Bull by the Horns

by Sheila Bair

  The OCC and a few Fed staff then tried to argue that the Collins Amendment applied only on an aggregate basis, so that if the Basel II advanced approaches produced higher capital in aggregate, individual big banks could still lower their capital below the requirements that applied to the smaller banks. So, for instance, if BofA had a capital increase under Basel II, JPMorgan Chase could lower its capital, so long as the average was the same. That was also clearly against the plain language and intent of the amendment, which banned any big bank from taking on more leverage than would be permitted for smaller institutions. There again, thanks to the strong position taken by Dan Tarullo, the OCC and Fed staff backed away from that argument, and in February 2011, the three agencies jointly proposed a rule that was true to Senator Collins’s intent. We finalized it196 in June 2011, less than a month before I left.

  But the battle royal came with the rules implementing our new resolution authority under Dodd-Frank. I was eager to finalize rules reinforcing the antibailout language for which we had worked so hard. Dodd-Frank strictly prohibits the Fed and FDIC from providing support to an individual failing or insolvent institution. Such an institution must be placed into bankruptcy or the FDIC resolution process. In addition, Dodd-Frank forbids the FDIC from favoring one group of creditors over another; they must be treated evenly, in accordance with the same priority followed in bankruptcy, with equity shareholders absorbing losses first. The act allows the FDIC to differentiate among creditors in two narrow situations, both of which also exist in bankruptcy. First, it can make payments to continue essential operations. Critical employees, technology providers, and security and maintenance personnel are examples of creditors who need to be paid to continue operations. Second, it can differentiate when it will maximize recoveries as the failed institution is sold off. That is essentially a mathematical determination. For instance, when an insured bank fails, we find that the bank acquiring it will frequently pay us extra to cover losses we would otherwise impose on the uninsured depositors. Large uninsured depositors are typically among a bank’s best customers, and the acquiring bank does not want to lose them. So it will pay us extra to make sure those big depositors are fully protected.

  I wanted to issue a rule reinforcing that those would be the only two limited circumstances when we would ever differentiate and that, further, certain classes of claimants, including common- and preferred-equity shareholders and subordinated debt and term unsecured debt holders would never qualify for extra payments. Throughout our decades of resolving thousands of failed banks, no one at the FDIC could ever remember a situation when those groups of claimants had needed to be paid to maximize recoveries or continue essential operations.

  I had discussed the rule with Ben, and he was comfortable with the approach we wanted to take. However, when I discussed it with Tim, he reacted very negatively. As usual, he was concerned about limits on the government’s discretion to bail out bondholders, but he could not provide me with plausible scenarios where protecting them while imposing losses on other creditors would meet the statutory criteria.

  Dodd-Frank required the FDIC to consult with the new Financial Stability Oversight Council (FSOC) on our rules implementing resolution authority. To that end, our staff had been having conversations with the staffs of the Fed, the Treasury, and other agencies since July 2010 on our plans to have very tight controls on differentiating among creditors. In addition, I circulated197 our proposal to the heads of all FSOC members a full week before our September 27, 2010, board meeting, when I had scheduled a vote to approve the rule for public comment. Nevertheless, John Walsh argued198 that we had not given FSOC members enough time for a meaningful consultation, even though there had been months of staff discussion. Moreover, the other agencies could continue providing input during the public comment process. In an effort to accommodate him, I had the staff brief the board on the proposed rule on September 27, but we waited until October 12199 to actually vote. (For all my reputation as a tough, hard-nosed FDIC chairman, in retrospect it amazes me how much I bent over backward to accommodate board members.)

  In early January, after receiving public comments, I decided to proceed to the final rule making. Again, we gave the other agencies several weeks’ notice that we would finalize the rule with only minor changes. None of the agencies, with the exception of the OCC, expressed a substantive objection to the rule, and Ben and Dan Tarullo made it very clear that the Fed was comfortable with our approach.

