credit
card relationships is limited. See 12 CFR 3 and related
interpretations.)
Risk-based capital is allocated for the lower of the full
amount of the assets transferred or the amount of the IO
strip, consistent with low-level recourse rules.
For revolving trusts, review procedures for accounting for new sales of
receivables to the trust.
a.
Verify that accrued interest on receivables sold is accounted for
properly.
b.
Determine whether gain or loss is properly booked.
Determine whether the bank maintains capital reserves for securitized
assets. Determine whether the method for calculating the reserves is
reasonable. Consider:
a.
The volume and nature of servicing obligations.
b.
The potential impact on liquidity of revolving-asset pools.
c.
Other potential exposures.
Recourse Transactions
29.
Determine whether the bank transfers loans with recourse. If so,
determine whether:
a.
Written policies guide management with respect to the type and
amount of recourse it can offer. Such policies should address:
•
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Full or partial recourse specified in the servicing contract;
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Asset Securitization
•
•
•
•
•
30.
Warranties and representations in the sale of loans,
including warranties against noncompliance with
consumer laws and regulations;
Repurchase agreements in case of early default or early
prepayment of securitized loans;
Spread accounts or cash reserves;
Vested business relationships with purchasers of whole
loans or investors in asset-backed securities; and
Environmental hazards.
b.
Adequate management information systems exist to track all
recourse obligations.
c.
Asset sales with recourse, including low-level transactions, are
reported appropriately in schedule RC-R of the report of condition
and income (call report).
d.
If recourse is limited, determine whether the bank’s systems
prevent it from making payments greater than its contractual
obligation to purchasers.
Determine whether the bank has developed written standards for
refinancing, renewing, or restructuring loans previously sold in assetbacked securities transactions. Determine whether:
a.
The standards distinguish a borrower’s valid desire to reduce an
interest rate through renewal, refinancing, or restructuring
designed to salvage weak credits.
b.
The standards prevent the bank from repurchasing distressed loans
from the securitized credit pool and disguising their delinquency in
the bank’s loan portfolio.
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Functions
The following guidelines supplement the procedures in the “Overview”
section. These procedures will often be performed by product (loan) type
and should be coordinated with other examination areas to avoid duplication
of effort.
Originations
31.
Determine whether senior management or the board is directly
involved in decisions concerning the quality and types of assets that are
to be securitized as well as those to be retained on the balance sheet.
Ensure that written policies:
a.
Outline objectives relating to securitization activities.
b.
Establish limits or guidelines for:
•
•
•
•
•
•
•
32.
Quality of loans originated
Maturity of loans originated
Geographic dispersion of loans
Acceptable range of loan yields
Credit quality
Acceptable types of collateral
Types of loans
Determine whether the credit standards for loans to be securitized are
the same as the ones for loans to be retained.
a.
If not, ascertain whether management consciously made this
decision and that it is clearly stated in the securitization business
plan.
b.
If higher quality loans are to be securitized in order to gain initial
market acceptance, determine whether the bank limits the amount
of lower quality assets it originates or retains. Also, determine
whether the allowance for loan and lease losses and capital are
adjusted for the higher proportion of risk in total assets.
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c.
33.
Determine whether there are sufficient administrative and
collection personnel on hand to properly administer and collect
lower quality credits.
Ensure that there is a complete separation of duties between the credit
approval process and loan sales/securitization effort. Determine
whether lending personnel are solely responsible for:
a.
The granting or denial of credit to customers.
b.
Credit approvals of resale counterparties.
34.
Ensure that loans to be sold or securitized are segregated or otherwise
identified on the books of the originating bank. Also, determine that
the bank is following appropriate accounting standards regarding
market valuation procedures on assets held for sale.
35.
If loans are granted or denied based on a credit scoring system,
ascertain whether the system was developed based on empirically
derived data. Ensure that it is periodically revalidated.
36.
Determine whether the bank is making efforts to ensure that the
customer base is not suffering from economic redlining. If economic
redlining is occurring, determine what actions the bank is taking to
counteract these effects. (Evidence of redlining should be immediately
discussed with the EIC and/or appropriate compliance examiner.)
37.
Determine whether written policies address borrower’s expectations of
confidentiality and rights to financial privacy by requiring:
a.
The opinion of counsel on what matters may be disclosed.
b.
Written notice (when counsel deems it necessary) that loans may
be sold in whole or pledged as collateral for asset-backed securities
and that certain confidential credit information may be disclosed to
other parties.
c.
When necessary, the borrower’s written waiver of confidentiality.
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Purchased Loans
38.
Determine whether the bank has written procedures on acquiring
portfolios for possible securitization. If so, determine whether the
procedures are adequate given the volume and complexity of the
potential purchases.
39.
Evaluate management’s method of determining whether prospective
asset purchases meet the quality standards represented by the seller.
Ensure that the process considers whether purchased assets are
compatible with the bank’s data systems, administration and collection
systems, credit review talent, and compliance standards, particularly
consumer protection laws.
40.
If the bank has recently purchased a portfolio for use in a securitization
transaction, review the due diligence work papers to assess their
adequacy and compliance with policy.
41.
Determine whether the bank conducts postmortem reviews on acquired
portfolios, and, if so, what procedures are used. Identify who receives
the results and whether appropriate follow-up action is taken (changes
in quality standards, due diligence procedures, etc.)
42.
Ensure that operating systems segregate or otherwise identify loans
being held for resale. Review accounting practices to ensure
appropriate treatment of assets held for resale.
43.
Evaluate the measures taken to control pipeline exposure.
a.
If pre-sales are routine, determine whether credit approval and
diversification standards for purchasers are administered by people
who are independent of the asset purchasing and packaging
processes.
b.
Evaluate the reasonableness of limits on inventory positions that
are not pre-sold or hedged.
Comptroller’s Handbook
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Asset Securitization
c.
If assets held for resale are required to be hedged, ensure that
controls over hedging include:
•
•
•
•
•
•
An approved list of hedging instruments;
Minimum acceptable correlation between the assets held
for sale and the hedging vehicle;
Maximum exposure limits to unhedged loan
commitments under various interest rate simulations;
Credit limits on forward sale exposure to a single
counterparty;
A prohibition against speculation; and
Acceptable reporting systems for hedging transactions.
Servicing
44.
Determine whether written policies are in place for servicing activities
that:
a.
Outline objectives for the servicing department.
b.
List the types of loans that the bank is permitted to service.
c.
Specify procedures for valuing retained and purchased servicing
rights.
d.
Require legal counsel to review each transaction for conflicts of
interest when the bank serves in multiple capacities such as:
•
•
•
•
•
•
•
Asset Securitization
Originator
Servicer
Trustee
Credit enhancer
Market maker
Lender in other relationships to borrowers, investors,
originators
Investor
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Comptroller’s Handbook
45.
Determine whether MIS reports for the servicing operation provide
adequate information to monitor servicing activities. Reports by asset
pool or transaction should include:
a.
Activity data, including:
•
•
•
•
•
46.
Aggregate data such as number of loans, dollar amount of
loans, yield on loans.
Delinquency information for at least the loans that are
more than 15/30/60/90 days past due;
Number and dollar amount of early payment default
(within first three months of closing);
Charge-off data; and
Repossession costs (if applicable).
b.
Profitability information, including all costs associated with direct
and indirect overhead, capital, and collections.
c.
Comparisons of the servicer’s costs and revenues with industry
averages.
Evaluate management’s planning process for future servicing activities.
Determine whether:
a.
Current systems are capable of handling the requirements for the
current and anticipated securitization volume.
b.
The planning process for the development of operating systems has
been coordinated with plans for anticipated future growth in
servicing obligations.
c.
Provisions exist for complete testing and personnel training before
adding systems or changing existing ones significantly.
d.
A sufficient number of experienced credit administration and
workout personnel are available to meet the added demands
associated with increased transaction and account volumes.
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Asset Securitization
47.
Determine whether the bank has contracted for an appropriate amount
of errors and omissions insurance to cover the risks associated with the
added transaction volumes from securitization activities.
48.
Determine whether internal or external auditors review the servicing
function. Determine whether they:
a.
Verify loan balances.
b.
Verify notes, mortgages, security interests, collateral, etc., with
outside custodians.
c.
Review loan collection and repossession activities to determine
that the servicer:
•
•
•
•
•
Promptly identifies problem loans;
Charges off loans in a timely manner;
Follows written guidelines for extensions, renegotiations,
and renewal of loans;
Clears stale items from suspense accounts in a timely
manner; and
Accounts for servicing fees properly (by amortizing excess
servicing fees, for example).
Collections
49.
Review policies and procedures for collecting delinquent loans.
a.
Determine whether collection efforts are consistent with pooling
and servicing agreement guidelines.
b.
Determine whether the bank documents all attempts to collect
past-due payments, including the date(s) of borrower contact, the
nature of communication, and the borrower’s response/comment.
c.
Evaluate methods used by management to ensure that collection
procedures comply with applicable state and federal laws and
regulations.
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Other Roles
Credit Enhancement Provider
50.
If the bank enhances the credit of securitized products it originates,
ensure that:
a.
It appropriately classifies the transactions as “financings” or “sales.”
b.
Accounting for this obligation does not underestimate predictable
losses or overestimate the adequacy of loan loss reserves.
c.
Standards for enhancing the bank’s own originations are not more
liberal than standards applied to securitized products originated by
others.
51.
Ensure that the authority to enhance the credit of other banks’
securitization programs is solely in the hands of credit personnel.
52.
Determine that all credit enhancement exposures are analyzed during
the bank’s internal credit review process. At a minimum, ensure that:
53.
a.
The accounting for this contingent obligation does not
underestimate predictable loan losses or overestimate the
adequacy of loan loss reserves.
b.
The limits on securitized credits that the bank enhances reflect the
bank’s overall exposure to the originator and packager of the
securitized credits.
c.
The bank consolidates its exposure to securitized credits it
enhances with exposure to the same credits held in its own loan
portfolio.
Determine whether the bank has established exposure limits for
pertinent credit criteria, such as the enhancer’s exposure by customers,
industry, and geography. Determine whether these exposures are
incorporated into systemic exposure reports.
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Asset Securitization
54.
Ascertain whether the bank has the capacity to fund the support they
have provided. Evaluate whether the bank considers this contingent
obligation in its contingency funding plans.
55.
Determine that the bank’s business plan for credit enhancement
addresses capital allocation and ensure that the associated costs of
capital usage are incorporated into pricing and transaction decisions.
56.
If credit enhancement facilities are provided for third parties, ensure
that risk-based capital allocations are consistent with current guidelines
set forth in 12 CFR 3 and the “Instructions for the Consolidated Reports
of Condition and Income.”
Trustee
These procedures supplement those in the Comptroller’s Handbook for
National Trust Examiners and are intended only to guide examiners during
the evaluation of the trustee’s role in the securitization process.
57.
Determine whether all indentures and contracts have been reviewed by
appropriate legal counsel. Establish whether the agreements have been
carefully worded to specify only services that the bank is capable of
performing.
58.
Review how bank management evaluates proposed customers and
transactions that involve the bank as trustee. At a minimum, an
evaluation should consider:
59.
a.
The bank’s capacity to perform all the tasks being requested.
b.
The financial and ethical backgrounds of the customer.
c.
The reputation and financial risks of entering into a relationship
with the customer or acting as trustee for the transaction.
Review conflicts of interest that could arise when the bank trustee acts
in an additional capacity in the securitization process. If the potential
for conflicts of interest is apparent, determine whether the bank’s legal
Asset Securitization
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Comptroller’s Handbook
counsel has reviewed the situation and rendered an opinion on its
propriety.
60.
Determine whether the audit of trust work on securitized products is
adequate.
Liquidity Enhancement Provider
61.
62.
Review agreements in which the bank agrees to provide back-up
liquidity (either as a servicer or third-party provider of liquidity
enhancement), and determine whether liquidity will be provided in the
event of credit problems. Consider whether:
a.
The bank (as liquidity provider) is required to advance for
delinquent receivables.
b.
The liquidity agreements cite credit-related contingencies that
would allow the bank to withhold advances.
If the bank, in agreeing to provide back-up liquidity, assumes any risk of
loss that would constitute providing recourse, ensure that appropriate
risk-based capital is maintained by the bank.
Underwriter and Packager
63.
Determine whether legal counsel has been used in arriving at
appropriate policies and procedures governing due diligence and
disclosure to investors.
a.
Ascertain whether the bank’s policy or practices require the bank
to inform customers that nonpublic information in the bank’s
possession may be disclosed as part of the underwriting process. If
not, determine whether legal counsel concurred with the decision
not to provide the disclosure and ensure that the rationale behind
it has been documented.
b.
Determine whether the bank has procedures to disclose all
material information to investors.
Comptroller’s Handbook
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Asset Securitization
c.
Determine whether the bank has procedures to ensure that:
•
•
64.
Publicly offered securities are registered under the
Securities Act of 1933; or
Any reliance upon an exemption from registration
(privately offered securities are exempt from such
registration) is supported by the opinion of counsel.
Evaluate the measures taken to limit the bank’s exposure in the event
that an issue the institution has agreed to underwrite cannot be sold.
Review systems used to quantify underwriting risks and to establish risk
limits. Consider:
•
•
•
•
Funding capacity necessary to support temporary and
long-term inventory positions;
Balance sheet compatibility;
Diversity of customer sales base and prospects for
subsequent sale; and
Hedging strategies.
65.
Ascertain whether the bank is prepared to make a market for all assetbacked securities that it underwrites. Also, determine whether this
question is addressed in the bank’s contingency funding plan.
66.
Determine whether the bank monitors securities it has underwritten and
adjusts funding plans according to noted or perceived market shifts and
investor actions.
67.
Review the bank’s files for current information on the asset-backed
security originator, credit enhancer, and other pertinent parties. Assess
the ability of these parties to meet their obligations.
Overall Conclusions
68.
Prepare a summary memorandum detailing the results of the asset
securitization examination. Address the following:
Asset Securitization
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Comptroller’s Handbook
a.
Adequacy of risk management systems, including the bank’s ability
to identify, measure, monitor, and control the risks of
securitization.
b.
Adequacy of the strategic plan or business plan for asset
securitization.
c.
Adequacy of policies and operating procedures and adherence
thereto.
d.
Quality and depth of management supervision and operating
personnel.
e.
Adequacy of management information systems.
f.
Propriety of accounting systems and regulatory reporting.
g.
Compliance with applicable laws, rulings, and regulations.
h.
Adequacy of audit, compliance, and credit reviews.
I.
Recommended corrective action regarding deficient policies,
procedures, or practices and other concerns.
j.
Commitments received from management to address concerns.
k.
The impact of securitization activities on reputation risk, strategic
risk, credit risk, transaction risk, liquidity risk, and compliance risk.
l.
The impact of securitization activities on the bank’s earnings and
capital.
m. The bank’s future prospects based on its finances and other
considerations.
n.
69.
Other matters of significance.
Discuss examination findings and conclusions with the EIC. Based on
Comptroller’s Handbook
87
Asset Securitization
this discussion, set up a meeting with bank management to share
findings and obtain any necessary commitments for corrective action.
70.
Write a memorandum specifically setting out what the OCC needs to
do in the future to effectively supervise the asset securitization function.
Include time frames, staffing, and workdays required.
71.
Update the examination work papers.
