Democrats Seize On Opponents' Role; Bipartisan Failures
As the falling housing market shakes financial institutions and pummels Americans in an election year, the nation's economic woes have surged to the top of voters' minds. The timely question: To what extent are politicians and regulators at fault?
Democrats are quick to blame Republicans, who were in power during the housing bubble and subprime lending frenzy. For years, America's leaders failed to restrain the markets, companies, investors and consumers from the missteps that led to the most pervasive financial crisis in decades.
But in hindsight, the failure stretches across government and across party lines. At bottom are two strong currents. From the Republican president to urban Democratic congressmen, homeownership was pushed as an overriding and unquestioned goal. And many significant attempts at regulation were obstructed by the prevailing belief that the economy did best when financial markets operated as freely as possible.
The Bush administration coupled cheerleading for homeownership with pressure on government-sponsored mortgage lenders Fannie Mae and Freddie Mac to provide funding for riskier mortgages. Both Democrats and Republicans stood by as Fannie and Freddie invested heavily in securities backed by subprime loans. Democratic congressmen pushed a federal law to restrain lending practices later discredited, but Republicans with some Democratic allies blocked or countered with weaker versions.
And at the Federal Reserve, Chairman Alan Greenspan, revered by both parties for his economic management, resisted using the Fed's authority to more aggressively regulate lender behavior.
The blame spreads beyond Washington, to state capitals. In California, home to most of the country's subprime lenders, Democratic state lawmakers didn't support laws that would have imposed tougher regulations on a prized local industry. Politicians of all stripes cheered on the lower interest rates that sparked the boom in housing and excesses in credit.
Now, as Washington scrambles to repair the damage, momentum appears to be swinging back toward a more significant role for government in the American economy. Congressional Democrats have proposed the federal government guarantee up to $400 billion in troubled mortgages if lenders first write down their value. The Bush White House, which opposes the use of public money to bail out borrowers and lenders, is signaling it is open to compromise.
It is impossible to know whether a different approach to housing and financial regulation would have produced a different outcome. As in the 1990s stock-market bubble, many victims began as willing participants seduced by ever-rising prices and easy credit.
One thing is clear. The nation gorged itself on home-buying, something once considered as American as apple pie. "Let's be honest with ourselves," Richard Syron, chief executive of Freddie Mac and a former Carter Treasury and Federal Reserve official, said in December. "We went crazy as a country with the goals...saying, 'Everybody's got to have a house.'"
Below, a look at what went wrong.
Pushing the Dream
As far back as the Civil War, owning a home has been associated with civic virtue and moral behavior. Democratic and Republican administrations alike sought to raise homeownership through subsidies, tax breaks and dedicated agencies.
When George W. Bush took office, that push became a pillar of his "ownership society" campaign. "We want everybody in America to own their own home," Mr. Bush said at a housing conference sponsored by the White House in October 2002. Earlier that year, he issued a "challenge" to lenders and others in the industry: Create 5.5 million new minority homeowners by the end of the decade. In 2003, he signed the American Dream Downpayment Act, creating a program that would offer money to the poor so they could secure a first mortgage.
These challenges came just as the lending industry was finding that subprime loans could be very profitable, at least in the short term. The administration's push also bolstered industry claims that such loans -- made to people with weak credit records -- were answering a vital social need.
Homeownership is "our mission," Angelo Mozilo, chief executive of Countrywide Financial Corp., a giant mortgage lender, said in a February 2003 speech. Citing Mr. Bush's drive, Mr. Mozilo said lenders needed to bring the rate of minority homeownership closer to that of whites. One answer, he said, was to stop requiring sizable down payments from people who couldn't afford them.
Countrywide and other lenders soon were promoting mortgages that allowed subprime borrowers to buy homes with little or no money down. The percentage of subprime borrowers who didn't fully document their income and assets grew from about 17% in early 2000 to 44% in 2006, according to data from First American CoreLogic, a research firm in San Francisco.
Subprime was initially aimed at people with weak credit. But by 2005 and 2006, lenders encouraged many types of better-off borrowers to take such loans, including people with large incomes who wanted to speculate on rental housing. Many subprime loans were made to refinance low-income people who already owned homes, often loading them up with more mortgage debt and creating the risk of foreclosure.
