The pre-emption debate.

A growing battle is under way over who has authority to regulate national banks and thrifts on the issue of predatory lending. Federal regulators for national banks and thrifts say their rules pre-empt state and local laws on predatory lending for their member institutions. State banking regulators are up in arms about it, while others say a uniform national law is the only solution.

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CHICAGO MIGHT HAVE BEEN FRANK SINATRA'S KIND OF TOWN, BUT IT'S debatable whether the mortgage industry feels that way. Companies that make subprime home loans in the Chicagoland market must contend with predatory lending ordinances from three government entities: the state of Illinois, the city of Chicago and Cook County. And of course there are myriad federal laws--a total of 22 by Robert Couch's count--that also apply to the origination and closing of mortgages. * "We're seeing this patchwork of [predatory lending] laws that make it very difficult to do business in multiple states," says Couch, president and chief executive officer at Birmingham, Alabama-based New South Federal Savings Bank and chairman of the Mortgage Bankers Association (MBA). "It has become a quagmire." * That is, unless the lender happens to be a nationally chartered commercial bank, in which case it can ignore those state laws and local ordinances--at least according to the Office of the Comptroller of the Currency (OCC). This federal agency is part of the U.S. Department of the Treasury, and supervises some 2,200 nationally chartered banks that account for 55 percent of the country's banking assets. * In January, the OCC issued a set of rules reaffirming its position as the sole supervision and enforcement authority over national banks--which means these institutions don't have to comply with predatory lending laws that have been popping up around the country. Another federal agency with a somewhat lower profile, the Office of Thrift Supervision (OTS), claims the same pre-emption authority over 928 federally chartered thrifts--so they wouldn't have to comply either with the rash of local laws. Instead, both agencies have issued their own rules against predatory lending.

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As one might expect, this does not sit well with angry state officials like Thomas Conway, chief of the consumer fraud bureau at the New York attorney general's office. Conway charges that the OCC has overstepped its authority in claiming such broad authority over national banks, and in so doing has made it more difficult for New York to protect its own consumers.

When the OCC released its new rules on national bank preemption, Conway's office happened to be following up on a complaint against Irving, Texas-based First Horizon Home Loan Corporation, a subsidiary of First Horizon National Corporation, a bank holding company headquartered in Memphis, Tennessee. First Horizon also owns First Tennessee Bank, a Memphis, Tennessee-based national bank subsidiary that is overseen by the OCC.

"On the day the regulation came out, we got a voicemail from [a lawyer at First Horizon] saying, 'We don't have to talk to you,'" Conway says.

To be sure, the National Bank Act does give the OCC pre-emption authority over many state laws. By asserting its regulatory prerogatives, the OCC has given national banks a distinct compliance advantage over a host of nonbank mortgage originators that still must contend with an increasing number of state, municipal and county predatory lending laws. And this has led to calls from a broad spectrum of interested parties for Congress to establish a uniform national predatory lending law that would apply equally to all types of mortgage originators.

In the midst of all this controversy, Washington lawmakers have stepped in. On April 28, a House Democrat joined by 29 co-sponsors introduced two resolutions (H.R. 4236 and H.R. 4237) to nullify the OCC's pre-emption regulations. On May 7, Sen. John Edwards (D-North Carolina) introduced similar resolutions (S.J. Res. 31 and S.J. Res. 32).

An industry coalition that includes MBA, the American Bankers Association (ABA), the Consumer Mortgage Coalition and others has urged Congress to reject those resolutions. Taking out a full-page ad in Roll Call and the Hill newspapers, the coalition calls the resolutions the "wrong solution."

To date, at least 31 states have passed some type of predatory lending law, according to Lotstein Buckman LLP, Washington, D.C., or, as in the case of Illinois and Massachusetts, have issued regulations through their state banking agencies. To make the matter even more confusing, at least nine cities--including New York, Los Angeles and Chicago--have issued their own predatory lending laws.