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Comptroller’s Handbook
Asset Securitization
References
Regulations
12 CFR 3, Minimum Capital Ratios; Issuance of Directives (including
Appendix A)
Issuances
Banking Circular 177, “Corporate Contingency Planning”
Comptroller’s Handbook , “Capital and Dividends”
Comptroller’s Handbook , “Mortgage Banking”
Comptroller’s Handbook for National Bank Examiners, “Funds
Management,” Section 405
Consolidated Reports of Condition and Income (the Call Reports)
Financial Accounting Standard 125, “Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities”
OCC 96-52, “Securitization — Guidelines for National Banks”
Comptroller’s Handbook
89
Asset Securitization
OCC 99−46
O
OCC BULLETIN
Comptroller of the Currency
Administrator of National Banks
Subject:
Interagency Guidance on
Asset Securitization Activities
TO:
Description: Asset Securitization
Chief Executive Officers of All National Banks, Department and Division Heads, and
All Examining Personnel
The attached “Interagency Guidance on Asset Securitization Activities” was issued jointly by the
Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve
System, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision (the
Agencies) on December 13, 1999. The provisions included in this policy statement are effective
immediately.
For several years, large commercial banks have been using asset securitization as an alternative
method of funding balance sheet assets, improving financial performance ratios and generating
fee income. While the OCC continues to endorse the use of asset securitization as a tool to
manage the bank's balance sheet and more efficiently meet customer needs, we remind bankers
that such activity is only appropriate when properly managed. During recent examinations, our
examiners have noted an unacceptable number of national banks with risk management systems
or internal control infrastructures insufficient to support the institution's securitization activities.
Particularly disturbing is the number of cases where the valuation of retained interests on the
bank’s balance sheet have not been in compliance with the standards prescribed in Statement of
Financial Accounting Standard No. 125, "Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities." In addition, several banks have inaccurately
reported their risk-based capital by failing to appropriately account for recourse obligations
arising from securitization activities.
The attached statement highlights particular areas of weakness, including the board and senior
management oversight. The statement reiterates our expectation that critical components of
an effective oversight program for asset securitization activities include: (1) independent
risk management commensurate with the complexity of securitization activities, (2)
comprehensive audit coverage, (3) appropriate residual interest valuation and modeling
methodologies, (4) accurate and timely risk-based capital calculations, and (5) prudent
internal limits to control the amount of equity capital at risk that is used to support
securitization retained interests.
Date:
December 13, 1999
Page 1 of 2
OCC examiners will continue to review asset securitization activities in national banks to ensure
that the board of directors and senior management are complying with the risk management
expectations detailed in this policy statement. In those cases where examiners identify weak risk
management practices or lax internal controls, bank management will be directed to take
immediate corrective action. In situations where bank management cannot provide objectively
verifiable support for the valuation of the retained interest, the asset will be classified as loss and
disallowed as an asset of the bank for regulatory capital purposes.
Additional guidance on OCC expectations for national banks involved in asset securitization
activities can be found in the "Asset Securitization" booklet of the Comptroller's Handbook.
Questions about the interagency statement or other policy issues related to asset securitization
activities may be directed to Kathy Dick, Director, Treasury and Market Risk Division at (202)
874-5670. Technical assistance can be provided by Greg Coleman or Jeffery Power at the same
location.
Emory Wayne Rushton
Senior Deputy Comptroller
Bank Supervision Policy
Attachment
Date:
December 13, 1999
Page 2 of 2
Office of the Comptroller of the Currency
Federal Deposit Insurance Corporation
Board of Governors of the Federal Reserve System
Office of Thrift Supervision
INTERAGENCY GUIDANCE ON ASSET SECURITIZATION ACTIVITIES
BACKGROUND AND PURPOSE
Recent examinations have disclosed significant weaknesses in the asset securitization practices of some
insured depository institutions. These weaknesses raise concerns about the general level of
understanding and controls among institutions that engage in such activities. The most frequently
encountered problems stem from: (1) the failure to recognize and hold sufficient capital against explicit
and implicit recourse obligations that frequently accompany securitizations, (2) the excessive or
inadequately supported valuation of “retained interests,”1 (3) the liquidity risk associated with over
reliance on asset securitization as a funding source, and (4) the absence of adequate independent risk
management and audit functions.
The Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Board
of Governors of the Federal Reserve System, and the Office of Thrift Supervision, hereafter referred to
as “the Agencies,” are jointly issuing this statement to remind financial institution managers and
examiners of the importance of fundamental risk management practices governing asset securitization
activities. This guidance supplements existing policy statements and examination procedures issued by
the Agencies and emphasizes the specific expectation that any securitization-related retained interest
claimed by a financial institution will be supported by documentation of the interest’s fair value, utilizing
reasonable, conservative valuation assumptions that can be objectively verified. Retained interests that
lack such objectively verifiable support or that fail to meet the supervisory standards set forth in this
document will be classified as loss and disallowed as assets of the institution for regulatory capital
purposes.
The Agencies are reviewing institutions' valuation of retained interests and the concentration of these
assets relative to capital. Consistent with existing supervisory authority, the Agencies may, on a case1
In securitizations, a seller typically retains one or more interests in the assets sold. Retained interests represent
the right to cash flows and other assets not used to extinguish bondholder obligations and pay credit losses,
servicing fees and other trust related fees. For the purposes of this statement, retained interests include overcollateralization, spread accounts, cash collateral accounts, and interest only strips (IO strips). Although servicing
assets and liabilities also represent a retained interest of the seller, they are cu rren tly determined based on different
criteria and have different accounting an d ris k-b as ed cap ital requirements. See applicable comments in Statement of
Financial Accounting Standard No. 125, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities" (FAS 125), for additional information about these interests and associated accounting
requirements.
Date:
December 13, 1999
Page
1
by-case basis, require institutions that have high concentrations of these assets relative to their capital, or
are otherwise at risk from impairment of these assets, to hold additional capital commensurate with their
risk exposures. Furthermore, given the risks presented by these activities, the Agencies are actively
considering the establishment of regulatory restrictions that would limit or eliminate the amount of certain
retained interests that may be recognized in determining the adequacy of regulatory capital. An
excessive dependence on securitizations for day-to-day core funding can also present significant liquidity
problems - either during times of market turbulence or if there are difficulties specific to the institution
itself. As applicable, the Agencies will provide further guidance on the liquidity risk associated with
over reliance on asset securitizations as a funding source and implicit recourse obligations.
CONTENTS
Page
Description of Activity ...................................................................................................2
Independent Risk Management Function .......................................................................4
Valuation and Modeling Process ....................................................................................6
Use of Outside Parties .....................................................................................................7
Internal Controls ..............................................................................................................7
Audit Function or Internal Review ..................................................................................7
Regulatory Reporting ......................................................................................................8
Market Discipline and Disclosures ..................................................................................9
Risk-Based Capital for Recourse and Low Level Recourse Transactions ......................9
Institution Imposed Concentration Limits on Retained Interests ..................................10
Summary ........................................................................................................................11
DESCRIPTION OF ACTIVITY
Asset securitization typically involves the transfer of on-balance sheet assets to a third party or trust. In
turn the third party or trust issues certificates or notes to investors. The cash flow from the transferred
assets supports repayment of the certificates or notes. For several years, large financial institutions, and
a growing number of regional and community institutions, have been using asset securitization to access
alternative funding sources, manage concentrations, improve financial performance ratios, and more
efficiently meet customer needs. In many cases, the discipline imposed by investors who buy assets at
their fair value has sharpened selling institutions’ credit risk selection, underwriting, and pricing practices.
Assets typically securitized by institutions include credit card receivables, automobile receivable paper,
commercial and residential first mortgages, commercial loans, home equity loans, and student loans.
While the Agencies continue to view the use of securitization as an efficient means of financial
intermediation, we are concerned about events and trends uncovered at recent examinations. Of
particular concern are institutions that are relatively new users of securitization techniques and institutions
whose senior management and directors do not have the requisite knowledge of the effect of
securitization on the risk profile of the institution or are not fully aware of the accounting, legal and riskbased capital nuances of this activity. Similarly, the Agencies are concerned that some institutions have
not fully and accurately distinguished and measured the risks that have been transferred versus those
Date:
December 13, 1999
Page
2
retained, and accordingly are not adequately managing the retained portion. It is essential that
institutions engaging in securitization activities have appropriate front and back office staffing, internal
and external accounting and legal support, audit or independent review coverage, information systems
capacity, and oversight mechanisms to execute, record, and administer these transactions correctly.
Additionally, we are concerned about the use of inappropriate valuation and modeling methodologies to
determine the initial and ongoing value of retained interests. Accounting rules provide a method to
recognize an immediate gain (or loss) on the sale through booking a “retained interest;” however, the
carrying value of that interest must be fully documented, based on reasonable assumptions, and regularly
analyzed for any subsequent value impairment. The best evidence of fair value is a quoted market price
in an active market. In circumstances where quoted market prices are not available, accounting rules
allow fair value to be estimated. This estimate must be based on the "best information available in the
circumstances."2 An estimate of fair value must be supported by reasonable and current assumptions. If
a best estimate of fair value is not practicable, the asset is to be recorded at zero in financial and
regulatory reports.
History shows that unforeseen market events that affect the discount rate or performance of receivables
supporting a retained interest can swiftly and dramatically alter its value. Without appropriate internal
controls and independent oversight, an institution that securitizes assets may inappropriately generate
“paper profits” or mask actual losses through flawed loss assumptions, inaccurate prepayment rates,
and inappropriate discount rates. Liberal and unsubstantiated assumptions can result in material
inaccuracies in financial statements, substantial write-downs of retained interests, and, if interests
represent an excessive concentration of the institution’s capital, the demise of the sponsoring institution.
Recent examinations point to the need for institution managers and directors to ensure that:
•
Independent risk management processes are in place to monitor securitization pool performance on
an aggregate and individual transaction level. An effective risk management function includes
appropriate information systems to monitor securitization activities.
•
Conservative valuation assumptions and modeling methodologies are used to establish, evaluate and
adjust the carrying value of retained interests on a regular and timely basis.
•
Audit or internal review staffs periodically review data integrity, model algorithms, key underlying
assumptions, and the appropriateness of the valuation and modeling process for the securitized
assets retained by the institution. The findings of such reviews should be reported directly to the
board or an appropriate board committee.
•
Accurate and timely risk-based capital calculations are maintained, including recognition and
reporting of any recourse obligation resulting from securitization activity.
•
Internal limits are in place to govern the maximum amount of retained interests as a percentage of
total equity capital.
2
Date:
FAS 125, at par. 43
December 13, 1999
Page
3
•
The institution has a realistic liquidity plan in place in case of market disruptions.
The following sections provide additional guidance relating to these and other critical areas of concern.
Institutions that lack effective risk management programs or that maintain exposures in retained interests
that warrant supervisory concern may be subject to more frequent supervisory review, more stringent
capital requirements, or other supervisory action.
INDEPENDENT RISK MANAGEMENT FUNCTION
Institutions engaged in securitizations should have an independent risk management function
commensurate with the complexity and volume of their securitizations and their overall risk exposures.
The risk management function should ensure that securitization policies and operating procedures,
including clearly articulated risk limits, are in place and appropriate for the institution’s circumstances. A
sound asset securitization policy should include or address, at a minimum:
•
A written and consistently applied accounting methodology;
•
Regulatory reporting requirements;
•
Valuation methods, including FAS 125 residual value assumptions, and procedures to formally
approve changes to those assumptions;
•
Management reporting process; and
•
Exposure limits and requirements for both aggregate and individual transaction monitoring.
It is essential that the risk management function monitor origination, collection, and default management
practices. This includes regular evaluations of the quality of underwriting, soundness of the appraisal
process, effectiveness of collections activities, ability of the default management staff to resolve severely
delinquent loans in a timely and efficient manner, and the appropriateness of loss recognition practices.
Because the securitization of assets can result in the current recognition of anticipated income, the risk
management function should pay particular attention to the types, volumes, and risks of assets being
originated, transferred and serviced. Both senior management and the risk management staff must be
alert to any pressures on line managers to originate abnormally large volumes or higher risk assets in
order to sustain ongoing income needs. Such pressures can lead to a compromise of credit underwriting
standards. This may accelerate credit losses in future periods, impair the value of retained interests and
potentially lead to funding problems.
The risk management function should also ensure that appropriate management information systems
(MIS) exist to monitor securitization activities. Reporting and documentation methods must support the
initial valuation of retained interests and ongoing impairment analyses of these assets. Pool performance
information has helped well-managed institutions to ensure, on a qualitative basis, that a sufficient
amount of economic capital is being held to cover the various risks inherent in securitization transactions.
Date:
December 13, 1999
Page
4
The absence of quality MIS hinders management’s ability to monitor specific pool performance and
securitization activities more broadly. At a minimum, MIS reports should address the following:
Securitization summaries for each transaction - The summary should include relevant
transaction terms such as collateral type, facility amount, maturity, credit enhancement and
subordination features, financial covenants (termination events and spread account capture
“triggers”), right of repurchase, and counterparty exposures. Management should ensure that the
summaries are distributed to all personnel associated with securitization activities.
Performance reports by portfolio and specific product type - Performance factors include
gross portfolio yield, default rates and loss severity, delinquencies, prepayments or payments, and
excess spread amounts. The reports should reflect performance of assets, both on an individual
pool basis and total managed assets. These reports should segregate specific products and different
marketing campaigns.
Vintage analysis for each pool using monthly data - Vintage analysis helps management
understand historical performance trends and their implications for future default rates, prepayments,
and delinquencies, and therefore retained interest values. Management can use these reports to
compare historical performance trends to underwriting standards, including the use of a validated
credit scoring model, to ensure loan pricing is consistent with risk levels. Vintage analysis also helps
in the comparison of deal performance at periodic intervals and validates retained interest valuation
assumptions.
Static pool cash collection analysis - This analysis entails reviewing monthly cash receipts
relative to the principal balance of the pool to determine the cash yield on the portfolio, comparing
the cash yield to the accrual yield, and tracking monthly changes. Management should compare the
timing and amount of cash flows received from the trust with those projected as part of the FAS
125 retained interest valuation analysis on a monthly basis. Some master trust structures allow
excess cash flow to be shared between series or pools. For revolving asset trusts with this master
trust structure, management should perform a cash collection analysis for each master trust structure.
These analyses are essential in assessing the actual performance of the portfolio in terms of default
and prepayment rates. If cash receipts are less than those assumed in the original valuation of the
retained interest, this analysis will provide management and the board with an early warning of
possible problems with collections or extension practices, and impairment of the retained interest.
Sensitivity analysis - Measuring the effect of changes in default rates, prepayment or payment
rates, and discount rates will assist management in establishing and validating the carrying value of
the retained interest. Stress tests should be performed at least quarterly. Analyses should consider
potential adverse trends and determine “best,” “probable,” and “worst case” scenarios for each
event. Other factors to consider are the impact of increased defaults on collections staffing, the
timing of cash flows, “spread account” capture triggers, over-collateralization triggers, and early
amortization triggers. An increase in defaults can result in higher than expected costs and a delay in
cash flows, decreasing the value of the retained interests. Management should periodically quantify
and document the potential impact to both earnings and capital, and report the results to the board
Date:
December 13, 1999
Page
5
of directors. Management should incorporate this analysis into their overall interest rate risk
measurement system.3 Examiners will review the analysis conducted by the institution and the
volatility associated with retained interests when assessing the Sensitivity to Market Risk component
rating.
Statement of covenant compliance - Ongoing compliance with deal performance triggers as
defined by the pooling and servicing agreements should be affirmed at least monthly. Performance
triggers include early amortization, spread capture, changes to over-collateralization requirements,
and events that would result in servicer removal.
