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Subprime Standardization - How Rating Agencies Allow Predatory Lending Flourish in The Secondary Mortgage

Subprime Standardization - How Rating Agencies Allow Predatory Lending Flourish in The Secondary Mortgage

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SUBPRIME STANDARDIZATION: HOW RATING AGENCIES ALLOW PREDATORY LENDING TOFLOURISH IN THE SECONDARY MORTGAGEMARKET
D
 AVID
R
EISS
*
I. I
NTRODUCTION
.................................................................................................. 986II. T
HE
P
ROBLEM OF
P
REDATORY 
L
ENDING
........................................................... 992
 A. The Explosive Growth of the Subprime Mortgage Market
......................... 992
 B. Predatory Lending in the Subprime Market
.............................................. 997III. T
HE
R
OLE OF
S
ECURITIZATION IN THE
P
REDATORY 
L
ENDING
C
RISIS
................ 1001
 A. Securitization Explained
............................................................................ 1001
 B. Government-Sponsored Enterprises (GSEs) Create the SecondaryMarket
........................................................................................................ 1005
C. The Ongoing Role of GSEs in the Secondary Market
................................ 1009IV. T
HE
R
OLE OF
R
 ATING
 A
GENCIES IN THE
S
ECURITIZATION OF
M
ORTGAGE
-B
 ACKED
S
ECURITIES
......................................................................................... 1012
 A. How Rating Agencies Rate
......................................................................... 1013
 B. The Dominant Rating Agencies Enjoy Privileged Regulatory Status asNationally Recognized Statistical Rating Organizations
.......................... 1016
C. Ratings by the Privileged Raters Are Biased Against the Public Interest
..... 1022 V. P
RIVILEGED
R
 ATERS
G
UT
S
TRONG
S
TATE
P
REDATORY 
L
ENDING
L
EGISLATION
... 1023
 A. The Home Ownership Equity Protection Act Provides Limited Protection
... 1025
 B. North Carolina Enacts a Predatory Lending Law That BuildsIncrementally on Federal Law
................................................................... 1028
C. The Privileged Raters Initially Underestimate the Impact of State Predatory Lending Legislation
.................................................................. 1029
 D. The Georgia Experience: Pushing Forward, Pulled Back
.......................... 1032
1. The Georgia Fair Lending Act Provides for Assignee Liability andUnquantifiable Damages
..................................................................... 1032
2. The Privileged Raters Exclude Georgia Loans from Their RatedTransactions Because of Concerns That Investors Will Be Liable forUncapped Damages
............................................................................. 1033
3. As Its Mortgage Market Dries Up, Georgia Acquiesces to the Demands of the Privileged Raters
....................................................... 1037
4. The Privileged Raters Allow Georgia Loans to Be Securitized Underan Amended Georgia Law
................................................................... 1037
E. The Privileged Raters Take a Stance Against Strong Predatory Lending Legislation
.................................................................................................. 1040
F. The New Jersey Experience: Testing the Privileged Raters’ Resolve
.......... 1043
1. The Original New Jersey Law
............................................................. 1043
2. The Privileged Raters Quickly Respond
.............................................. 1045
3. Standard & Poor’s Backs Down
.......................................................... 1048
4. Standard & Poor’s Reverses Course and Imposes New Restrictions,Forcing New Jersey to Amend Its Law
................................................ 1051 VI. T
HREE
F
ORCES
M
 AY 
S
TANDARDIZE THE
O
PERATIONS OF THE
S
UBPRIME
M
 ARKET
............................................................................................................ 1053
 A. Federal Preemption Is Premature
.............................................................. 1053
1. Regulatory Preemption
........................................................................ 1053
2. Possible Congressional Preemption
..................................................... 1055
 B. GSEs Will Have an Incremental Impact
.................................................... 1055
C. Privileged Raters Are Standardizing the Subprime Market at theExpense of the Public Interest
.................................................................... 1056
 
986
FLORIDA STATE UNIVERSITY LAW REVIEW 
[Vol. 33:985
 VII. M
 AKING THE
P
RIVILEGED
R
 ATERS
T
 AKE
R
ESPONSIBILITY FOR
T
HEIR
I
MPACTON THE
P
UBLIC
I
NTEREST
................................................................................. 1059
 A. Wait and See
.............................................................................................. 1059
 B. Deregulation
............................................................................................... 1061
C. Increased Regulation
.................................................................................. 1063 VIII. C
ONCLUSION
..................................................................................................... 1064
I. I
NTRODUCTION
 Predatory lending is today’s most pressing consumer protectionissue, costing American families over an estimated $9 billion a year.
1
 Predatory lending is particularly rampant in the subprime home eq-uity loan market—inhabited largely by unsophisticated borrowers— where lenders have made billions upon billions of dollars of loanswith abusive terms.
2
After years of legislative and regulatory neglect,state governments have, in recent years, produced a variety of re-forms and regulations on the terms and methods of lending in thesubprime market, in an attempt to ameliorate the worst aspects of predatory lending.Specifically, in the last few years, many states have enacted lawsto limit abusive home lending practices within their own jurisdic-tions.
3
Large segments of the lending industry opposed these laws,claiming that the resulting regulatory patchwork increases theircompliance costs, exposes even the most law-abiding lender to liabil-ity, and thereby ultimately increases loan costs for consumers.
4
 In large part as a result of these complaints, momentum is build-ing on three fronts to standardize the operations of the subprimemortgage market. First, federal banking regulators in the Office of 
* Assistant Professor, Brooklyn Law School; B.A., Williams College; J.D., New YorkUniversity School of Law. This Article was granted an award as the best academic articleon a topic addressing consumer financial services law in 2006 by the American Academy of Consumer Financial Services Lawyers. The author would like to thank the following peo-ple for helpful comments on earlier drafts: Baher Azmy, Larry Barnett, Susan Block-Lieb,Dana Brakman-Reiser, Michael Cahill, Neil Cohen, Nestor Davidson, Steven Dean, JennyDiamond Cheng, James Fanto, Linda Fisher, Claire Hill, Edward Janger, Heidi Kitrosser,Claire Kelly, Rufina Lee, Ronald Mann, Lisa Nicholson, Arthur Pinto, Larry Solan, KenZimmerman, and workshop participants at Brooklyn Law School and the AALS 2005Clinical Conference. The author also acknowledges the support of the Brooklyn Law SchoolSummer Research Stipend Program. Thanks also to Lawrence Hansen and MichaelFreedman for excellent research assistance and to the Brooklyn Law School librarians fortirelessly tracking down numerous hard-to-find items.1. E
RIC
S
TEIN
,
 
