Wednesday, March 14, 2007



FED, OCC Publicly Chastised Few Lenders During Boom

By Craig Torres and Alison Vekshin

March 14 (Bloomberg) -- The Federal Reserve and the Office of the Comptroller of the Currency took little action in public to police the $2.8 trillion boom in the U.S. mortgage market -- whose bust now risks worsening the housing recession.

The Fed, which is responsible for the stability of the banking system, didn't publicly rebuke any firm for failing to follow up warnings on home-lending practices between 2004 and 2006. The OCC, which supervises 1,793 national banks, took only three public mortgage-related consumer-protection enforcement actions over the same period.

Consumer advocates and former government officials say the regulators, by acting behind the scenes rather than openly advertising the shortcomings of some firms, failed to discipline an industry that loaned too much money to borrowers who couldn't repay it.

Now, more lenders are being forced to shut and foreclosures are rising, threatening to scuttle any chance of an early recovery in housing.

``There was tension between the responsibilities not to mess up some banks' businesses and the responsibility to consumers,'' said Edward Gramlich, a Fed governor from 1997 to 2005 who is writing a book about the mortgage market at the Urban Institute in Washington. The result, he said, is that ``we could have real carnage for low-income borrowers.''

Private Actions

Officials at the Fed and OCC say their examination process was rigorous and resulted in private enforcement and correction of abuses.

The agencies say they aren't allowed to disclose how many non-public actions they took between 2004 and 2006 that were aimed at protecting consumers from home-loan abuses. Private enforcement action ``contains confidential supervisory information,'' said Susan Stawick, a Fed spokeswoman in Washington. The OCC considers the information ``proprietary and confidential,'' said Kevin Mukri, a spokesman in Washington.

``Making sure people understand what they're getting into is very important,'' Fed Chairman Ben S. Bernanke said in Stanford, California, on March 2. ``We've issued several guidances. We hope that they'll be helpful.''

Mortgage delinquencies rose to 4.95 percent in the fourth quarter, the Mortgage Bankers Association said yesterday; that's the highest level since the second quarter of 2003. The trade group said 13.33 percent of ``subprime'' borrowers --those with poor or limited credit histories -- were behind on payments, the highest rate since the third quarter of 2002.

Because borrowers are having difficulty paying in a time of economic expansion and low unemployment, Congress and consumer advocates want to know how regulators allowed lenders to write loans borrowers would never be able to repay.

Prodded by Dodd

After being rebuked for foot-dragging by Senator Christopher Dodd, a Connecticut Democrat who chairs the Senate Banking Committee, federal regulators issued proposed guidelines aimed at subprime lending on March 2.

``We ought to let businesses decide how to price their products,'' said William Isaac, who oversaw the largest rescue of bank depositors in American history as chairman of the Federal Deposit Insurance Corp. from 1978 to 1986. Still, he said, ``if you are putting a whole bunch of teaser loans out there and people aren't going to be able to afford them when they pop up in three years, the government has the responsibility to look into these institutions and say, `What are you going to do?'''

The subprime industry's woes have their roots in the tenure of former Fed Chairman Alan Greenspan. The Greenspan-led Fed collapsed its benchmark rate to 1 percent in 2003 and kept it there for over a year, helping foster a housing bubble.

Philosophically Opposed

At the same time, Greenspan was philosophically opposed to heavy-handed intervention or rule-writing, and favored self- regulation and the primacy of markets. The former chairman declined to comment.

As Wall Street's appetite for high-yielding mortgage bonds drove demand for high-risk loans, lending standards declined. Subprime mortgages almost doubled to $640 billion in 2006 from $332 billion in 2003, according to the newsletter Inside B&C Lending.

In response, the Fed and other regulators issued non- enforceable warnings, advising bankers and federal examiners about best practices in mortgage lending. Agencies issued guidelines defining unfair and deceptive practices in 2004, on home-equity lending in 2005, and on non-traditional mortgages in 2006.

Shared Responsibilities

While the Fed and OCC regulate the largest banks, some responsibilities are shared with three other federal agencies: the FDIC, the Office of Thrift Supervision and the National Credit Union Administration.

Federal bank regulators say their authority is limited to the institutions they oversee and doesn't extend to the state- chartered mortgage brokers that represent a large share of the industry.

Consumer advocates say the Fed has expansive authority and could have stopped abuses. The Truth in Lending Act gives the Fed rule-writing authority over disclosures for consumer credit among all financial institutions. The Home Ownership and Equity Protection Act of 1994 also gave the Fed a role in preventing predatory lending, according to consumer advocates.

In addition, federally regulated banks and Wall Street firms are often the financiers standing behind state-regulated mortgage lenders. New Century Financial Corp., the nation's second-biggest subprime lender, includes Morgan Stanley, Citigroup Inc., and Goldman Sachs Group Inc. -- all regulated by federal agencies -- among its creditors. Gramlich says the Fed should seek an expansion of its authority to supervise mortgage subsidiaries of bank holding companies.