In early January, the OCC issued two rules in which the agency unambiguously exerted its authority over national banks in all matters that involve their lawful banking activities. In its first rule, the OCC identified the types of state laws that are pre-empted by its authority and therefore are not applicable to national banks.

For a bank's lending activities, this would include licensing laws, as well as laws that address the terms of credit, permissible rates of interest, escrow accounts, and disclosure and advertising. Included in this broad pre-emptive sweep would be any state law that prohibits predatory lending activities.

The types of laws that generally are not pre-empted are those that apply to all business enterprises regardless of their industry classification, including zoning ordinances, criminal codes, torts and laws on contracts. The OCC justified its action, in part, by citing language in the National Bank Act, which gives the authority to prescribe rules and regulations for banks having a national charter.

In this first rule, the OCC also adopted new predatory lending standards that applied to the lending activities of national banks nationwide. Here, the agency actually revised an earlier standard by expressly prohibiting national banks from engaging in unfair and deceptive trade practices under Section 5 of the Federal Trade Commission Act. The new standard also clarified that its predatory lending standard applied only to consumer loans and not to commercial loans.

The OCC also adopted a second rule that staked out its position on so-called visitorial powers, which is the authority of a regulator to inspect, examine or supervise the affairs of a legal entity. "Our regulation clarifies that the scope of the OCC's exclusive visitorial authority applies to the content and conduct of national bank activities under federal law," the agency stated in a briefing document that it made available when the rule was issued. "In other words, the OCC is the exclusive supervisor of a national bank's banking activities; the OCC does not enforce fire codes, environmental laws, etc."

Although the OCC argues that its pre-emption authority rests on constitutional principles that extend as far back as an 1819 Supreme Court case involving the federally chartered Second Bank of the United States, it was a much more recent situation that spurred it to reaffirm that authority.

When Georgia passed its Fair Lending Act in 2002, which imposed restrictions on the ability of lenders there to make certain types of mortgage loans, Cleveland-based National City Corporation asked the OCC to determine whether the new Georgia statute was pre-empted by federal law. In other words, did national banks like National City have to comply? The OCC ultimately decided to override the Georgia law, and it took the occasion to issue its broad manifesto on national bank pre-emption.

Knowing full well that it was taking an immensely unpopular action with state officials and many consumer activist groups, the OCC has argued that it is merely upholding its congressional mandate. "There are fundamentally two reason why pre-emption and visitorial issues are important and worth fighting for today," says Julie Williams, the OCC's chief counsel and first senior deputy comptroller. "One is [that] it's a correct implementation of the powers of national banks under federal law. And second is the practical matter [that] pre-emption and visitorial powers translate into the ability to operate under consistent, predictable standards of operation with a consistent supervisory presence and that's a meaningful, valuable aspect of a bank's ability to do business today.

"We have situations where there are state laws and in some circumstances county or city laws that interject themselves, and I think people would agree that where you have multiple standards for conducting an activity, [you end up with] higher cost, higher execution risks and inefficiencies," Williams continues. "And some of that gets translated into higher costs for customers and, in some cases, diminished variation in the products that the banks are willing to offer."

The OCC isn't the only federal regulator to assert broad preemptive power over the financial institutions under its supervision. The OTS traces its pre-emptive authority back to the 1930s and the creation of the federal thrift charter under the old Federal Home Loan Bank Board.

"Congress really gave the Federal Home Loan Bank Board, now the OTS, the power to decide for itself how [federal] thrifts could engage in banking activities," says Carolyn Buck, the agency's chief counsel. And like the OCC, the OTS has the authority to pre-empt any state law--including predatory lending laws--that conflict with federal laws that deal directly with the core activities of running a thrift. In fact, Buck says the OTS' pre-emptive power is even broader in authority and privilege than the OCC's.