VALUATION AND MODELING PROCESSES
The method and key assumptions used to value the retained interests and servicing assets or liabilities
must be reasonable and fully documented. The key assumptions in all valuation analyses include
prepayment or payment rates, default rates, loss severity factors, and discount rates. The Agencies
expect institutions to take a logical and conservative approach when developing securitization
assumptions and capitalizing future income flows. It is important that management quantifies the
assumptions on a pool-by-pool basis and maintains supporting documentation for all changes to the
assumptions as part of the valuation process, which should be done no less than quarterly. Policies
should define the acceptable reasons for changing assumptions and require appropriate management
approval.
An exception to this pool-by-pool valuation analysis may be applied to revolving asset trusts if the
master trust structure allows excess cash flows to be shared between series. In a master trust, each
certificate of each series represents an undivided interest in all of the receivables in the trust. Therefore,
valuations are appropriate at the master trust level.
In order to determine the value of the retained interest at inception, and make appropriate adjustments
going forward, the institution must implement a reasonable modeling process to comply with FAS 125.
The Agencies expect management to employ reasonable and conservative valuation assumptions and
projections, and to maintain verifiable objective documentation of the fair value of the retained interest.
Senior management is responsible for ensuring the valuation model accurately reflects the cash flows
according to the terms of the securitization’s structure. For example, the model should account for any
cash collateral or over-collateralization triggers, trust fees, and insurance payments if appropriate. The
board and management are accountable for the “model builders” possessing the necessary expertise
and technical proficiency to perform the modeling process. Senior management should ensure that
internal controls are in place to provide for the ongoing integrity of MIS associated with securitization
activities.
As part of the modeling process, the risk management function should ensure that periodic validations
3
Under the Joint Agency Policy Statement on Interest Rate Risk, institutions with a high level of exposure to
interest rate risk relative to capital will be directed to take corrective action. Savings associations can find OTS
guidance on interest rate risk in Thrift Bulletin 13a - Management of Interest Rate Risk, Investment Securities, and
Derivative Activities.
Date:
December 13, 1999
Page
6
are performed in order to reduce vulnerability to model risk. Validation of the model includes testing the
internal logic, ensuring empirical support for the model assumptions, and back-testing the models with
actual cash flows on a pool-by-pool basis. The validation process should be documented to support
conclusions. Senior management should ensure the validation process is independent from line
management as well as the modeling process. The audit scope should include procedures to ensure that
the modeling process and validation mechanisms are both appropriate for the institution’s circumstances
and executed consistent with the institution's asset securitization policy.
USE OF OUTSIDE PARTIES
Third parties are often engaged to provide professional guidance and support regarding an institution's
securitization activities, transactions, and valuing of retained interests. The use of outside resources does
not relieve directors of their oversight responsibility, or senior management of its responsibilities to
provide supervision, monitoring, and oversight of securitization activities, and the management of the
risks associated with retained interests in particular. Management is expected to have the experience,
knowledge, and abilities to discharge its duties and understand the nature and extent of the risks
presented by retained interests and the policies and procedures necessary to implement an effective risk
management system to control such risks. Management must have a full understanding of the valuation
techniques employed, including the basis and reasonableness of underlying assumptions and projections.
INTERNAL CONTROLS
Effective internal controls are essential to an institution’s management of the risks associated with
securitization. When properly designed and consistently enforced, a sound system of internal controls
will help management safeguard the institution’s resources, ensure that financial information and reports
are reliable, and comply with contractual obligations, including securitization covenants. It will also
reduce the possibility of significant errors and irregularities, as well as assist in their timely detection
when they do occur. Internal controls typically: (1) limit authorities, (2) safeguard access to and use of
records, (3) separate and rotate duties, and (4) ensure both regular and unscheduled reviews, including
testing.
The Agencies have established operational and managerial standards for internal control and information
systems.4 An institution should maintain a system of internal controls appropriate to its size and the
nature, scope, and risk of its activities. Institutions that are subject to the requirements of FDIC
regulation 12 CFR Part 363 should include an assessment of the effectiveness of internal controls over
their asset securitization activities as part of management’s report on the overall effectiveness of the
system of internal controls over financial reporting. This assessment implicitly includes the internal
controls over financial information that is included in regulatory reports.
4
Date:
Safety and Soundness Standards 12 CFR Part 30 (OCC), 12 CFR Part 570 (OTS).
December 13, 1999
Page
7
AUDIT FUNCTION OR INTERNAL REVIEW
It is the responsibility of an institution’s board of directors to ensure that its audit staff or independent
review function is competent regarding securitization activities. The audit function should perform
periodic reviews of securitization activities, including transaction testing and verification, and report all
findings to the board or appropriate board committee. The audit function also may be useful to senior
management in identifying and measuring risk related to securitization activities. Principal audit targets
should include compliance with securitization policies, operating and accounting procedures (FAS 125),
and deal covenants, and accuracy of MIS and regulatory reports. The audit function should also confirm
that the institution’s regulatory reporting process is designed and managed in such a way to facilitate
timely and accurate report filing. Furthermore, when a third party services loans, the auditors should
perform an independent verification of the existence of the loans to ensure balances reconcile to internal
records.
REGULATORY REPORTING
The securitization and subsequent removal of assets from an institution’s balance sheet requires
additional reporting as part of the regulatory reporting process. Common regulatory reporting errors
stemming from securitization activities include:
•
Failure to include off-balance sheet assets subject to recourse treatment when calculating risk-based
capital ratios;
•
Failure to recognize retained interests and retained subordinate security interests as a form of credit
enhancement;
•
Failure to report loans sold with recourse in the appropriate section of the regulatory report; and
•
Over-valuing retained interests.
An institution’s directors and senior management are responsible for the accuracy of its regulatory
reports. Because of the complexities associated with securitization accounting and risk-based capital
treatment, attention should be directed to ensuring that personnel who prepare these reports maintain
current knowledge of reporting rules and associated interpretations. This often will require ongoing
support by qualified accounting and legal personnel.
Institutions that file the Report of Condition and Income (Call Report) should pay particular attention to
the following schedules on the Call Report when institutions are involved in securitization activities:
Schedule RC-F: Other Assets; Schedule RC-L: Off Balance Sheet Items; and Schedule RC-R:
Regulatory Capital. Institutions that file the Thrift Financial Report (TFR) should pay particular
attention to the following TFR schedules: Schedule CC: Consolidated Commitments and
Contingencies, Schedule CCR: Consolidated Capital Requirement, and Schedule CMR:
Consolidated Maturity and Rate.
Date:
December 13, 1999
Page
8
Under current regulatory report instructions, when an institution’s supervisory agency’s interpretation of
how generally accepted accounting principles (GAAP) should be applied to a specified event or
transaction differs from the institution’s interpretation, the supervisory agency may require the institution
to reflect the event or transaction in its regulatory reports in accordance with the agency’s interpretation
and amend previously submitted reports.
MARKET DISCIPLINE AND DISCLOSURES
Transparency through public disclosure is crucial to effective market discipline and can reinforce
supervisory efforts to promote high standards in risk management. Timely and adequate information on
the institution’s asset securitization activities should be disclosed. The information contained in the
disclosures should be comprehensive; however, the amount of disclosure that is appropriate will depend
on the volume of securitizations and complexity of the institution. Well-informed investors, depositors,
creditors and other bank counterparties can provide a bank with strong incentives to maintain sound risk
management systems and internal controls. Adequate disclosure allows market participants to better
understand the financial condition of the institution and apply market discipline, creating incentives to
reduce inappropriate risk taking or inadequate risk management practices. Examples of sound
disclosures include:
•
Accounting policies for measuring retained interests, including a discussion of the impact of key
assumptions on the recorded value;
•
Process and methodology used to adjust the value of retained interests for changes in key
assumptions;
•
Risk characteristics, both quantitative and qualitative, of the underlying securitized assets;
•
Role of retained interests as credit enhancements to special purpose entities and other securitization
vehicles, including a discussion of techniques used for measuring credit risk; and
•
Sensitivity analyses or stress testing conducted by the institution showing the effect of changes in key
assumptions on the fair value of retained interests.
RISK-BASED CAPITAL FOR RECOURSE AND LOW LEVEL RECOURSE
TRANSACTIONS
For regulatory purposes, recourse is generally defined as an arrangement in which an institution retains
the risk of credit loss in connection with an asset transfer, if the risk of credit loss exceeds a pro rata
share of the institution’s claim on the assets.5 In addition to broad contractual language that may require
5
The risk-based capital treatment for sales with recourse can be found at 12 CFR Part 3 Appendix A, Section
(3)(b)(1)(iii) {OCC}, 12 CFR Part 567.6(a)(2)(i)(c) {OTS}. For a further explanation of recourse see the glossary entry
"Sales of Assets for Risk-Based Capital Purposes" in the instructions for the Call Report.
Date:
December 13, 1999
Page
9
the selling institution to support a securitization, recourse can also arise from retained interests, retained
subordinated security interests, the funding of cash collateral accounts, or other forms of credit
enhancements that place an institution’s earnings and capital at risk. These enhancements should
generally be aggregated to determine the extent of an institution’s support of securitized assets.
Although an asset securitization qualifies for sales treatment under GAAP, the underlying assets may still
be subject to regulatory risk-based capital requirements. Assets sold with recourse should generally be
risk-weighted as if they had not been sold.
Securitization transactions involving recourse may be eligible for “low level recourse” treatment.6 The
Agencies’ risk-based capital standards provide that the dollar amount of risk-based capital required for
assets transferred with recourse should not exceed the maximum dollar amount for which an institution is
contractually liable. The “low level recourse” treatment applies to transactions accounted for as sales
under GAAP in which an institution contractually limits its recourse exposure to less than the full riskbased capital requirements for the assets transferred. Under the low level recourse principle, the
institution holds capital on approximately a dollar-for-dollar basis up to the amount of the aggregate
credit enhancements.
Low level recourse transactions should be reported in Schedule RC-R of the Call Report or Schedule
CCR of the TFR using either the “direct reduction method” or the “gross-up method” in accordance
with the regulatory report instructions.
If an institution does not contractually limit the maximum amount of its recourse obligation, or if the
amount of credit enhancement is greater than the risk-based capital requirement that would exist if the
assets were not sold, the low level recourse treatment does not apply. Instead, the institution must hold
risk-based capital against the securitized assets as if those assets had not been sold.
Finally, as noted earlier, retained interests that lack objectively verifiable support or that fail to meet the
supervisory standards set for in this document will be classified as loss and disallowed as assets of the
institution for regulatory capital purposes.
INSTITUTION IMPOSED CONCENTRATION LIMITS ON RETAINED INTERESTS
The creation of a retained interest (the debit) typically also results in an offsetting “gain on sale” (the
credit) and thus generation of an asset. Institutions that securitize high yielding assets with long durations
may create a retained interest asset value that exceeds the risk-based capital charge that would be in
place if the institution had not sold the assets (under the existing risk-based capital guidelines, capital is
not required for the amount over eight percent of the securitized assets). Serious problems can arise for
institutions that distribute contrived earnings only later to be faced with a downward valuation and
charge-off of part or all of the retained interests.
6
The banking agencies’ low level recourse treatment is described in the Federal Register in the following locations:
60 Fed. Reg. 17986 (April 10, 1995) (OCC); 60 Fed. Reg. 8177 (February 13, 1995)(FRB); 60 Fed. Reg. 15858 (March
28,1995)(FDIC). OTS has had a low level recourse rule in 12 CFR Part 567.6(a)(2)(i)(c) since 1989. A brief explanation
is also contained in the instructions for regulatory reporting in section RC-R for the Call Report or schedule CCR for
the TFR.
Date:
December 13, 1999
Page
10
As a basic example, an institution could sell $100 in subprime home equity loans and book a retained
interest of $20 using liberal “gain on sale” assumptions. Under the current capital rules, the institution is
required to hold approximately $8 in capital. This $8 is the current capital requirement if the loans were
never removed from the balance sheet (eight percent of $100 = $8). However, the institution is still
exposed to substantially all of the credit risk, plus the additional risk to earnings and capital from the
volatility of the retained interest. If the value of the retained interest decreases to $10 due to inaccurate
assumptions or changes in market conditions, the $8 in capital is insufficient to cover the entire loss.
Normally, the sponsoring institution will eventually receive any excess cash flow remaining from
securitizations after investor interests have been met. However, recent experience has shown that
retained interests are vulnerable to sudden and sizeable write-downs that can hinder an institution’s
access to the capital markets, damage its reputation in the market place, and in some cases, threaten its
solvency. Accordingly, the Agencies expect an institution's board of directors and management to
develop and implement policies that limit the amount of retained interests that may be carried as a
percentage of total equity capital, based on the results of their valuation and modeling processes. Well
constructed internal limits also serve to lessen the incentive of institution personnel to engage in activities
designed to generate near term “paper profits” that may be at the expense of the institution’s long term
financial position and reputation.
SUMMARY
Asset securitization has proven to be an effective means for institutions to access new and diverse
funding sources, manage concentrations, improve financial performance ratios, and effectively serve
borrowing customers. However, securitization activities also present unique and sometimes complex
risks that require board and senior management attention. Specifically, the initial and ongoing valuation
of retained interests associated with securitization, and the limitation of exposure to the volatility
represented by these assets, warrant immediate attention by management.
Moreover, as mentioned earlier in this statement, the Agencies are studying various issues relating to
securitization practices, including whether restrictions should be imposed that would limit or eliminate the
amount of retained interests that qualify as regulatory capital. In the interim, the Agencies will review
affected institutions on a case-by-case basis and may require, in appropriate circumstances, that
institutions hold additional capital commensurate with their risk exposure. In addition, the Agencies will
study, and issue further guidance on, institutions' exposure to implicit recourse obligations and the
liquidity risk associated with over reliance on asset securitization as a funding source.
Date:
December 13, 1999
Page
11
OCC Bulletin 2007-1
Page 1 of 3
OCC 2007-1
OCC BULLETIN
Comptroller of the Currency
Administrator of National Banks
Subject:
Complex Structured Finance
Notice of Final
Description:
Transactions
Interagency Statement
Date: January 5, 2007
TO: Chief Executive Officers of National Banks, Department and Division Heads, All
Examining Personnel, and Other Interested Parties
The Office of the Comptroller of the Currency, the Board of Governors of the Federal
Reserve System, the Federal Deposit Insurance Corporation, the Office of Thrift
Supervision, and the Securities and Exchange Commission (the agencies) are adopting
the attached “Interagency Statement on Sound Practices Concerning Complex
Structured Finance Activities” that may pose heightened legal or reputational risks to
financial institutions. The statement was issued on January 5, 2007, and will be
published in the Federal Register.
SUMMARY
In May 2004, the agencies issued and requested comment on a proposed “Interagency
Statement on Sound Practices Concerning Complex Structured Finance
Activities” (initial statement). After carefully considering comments received, the
agencies issued a revised statement for comment in May 2006. The modifications to the
initial statement addressed issues and concerns raised by commenters. These
modifications made the statement more principles-based; focused the statement on those
complex structured finance transactions (CSFTs) that may pose heightened levels of
legal or reputational risk to the relevant institution (referred to as elevated risk CSFTs);
recognized more explicitly that an institution’s review and approval process for elevated
risk CSFTs should be commensurate with, and should focus on, the potential risks
presented by the transaction to the institution; clarified that the statement does not create
any private rights of action, nor does it alter or expand the legal duties and obligations
that a financial institution may have to a customer, to its shareholders, or to other third
parties under applicable law; and noted that it does not affect the vast majority of
financial institutions, including most small financial institutions. The agencies have
adopted the final statement with minor modifications designed to clarify, but not alter,
the principles outlined in the revised statement.
