Production Incentives: Protecting the Consumer

Jonathan Foxx

Managing Director

Lenders Compliance Group

Production incentives have been around since the dawn of modern capitalism. They are not going anywhere. Incentives have been called sales incentives, sales bonuses, compensation bonuses, and take into account any additional remuneration that tends to be transactionally based. All such incentives can be grouped into business objectives where a transaction may be tied to certain benchmarks, met by employees or service providers, the achievement of which leads to an increase in wage or reward for the party achieving the stated goal. For the sake of discussion, let’s call forms of such economic inducement, collectively, as “incentives.”

Typical incentives include cross-selling, where sales or referrals of new products or services are pitched to existing consumers; sales of products or services to new customers; sales at higher prices where pricing discretion exists; quotas for customer calls completed; and collections benchmarks.

Some of these incentives are very complex in the way they are achieved and applied, whether optionally or required. The incentive challenge is one of the usual conundrums arising when money and capital formation meet: the opportunity for harm to the consumer. Obviously, incentives offer a way to further enhance revenue for the seller of services and products. Indeed, in our market economy, an incentive can reveal the economic interest of market participants in a particular service or product, which is extrapolated from consumers’ responses to the offerings. Like so much in finance, incentives are not inherently good or bad, but how they are applied makes them so!

The Consumer Financial Protection Bureau (“Bureau”) has decided to weigh in with guidance on production incentives. I am going to provide my reading of the Bureau’s most recent bulletin on this topic, entitled “Detecting and Preventing Consumer Harm from Production Incentives” (Bulletin 2016-03, November 28, 2016, hereinafter “Bulletin”). It is an interesting read, because it endeavors not only to compile guidance that the Bureau had provided in other contexts but also draws attention to the Bureau’s supervisory and enforcement experience in which incentives contributed to substantial consumer harm. Importantly, the Bulletin offers some actions that supervised entities should take to mitigate risks posed by incentives.

RISKS

The most obvious risk of incentives to the consumer is a sales program that includes an enhanced economic motivation for employees or service providers to pursue overly aggressive marketing, sales, servicing, or collections tactics. These kinds of incentives are and always have been features of sales tactics that do not meet regulatory scrutiny. Consequently, it is the case that the Bureau has taken enforcement action against financial institutions that have expected or required employees to open accounts or enroll consumers in services without consent or where employees or service providers have misled consumers into purchasing products the consumers did not want, were unaware would harm them financially, or came with an unexpected ongoing periodic fee.

When does the “foreclosure clock” start ticking?

Jonathan Foxx

Managing Director

Lenders Compliance Group

One of the cases I have been monitoring is U.S. Bank NA v Bartram, which had been argued before the Florida Supreme Court (“Supreme Court”). The issue at bar concerns the statute of limitations for filing a foreclosure suit. I think this case is being watched closely not only because of its impact on Florida’s statute of limitation provisions but also because of its wider, national implications.

Last week, the Supreme Court ruled that each monthly default on a mortgage loan payment resets the five-year statute of limitations for filing a foreclosure suit. This ruling affirms a lower court's decision, which stemmed from a foreclosure action in Ponte Vedra, Florida.

The Supreme Court affirmed a Fifth District Court of Appeal (“Appeals Court”) ruling that the statute of limitations was reset each time the borrower failed to make a payment to U.S. Bank NA on the mortgage.

This is a long, winding, and somewhat complicated case with tons of citations and plenty of positions taken via amici curiae. I wish only to hit on a few salient observations. I will conclude with a view of the remarks of one of the Justices, who concurred as to “result only,” which means that the Justice agreed with the decision made by the majority of the court, but stated different (or additional) reasons as the basis for the decision.

Now, the big question that the Supreme Court needed to answer was:

If there is a default on a loan, causing an acceleration thereof, where the lawsuit to foreclose has been dismissed and a five-year statute of limitations has run out, is the lender permanently prevented from subsequent foreclosure proceedings because of the statute of limitations?

Here is a meta-outline:

• Loan defaults,
• Lender accelerates,
• Foreclosure lawsuit,
• Foreclosure dismissed, and
• Five-year statute of limitations elapses. 

Or, to put the question more precisely into the framework of the litigation:

Does acceleration of payments due under a residential note and mortgage with a reinstatement provision in a foreclosure action that was dismissed trigger application of the statute of limitations to prevent a subsequent foreclosure action by the mortgagee based on payment defaults occurring subsequent to dismissal of the first foreclosure suit?

The Supreme Court answered in the negative.

Let me provide some background.

This dispute began with a 2006 foreclosure lawsuit against Lewis Bartram after he stopped making payments on the mortgage. In April 2011, with Bartram's suit still in litigation, his ex-wife Patricia Bartram filed a suit to foreclose her mortgage, naming her ex-husband, the bank and the homeowners' association as defendants.

