By Kevin G. Hall | McClatchy Newspapers

WASHINGTON — Amid tightening credit, rising default rates on home loans and concerns that larger investors aren't sufficiently scrutinized, a top Treasury Department official told Congress on Wednesday that his agency is reviewing rules with an eye toward greater regulation of the financial services sector.

Robert K. Steel, Treasury's undersecretary of domestic finance, told the House Financial Services Committee in written remarks that by early next year Treasury would release "a blueprint of structural reforms" to provide broader and more effective regulation.

When grilled by lawmakers, Steel refused to provide details, saying he didn't want to prejudge the internal review by an interagency task force.

"The regulatory structure that we have, through our view, could use a fresh re-look. And that's what we at Treasury plan to do," Steel said. "I can't tell you where that will go. Let's do the work before we have the conclusions."

Steel added that innovation has outpaced regulation, meaning current regulation "is just not attuned as it should be."

Regulation is at the heart of today's financial turmoil. Despite a wide array of federal bank regulators, the standards used by mortgage lenders weakened considerably after 2004. For example, New Century Financial Corp., which wasn't federally regulated and is now bankrupt, underwrote millions of dubious home loans, many with adjustable-rate mortgages to so-called subprime borrowers — those with the weakest credit histories.

Stocks continue to swing wildly as Wall Street frets that worse economic fallout from the housing sector looms. The Dow Jones Industrial Average closed down 143.39 points, or 1.07 percent on Wednesday.

Sheila Bair, the chairman of the Federal Deposit Insurance Corp. (FDIC), which regulates many national banks, testified Wednesday that $353 billion worth of adjustable-rate subprime loans are set to jump to much higher rates between now and the end of 2008, affecting an estimated 1.5 million households.

In an unusual mea culpa, Bair acknowledged in written testimony that regulators saw the mortgage industry changing but, unlike consumer advocacy groups, they "failed to fully appreciate the depth of the underwriting problems and the severity of subprime payment resets until late last year."

Bair and other witnesses suggested that the area ripest for new regulation is securitization, in which banks quickly sell mortgages into a secondary market instead of holding them on their books. Once there, the mortgages are bundled together as bonds, assigned yields commensurate to their risk and sold to investors.

The quasi-government entity Fannie Mae has long promoted home lending with similar financial instruments for mortgages given to borrowers with good credit. But from 2004 to 2006, lending standards weakened in the subprime market, which prompted explosive growth in private-label, or non-agency, mortgage bonds, which weren't regulated as tightly as government-sanctioned bonds.

In 2002, non-traditional or exotic home loans, characterized by paying only the interest or giving the borrower a multitude of payment options, made up only 3 percent of subprime loans that were packaged together in non-agency mortgage bonds. By 2005, said Bair, that number had soared to about 50 percent.

The head of regulation for the U.S. Securities and Exchange Commission, Erik Sirri, told lawmakers on Wednesday that his agency is examining whether bond-rating agencies such as Moody's, Standard & Poor's and Fitch sufficiently disclosed potential conflicts of interest to investors.

Those rating agencies failed to downgrade most housing-related bonds when problems first became apparent. Critics charge that the firms were reluctant to alter their ratings because they were earning lucrative fees from the issuers of the bundled mortgage packages that they were evaluating.

Meanwhile, in the Senate on Wednesday, Banking Committee Chairman Christopher Dodd, D-Ct., proposed his own new regulations. His legislation would:

• Make it illegal for lenders to steer consumers into more costly loans if they qualify for cheaper ones.
• Prohibit prepayment penalties that penalize the poor when they try to refinance out of adjustable-rate loans.
• Stipulate that mortgage brokers, who originated about 70 percent of sub-prime mortgages in recent years, have a fiduciary duty to borrowers. Right now they don't, while real estate agents do.
• Require an analysis of a borrower's ability to pay when adjustable-rate loans reset.