Examples of CSFTs that often pose elevated risks and thus would be covered by the
final statement include transactions that:
•
Lack economic substance or business purpose;
http://www.occ.treas.gov/ftp/bulletin/2007-1.html
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OCC Bulletin 2007-1
•
•
•
•
•
•
Page 2 of 3
Are designed or used primarily for questionable accounting, regulatory, or tax
objectives, particularly when the transactions are executed at year end or at the
end of a reporting period for the customer;
Raise concerns that the client will report or disclose the transaction in its
public filings or financial statements in a manner that is materially misleading
or inconsistent with the substance of the transaction or with applicable
regulatory or accounting requirements;
Involve circular transfers of risk (either between the financial institution and
the customer or between the customer and other related parties) that lack
economic substance or business purpose;
Involve oral or undocumented agreements that, when taken into account,
would have a material impact on the regulatory, tax, or accounting treatment
of the related transaction, or the client’s disclosure obligations;
Have material economic terms that are inconsistent with market norms (e.g.,
deep “in the money” options or historic rate rollovers); or
Provide the financial institution with compensation that appears substantially
disproportionate to the services provided or investment made by the financial
institution or to the credit, market, or operational risk assumed by the
institution.
The statement points out that if a financial institution determines through its due
diligence that participation in a particular CSFT would create significant legal or
reputational risks for the institution, the institution should take appropriate steps to
address those risks. Such actions may include declining to participate in the transaction,
or conditioning its participation upon the receipt of representations or assurances from
the customer that reasonably address the heightened legal or reputational risks presented
by the transaction. The statement also establishes that a financial institution should
decline to participate in an elevated risk CSFT if, after conducting appropriate due
diligence and taking appropriate steps to address the risks from the transaction, the
institution determines that the transaction presents unacceptable risk to the institution or
would result in a violation of applicable laws, regulations, or accounting principles.
FURTHER INFORMATION
For further information, please contact Kathy Dick, Deputy Comptroller for Credit and
Market Risk, (202) 874-4660; Grace Dailey, Deputy Comptroller for Large Banks, (202)
874-4610; or Ellen Broadman, Director, Securities and Corporate Practices Division,
(202) 874-5210.
/signed/
Emory W. Rushton
Senior Deputy Comptroller and Chief National Bank Examiner
/signed/
Douglas W. Roeder
Senior Deputy Comptroller for Large Bank Supervision
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OCC Bulletin 2007-1
Page 3 of 3
Attachment – http://www.occ.treas.gov/ftp/bulletin/2007-1a.pdf
[http://www.occ.treas.gov/ftp/bulletin/2007-1a.pdf]
http://www.occ.treas.gov/ftp/bulletin/2007-1.html
3/31/2010
DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
[Docket No. 06-17]
Office of Thrift Supervision
[Docket No. 2006-55]
FEDERAL RESERVE SYSTEM
[Docket No. OP-1254]
FEDERAL DEPOSIT INSURANCE CORPORATION
SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-55043; File No. S7-08-06]
Interagency Statement on Sound Practices Concerning
Elevated Risk Complex Structured Finance Activities
AGENCIES: Office of the Comptroller of the Currency, Treasury (“OCC”); Office of
Thrift Supervision, Treasury (“OTS”); Board of Governors of the Federal Reserve
System (“Board”); Federal Deposit Insurance Corporation (“FDIC”); and Securities and
Exchange Commission (“SEC”) (collectively, the “Agencies”).
ACTION: Notice of final interagency statement.
SUMMARY: The Agencies are adopting an Interagency Statement on Sound Practices
Concerning Elevated Risk Complex Structured Finance Activities (“Final Statement”).
The Final Statement pertains to national banks, state banks, bank holding companies
(other than foreign banks), federal and state savings associations, savings and loan
holding companies, U.S. branches and agencies of foreign banks, and SEC-registered
broker-dealers and investment advisers (collectively, “financial institutions” or
“institutions”) engaged in complex structured finance transactions (“CSFTs”). In May
2004, the Agencies issued and requested comment on a proposed interagency statement
(“Initial Proposed Statement”). After reviewing the comments received on the Initial
Proposed Statement, the Agencies in May 2006 issued and requested comment on a
revised proposed interagency statement (“Revised Proposed Statement”). The
modifications to the Revised Proposed Statement, among other things, made the
statement more principles-based and focused on the identification, review and approval
process for those CSFTs that may pose heightened levels of legal or reputational risk to
the relevant institution (referred to as “elevated risk CSFTs”). After carefully reviewing
the comments on the Revised Proposed Statement, the Agencies have adopted the Final
Statement with minor modifications designed to clarify, but not alter, the principles set
forth in the Revised Proposed Statement. The Final Statement describes some of the
internal controls and risk management procedures that may help financial institutions
identify, manage, and address the heightened reputational and legal risks that may arise
from elevated risk CSFTs. As discussed further below, the Final Statement will not
affect or apply to the vast majority of financial institutions, including most small
institutions, nor does it create any private rights of action.
EFFECTIVE DATE: The Final Statement is effective upon [INSERT DATE OF
PUBLICATION IN THE FEDERAL REGISTER].
FOR FURTHER INFORMATION CONTACT:
OCC: Kathryn E. Dick, Deputy Comptroller, Credit and Market Risk,
(202) 874-4660; Grace E. Dailey, Deputy Comptroller, Large Bank Supervision, (202)
874-4610; or Ellen Broadman, Director, Securities and Corporate Practices Division,
(202) 874-5210, Office of the Comptroller of the Currency, 250 E Street, SW,
Washington, DC 20219.
OTS: Fred J. Phillips-Patrick, Director, Credit Policy, (202) 906-7295,
and Deborah S. Merkle, Project Manager, Credit Policy, (202) 906-5688, Examinations
and Supervision Policy; or David A. Permut, Senior Attorney, Business Transactions
Division, (202) 906-7505, Office of Thrift Supervision, 1700 G Street, NW, Washington,
DC 20552.
Board: Sabeth I. Siddique, Assistant Director, (202) 452-3861, or Virginia
Gibbs, Senior Supervisory Financial Analyst, (202) 452-2521, Division of Banking
Supervision and Regulation; or Kieran J. Fallon, Assistant General Counsel, (202) 4525270, or Anne B. Zorc, Senior Attorney, (202) 452-3876, Legal Division, Board of
Governors of the Federal Reserve System, 20th Street and Constitution Avenue, NW,
Washington, DC 20551. Users of Telecommunication Device for Deaf (TTD) only, call
(202) 263-4869.
FDIC: Jason C. Cave, Associate Director, (202) 898-3548; Division of
Supervision and Consumer Protection; or Mark G. Flanigan, Counsel, Supervision and
Legislation Branch, Legal Division, (202) 898-7426, Federal Deposit Insurance
Corporation, 550 17th Street, NW, Washington, DC 20429.
SEC: Mary Ann Gadziala, Associate Director, Office of Compliance
Inspections and Examinations, (202) 551-6207; Catherine McGuire, Chief Counsel,
Linda Stamp Sundberg, Senior Special Counsel (Banking and Derivatives), or Randall
W. Roy, Branch Chief, Division of Market Regulation, (202) 551-5550, Securities and
Exchange Commission, 100 F Street, NE, Washington, DC 20549.
SUPPLEMENTARY INFORMATION:
I.
Background
Financial markets have grown rapidly over the past decade, and
innovations in financial instruments have facilitated the structuring of cash flows and
2
allocation of risk among creditors, borrowers, and investors in more efficient ways.
Financial derivatives for market and credit risk, asset-backed securities with customized
cash flow features, specialized financial conduits that manage pools of assets, and other
types of structured finance transactions serve important purposes, such as diversifying
risk, allocating cash flows and reducing cost of capital. As a result, structured finance
transactions, including the more complex variations of these transactions, now are an
essential part of U.S. and international capital markets.
When a financial institution participates in a CSFT, it bears the usual
market, credit, and operational risks associated with the transaction. In some
circumstances, a financial institution also may face heightened legal or reputational risks
due to its involvement in a CSFT. For example, a financial institution involved in a
CSFT may face heightened legal or reputational risk if the customer’s regulatory, tax or
accounting treatment for the CSFT, or disclosures concerning the CSFT in its public
filings or financial statements, do not comply with applicable laws, regulations or
accounting principles. 1
In some cases, certain CSFTs appear to have been used in illegal schemes
that misrepresented the financial condition of public companies to investors and
regulatory authorities. After conducting investigations, the OCC, Federal Reserve
System and SEC took strong and coordinated civil and administrative enforcement
actions against certain financial institutions that engaged in CSFTs that appeared to have
been designed or used to shield their customers’ true financial health from the public.
These actions involved the assessment of significant financial penalties on the institutions
and required the institutions to take several measures to strengthen their risk management
procedures for CSFTs. 2 The complex structured finance relationships involving these
financial institutions also sparked an investigation by the Permanent Subcommittee on
Governmental Affairs of the United States Senate, 3 as well as numerous lawsuits by
private litigants.
1
For a memorandum on the potential liability of a financial institution for securities laws violations arising
from participation in a CSFT, see Letter from Annette L. Nazareth, Director, Division of Market
Regulation, Securities and Exchange Commission, to Richard Spillenkothen and Douglas W. Roeder, dated
December 4, 2003 (available at http://www.federalreserve.gov/boarddocs/srletters/2004/ and
http://www.occ.treas.gov).
2
See, e.g., In the Matter of Citigroup, Inc., Securities Exchange Act Release No. 48230 (July 28, 2003),
Written Agreement by and between Citibank, N.A. and the Office of the Comptroller of the Currency, No.
2003-77 (July 28, 2003) (pertaining to transactions entered into by Citibank, N.A. with Enron Corp.) and
Written Agreement by and between Citigroup, Inc. and the Federal Reserve Bank of New York, dated July
28, 2003 (pertaining to transactions involving Citigroup Inc. and its subsidiaries and Enron Corp. and
Dynegy Inc.); SEC v. J.P. Morgan Chase, SEC Litigation Release No. 18252 (July 28, 2003) and Written
Agreement by and among J.P. Morgan Chase & Co., the Federal Reserve Bank of New York, and the New
York State Banking Department, dated July 28, 2003 (pertaining to transactions involving J.P. Morgan
Chase & Co. and its subsidiaries and Enron Corp.).
3
See Fishtail, Bacchus, Sundance, and Slapshot: Four Enron Transactions Funded and Facilitated by U.S.
Financial Institutions, Report Prepared by the Permanent Subcomm. on Investigations, Comm. on
Governmental Affairs, United States Senate, S. Rpt. 107-82 (2003).
3
The OCC, Federal Reserve System and SEC also conducted special
reviews of several large financial institutions engaged in CSFTs, and the Agencies have
focused attention on the CSFT activities of financial institutions in the normal course of
the supervisory process. These reviews and activities indicate that many of the large
financial institutions engaged in CSFTs have taken meaningful steps in recent years to
improve their control infrastructure relating to CSFTs.
II.
Initial and Revised Proposed Statements
To assist financial institutions in identifying, managing, and addressing
the risks that may be associated with CSFTs, the Agencies developed and requested
public comment on the Initial Proposed Statement. 4 The Initial Proposed Statement
described the types of policies and procedures that a financial institution engaged in
CSFTs should have in place to allow the institution to identify, document, evaluate, and
control the full range of credit, market, operational, legal, and reputational risks that may
arise from CSFTs. The agencies collectively received comments from more than 40
commenters on the Initial Proposed Statement. Although commenters generally
supported the Agencies’ efforts to describe the types of risk management procedures and
internal controls that may help institutions manage the risks associated with CSFTs,
virtually all of the commenters recommended changes to the Initial Proposed Statement.
After carefully reviewing the comments on the Initial Proposed Statement,
the Agencies issued and requested comment on a Revised Proposed Statement. 5 The
Revised Proposed Statement was modified in numerous respects to clarify the purpose,
scope and effect of the statement; make the statement more risk-focused and principles
based; and focus the statement on those CSFTs that may pose elevated levels of legal or
reputational risk to the relevant institution. 6
III.
Overview of Comments on the Revised Proposed Statement
The Agencies collectively received written comments from 19
commenters on the Revised Proposed Statement, although many commenters submitted
identical comments to multiple Agencies. Commenters included banking organizations,
financial services trade associations, and individuals. Commenters generally expressed
strong support for the Revised Proposed Statement, including its principles-based
structure and focus on elevated risk CSFTs. Many commenters also asserted that the
Revised Proposed Statement provides a financial institution appropriate flexibility to
develop internal controls and risk management procedures that are tailored to the
institution’s own business activities and organizational structure.
4
See 69 FR 28980, May 19, 2004.
5
See 71 FR 28326, May 16, 2006.
6
A more detailed summary of the comments on the Initial Proposed Statement, as well as the changes
made in response to those comments, is contained in the Federal Register notice accompanying the Revised
Proposed Statement (71 FR 28326, 28328-29 (May 16, 2006)).
4
Several commenters requested that the Agencies clarify or revise the
Revised Proposed Statement in certain respects. For example, some commenters asked
the Agencies to further streamline the provisions in the statement pertaining to
documentation of elevated risk CSFTs, or clarify how the U.S. branches or agencies of
foreign banks might implement risk management systems, policies or controls consistent
with the statement’s principles. In addition, some commenters asked the Agencies to set
forth or clarify the legal standards governing the potential liability of financial institutions
for CSFTs or provide “safe harbors” from such potential liability. One group of
commenters also argued that the Revised Proposed Statement should not be implemented
because it allegedly would encourage or condone illegal conduct by financial institutions.
The comments received on the Revised Proposed Statement are further discussed below.
IV.
Overview of Final Statement
After carefully reviewing the comments on the Revised Proposed
Statement, the Agencies have made minor modifications to the Revised Proposed
Statement in response to comments and to clarify the principles, scope, and intent of the
Final Statement. The Final Statement has been adopted as supervisory guidance by the
Board, OCC, FDIC and OTS and as a policy statement by the SEC. The Agencies will
use the Final Statement going forward in reviewing the internal controls and risk
management policies, procedures and systems of financial institutions engaged in CSFTs
as part of the Agencies’ ongoing supervisory process.
The Agencies continue to believe that it is important for a financial
institution engaged in CSFTs to have policies and procedures that are designed to allow
the institution to effectively manage and address the full range of risks associated with its
CSFT activities, including the elevated legal or reputational risks that may arise in
connection with certain CSFTs. For this reason, the Final Statement describes the types
of risk management principles that the Agencies believe may help a financial institution
to identify elevated risk CSFTs and to evaluate, manage, and address these risks within
the institution’s internal control framework. 7 These policies and procedures should,
among other things, be designed to allow the institution to identify elevated risk CSFTs
during its transaction and new product approval processes, and should provide for
elevated risk CSFTs to be reviewed by appropriate levels of control and management
personnel at the institution, including personnel from control areas that are independent
of the business line(s) involved in the transaction.
The Final Statement – like the Revised Proposed Statement – applies to
financial institutions that are engaged in CSFT activities and focuses on those CSFTs that
may create heightened levels of legal or reputational risks for a participating financial
institution. Because CSFTs typically are conducted by a limited number of large
7
As noted in the Final Statement, financial institutions are encouraged to refer to other supervisory
guidance and materials prepared by the Agencies for further information concerning market, credit and
operational risk, as well as for further information on legal and reputational risk, internal audit and internal
controls.
5
financial institutions, the Final Statement will not affect or apply to the vast majority of
financial institutions, including most small institutions.
