Does GOP want to fuel new mortgage crisis?

Sen. Elizabeth Warren, D-Mass., listens to a witness at a Senate Banking Committee hearing March 7, 2013. Warren rose to national prominence as an outspoken consumer advocate decrying Wall Street abuses. (AP Photo / Cliff Owen)

The lingering debate over the Dodd-Frank Act's financial reforms typically centers on what happens after the next financial crisis hits. In particular, many experts from across the political spectrum worry that it won't end the problem known as "too big to fail" - that the federal government still won't feel confident enough about the economic fallout to force one or more of our largest, most complex financial institutions into receivership much as the Federal Deposit Insurance Corp. routinely unwinds smaller banks.

Sen. Elizabeth Warren (D., Mass.) recently joined with Sen. John McCain (R., Ariz.) to address that problem by trying to avert it - by forcing the dismemberment of some of the mega-banks in question. The unlikely pair called for a return of the Glass-Steagall Act - the Depression-era law that walled off ordinary commercial banking, protected by FDIC insurance, from riskier investment banking. (Warren steadfastly defends that proposal, which echoes a stream of similar calls since the 2008 crash, in a CNBC video that you can view below.)

Warren, who formerly headed the panel charged with overseeing the Troubled Asset Relief Program, recognizes as well as anyone that preventing the next crisis - or at least minimizing its likelihood - is as important as mapping out what happens once it hits.  And yesterday, both she and the agency that she first proposed, the Consumer Financial Protection Bureau, again helped turn the spotlight on that crucial goal - and on evidence that some congressional Republicans still haven't grasped a key lesson from the last crisis.

In an op-ed in the American Banker, Warren and U.S. Rep. Maxine Waters (D., Calif.) warn against legislation they say would again expose consumers to the kinds of "faulty mortgage products that wrecked the economy":

The latest danger is H.R. 1077 and its companion bill, S. 949. Deceptively entitled the "Consumer Mortgage Choice Act," the bills seek to undermine Dodd-Frank’s ability-to repay provision. This provision, one of the most direct and important responses to the mortgage crisis, requires lenders to determine whether a borrower can afford a mortgage before they extend a loan. The rule was adopted to prohibit loans that were "designed to fail," a practice that was central to the origination model that brought on the financial crisis. Under the new rule, if lenders offer loans that meet the qualified mortgage standards provided by the Consumer Financial Protection Bureau , they are presumed to have proven the borrower’s ability to repay and are therefore protected from litigation.

One of these standards is a cap on points and fees, the up-front cost of getting a loan, at 3% of the loan amount. H.R. 1077 and S. 949 would create significant exceptions to this, allowing many more high-cost loans to qualify as QM loans.

Specifically, these bills recreate incentives for lenders to steer families into high-risk, high-fee loans they do not understand and cannot afford. In recent investigations, the U.S Department of Justice discovered that, in the lead up to the financial crisis, tens of thousands of borrowers, especially minorities, were sold unsustainable subprime loans even when they qualified for more affordable loans. The mark-up in the cost of those loans led to increased profits for the lenders and also became an indirect form of compensation and dangerous incentive for mortgage brokers. The ability-to-repay rule regulates this indirect compensation by counting it toward the points and fees cap. The new bill, however, would remove indirect compensation from the cap and encourage the same predatory loan companies that dominated the subprime market back into our neighborhoods.

Alas, you don't have to look back to the years before the 2008 crisis to find evidence that the problem lingers. In an enforcement action announced Tuesday, the CFPB filed a complaint against a Utah company, Castle & Cooke Mortgage LLC that illustrates how some mortgage originators continue to behave in ways that needlessly increase default risks.

The CFPB's complaint outlines the basic problem - incentive structures designed to push borrowers into costlier mortgages that are more likely to lead to defaults:

1. For years before the recent mortgage crisis, loan originators often steered consumers into mortgages with terms that were less favorable to the consumer but more profitable for the loan originator.

2. Seeking to stop this practice, in September 2010, the Federal Reserve Board amended Regulation Z to prohibit certain compensation schemes for loan originators (the “Compensation Rule”). The Compensation Rule, which became mandatory on April 6, 2011 (“Implementation Date”), prohibits any person from compensating a loan originator based on a term or condition of a mortgage loan. See 12 C.F.R. § 1026.36(d)(1)(i). A violation of the Compensation Rule is a violation of section 1036 of the Consumer Financial Protection Act of 2010 (“CFPA”). 12 U.S.C. § 5536(a)(1)(A).

3. Defendants have violated the Compensation Rule by paying the Company’s loan officers quarterly bonuses in amounts based on terms or conditions of the loans they close, thus incentivizing loan officers to steer consumers into mortgages with less favorable terms, the very practice the Compensation Rule sought to prohibit.

The CFPB says Castle & Cooke originated about $1.3 billion in loans in 2012, and does business in about 22 states. Its website lists just 13, largely in the West and South. In an email statement reported by the Salt Lake Tribune, a spokesman said the company "has been cooperating with the CFPB in its investigation for more than a year, and anticipates an amicable resolution in this complex regulatory matter."

The CFPB estimates that Castle & Cooke loan officers have earned more than 1,100 illegal quarterly bonuses since April 2011, when the rule took effect, and that "tens of thousands of customers" were likely pushed into more expensive mortgages than they should have been offered.

Those mortgages, in addition to gouging borrowers, are potential building blocks for the next financial crisis. Warren and Waters are right to warn against legislation that could re-open the floodgates to more of the same.