WaPo: How the Fed Failed to Protect Consumers

The Washington Post ran an excellent story yesterday looking at the Federal Reserve’s utter failure to protect consumers—indeed to even try to—from the subprime wolves during the housing bubble.

This is timely coming as it does amidst bureaucratic infighting and rear-guard actions by the banks over who should be responsible for consumer financial regulation: The Fed, whose main constituents are bankers and whose track record is dirt, or a new Consumer Financial Protection Agency, which has no track record but would focus entirely on protecting consumers. Hmmm.

This shows you why it might be a good idea to have a regulator focused on where the financial industry meets the consumer—the financial industry is ill-defined and innovation leaves gaps you can drive a moving van through:

Subprime mortgage lending sneaked up on the Federal Reserve.

Most subprime affiliates began life as independent consumer finance companies, beyond the watch of banking regulators. These firms made loans to people whose credit was not good enough to borrow from banks, generally at high interest rates, often just a few thousand dollars for new furniture or medical bills.

Look at this:

The advocates amassed evidence of abusive practices by lenders, such as Fleet Finance, an affiliate of a New England bank that eventually paid the state of Georgia $115 million to settle allegations that it charged thousands of lower-income black families usurious interest rates and punitive fees on home-equity loans. The National Community Reinvestment Coalition pressed the Fed to investigate allegations against other affiliates.

On Jan. 12, 1998, the Fed demurred. Acting on a recommendation from four Fed staffers including representatives of the Philadelphia, St. Louis and Kansas City regional reserve banks, the Fed’s Board of Governors unanimously decided to formalize a long-standing practice, “to not conduct consumer compliance examinations of, nor to investigate consumer complaints regarding, nonbank subsidiaries of bank holding companies.”

In other words: “The Fed Board decided that even when a nonbank was purchased by a bank holding company, the Fed still lacked authority to police its operations.”

Reporter Binyamin Appelbaum, who knows whereof he speaks when writing about subprime predation, spells out matter of factly why the Fed didn’t do its job:

The Fed’s performance was undercut by several factors, according to documents and more than two dozen interviews with current and former Fed governors and employees, government officials, industry executives and consumer advocates. It was crippled by the doubts of senior officials about the value of regulation, by a tendency to discount anecdotal evidence of problems and by its affinity for the financial industry.

No beating around the bush there, but I’ll put it a bit more bluntly: Alan Greenspan was a Randian zealot, his beloved theories outweighed the realities on the ground, and anyway, he preferred bankers over the masses.

Reason No. 527 why it’s amazing that the press treated Greenspan as a demigod for the better part of two decades:

Alan Greenspan, then chairman of the Fed, recalled that Gramlich broached the subject (of regulating nonbank subsidiaries) at a private meeting in 2000. Greenspan said that he disagreed with Gramlich, telling him that such inspections would require a vast effort with no certainty of results, and that the Fed’s involvement might give borrowers a false sense of security.

As Felix Salmon says:

In hindsight, both of these reasons are ludicrous. Policework, by its very nature, involves a lot of effort and no certainty of results. That doesn’t mean there shouldn’t be any policing…

In reality, of course, Greenspan was simply casting about for a reason — any reason — to indulge his deregulatory instincts.

This is good reporting by Appelbaum, and it’s especially good that he’s showing how the big banks were directly involved in the subprime lending scandal. Wall Street fed the beast by creating securities comprised of this crud, but it’s been too little reported that it was on the consumer-facing side as well.

Appelbaum notes a rogue’s gallery of companies bought up by the big banks: Associates First Capital, Fleet Finance, Household International, something Audit Inspector General Dean Starkman has repeatedly pointed out, and writes that:

By 2004, the consumer finance industry had largely been folded into the banking industry, and the finance arms of bank holding companies were making at least 12 percent of all mortgage loans with high interest rates, according to data reported by lenders under the Home Mortgage Disclosure Act.

And this is news, as far as I can tell. The Great Greenspan is calling for a consumer-protection agency. Or, well, sort of:

He said the administration’s plan to create a consumer protection agency was “probably the right decision.”

Salmon is right to say that Appelbaum’s story shows pretty convincingly that the Fed can’t handle consumer protection. That isn’t its primary job and it isn’t built to think like that. The Post (emphasis mine):

Throughout the lending boom, consumer advocates trooped regularly to the Fed’s monumental marble headquarters on Constitution Avenue to offer specific accounts of abuses in financial transactions. But what seemed powerful to advocates often was dismissed as anecdotal by regulators.

“The response we were getting from most of the governors and the staff was, ‘All you’re able to do is point to the stories of individual consumers, you’re not able to show the macroeconomic effect,’ ” said Patricia McCoy, a law professor at the University of Connecticut who served on the Fed’s consumer advisory council from 2002 to 2004. “That is a classic Fed mindset. If you cannot prove that it is a broad-based problem that threatens systemic consequences, then you will be dismissed.”

As the anecdotes piled up, so did the frustration of advocates. By refusing to conduct examinations of lending affiliates — by refusing to look systematically — the Fed was basically preventing itself from finding systemic problems.

Nice work.

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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at rc2538@columbia.edu. Follow him on Twitter at @ryanchittum.