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Crashing the Subprime PartyHow the feds stopped the states from averting the lending mess.

By Nicholas BagleyPosted Thursday, Jan. 24, 2008, at 11:19 PM ET

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That's when the feds came in. Some of the biggest players in the secondary mortgage market are national banks, and the states' efforts to curb predatory lending clashed with the banks' fervent desire to keep the market in subprime loans rolling. And so the national banks turned to the Treasury Department's Office of the Comptroller of the Currency. The OCC is a somewhat conflicted agency: While its primary regulatory responsibility is ensuring the safety and soundness of the national bank system, almost its entire budget comes from fees it imposes on the banks—meaning that its funding depends on keeping them happy. It was unsurprising, then, that the OCC leapt to attention when the national banks asked it to pre-empt the Georgia-like subprime laws on the grounds that they conflicted with federal banking law.

While the banks' legal arguments were thin, the OCC issued regulations in early 2004 nullifying the state laws as they applied to national banks. In part, the OCC reasoned that the states just got it wrong: As the then-comptroller explained in a speech to the Federalist Society, "We know that it's possible to deal effectively with predatory lending without putting impediments in the way of those who provide access to legitimate subprime credit." With the state laws nullified, national banks were free to engage in the sharp practices the states were hoping to stamp out. (Indeed, Georgia scuttled its law because it didn't want to give national banks a competitive advantage over its state institutions.) Facing intense pressure from subprime lenders and Wall Street, and left without a real chance of holding investors responsible for purchasing ill-advised loans, state legislatures gave up.

In retrospect, the OCC's decision looks boneheaded. What the OCC took to be shortsighted consumer-protection laws laden with hidden costs turned out to be prescient market-correcting reforms. It's impossible, of course, to know for sure what might have happened had the OCC stayed its hand. Subprime lenders have lobbied hard against the state laws, and the incipient legislation could have been strangled in its infancy anyway. But the bottom line is that, had the state laws been permitted to go into effect, investors would now be sitting on fewer subprime loans that will never be repaid. The subprime catastrophe might have been more like a mini-crisis.

The feds really should have known better. Yet they ignored a basic principle—that no level of government has a monopoly on good policy—to brush aside state legislatures' thoughtful efforts to protect their citizens from rapacious lenders. As the feds move to clean up the subprime mess, it's worth remembering that they helped create it. Maybe the next time around, they'll remember that sometimes the states know best.

A version of this article also appears in the Washington Post op-ed page.