To provide some dates and actions:

• November 14, 2002: Lewis Bartram and Patricia Bartram purchase real property in St. Johns County, Florida
• November 5, 2004: marriage is officially dissolved, with the divorce court ordering Lewis to purchase Patricia’s interest in the property, pursuant to their prenuptial agreement
• February 16, 2005: Bartram obtains $650,000 loan through Finance America, LLC, and Finance America subsequently assigns the mortgage to U.S. Bank, with March 1, 2035 as the designated maturity date of the note
• February 17, 2005: Bartram executes a $120,000 second mortgage to Patricia to buy her interest in the real property, in accordance with the prenuptial agreement, thus she ends up with a recorded interest in the same real property as the Bank
• January 1, 2006: mortgage goes into default
• May 16, 2006: U.S. Bank files complaint to foreclose
• December 12, 2006: Lewis Bartram files answer to the complaint
• December 19, 2006: U.S. Bank moves for final summary judgment of foreclosure, which does not appear to have been denied
• February 23, 2009: U.S. Bank files renewed motion for summary judgment

First thing we do, let’s kill all the regulators!

Jonathan Foxx

Managing Director

Lenders Compliance Group

“First thing we do, let’s kill all the regulators!”

Actually, Shakespeare's exact line is ''The first thing we do, let's kill all the lawyers.''

This famous exhortation was stated by Dick the Butcher in Henry VI. Dick the Butcher was a follower of the rebel Jack Cade, who thought that if he disturbed law and order, he could become the king. So, carrying out the inference, Shakespeare was suggesting that if the rebels kill all the lawyers law and order would be destroyed and he, Jack Cade, could become king. This incitement was not a denigration of lawyers, but a veiled homage to them!

In my recent article, Wells Fargo, A Predator’s Tale, I wrote about how the lack of systemic accountability is at the core of illegal banking practices. Since the news broke of Wells Fargo’s financial debauchery, there has been no dearth of eschewing the encumbrance of blame.

The circular firing squad has begun! Let us count the ways.

·         Damned if you do. Damned if you don’t.

o   Politicians who want to dismantle the Consumer Financial Protection Bureau blame it for not going after Wells Fargo sooner.

·         Proof of the pudding is in the eating.

o   Politicians who want to strengthen the CFPB declare its virtues for having gone aggressively after a Too Big To Fail bank.

·         Fix the problem. Not the blame. (Sort of!)

o   Fire 5,300 low level employees – problem supposedly fixed – but management and compliance personnel remain largely unscathed and fully employed.

·         The devil made me do it!

o   Many of the fired 5,300 low level employees accuse management’s excessive sales demands for causing them to commit fraud in the service of performance goals.

·         Rock the ramparts!

o   Castigate the regulators for purportedly failing to find violations in examinations and then only belatedly pursuing enforcement.

·        Quis custodiet ipsos custodies? - pace Juvenal

 (Who will guard the guards themselves?)

o   Compliance department could not possibly have not known about the violations, but apparently nobody was overseeing the compliance department, at least not with compelling oversight.

This scam began as a result of a whistleblower. Then an investigation ensued, triggered by the whistleblower’s information. Shortly after the investigation began, the dark swindle leaked into the news – back in 2013! However, the fraud itself traces its sorry history to 2011.

Or to be precise, Wells Fargo began firing employees in 2011, the Los Angeles Times ran stories on the spurious practices in 2013, and the Los Angeles City Attorney filed his lawsuit against the bank in May 2015.

But why did the regulators not discover the violation? At this point, it appears that they missed it! Is that really possible? Maybe this was a resource issue. Somehow, I don’t think a resource issue caused the violation, if you consider that in 2015 Wells Fargo was the world's second largest bank by market capitalization and the third largest bank in the U.S. by assets. Let’s give them that for the moment! Let’s just assume it was a resource issue. Even so, that assumption would kind of lead to a big crack in the fault lines, a steep ravine in the culpability abyss, a chasmal canyon filled with unrequited expectations, a wobbly thread dangling from the drooping rafters of safety and soundness; for, practically speaking, it sure does seem that the examiners did not review the merely trifling routine details of opening new accounts.

Wells Fargo, A Predator’s Tale

Jonathan Foxx

Managing Director

Lenders Compliance Group

It seems it all comes down to money, sooner or later. Anthropologists have long known that we are a predatory species. Our laws and rules are meant not as guides to decent behavior but to keep our primal instincts in check. And where money is involved, the rapacious and ravening impulse to plunder, pillage, covet and steal is fully aroused.

By now you have heard about Wells Fargo’s unrestrained, pitiless rampaging over the laws meant to protect consumers from financial predation. Is Wells Fargo the only company that has preyed on consumers? We all know deep down that this is a case of breaking rule number one: don’t get caught! Most of us do our best to abide by the vast network of mortgage acts and practices. We want to abide by the law because we respect the law and respect one another. Yet is Wells Fargo no more than an outlier? An edacious eccentricity of deviance?

Will Wells Fargo paying $185 million to settle allegations of “widespread illegal practices” stop depredation? Will it even slow it down? 