  Then the Treasury’s legal counsel contacted Mike Krimminger, giving him a heads-up that Tim would be contacting me to discuss the interplay between Section 203 of Dodd-Frank, which gave Tim approval authority over FDIC rules governing the Treasury line of credit, and Section 209, which gave the FDIC authority to write rules implementing resolution authority. According to the Treasury legal staff, “Geithner feels that Treasury200 should have a larger role than it has had to date on what they view as a large policy issue on the extent to which FDIC would or would not make additional payments to creditors in a Title II orderly liquidation.”

  So there it was. As I had feared, Obama’s Treasury secretary was trying to use the line of credit the Republicans had put into the bill as a way to try to get us to loosen our proposed restrictions on the payment of creditors. Tim pushed me hard on the rule, I pushed back, but here again, to accommodate him, I told him we would approve the rule as an “interim final.” That meant that the rule would go into effect but we would solicit another round of comments on it and leave the door slightly ajar for further changes. So on January 18, the FDIC board did just that, with the OCC’s new comptroller, John Walsh—whom I had come to view as Tim’s mouthpiece—complaining that we shouldn’t be limiting our discretion to pay long-term bondholders and that we would be discouraging investors from buying long-term debt.

  The back-and-forth with Tim over the Treasury’s role in our rule making continued. On March 21201, I sent him a polite letter explaining that the proposed rule did not involve policies and procedures governing the use of Treasury funds and thus they did not have to be acceptable to him. The second round of comments gave us nothing new, so in June 2011, we made the rule permanent. Perhaps because the Fed was supportive of our approach, Tim ultimately dropped his objections to it. (Or maybe he hoped to undo it after I left.)

  Another extremely important rule related to resolution authority was the Dodd-Frank requirement for large financial institutions to file so-called living wills with both the Fed and the FDIC. Specifically, it required them to demonstrate to us and the Fed how their nonbank functions could be wound down in a bankruptcy process without systemic disruptions. (Insured banks remain subject to the FDIC’s preexisting resolution powers. For large organizations such as Citigroup that have both bank and nonbank operations, the bank is resolved under FDIC’s preexisting powers, and the nonbank affiliates are resolved by the FDIC under the new powers contained in Dodd-Frank.) If a large institution cannot show that its nonbank operation can be resolved in an orderly way in bankruptcy, the Fed and the FDIC have joint powers to order it to restructure itself or become smaller through divestiture.

  I viewed the living will requirement as a potent new tool in the regulators’ arsenal to end too big to fail. Because of inherent flaws in the bankruptcy process, discussed earlier, I doubt that any large financial institution can make the required statutory showing. Thus, the regulators will likely have strong grounds to order divestiture or require that a failing behemoth reorganize into simpler, stand-alone subsidiaries that can be easily hived off and sold (or put into bankruptcy) without threatening the viability of the rest of the institution. Even more important, the living wills will be essential to improving information—which we lacked during the 2008 crisis—about the structure and location of major business lines, as well as the big institutions’ exposures to one another. Each of the megabanks has thousands of different legal entities, making it virtually impossible to identify and locate all of the different entities that support each o
f the bank’s business lines. Each institution is also required to identify every other institution to which it has a major credit exposure. During the crisis, we did not have good information about other institutions that might fail if, for instance, we put Citi into our resolution process and imposed losses on all of its unsecured creditors, including unsecured trading partners. Uncertainty about those types of interrelationships drove many of the decisions to bail out banks such as Citi and AIG.

  However, under the statute, the first stage of the process is to give large financial institutions the opportunity to develop and present their plans. After that there needs to be a review process and a back-and-forth among the Fed, the FDIC, and the institution to determine whether it has shown that it can be resolved in bankruptcy in an orderly way. I thought that it would likely take at least a year before the Fed and FDIC would have final living wills, as well as the grounds, if necessary, to start ordering structural changes or divestitures. With Citi and BofA still in tenuous shape, it was essential to get the ball rolling.

