Federal Reserve: Home Rule

, The American Lawyer

Some might call it locking the barn door after the horse is long gone. In July the Federal Reserve tightened home mortgage lending regulations under the Truth in Lending Act of 1968 (TILA), responding to a housing downturn that exposed gaps in regulatory oversight. While the regulatory changes will have their largest immediate impact on lending practices, they’re also likely to lead to increased litigation, several bank regulatory lawyers say. "The Fed is enacting tougher rules that will enable private plaintiffs to have more arrows in their quiver to bring litigation," says Womble Carlyle Sandridge & Rice partner Donald Lampe, who chairs the American Bar Association’s Consumer Financial Services Committee.

The new litigation targets are expected to be loan originators and lenders, who are likely to see an increase in TILA class actions after most of the new rules become effective beginning in October 2009. Under the toughened-up regulations, lenders are barred from making loans in the subprime market without taking into account the borrowers’ ability to repay them from income and other assets.

Borrowers have been filing class actions under TILA for the past two decades, but the new regu-lations give plaintiffs new grounds to sue over alleged abuses. Meanwhile, a worsening economy is building momentum for suits against both lenders and the Wall Street firms that securitized loans. "[TILA] is rife with litigation," says Gilbert Schwartz, who was a Federal Reserve lawyer before founding Washington, D.C.’s Schwartz & Ballen, which represents financial institutions.

Now, Schwartz adds, "given the fact that the rules will change, there will be much more opportunity to bring class action lawsuits against lenders." In earlier consumer mortgage class actions, borrowers usually alleged misrepresentation of loan terms and predatory lending practices. The new regulations will allow plaintiffs to sue lenders who fail to assess a borrower’s repayment ability when making a subprime loan. New class actions also may arise from deceptive advertising practices: The new regulations ban using the word "fixed" to represent a mortgage payment that can change. Plaintiffs lawyers will likely use TILA, often in concert with the Real Estate Settlement Procedures Act and state predatory lending laws, to challenge foreclosures and mortgage loan delinquencies.

Of course, changes to TILA only mark the beginning of the regulatory reforms spurred by the housing bubble burst, says former Fed lawyer Paul Pilecki, now a partner at Winston & Strawn. The run on The Bear Stearns Companies Inc. and its subsequent Fed-orchestrated sale to JPMorgan Chase & Co., gave the Fed more authority to intervene in the oversight of investment banks, traditionally the Securities and Exchange Commission’s responsibility. The sale of Merrill Lynch & Co., Inc., to Bank of America and the recent conversion of investment banks Morgan Stanley and The Goldman Sachs Group, Inc., to bank holding companies only adds to the Fed’s newfound power, says Pilecki. "Those actions pretty much put all the major investment assets under Federal Reserve supervision," he says.

Even before the new TILA regulations kick in, the housing crisis has already sparked a litigation boom: In the last two years, shareholders have filed a slew of securities class actions against mortgage companies, such as Countrywide Financial Corporation; investment banks that issued and sold securities backed by subprime loans, such as Merrill Lynch & Co., Inc.; and insurers that invested in such securities, including American International Group, Inc. Subprime-related securities class actions numbered 120 at press time in late September, according to one tracker, the online D & O Diary, published by Kevin LaCroix, an attorney and partner in the Beachwood, Ohio, office of OakBridge Insurance Services, Inc.

Much of this securities litigation, in which investors typically claim that financial institutions misrepresented risk, is in the early stages. But the plaintiffs bar is hoping for big returns, even as the credit crisis leaves Wall Street reeling. And as the responsibility for sorting out financial regulation passes to the next administration, litigators can expect to be busy, says American Enterprise Institute resident scholar Vincent Reinhart, former director of the Fed’s division of monetary affairs.

"Historical episodes make it clear that there will be ex post facto finger-pointing," Reinhart says. "When that happens, there will be litigation."