Saturday, February 16, 2008

MORTGAGES | Where Were the Regulators?

Feb. 17, 2008–Matthew Padilla asked in the Feb. 15, 2008 Orange County Register, "Where Were the Regulators?" He says he started writing on loan delinquencies in June 2006 with a critical profile of Irvine's ECC Capital, which was accused of the now-familiar offense of making loans to borrowers who could not afford them long term (e.g., after the teaser rates expired). It was this issue that state attorneys general raised (and settled) with Ameriquest Mortgage in Orange.

Padilla asks whether it is the government's job to protect consumers from making bad choices. Should the government have cracked down on brokers who pursued bigger commissions by selling consumers loans that were unaffordable over time? He specifically asks whether the Fed should have done more with its 1994 HOEPA consumer protection powers and whether the FDIC moved quickly enough (e.g., on Fremont Investment & Loan). He also asks whether California was too lax and what role California's AG play in getting a 49-state settlement with Ameriquest in 2006.

Comment: Matt has a lot of good questions. With hindsight, the regulators surely should have intervened earlier. But Chairman Greenspan told the Greenlining Institute (as reported by Gretchen Morgenson of the NY Times on December 18) that he didn’t want to interfere with financial innovation. Would Edward Gramlich have taken such a benign view of lax regulation if he were rewriting his article for the Kansas City Fed from today's vantage point? How many of the 12 million homeowners financed by the subprime industry since 1993 will be left owning their homes in 2010 than there would have been if the economy had avoided the excesses of the last few years?

The financial system broke down at both ends of the mortgage process and the weaknesses fed on each other. At the mortgage origination end, rules were not enforced by anyone, and at the securitization end the CDOs appear to have been orphans in the regulatory arena. The ability of the mortgage brokers to engage in predatory lending activity depended on the insatiable demand for mortgage paper, and this demand in turn came from the massive mispricing of collateralized debt obligations that raised yields 1,2,3 while raising risks 1,2,4. Even Milton Friedman accepted that the government has to set the rules of the game – and enforce them.

Fixing the regulatory system may seem like calling in a locksmith after a theft, but after the mortgage lending mess of the 1980s the Office of Thrift Supervision was supposed to have been the cleanup. Obviously the OTS was not enough.

Here are a few ideas for a concerned Senator or an incoming President seeking to clean up the mess: (1) Can the near-bank mortgage lenders and bank-like SIV structures be brought under some kind of regulatory umbrella?
(2) Could the SEC look at new financial products as they come on the market and to evaluate their risk?
(3) Should the FDIC be pricing risk more aggessively in its deposit insurance premiums, and can the Basel II bank capital-adequacy guidelines be introduced ahead of schedule?
(4) Can the Fed raise the profile of its HOEPA activity and beyond that make basic financial education a national priority. How about a comic book (with a cautionary tale about a young couple hornswoggled into borrowing for a house that they can't afford when the teaser rates end) on how to borrow money for your first house?
(5) Where has HUD been on all of this? Anyone who has ever bought or sold a house is familiar with pages in the closing document that warn buyers about closing costs. When did someone with a consumer orientation last take a look at these pages? 2/17/08 John Tepper Marlin, Blogspot, Where Were the Regulators?

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