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1.3.1 Market Deregulation and the Crisis

The surge of abusive mortgage loans in the 2000s, particularly predatory loans, and the resulting foreclosure crisis proved the existence of major flaws in market practices. Competition and self-regulation did not prevent lenders from making predatory and unaffordable loans, nor did the weak enforcement of existing laws. Instead these practices appear to have helped promote the crisis.

Securitization stimulated the conditions leading to the collapse by pumping an enormous volume of money into subprime mortgage loans.222 Even more importantly, the participants in the securitization process failed to accurately police the quality of the underlying mortgage loans and to accurately assess the ensuing heightened risks.223 For example, one study found that securitization reduced lender incentives to carefully screen and monitor borrower default risk beyond relying on credit scores for those with FICO scores exceeding 620.224 Loans with low documentation or no verification of income and assets tended to default at higher rates within two years of origination, even if the borrower’s credit score was above the credit threshold of 620.

The Financial Crisis Inquiry Commission, created pursuant to the Fraud Enforcement and Recovery Act,225 conducted an extensive investigation into the causes of the financial crisis and released its findings in January 2011.226 According to its report, a number of factors played a role: the collapse of the housing bubble fueled by low interest rates, easy credit, toxic mortgages, and—of special note—negligible regulation.227

More specifically, the Commission found many problems with regulation and oversight: widespread failures in financial regulation and supervision by key federal agencies; failures of corporate governance and heightened risk-taking; excessively leveraged financial institutions and high consumer debt loads; deterioration of mortgage-lending standards; loosening of due diligence standards applied in the securitization process; the repackaging and sale of questionable mortgage-backed securities into collateralized debt obligations and the sale of credit default swaps to hedge against the collapse of the securities; failures of the credit rating agencies; and an unprepared government that responded inconsistently to the crisis.228

Federal and state enforcement actions ensued. For example, as a result of reduced due diligence and alleged fraud related to the packaging and sale of mortgage-backed securities, in 2014 the Department of Justice reached a settlement with Bank of America and its former and current subsidiaries, including Countrywide Financial Corp. and Merrill Lynch. Bank of America agreed to pay almost $16 billion, $7 billion of which was earmarked in the form of relief to aid consumers harmed by the financial crisis.229 The Department of Justice later filed and settled several cases alleging that specific investment firms discovered shoddy mortgages in the securitized pools but did not inform investors.230 These firms agreed to pay over $44 billion in penalties. Several banking agencies also filed securities fraud actions alleging that sellers, issuers, and underwriters of residential mortgage-backed securities misrepresented the quality of the underlying mortgage loans causing losses and contributing to the failure of depository institutions under their jurisdictions.231 The penalties collected were used to support general government services, provide redress to harmed consumers, and for other purposes.232

These failures in the marketplace were accompanied by—and possibly facilitated by—an astonishing level of deregulation of consumer lending that left the door wide open for unscrupulous operators. Not only did federal regulators fail to police federal depository institutions, but federal laws and regulations preempted the ability of states and consumers to use state law to regulate and remedy abuses. Federal laws preempted both state usury ceilings on first mortgages (whether purchase money or not)233 and limitations on risky, “creative financing” options, such as negatively amortizing loans, balloon payments, and prepayment penalties.234 Municipal efforts at regulation were also thwarted.235 Preemption was even broader for banks and savings associations—national banks and federal savings associations in particular.236

Federal deregulation also set the stage for many states to remove interest rate caps and other limitations on home lending, including limits on subordinate mortgage loans. Deregulation unleashed a wave of predatory lending across the country, even in times of low interest rates, and eventually led to the foreclosure crisis. While classical economic theories of competition and market forces suggest that this should not have happened, there are a number of reasons why those theories do not work in the mortgage marketplace.237


  • 222 {222} The terms “subprime” as well as “prime” and “Alt-A” are defined in § 2.4, infra.