Employees of Wells Fargo secretly opened 2,000,000 unauthorized deposit and credit card accounts in order to meet sales targets and receive bonuses.

Pressure points: Sales targets and bonuses. Now those are familiar carrots and sticks!

Will throwing monetary penalties at the problem make it go away? Will money paid for violations solve the problem of money illicitly taken by a marauding horde of 5,300 Wells Fargo employees? The violations in this instance brought about a $100 million fine from the CFPB, a $35 million fine from the OCC, and a $50 million fine from the City and County of Los Angeles. $185 million sure seems like a lot of money. You tell me. Last year, Wells Fargo had net interest income of $45 billion – meaning that the monetary penalty is .0411% of the total, based on using the foregoing metric. I can use many other metrics and the ratio does not improve. I think you get it.

And then there’s this quirkiness of legal maneuvering to avoid larger fines, stay out of or get out of court, avoid certain onerous litigation, and let it all just dissipate from public view and memory: agree to a settlement without admitting or denying wrongdoing. Yet, without admitting or denying wrongdoing, the bank gets to unabashedly make this statement: “We regret and take responsibility for any instances where customers may have received a product that they did not request.” Note the weasel word, “may,” on which the whole statement rests.

Settlements are a fact of life. I doubt that anybody would reasonably dispute the value of settlements as a tool toward bringing about a resolution between litigating parties. However, there is that distressing, oppressive, and vexatious issue of accountability. Being provably culpable for a capital offense, for instance, usually sends people to jail. Being provably culpable for conning and swindling people usually gets people sent to the clink. Being provably culpable for fraud usually has people on a lockup line. Being provably culpable leads to a monetary settlement, neither admitting or denying wrongdoing, for an “incentive compensation program and plans [that] … fostered the unsafe or unsound sales practices … and pressured bank employees to sell bank products not authorized by the customer.”

Pressure points.

Blame the employees for doing what the company’s culture expected of them!

Yet even though this army of plundering bandits preyed on unsuspecting consumers, Wells Fargo pays a puny fine relative to its assets and skips away, unsullied by admissions of wrongdoing.

We should not jettison notions of checking predatory instincts by regulations, even when it all comes down to notions of just misbehaving and trifling monetary fines for being merely disobedient. In my view, this is where compliance situates its most important role. It is in the interstitial space between the boundaries of regulatory rules and instinctual reflexes that compliance is the first line of defense, ensuring that the social fabric of society, so deeply enmeshed in the interests of money, is kept intact. 

Compliance may unearth systemic defects, but it cannot rectify the inadequacy of systemic accountability.

Flipping the Bird at the CFPB!

Jonathan Foxx
Managing Director
Lenders Compliance Group

Do you really want to tell the Consumer Financial Protection Bureau (CFPB) that it doesn’t regulate you?

Before flipping the bird at the CFPB, a company had better do some deep and serious deliberations!

Take the case of Intercept Corp., a company that the CFPB asserted allegedly took money from consumers’ bank accounts without authorization to do so. It was claimed that the company willfully ignored red flags and thereby allowed its client companies to take consumers’ funds.

Here’s what happened, as described in the complaint,[i] and argued in federal court a few days ago.

Intercept does business as InterceptEFT. The CFPB claimed that InterceptEFT, and its President, Bryan Smith, and also its CEO, Craig Dresser, knew about the alleged illegal withdrawals but they did nothing to protect consumers.

Intercept tried a gambit that, in this instance, seems to have been destined to failure: when in doubt, remove the opposing litigant for lack of standing. So, let’s do it, let’s try to remove the CFPB! Let’s contend - or maybe “pretend” should be the best word here - that we’re not governed by the Consumer Financial Protection Act (CFPA). Sure, that will work!

The CFPB, it seems, successfully argued otherwise.

What does InterceptEFT do? The CFPB describes this company as a financial service that is mainly used for consumer purposes – meaning personal, family, or household needs. It is a third party vendor. The CFPB took the position that although consumers don’t directly work with this third party vendor doesn’t alter the service, and the company's classification doesn't change just because the complaint doesn’t explicitly state that its products are offered for those consumer purposes.

Specifically, the CFPB alleges that Intercept and its executives processed transactions for clients they knew, or should have known, were making fraudulent or other illegal transactions, even after being warned several times of the wrongdoing. The injury to consumers reached into the many millions lifted from consumers’ bank accounts.

Now the gambit: Intercept claimed that it met exceptions for the law, including one that would allow it to escape the suit because not all of its clients are covered by the CFPA.

The CFPB descanted critically:

“That reading would produce the absurd result that an entity could not be a service provider if it provided support services to even a single non-covered-person client - regardless of the entity’s conduct with respect to covered persons.” … “Intercept provides no justification for such an arbitrary result, and indeed there is none.”

