by Sheila Bair
CHAPTER 20
Dodd-Frank Implementation: The Final Stretch (or So I Thought)
The battles over financial reform did not end with the president signing Dodd-Frank. Virtually all of the reforms in the new law relied on agency rule makings for implementation. So as the industry redirected its army of lobbyists to the rule-writing process, I decided to try to outrun them. I knew that the longer regulators waited to finalize the rules, the greater the risk that they would be watered down. There was also another need for expediency: I had barely a year left in my five-year term. I wanted to make sure we finished the rules on resolution authority, deposit insurance, and the all-important Collins Amendment before I left office. I also wanted to complete rules that we had initiated containing important reforms to the securitization process.
Already amnesia was setting in about how bad the crisis had been. The Tea Party—born of outrage over the 2008 bailouts—was redirecting its ire toward government. Instead of providing political support for commonsense measures such as higher capital requirements, resolution authority, and mortgage-lending reform, it was bashing government and regulations for impeding the economic recovery, forgetting that the recession had been caused by the excesses of many large financial institutions. That, of course, was playing into the hands of industry, and it frustrated me no end. As a market-oriented Republican, I was outraged at the way some of the big firms had come running to Washington to be bailed out of problems of their own making. They had been worse than the proverbial welfare queen. Yet the narrative in some (not all) conservative circles was becoming that the crisis had been the government’s fault; folks at those poor big financial firms had been forced to do all those stupid things and be paid all of those big, multimillion-dollar bonuses because the government had wanted poor people to have mortgages. Right.
With less than twelve months left in my tenure, I had a very full plate. I moved quickly on organizational changes to implement the new law. We created an Office of Complex Financial Institutions (CFI). The office would take responsibility for backup supervision and resolution of bank and nonbank institutions with more than $100 billion in assets. I promoted Jim Wigand, who had been a superstar in handling our bank failures, to be in charge of the new office. Jason Cave was installed as his deputy in charge of creating better systems to monitor big banks. During the crisis, we had learned the hard way that we needed to keep a closer eye on them.
We also created a new division focused solely on consumer protection, consolidating our public education programs for deposit insurance and community outreach with our consumer examination functions for institutions with less than $10 billion in assets. To head the division, I hired Mark Pearce, who had overseen bank supervision for the North Carolina banking department and before that had worked at the Center for Responsible Lending. I wanted us to have a better consumer focus and a more cohesive examination strategy for ensuring compliance with consumer laws. I’ve always prided myself on being proconsumer, but during the crisis, I found that consumer issues—as is all too often the case—took a backseat to our safety and soundness responsibilities. To be sure, we had a good consumer record during my tenure at the FDIC. We had great consumer compliance examiners, second to none among the banking agencies. We initiated a number of high-profile consumer enforcement cases and also pioneered research to support banks in their efforts to offer safe, simple products to less sophisticated populations, such as low-cost small-dollar loans and low-fee checking accounts. Retail banking products had become far too complicated for many consumers. With a new division, headed by a strong leader like Mark, consumer issues would always stay front and center before the FDIC chairman and board. Mark’s shop would also be responsible for coordinating with the new Consumer Financial Protection Bureau on its rule makings related to FDIC-insured banks.
For the Dodd-Frank rule writings, I organized the FDIC staff into implementation teams and scheduled weekly meetings to receive progress reports. Helping me in this endeavor were our deputy general counsel, Roberta McInerney, and her top lieutenant, Kym Copa. Kym was one of our brightest attorneys, a whiz at drafting legislation and rules. She and Roberta had worked tirelessly during the congressional consideration of Dodd-Frank.
I also instituted189 a new transparency policy: we would adhere to an open-door policy for anyone who wanted to meet with us on pending rule makings. Industry groups, consumer groups, reform advocates, all would get an equal hearing. But we would publish on our website the names and affiliations of people who met with us and the topics they discussed. To try to preempt industry lobbying, I organized roundtable discussions on important rule-making topics that we could control in terms of who came and the topics discussed. The roundtables provided an excellent way to get technical input from the industry and others, but in an open and transparent way; we webcast all of them. We were the first to propose a transparency initiative, but soon thereafter a number of other agencies did the same.
The rules related to deposit insurance were the easiest to accomplish because we had sole authority for getting them done. For instance, the rule to implement the higher deposit insurance limits was completed on August 10. The more complicated rules related to the way we charge banks’ deposit insurance premiums were proposed in early November. Consistent with Dodd-Frank, the rules allowed us to look at all sources of a bank’s funding in determining the amount of its insurance premium, and they also improved the way we adjust large banks’ premiums on the basis of risk. We looked back at the attributes of weak banks such as Citi, Wachovia, and WaMu several years before the crisis to find common predictors of risk. We wanted to see what they had looked like before their problems became prominent to reduce the procyclicality of our assessment system. Our goal was to assess risk throughout the cycle, not just penalize mismanaged banks once they started experiencing losses. In that way, we hoped our risk-based premium system could deter risk taking before big problems emerged.
