They Warned Us About the Mortgage Crisis

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Roy Cooper, North Carolina AG Ethan Hill

Former OCC Chief John Hawke Ethan Hill

Georgia legal aid attorneys Brennan and Brown Ethan Hill

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Hawke blames much of the mess on mortgage brokers and originators who, he says, were the responsibility of states. "I can understand why state AGs would try to offload some responsibility here," he adds. "It's important to remember when people are trying to assign blame here that the courts uniformly upheld our position."

His arguments have some merit. The federal judiciary has bolstered preemption in the name of uniform national rules, not just for banks but also for manufacturers of drugs and consumer products. And state oversight alone is no panacea, as the chaotic state-regulated insurance market illustrates. Inadequate supervision of mortgage companies in some states contributed to the subprime explosion. But the hands-off signals sent from Washington only invited complacency. When some state officials fired warning flares, the Administration doused them.

Consider a clash in 2004 between the OCC and regulators in Michigan. In January of that year attorneys working for Hawke filed a brief in federal court in Grand Rapids on behalf of Wachovia (WB), the national bank with $800 billion in assets based in Charlotte, N.C. Michigan wanted to continue to examine a Wachovia-controlled mortgage unit in the state, which the bank had converted to a wholly owned subsidiary. The parent bank sued, claiming Michigan could no longer look at the mortgage lender's books. Citing the threat of unspecified "hostile state interests," the OCC argued in its brief that "states are not at liberty to obstruct, impair, or condition the exercise of national bank powers, including those powers exercised through an operating subsidiary."

Michigan countered that Wachovia Mortgage was not itself a national bank. The Constitution preserves state authority to protect its residents when federal statutes don't explicitly bar such regulation, Michigan contended. Ken Ross, the state's top financial regulator, says his department fought Wachovia all the way to the U.S. Supreme Court in part because it feared a growing subprime mortgage problem: "We knew there needed to be [state] regulation in place or there could be gaps." The OCC, he adds, "did not have robust regulatory provisions over these operating subsidiaries."

The nation's highest court sided with the Bush Administration, ruling in April 2007 that the OCC had exclusive authority over Wachovia Mortgage. Justice Ruth Bader Ginsburg, writing for a five-member majority, pointed to the potential burdens on mortgage lending if there were "duplicative state examination, supervision, and regulation." In a dissenting opinion, Justice John Paul Stevens said that it is "especially troubling that the court so blithely preempts Michigan laws designed to protect consumers."

By the time of the Supreme Court decision last year, Wachovia and its mortgage operations in Michigan and elsewhere were feeling the ill effects of unwise lending. As real estate prices continued to fall this year, pushing many borrowers into default, Wachovia teetered on the edge of failure. In late September the federal government stepped in to arrange a fire sale. Wachovia now may be carved up between Citigroup (C) and Wells Fargo (WFC).

Confrontations such as Michigan's battle with Wachovia became far more common after George W. Bush took over the White House in 2001 and instituted a broad deregulatory agenda. The OCC, an arm of the Treasury Dept., has adhered closely to it. The agency oversees more than 1,700 federally chartered banks, controlling two-thirds of all U.S. commercial bank assets. Historically, its examiners have monitored bank capital levels and lending to corporations more attentively than they have the treatment of individual borrowers. "Consumer protection has always been an orphan [among federal bank regulators]," says Adam J. Levitin, a commercial law scholar at Georgetown University Law Center.