As to attempts to remove the President and the CEO from the litigation, the CFPB said that they should be held accountable as individuals because they’re involved in the company’s day-to-day operations and not just “uninvolved company figureheads or passive shareholders.” These company officers had said that they worked with the banks on due diligence checks, so their work was not recklessness.

But, that position came under this withering fire from the CFPB:

“[That argument] contradicts the factual allegations in the complaint, which describe how numerous banks warned Smith and Dresser about apparent fraud and illegality and how the two men responded, not by acting on those concerns, but by seeking to minimize and work around them.” ... “Smith and Dresser cannot now hope to hide behind the very warnings they previously chose to ignore.”

The injury was substantive, claimed the CFPB. The Bureau said that it had proved substantial injury was caused as direct monetary losses, as described by category in the suit. Indeed, consumers couldn’t have avoided the harm because they didn’t even know about the unauthorized withdrawals in the first place.

So, first gambit: fail.

Second gambit: obfuscate, complicate, baffle and befuddle.

InterceptEFT launched a second line of counter-attack. As the CFPB stated in its suit, “…rather than confronting these allegations head-on, defendants claim not to understand them, asserting that the complaint is too vague or ambiguous for defendants even to present a defense on this element of unfairness.”

If adumbration is the tactic, better be prepared with a phalanx of facts! Unfortunately, Intercept had few facts to support their endeavor to becloud the issues. Although the Bureau did not name the clients, the complaint points to specific communications that Intercept had concerning access as well as its more common practices – such as allegedly ignoring specific warnings.

Second gambit: arrested development.

Third gambit: invoke statute of limitations.

Worth mentioning is that the motion to dismiss had also claimed the suit was barred under the statute of limitations. This really could not go anywhere, since the CFPB said the dates Intercept proffered regarding the government's discovery of the alleged violations were irrelevant because they were determined by when the Federal Trade Commission did a separate investigation, not the one conducted by the Bureau itself.

Third gambit: boomerang.

Now comes the last and fourth gambit, one that is like a last gasp of air in a hot air tunnel: challenge the constitutionality of the Consumer Financial Protection Bureau.

Intercept raised a motion challenging the constitutionality of the CFPB as an agency. The Bureau squelched that line of reasoning by stating every court that has considered the Bureau’s constitutionality has ruled in the government’s favor and that Intercept didn’t provide any new, substantial arguments that would justify a ruling otherwise.

Fourth gambit: crash and burn.

In sum, the Bureau pled that Intercept and its officers failed to meet the standard of proof needed to dismiss a case at this stage. The court will determine if the foregoing gambits will put this case down or keep it going forward on some subtle and abstruse vapors. 

But why prolong the agony?

---

[i] Consumer Financial Protection Bureau v. Intercept Corp. et al., case number 3:16-cv-00144, in the U.S. District Court for the District of North Dakota. 

Going Rogue

Jonathan Foxx

Managing Director
Lenders Compliance Group

There has been a lot of media attention recently about the political class endeavoring to trim the CFPB’s sails. It seems like many of these politicians have taken the view that the CFPB is an out-of-control agency which should be tamped down. A few of them seem to suffer from such flagitious aggravations that I fear they may die of apoplexy.

Like state banking departments, the CFPB views itself as a consumer advocacy agency. Given that proposition, it will always potentially bear the brunt of corporate concerns not only for the corporations themselves but also for what is best for consumers. This balancing of interests is the way that federal and state agencies work with the financial institutions they supervise.

There are some politicians who believe that there are too many restrictions on financial activities and the CFPB is the cause of a financial system weighed down by so many rules and regulations. But is the Bureau really the cause of too much rulemaking or a symptom of too few boundaries?  

It takes no courage for a politician to try to make a lot of noise about undoing the undoable. Dodd-Frank, the foundation on which the Consumer Financial Protection Bureau is codified, is simply not going anywhere. We can expect the Bureau and its Director to push and test the limits of the authorities vested in the CFPB. It is unrealistic to expect less!

The CFPB is a new federal agency and precedent may lead to fiat, unless corporate stakeholders litigate and push back on its plans. And that struggle is not only an opportunity to improve the supervision of institutions but also an obligation to ensure that the consumer is receiving financial protection.

There are claims and counterclaims, disputes and counter-disputes. The 19^th century philosopher Georg Hegel described history as a triad process consisting of thesis, antithesis, and synthesis. Applied to an interpretative method, the process sets forth an assertable proposition (thesis), which is necessarily opposed by its apparent contradiction (antithesis), and both thesis and antithesis are reconciled on a higher level of truth by a third proposition (synthesis). In context, the thesis is the rulemaking, the antithesis is the apparent contradiction and concerns, and the synthesis is a reconciliation of both projects.

Here’s the problem, though: the CFPB seems to be setting rules outside of the judicial and rulemaking process, thereby removing the force of the triad, the means by which precedent and rulemaking are built. It has adopted a pattern of promulgating rules by means of administrative action. Put otherwise, we are getting the thesis, by-passing the antithesis, and never getting to synthesis. This means that the so-called “grey area” expands into a treacherous badland where a chain reaction of results cannot be predicted. To put a finer point on this outcome, it makes companies into vagabonds, unwittingly going rogue in the midst of an already highly regulated legal and regulatory environment.

