http://www.nytimes.com/2007/12/18/business/18subprime.html?_r=2&pagewanted=print&oref=slogin
The New York Times
December 18, 2007
By EDMUND L. ANDREWS
WASHINGTON — Until the boom in subprime mortgages turned
into a national nightmare this summer, the few people who tried to warn federal
banking officials might as well have been talking to themselves.
Edward M. Gramlich, a Federal Reserve governor who died in
September, warned nearly seven years ago that a fast-growing new breed of
lenders was luring many people into risky mortgages they could not afford.
But when Mr. Gramlich privately urged Fed examiners to
investigate mortgage lenders affiliated with national banks, he was rebuffed by
Alan Greenspan, the Fed chairman.
In 2001, a senior Treasury official, Sheila C. Bair, tried
to persuade subprime lenders to adopt a code of “best practices” and to let
outside monitors verify their compliance. None of the lenders would agree to
the monitors, and many rejected the code itself. Even those who did adopt those
practices, Ms. Bair recalled recently, soon let them slip.
And leaders of a housing advocacy group in California,
meeting with Mr. Greenspan in 2004, warned that deception was increasing and
unscrupulous practices were spreading.
John C. Gamboa and Robert L. Gnaizda of the Greenlining
Institute implored Mr. Greenspan to use his bully pulpit and press for a
voluntary code of conduct.
“He never gave us a good reason, but he didn’t want to do
it,” Mr. Gnaizda said last week. “He just wasn’t interested.”
Today, as the mortgage crisis of 2007 worsens and threatens
to tip the economy into a recession, many are asking: where was Washington?
An examination of regulatory decisions shows that the
Federal Reserve and other agencies waited until it was too late before trying
to tame the industry’s excesses. Both the Fed and the Bush administration
placed a higher priority on promoting “financial innovation” and what President
Bush has called the “ownership society.”
On top of that, many Fed officials counted on the housing
boom to prop up the economy after the stock market collapsed in 2000.
Mr. Greenspan, in an interview, vigorously defended his
actions, saying the Fed was poorly equipped to investigate deceptive lending
and that it was not to blame for the housing bubble and bust.
On Tuesday, under a new chairman, the Federal Reserve will
try to make up for lost ground by proposing new restrictions on subprime
mortgages, invoking its authority under the 13-year-old Home Ownership Equity
and Protection Act. Fed officials are expected to demand that lenders document
a person’s income and ability to repay the loan, and they may well restrict
practices that make it hard for borrowers to see hidden fees or refinance with
cheaper mortgages.
It is an action that people like Mr. Gramlich and Ms. Bair
advocated for years with little success. But it will have little impact on many
existing subprime lenders, because most have either gone out of business or
stopped making subprime loans months ago.
Before this year, officials here enthusiastically praised
subprime lenders for helping millions of families buy homes for the first time.
“I was aware that the loosening of mortgage credit terms for subprime borrowers
increased financial risk,” Mr. Greenspan wrote in his recent memoir, “The Age
of Turbulence: Adventures in a New World.” “But I believed then, as now, that
the benefits of broadened home ownership are worth the risk.”
As housing prices soared in what became a speculative
bubble, Fed officials took comfort that foreclosure rates on subprime mortgages
remained relatively low. But neither the Fed nor any other regulatory agency in
Washington examined what might happen if housing prices flattened out or
declined.
Had officials bothered to look, frightening clues of the
coming crisis were available. The Center for Responsible Lending, a nonprofit
group based in North Carolina, analyzed records from across the country and
found that default rates on subprime loans soared to 20 percent in cities where
home prices stopped rising or started to fall.
“The Federal Reserve could have stopped this problem dead in
its tracks,” said Martin Eakes, chief executive of the center. “If the Fed had
done its job, we would not have had the abusive lending and we would not have a
foreclosure crisis in virtually every community across America.”
Mr. Greenspan, hailed as perhaps the best central banker in
history when he left the Fed in early 2006, is now feeling defensive. In an
extensive interview last week, he adamantly disputed the assertion that he
could have prevented the mortgage bust.
The housing bubble, he said, had far less to do with the
Fed’s policy on interest rates than on a global surplus in savings that drove
down interest rates and pushed up housing prices in countries around the world.
