How the SEC Could Have Regulated Subprime Mortgages

From a new paper (link below):

Kafka would have loved this story: According to our current understanding of U.S. law there is far better consumer protection for people who play the stock market than for people who are duped into buying a house with an exotically structured subprime mortgage, even when the mortgage instrument is immediately packaged and sold as part of a security.

The crux of the matter is that securities transactions – notably, the sale of a security to a customer by a broker – are governed by SEC regulations, which impose a fiduciary relationship on the broker, meaning, among other things, that the broker can only sell financial products that are suitable for that customer. However, no such rule governs the relationship of a homebuyer to a mortgage broker or company, meaning that behavior by the latter must be actually fraudulent before it can be sanctioned.

Jonathan Macey, Maureen O’Hara, and Gabe Rosenberg (two of whom are at my very own Yale Law School) have a new paper (abstract and download available) arguing not only that mortgage brokers should have a fiduciary responsibility to their customers, but that they already do under two reasonable interpretations of existing SEC regulations. (It has to do with whether a complex subprime mortgage is already a security or, failing that, whether it is related to a security transaction.) This means that the SEC could have been regulating these things all along.

3 thoughts on “How the SEC Could Have Regulated Subprime Mortgages

  1. Of course they have a fiduciary responsibility. i worked at a ‘residential finance’ shop in Irvine, CA. i had just started working there and observed the ‘credit evaluation’ of prospective borrowers. to say it was a pathetic evaluation would be to make a gross understatement.

    right about the time i left, there was a class action lawsuit against the firm. no one listened to any complaints from us or anyone else. society just let it go on. never in my wildest dreams would i have imagined that this would’ve brought about a global epidemic. but, i guess this had been 25 years in the making.

    it’s no coincidence that the process went on until failure. people were milking it for as much as they could get with total disregard for the repercussions: they just wanted theirs.

  2. I’ve got a host of problems with the argument that consumer home mortgage origination could have/should have been — or going forward should be — brought under SEC jurisdiction. It’s an entertaining notion if you don’t think about it for more than a few seconds, but I hope it doesn’t attract any attention. The argument simply diverts energy from any attempts to understand where our current regulatory structure failed or how we should improve it.

    First, securities protection for the mortgage borrower simply doesn’t fit with the spirit of the regulatory philosophy on which US securities regulation is based. To the extent a mortgage is a financial instrument that might be treated as a security, it’s the borrower (that is in the case of a home mortgage, the consumer) who is the “issuer” of the “note”, and therefore it’s the borrower on whom the obligations of full and fair disclosure are placed. The originating financial institution sets the terms, exotic or plain vanilla, in order for it to be willing to lend, that is to purchase the “note” — accordingly it is to the lender that the borrower’s duties are owed. Obviously, the lender has to comply with the terms of the contract it agrees to — that is, the “note” it “purchased” — and can’t commit fraud in the process of enducing the borrower to agree to the mortgage, but securities regulation doesn’t produce any additional duties of the buyer/lender to the issuer/borrower. The mortgage broker brings together the borrower (issuer) and lender (purchaser) and facilitates the exchange of information between the borrower and lender but isn’t engaged in selling a financial instrument to the borrower. The broker’s duties extend principally to the purchaser of the security, that is, to the lender.

    All of our securities laws protections are geared around protecting buyers from unscrupulous (or grossly negligent) issuers and intermediaries, not protecting issuers from unscrupulous buyers. Treating the borrower as the “purchaser” of a short position in a 30-year cash flow stream or annuity, and then angling for some sort of “derivative” analysis is a horribly strained attempt to reverse the logic at the core of our securities regulation. And it invades the more orderly and less problematic traditional mortgage financing business by banks and thrifts. What under this novel theory distinguishes sub-primes from traditional mortgages, even when the later are sliced and diced for securitization purposes, as done for decades safely and successfully under Fannie and Freddie aegis?

    I agree that the SEC could have used its traditional regulatory powers more effectively in several ways to have reduced the extent of the sub-prime crisis, but not in the ways the authors propose. The SEC could have been more aggressive in challenging the risk analysis disclosure in the sale of securitized financial products, which might have reduced the securitization market for the more questionable of sub-prime lending, which in turn would have slowed the flow of funds to sub-prime origination in later years of the housing bubble. Especially after the Asian Debt Crisis, the SEC could have been far more aggressive vis a vis the role of the rating agencies in handing out AAAs like candy. Either of those approaches would have been consistent with its traditional mandate for encouraging the safety and soundness of the securities markets through (1) disclosure of risks, with a modest consumer protection against the sale of unsuitable product to unsophisticated investors of modest means, (2) prosecution of fraud, and (3) ensuring the financial soundness of financial institutions that are market participants.

    But supervising the consumer side of the mortgage industry would have been entirely inconsistent with the objectives and foundational principles of the SEC’s regulatory mandate. If that mandate should have been extended to the consumer side of financial products like mortgages that are not issued or traded in securities markets, then should the SEC have seen its mandate as including the supervision of the entire consumer side of the mortgage industry since 1933? Or if not since 1933, since what date? Did the first securitization by Fannie suddenly invert the borrower/issuer vs lender/buyer relationship on which securities regulation was assumed to be based?

    That’s not to say that borrowers (consumers) shouldn’t have a host of protections against mortgage brokers and lenders which make fiduciary duties to customers more explicit and enforceable. Nor would I argue against importing from securities regulation its regime of customer suitability requirements — both traditional “product” standards and the “transactional forms” test that the authors propose.

    But that’s a pretty simple insight that doesn’t require far fetched speculation about whether we should turn securities regulation inside out and upside down by treating a borrower as a “purchaser” of a “security”. Instead, let’s simply assign responsibility for consumer protection — including incorporating the notion of suitability duties of financial intermediaries — to those agencies which are already in the business of dealing with consumer lending and bring unregulated business practices within the mandate of the banking authorities.

    Regulatory regimes involve not only liability standards that can be established in litigation under the letter of the law. They require regulatory institutions which know the markets and institutions they regulate — which can readily identify market participants who are subject to their rules and which have knowledgeable supervisory personnel and widely known, consistently applied practices. The SEC had no such regulatory advantages with respect to consumer mortgage lending. I think that even if a legalistic case could have been made to support SEC jurisdiction over sub-prime mortgage origination, such a move would have been an extreme abuse of regulatory authority which would have been defeated in the courts and/or Congress.

  3. I’ve read many articles about the this crisis, listened to reports on NPR, viewed the classes on this website, etc. and what strikes me as odd is the lack of prosecution and civil law suits for those involved. For those at the top that made huge profits from: making these mortgages to unqualified borrowers, bundling the bad mortgages into CDO’s, rating the CDO’s AAA, creating credit default swaps on the resulting toxic products, etc. there needs to be a day of reckoning with our legal system. The profits from this conspiracy of silence must be reclaimed / disgorged. It is beyond belief that the heads of these organizations did not realize the towering house of cards they were creating with these toxic products.

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