Why then hasn't the OCC's sister agency taken as much heat recently? For one thing, the OTS supervises fewer institutions, and they tend to be smaller in size. For another, the agency issued its ruling on pre-emptive authority back in the mid-1990s, well before the current controversy over predatory lending laws began. Still, in a recent speech to a group of thrift and commercial bank executives at a meeting of the Washington, D.C.-based trade group America's Community Bankers (ACB), Williams playfully expressed her envy of the OTS' anonymity.

"What I really want to know is why our regulations have provoked such controversy when the OTS issued virtually identical regulations nearly 10 years ago and there was hardly a ripple," she said. "Obviously, we need to ask [OTS Director] Jim Gilleran where he got his Teflon[TM] suit--some days I feel what I need is a suit of armor."

The OCC's claim of sole regulatory authority for national banks might require thicker armor as well if New York Attorney General Eliot Spitzer has anything to say about it. Spitzer, who upstaged the Securities and Exchange Commission (SEC) a couple of years ago when he aggressively pursued several Wall Street brokerage firms for securities law violations while the SEC dragged its feet, and later took on the mutual fund industry, has now squared off against the OCC over predatory lending.

The New York attorney general has sued First Horizon--the subsidiary of a national bank--over a dispute involving a home mortgage in which the company had threatened to foreclose on the borrower. The OCC got involved in the matter after state officials brought it to the agency's attention, but Spitzer has decided to use it as a test case even though it does not involve predatory lending per se. In fact, he is only seeking a $500 fine against First Horizon.

"This is an effort by Attorney General Spitzer to test the extent to which pre-emption and the OCC's visitorial powers over national banks apply to operating subsidiaries of national banks," says Williams. "We feel that our position on this is strong, and the issues that are at the heart of this case have been looked at and decided by three [federal] district courts and at least in those decisions they've agreed with us."

Angering state banking regulators

It's probably not surprising that the OCC's pre-emption rule set off a firestorm of protest from state officials like Gavin Gee, director of the Idaho Department of Finance and chairman of the Conference of State Bank Supervisors. Gee maintains that 70 percent of the banks in his state have national charters, and when the OCC asserted its pre-emption authority it greatly undercut his ability to protect Idaho consumers from illegal banking practices, including predatory lending.

Gee adds that most consumer complaints in his state involve national banks--which is hardly surprising, given their predominance there--and yet the OCC's stand on pre-emption has eviscerated his own authority over these institutions. "Consumers no longer have the opportunity to go to authorities in their own state and seek recovery," he says.

Gee also complains that the OCC has little visibility in his state, and that most Idaho consumers with a complaint against a national bank wouldn't even know who to call. "They're not even in the phone books here," he says. Neither does he have much confidence in the OCC's ability to handle consumer complaints about predatory lending. The agency runs a call center in Houston called the Consumer Assistance Group that fields all types of complaints against national banks, but Gee believes this is woefully inadequate to cover the entire country.

"From our perspective, they don't have a good track record," Gee says. "And they don't have a good track record about reporting back to us."

Conway of the New York Attorney General's office, not surprisingly, sides with Gee's blunt assessment: "It's silly," he says. "We have in New York State the same number of people to resolve complaints as they have in the whole country. Who knows the OCC?" The debate smacks of regulatory territorialism.

Williams defends her agency's performance when it comes to consumer protection, pointing out that its Houston call center is just one weapon in its arsenal. Indeed, the agency puts a great deal of effort into prevention through its supervisory function--a point that state officials often fail to mention.

"We have hundreds of examiners nationwide that specialize in compliance issues, and the overall number of examiners we have in the field totals around 1,700," she says. "And that's not counting all of my attorneys in Washington, as well as in the district offices. The Consumer Assistance Group in Houston is a piece of our compliance function, but it's by no means the biggest piece of what we do."