As Thomas Harman wrote in the 16^th century in his book on vagabonds and rogues – indeed, he was one of the first writers to use the word “rogue” -  there is a taxonomy of rogues in a vagabond society. He categorized these rascals as Abram Men, Autem Morts, Bawdy Baskets, Counterfeit Cranks, Demanders for Glimmer, Dells, Doxies, Dummerers, Fraters, Hookers or Anglers, Jarkmen or Patricos, Kinchin Coves, Kinchin Morts, Palliards, Priggers of Prancers, Rufflers, Swadders or Pedlars, Tinkers or Priggs, Upright Men, Walking Morts, Whipjacks or Freshwater Mariners, Wild Rogues, and, of course, just plain Rogues. Given the way that the Bureau leaves this terra incognita so unattended by judicial process, but seemingly made less unruly by administrative process, perhaps it views the interstitial inhabitants residing there as boonies in the boondocks, Swadders or Pedlars, as Harman states, who "not all be evil, but of an indifferent behaviour". Since Harman’s day, some well-known thinkers have noted that the vagabond barrens are “fruitful sources of fertile error.” To the financial institutions supervised by the Bureau, it surely seems to be the case!

So, next time politicians get all uppity and glowing in effervescent contemptuousness about restraining the Bureau from its overreaching tactics, maybe it would be a better use of their zeal to insist on a way to require the Bureau to implement its rulemaking along mostly already existing means. Maybe that will sufficiently excite these politicians to climb down from their inveterately pusillanimous posturing and actually do something for the boonies who are just trying to comply with the law.

Rescission: One for All

Jonathan Foxx

President & Managing Director

Lenders Compliance Group

Recently, we have had an increase in questions about the right of rescission; specifically, about whether the exercise of the right of rescission ("ROR”) by one consumer is effective to all consumers. 

Let's get clarity into this aspect of the ROR requirements. 

In any credit transaction where a security interest is or will be retained or acquired in a consumer’s principal dwelling, section 1026.23(a) [Regulation Z, Truth in Lending Act] provides that each consumer whose ownership interest is or will be subject to the security interest has the right to rescind the transaction. 

The right of rescission also applies to the addition of a security interest in a consumer’s principal dwelling that is added to an existing loan, although rescission only applies to the security interest itself, not the loan.

Note that the right of rescission applies to any consumer with an ownership interest in the property. Therefore, if a consumer signs the note but has no ownership in the property securing the loan, that consumer has no right of rescission. Conversely, if a consumer offers the principal dwelling as security for a loan but is not obligated on the note, that consumer still has the right of rescission.

To exercise the right to rescind, the consumer must notify the creditor of the rescission by mail, telegram, or other means of written communication. Notice is considered given when mailed, or when filed for telegraphic transmission, or, if sent by other means, when delivered to the creditor’s designated place of business.

The consumer can exercise the right to rescind until midnight of the third business day following the occurrence the last of the following events:

• The date of consummation of the transaction;
• Delivery of the rescission notice required by section 1026.23(b); and
• Delivery of all material disclosures.

For this purpose, the term “material disclosures” means the required disclosures of:

• The annual percentage rate;
• The finance charge;
• The amount financed;
• The total payments;
• The payment schedule;
• The HOEPA disclosures and limitations referred to in sections 1026.32(c) and (d); and
• The “higher-priced mortgage loan” disclosures and limitations in section 1026.35(g).

If the required notice and material disclosures are not delivered, the right to rescind does not expire until three years after the date of the transaction, or upon transfer of all of the consumer’s interest in the property, or upon sale of the property, whichever occurs first.

When more than one consumer has the right to rescind, the exercise of the right by one consumer is effective to all consumers. 

Therefore, the exercise of the right to rescind by one applies to all.

Too Big to Fail: End Run around a Bank Run

A startling feature of Dodd-Frank is the impression it gives that “Too Big to Fail” - otherwise known as “TBTF” - has been legislatively fixed. The impression is quite misleading. Sort of like the impression that some bank executives are Too Big to Jail! They aren’t; but nobody’s in jail, last time I looked.

Dodd-Frank is a beast that chomps submissively at the rancid remains of a decomposing TBTF bank.  

What is TBTF anyway, but a hypothetical, counterfactual, arbitrary assemblage of somewhat dubious allegations based on the effect of a bank’s failure perpetrated on the entire financial system?

The public screams, “save us from another repeat of the recent financial crisis;” politicians twist and twitch fretfully over a re-occurrence, though they have no idea really how to figure out how big is “Big;” lobbyists for the banks write the legislation that primes the TBTF bizarre spectacle of wondering what metrics to use to quantify systemically explosive financial entities; and Congressman Barney Frank, whose eponymous legislation seems to offer some solace, leaves Congress and rationalizes his decision to join the Board of Signature Bank – appearances be damned!