As for his role as a regulator, Mr. Greenspan argued that
the Fed was ill-suited to investigate deceptive lending practices.
“I got the impression that there were a lot of very
questionable practices going on,” he said. “The problem has always been, what
basically does the law mean when it says deceptive and unfair practices?
Deceptive and unfair practices may seem straightforward, except when you try to
determine by what standard.”
Mr. Greenspan also contended that the Federal Reserve’s
accountants and bank examiners were ill-suited to the job of investigating
fraud.
“It becomes essentially an enforcement action, and the
question is, who are the best enforcers?” he said. “A large enough share of
these cases are fraud, and those are areas that I don’t think accountants are
best able to handle.”
Others are more critical.
“Hindsight is always 20-20, but it’s clear the Fed should
have acted earlier,” said Ms. Bair, who became chairman of the Federal Deposit
Insurance Corporation in 2006. “Financial innovation is great, but you have to
have some basic rules. One of the most basic rules is that a borrower should
have the ability to repay.”
A Booming Industry
Mr. Greenspan and other Fed officials repeatedly dismissed
warnings about a speculative bubble in housing prices. In December 2004, the
New York Fed issued a report bluntly declaring that “no bubble exists.” Mr.
Greenspan predicted several times — incorrectly, it turned out — that housing
declines would be local but almost certainly not nationwide.
The Fed was hardly alone in not pressing to clean up the
mortgage industry. When states like Georgia and North Carolina started to pass
tougher laws against abusive lending practices, the Office of the Comptroller
of the Currency successfully prohibited them from investigating local
subsidiaries of nationally chartered banks.
Virtually every federal bank regulator was loathe to impose
speed limits on a booming industry. But the regulators were also fragmented
among an alphabet soup of agencies with splintered and confusing jurisdictions.
Perhaps the biggest complication was that many mortgage lenders did not fall
under any agency’s authority at all.
Subprime loans carry high interest rates, sometimes as high
as 12 percent, and were designed for people with weak credit records. Unlike
traditional banks and thrifts, which traditionally financed their loans with
deposits, most subprime lenders are financed by investors on Wall Street who
buy packages of loans called mortgage-backed securities.
Starting from a virtual standstill 10 years ago, subprime
lenders became by far the fastest-growing segment of mortgage lending before
they collapsed. They made $540 billion in mortgages by 2004 and $625 billion at
their peak in 2006 — about one-quarter of all new mortgages.
Mr. Gramlich, a Democratic appointee to the Federal Reserve
who had spent much of his career studying problems of poverty, saw both great
benefits and great perils in the new industry.
As head of the Fed’s Committee on Consumer and Community
Affairs from 1997 to 2005, he agreed that subprime lending had opened new doors
to people with low incomes or poor credit histories. Home ownership, which had
hovered around 64 percent for years, climbed to almost 70 percent by 2005. The
biggest gains were among blacks and Hispanics, groups that had suffered
discrimination for decades.
What alarmed Mr. Gramlich was that many subprime loans were
extremely complicated and loaded with hidden risks.
Borrowers were being qualified for loans based on low
initial teaser rates, rather than the much higher rates they would have to pay
after a year or two. Many of the loans came with big fees that were hidden in
the overall interest rate. And many had prepayment penalties that effectively
blocked people from getting cheaper loans for two years or longer.
“Why are the most risky loan products sold to the least
sophisticated borrowers?” Mr. Gramlich asked in a speech he prepared last
August for the Fed’s symposium in Jackson Hole, Wyo. “The question answers
itself — the least sophisticated borrowers are probably duped into taking these
products.”
Turning Away a Bigger Role
In 2000, Mr. Gramlich privately urged the Fed chairman to
send examiners into the mortgage-lending affiliates of nationally chartered
banks. Many of them, like Bank of America’s affiliate, had already come under
fire from state regulators and consumer groups. Fed examiners, Mr. Gramlich
argued, could clean up those practices from the inside.
Mr. Greenspan was against the idea. In an interview last
week, he said he feared that Fed examiners would fail to spot deceptive
practices and inadvertently give dubious lenders what amounted to a government
seal of approval.
“I remember telling him, ‘be careful,’ ” Mr. Greenspan said.
