As foreclosures began to mount across the country three years ago, a group of state bank regulators suspected that some borrowers might be losing their homes unnecessarily. So the state officials asked the biggest national banks for details about their foreclosure operations.
When two banks -- J.P. Morgan Chase and Wells Fargo -- declined to cooperate, the state officials asked the banks' federal regulator for help, according to a letter they sent. But the Office of the Comptroller of the Currency, which oversees national banks, denied the states' request, saying the firms should answer only to inquiries from federal officials.
In a response to state officials, John Dugan, comptroller at the time, wrote that his agency was already planning to collect foreclosure information and that any additional monitoring risked "confusing matters." But even as it closed the door on state oversight, the OCC chose itself not to scrutinize the foreclosure operations of the largest national banks, forgoing any examination of their procedures and paperwork.
Instead, the agency relied on the banks' in-house assessments. These provided no hint of the problems to come until they had tripped the nation's housing market, agency officials later acknowledged.
"Based on what we were seeing and what we were concerned about, it felt like a chronic underreaction at the federal level," said John Ryan, a senior official with the Conference of State Bank Supervisors.
Even when the mortgage industry itself identified possible flaws in foreclosure paperwork, the agency was slow to act.
In September, Ally Financial suspended foreclosures after discovering problems with tens of thousands of cases. But even then, the OCC did not begin to examine the operations of other major banks. Instead, the agency asked them to undertake internal reviews and told them it would conduct its own examination later, an OCC official said.
Over the following weeks, most of the major national banks announced one after the next that they were reviewing their foreclosure practices and putting thousands of cases temporarily on hold. While the freeze offered new hope to thousands of distressed borrowers, it also threatened to undermine the real estate market, which already was struggling to recover from crisis.
Two weeks ago, for the first time, the OCC began sending its staff into the banks to examine their foreclosure operations, interview bank employees and review paperwork.
The OCC is one of the nation's four federal bank regulators and has primary oversight over the largest banks, while the other three - the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of Thrift Supervision -- share responsibility for many small and medium-size financial firms. All the agencies failed to spot problems in the foreclosure process.
The OCC's recent initiative is part of a broad federal effort to assess the U.S. foreclosure breakdown. Regulators said they hope to complete a preliminary report this month but have not decided whether it will be made public.
In monitoring the financial health of banks over the years, the OCC had been far more aggressive. Agency staff members have been assigned to work full time inside the largest banks, checking to see whether the banks are taking excessive risks, for instance, by analyzing their holdings.
But the agency did not look closely at how banks foreclose when borrowers don't make their mortgage payments. OCC officials treated foreclosures as the simple act of filing documents to seize ownership of a home once a borrower couldn't pay.
"We looked at the final stage of the process and thought of it as one that would be governed by standards and procedures in internal controls," said Julie Williams, the OCC's top lawyer. "You would only be able to know for sure if there was a problem with the document-signing process if you were standing in the room watching someone sign documents. That is not traditionally part of the bank examination process." Even as the OCC and other federal regulators were failing in recent years to detect flawed foreclosure practices, evidence was building that abuses were widespread, according to interviews with federal regulators and outside lawyers. It was surfacing in academic studies, court cases, complaints that other regulators brought against mortgage companies, and reports by federal watchdogs.
There was much evidence, for instance, that mortgage servicers - responsible for collecting payment from borrowers and foreclosing when loans default - were charging improper fees and engaging in other questionable practices.
A 2007 study by Kathleen Porter, a University of Iowa law professor, found that servicers often tried to seize people's homes improperly, adding new fees when borrowers wanted to try saving them.
She found that many servicers "lack the required documentation necessary to establish a valid debt." Her findings prompted a hearing by the Senate Judiciary Committee held in May 2008.
Afterward, Sen. Charles Schumer, D-N.Y., who chaired the hearing, concluded that mortgage servicers have "failed to keep even the most basic records to justify their claim."
Meanwhile, the Federal Trade Commission, which traditionally regulates non-bank financial companies, had been receiving complaints from consumers for several years. In 2003, the FTC reached a $40 million settlement with Fairbanks Capital for defrauding borrowers by not crediting them for payments.
Then in 2008, the FTC reached a $28 million settlement with EMC Mortgage, later bought by J.P. Morgan Chase, to resolve complaints about defrauding borrowers and failing to properly keep track of mortgage documents.
Joel Winston, associate director of the division of financial practices at the FTC, said the two cases were a warning sign about the foreclosure industry. "The conclusion could certainly be drawn that the practices at these companies were at best sloppy and in many cases they were deliberately gouging consumers," Winston said.
He said the FTC routinely passed complaints on to banking regulators and often coordinated with them in sorting out which agency had jurisdiction. "It's fair to say that, over this span, there were frequent and regular communications between us and the bank agencies about servicing issues and companies that might be engaged in problematic practices," he said.
The courts also highlighted abuses. In 2008, for instance, a federal judge in Texas sharply criticized Countrywide Financial, later acquired by Bank of America, for hiring lawyers who ignored the rights of borrowers and being part of a "corrosive assembly line culture of practicing law." The Justice Department was a party to the case.
Then, last year, a pair of reports by federal watchdogs highlighted troubles inside the mortgage business that were undercutting efforts by the Obama administration to help distressed borrowers modify their mortgages to avoid foreclosure. The reports, from the Government Accountability Office and the Congressional Oversight Panel for the government bailout of the financial industry, warned that mortgage servicers were understaffed, gave borrowers inaccurate information, failed to track complaints and lost important paperwork.
Some critics say the OCC's failure to effectively regulate the foreclosure operations of banks echoed other oversight failures in the lead-up to the housing crisis. For instance, state officials criticized the OCC for pre-empting local laws that restrict risky lending practices, which could have protected many borrowers against taking on unaffordable loans.
"They were a light-touch regulator all along the way," said Kathleen Keest, a consumer lawyer at the Center for Responsible Lending.
While acknowledging they did not police foreclosure practices, OCC officials defended their oversight of banks' mortgage operations. They cite multiple cases brought against loan servicers in recent years. In an instance where the agency caught a manager allowing legal documents to be improperly signed, the OCC fined her $5,000 and told her not to do it again.
OCC officials said they have put their energies into examining whether banks take steps to help borrowers avoid foreclosure. The agency has sent staff into banks to review their mortgage-modification efforts and instructed the firms to hire more staff. The OCC says banks have complied.
"With the benefit of hindsight, would it have made more sense to look more at the foreclosure process?" said Williams, the OCC official. Without answering her question, she said: "In the context of the need for preventing avoidable foreclosures, we put emphasis on the modification process."