Maybe there is a tentative solution if we wind up in the midst of a long term financial crisis. Perhaps a proposal, suggested on Tuesday by the FDIC and the OCC, might be worth considering. The proposal would require the biggest banks to retain sufficient assets to be convertible into cash if there is a financial crisis. The tool is known as the “net stable funding ratio.” This ratio requires banks to balance the use of short-term funding sources – the type of sources that come under intense pressure in a financial crisis, such disruption typified by a run on a bank – with more stable funding sources, for instance, deposits and regulatory capital tools, such as equity.

The proposal forces a bank with more than $250 billion in assets and $10 billion in foreign exposures to maintain enough easily convertible capital to allow it to cover any liquidity needs for up to a year. The FRB is also working on a liquidity proposal for banks with between $50 billion and $250 billion in total assets.

The net stable funding ratio, which is often referred to as the NSF, is really a creature of the 2008 financial crisis. As bank failures or near failures abounded, regulators felt that even the then-currently maintained capital levels could be in danger if there were too much reliance on the repo market and other wholesale funding sources. The big fear was that banks would not maintain enough liquid assets to withstand a run on the riskier entries on their balance sheets.

Functionally, the NSF works this way: it requires banks to measure their capital levels along with consumer and small business deposits – traditionally considered stable funding sources - against less stable funding mechanisms. Other assets, such as gold and loans, carry different risk weights in the way they count toward the ratio, based on a Basel Committee release in 2014 involving banking supervision.

So, banks are expected to carry a 100% funding ratio, which means they should be able to handle a short term run by either (A) paying out cash, or (B) quickly converting assets into cash. Hence, the FDIC, FRB, and OCC are devising their own adaptation of the Basel findings. Their NSF endeavors to be consistent with the Basel’s NSF.

Wonk ON!

Now to get a bit wonkish. The proposal would rate a balance sheet’s asset stability on such categories as the type of funding, including regulatory capital, long-term debt and deposits, its maturity horizon and the counterparty to the asset. Insured deposits would be given the highest stability “rating” while short term wholesale funding would be considered significantly less stable.

Skating into the Mortgage Meltdown

The mortgage meltdown goes on and on. Like a nuclear explosion that propagates in a gigantic, lethal plume and roils laterally in wave after wave across a huge landscape, leaving death and destruction in the wake, the financial crisis has yet to find its termination point in the mortgage origination world. Litigation is rife with claims and counterclaims. Billions of dollars in judgments, let alone the high cost of attorneys’ fees, continue to blemish banks and Wall Street securitizers. Main Street has yet to recover, although some pockets of residential real estate seem to be stabilizing somewhat. And, of course, almost nobody has gone to jail!

So, the court of public opinion and the court of jurisprudence is where any resolution must find its grounding. Case in point is trustee U.S. Bank’s claim that a UBS unit knowingly sold thousands of bad home loans into securitized trusts, costing investors $2 billion. We get this conundrum courtesy of the rather unprecedented trial that commenced yesterday in New York, at the U.S. District Court. UBS has so much blood on its hands at this point that no bleach is strong enough! At the conclusion of this trial, UBS may wind up paying more than it has paid out altogether since the crisis hit. The bone of contention: mortgage bundling.

Here’s the allegation made by U.S. Bank: it has "overwhelming, irrefutable and largely undisputed" evidence, including emails suggesting UBS Real Estate Securities Inc. knew it was bundling bad loans from “shady originators” in 2006 and 2007.

Those “shady originators” would be the once-upon-a-time premier, illustrious, esteemed originators known as American Home Mortgage Servicing Inc., Countrywide and IndyMac Bank. Did I mention that all three of them failed?

Further, U.S. Bank asserted that “UBS knew of the defects and decided to ignore them or – in some cases – turn[ed] a blind eye to them.” Recognizing that usually motivation precedes the crime, it is alleged that UBS was motivated by a fear that the originators (sic) would give their loans to other banks to bundle, so it declined to hold those originators to high standards even though it “didn't trust them.”

As U.S. Bank says, “UBS constantly disparaged these originators.” Oh for shame!

Emails are given as evidence of UBS’s naughty attitude. For instance, a UBS trader emailed that "HUGE delinquencies" in the securitized trusts, but joked that this was a "big surprise!" [Emphasis in original.]

Or how about a more poignant expression of substance, such as where another UBS trader received an email from a bank colleague that said the originators "run their deals like a sh-- show."

One thing to denigrate the originators, but how about some due diligence here, please? It would seem that UBS allegedly did not investigate ridiculously absurd income claims. A particularly fine specimen of this debt-to-income fiasco is where a “pro skater” claimed to make $12,000 per month but who actually earned $15,000 a year – plus already had two unreported mortgages. Ouch!

Of course, one fraudulent loan does not a litigation make of this magnitude. How about 3,500? Yes, that is the alleged number of possible borrower fraud involving “stated income loans.”