`Systematic Fraud'

``There is no question that mortgage brokers are on the street committing systematic fraud on the American homeowner,'' said Irv Ackelsberg, a Philadelphia attorney who testified at a Fed hearing last year in the city. He said there is a ``lack of will'' on the part of the Fed to use its power to stop abuses.

Fed officials defend their approach, saying that over- zealous regulation might cut off credit to people who need it most.

``There is going to be a fraction of people that get the wrong product and that is regrettable,'' Richmond Fed President Jeffrey Lacker said in an interview. ``Should we do something to limit that probability? Well, we could, but it would also limit credit to people for whom that is the right product.''

Fed and OCC officials say their routine bank examinations, which aren't disclosed, have enabled them to intercept trouble as they find it. Together, the organizations oversee financial institutions with more than $8.2 trillion in assets.

`Process Is Working'

``The problem is normally addressed through non-public supervisory and informal actions, and only rarely reaches the point where a formal action is necessary,'' said the OCC's Mukri. ``In fact, the relatively low number of formal actions is an indication that the supervisory process is working.''

The Fed's Stawick said the central bank ``has in place a rigorous supervision and examination program and routinely examines the institutions it supervises for compliance with all consumer protection requirements.''

While no enforcement actions resulting from the Fed's consumer-loan guidelines have been disclosed, ``non-public action has been taken,'' Stawick added.

Total OCC enforcement actions against banks, both public and private and omitting so-called affiliated parties, averaged 81 a year between 2004 and 2006. Fed banks completed 102 non- public enforcement actions in 2004 and 95 in 2005, including those against affiliated parties. Data for 2006 aren't yet available.

The Right to a Remedy

Critics say the regulators' private responses harm consumers by depriving them of information they might need to take action on their own behalf. ``Borrowers hurt by an abusive practice have the right to a remedy,'' said Alys Cohen, a staff attorney at the National Consumer Law Center in Washington.

The Fed has published some large enforcement orders. CitiFinancial Credit Company of Baltimore, a subsidiary of Citigroup Inc., paid a fine and restitution to customers that totaled $70 million or more under a 2004 order, according to the Fed. The disciplinary action was related to home and personal lending between 2000 and 2001, prior to the mid-decade surge in mortgage lending.

Fed officials last year held lengthy hearings on home lending in four cities, where they were warned about predatory lending and given specific examples of abuses by witnesses.

One witness at a June 9 hearing in Philadelphia was Ackelsberg, who received a 2001 award from that city's bar association for his work for the public interest.

`Fundamentally Broken'

Ackelsberg told former Fed Governor Mark Olson and Consumer Affairs Director Sandra Braunstein that the subprime market was ``fundamentally broken,'' and presented an example of a loan that left a Social Security recipient with about $10 a day to live on after she paid her mortgage.

He and other critics say the lack of public action is symptomatic of a too-cozy relationship between the overseers and the overseen, with consumers and the U.S. economy paying the price. ``We have regulators almost competing with one another to be clients of the industry,'' said David Berenbaum, executive vice president for the National Community Reinvestment Coalition in Washington ``What we need is for regulators to be competing to offer consumer protection.''

To contact the reporters on this story: Craig Torres in Washington at ; Alison Vekshin in Washington at .

Last Updated: March 14, 2007 11:06 EDT



Four to Blame for the Subprime Mess
By Doug Kass
Street Insight Contributor

3/14/2007 10:38 AM EDT

There are four main culprits responsible for the expanding subprime debacle that threatens to upset the 'Goldlicks' scenario so many are trumpeting. I've listed them in descending order of importance -- and ranked by school grade!:

Culprit #1:
Former Federal Reserve Chairman Alan Greenspan was no smarter than a fifth grader. Greenspan did two big things wrong. First, the former Fed chairman took interest rates far too low and maintained those levels for far too long a period in the early 2000s, well after the stock market's bubble was pierced. (Stated simply, he panicked).

The Fed's very loose monetary policy served to encourage the new, marginal and non-traditional home buyer -- the speculator and the investor, not the dweller -- to embark on a speculative orgy in home purchases not seen in nearly a century. Over time, home prices, especially on the coasts, were elevated to levels that stretched affordability well beyond the means of most buyers. Ultimately, despite relatively strong employment and low interest rates, the residential housing market crashed hard.