  But we had a tight time frame to work under, and the living will rule had to be joint with the Fed. I was already hearing that some of the Fed staff did not want to prioritize the living will requirement. Rather, they wanted to hold it back and issue it when the Fed issued other proposed regulations related to supervision of large financial institutions. So I reached out to Ben and Dan Tarullo, and both agreed to try to get it done before I left. We kept the pressure on the staff, but even with our efforts, the Fed and FDIC staff did not reach agreement until late March 2011. On March 29, we issued our joint proposed rule, with a forty-five-day public comment period. That would be barely enough time to finalize the rule before my scheduled departure on July 8.

  Both Ben and Dan made yeoman’s efforts to complete the rule before I left, but the time was too short. Ben promised me he would do everything he could to complete it by August. (They almost made it. It was approved by the FDIC on September 13, 2011, and shortly thereafter by the Fed.) I’m glad I pushed, because if I hadn’t, the living will rule would have been held back and included in other Fed rules relating to large banks. Those were not proposed by the Fed until December 2011 and will be finalized in the summer of 2012 at the earliest. In contrast, because the FDIC and Fed acted early, the biggest banks should complete their first living will submissions by July 1, 2012.

  My final board meeting was on July 6. Though the living will rule was not completed until after I left, I did complete action on another item of priority importance to me. That was a rule authorizing the FDIC to claw back two years’ worth of compensation from officers or directors who had been “substantially responsible” for the failure of a financial institution. The rule created a strong presumption that senior executives and key board members were substantially responsible if they had been in charge when the institution got into trouble. I was dismayed, as were most Americans, at the way boards continued to hand out large bonuses and pay packages to senior executives of bailed-out financial firms. Even when the CEOs were terminated, they typically received a generous severance settlement. Never again. If there were to be a next time (and there likely will be; there will always be boneheads out there who somehow rise to the top of bank management), I wanted to make sure that not only would they lose their jobs but they would pay substantial personal financial penalties.

  CHAPTER 21

  Robo-Signing Erupts

  I thought I was in the home stretch with the enactment of Dodd-Frank and the completion of priority rule makings. But by the fall of 2010, we were seeing clear signs that the major loan servicers—primarily owned by the nation’s biggest banks—were failing to perform their basic obligations to borrowers, investors, and the government in dealing with troubled loans. At the beginning of 2010, I had started seeing scattered press reports of home owners challenging foreclosure proceedings based on faulty paperwork submitted by loan servicers. The most cited problem was “robo-signing”—a practice at some big bank servicers of having a single employee sign thousands of affidavits swearing that the borrower was in default and that the servicer had all of the documents necessary to prove legal standing to foreclose. When home owners challenged those affidavits, the courts were finding that the employee signing the affidavit had had no personal knowledge whatsoever as to the borrower’s status or the adequacy of the servicer’s documentation. Indeed, in some instances, the documentation was woefully insufficient, not even containing the mortgage note that proved that the servicer had the right to claim the house as collateral for the loan.

  I would pass the articles along to my staff, but they seemed to be isolated cases, and in any event, the reports did not involve servicers that we regulated. Since 2007, we had made foreclosure prevention and loss mitigation an area of priority focus for our examiners. We had seen no problems of that type among the banks we oversaw (and I am happy to say that no FDIC-regulated banks were ever implicated in the robo-signing scandal). We assumed that any problems were being handled by the primary regulators of the major servicers: the OCC and, for a few servicers, the Fed.

  But in September 2010, it became clear that the robo-signing controversy involved far more than a few isolated cases. On September 20202, the press reported that GMAC Mortgage was suspending foreclosures in a number of states in order to review paperwork to make sure that foreclosures were being done correctly. That was followed by similar actions by JPMorgan Chase, Bank of America, and most of the other major servicers. The press went wild as the major servicers announced the foreclosure “moratoriums.” As the media scrutiny intensified, there were immediate demands for federal investigations and actions.