  • 223 {223} See Kathleen C. Engel & Patricia A. McCoy, The Subprime Virus: Reckless Credit, Regulatory Failure, and Next Steps Ch. 3 (2011). See generally Kurt Eggert, The Great Collapse: How Securitization Caused the Subprime Meltdown, 41 Conn. L. Rev. 1257 (2009).

  • 224 {224} Benjamin J. Keys, Tanmoy K. Mukherjee, Amit Seru & Vikrant Vig, Did Securitization Lead to Lax Screening? Evidence from Subprime Loans, 125 Q.J. of Econ. 307 (2010) (concluding that the drive to “originate-to-distribute,” in other words, to securitize, in the subprime non-FHA mortgage market from January 2001 to December 2006, and the greater default probability of loans above a 620 credit score threshold must be due to a reduction in screening by lenders). See also Ronel Elul, Fed. Reserve Bank of Philadelphia, Working Paper No. 15-15, Securitization and Mortgage Default 3–4, 8–9 (Mar. 2015), available at (for first lien owner-occupied ARM loans originated during 2005 and 2006, privately securitized prime loans performed significantly worse than non-privately securitized loans; privately securitized subprime loans defaulted at lower rates than the prime loans but many of the subprime low-documentation ARM loans defaulted before the lenders had a chance to sell them).

  • 225 {225} Pub. L. No. 111-21, 123 Stat. 1617 (2009).

  • 226 {226} Fin. Crisis Inquiry Comm’n, The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States xi (2011), available at

  • 227 {227} Id. at xvi. See also FDIC Oversight: Examining and Evaluating the Role of the Regulator During the Financial Crisis and Today: Hearing Before the Subcomm. on Fin. Institutions & Consumer Credit of the H. Fin. Services Comm., 112th Cong. 5–12 (2011) (statement of Sheila C. Bair) (identifying the roots of the financial crisis—excessive reliance on debt and financial leverage, misaligned incentives in financial markets, failures and gaps in financial regulation, and erosion of market discipline due to “too big to fail”); Ryan Bubb & Prasad Krishnamurthy, Regulating Against Bubbles: How Mortgage Regulation Can Keep Main Street and Wall Street Safe—From Themselves, 163 U. Pa. L. Rev. 1539 (2015) (highlighting the central role of the housing bubble and the related irrational exuberance of virtually all of the players in the mortgage lending, securitization, and investment markets in the decline in underwriting standards, the expansion of subprime lending, and the emergence of the complex loans sold to riskier borrowers; describing the size of the bubble by contrasting the increase in house prices nationally between 1890 and 1997 of only 7% (annual growth rate 0.06%) with the 85% (annual growth rate 7%) growth of real house prices between 1997 and 2006).

  • 228 {228} Fin. Crisis Inquiry Comm’n, The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States xvii–xxviii (2011), available at

  • 229 {229} U.S. Dep’t of Justice, Press Release, Bank of America to Pay $16.65 Billion in Historic Justice Department Settlement for Financial Fraud Leading up to and During the Financial Crisis (Aug. 21, 2014), available at (settlement based in part on allegations that Countrywide and Bank of America sold “toxic” mortgage loans to Fannie Mae and Freddie Mac and falsely represented that the loans were prime or quality loans).

    The monitor overseeing Bank of America’s compliance with the consumer relief portion of this settlement issued his first report on February 17, 2015. Initial Progress Report from the Monitor of the 2014 Bank of America Mortgage Settlement 31–36 (Feb. 17, 2015) (Bank of America modified the initial 100 first-lien mortgage loans properly and forgave almost $12 million in principal).

  • 230 {230} U.S. Dep’t of Justice, Press Release, Goldman Sachs Agrees to Pay More than $5 Billion in Connection with Its Sale of Residential Mortgage Backed Securities (April 11, 2016); U.S. Dep’t of Justice, Press Release, Morgan Stanley Agrees to Pay $2.6 Billion Penalty in Connection with Its Sale of Residential Mortgage Backed Securities (Feb. 11, 2016); U.S. Dep’t of Justice, Press Release, Justice Department, Federal and State Partners Secure Record $7 Billion Global Settlement with Citigroup for Misleading Investors About Securities Containing Toxic Mortgages (July 14, 2014); U.S. Dep’t of Justice, Press Release, Justice Department, Federal and State Partners Secure Record $13 Billion Global Settlement with JPMorgan for Misleading Investors About Securities Containing Toxic Mortgages (Nov. 19, 2013).