Second, Greenpsan suggested -- at just the wrong time and at the very bottom of the interest rate cycle -- that homeowners retreat from traditional, fixed rate mortgages and turn to more creative and floating rate mortgages -- interest only, adjustable option ARMs, negative amortization, etc. He said this in February 2004 at a Credit Union National Association 2004 Governmental Affairs Conference: "American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest-rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home." One year later Greenspan continued the same mantra and cited the social benefits of the financial industry's innovation as reflected in the proliferation of the subprime mortage market.
A brief look back at the evolution of the consumer finance market reveals that the financial services industry has long been competitive, innovative, and resilient. Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. Such developments are representative of the market responses that have driven the financial services industry throughout the history of our country. With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. The widespread adoption of these models has reduced the costs of evaluating the creditworthiness of borrowers, and in competitive markets cost reductions tend to be passed through to borrowers. Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending; indeed, today subprime mortgages account for roughly 10% of the number of all mortgages outstanding, up from just 1% or 2% in the early 1990s...We must conclude that innovation and structural change in the financial services industry has been critical in providing expanded access to credit for the vast majority of consumers, including those of limited means. Without these forces, it would have been impossible for lower-income consumers to have the degree of access to credit markets that they now have. This fact underscores the importance of our roles as policymakers, researchers, bankers, and consumer advocates in fostering constructive innovation that is both responsive to market demand and beneficial to consumers.
But even as Greenspan was taking interest rates to levels that encouraged the egregious use of mortgage debt and exhorting the opportunities in creative and variable mortgage financing, there were some smart cookies out there who recognized the risks; here are quotes from two of the smartest who warned of the danger in the mortgage market.
When I took economics in World War II, and we were studying the Great Depression, one of the reasons given were all the interest-only loans that came due. They were an indication of an economy getting into unsound lending. Ever since then it's been a rule that when you go into interest-only loans, you're very substantially increasing the risk of default. -- L. William Seidman. Former Chairman of the Federel Deposit Insurance Corporation and Chairman of the Resolution Trust Corporation
Our own Robert Marcin put it even more precisely (and vividly) in his prescient warning back in mid-2005.
If Greenspan had a clue (remember, he didn't have one in the tech bubble, or maybe he did), he would jawbone the banking industry to tighten or even strangle lending standards for residential real estate. He should not kill the entire economy to slow the real estate markets. Now that bag people can buy condos in Phoenix with no down payments, maybe the Fed should get involved. You can't expect mortgage bankers to do anything; they get paid to lend money. But like Greenspan's unwillingness to raise margin rates in 1999, I expect him to do nothing until the market declines. Then, the taxpayers will be on the hook for the stupidities of the real estate speculators. Remember, I expect a sequel to the RTC in the future. -- Robert Marcin, Making Money Before Housing Crumbles.
Greenspan will go untouched and will continue to give speeches at $200,000 a pop.

Culprit #2:
Irrational lenders like Novastar, New Century, Fremont General, Option One, Accredited Home, OwnIt Mortgage Solutions and others were no smarter than a sixth grader. Many of these mono-line subprime lenders grew from nothing to originating billions of dollars of mortgage loans almost overnight. Their rush to lend and helter skelter growth relied on the candor of the mortgagees and not on common sense, prudent lending or reasonable underwriting standards. The growth in subprime-only originators was irrational, but the industry will now be rationalized and the marginal lenders will go bankrupt. And, in the fullness of time, the more diversified lenders will benefit from their demise.

Culprit #3:
Wall Street was no smarter than a seventh grader. The role of the brokerage community in the packaging, warehousing and trading of mortgage securities is immense, with about a 60% share of the mortgage financing market. After tax shelter abuses in the early 1980s, junk(y) bonds in the late 1980s, overpriced technology stocks and ludicrous IPOs and disingenuous research reports in the late 1990s, one would think that Wall Street had learned its lesson. It has not. Defending the indefensible -- despite the "policing" of the SEC and Gov. Spitzer's initiatives -- remains Wall Street's credo. Time and time again, the major brokerage firms exist for the purpose of selling product (stocks and bonds), not for providing objective research or for the commitment to client's profitability. The higher a market surges, the easier it is for Wall Street to peddle, and package, junk. The magnitude of the potential gains are always too attractive and tempting particularly as product demand swells into another cycle excess, as it did in subprime. Astonishingly, even the obligatory emergency conference calls intended to persuade investors that all is well were superficial and failed to disclose the inherent conflicts that each and every multiline brokerage has. The major brokerages will be litigated against -- again. They will pay large fines but will proceed in business until the next bubble -- which they will also capitalize on.

Culprit #4:
The rating agencies were no smarter than an eighth grader . The little-known secret in the subprime market is that the principal ratings agencies have been lax in their downgrades of subprime paper and securitizations. This should not be considered a surprise, because like their Wall Street brethren, they prosper from the rising tide of credit issuances. In doing so, like a teacher who has turned his back on a boisterous and disobedient class, those recalcitrant agencies -- Moody's, Fitch and S&P -- have ignored the erosion in credit quality and abetted the rush and market share taking of subprime lending. According to Jim Grant's Interest Rate Observer, downgrades at Moody's were even with upgrades in 2005. In 2006, downgrades/upgrades rose slightly to 1.19 to 1; this compares to the historical downgrade/upgrade ratio of 2.5 to 1. Importantly, until downgrades are issued by the agencies, investors routinely carry their investments at cost, or par -- downgrades force investments to mark to market ... and sell. The rating agencies will likely go unscathed because they always do.
Programming note: I discussed the "four culprits" and my broader view of the subprime debacle on Aaron Task's Real Story podcast last night.

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