Just recently, Federal Reserve Chairman Ben Bernanke blamed part of the recent financial crisis on a lack of consumer protection carried out by the Federal Reserve. Bernanke (my underline):
What policy implications should we draw? I noted earlier that the most important source of lower initial monthly payments, which allowed more people to enter the housing market and bid for properties, was not the general level of short-term interest rates, but the increasing use of more exotic types of mortgages and the associated decline of underwriting standards. That conclusion suggests that the best response to the housing bubble would have been regulatory, not monetary. Stronger regulation and supervision aimed at problems with underwriting practices and lenders’ risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates…
The Federal Reserve and other agencies did make efforts to address poor mortgage underwriting practices. In 2005, we worked with other banking regulators to develop guidance for banks on nontraditional mortgages, notably interest-only and option-ARM products. In March 2007, we issued interagency guidance on subprime lending, which was finalized in June. After a series of hearings that began in June 2006, we used authority granted us under the Truth in Lending Act to issue rules that apply to all high-cost mortgage lenders, not just banks. However, these efforts came too late or were insufficient to stop the decline in underwriting standards and effectively constrain the housing bubble.
David Leonhardt points out, with some excellent quotes from 2004 to 2007, how the Federal Reserve missed the housing bubble completely. But I want to look at the underlines above. Bernanke applauds the Federal Reserves practices from 2005 to 2007 to address the problems with subprime mortgages, as if it came out of nowhere, instead of something they actively ignored for almost a decade beforehand.
We know that on Jan. 12, 1998, the Federal Reserves Board of Governors unanimously decided “to not conduct consumer compliance examinations of, nor to investigate consumer complaints regarding, nonbank subsidiaries of bank holding companies.” This policy was proposed and recommended by Glenn Loney of Board staff, Michael Collins of the Philadelphia Fed, Joan Cronin of the St. Louis Fed and John Yorke of the Kansas City Fed, who put the memo out from the “Fed’s Division of Division of Consumer and Community Affairs.” This isn’t the bosses upstairs overriding the consumer affairs people; the actual consumer protection people at the Federal Reserve said their job regulating subprime loans at shadow subsidiary banking that existed outside traditional regulation wasn’t necessary.
In the past, the rortybomb blog also took a peek at the transcript for “Morning Session of Public Hearing on Home Equity Lending, July 27, 2000″, where Martin Eakes (later of The Center For Responsible Lending) and community bankers begged the Fed to intervene and bring recommendations to the subprime market, something that was well within their power to do. Here is a snippet of Federal Reserve Governor Gramlich’s, who headed the meeting, opening remarks:
GOVERNOR GRAMLICH:…The last few years have seen enormous growth in subprime lending. …This is mainly, surely, a good thing in the sense that this growth in the subprime lending market has brought credit to low and moderate income households…But there are also seemingly some abuses.
There have been a series of anecdotes, a series of TV programs mentioning some of these abuses, there has been a rise in the foreclosure rate, and these adverse statistics have attracted our attention….
We want to keep a relatively analytical focus and focus on specific things that the Fed might do, trying to make sure that, in technical talk, the benefits of what we do outweigh the costs….
If predatory lending is as significant a problem as some people are alleging….
Consumer education is undoubtedly an important facet here because a lot of what we’re going to be talking about are people who are taking loans that they probably wouldn’t have taken if they had fully understood the implications of all of the transactions. And so the Fed has already started on an effort to improve financial literacy, consumer education, and will keep doing that, as will other agencies.
Note: “seemingly some” ; “as some…are alleging” ; “a series of anecdotes, a series of TV programs” ; etc. Even though Eakes and the community bankers give statistics and hard evidence that there are abusive practices going on in the subprime market, the transcript reads of the Federal Reserve holding what is simply a check-the-box meeting, complete with the nod to financial literacy being the best solution. At the meeting, they could have brought up the prospect of doing any number of the later reforms they introduced, but instead they gave a signal to the market that everything will continue as normal.
All the more reason that consumer protection needs to be removed from the Federal Reserve and other locations consolidated inside a separate agency.