As the Final Statement recognizes, structured finance transactions
encompass a broad array of products with varying levels of complexity. Most structured
finance transactions, such as standard public mortgage-backed securities and hedgingtype transactions involving “plain vanilla” derivatives or collateralized debt obligations,
are familiar to participants in the financial markets, have well-established track records,
and typically would not be considered CSFTs for purposes of the Final Statement. Some
commenters requested that the Agencies provide a more extensive list of structured
finance transactions that typically would not be considered CSFTs. The Agencies note
that the types of non-complex transactions listed in the Final Statement are only examples
of the types of transactions that typically would not be considered CSFTs and that any list
of examples would not, and could not, be all inclusive given the changing nature of the
structured finance market. Consistent with the principles-based approach of the Final
Statement, the Agencies believe the statement appropriately highlights the hallmarks of a
non-complex transaction – i.e., a well established track record and familiarity to
participants in the financial markets – that may guide institutions and examiners in
considering whether a particular type of transaction should be considered a CSFT now or
in the future.
A.
Identification, Due Diligence, and Approval Processes for Elevated Risk
CSFTs
As noted above, a financial institution should establish and maintain
policies, procedures and systems that are designed to identify elevated risk CSFTs as part
of the institution’s transaction or new product approval processes, and to ensure that
transactions or new products identified as elevated risk CSFTs are subject to heightened
review. 8 In general, a financial institution should conduct the level and amount of due
diligence for an elevated risk CSFT that is commensurate with the level of risks
identified. A financial institution’s policies and procedures should provide that CSFTs
identified as potentially having elevated legal or reputational risk are reviewed and
approved by appropriate levels of management. The Agencies continue to believe that
the designated approval process for elevated risk CSFTs should include the institution’s
representatives from the relevant business line(s) and/or client relationship management,
as well as from appropriate control areas that are independent of the business line(s)
involved in the transaction. An institution’s policies should provide that new complex
8
In response to comments, the Agencies have modified the Final Statement to clarify that a U.S. branch or
agency of a foreign bank is not necessarily expected to establish or adopt separate U.S.-based risk
management structures or policies for its CSFT activities. In addition, the Agencies believe the Final
Statement provides U.S. branches and agencies of foreign banks sufficient flexibility to develop controls,
risk management and reporting structures, and lines of authority that are consistent with the internal
management structure of U.S. branches and agencies. However, the risk management structure and
policies used by a U.S. branch or agency, whether adopted or implemented on a group-wide or stand-alone
basis, should be effective in allowing the branch or agency to manage the risks associated with its CSFT
activities.
6
structured finance products receive the approval of all relevant control areas that are
independent of the profit center before the product is offered to customers. 9
The Final Statement – like the Revised Proposed Statement – provides
examples of transactions that may warrant additional scrutiny by an institution. These
examples include, among other things, transactions that appear to the institution to:
•
•
•
Lack economic substance or business purpose;
Be designed or used primarily for questionable accounting, regulatory,
or tax objectives, particularly when the transactions are executed at
year-end or at the end of a reporting period for the customer; or
Raise concerns that the client will report or disclose the transaction in
its public filings or financial statements in a manner that is materially
misleading or inconsistent with the substance of the transaction or
applicable regulatory or accounting requirements.
A few commenters contended that the examples of elevated risk CSFTs
contained in the Revised Proposed Statement have characteristics that are signals, if not
conclusive proof, of fraudulent activity, and recommended that the Agencies inform
financial institutions that transactions or products with any of these characteristics should
be considered presumptively prohibited. The commenters also argued that the statement
encourages or condones illegal conduct by financial institutions. The Agencies believe
that CSFTs that initially appear to an institution, during the ordinary course of its new
product or transaction approval process, to have one or more of the characteristics
identified in the Final Statement should generally be identified as an elevated risk CSFT,
and the institution should conduct due diligence for the transaction that is commensurate
with the level of identified, potential risks. The Agencies, however, do not believe it is
appropriate to provide that all transactions initially identified as potentially creating
elevated legal or reputational risks for an institution should be considered presumptively
prohibited. For example, an institution, after conducting additional due diligence for a
transaction initially identified as an elevated risk CSFT, may determine that the
transaction does not, in fact, have the characteristics that initially triggered the review.
Alternatively, the institution may take steps to address the legal or reputational risks that
initially triggered the review. In this regard, the Final Statement expressly provides that,
if after evaluating an elevated risk CSFT, a financial institution determines that its
participation in the transaction would create significant legal or reputational risks for the
institution, the financial institution should take appropriate steps to manage and address
these risks. Such steps may include modifying the transaction or conditioning the
institution’s participation in the transaction upon the receipt of representations or
9
One commenter sought clarification regarding when during the new product approval process a new
complex structured finance product should receive the approval of relevant control areas. The Agencies
note that the Final Statement is not intended to prevent institutions from engaging in initial or preliminary
discussions or negotiations with potential customers about a new complex structured finance product.
However, an institution should obtain the necessary approvals for a new complex structured finance
product from appropriate control areas before the institution enters into, or becomes obligated to enter into,
a transaction with the customer.
7
assurances from the customer that reasonably address the heightened risks presented by
the transaction.
Importantly, the Final Statement continues to provide that a financial
institution should decline to participate in an elevated risk CSFT if, after conducting
appropriate due diligence and taking appropriate steps to address the risks from the
transaction, the institution determines that the transaction presents unacceptable risks to
the institution or would result in a violation of applicable laws, regulations or accounting
principles. 10 The Final Statement also expressly notes that financial institutions must
conduct their activities in accordance with applicable statutes and regulations. The
Agencies believe the Final Statement should assist financial institutions engaged in
CSFTs in managing the risks associated with these activities and complying with the law,
and does not, as some commenters alleged, encourage or condone illegal conduct.
Some commenters also requested that the Agencies enunciate, clarify or
modify the legal standards governing the potential liability of a financial institution for
participating in a CSFT that is used for fraudulent or illegal purposes. For example, some
commenters asked the Agencies to declare that institutions do not have a duty to ensure
the accuracy of a client’s public filings or accounting. Other commenters asked that the
Agencies state that an institution will not be held liable or responsible for a CSFT if the
institution has a reasonable degree of confidence that the customer will report or account
for the transactions properly. Other commenters expressed concern that the Revised
Proposed Statement, or the comments submitted on that document, attempted to alter the
current legal standards under which a financial institution may be held liable for
fraudulent activity or criminally responsible under the Federal securities law or other
laws.
As events in recent years have highlighted, institutions may in certain
circumstances bear significant legal or reputational risk from participating in a CSFT. In
light of these risks, the Final Statement describes the types of risk management systems
and internal controls that may help a financial institution engaged in CSFTs to identify
those CSFTs that may pose heightened legal or reputational risk to the institution, and to
evaluate, manage, and address those risks. Because the Final Statement represents
guidance on the part of the Banking Agencies and a policy statement on the part of the
SEC, it does not, by itself, establish any legally enforceable requirements or obligations.
Moreover, as the Final Statement expressly provides, it does not create any private rights
of action, nor does it alter or expand the legal duties and obligations that a financial
institution may have to a customer, its shareholders or other parties under applicable law.
10
Some commenters asked the Agencies to clarify that the Final Statement does not necessarily prevent a
financial institution from proceeding with a CSFT simply because there may be some ambiguity in how the
transaction might be viewed under the law or applicable accounting principles. The Agencies recognize
that in certain circumstances ambiguities may exist as to how the law or accounting principles apply to a
CSFT, particularly in light of the inherent complexity and rapidly evolving nature of CSFTs. Nevertheless,
as discussed in the Final Statement, a financial institution should maintain strong and effective processes
and controls designed to determine whether any such ambiguities may create significant legal or
reputational risks for the institution and to manage and address those risks as appropriate.
8
Accordingly, the Agencies do not believe it is appropriate or possible to address in the
Final Statement these legal concerns expressed by commenters.
B.
Documentation
The Final Statement states that a financial institution should create and
collect sufficient documentation to, among other things, verify that the institution’s
policies and procedures related to elevated risk CSFTs are being followed and allow the
internal audit function to monitor compliance with those policies and procedures. The
Final Statement also provides that, when an institution’s policies and procedures require
an elevated risk CSFT to be submitted for approval to senior management, the institution
should maintain the transaction-related documentation provided to senior management as
well as other documentation that reflect management’s approval (or disapproval) of the
transaction, any conditions imposed by senior management, and the reasons for such
action.
Several commenters strongly suggested that the Agencies should eliminate
or modify the portions of the statement that provide for a financial institution to maintain
certain documentation related to elevated risk CSFTs that are submitted to the
institution’s senior management for approval (or denial). For example, some commenters
argued that institutions should not be required to maintain any documentation for
declined transactions. Other commenters expressed concern that this provision was
inconsistent with the current practice of financial institutions, would require financial
institutions to create new and potentially extensive documentation to memorialize all
aspects of the institution’s analytical and decision-making process with respect to an
elevated risk CSFT, or would require institutions to create or maintain extensive
documentation even for transactions that are approved or rejected by junior staff.
As an initial matter, the Agencies note that the Final Statement’s
provisions regarding documentation for elevated risk CSFTs submitted to senior
management for approval (or disapproval) do not apply to transactions that may be
reviewed and acted on by more junior personnel in accordance with the institution’s
policies and procedures. Rather, these provisions apply only to those elevated risk
CSFTs that are identified by the institution as potentially involving the greatest degree of
risk to the institution and, for this reason, are required to be reviewed by the institution’s
senior management. The Agencies believe that it is important for institutions to maintain
documentation for this category of elevated risk CSFTs, whether approved or declined,
that reflects the factors considered by senior management in taking such action. The
Agencies believe this type of documentation may be of significant benefit to the
institution and to the Agencies in reviewing the effectiveness of the institution’s CSFTrelated policies, procedures, and internal controls. However, to help address the
commenter’s concern about potential burden, the Agencies have modified the Final
Statement to recognize that the minutes of an institution’s reviewing senior management
committee may have the information described and to clarify that the documentation for a
transaction should reflect the factors considered by senior management in taking action,
9
but does not have to detail every aspect of the institution’s legal or business analysis of
the transaction. 11
C.
General Risk Management Principles for Elevated Risk CSFTs
The Final Statement – like the Revised Proposed Statement – also
describes some of the other key risk management policies and internal controls that
financial institutions should have in place for elevated risk CSFTs. For example, the
Final Statement provides that the board of directors and senior management of an
institution should establish a “tone at the top” through both actions and formalized
policies that sends a strong message throughout the financial institution about the
importance of compliance with the law and overall good business ethics. The Final
Statement also describes the types of training, reporting mechanisms, and audit
procedures that institutions should have in place with respect to elevated risk CSFTs.
The Final Statement also provides that a financial institution should conduct periodic
independent reviews of its CSFT activities to verify and monitor that its policies and
controls relating to elevated risk CSFTs are being implemented effectively and that
elevated risk CSFTs are accurately identified and receive proper approvals.
In response to comments, the Agencies have modified the Final Statement
to clarify that the independent reviews conducted by a financial institution may be
performed by the institution’s audit department or an independent compliance function
within the institution. One commenter also asked the Agencies to state that the proper
role of an institution’s independent review function is only to confirm that the
institution’s policies and procedures for elevated risk CSFTs are being followed and that
the function should not assess the quality of the decisions made by institution personnel.
The Agencies believe that an institution’s audit or compliance department should have
the flexibility, in appropriate circumstances, to review the decisions made by institution
personnel during the review and approval process for elevated risk CSFTs and for this
reason have not made the recommended change.
V.
Paperwork Reduction Act
In accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. §
3506; 5 CFR 1320 Appendix A.1), the Agencies reviewed the Final Statement. The
Agencies may not conduct or sponsor, and an organization is not required to respond to,
this information collection unless it displays a currently valid OMB control number. The
Agencies previously determined that certain provisions of the Revised Proposed
Statement contained information collection requirements. OMB reviewed and approved
the information collections contained in the Revised Proposed Statement for the FDIC,
OTS, OCC and SEC; and the Board reviewed the Revised Proposed Statement under the
authority delegated to the Board by OMB (5 CFR 1320, Appendix A.1).
11
In light of comments, the Agencies have modified the Documentation section of the Statement to clarify
that an institution should retain sufficient documentation to establish that it has provided the customer any
disclosures concerning an elevated risk CSFT that the institution is otherwise required to provide to the
customer.
10
OMB control numbers:
OCC: 1557-0229.
OTS: 1550-0111.
FRB: 7100-0311.
FDIC: 3064-0148.
SEC: 3235-0622.
Burden Estimates
OCC
Number of Respondents: 21.
Estimated Time per Response: 25 hours.
Total Estimated Annual Burden: 525 hours.
OTS
Number of Respondents: 5.
Estimated Time per Response: 25 hours.
Total Estimated Annual Burden: 125 hours.
Board
Number of Respondents: 20.
Estimated Time per Response: 25 hours.
Total Estimated Annual Burden: 500 hours.
FDIC
Number of Respondents: 5.
Estimated Time per Response: 25 hours.
Total Estimated Annual Burden: 125 hours.
SEC
Number of Respondents: 5.
Estimated Time per Response: 25 hours.
Total Estimated Annual Burden: 125 hours.
No commenters addressed the Agencies’ information collection estimates.
The Agencies do not believe that the clarifications included in this Final Statement
impact the burden estimates previously developed and approved for these information
collections. The Agencies have a continuing interest in the public's opinions of our
collections of information. At any time, comments regarding the burden estimate, or any
other aspect of this collection of information, including suggestions for reducing the
burden, may be sent to:
OCC: You should direct your comments to:
Communications Division, Office of the Comptroller of the Currency, Public
Information Room, Mailstop 1-5, Attention: 1557-0229, 250 E Street, SW., Washington,
DC 20219. In addition, comments may be sent by fax to (202) 874-4448, or by electronic
11
mail to regs.comments@occ.treas.gov. You can inspect and photocopy the comments at
the OCC’s Public Information Room, 250 E Street, SW., Washington, DC 20219. You
can make an appointment to inspect the comments by calling (202) 874-5043.
Additionally, you should send a copy of your comments to OCC Desk Officer, 15570229, by mail to U.S. Office of Management and Budget, 725 17th Street, NW., #10235,
Washington, DC 20503, or by fax to (202) 395-6974.
You can request additional information or a copy of the collection from Mary
Gottlieb, OCC Clearance Officer, or Camille Dickerson, (202) 874-5090, Legislative and
Regulatory Activities Division, Office of the Comptroller of the Currency, 250 E Street,
SW., Washington, DC 20219.
OTS: Information Collection Comments, Chief Counsel’s Office, Office of
Thrift Supervision, 1700 G Street, NW., Washington, DC 20552; send a facsimile
transmission to (202) 906-6518; or send an e-mail to
infocollection.comments@ots.treas.gov. OTS will post comments and the related index
on the OTS Internet site at http://www.treas.gov. In addition, interested persons may
inspect the comments at the Public Reading Room, 1700 G Street, NW., by appointment.
To make an appointment, call (202) 906-5922, send an e-mail to
public.info@ots.treas.gov, or send a facsimile transmission to (202) 906-7755.
To obtain a copy of the submission to OMB, contact Marilyn K. Burton at
marilyn.burton@ots.treas.gov, (202) 906-6467, or fax number (202) 906-6518, Chief
Counsel’s Office, Office of Thrift Supervision, 1700 G Street, NW., Washington, DC
20552
Board: You may submit comments, identified by FR 4022, by any of the
following methods:
• Agency Web site: http://www.federalreserve.gov. Follow the
instructions for submitting comments at http://www.federalreserve.gov/
generalinfo/foia/ProposedRegs.cfm.
• Federal eRulemaking Portal: http://www.regulations.gov. Follow the
instructions for submitting comments.
• E-mail:
Regs.comments@federalreserve.gov. Include docket number in the subject line
of the message.