UBS’s defense leaves me breathless: the evidence at trial will show that most of the loans were not materially deficient at the time of their origination. Say what?

I’ll let the judge’s question take the stage: “How did anybody ever think that was a good idea?”

But, says UBS’s defenders at bar, “hindsight is not the standard.” This gambit implies that loans later shown to be defective don't impute liability to UBS. But, if that tactic doesn’t work, how about asserting that those naughty internal UBS communications cited by the plaintiff were “a distraction” and were “taken completely out of context.” 

And, if that tactic doesn’t work, UBS wants to use the old Tu Quoque (you did it too) defense – like when a child fights with his brother and is punished by a parent, and the child says, ‘but he did it, too’! So, in its defense UBS states that it wasn't the only “sophisticated party” (sic) in the transaction and asserted that the trustee, too, knew well of the inherent risks of “stated income” and other loans. Right! That gambit will work – perhaps in a parallel universe.

The court will likely focus on exactly in what instances UBS might bear liability, among other things, for failing to vet obviously false homebuyer income representations – such as the one offered by the “pro skater.”

This is a bench trial and will probably last a few weeks. But it is the first time a trustee has taken such claims to trial.

Jonathan Foxx

President & Managing Director

Lenders Compliance Group

Going after the Big Cheese (PHH takes on CFPB’s Director)

As many of you know, I have been following the PHH dispute with the CFPB virtually from its inception. Although PHH is a large organization, let’s face it, this is still like a mouse (PHH) squeaking at an elephant (CFPB)! The bite, in this instance, happens to be a $109 million penalty that the CFPB is assessing against PHH.

Reduced to the least common denominator, this is a fight against the authority vested in the Director of the CFPB, or, better said, the authority that the Director presumes to have vested in himself versus a play at arrogating to himself certain authority that he simply does not have.

Going after the Big Cheese himself is no mean feat!

But PHH has assembled a highly skilled and prominent legal team.

And there are amici curiae on both sides.

Let me back up a few steps and give a wider angle. PHH appealed to the DC Circuit Court because the Bureau’s Director Richard Cordray raised a $6 million penalty for mortgage insurance kickbacks - such penalty issued by an administrative law judge - to a whopping $109 million.

To ensure that the information presented at bar was applicable to Dodd-Frank, the hearing judges required the Bureau to provide answers in oral arguments regarding substantive provisions as to the president’s authority to remove the CFPB director only for cause, and, importantly, about how the Court should view an administrative agency led by a single director rather than the more typical commission structure.

Today is the day for those oral arguments!

Here’s one bottom line that may come from the foregoing aspects of the dispute: if the Bureau loses, the Director may find that his authority, presumed or otherwise, will be vitiated.

An access point to the litigation is to challenge the constitutionality of the Bureau itself! Areas of contention, right from the inception, have been the supposed, czarist-like construct of having a single director in charge of the Bureau, plus the view that the CFPB’s funding should come from congressional appropriations rather than from the Federal Reserve’s own budget.

Is it surprising that the DC Circuit recently required the Bureau to be prepared to face questions about whether Dodd-Frank’s provision - stating that the president can remove the CFPB director only for “inefficiency, neglect of duty, or malfeasance in office” - passed constitutional muster? Actually, I don’t think so. After all, the Bureau has been challenged on these issues all along and there is clearly an interest in determining the scope of authorities vested in the Director. If adjudication seems to reach to an unassailable decision, the viability of claims involving the CFPB’s constitutionality may be finally resolved. Or maybe not! The Supreme Court would be the next step along this circuitous path to a decision.

Should we be surprised that the Court is looking for answers about potential remedies for any problems that the applicable provision brings, including potentially removing it from the statute and allowing the president to remove the CFPB director without any specific cause?

Again, I am not surprised. If it turns out that the cures (remedies) are worse than the infection (overreaching authority) and the treatment needs to be changed, the Court will need to determine the extent to which such changes could affect the Director’s authority.

So, even though PHH is challenging Director Cordray’s interpretation of violations under RESPA that allowed him to distend a $6 million penalty handed down by an administrative law judge into an engorged, ballooned penalty of $109 million that the CFPB director handed down when PHH appealed, the fact is the instant arguments are really going quite far beyond that issue.

Here’s a pivot point: whether the Constitution allows Congress to put in restrictions on when the president can fire officials at an administrative agency. Short answer: Yes, it is constitutional if you go by the Supreme Court’s decision in 2010 in Free Enterprise Fund v. Public Company Accounting Oversight Board, which affirmed the DC Court’s ruling that such protections were constitutional.

But here’s some drama: Judge Brett M. Kavanaugh, the Circuit judge that leads the impaneled court, happened to cast a dissenting vote in that case. His view was that a president should not have to notify Congress as to why the director of an administrative agency is removed.

