New Y ork TImes February 23, 2008 NEWS ANALYSIS A ‘Moral Hazard’ for a Housing Bailout: Sorting the Victims From Those Who Volunteered By EDMUND L. ANDREWS WASHINGTON — Over the last two decades, few industries have lobbied more ferociously or effectively than banks to get the government out of its business and to obtain freer rein for “financial innovation.” But as losses from bad mortgages and mortgage-backed securities climb past $200 billion, talk among banking executives for an epic government rescue plan is suddenly coming into fashion. A confidential proposal that Bank of America circulated to members of Congress this month provides a stunning glimpse of how quickly the industry has reversed its laissez-faire disdain for second-guessing by the government — now that it is in trouble. The proposal warns that up to $739 billion in mortgages are at “moderate to high risk” of defaulting over the next five years and that millions of families could lose their homes. To prevent that, Bank of America suggested creating a Federal Homeowner Preservation Corporation that would buy up billions of dollars in troubled mortgages at a deep discount, forgive debt above the current market value of the homes and use federal loan guarantees to refinance the borrowers at lower rates. “We believe that any intervention by the federal government will be acceptable only if it is not perceived as a bailout of the bond market,” the financial institution noted. In practice, taxpayers would almost certainly view such a move as a bailout. If lawmakers and the Bush administration agreed to this step, it could be on a scale similar to the government’s $200 billion bailout of the savings and loan industry in the 1990s. The arguments against a bailout are powerful. It would mostly benefit banks and Wall Street firms that earned huge fees by packaging trillions of dollars in risky mortgages, often without documenting the incomes of borrowers and often turning a blind eye to clear fraud by borrowers or mortgage brokers. A rescue would also create a “moral hazard,” many experts contend, by encouraging banks and home buyers to take outsize risks in the future, in the expectation of another government bailout if things go wrong again. If the government pays too much for the mortgages or the market declines even more than it has already, Washington — read, taxpayers — could be stuck with hundreds of billions of dollars in defaulted loans. But a growing number of policy makers and community advocacy activists argue that a government rescue may nonetheless be the most sensible way to avoid a broader disruption of the entire economy. The House Financial Services Committee is working on various options, including a government buyout. The Bush administration may be softening its hostility to a rescue as well. Top officials at the Treasury Department are hoping to meet with industry executives next week to discuss options, according to two executives. “There are a lot of ideas out there,” said Scott Stanzel, a spokesman for President Bush, when asked at a White House press briefing on Friday about a possible buyout program. “There are many different ways in which we can address this problem and we continue to look at ways in which we can do that.” Supporters contend that a government rescue could be the fastest and cleanest way to force banks and investors to book their losses from bad mortgages — a painful but essential first step toward stabilizing the housing market. The government would buy the mortgages at their true current value, perhaps through an auction, at what would probably be a big discount from the original loan amount. The mortgage lenders, or the investors who bought mortgage-backed securities, would be free of the bad loans but would still have to book their losses. If the government took control of the bad mortgages, supporters of a rescue contend, it could restructure the loans on terms that borrowers could meet, keep most of them from losing their homes and avoid an even more catastrophic plunge in housing prices. “Every citizen has a dog in this hunt,” said John Taylor, president of the National Community Reinvestment Coalition, a community advocacy group that has developed its own mortgage buyout plan. “The cost of spending our way out of a recession is something that everybody would have to bear for a very long time.” Mr. Taylor estimated the government might end up buying $80 billion to $100 billion in mortgages. But he said the government could recoup its money if it was able to buy the mortgages at a proper discount, repackage them and sell them on the open market. Surprisingly, the normally free-market Bush administration has expressed interest. Treasury officials confirmed that several senior officials invited Mr. Taylor to present his ideas to them on Feb. 15. Mr. Taylor said he had also received calls from officials at the Office of Thrift Supervision and the Office of the Comptroller of the Currency, which is part of the Treasury Department. But even supporters acknowledge that a government rescue poses risks to taxpayers, who could be left holding a very expensive bag. Ellen Seidman, a former director of the Office of Thrift Supervision and now a senior fellow at the moderate-to-liberal New America Foundation, said the government’s first challenge is to buy mortgages at their true current value. If the government overpaid or became