• Fax: (202) 452-3819 or (202) 452-3102.
• Mail: Michelle Long, Federal Reserve Board Clearance Officer (202)
452-3829, Division of Research and Statistics, Board of Governors of the Federal
Reserve System, Washington, DC 20551. Telecommunications Device for the
Deaf (TDD) users may contact (202) 263-4869, Board of Governors of the
Federal Reserve System, Washington, DC 20551.
All public comments are available from the Board’s Web site at
http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as submitted, unless
modified for technical reasons. Accordingly, your comments will not be edited to
remove any identifying or contact information. Public comments may also be viewed
electronically or in paper in Room MP-500 of the Board’s Martin Building (20th and C
Streets, NW) between 9 a.m. and 5 p.m. on weekdays.
12
FDIC: Interested parties are invited to submit written comments to the FDIC
concerning the Paperwork Reduction Act implications of this proposal. Such comments
should refer to “Complex Structured Finance Transactions, 3064-0148.” Comments may
be submitted by any of the following methods:
• http://www.FDIC.gov/regulations/laws/federal/propose.html.
• E-mail: comments@FDIC.gov. Include Complex Structured
Financial Transactions, 3064-0148 in the subject line of the message.
• Mail: Steven F. Hanft (202) 898-3907, Federal Deposit Insurance
Corporation, 550 17th Street, NW., Washington, DC 20429.
• Hand Delivery: Comments may be hand-delivered to the guard station
at the rear of the 17th Street Building (located on F Street), on business days
between 7 a.m. and 5 p.m.
SEC: You should direct your comments to: Office of Management and
Budget, Attention Desk Officer for the Securities and Exchange Commission, Office of
Information and Regulatory Affairs, Room 10102, New Executive Office Building,
Washington, DC 20503, with a copy sent to Nancy M. Morris, Secretary, Securities and
Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090 with reference
to File No. S7-08-06.
The Final Statement follows:
Interagency Statement on Sound Practices Concerning
Elevated Risk Complex Structured Finance Activities
I. Introduction
Financial markets have grown rapidly over the past decade, and
innovations in financial instruments have facilitated the structuring of cash flows and
allocation of risk among creditors, borrowers and investors in more efficient ways.
Financial derivatives for market and credit risk, asset-backed securities with customized
cash flow features, specialized financial conduits that manage pools of assets and other
types of structured finance transactions serve important business purposes, such as
diversifying risks, allocating cash flows, and reducing cost of capital. As a result,
structured finance transactions now are an essential part of U.S. and international capital
markets. Financial institutions have played and continue to play an active and important
role in the development of structured finance products and markets, including the market
for the more complex variations of structured finance products.
When a financial institution participates in a complex structured finance
transaction (“CSFT”), it bears the usual market, credit, and operational risks associated
with the transaction. In some circumstances, a financial institution also may face
heightened legal or reputational risks due to its involvement in a CSFT. For example, in
some circumstances, a financial institution may face heightened legal or reputational risk
if a customer’s regulatory, tax or accounting treatment for a CSFT, or disclosures to
13
investors concerning the CSFT in the customer’s public filings or financial statements, do
not comply with applicable laws, regulations or accounting principles. Indeed, in some
instances, CSFTs have been used to misrepresent a customer’s financial condition to
investors, regulatory authorities and others. In these situations, investors have been
harmed, and financial institutions have incurred significant legal and reputational
exposure. In addition to legal risk, reputational risk poses a significant threat to financial
institutions because the nature of their business requires them to maintain the confidence
of customers, creditors and the general marketplace.
The Office of the Comptroller of the Currency, the Office of Thrift
Supervision, the Board of Governors of the Federal Reserve System, the Federal Deposit
Insurance Corporation, and the Securities and Exchange Commission (the “Agencies”)
have long expected financial institutions to develop and maintain robust control
infrastructures that enable them to identify, evaluate and address the risks associated with
their business activities. Financial institutions also must conduct their activities in
accordance with applicable statutes and regulations.
II. Scope and Purpose of Statement
The Agencies are issuing this Statement to describe the types of risk
management principles that we believe may help a financial institution to identify CSFTs
that may pose heightened legal or reputational risks to the institution (“elevated risk
CSFTs”) and to evaluate, manage and address these risks within the institution’s internal
control framework. 12
Structured finance transactions encompass a broad array of products with
varying levels of complexity. Most structured finance transactions, such as standard
public mortgage-backed securities transactions, public securitizations of retail credit
cards, asset-backed commercial paper conduit transactions, and hedging-type transactions
involving “plain vanilla” derivatives and collateralized loan obligations, are familiar to
participants in the financial markets, and these vehicles have a well-established track
record. These transactions typically would not be considered CSFTs for the purpose of
this Statement.
Because this Statement focuses on sound practices related to CSFTs that
may create heightened legal or reputational risks – transactions that typically are
conducted by a limited number of large financial institutions – it will not affect or apply
to the vast majority of financial institutions, including most small institutions. As in all
12
As used in this Statement, the term “financial institution” or “institution” refers to national banks in the
case of the Office of the Comptroller of the Currency; federal and state savings associations and savings
and loan holding companies in the case of the Office of Thrift Supervision; state member banks and bank
holding companies (other than foreign banking organizations) in the case of the Federal Reserve Board;
state nonmember banks in the case of the Federal Deposit Insurance Corporation; and registered brokerdealers and investment advisers in the case of the Securities and Exchange Commission. The U.S.
branches and agencies of foreign banks supervised by the Office of the Comptroller, the Federal Reserve
Board and the Federal Deposit Insurance Corporation also are considered to be financial institutions for
purposes of this Statement.
14
cases, a financial institution should tailor its internal controls so that they are appropriate
in light of the nature, scope, complexity and risks of its activities. Thus, for example, an
institution that is actively involved in structuring and offering CSFTs that may create
heightened legal or reputational risk for the institution should have a more formalized and
detailed control framework than an institution that participates in these types of
transactions less frequently. The internal controls and procedures discussed in this
Statement are not all inclusive, and, in appropriate circumstances, an institution may find
that other controls, policies, or procedures are appropriate in light of its particular CSFT
activities.
Because many of the core elements of an effective control infrastructure
are the same regardless of the business line involved, this Statement draws heavily on
controls and procedures that the Agencies previously have found to be effective in
assisting a financial institution to manage and control risks and identifies ways in which
these controls and procedures can be effectively applied to elevated risk CSFTs.
Although this Statement highlights some of the most significant risks associated with
elevated risk CSFTs, it is not intended to present a full exposition of all risks associated
with these transactions. Financial institutions are encouraged to refer to other
supervisory guidance prepared by the Agencies for further information concerning
market, credit, operational, legal and reputational risks as well as internal audit and other
appropriate internal controls.
This Statement does not create any private rights of action, and does not
alter or expand the legal duties and obligations that a financial institution may have to a
customer, its shareholders or other third parties under applicable law. At the same time,
adherence to the principles discussed in this Statement would not necessarily insulate a
financial institution from regulatory action or any liability the institution may have to
third parties under applicable law.
III. Identification and Review of Elevated Risk Complex Structured Finance
Transactions
A financial institution that engages in CSFTs should maintain a set of
formal, written, firm-wide policies and procedures that are designed to allow the
institution to identify, evaluate, assess, document, and control the full range of credit,
market, operational, legal and reputational risks associated with these transactions. These
policies may be developed specifically for CSFTs, or included in the set of broader
policies governing the institution generally. A financial institution operating in foreign
jurisdictions may tailor its policies and procedures as appropriate to account for, and
comply with, the applicable laws, regulations and standards of those jurisdictions. 13
13
In the case of U.S. branches and agencies of foreign banks, these policies, including management,
review and approval requirements, should be coordinated with the foreign bank’s group-wide policies
developed in accordance with the rules of the foreign bank’s home country supervisor and should be
consistent with the foreign bank’s overall corporate and management structure as well as its framework for
risk management and internal controls.
15
A financial institution’s policies and procedures should establish a clear
framework for the review and approval of individual CSFTs. These policies and
procedures should set forth the responsibilities of the personnel involved in the
origination, structuring, trading, review, approval, documentation, verification, and
execution of CSFTs. Financial institutions may find it helpful to incorporate the review
of new CSFTs into their existing new product policies. In this regard, a financial
institution should define what constitutes a “new” complex structured finance product
and establish a control process for the approval of such new products. In determining
whether a CSFT is new, a financial institution may consider a variety of factors,
including whether it contains structural or pricing variations from existing products,
whether the product is targeted at a new class of customers, whether it is designed to
address a new need of customers, whether it raises significant new legal, compliance or
regulatory issues, and whether it or the manner in which it would be offered would
materially deviate from standard market practices. An institution’s policies should
require new complex structured finance products to receive the approval of all relevant
control areas that are independent of the profit center before the product is offered to
customers.
A. Identifying Elevated Risk CSFTs
As part of its transaction and new product approval controls, a financial
institution should establish and maintain policies, procedures and systems to identify
elevated risk CSFTs. Because of the potential risks they present to the institution,
transactions or new products identified as elevated risk CSFTs should be subject to
heightened reviews during the institution’s transaction or new product approval
processes. Examples of transactions that an institution may determine warrant this
additional scrutiny are those that (either individually or collectively) appear to the
institution during the ordinary course of its transaction approval or new product approval
process to:
•
•
•
•
•
Lack economic substance or business purpose;
Be designed or used primarily for questionable accounting, regulatory,
or tax objectives, particularly when the transactions are executed at
year end or at the end of a reporting period for the customer;
Raise concerns that the client will report or disclose the transaction in
its public filings or financial statements in a manner that is materially
misleading or inconsistent with the substance of the transaction or
applicable regulatory or accounting requirements;
Involve circular transfers of risk (either between the financial
institution and the customer or between the customer and other related
parties) that lack economic substance or business purpose;
Involve oral or undocumented agreements that, when taken into
account, would have a material impact on the regulatory, tax, or
16
•
•
accounting treatment of the related transaction, or the client’s
disclosure obligations; 14
Have material economic terms that are inconsistent with market norms
(e.g., deep “in the money” options or historic rate rollovers); or
Provide the financial institution with compensation that appears
substantially disproportionate to the services provided or investment
made by the financial institution or to the credit, market or operational
risk assumed by the institution.
The examples listed previously are provided for illustrative purposes only,
and the policies and procedures established by financial institutions may differ in how
they seek to identify elevated risk CSFTs. The goal of each institution’s policies and
procedures, however, should remain the same – to identify those CSFTs that warrant
additional scrutiny in the transaction or new product approval process due to concerns
regarding legal or reputational risks.
Financial institutions that structure or market, act as an advisor to a
customer regarding, or otherwise play a substantial role in a transaction may have more
information concerning the customer’s business purpose for the transaction and any
special accounting, tax or financial disclosure issues raised by the transaction than
institutions that play a more limited role. Thus, the ability of a financial institution to
identify the risks associated with an elevated risk CSFT may differ depending on its role.
B. Due Diligence, Approval and Documentation Process for Elevated Risk CSFTs
Having developed a process to identify elevated risk CSFTs, a financial
institution should implement policies and procedures to conduct a heightened level of due
diligence for these transactions. The financial institution should design these policies and
procedures to allow personnel at an appropriate level to understand and evaluate the
potential legal or reputational risks presented by the transaction to the institution and to
manage and address any heightened legal or reputational risks ultimately found to exist
with the transaction.
Due Diligence. If a CSFT is identified as an elevated risk CSFT, the
institution should carefully evaluate and take appropriate steps to address the risks
presented by the transaction with a particular focus on those issues identified as
potentially creating heightened levels of legal or reputational risk for the institution. In
general, a financial institution should conduct the level and amount of due diligence for
an elevated risk CSFT that is commensurate with the level of risks identified. A financial
institution that structures or markets an elevated risk CSFT to a customer, or that acts as
an advisor to a customer or investors concerning an elevated risk CSFT, may have
additional responsibilities under the federal securities laws, the Internal Revenue Code,
state fiduciary laws or other laws or regulations and, thus, may have greater legal and
14
This item is not intended to include traditional, non-binding “comfort” letters or assurances provided to
financial institutions in the loan process where, for example, the parent of a loan customer states that the
customer (i.e., the parent’s subsidiary) is an integral and important part of the parent’s operations.
17
reputational risk exposure with respect to an elevated risk CSFT than a financial
institution that acts only as a counterparty for the transaction. Accordingly, a financial
institution may need to exercise a higher degree of care in conducting its due diligence
when the institution structures or markets an elevated risk CSFT or acts as an advisor
concerning such a transaction than when the institution plays a more limited role in the
transaction.
To appropriately understand and evaluate the potential legal and
reputational risks associated with an elevated risk CSFT that a financial institution has
identified, the institution may find it useful or necessary to obtain additional information
from the customer or to obtain specialized advice from qualified in-house or outside
accounting, tax, legal, or other professionals. As with any transaction, an institution
should obtain satisfactory responses to its material questions and concerns prior to
consummation of a transaction. 15
In conducting its due diligence for an elevated risk CSFT, a financial
institution should independently analyze the potential risks to the institution from both
the transaction and the institution’s overall relationship with the customer. Institutions
should not conclude that a transaction identified as being an elevated risk CSFT involves
minimal or manageable risks solely because another financial institution will participate
in the transaction or because of the size or sophistication of the customer or counterparty.
Moreover, a financial institution should carefully consider whether it would be
appropriate to rely on opinions or analyses prepared by or for the customer concerning
any significant accounting, tax or legal issues associated with an elevated risk CSFT.
Approval Process. A financial institution’s policies and procedures should
provide that CSFTs identified as having elevated legal or reputational risk are reviewed
and approved by appropriate levels of control and management personnel. The
designated approval process for such CSFTs should include representatives from the
relevant business line(s) and/or client management, as well as from appropriate control
areas that are independent of the business line(s) involved in the transaction. The
personnel responsible for approving an elevated risk CSFT on behalf of a financial
institution should have sufficient experience, training and stature within the organization
to evaluate the legal and reputational risks, as well as the credit, market and operational
risks to the institution.
The institution’s control framework should have procedures to deliver the
necessary or appropriate information to the personnel responsible for reviewing or
approving an elevated risk CSFT to allow them to properly perform their duties. Such
information may include, for example, the material terms of the transaction, a summary
of the institution’s relationship with the customer, and a discussion of the significant
legal, reputational, credit, market and operational risks presented by the transaction.
15
Of course, financial institutions also should ensure that their own accounting for transactions complies
with applicable accounting standards, consistently applied.
18
Some institutions have established a senior management committee that is
designed to involve experienced business executives and senior representatives from all
of the relevant control functions within the financial institution (including such groups as
independent risk management, tax, accounting, policy, legal, compliance, and financial
control) in the oversight and approval of those elevated risk CSFTs that are identified by
the institution’s personnel as requiring senior management review and approval due to
the potential risks associated with the transactions. While this type of management
committee may not be appropriate for all financial institutions, a financial institution
should establish processes that assist the institution in consistently managing the review
and approval of elevated risk CSFTs on a firm-wide basis. 16
If, after evaluating an elevated risk CSFT, the financial institution
determines that its participation in the CSFT would create significant legal or reputational
risks for the institution, the institution should take appropriate steps to address those
risks. Such actions may include declining to participate in the transaction, or
conditioning its participation upon the receipt of representations or assurances from the
customer that reasonably address the heightened legal or reputational risks presented by
the transaction. Any representations or assurances provided by a customer should be
obtained before a transaction is executed and be received from, or approved by, an
appropriate level of the customer’s management. A financial institution should decline to
participate in an elevated risk CSFT if, after conducting appropriate due diligence and
taking appropriate steps to address the risks from the transaction, the institution
determines that the transaction presents unacceptable risk to the institution or would
result in a violation of applicable laws, regulations or accounting principles.