  • 231 {231} E.g., Fed. Deposit Ins. Corp. v. RBS Securities Inc., 798 F.3d 244 (5th Cir. 2015); Nat’l Credit Union Admin. Bd. v. Barclays Capital, Inc., 785 F.3d 387 (10th Cir. 2015); Nat’l Credit Union Admin. Bd. v. HSBC Bank USA, 117 F. Supp. 3d 392 (S.D.N.Y. 2015); Fed. Deposit Ins. Corp. v. Bear Stearns Asset Backed Securities I L.L.C., 92 F. Supp. 3d 206 (S.D.N.Y. 2015), vacated sub nom. Fed. Deposit Ins. Corp. v. Credit Suisse First Boston Mortg. Securities Corp., 674 Fed. Appx. 86 (2d Cir. 2017) (mem.); Fed. Deposit Ins. Corp. v. Morgan Stanley Capital I Inc., 2015 WL 1381875 (D. Colo. Mar. 24, 2015). See also Fed. Deposit Ins. Corp. v. Royal Bank of Scotland Grp. PLC, 124 F. Supp. 3d 92 (D. Conn. 2015) (case filed based on losses by Fannie Mae and Freddie Mac); Fed. Hous. Fin. Agency v. Nomura Holding Am., Inc., 104 F. Supp. 3d 441 (S.D.N.Y. 2015), aff’d, 873 F.3d 85 (2d Cir. 2017); U.S. Dept. of Justice, Press Release, Justice Department, Wells Fargo Bank Agrees to Pay $1.2 Billion for Improper Mortgage Lending Practices (Apr. 8, 2016) (Wells Fargo Bank admitted to certifying that loans were eligible for FHA mortgage insurance when they were not and failing to disclose thousands of shoddy mortgage loans to HUD).

  • 232 {232} U.S. Gov’t Accountability Office, Pub. No. GAO-17-11R, Financial Institutions: Penalty and Settlement Payments for Mortgage-Related Violations in Selected Cases (Nov. 10, 2016), available at (reporting on the use of the penalties collected in a sample of settlements involving origination, servicing, and residential mortgage backed securities violations).

  • 233 {233} Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDA), Pub. L. No. 96-221, § 501, 94 Stat. 144, 161 (codified at 12 U.S.C. § 1735f-7a).

  • 234 {234} The Alternative Mortgage Transaction Parity Act of 1982 (AMTPA), codified at 12 U.S.C. §§ 3801 to 3805. While some of the AMTPA limitations have been reversed by the Home Ownership and Equity Protection Act (HOEPA), state protections against lending abuses are still limited by federal regulators’ efforts to preempt state laws.

  • 235 {235} See generally Kathleen C. Engel, Local Governments and Risky Home Loans, 69 SMU L. Rev. 609 (2016).

  • 236 {236} See Ch. 5, infra; Patricia A. McCoy & Elizabeth Renuart, The Legal Infrastructure of Subprime and Nontraditional Home Mortgages, in Borrowing to Live: Consumer and Mortgage Credit Revisited (Nicolas P. Retsinas & Eric S. Belsky, eds. 2008), available at (tracing the history of the state and federal usury caps applying to mortgage loans, including the deregulation of the federal usury caps, the preemption of state usury caps, and the consequences of both).

  • 237 {237} See David Min, How Government Guarantees Promote Housing Finance Stability, 50 Harv. J. on Legis. 437, 468–483 (2013) (comparing the state of the housing market before and after the Great Depression in the context of arguing that prudential federal banking regulation and the government guarantees provided by Fannie Mae and Freddie Mac created stability in the housing market until the early 2000s).