CAMBRIDGE, MA: 12 April 2013 - In 2008, shortly after becoming chief of staff for the newly elected President Obama, Rahm Emanuel pondered the implications of the crumbling economy and pronounced: “You never want a serious crisis to go to waste.” 

It would appear that a select core of consultants employed by federal banking regulators took his advice to heart. A riveting Senate subcommittee hearing this week revealed how the foreclosure crisis may have wreaked unfathomable pain on millions of Americans, but for banking consultants certified by regulators, it meant a multi-billion dollar payday.

From an institutional corruption standpoint, the so-called Independent Foreclosure Review, initiated in 2011, bears scrutiny from several angles. From a revolving door position, the consulting firms who raked in huge fees are brimming with former regulators and other insiders. On the issue of transparency, what the consultants actually found remains largely undisclosed – even though the information is in the hands of regulators who ostensibly serve the public. As for conflicts of interest, there’s the subject of whether regulators’ first loyalty is to the public or the institutions they oversee. And there are unsettling symptoms of dependence corruption: The banks were paying the consultants who were examining them. Finally, there’s the overriding issue of just why regulators are doling out contracts rather than do the job themselves.

What’s clear is that this unprecedented effort to funnel public oversight functions to profit-driven firms on a massive scale was rife with problems that precluded achieving the primary public policy goal – assisting distressed homeowners. In a report released earlier this month, the Government Accountability Office listed a litany of issues and advised that “the foreclosure review process offers an opportunity for the regulators to leverage this experience to help ensure that similar difficulties are better addressed in future efforts.” It was the second time the GAO issued a report critical of the foreclosure review.

Hope and Promise

Time will tell if the GAO’s hopes are realized. But first, some quick background on the promising beginning when the foreclosure review effort was announced.

In 2011, 14 large mortgage servicers – including most of the country’s major banks – were ordered by the Federal Reserve and the Office of the Comptroller of the Currency to hire the consultants to review foreclosures filed in 2009 and 2010. The mission: look for legal errors, shoddy paperwork and other problems, to determine possible damages. Sampling was allowed, to ascertain the error rate.

“These comprehensive enforcement actions, coordinated among the federal banking regulators, require major reforms in mortgage servicing operations,” John Walsh, acting Comptroller of the Currency at the time, said. “These reforms will not only fix the problems we found in foreclosure processing, but will also correct failures in governance and the loan modification process and address financial harm to borrowers.”

No question, many of the consultants hired knew banking – they were in fact former regulators themselves. Perhaps the most prominent consultant was Promontory Financial Group, founded by Eugene Ludwig, who formerly headed the OCC in the Clinton administration.

Though it was only founded in 2001, Promontory has quickly become known as a Washington power player. Just recently it also hired Mary Schapiro, who left as head of the Securities and Exchange Commission last December. Press reports regularly refer to Promontory as a “quasi-regulator” for its role as a conduit between government and bankers.

Regulators initially wanted the job done in 120 days. In fact, it’s a task that will never be completed. The Independent Foreclosure Review was scuttled prematurely in January, and a settlement with most of the banks, covering 90 percent of the cases, was announced. The agreement was touted as valued at $9 billion. However, homeowners are actually only entitled to $3.6 billion in cash, the rest of it in things like advice on avoiding foreclosure.

Regulators had let it be known that some recipients would get up to $125,000. But this week the Fed and OCC issued a payout schedule that showed a bare handful of people will receive that amount. Most of the recipients had mortgage servicing issues, but didn’t face foreclosure. For the majority of those the payment is just $300.

At Thursday’s hearing of the Senate’s subcommittee on financial institutions and consumer protection, both regulators and consultants defended their reviews, though acknowledging certain flaws. But Sen. Elizabeth Warren, the Massachusetts Democrat, said the process smacked of cover-up.

Little Specific Information

Warren said she and Rep. Elijah Cummings, a Maryland Democrat, had made 14 specific requests for documents from the OCC and the Fed since January. “You have provided only one full response, three partial or minimal responses and no responses to nine requests,” Warren said. “You’ve provided little specific information, such as the number of improper foreclosures.”

Sen. Sherrod Brown, an Ohio Democrat who chairs the subcommittee, said that the role of former regulators as consultants raises the troublesome issue of revolving door syndrome. Even if consultants and regulators mean well, the constant flow of regulatory talent to lucrative jobs at shops like Promontory produces what Brown called “cognitive capture.” In other words, the adversarial element of the banker-examiner relationship is supplanted with more symbiotic thinking. With “the influence of the revolving door, bright-line rules become all the more important,” he said.