Documentation. The documentation that financial institutions use to
support CSFTs is often highly customized for individual transactions and negotiated with
the customer. Careful generation, collection and retention of documents associated with
elevated risk CSFTs are important control mechanisms that may help an institution
monitor and manage the legal, reputational, operational, market, and credit risks
associated with the transactions. In addition, sound documentation practices may help
reduce unwarranted exposure to the financial institution’s reputation.
A financial institution should create and collect sufficient documentation
to allow the institution to:
•
•
•
Document the material terms of the transaction;
Enforce the material obligations of the counterparties;
Confirm that the institution has provided the customer any disclosures
concerning the transaction that the institution is otherwise required to
provide; and
16
The control processes that a financial institution establishes for CSFTs should take account of, and be
consistent with, any informational barriers established by the institution to manage potential conflicts of
interest, insider trading or other concerns.
19
•
Verify that the institution’s policies and procedures are being followed
and allow the internal audit function to monitor compliance with those
policies and procedures.
When an institution’s policies and procedures require an elevated risk
CSFT to be submitted for approval to senior management, the institution should maintain
the transaction-related documentation provided to senior management as well as other
documentation, such as minutes of the relevant senior management committee, that
reflect senior management’s approval (or disapproval) of the transaction, any conditions
imposed by senior management, and the factors considered in taking such action. The
institution should retain documents created for elevated risk CSFTs in accordance with its
record retention policies and procedures as well as applicable statutes and regulations.
C. Other Risk Management Principles for Elevated Risk CSFTs
General Business Ethics. The board and senior management of a financial
institution also should establish a “tone at the top” through both actions and formalized
policies that sends a strong message throughout the financial institution about the
importance of compliance with the law and overall good business ethics. The board and
senior management should strive to create a firm-wide corporate culture that is sensitive
to ethical or legal issues as well as the potential risks to the financial institution that may
arise from unethical or illegal behavior. This kind of culture coupled with appropriate
procedures should reinforce business-line ownership of risk identification, and encourage
personnel to move ethical or legal concerns regarding elevated risk CSFTs to appropriate
levels of management. In appropriate circumstances, financial institutions may also need
to consider implementing mechanisms to protect personnel by permitting the confidential
disclosure of concerns. 17 As in other areas of financial institution management,
compensation and incentive plans should be structured, in the context of elevated risk
CSFTs, so that they provide personnel with appropriate incentives to have due regard for
the legal, ethical and reputational risk interests of the institution.
Reporting. A financial institution’s policies and procedures should
provide for the appropriate levels of management and the board of directors to receive
sufficient information and reports concerning the institution’s elevated risk CSFTs to
perform their oversight functions.
Monitoring Compliance with Internal Policies and Procedures. The
events of recent years evidence the need for an effective oversight and review program
for elevated risk CSFTs. A financial institution’s program should provide for periodic
independent reviews of its CSFT activities to verify and monitor that its policies and
controls relating to elevated risk CSFTs are being implemented effectively and that
17
The agencies note that the Sarbanes-Oxley Act of 2002 requires companies listed on a national securities
exchange or inter-dealer quotation system of a national securities association to establish procedures that
enable employees to submit concerns regarding questionable accounting or auditing matters on a
confidential, anonymous basis. See 15 U.S.C. 78j-1(m).
20
elevated risk CSFTs are accurately identified and received proper approvals. These
independent reviews should be performed by appropriately qualified audit, compliance or
other personnel in a manner consistent with the institution’s overall framework for
compliance monitoring, which should include consideration of issues such as the
independence of reviewing personnel from the business line. Such monitoring may
include more frequent assessments of the risk arising from elevated risk CSFTs, both
individually and within the context of the overall customer relationship, and the results of
this monitoring should be provided to an appropriate level of management in the financial
institution.
Audit. The internal audit department of any financial institution is integral
to its defense against fraud, unauthorized risk taking and damage to the financial
institution’s reputation. The internal audit department of a financial institution should
regularly audit the financial institution’s adherence to its own control procedures relating
to elevated risk CSFTs, and further assess the adequacy of its policies and procedures
related to elevated risk CSFTs. Internal audit should periodically validate that business
lines and individual employees are complying with the financial institution’s standards
for elevated risk CSFTs and appropriately identifying any exceptions. This validation
should include transaction testing for elevated risk CSFTs.
Training. An institution should identify relevant personnel who may need
specialized training regarding CSFTs to be able to effectively perform their oversight and
review responsibilities. Appropriate training on the financial institution’s policies and
procedures for handling elevated risk CSFTs is critical. Financial institution personnel
involved in CSFTs should be familiar with the institution’s policies and procedures
concerning elevated risk CSFTs, including the processes established by the institution for
identification and approval of elevated risk CSFTs and new complex structured finance
products and for the elevation of concerns regarding transactions or products to
appropriate levels of management. Financial institution personnel involved in CSFTs
should be trained to identify and properly handle elevated risk CSFTs that may result in a
violation of law.
IV. Conclusion
Structured finance products have become an essential and important part
of the U.S. and international capital markets, and financial institutions have played an
important role in the development of structured finance markets. In some instances,
however, CSFTs have been used to misrepresent a customer’s financial condition to
investors and others, and financial institutions involved in these transactions have
sustained significant legal and reputational harm. In light of the potential legal and
reputational risks associated with CSFTs, a financial institution should have effective risk
management and internal control systems that are designed to allow the institution to
identify elevated risk CSFTs, to evaluate, manage and address the risks arising from such
transactions, and to conduct those activities in compliance with applicable law.
21
Dated: December 12, 2006.
John C. Dugan (signed)
John C. Dugan,
Comptroller of the Currency.
_______________________________________________
Dated: December 21, 2006.
Scott M. Polakoff (signed)
By the Office of Thrift Supervision.
Scott M. Polakoff,
Deputy Director & Chief Operating Officer
_______________________________________________
By order of the Board of Governors of the Federal Reserve System, December 20, 2006.
Jennifer J. Johnson (signed)
Jennifer J. Johnson,
Secretary of the Board.
_______________________________________________
Dated at Washington, DC, the 22nd day of December, 2006.
Robert E. Feldman (signed)
By order of the Federal Deposit Insurance Corporation.
Robert E. Feldman,
Executive Secretary.
_______________________________________________
Dated: January 5, 2007
Nancy M. Morris (signed)
By the Securities and Exchange Commission
Nancy M. Morris
Secretary
22
APPENDIX E: OCC SUPERVISION OF CITIBANK, N.A.
I.
OCC’s Supervision of Large National Banks
The foundation of the OCC’s supervision of the largest national banks is our continuous,
on-site presence of examiners at each of our 15 largest banking companies. Citibank is one of
the banks in our Large Bank Program. These 15 banking companies account for approximately
89 percent of the assets held in all of the national banks under our supervision. The resident
examiner teams are supplemented by subject matter experts in our Policy Division, as well as
Ph.D. economists from our Risk Analysis Division trained in quantitative finance. Since 2005,
the resident examiner team at Citibank averaged approximately 50 resident examiners,
supplemented by the subject matter experts and economists mentioned above, and additional
examiners as needed on specific targeted examinations.
Our Large Bank Program is organized with a national perspective. It is highly
centralized and headquartered in Washington, and structured to promote consistency and
coordination across institutions. The onsite teams at each or our 15 largest banks are led by an
Examiner-In-Charge (“EIC”), who reports directly to one of the Deputy Comptrollers in our
Large Bank Supervision Office in Washington, DC. This enables the OCC to maintain an ongoing program of risk assessment, monitoring, and communication with bank management and
directors.
Resident examiners apply risk-based supervision to a broad array of risks, including
credit, liquidity, market, compliance, and operational risks. Supervisory activities are based on
supervisory strategies that are developed for each institution that are risk-based and focused on
the more complex banking activities. Although each strategy is tailored to the risk profile of the
individual institution, our strategy development process is governed by supervisory objectives set
forth annually in the OCC’s Bank Supervision Operating Plan. Through this operating plan, the
OCC identifies key risks and issues that cut across the industry and promotes consistency in
areas of concerns.
With the operating plan as a guide, EICs develop detailed strategies that will direct
supervisory activities and resources for the coming year. Each strategy is reviewed and
approved by the appropriate Large Bank Deputy Comptroller. Our risk-based supervision is
flexible, allowing strategies to be revised, as needed, to reflect the changing risk profile of the
supervised institutions.
Our risk-based supervision seeks to identify the most significant risks and then to
determine whether a bank has systems and controls appropriate to identify, measure, monitor,
and control those risks affecting the institution. We assess the integrity and effectiveness of risk
management systems, with appropriate validation through testing.
Our supervisory process involves a combination of ongoing monitoring and targeted
examinations. Our ongoing supervision allows us to review management reports, discuss
business and risk issues, and maintain an understanding of the bank’s risk profile. The purpose
of our targeted examinations is to validate that risk management systems and processes are
functioning as expected and do not present significant supervisory concerns. Our supervisory
conclusions are communicated directly to bank senior management. When we identify concerns,
Appendix E
Page 2
we “drill down” to test additional transactions. These concerns are then highlighted for
management and the Board as “Matters Requiring Attention” (“MRAs”) in supervisory
communications. If these concerns are not appropriately addressed within a reasonable period,
we have a variety of regulatory and enforcement tools with which to respond, ranging from
informal supervisory actions directing corrective measures, to formal enforcement actions, to
referrals to other regulators or law enforcement.
It is not uncommon to find weaknesses in structure, organization, or management
information, which we address through MRAs and other supervisory processes described above.
But more significantly at some of our institutions, what appeared to be an appropriate
governance structure was made less effective by a weak corporate culture, which discouraged
credible challenge from risk managers and did not hold lines of business accountable for
inappropriate actions. Corporate culture issues can be difficult to assess during benign economic
times. But when the market disruption began to occur in mid-2007, we began to document
examples where risk management did not appropriately constrain certain business activities, at
least in part due to its relative lack of stature.
As previously noted, we have a staff of experts who provide on-going technical
assistance to our on-site examination teams. Our Risk Analysis Division includes 40 Ph.D.
economists and mathematicians who have strong backgrounds in statistical analysis and risk
modeling. These individuals frequently participate in our examinations to help evaluate the
integrity and empirical soundness of banks’ risk models and the assumptions underlying those
models. Our policy experts help keep abreast of emerging trends and issues within the industry
and the supervisory community. Staffs from our Credit and Market Risk, Operational Risk, and
Capital Policy units have been key participants and contributors to the ongoing work of the
Senior Supervisors Group, Financial Stability Forum, President’s Working Group, and Basel
Committee on Bank Supervision.
II.
Citigroup/Citibank Organization
Citigroup is one of the largest financial institutions in the world. It has operations in
approximately 100 countries and provides a full set of financial products. Its major business
segments are commercial banking, consumer financial services, and broker-dealer and
investment banking activities. These businesses are conducted through a variety of legal entities,
including national banks and their subsidiaries, which are subject to regulation and supervision
by the OCC, and non-bank subsidiaries of the holding company that are affiliates but not
subsidiaries of Citibank (“holding company affiliates”), which are subject to regulation by other
federal and state regulators. The key entities referred to in the discussion below, and their
relevant regulators, are depicted in the simplified chart below, with the green boxes depicting the
entities subject to OCC supervision.
Appendix E
Page 3
Citigroup Inc.
(FRB)
Citibank, N.A.
(OCC)
Operating
Subsidiaries
(OCC)
A.
Citigroup
Financial
Products, Inc.
(FRB)
Citigroup
Global
Markets, Inc.
(SEC)
Citigroup North
America, Inc.
(FRB)
CitiFiancial
(FRB/States)
Citibank (West),
FSB
(OTS)
Merged into Citibank,
N.A., Oct. 2006
Citigroup
Global Markets
Limited
(UKFSA)
Citibank, N.A.
Citibank, N.A., is the largest single legal entity in Citigroup, although it represented less
than half of Citigroup’s assets for the five years prior to the financial crisis. In 2002, Citibank
constituted 43.1 percent of Citigroup assets. In 2006, it constituted 49.5 percent of the group
total. Throughout this time, Citibank, N.A. functioned primarily as a corporate bank in the
United States and abroad, with retail operations mainly in New York State and internationally.
A major legal vehicle restructuring occurred in late 2006 that brought most domestic retail
activities into Citibank, N.A. and OCC supervised subsidiaries of the bank. At year-end 2009,
the bank constituted 62 percent of Citigroup. Citigroup also uses separate national banks to
conduct its credit card lending. Citibank, N.A., its operating subsidiaries, and the other national
banks and their subsidiaries are supervised by the OCC.
B.
Key Non-bank Entities Owned by Citigroup
Citigroup conducts a substantial amount of its business in holding company affiliates.
These holding company affiliates are subject to regulation by the Federal Reserve, the states, and
in some cases, other regulators such as the Securities and Exchange Commission. Holding
company affiliates are not regulated by the OCC. For the purposes of the Commission’s inquiry,
several key holding company affiliates are as follows:
•
•
Citigroup Global Markets, Inc. (“CGMI”), a holding company affiliate of the bank, is a U.S.
broker-dealer subject to supervision primarily by the Securities and Exchange Commission
(“SEC”), but also by the Federal Reserve. CGMI conducted the cash collateralized debt
obligation (“CDO”) structuring business for the group and was the main warehouse for the
CDO structuring business.
Citigroup Financial Products, Inc. (“CFPI”), a holding company affiliate, was used as a
warehouse for the CDO structuring business. It is supervised by the Federal Reserve.
Appendix E
•
•
Page 4
CitiFinancial is a non-bank holding company affiliate used for subprime lending and
consumer finance activities and is supervised by the Federal Reserve and the states.
Citigroup North America, Inc. (“CNAI”) is a non-bank holding company affiliate used for
booking and assigning capital for certain leveraged loans and bridge loans. CNAI is also
supervised by the Federal Reserve.
C.
Legal Vehicle Simplification Project
Citigroup completed a major legal vehicle simplification project in October 2006.
Citigroup management recognized the need to streamline its activities and improve oversight and
control. It wanted to concentrate its business activities in three main legal vehicles: an
investment bank, a commercial bank, and a credit card bank. This project also diversified
Citibank’s domestic activities.
The simplification project reduced the number of insured depository institutions from
twelve to five, and consolidated approximately $200 billion of assets into Citibank, N.A.
Approximately 10 percent of these assets were subprime mortgages that had been originated
outside of the national bank (either through the CitiFinancial or Citibank (West), FSB).
After the consolidation, the OCC discovered that management was not consistently
applying the Interagency Policy Statement on Loan Loss Reserves at its former thrift and finance
company entities. The OCC directed bank management to improve processes and augment
reserves. In addition, the quality of mortgages was substantially worse than expected. At the
time of the conversion, the 2005 and most of the 2006 mortgage vintages had already been
completed, and the 2007 production was gearing up. As with other mortgage lenders, these three
years turned out to be problematic. Citibank subsequently incurred substantial credit losses and
increased loan loss provisions from this mortgage lending business.
D.
Current Operating Structure
Citigroup currently operates, for management reporting purposes, via two primary
business segments which span multiple legal entities: Citicorp and Citi Holdings. Citicorp (core
business) includes the Institutional Clients Group (securities & banking and transaction services)
and Regional Consumer Banking (traditional banking services). Citi Holdings (noncore
business) include Brokerage and Asset Management, Local Consumer Lending (residential
mortgages, private-label cards, student and auto loans, Primerica Financial Services), and a
special asset pool (securities, wholesale and consumer credits, leverage loans, SIV assets).