The combined effect190 of the rules was to shift about 80 percent of the assessment burden to large banks, reducing small banks’ assessment burden by 30 percent. Thanks to the outstanding work of Art Murton, Diane Ellis, and their team, the rules were promptly finalized in February 2011.
Another area in which we had exclusive authority related to how we viewed securitizations during a bank failure. A late-2009 accounting change had created confusion about whether loans a bank sold into a securitization were the property of securitization investors or the FDIC if the bank failed. The securitization industry was lobbying us to provide relief on the issue. They basically wanted us to issue a carte blanche rule that said we would not try to claim ownership of any failed banks’ securitized assets that met the old accounting standard. I was willing to approve that kind of relief—called a “safe harbor”—for old securitizations. In fairness, they had been issued when the old rules applied and investors had purchased the mortgage-backed securities based on the expectation that the FDIC would not try to claim ownership of the underlying mortgages. However, for future securitizations, I wanted better standards to apply. Securitizations had provided the fuel for the conflagration that had consumed our housing market and our economy. I wasn’t going to facilitate a return to the old ways. We needed better safeguards in place.
In December 2009, we provided temporary relief, saying that we would continue to apply the old standards until March 2011. But we also requested comment on additional conditions that might be imposed to address the misaligned incentives in securitizations that had caused so much damage. After receiving comments, in May 2010, we proposed191 a rule imposing a number of conditions. The most important of them was “risk retention”—the idea that those who issue mortgage-backed securities to investors have to keep some of the risk of losses if the mortgages go bad. A 5 percent risk retention requirement was already included in the Dodd-Frank bill, then still wending its way to final passage, so we also proposed a 5 percent risk retention requirement in our rule. The idea was that for every dol
lar of loss on a mortgage that went bad in a securitization, the issuer would have to absorb 5 cents. (I would have preferred 10 percent, but we went with the 5 percent standard.)
In addition, working closely with Chairman Mary Schapiro and her staff at the SEC, we conditioned the safe harbor on new disclosure rules the SEC had proposed in April. Those important rules would give investors better information about the quality of loans in securitizations and more time to review that information before making the decision to invest. Finally, we imposed conditions on how servicers are compensated to make sure they had incentives to restructure loans when it would minimize losses for all investors, to end the “tranche warfare” that had so impeded loan modifications. All of those reforms were carefully coordinated with the SEC so that all securitizers would have to abide by them. Our safe harbor would apply only to insured banks. The SEC rules could reach everyone else.
After receiving a second round of comments on the proposed rule, I decided to move ahead with finalizing it. The industry was apoplectic. Late in the Dodd-Frank legislative process, it had been able to secure a significant weakening of the risk retention requirement. Specifically, the final law said that securitizers did not need to retain any risk in the mortgages they securitized if the mortgages met very high lending standards. Dodd-Frank further directed all of the major agencies to develop the new standards jointly. Mortgages that met the new, higher “gold standards” were called qualified residential mortgages (QRMs). The industry now wanted us to hold off on imposing risk retention or any other condition on bank-issued securitizations until the regulators wrote the QRM rules.
Having been a regulator for most of my career, I knew how long the writing of interagency rules could take. We had been generous enough with the industry. I knew that it would just try to drag out and water down the QRM rules (and it has). In the meantime, no new standards would apply if we backed down. So I instructed our staff to continue moving forward, and I notified our board that there would be a final vote at our September 27 meeting. I also told our board members that we would include something called an “auto-conform” provision in our final rule. That meant that if and when the regulators finalized the QRM standard for risk retention, our rule would automatically conform to that rule.
On Sunday, September 26, at 7 P.M., the evening before our board meeting, in an astonishing assault on the FDIC’s independence, Tim sent an email to the heads of all the major regulatory agencies asking for their views as to whether the FDIC should proceed with the final rule or whether we should grant the relief the industry sought, without conditions. The only agency head not included in the email was Ben. Instead, Tim sent it to a senior staffer at the Fed, a holdover from the Greenspan era. My jaw dropped when I saw the email. I was working at home, and I howled so loudly that my kids came running to find out what the problem was. Then I started receiving calls at home from other agency heads telling me that one of Tim’s deputies, Jeffrey Goldstein, had been calling them, encouraging them to email back that they wanted us to delay our rule and extend relief without conditions, just as the industry wanted.