When pressed, Williams is quick to agree that states do have an interest in safeguarding their residents against predatory lending. "It's just a question of how you get to it," she says. "Pre-emption and visitorial power issues don't mean that the states are cut out of having a role in protecting consumers. If they become aware of [predatory lending] issues [and] bring those to our attention, we are certainly willing to follow up on them and tell the states what we have done. So it doesn't divorce them from the ability to care about and oversee how consumers in their states are treated."

She adds, "We get a fair amount of referrals from the states--which might surprise you, given the current rhetoric."

Unlevel playing field

The OCC and states like Idaho and New York aren't the only interested parties in the pre-emption debate. The plethora of originators--including mortgage bankers and state-chartered depository institutions--that don't happen to be national banks or federal thrifts have no choice but to comply with the growing number of state and local predatory lending laws.

"It certainly has been a challenge for a company like ours because we don't have pre-emption like the national banks do," says Faith Schwartz, senior vice president for government affairs at Irvine, California-based Option One Mortgage Corporation.

Option One is a nationwide originator of subprime mortgage loans through a network of offices in 48 states. Schwartz cites the example of Option One's offices in Virginia, which also service customers in neighboring Maryland. The states have different approaches to predatory lending, and office personnel must be very knowledgeable about both. "Your training has to be quite specific," she says. The multiplicity of state laws on predatory lending has made the origination of subprime loans "much more cumbersome," she adds.

One organization that is helped by national pre-emption is Countrywide Financial Corporation, Calabasas, California, another nationwide lender that originates some of its subprime mortgages through a national bank subsidiary. And even though the OCC's pre-emption authority has lightened Countrywide's compliance burden, Chief Legal Officer Sandor E. Samuels says the patchwork of state predatory lending laws hurts all mortgage originators because it reduces uniformity throughout the industry. "The uniform system that Fannie Mae and Freddie Mac helped create has been a benefit to consumers and businesses alike," he says.

There seems to be an emerging consensus that Congress should establish a national standard for preventing predatory lending--a step that would trump the pre-emption power of the OCC and OTS and create one law for everyone.

Both Countrywide and New South Federal, a federally chartered thrift, have voiced their support for a national standard, as has MBA. "A uniform standard is needed," says Couch. MBA has officially endorsed a national standards bill introduced in the House of Representatives by Rep. Bob Ney (R-Ohio). "In a perfect world, we would like to see that bill pass," says Couch.

Choking off credit

One factor that could bring about congressional action is the impact that predatory lending measures have had on the availability of funding in some states. Within two months of a New Jersey predatory lending law taking effect in November 2003, the volume of cash-out refinance loans had declined by 67 percent, and home-improvement loans had dropped by 75 percent, according to a survey by Richard F. DeMong, a finance professor at the McIntire School of Commerce at the University of Virginia, Charlottesville, Virginia.

Many lenders were worried about the "vagueness of the law" as well as their potential liability, according to DeMong.

Laws that contain poorly defined compliance procedures or entail unlimited potential liability on lenders make it almost impossible for loans originated in those states to be securitized if investors worry that they might ultimately be responsible for judgments against a lender. The problem has been exacerbated by the reluctance of the three primary bond rating agencies to rate some mortgage loan securitizations in states with problematic predatory lending statutes.

Samuels declined to predict whether Congress will give serious consideration to a national predatory lending bill, especially during a presidential election year. "If I knew the answer to that question, I could be having this conversation from the south of France," he laughs. But he does believe the issue is starting to "get traction" in Washington, particularly when poorly crafted laws like the New Jersey initiative effect the flow of funds in congressional districts.

For his part, Couch says it's crucial that Congress write any national standard for predatory lending with the utmost care to avoid turning the New Jersey example into a nationwide phenomenon. "We have to be so careful with the way we craft the law," he says. "We have to use a razor blade rather than a chainsaw."

Jack Milligan is a freelance writer based in Charlottesville, Virginia, and the former editor-in-chief of U.S. Banker. He can be reached at [e-mail].