  On October 18, Chairman Dodd’s staff demanded a briefing from the regulators. Though the OCC was the primary target of their questions, all of our staffs were asked to attend. During the briefing, the OCC acknowledged that it did not look at servicers’ compliance with legal requirements outside of the requirements of the securitization trusts. The OCC and Fed203 also acknowledged that they had heard about the robo-signing problems from press reports, not the examination process.

  Tim and HUD Secretary Shaun Donovan then convened a meeting at HUD on October 20 with all of the bank regulators and representatives from the Department of Justice, the Federal Trade Commission, the SEC, and the Federal Housing Finance Agency, the regulator of Fannie Mae and Freddie Mac. Elizabeth Warren was also invited in her capacity of special adviser to Tim and the president on setting up the new consumer agency. I was not surprised at Warren’s presence. It made sense insofar as Dodd-Frank expressly gave the new consumer bureau authority to write mortgage-servicing standards. Even though the agency was not up and running yet, its views were obviously important, as in less than a year, it would have the lead role in overseeing big-bank servicing and treatment of borrowers.

  Not much was accomplished at the meeting. HUD and the Treasury Department204 issued a statement that the meeting had occurred and detailed some of the individual initiatives each of the agencies was taking to hold mortgage servicers accountable. I was amazed to learn during that and subsequent meetings about the severity of penalties HUD could assess against servicers that did not comply with its strict loss mitigation requirements for mortgages guaranteed by the Federal Housing Administration (FHA), which is part of HUD. Theoretically, it could assess triple the amount of the insured unpaid balance on each mortgage on which a servicer had violated HUD rules. Given the pervasive problems we would later discover at some of the banks, if the FHA wanted to pursue the maximum penalties allowed by law, it could probably have threatened the financial viability of some of them.

  Though we didn’t have direct jurisdiction over any of the large servicers, a few of them had purchased failed banks from us under terms that required us to share the losses on the failed banks’ mortgages. Those agreements gave us the authority to audit the servicing of mortgages since we were exposed to some of the losses if they defaulted. Our loss-sharing agreements required banks to restructure
loans when doing so would mitigate our losses and also fully comply with foreclosure laws if foreclosure became necessary. As we learned more about the robo-signing scandal, it became apparent that robo-signing was simply one symptom of a much deeper problem: chronic underfunding and mismanagement of servicing operations by the major banks. So I asked our examiners, led by Stan Ivie and Frank Hartigan in our San Francisco regional office, to conduct detailed file reviews of loss-share banks to make sure they weren’t foreclosing unnecessarily. Since the loss on a foreclosed loan could be 40 to 60 percent of the unpaid balance, we wanted to avoid it whenever a restructured loan would be a better economic alternative.

  The OCC and Fed decided (obviously) that they needed to do a thorough review of all their major bank servicers to determine their compliance with foreclosure requirements, which are governed by state and local laws. As the deposit insurer, I was becoming increasingly concerned about the impact the controversy could have on the financial strength of the big banks. The maximum FHA fines by themselves could be a huge problem. And that was only the tip of the iceberg. State attorneys general were already launching investigations, and the trial bar was gearing up to challenge foreclosure actions en masse. Similarly, those who held mortgage-backed securities that were serviced by the big banks would have claims against them if they failed to adhere to basic standards of servicing competence.

  Around the same time that the Fed and OCC began their reviews of the major bank servicers, they notified us that they wanted to start letting banks increase their dividend payments to shareholders. Since the crisis, we had kept a tight rein on dividends to make the banks conserve capital. I was concerned that letting banks raise their dividend payments at that point was premature. It would be better for the banks to hold on to their earnings, at least until we had a better idea of what their losses related to the robo-signing mess would be. In addition to the robo-signing controversy, the banks also had to contend with preparing to meet higher international capital requirements. Other jurisdictions, including Canada, were refusing to approve dividend increases until banks significantly raised its capital levels.