Management plans to reduce the assets in Citi Holdings over time through asset and business
sales and amortizations.
III.
Citibank’s Financial Condition
Citibank, N.A., the largest national bank owned by the holding company, Citigroup, had
substantial financial strength as it entered the crisis. Citigroup management had committed to
the OCC to maintain Citibank’s capital at a range significantly above minimum “well
capitalized” levels of 6 percent Tier 1 risk-based capital, 10 percent total risk-based capital, and
Appendix E
Page 5
5 percent leverage capital. In fact, for many years, Citibank’s Tier 1 capital was above 8 percent
and its total risk-based capital was above 12 percent. Citibank would dividend capital in excess
of this range for Citigroup’s strategic use. At year end 2006, Citibank had total equity capital of
$72 billion, Tier 1 capital of 8.3 percent, and Total capital of 12.4 percent, which was consistent
with this agreement. Nevertheless, the bank’s Tier 1 leverage capital ratio had been declining,
and the OCC downgraded its capital rating at that time to reflect this trend. Around this time,
Citibank was assigned a “Aaa” rating from Moody’s.
As shown in the chart below, Citibank, N.A., and its sister national bank (a credit card
specialty bank), reported net income of $13.1 billion in 2006. As the financial crisis began to
unfold, the national banks reported a positive, though decreased, net income in 2007 of $5.1
billion, compared with a loss of $1.5 billion in Citigroup, excluding the national banks. In 2008,
the national banks reported a loss of $6.3 billion, compared with losses of approximately $21.4
billion in Citigroup, again excluding the national banks. For 2009, the national banks reported a
loss of $3.0 billion. In both 2008 and 2009, OCC examiners required management to
downstream capital to strengthen the bank.
Net Income $B
National Banks
Non-Banks
2006
$13.1
$8.5
2007
$5.1
-$1.5
2008
- $6.3
-$21.4
2009
-$3.0
$1.4
Prior to the crisis, Citigroup management faced ongoing shareholder criticism for
lackluster stock performance. Management attempted to improve income by making the
strategic decisions to expand the cash CDO structuring business, synthetic CDO business, and
syndicated (including) leveraged lending activities. These activities crossed multiple products,
legal vehicles, and geographies. The cash CDO business was run from the CGMI, the U.S.
broker-dealer, which also served as the main warehouse for the CDO structuring business; a
CDO warehouse also was run from CFPI; the synthetic CDO business was managed in London,
at both the national bank branch and a London-based holding company affiliate, Citigroup
Global Markets Limited (“CGML”); and the loan syndication and bridge loan business was
booked primarily through the non-bank holding company affiliate, CNAI. The complexity of the
exposures and processes made it difficult to have a complete picture of the risks. These
businesses became the sources of most of the bank’s subprime and leveraged lending exposures
and its subsequent losses.
IV.
Citigroup’s Subprime Exposure
Leading up to the crisis, Citigroup’s exposure to subprime credit risk took various forms.
One was from the direct origination of subprime loans that were held on the company’s books.
These were predominantly originated by entities other than OCC-supervised national banks or
national bank subsidiaries.
A second form was from the structuring and ownership of securities backed by subprime
loans. Most, but not all, of this structuring business was conducted by holding company
affiliates of Citibank that were not supervised by the OCC. However, Citibank, N.A. came to
Appendix E
Page 6
own and otherwise be exposed to significant risks from those securities, which resulted in
significant losses during the crisis.
A
Subprime Loan Origination
Subprime mortgages were originated by CitiFinancial, a holding company affiliate, and
to a lesser degree by CitiMortgage, while it was an OTS-regulated subsidiary of Citibank (West),
FSB. As a result of the Legal Simplification Project described above in subsection II.C.,
subprime mortgages originated by CitiFinancial and Citibank (West), FSB, were transferred to
Citibank, N.A. After the consolidation, Citibank continued to originate and hold on its books a
limited volume of subprime mortgages in 2007, but these mortgages became subject to the new
interagency guidance on subprime lending adopted that year, as well as OCC lending standards.
As with many of the mortgages on Citibank’s books, both prime and nonprime, originated during
2005 – 2007, the bank has taken significant losses on these subprime loans.
B.
Exposure to Securities backed by Subprime Loans
A significant exposure of Citibank, N.A. to securities backed by pools of subprime loans
came from collateralized debt obligations, or CDOs. In particular, Citibank was exposed to the
highest or “safest” tranches of these subprime CDOs, sometimes referred to as “super senior”
tranches that were rated “triple A” by the credit rating agencies. The bank had two sources of
super senior exposure: liquidity puts issued to support Citigroup’s Cash CDO Business in the
U.S., and synthetically produced CDO exposure through its London branch office.
1.
Liquidity Puts and Cash CDO Exposures
In late 2004, Citigroup management made the strategic decision to expand the CDO
structuring and warehousing business. It is our understanding that this business purchased
mortgages, including subprime mortgages, from third parties (not from the national bank or its
subsidiaries) and packaged them into residential mortgage-backed securities (“RMBS”). These
RMBS, along with other RMBS purchased from third parties, were then packaged into cash
CDOs. Each cash CDO was sold to investors through an off-balance sheet, special purpose
vehicle or SPV. The CDO SPV issued equity and classes of debt, with short-term commercial
paper constituting the most senior class of debt. In essence, the first cash flows of the CDO/SPV
were dedicated to the commercial paper investors, and because of the credit support provided in
lower tiers of the funding structure, the commercial paper investors had very limited or “super
senior” credit exposure to losses generated by the loans underlying the CDO.
This CDO structuring business, and the associated pipeline and warehouse activities, was
not conducted by the national bank. Instead, it was conducted by the Cash CDO Desk of CGMI,
the U.S. broker-dealer holding company affiliate of the bank, as well as by CFPI, a CDO
warehousing affiliate. However, the national bank became exposed to the CDO SPV by issuing
“liquidity puts” that guaranteed funding to the SPV in the event that short-term commercial
paper investors became unwilling, presumably in a liquidity crisis, to roll over their funding.
Such puts, which helped obtain high credit ratings for the commercial paper, were similar in
nature to the kind of liquidity support that the bank typically provided to other funding vehicles,
Appendix E
Page 7
such as multi-seller conduits, that issued commercial paper. By providing this support, the bank
was essentially assuming, in the event of a prolonged and critical liquidity problem, the “super
senior” credit exposure that had been held by the commercial paper investors. The deals
supported by these puts were all managed by external investment managers. This did not serve
to reduce franchise risk.
The OCC is restricted in its ability to examine broker-dealer or other holding company
affiliates. As a result, examiners did not possess direct knowledge of the nature or quality of the
loans that backed the cash CDOs. However, because of the high credit ratings of the exposure,
and the fact that the liquidity support was similar in nature to other kinds of low risk support
provided to other funding conduits, the risk of these liquidity puts was viewed as low. Indeed,
Citigroup management considered the possibility of losses from liquidity puts to be extremely
remote based on a variety of factors, including that the bank would only be legally required to
fund in a short-term market liquidity event; that the puts only covered the super senior exposures
of the CDO, and could not be exercised in the event of credit problems rather than liquidity
problems; and that super senior positions were above the highest AAA ratings provided by the
rating agencies , and the commercial paper rating was the highest as well. These ratings
indicated that the exposure was extremely well protected by the other, subordinate classes in the
CDO.
Moreover, when the liquidity puts were first provided to CDOs, nearly seven years ago,
only high quality asset-backed securities (“ABS”) and mortgage product was included in these
structures, and they performed well. However, during the middle years of this past decade, the
business and the industry began introducing riskier subprime collateral into the CDOs. While
the credit ratings for the super senior exposures remained high, the use of this riskier collateral
was a significant change. As the OCC was not able to examine the structuring and warehousing
elements of this business, we are not able to comment on the risk assessments and controls over
this change.
When the liquidity crisis occurred, Citibank, as the result of the liquidity puts, assumed
the credit risk of super senior exposures to subprime RMBS CDOs totaling $25 billion. This
exposure generated significant mark-to-market losses to the bank, although the obligations
remain current and the ultimate credit loss is not yet known.
2.
Synthetic CDOs
Citibank’s London branch and CGML, its London-based operating subsidiary also
supervised by the OCC, created synthetic CDO exposures through its ABS correlation desk in
London. These exposures were ramped up in 2006 and early 2007, reportedly following the
capping of the limit on the New York Cash CDO business. The bank’s activities were reviewed
by the OCC during an examination of the EMEA (Europe, Middle East, and Africa) Structured
Credit Business in the first quarter of 2007. Exposure to subprime credit was created
synthetically using credit derivatives on either the underlying ABS securities or relevant indices.
When the structured deals were packaged, equity and mezzanine tranches were sold to Citigroup
clients, and unlike the NY CDO desk that distributed the super senior positions, the London
trading desk retained the super senior position. Super senior exposure is the most protected level
Appendix E
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in a CDO structure, with all subordinate classes expected to absorb any expected or stressed
losses anticipated in the deal. As such, these super senior pieces were either rated or sat above
the AAA by rating agencies who routinely provided ratings to these structures. Our understanding is that for a synthetically created CDO, a total return swap can be used to transfer the
economic exposure from the synthetically created pool of credit risk exposure (ABS and/or
RMBS) into the associated special purpose entity. The special purpose entity would then create
the tranched securities to be sold to investors. An estimate of $6 billion of super senior notional
exposure was created in the bank; and additional exposures were also created and booked in
CGML, the non-bank entity in London that was a subsidiary of the bank. The amounts of
exposure reported in late 2007 were significantly greater than what we observed on risk reports
earlier in the year.
V.
Impact on Citibank of Syndicated and Leveraged Lending Conducted in Holding
Company Affiliates
Citigroup also committed itself to the syndicated and leverage lending markets. Group
management felt that as a major financial institution, it was important for it to participate in a
large percentage of the syndicated market. In 2006, bank management increased its loan
syndication pipeline limit 40 percent (from $35B to $50B), and then doubled it to $100B six
months later in 2007. Management expected to participate in all large, significant sponsorbacked transactions, and it joined in more than ten material transactions simultaneously in 2007.
Citigroup used CNAI, the non-bank, holding company affiliate supervised by the Federal
Reserve Bank of New York, as the primary vehicle for managing the syndication process.
Approximately 80 percent of leveraged syndications and bridge loans were booked in CNAI, and
the remaining 20 percent booked directly in the bank. When the syndication markets closed
down in mid-2007, CNAI did not have the capital or liquidity to support the huge pipeline.
Citigroup management then decided to use Citibank’s balance sheet to book these high-risk and
ultimately costly deals. The assets came on balance sheet, and ultimately some had to be
substantially written down.
VI.
OCC Regulatory Focus
A.
Overview
The OCC identified a number of risk management issues over the years that we treated as
“Matters Requiring Attention” in Supervisory Letters to bank management. Some of the issues
involved consolidated risk reporting, risk measurement, model validations, and credible
challenge by independent risk management. We brought forward certain issues to our Reports of
Examination that were presented to the bank’s audit committee. We also had enforcement
actions specific to identified issues. Management was responsive to each individual issue, and
personnel actions and organizational changes periodically occurred as a result of our letters.
One regulatory focus during these years was on the massive expansion of the complexity
and volume of credit derivatives instruments. These risks centered on a problematic operational
risk profile, and control over highly complex products and risk exposures via complex modeling.
Appendix E
Page 9
In 2005, we were highly critical of management and risk management oversight of the areas that
were considered higher risk. In this case, management responded to our criticisms by curtailing
trading activities and changing management within the business. As such, our supervision was
trying to ensure that the growth in a complex business was prudent and commensurate with
infrastructure.
The company’s Capital Markets Approval Committee process had looked at and
approved liquidity puts and management’s desire to book synthetic exposures in the bank.
However, nowhere did these documents discuss the deterioration in collateral supporting these
“highly rated” ABS securities or indices. Market events, and the substantial deterioration in the
quality of underlying mortgage collateral, placed a significant burden on vehicles that were
intended to work under usual and expected stressed situations. That said, participants in this
business, and with this collateral, should have anticipated the potential for this market event, and
risk management should have been aware of the asset quality deterioration that effectively went
unheeded.
In early 2007, we examined the activities of the London branch and its ABS correlation
desk. During this examination, we noted that the desk had switched emphasis to structured
deals, and that synthetic exposures had been created at both the branch and the local non-bank
entity, CGML. We determined that risk was high, and required additional work on the expansion
of risk in synthetic exposures in concert with market events unfolding. By this time, the bank’s
exposure was already considerable. Just prior to issuing our supervisory letter, the bank changed
desk management to an individual with whom we were comfortable.
During the summer of 2007, as events were unfolding related to subprime mortgages, we
were informed of the critical nature of this exposure by Citigroup’s Treasury upon the funding of
the liquidity puts in August 2007. We and examiners from other agencies then began additional
research on the liquidity puts and the potential exposures. We found that the assets under the
liquidity puts had older vintages than the production the markets had seen in the most recent runup of subprime loans in 2006 and 2007. This was due to the longer existence of those structures
and the fact that replenishment of those structures was reportedly mostly subprime, where initial
RMBS were of higher quality.
We were also informed that Commercial and Investment Bank management sought to
acquire its own subprime mortgage origination source after confirming that Citibank would not
be a source of subprime mortgage paper. This led management to pursue the purchase of a
subprime originator Argent. While the Commercial and Investment Bank management’s
decision to bring in house a subprime originator was faulty, Argent did not include any loans,
and no additional loans were generated by the entity due to the fact that the market had
significantly deteriorated by that time.
We performed a comprehensive examination in the fourth quarter of 2007 to determine
the nature of the problem and whether the company was properly valuing these CDO
instruments. The findings of this exam are in the materials that have been provided to the
commission.
Appendix E
B.
Page 10
Administrative Actions
During the five year period prior to the crisis, Citibank was subject to both formal and
informal regulatory actions. Formal action came in 2003 when the OCC put Citibank under a
Formal Agreement for activities related to Enron, WorldCom, and others. The bank was using
Complex Structured Financial Products to provide funding to these companies without having
the transactions appear on the client’s financial statements. The formal agreement (“FA”)
required the bank to implement enhanced oversight and controls over all complex structured
finance transactions. Most of the requirements of the FA were later codified in an interagency
policy statement on Complex Structured Financial Products issued to the industry. The bank
achieved compliance with the FA in late 2006.
Informal actions were imposed to address legal, compliance, and control issues that
became evident in a number of high-profile events. These included deficiencies in Citibank’s
Japan Private Bank, a trading incident in London, and a number of other non-public events. The
bank embarked on a “Five Point Plan for Improvement” in 2005 to strengthen culture and
control. The five point plan was supplemented by an extensive corrective action plan to address
legal, compliance, and control issues. Extensive work was performed to improve processes and
controls, and the bank achieved substantial compliance with this plan in early 2007.
The OCC’s administrative actions did not directly apply to the syndicated lending and
CDO businesses. The FA dealt with client specific transactions. Informal actions covered legal,
compliance, and internal control issues. Neither dealt with specific businesses, and as such, they
did not constrain the group’s expansion into syndicated lending and CDO warehousing. In fact,
the bank began increasing syndicated loan limits while the FA was still in place. Moreover, both
businesses were mostly conducted in legal vehicles outside of the OCC’s supervisory control.
Syndicated lending was managed mostly through the non-bank holding company affiliate CNAI,
and CDO structuring and warehousing was done in the broker-dealer and CFPI, both of which
were holding company affiliates.
@FedFRASER