In response to the financial crisis, regulators and lawmakers undertook a massive re-engineering of the U.S. financial regulatory framework. Then everything changed -- mostly for the good, though not without unintended consequences.
Some of these unintended consequences put you and your family at increased risk of fraud, mistreatment, and potentially foreclosure.
The shadow banking system
One of the many reforms enacted since 2008 is the implementation of the Basel III capital requirements. These regulations increased the capital required of banks, with even more capital required for banks that hold certain risky assets on their books.
Among the assets deemed risky are mortgage servicing assets, or MSAs. When you take out a mortgage loan, many banks outsource the routine collection and maintenance of your loan. These servicers take a small fee every month from the payment. If your loan were to go past due or move into foreclosure, the mortgage servicer manages that process. Banks and servicers report this business as mortgage servicing assets on the balance sheet.
Traditionally, banks serviced their own loans or sold the MSAs to larger banks with servicing subsidiaries that are expert in mortgage laws and monitored by traditional bank regulators.
However, the new capital requirements make owning and operating these businesses far less appealing because they require so much new capital under Basel III. As such, banks have been selling these mortgage servicing assets to non-bank companies -- companies such as Ocwen Financial Corp. (NYSE:OCN).
These companies operate outside the bank regulatory framework because they aren't banks. Some have referred to these unregulated businesses as the "shadow banking system." That means it's possible for these companies to skirt regulations, bypass consumer protection laws, and create massive conflicts of interest between their own profitability and consumer rights.
Ocwen Financial: an example of why the shadow banking system is dangerous
For many mortgage servicers, the temptation to break the rules is simply too great to resist. In 2013, for example, Ocwen settled with the Consumer Financial Protection Bureau, or CFPB, for $2.2 billion for mishandling a huge number of foreclosures in the years following the crisis.
The New York Times reported that the company was accused of "charging borrowers unauthorized fees, deceiving consumers about foreclosure alternatives, and providing false or misleading information about the status of foreclosure proceedings."
The settlement covered misdeeds between 2009 and 2012, a period when the company's stock exploded 530%, quarterly net income grew 333%, and quarterly revenue grew 98%.
The story of Ocwen's wrongdoings continued this week. New York state's top regulator, the state's Department of Financial Services, or DFS, settled a separate investigation for an additional $150 million, though the real teeth of this settlement are far more significant than the cash.
Ocwen agreed to a laundry list of restrictive requirements, among them:
- Founder and Chairman Bill Erbey will resign from the company.
- DFS will install a team of regulatory monitors onsite for the next three years.
- The monitors will add two new directors to the board.
- Any acquisitions must be approved by the state.
- Ocwen must turn over complete loan files to current and former borrowers.
These are serious punishments, and they are well deserved, given the depth and scope of Ocwen's misdeeds. Consider the New York Post's report this week that "among other dubious practices, Ocwen was dinged for sending backdated letters to struggling borrowers, which essentially cheated them out of the chance to rework their loans."
The bigger picture
The vast new regulatory burden being shouldered by U.S. banks is necessary. Banking is too critical of an industry to allow the greed and malfeasance seen in the mid-2000s to put the entire economy at risk.
The scary part is not that banks' return on equity may be lower tomorrow than it was yesterday, or that expenses may be a few basis points higher next year than this year. The scary part is that in a system as complex as the U.S. financial system, it's impossible to anticipate the unintended consequences.
Ocwen operated on the fringes for years before the CFPB finally stepped in. Ocwen's wrongdoings occurred after the crisis despite Dodd-Frank, Basel III, and the other new regulations.
As banks are forced to recalibrate their businesses to optimize profits and returns in the new regulatory environment, what other businesses will shift into the shadow banking system? What other characters are operating today like Ocwen did just a few years ago, outside the view of regulators or even the scope of consumer protection laws?
The sad reality is that we won't know until it's too late. Punishments will come only after the fact, and as those who lost their homes to an improper Ocwen foreclosure will tell you, those punishments can never make up for the loss of a home.