Government-sponsored companies that buy and guarantee mortgages also joined the subprime fray. In 2002, the Bush administration began criticizing the companies, Freddie Mac and Fannie Mae, saying they were "trailing" the rest of the mortgage market in terms of their financing of homes for low-income people and minorities.
To push Fannie and Freddie, the Department of Housing and Urban Development, or HUD, eventually required that a higher percentage of loans they fund go to low-income borrowers. The pair met HUD's requirements partly by buying the AAA-rated portions of mortgage securities created by Wall Street firms and backed by subprime home loans. After the initial low-payment period, many of those loans proved unaffordable to borrowers and are now going into foreclosure.
The homeownership rate, which rose from 65% in early 1996 to a record 69% in 2004, has since fallen below 68% and is almost certain to fall further as foreclosures rise and credit tightens for first-time buyers. Moody's Economy.com forecasts that three million home loans will go into default in the 30 months ending in mid-2009, with about two-thirds of them resulting in foreclosures.
HUD says minority homeownership has increased by about 3.1 million since mid-2002 -- more than two million shy of President Bush's goal. The Bush administration is "proud" of having pushed for more minority homeownership and never favored reckless lending, says Tony Fratto, a White House spokesman.
From the time subprime took off in the mid 1990s, legislators and regulators tried to balance two conflicting goals: increasing low-income families' access to credit and minimizing the potential for abuses by lenders. As home prices soared, tighter curbs usually lost out to a laissez-faire attitude in tune with the ruling Republicans. The result: Congress blocked legislation and the Fed was slow to regulate.
Congress Adrift
In 1999, Democrats, inspired by a groundbreaking antipredatory lending law in North Carolina, sought a federal equivalent. Predatory loans are typically described as those that involve excessive fees and high interest rates. Generally, such abuses occur in the market for subprime loans, those for people with weak credit records or high debt in relation to their income. Republicans, who controlled Congress, blocked the antipredatory legislation, arguing it would interfere with legitimate lending.
"Don't apologize when you make a loan above the prime rate to someone that has a marginal credit rating," Texas Republican Phil Gramm, then chairman of the Senate Banking Committee, told a group of bankers in 2000. "In the name of predatory lending, we could end up denying people with moderate income and limited credit ratings the opportunity to borrow money."
From 2000 on, Democrats continued to introduce bills aimed at safeguarding against alleged predatory lending. In 2005, Rep. Brad Miller of North Carolina and two other Democrats introduced one such bill. Alabama Republican Spencer Bachus, the Republican chairman of a House committee on mortgage lending, was interested in co-sponsoring the bill.
In spring 2006, Mr. Bachus abruptly toughened his stance, in effect killing negotiations, Mr. Miller says. Barney Frank, then a senior Democrat and a co-sponsor of the bill, says while Mr. Bachus was cooperative, the Republican house leadership didn't want any such bill reaching the floor.
Mr. Bachus disputes that the Republican leadership interfered with his efforts, adding: "I was very concerned about the subprime situation." He says Democrats were the ones who toughened their negotiating stance. Mr. Bachus notes that many of his provisions are contained in a bill that the House approved last year.
Fed's Light Touch
Even without congressional intervention, regulators had other tools to address potential abuse. But Alan Greenspan, chairman of the Federal Reserve until 2006, wanted to be sparing in their use.
In 2000, he rejected an informal proposal by then-Fed governor Edward Gramlich that Federal Reserve staffers examine the lending practices not just of banks but of their mortgage affiliates. In 2002, he rejected calls from Democrats to use the Fed's power under the Federal Trade Act to write rules on unfair and deceptive practices.
Mr. Greenspan, in an interview, said examining mortgage affiliates wouldn't have prevented fraud, and would have given shady operators the additional cover of claiming to be Fed-regulated. Regarding the calls from Democrats, he said he and the other governors were following the advice of the Fed's professional staff. More broadly, he said, Congress, not the Fed, was best suited to define "unfair and deceptive" practices and to create legislation to address such lending.
He says he erred in thinking that other investors and market participants would adequately monitor lending standards in the mortgage-backed securities market. "I turned out to be wrong, much to my surprise and chagrin," he said.
Mr. Greenspan and other bank regulators did take some steps to tighten oversight. In 2001, they barred banks from making "loans to borrowers who do not demonstrate the capacity to repay the loan." But that didn't explicitly apply to state-regulated finance companies and mortgage brokers, the entities that originated the majority of subprime loans. Many observers say the Fed also fueled the housing bubble by keeping short-term interest rates low in 2003 and 2004.