If the Fed gave the appearance that it was overseeing thousands of local
institutions, which he said it did not have the resources to do, “we’re going
to end up with a situation that very well could be worse rather than better.”
To be sure, some of the speculative excesses of the housing
bubble and the subsequent bust were driven by broader forces.
The Fed helped stoke the housing market by slashing
short-term interest rates from 2000 to 2004. The rate cuts drastically reduced
the effective cost of buying a house, which added more fuel to what was already
a powerful housing boom.
In addition, foreign investors were pouring trillions of
dollars into American securities. Much of that money, often described as the
“global savings glut,” flowed directly into mortgage-backed securities that
were used to finance subprime mortgages.
But by 2005, federal banking regulators were beginning to
worry that mortgage lenders were running amok with exotic and often inscrutable
new products.
The agencies, however, were like a Rube Goldberg machine
with parts moving in different directions. The Office of the Comptroller of the
Currency was in charge of nationally chartered banks and their subsidiaries.
The Federal Reserve covered affiliates of nationally chartered banks. The
Office of Thrift Supervision oversaw savings institutions. The Federal Deposit
Insurance Corporation insured deposits of both state-chartered and nationally
chartered banks.
Because each agency receives its funding from fees paid by
the banks or thrifts they regulate, critics have long argued that they often
treat the institutions they regulate as constituents to be protected. All of
them are wary about stifling new financial services.
Ms. Bair was an exception, especially for the
deregulation-minded Bush administration. As a former assistant secretary of the
Treasury in 2001 and 2002, she had worked with Mr. Gramlich to raise concerns
about abusive lending practices. Indeed, she tried to hammer out an agreement
with mortgage lenders and consumer groups over a tough set of “best practices”
that would have covered subprime mortgages.
But that effort largely stalled because of disagreement.
Though some big lenders did endorse a broad code of conduct, she recalled, they
soon began loosening standards as competition intensified.
The drop in lending standards became unmistakable in 2004,
as lenders approved a flood of shaky new products: “stated-income” loans, which
do not require borrowers to document their incomes; “piggyback” loans, which
allow people to buy a home without making a down payment; and “option ARMs,”
which allowed people to make less than the minimum payment but added the unpaid
amount to their total mortgage.
Fed officials noticed the drop in standards as well. The
Fed’s survey of bank lenders showed a steep plunge in standards that began in
2004 and continued until the housing boom fizzled in 2006.
But the regulators found themselves hopelessly behind the
fast-changing practices of lenders. In a bid to set new standards for exotic
mortgages, the agencies waited until December 2005 to propose a “guidance” to
banks and thrifts. They did not agree on the final standard until September
2006.
Standards for Lenders
But the real shock to consumer groups — and even to some of
the regulators — was that the new underwriting standards did not apply to
subprime loans. Instead, they applied to only a fairly narrow array of exotic
mortgages like “option ARMs.”
“The gaping hole was that it would only apply to
nontraditional mortgages,” Ms. Bair said. But the exotic mortgages were already
fading from the market, in part because of bad publicity. Subprime lending, by
contrast, was still booming and represented a much bigger business.
“We hadn’t really focused on that,” said John C. Dugan,
Comptroller of the Currency, who had pushed hard for the new guidance. “From
our own perspective of national banks, it was really a smaller part of our
universe.”
It was not until March 2007 that the group of regulators
proposed yet another “guidance,” this one to address standards for subprime
lending. But those standards were not finished until June 29. By that time,
more than 30 subprime lenders had gone out of business and many more were
headed that way.
Several people familiar with the regulatory deliberations
said the delays stemmed in part from intense resistance among some policy
makers to challenging subprime lenders.
“I had concerns, I really had concerns,” acknowledged Mr.
Dugan, adding that he became convinced after listening to enough public comment
on the issue.
In the end, any concerns for the industry quickly became
moot. Less than two months after the new standards were issued, the subprime
industry was essentially dead.
Ben S. Bernanke, who succeeded Mr. Greenspan as Fed
chairman, is now scrambling to head off a recession. Last week, the Fed lowered
its benchmark interest rate for the third time since August, and officials now
worry that the subprime crisis has inflicted deep damage on credit markets that
could in turn derail the entire economy.
Gretchen Morgenson contributed reporting from New York.
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