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Agencies failed to rein in subprime lending

WASHINGTON — Anyone looking to point a finger of blame for the meltdown in the subprime mortgage market may need more than two hands. It took the action, and the inaction, of many players to produce today's mess, which threatens to slow the U.S. economy further.

"Everyone has a share in the blame—lenders, borrowers, regulators, investors. There were a lot of mistakes, and everyone made them," said Mark Zandi, the chief economist for Moody's, a consultancy in West Chester, Pa.

The federal government arguably failed most of all. It shirked its responsibility to regulate this critical area of home finance—much as it had during the savings-and-loan crisis of the 1980s. At least nine federal agencies oversee some portion of the mortgage market, and over the past three years nearly all of them issued warnings about risky loan terms.

But not one of them—or Congress—moved to regulate non-bank lenders and mortgage brokers. Both fall through the cracks of direct federal regulation. Together, they originate more than half of all "subprime" loans to borrowers with weak credit histories, according to the Federal Reserve. They also account for 80 percent of the adjustable-rate, subprime mortgages that are the heart of today's problems.

Why didn't regulators act more forcefully?

When times are good, regulators are wary of taking away the punch bowl. During the housing boom of 2001-2005, President Bush talked up soaring home sales to tout his vision of an "ownership society."

Home sales buoyed an economy that was rocked by the dot-com bust, but regulators knew that problems were brewing in the subprime mortgage market, much as they had in the earlier S&L crisis. Still, they watched as the sector slowly crumbled into financial disaster because it was something of a sideshow. The main imperative was to keep the economy growing.

"We knew there was excessive use of adjustable (mortgage) rates. That was a time when the Fed had interest rates very low, for good macroeconomic reason, but it made everyone vulnerable to this problem" that we have today, said Edward Gramlich, a Federal Reserve governor from 1997 to 2005 and the author of the forthcoming book "Subprime Mortgages: America's Latest Boom and Bust."

With lending rates low and home prices soaring in 2004 and 2005, many borrowers took on heavy risks, some gambling that home prices would keep climbing and that interest rates would remain low.

But in June 2004, the Fed began 17 consecutive quarter-point interest rate increases over two years, bringing its benchmark rate up to the current 5.25 percent from 1 percent. For many consumers, adjustable rates rose, and borrowers saw their monthly mortgage payments jump by 30 percent or more.

Today, about 14 percent of subprime loans are delinquent. Industry research shows that another 2 million adjustable-rate loans will reset this year and next, which could cause delinquency and foreclosure rates to soar.

Concerns about the subprime market and bad weather combined in March to spark the biggest monthly drop in existing home sales in 18 years. The National Association of Realtors said Tuesday that March sales slumped 8.4 percent over February figures.

Subprime loans make up 15 percent of the mortgage market, which limits their damage to the broader economy. But similar mortgage delinquency problems also are emerging among borrowers with better credit. Nervous lenders are tightening credit defensively, further delaying the recovery of the moribund housing market.

During the housing boom, global investment banks such as HSBC snapped up non-bank lenders such as Household International, a large mortgage-issuing finance company that specializes in the subprime market. It wasn't subject to federal banking supervision, either.

These non-bank lenders and mortgage brokers began issuing large numbers of risky and exotic adjustable-rate loans with low teaser rates, as well as so-called "liar loans," which asked borrowers their income but rarely verified it.

Federal regulators did little but issue warnings.

Since 2003, the federal regulators that oversee banks, savings and loans institutions and credit unions all warned about loose lending standards and risky loans. The regulators include the Federal Deposit Insurance Corp., the Treasury Department's Office of the Comptroller of the Currency and the Office of Thrift Supervision.

But none of them suggested that they be granted powers to regulate mortgage brokers, which today are subject only to a patchwork of state regulations and no national licensing or standards. Nor did anyone seek to regulate non-bank lenders, which increasingly are bankrolled by Wall Street. That left plenty of room for predatory lending and looser standards.

In short, there was a gaping hole in the regulatory net, but no one tried to mend it. Not the regulators. Not the Bush administration. Not the Congress.

Today, as defaults rise, major subprime lenders such as New Century Financial, the second largest unregulated non-bank lender, are racing each other into bankruptcy. At least 21 non-bank lenders have filed for bankruptcy protection or shut down since early last year. And the stocks of investment banks with large subprime holdings, such as Merrill Lynch and HSBC, are taking a hit as mortgage defaults and foreclosures climb.

