A National Consumer Law Center White Paper, September 2009
Consumer protection in the financial world has been dramatically weakened in the last several years by preemption of state consumer protection laws. Broad preemption of state law is a recent phenomenon; for most of the 150 years since national banks were created, they have complied with state law. Preemption has harmed states’ ability to respond to financial abuses in both the banking and the nonbank world. Restoring the states’ role as “first responders” is an essential element of regulatory reform.
For most of this nation’s history, consumers have depended on states, not the federal government, to protect them. Even in the banking world, national banks were expected to comply with state law. Only in the last decade or so have federally-chartered depositories been able to ignore state laws with impunity.
• From 1864 to 1978, state laws were preempted only if they prevented or significantly interfered with national banks’ exercise of their powers, or the law favored state banks over national banks.
• From 1978 to 1995, preemption of state laws governing interest rates began and laws covering certain mortgage terms were preempted for any lender, including nonbanks.
• From 1996 to the present, national banks have been able to ignore wide swaths of consumer protection laws.
The preemption of state consumer protection laws has harmed consumers. In area after area, abuses have followed preemption.
• Mortgages. The preemption of state laws in the mortgage area is a significant cause of the current crisis. In 2006, the peak year of irresponsible lending, national banks, federal thrifts, and their subsidiaries made 32% of subprime loans, 40% of Alt A loans, and 51% of interest-only and option ARM loans. A total of over $700 billion in risky loans were made by entities that states could not touch. States were also preempted from regulating any mortgage lender on the very terms that made many mortgages dangerous: balloon payments, negative amortization, variable rates, and other nontraditional terms.
• Credit cards. The abuses that eventually led to a federal crackdown – bait and switch rate increases, abusive fees, payment manipulations – were allowed to take off and grow due to preemption.
• Overdraft fees. Federal regulators preempted state laws while watching programs designed to induce overdraft fees grow into a $27 billion tax on the very consumers who need those funds the most.
• Exploding debt, a climate of deception and high rate predatory lending. The explosion of unaffordable debt that has destroyed many families and the growth of destructive forms of predatory lending have their seeds in preemption and the race to the bottom that preemption triggered.
States are our nation’s first responders when new threats target consumers. Restoring their vital role in protecting consumers is a critical piece of regulatory reform.
• Only states provide comprehensive consumer protection. Flexible state laws are critical when gaps in protection or new abuses emerge.
• States see abuses sooner, react more quickly, and can address local problems before they become national ones. States have the tools and the incentives to enforce their laws and can augment federal resources.
• State laws provide the models for federal law. They are an essential element of our constitutional system of federalism.
• Exempting some entities from state laws leads to an uneven playing field and inconsistencies that are easily exploited.
• Preemption allows banks to cherry-pick those parts of state laws they need and ignore consumer protections in other parts of those same laws.
• Preemption undermines our dual banking system.
Contrary to the claims of bank lobbyists, restoring the role of states to protect individuals from banking and mortgage abuses will not impede nationwide commerce.
• When new problems arise, states approaches tend to converge. The uniform law movement and other national organizations promote uniform and model state laws. The uniform mortgage broker licensing laws that 49 states adopted in the past year are a case in point.
• Other nationwide corporations comply with state laws, and banks do in many areas. Banks tailor their products to many niche markets and can adapt to state variations. Minor differences do not prevent banks from marketing a standard product.
• Congress can adopt uniform national rules in particular areas, but state consumer protections should not be cleaved off with a meat-ax wholesale.
The uniformity achieved by preemption comes at a heavy price. States act when there is a problem. We have a choice: we can have uniformly weak protection, or vibrant consumer protection that uses the strengths of our system of federalism.