Foreclosure crisis puts Wall St. reform to the test

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By Neil Irwin
Friday, October 22, 2010

The foreclosure problems that have unfolded in recent weeks present a test of whether financial regulators can respond more cohesively and aggressively to an emerging problem than they did to the subprime crisis three years ago.

The Wall Street reform legislation that was passed over the summer created new procedures for financial policymakers to coordinate their response to big, overarching risks like this one. So far, officials at the Treasury Department, federal bank regulators and housing-related agencies say they are in frequent contact, swapping information about the crisis that has stemmed from faulty documentation behind many home foreclosures.

The Financial Stability Oversight Council, which brings together the Treasury secretary and heads of major financial regulators to consider such broad potential threats to the financial system, has met only once, just before the current crisis broke out.

But now, several of its members and their deputies are trying to coordinate their efforts to understand the scope of the current problem.

The consensus view among the officials involved is that although the latest problems will probably tie up the big banks in expensive litigation for years and slow down the foreclosure process, the banks should be able to weather the losses and the problems are unlikely to cause a broader crisis for the overall housing market or economy.

But the government failed to foresee the ways the subprime mortgage crisis that began in 2007 would ripple through the economy, and now a Treasury official said there is a concerted push to understand the full potential of the new problem.

The Federal Reserve, the Office of the Comptroller of the Currency, and other bank regulators have examiners on the ground inside major banks - and the power to force them to improve their procedures. Fed economists are constantly monitoring risks to the economy as a whole. The Federal Housing Finance Agency oversees Fannie Mae and Freddie Mac, which in turn can lean on mortgage-servicing companies that may not be complying with their obligations in how they deal with borrowers. The Securities and Exchange Commission has responsibilities over disclosure matters in mortgage-backed securities.

"We'll learn something from this mess about how the new coordination structure works," said Douglas Elliott, a fellow at the Brookings Institution.

One major challenge for financial regulators is that even if they accurately identify the risks that the new crisis poses for the broader economy, they may not be able to do much about them. Mistakes by mortgage-servicing companies generally involve state property laws, leaving enforcement in the hands of state attorneys general and judges around the country.

If their decisions end up making it so much harder to foreclose on properties that mortgage-backed securities become more expensive, it could make it harder to get a mortgage loan and thus cause damage to the housing market as a whole. Yet in that scenario, federal economic policymakers would be challenged to find ways to fix the problem.

Bank regulators, including the OCC and the Fed, could have more of a role to play in trying to prevent the foreclosure mistakes from recurring, and have clear tools with which to put pressure on banks to clean up their act.

"The regulators will probably want to send in examiners to assess the situation in very focused examinations, to try to ascertain how much of a problem there is," said Ernest Patrikis, a partner who practices banking law at White & Case and a former general counsel of the Federal Reserve Bank of New York. "Then where they find problems, they will say, 'What are your remedial plans, how will you fix it?'"

If the foreclosure process is slowed down too much, it could lead people to hold off on home purchases as they wait for a new, cheaper supply of homes to hit the market. In that sense, it could further delay a recovery in the long-ailing housing market.

"There are very serious issues to be worked through, and there are a wide range of possibilities of how severe the impact will be," said Elliott. "At the same time, it's not a perfect test of the new approach to financial regulation because so many of the issues here are legal ones and lay outside the direct influence of financial regulators."


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