"It's hard to blame the regulators for most of this, because these guys like New Century and other outfits in trouble are unregulated," said Robert Litan, an expert on federal regulation at the Brookings Institution, a liberal think tank in Washington.

Former Federal Reserve Governor Gramlich rejects some Democrats' criticism that former Fed Chairman Alan Greenspan failed to issue strong enough warnings about new exotic loans that were designed to get more Americans into the Republicans' "ownership society".

"We have a structural flaw in the system, and lenders and borrowers took advantage of this, and people got whacked," Gramlich said. He blamed Congress, which the Republicans controlled until January. "Most of the fixes are, and have been all along, measures that could only be changed by legislation."

The Republican-led Congress didn't much believe in federal regulation. It believed in free markets, and there was big money in subprime loans.

Questionable lending flourished in part because unregulated lenders resell risky loans to the secondary mortgage market. The loans are bundled together for sale as bonds, called mortgage-backed securities. The process—called securitization—helped many Americans get into their first homes. But where there were weak lending standards, it pushed the problems farther up the investment chain.

Traditionally, this bundling of loans for sale was done by two congressionally mandated public corporations—the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan and Mortgage Corp. (Freddie Mac).

That started changing in 2003. By 2005, so-called private-label mortgage-backed securities—those offered by private entities—surpassed Fannie Mae and Freddie Mac as the top issuers of these debt instruments.

The ultra-wealthy, private equity firms and hedge funds—unregulated pools of capital—snapped up the mortgage bonds because some had returns more than 10 times higher than Treasury bills. Last year, the subprime mortgage bonds market exceeded $540 billion, according to Bear Stearns, the largest packager of these bonds.

Fannie Mae and Freddie Mac are both regulated by the Office of Federal Housing Enterprise Oversight, but there's no regulation of private-label issuances. They're subject only to the general disclosure rules of the Securities and Exchange Commission, like any corporation issuing stock or corporate bonds.

The Congress had no appetite for regulating them, either. Senate Republicans last year quashed a bipartisan measure that had passed the House of Representatives overwhelmingly. It would've empowered the Federal Housing Administration (FHA) to compete for loans to the same population sought by subprime lenders. GOP senators thought the growing subprime market could better serve those lower- and middle-income people.

At an April 17 House Financial Services Committee hearing into the mortgage industry's problems, Assistant Housing and Urban Development Secretary Brian D. Montgomery reminded lawmakers that he'd warned them in May 2005 that a stronger FHA could keep many Americans out of troubling subprime mortgages.

"The rise in subprime foreclosures is far from a surprise to most people in this room," Montgomery said.

Now that the boom is over, some mortgage brokers welcome the call for regulation.

"I don't think there is enough scrutiny of our world," admitted Kristofer Webb, a mortgage broker in Annapolis, Md. He said he was shocked by the amount of abusive lending to uneducated borrowers during the housing boom. "It's very simple for a broker to back clients into a corner where they don't see any way out."


If you have a subprime mortgage that you can't afford, there is some help available. The Federal Reserve has directed banks and other lenders to work with homeowners to avoid foreclosure. If your lender is not being helpful in restructuring your loan, here are some other options.

_ Contact the Federal Housing Administration. It keeps a list of non-profit counseling agencies that provide advice before and after you purchase a home. The FHA is trying to help holders of subprime mortgages refinance into fixed-year FHA loans. For more on qualifying requirements, go to the FHA Resource Center at The FHA has set up a customer helpline for individuals seeking to refinance their subprime mortgages: 1-800-CALL-FHA. Also, the Office of the Comptroller of the Currency offers this hotline: 1-800-613-6743.

_ The Federal Home Loan and Mortgage Corp., or Freddie Mac, announced it will purchase an additional $20 billion in fixed rate and hybrid adjustable-rate mortgages to assist lenders restructure loans held by sub-prime borrowers. Freddie Mac's program will be ready by mid-summer. For information, visit

_ The Federal National Mortgage Association also has a hotline to help consumers—1-800-7Fannie. A customer service representative can direct your call to a specialist.

_ If your mortgage was issued by a traditional bank, the Federal Deposit Insurance Corp.'s consumer hotline is 1-877-275-3342.

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