Thus, removing that provision from the statute could very well limit the Bureau’s independence – and, mutatis mutandis, limit as well that distinct authority of other administrative agencies for which the statute requires a reason for the dismissal of officials. Put bluntly, the Bureau currently acts independently and does not have to discuss with the White House its decisions regarding enforcement actions. That could change, depending on the Court’s decision.

There are a few moving parts, too. For instance, another case that will be considered is the 1935 Supreme Court’s decision in Humphrey’s Executor v. United States, which allowed for restrictions on the removal of Federal Trade Commission commissioners. It will be considered because, among other things, the Bureau itself relied on that case in its filings with the DC Circuit. The CFPB’s lawyers will likely be showered with plenty of questions from the bench about the Humphrey case.

As I have said numerous times in these brief epistles on the CFPB's enforcement tactics, regulating by enforcement deprives judicial review. It may be expedient, from the Bureau’s standpoint, but it leaves us with no judicial precedent.

The role of the Court as finder of fact, thereby vetting the issues, and weighing the claims pursuant to the appropriate statutory framework, should be a viable option to an enforcement by settlement that provides a one-sided interpretation.

Jonathan Foxx
President & Managing Director
Lenders Compliance Group

Marketplace Lenders: The CFPB’s Surveillance Begins

Marketplace lenders have been quite a bit in the news these days. Just about every aspect of this business model is being looked at by investors and regulators – particularly the regulators and most particularly the CFPB!

Just yesterday, the Bureau announced that it would start tracking complaints relating to online marketplace lending. From this we can infer – given the CFPB’s past method of rulemaking by enforcement – that these complaints will lead to heightened scrutiny, which will lead to non-judicial proceedings, which will lead to enforcement by settlement.

The Bureau will be adding these complaints to its complaint database, and especially that part of the database that involves “financial technology,” the term applied to the systemic technological process whereby individuals and even small businesses obtain access to loans funded by investors. This initiative was not just a tactic spawned out of its own regulatory mandate, since it was established after the Treasury sent out a request for information about the industry’s operation last summer.

Director Richard Cordray has stated that the Bureau wants to ensure that consumers know exactly what to expect when they are seeking a loan. The CFPB’s modus operandi reminds me of the policing equivalent of “taking names and numbers,” for, to quote Director Cordray, by collecting complaints, the CFPB will have a “better idea of how the marketplace lending industry works.” Having collected the complaints in Stage 1, probably Stage 2 will start the examination and non-judicial proceedings, thereafter to Stage 3, where settlements will flourish without adjudication of the claims in a court.

States Cordray:

“When consumers shop for a loan online, we want them to be informed and to understand what they are signing up for…All lenders, from online startups to large banks, must follow consumer financial protection laws.”

I dare say that most of us would agree with such a platitude!

The Bureau has also issued a consumer bulletin on marketplace lenders, highlighting issues that consumers should consider before they take out a loan using this type of loan origination platform.

How did marketplace lending get started? Online marketplace lenders – otherwise known as “peer to peer lenders” – actually began to grow as a result of the 2008 financial crisis. The goal of the marketplace lender was to offer credit financing to consumers and small businesses that were being shut out of the traditional banking system. These lenders saw their loan volumes surge after 2008, due to the fact that many banks strongly tightened their underwriting standards, resulting in more and more potential borrowers being denied credit. In effect, both consumers and small businesses, having been pushed aside with few financial resources, found marketplace lenders a viable option.

These are not large loans. Typically, they are small, with small businesses applying for loan amounts under $100,000 and consumers applying for even smaller loan amounts. So this business model is a volume-based proposition. Unit volume is the key metric, and volume is very high. So high, it seems, that the Treasury claims this segment of the lending industry originated about $12 billion in loans in 2014.

Upstream of the marketplace lender are the investors that purchase a cache of the loan units. The investors are mostly institutional; for example, pension funds, hedge funds, and so forth. Like many past instances of loan product securitization, this is Wall Street all the way! Companies that have made it to the top tier are such as Prosper Marketplace and Lending Club.

Lenders that sell their loans to investors are subject to all state and federal consumer financial protection laws as well as, where applicable, regulation by the Securities and Exchange Commission; and, to the extent that an investor has an alliance with a bank, that bank is also subject to the rules set forth by its prudential regulator.

But, oddly, there simply is no specific federal regulation at this time for online marketplace lenders – which leads us back to the Treasury’s interest and, mutatis mutandis, the CFPB’s escalation of monitoring and probable enforcement by settlement.

Since the Bureau has said that it expects to release a “larger participant” rule for consumer installment and vehicle title loans, such a rule giving the CFPB the authority to examine and directly supervise the largest firms in an industry, it is quite likely that this new rule will either directly state its application to marketplace lenders or be interpreted to include them. 

Clearly, marketplace lenders have been responding to the financing needs of consumers and small businesses. It is equally obvious that consumers and small businesses want the financing being offered. Therefore, it will be important to determine whether any new regulations will constrain the fulfillment of those needs.

Jonathan Foxx

President & Managing Director

Lenders Compliance Group