The Fed staffer responded immediately to Tim’s email that the Fed wanted us to delay. Ben was traveling, and it was not until early the next morning that I could reach him. I emailed him tersely: “This rule has been in the works for a year. If you really want to get into the middle of this, I’d prefer a call and not hear through an intermediary.” Ben had always been professional and courteous to me, and my guess is that the staffer was pursuing her own agenda. In the meantime both Ed DeMarco, the head of the Federal Housing Finance Agency, and Mary Schapiro weighed in favor of the FDIC exercising its “independent judgment.” When I did finally192 reach Ben, he tried to finesse the issue by saying that the Fed would prefer that we delay but that he respected that it was our decision to make. The next day, my board voted to finalize the rule, with only one dissent, John Walsh—Dugan’s chief of staff, who had replaced him on an interim basis as acting comptroller of the currency. The irony is that another board member, acting OTS head John Bowman, was unsure of how he would vote on the rule, but I think he decided to support it partly in reaction to Tim’s heavy-handed tactics.
John Dugan stepped down as the acting comptroller of the currency at the expiration of his term in August 2010. I was surprised that the administration did not nominate a replacement for Dugan, as it was probably one of the most important jobs for Obama to fill if he wanted to have a stronger regulator for the big banks. As secretary of the Treasury, it was Tim’s responsibility to recommend candidates for financial regulatory agencies to the White House; they would then be nominated by the president and confirmed by the Senate. But in the case of the OCC, Tim had failed to recommend a replacement. Instead, he exercised his statutory right to appoint Walsh. In doing so, Tim passed over the OCC’s top career official, Julie Williams, who had been with the OCC for decades and had served as the acting comptroller in the past when temporary vacancies had occurred. Julie was controversial with consumer groups and reform advocates, as she was generally viewed as friendly to the big banks. Ostensibly, that was the reason Tim passed her over. But Walsh turned out to be as much a supporter of industry as Julie was, as I learned with that securitization vote. I suspect that the real reason Walsh was named was that Tim thought he could control him, while Julie—a smart, tough-minded lawyer—would be more independent.
As we put our own conditions on securitizations into place, we continued working with the other regulators on the Dodd-Frank risk retention requirement and QRM exception. We pushed hard for very stiff standards for QRMs. I believed—and continue to believe—that the best way to prevent lax lending is to make sure that those securitizing the mortgages are on the hook for losses. QRMs provided a way for securitizers to escape having any “skin in the game.” As such, the QRM criteria needed to be narrowly drawn. We strongly supported a minimum 20 percent down payment requirement, as well as tough income documentation standards and a low debt-to-income ratio.
We also pushed193 for servicing standards in the risk retention rules along the lines of those we had included in our own securitization safe harbor. We wanted to end compensation structures that made it profitable to the servicer to foreclose and ban other conflicts that had skewed economic incentives and sent so many families into unnecessary foreclosures. Those standards would have applied prospectively to future securitizations, as we could not rewrite securitization contracts that were already in place. But going forward, we wanted to make sure that servicers were required to take prompt action to mitigate losses and act solely in the interests of maximizing recoveries for investors as a whole.
Here again, John Walsh fought us tooth and nail on including servicing standards in the risk retention rule, while the Fed remained neutral. Finally, after receiving letters194 from consumer groups and Congress and 12,000 signatures on a petition circulated by the naked capitalism blog, the Fed came our way and helped convince the OCC to agree to most of our requested changes. (The other regulators already supported us.) But disagreements over that and many other facets of the rule delayed its publication for comment by all of the agencies until April 2011. Regrettably, once the proposed rules were issued, the 20 percent down payment requirement met with a storm of criticism from many (but not all) low-income advocacy groups and the real estate industry. They grossly misrepresented the risk retention rules as requiring everyone to have a 20 percent down payment. For instance, Bob Nielsen, the chairman of the National Association of Home Builders, was quoted as saying:
By mandating195 a 20 percent down payment on qualified residential mortgages, the administration and federal regulators are excluding those without huge cash reserves—which constitutes most first-time home buyers and many middle-class households—from a chance to buy a home.
Of course the QRMs, those requiring 20 percent down, were meant to be a small part of the market—the exception, not the rule. Mortgages that banks kept in their own portfolios or securitized whi
le retaining 5 percent of the risk could have lower down payments. That controversy and others prevented the regulators from taking final action, and I am very fearful that in the 2012 election year, they will succumb to political pressure and lower the QRM standards. In any event, as I write this in the middle of 2012, the agencies have still not finalized that or any other major rules reforming the private securitization market. Our hard-fought safe harbor rule is the only reform that has been put into place, four years after the crisis.
We also had a completely gratuitous, time-wasting fight with the OCC over rules to implement the Collins Amendment. Our FDIC Basel team drafted a straightforward rule that set a floor on big-bank capital requirements based on the generally applicable standard to all banks. Julie Williams, representing the OCC, then argued that the Basel II advanced approaches were the “generally applicable standard” for the large banks, so that Basel II should set the floor. That, of course, would have nullified the plain language of the Collins Amendment, as well as Senator Collins’s express intent in her remarks on the Senate floor. She did not want the regulators to allow the big banks to take on more leverage than was allowed for the rest of the banking industry. Basel II didn’t yet apply to any bank; the FDIC had successfully delayed its implementation, and in any event, by definition, it was not generally applicable because it was meant to be available only to the largest banks.