Welcome back to Week #3 of Conglomerate Junior Scholars Workshop!  Our featured paper today is Subprime Standardization:  How Rating Agencies Allow Predatory Lending to Flourish in the Secondary Mortgage Market by David Reiss.  David is an assistant professor at Brooklyn Law School nad has written on the topic of predatory lending before.

Our expert reviewer today is Ronald Mann, a law professor at Texas and esteemed scholar in the field of commercial law, secured credit, and payment systems, including electronic payment systems.  We are excited to welcome Professor Mann to our electronic corner of the legal world today.  Professor Mann's comments on today's paper appear above and below the fold:

David’s paper provides a fascinating account of the interaction between ratings agencies attempting to protect investors in the secondary market and state-level policymakers attempting to protect their citizenry from predatory lending practices in home mortgage markets. The detail and care with which he tells the story accomplish several things. First, at a purely descriptive level, this is a story worth telling. Second, he persuades me of his basic thesis that the ratings agencies in fact are impeding well-intended regulatory initiatives of those policymakers. Third, he convinces me of his basic normative point: it is unsatisfying for the initiatives of public officials to be thwarted by the market-driven preferences of the ratings agencies, and particularly unsatisfying to think that the power of the ratings agencies derives in part from quasi-monopolistic power given to them by the SEC. All of those are good things, and I suspect that David would be happy if his paper could accomplish so much with all of its readers. What follows, then, is more a question about the kind of paper David has chosen to write than a criticism of the paper that he has written.

For me, the most important stage of an academic project is the stage where the project moves from general inquiry about a particular area to a focused topic for a particular paper. That is the stage where the scholar must ask precisely what the question is to be investigated, and precisely what kinds of evidence or analytical tools can be brought to bear on it. So, for example, it is usually not a good idea for a legal academic to write a journalistic paper that is designed to describe recent high-profile events in economics or finance; journalists at financial periodicals are likely to be more adept at obtaining, collecting and organizing that information. Conversely, a legal academic might be best placed to analyze the relative attractiveness of regulatory approaches to a particular problem.

This area of project definition is where I think David’s work could use some additional tightening. Aside from the lengthy literature survey (which I would truncate considerably), the existing paper seems to me to put an interesting question of regulatory policy on the table: what should we think (or do) about the practical ability of the ratings agencies to veto state predatory lending initiatives. There are several approaches to take. One might argue that the ratings agencies have power only because the SEC has given it to them and that the SEC should strip them of that power. That plainly is not David’s paper; it appears that several others have written papers in that vein. Another approach would be to argue that none of this matters, because predatory lending is not in fact a serious problem. That plainly is not his view.

He argues (in Parts V and VI) that the existing activities of the ratings agencies harm the public interest by “gut[ting] strong state predatory legislation.” For me, this part of the paper raises the most interesting question. As I read David’s description of the problem, the central complaint of the ratings agencies is with state legislation that imposes liability on investors for misconduct by the original issuers of loans. Essentially, the ratings agencies are insisting that the states not undermine the ability of investors to obtain holder-in-due-course status.

One interesting point that I would have made is that the ability of those investors to obtain holder-in-due-course status in fact is subject to considerable doubt. I wrote almost a decade ago (44 UCLA L Rev 951) explaining that a close reading of the standard FNMA home mortgage note (the ordinary document for home loans sold into the secondary market) suggests that it is not in fact a negotiable instrument, which means that purchasers and investors in that paper do not become holders in due course. To be sure, it is true that actors in the secondary market treat the notes as negotiable in practice. Still, although I have heard a lot of broad assertions that the notes plainly are negotiable, I do not think there has been any definitive case or substantial academic argument to the contrary during the intervening decade.

More broadly, however, the interesting question of regulatory policy is to assume that there is in fact a sufficiently substantial problem of predatory lending to justify regulatory intervention and ask how this best should be done. In my view, the case for imposing liability on secondary-market investors is quite a weak one. To be sure, those investors could be thought of as gatekeepers that might force the issuers to comply with predatory lending rules by refusing to buy noncomplying paper. The difficulty, however, is that existing predatory lending rules are sufficiently subjective that a substantial quantity of lawful paper cannot without considerable cost be differentiated from unlawful paper. That means that the logical response of secondary market investors is to disqualify (or pay substantially less for) large shares of the loans coming from states with the most restrictive predatory lending regulations. That is much different, for example, from a usury regulation that bars a loan with an interest rate above 18% -- something that can be evaluated with little time and expense.

At the same time, it is not at all clear why regulators concerned about predatory lending cannot accomplish many of their goals through direct regulation of the issuers. For one thing, the issuers by definition will be doing business in the jurisdiction that wants to regulate them. And there is little or no problem of federal preemption, at least if you take David’s view that the portion of predatory lending that is a serious concern does not involve actions of national banks protected by the National Banking Act. {I do not think that view is universally shared.} Thus, if state regulators wanted to, nothing would stop them from creating a licensing regime that would impose substantial fines for predatory practices and match those with financial responsibility rules (to ensure that the fines would be paid – and thus that they would affect the underlying misconduct). The costs of such a regime likely would be some mix of increased prices of loans to high-risk borrowers, coupled with a lessening of predatory practices. The better tailored and more objective the enforcement criteria, the more the response would be reflected in a lessening of the listed practices; the less well tailored and more subjective the criteria, the more the response would be reflected in increased prices.

This is of course an off-the-cuff analysis of the problem. David’s investment in learning about the market doubtless gives him a comparative advantage in understanding precisely what kinds of regulation are more, and less, likely to be effective. My only purpose here is to encourage him to ask those questions, and give us the benefit of his answers. Basically, I am a big fan of papers that provide a lot of context, but in this case I think the descriptive information obscures the take-away points that he is trying to make. One final comment: I also would have liked to see more thought given to the idea (which he mentions but leaves hanging) that global competition and technology are forcing premature standardization, which curtails the ability of state regulators to experiment with different regulatory approaches. The predatory lending example is a good case study for that problem.

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