Besides its former regulators on staff, Promontory’s advisory board includes Alan Blinder, the highly regarded Princeton economist and former vice chair of the Fed, Arthur Levitt, the former chief of the SEC, and Stephen G. Thieke, who was executive vice president of the Federal Reserve Bank of New York in the 1980s before becoming a managing director of JPMorgan. The company’s co-founder, Alfred Moses, was once special counsel to President Carter.

Such close ties might call into question the influence the independent consultants have with regulators. But Daniel Stipano, the OCC’s deputy chief counsel, maintained that’s a non-issue. “In all of these cases, the OCC considers the qualifications” of the consultants, Stipano said at the hearing. “The OCC also oversees and monitors the work of the consultants.” But that system failed – badly – during the Independent Foreclosure Review, both sides agreed, in one of the hearing’s few moments of consensus. Consultants testified that it was immediately apparent that the 120-day deadline was unrealistic for reviewing 4 million home loans. Some consultants began sending work abroad, Brown said.

 “We had a history of requiring banks to retain consultants in the past,” said Richard Ashton, deputy general counsel for the Fed. With foreclosures, “we thought that model could be adopted. What we found out, in practice, was the scope was so extensive it just was not effective.”

Brown, meanwhile, repeatedly asked why, if the program was so badly flawed, billing was allowed to rise to $2 billion before the plug was pulled. “I don’t think that decision was driven by compensation being paid to consultants,” Stipano, of the OCC, said.

The Outsiders

The Senate hearing was titled, “Outsourcing Accountability?” And its focus on outside consultants reflected a growing reality that has institutional corruption implications. Specifically, regulatory agencies are increasingly reliant on consultants because they lack the institutional resources to do the job themselves. This has the effect of introducing a profit-oriented constituency into an oversight function that is purportedly accountable first and foremost to the public.

“The problem with having the OCC do the job itself is, it’s just beyond the means” of any banking agency, Stipano said. He said the agency might have needed to triple its staff to handle the foreclosure reviews, something that wasn’t feasible.

After a recess, Brown returned to a situation that hinted at what students of institutional corruption sometimes call dependence corruption. The dynamics: The consultants are there at the behest of the regulators. But they’re actually the client of the banks, who are paying the fees. (At Thursday’s hearing, PricewaterhouseCoopers, one of the lead consultants, said it billed over $400 million conducting foreclosure reviews.)

“You work for the banks, they pay you, but you’re supposed to represent the public interest,” Brown said to several consultants who’d been asked to testify. “That’s almost an inherent, automatic conflict of interest.” It’s a pattern that resembles the highly criticized pre-crisis pattern with credit rating agencies, which gave glowing ratings to toxic mortgage securities being offered by their clients.

Konrad Alt, managing director of Promontory Financial, conceded there’s an issue. “There is an inherent conflict, and you are right to focus on it,” he said. But he added that, “there are checks, and the primary check is regulatory oversight. We met with regulators constantly.”

Clearly Not Transparent?

Warren, however, added that conflict of interest concerns extend to regulators as well. When the foreclosure review was announced in 2011, it was hailed as an effort to bring relief to besieged homeowners. But in practice regulators appear to be siding with banks, she said. As one example, consultants gathered data on foreclosures that appear to have violated laws. But the OCC is keeping that and most other information collected to itself. Given the dearth of details, it’s impossible to judge whether the settlement is fair or not, Warren said.

Stipano, the OCC official, said revealing information like error rates on foreclosures would violate confidentiality agreements it has with financial institutions, although it could occur in the future.

“So you’ve made the decision to protect banks, but not to help families that have been foreclosed illegally,” Warren said. “You know individual cases where banks violated laws and you’re not going to help the homeowners. Without transparency we can’t have any confidence in your oversight or that the markets are functioning properly at all.”

THIS PIECE WAS FIRST PUBLISHED BY THE EDMOND J SAFRA CENTER FOR ETHICS AT HARVARD UNIVERSITY ON 12 ARPIL 2013 AND IS REPUBLISHED WITH PERMISSION THROUGH A RECIPORCAL ARRANGEMENT WITH THE CLMR. FOR DETAILS OF THE WORK OF THE HARVARD CENTER AND ITS INNOVATIVE LAB PROGRAM, SEE http://www.ethics.harvard.edu/lab