The pendulum is now swinging back toward intervention. Mr. Frank last November pushed an aggressive antipredatory lending bill through the House with the cooperation of Republicans. Among other things, the law would hold firms that package mortgages into securities responsible if those mortgages were predatory -- even if someone else, like a mortgage broker, originated them. The Senate has yet to take up the matter.
Rep. Scott Garrett, a New Jersey Republican who actively opposed many antipredatory-lending bills, says earlier action might not have mitigated the subprime crisis. He says innovation in the lending market would have found a way around even an all-encompassing bill. "Just a year ago we were talking about how great it was [that] the highest percentage of Americans ever were in their homes," he says.
A State's Blind Eye
The nation's laissez-faire climate permeated California, where subprime lending soared as home prices outraced incomes. Here, regulatory shortcomings spanned party lines. Republican legislators generally opposed antipredatory lending bills. And Democrats, who controlled the state legislature, didn't want to threaten one of the state's star industries. The state's regulators, meanwhile, were poorly equipped to oversee the booming mortgage industry.
California banks are regulated federally, some jointly with the state's Department of Financial Institutions. But the largest subprime originators were other kinds of institutions: mortgage brokers and finance companies which were overseen by the Department of Real Estate and Department of Corporations, respectively.
The Department of Corporations, which regulates more than 300,000 corporate entities in a wide variety of investment and financial businesses, has long been business friendly. Spokesman Mark Leyes says it has to strike a balance between regulating and facilitating business. "We're the cop, but we're the friendly cop," he says.
Since 2003, the department had been run by a series of interim commissioners. Preston DuFauchard, an assistant general counsel for Bank of America, was appointed and confirmed commissioner in June 2006. That year, companies regulated by the department loaned $252 billion to Californian home buyers.
But the mortgage industry wasn't the top priority. Mr. DuFauchard says his first tasks were to bring securities regulations in line with federal rules and to tackle concerns involving financial scams against senior citizens. Mortgages moved to the top of the list only in early 2007, after a high-profile California lender collapsed.
Armed with 27 examiners for 4,800 consumer-finance companies, including mortgage lenders, the department examined mortgage companies once every four years. The department checked whether these companies charged proper fees to borrowers and kept adequate capital reserves, but it generally wasn't tasked with assessing whether the loans themselves were sound.
In August 2006, the department examined Irvine, Calif.-based New Century Financial Corp., one of the biggest subprime lenders, and found no violation of state laws. What the examiners missed, because it wasn't technically their mandate to look, was the rapid corrosion of loan quality that would force New Century out of business seven months later.
That same month, the department notified Ownit Mortgage Solutions, Agoura Hills, Calif., another big subprime lender, that it was four months late filing its 2005 audit report and levied a $1,000 fine. In December 2006, unable to honor commitments to repurchase defaulting mortgages from investors, Ownit ceased all lending and filed for bankruptcy protection. Only nine months after that did the Department revoked its license.
"The Department of Corporations effectively fulfilled our obligations as state regulator of both" New Century and Ownit, says spokesman Mr. Leyes.
In January 2007, Democratic State Sen. Michael Machado pressed Mr. DuFauchard, the Department of Corporations commissioner, to adopt tougher federal guidelines for state lenders. Mr. DuFauchard began the process of approving the rules, but cautioned it could take months. Enforcing them "may be a bigger pill than the Department of Corporations can swallow with existing resources," he told the state senate banking committee.
Last summer, after soaring defaults ended the most questionable practices, the department swung into action. Mr. DuFauchard said the federal guidelines would apply to state lenders effective January 2008. He also initiated talks that led to mortgage-servicing companies agreeing to extend some initial interest rates to protect some homeowners from defaulting.
The department has added seven examiners while the number of mortgage lenders it oversees has shrunk by more than 100. It also has broader scope to audit licensees. Under a new state law, subprime and nontraditional mortgage lenders must evaluate a borrower's ability to repay the loan over its full life, not just during the period of introductory fixed interest rates. The state legislature had blocked such a provision back in 2001.
By: Greg Ip, James Hagerty, & Jonathan Karp
Wall Street Journal; February 27, 2008