C
OAL
.
FOR
R
ESPONSIBLE
L
ENDING
,
 
Q
UANTIFYING THE
E
CONOMIC
C
OSTOF
P
REDATORY 
L
ENDING
3 (2001), http://www.responsiblelending.org/pdfs/Quant10-01.pdf (estimating the annual economic cost of predatory lending to be $9.1 billion); Christopher A. Richardson, Predatory Lending and Housing Disinvestment, Presentation at SyracuseUniversity, Center for Policy Research 19 (May 17-18, 2003) (transcript available athttp://ssrn.com/abstract=338660) (estimating annual cost of predatory lending to be $9.53billion).2.
See
 
infra
Part II.B.3.
See
 
infra
Part V.4.
See
 
id.
 
 
2006]
SUBPRIME STANDARDIZATION 
987
the Comptroller of Currency (OCC) and the Office of Thrift Supervi-sion (OTS) have already preempted the application of state predatorylending laws to a broad array of lending institutions.
5
Following theregulators’ lead, Congress is also considering legislation to preemptmore broadly their application to the remaining financial institutionsstill subject to state laws.
6
 Second, two government-sponsored enterprises (GSEs),
7
 —FannieMae and Freddie Mac, the two largest purchasers of residentialmortgages on the secondary mortgage market (“secondary market”)
8
  —indicated that they would not purchase loans from loan originatorsthat contain certain terms they deem abusive, such as harsh pre-payment penalties, as well as those loans that are most heavily regu-lated by predatory lending laws.
9
 Finally, Standard & Poor’s, Moody’s Investors Services and FitchRatings, the three major bond and securities rating agencies (collec-tively, the “privileged raters”), indicated that they will not rate securi-ties
10
backed by pools of residential mortgages if any of those mort-gages violate their rating guidelines relating to acceptable liability riskstemming from state predatory lending laws.
11
Rating agencies are in
5. Baher Azmy,
Squaring the Predatory Lending Circle: A Case for States as Labora-tories of Experimentation
, 57 F
LA
.
 
L.
 
R
EV
. 295, 358-60 (2005).6.
See
 
infra
Part VI.A.7. The term “GSE” refers to “a federally chartered, privately owned, privately man-aged financial institution that has only specialized lending and guarantee powers and thatbond-market investors perceive as implicitly backed by the federal government.” RichardScott Carnell,
Handling the Failure of a Government-Sponsored Enterprise
, 80 W
 ASH
.
 
L.
 
R
EV
. 565, 570 (2005). Some use the term “Government-Sponsored
Entity
” instead of “
enter- prise
.”
See, e.g.
, note 504
infra
. There is no material distinction between these two terms.
 
Iuse the term “GSEs” as shorthand for Fannie Mae and Freddie Mac, unless otherwisenoted, notwithstanding the fact that other entities, such as the Federal Home Loan BankSystem, are also GSEs. Carnell,
supra
, at 573.8. The market for mortgage-backed securities is known as the “secondary mortgagemarket,” or “secondary market” for short. Amy Crews Cutts et al
.
, Adverse Selection, Licens-ing and the Role of Securitization in Financial Market Evolution, Structure and Pricing 2 n.1(July 2001) (unpublished manuscript),
available at
http://ssrn.com/abstract=280388. The sec-ondary mortgage market is easiest to visualize as “a network of lenders who sell and inves-tors who buy existing mortgages or mortgage-backed securities. This infusion of capital frominvestors provides mortgage lenders such as banks, thrifts, mortgage bankers and other loanoriginators with a market for their interests.” K 
ENNETH
G.
 
L
ORE
&
 
C
 AMERON
L.
 
C
OWAN
,
 
M
ORTGAGE
-B
 ACKED
S
ECURITIES
§ 1.1 (2005).9.
See
 
infra
Part VI.B.10. There is no single legal definition of a “security.” For the purposes of this Article,“security” shall mean “any instrument,” such as a mortgage note, “that might be sold as aninvestment.”
 
Reves v. Ernst & Young, 494 U.S. 56, 61 (1990) (defining “security” for pur-poses of the Securities Acts).11.
See
 
infra
Part VI.C.

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