caught by an even further decline in the market value of its mortgages, taxpayers would indeed be bailing out both the industry and imprudent home buyers. “It’s not easy, but it’s not impossible,” Ms. Seidman said. “There are various auction mechanisms, both inside and outside government.” A second challenge would be to start a program quickly enough to prevent the housing and credit markets from spiraling further downward. Industry executives and policy analysts said it would take too long to create an entirely new agency, as Bank of America suggested. But they expressed hope that the government could begin a program from inside an existing agency. But even if the government did buy up millions of mortgages and force mortgage holders to take losses, the biggest problem could still lie ahead: deciding which struggling homeowners should receive breaks on their mortgages. Administration officials have long insisted that they do not want to rescue speculators who took out no-money-down loans to buy and flip condominiums in Miami or Phoenix. And even Democrats like Representative Barney Frank of Massachusetts, chairman of the House Financial Services Committee, have said the government should not help those who borrowed more than they could ever hope to repay. But identifying innocent victims has already proved complicated. The Bush administration’s Hope Now program offers to freeze interest rates for certain borrowers whose subprime mortgages were about to jump to much higher rates. But the eligibility rules are so narrow that some analysts estimate only 3 percent of subprime borrowers will benefit. Bank executives, meanwhile, warn that the mortgage mess is much broader than people with subprime loans. Problems are mounting almost as rapidly in so-called Alt-A mortgages, made to people with good credit scores who did not document their incomes and borrowed far more than normal underwriting standards would allow. Borrowers who overstated their incomes are not likely to get much sympathy. But industry executives and consumer advocates warn that foreclosed homes push down prices in surrounding neighborhoods, and a wave of foreclosures could lead to another, deeper plunge in home prices. Right or wrong, the arguments for rescuing homeowners are likely to be blurred with arguments for rescuing home prices. At that point, industry executives are likely to argue that what is good for Bank of America is good for the rest of America. OC register Wall Street refugee examines mortgage bust February 23rd, 2008 · 3 Comments · posted by Matt Don’t hate Louis Pizante. He worked for a Wall Street firm that made mortgage- backed securities, but he personally never to uched subprime. Still, now seems like a good time to pick his brain on what the heck is going on in Wall Street’s world and where we go from here. Pizante, 37, previously was an associate in the investment banking arm of Greenwich Capital Markets, a bond specialist based in Greenwich and owned by the Royal Bank of Scotland. Before that he worked for New York-based Nomura Asset Capital, Goldman Sachs, and Deloitte & Touche. These days Pizante, who has a law degree from New York University School of Law, is chief of Irvine-based Mavent Inc., a company that automatically checks if home loans comply with more than 300 federal, state and local consumer protection laws. His clients range from Fannie Mae, the largest U.S. funder of home loans, to Wall Street firms such as Citigroup and Morgan Stanley. Pizante gives Mortgage Insider his scorecard on Wall Street winners and losers as well as what regulators should or shouldn’t do next. Q. What do you think of the brouhaha over rating agencies giving investment grade blessings to subprime-related debt that now doesn’t look so investment grade? A. Clearly a great many of those ratings were — to be kind — wide of the mark. Critics point to several problems, including: (1) inherent conflicts of interest because issuers pay the agencies; (2) bad advice because ratings are based on data taken at face value and supplied by issuers; and, (3) oligopolistic inefficiencies because financial regulations require ratings. These are difficult issues to resolve. The agencies have introduced some meaningful, albeit limited, changes to their businesses. But the most practical solution would be an independent standards board with policing authority, similar to the accounting industry. And investors have to do more due diligence themselves. Of course, it may all be moot depending on when the market comes back and what it looks like then. Q. So how do you rate the performance of your former Wall Street investment banking colleagues during the credit boom and bust? A. The writedowns provide a pretty unambiguous scorecard on the Street’s performance. Clearly some institutions — such as Goldman and JP Morgan — get high marks. But others got high on their own supply, holding onto the less marketable classes of mortgage-laced securities. Unquestionably, greed got ahead of good judgment. But lost in all this is that for a while the subprime and securitization markets did provide meaningful liquidity to an underserved borrower segment, increasing homeownership rates nationally. The problem is that the market as a whole, and its regulators, did not exercise responsible checks and oversight. In this light, is levying a wholesale indictment of Wall Street akin to throwing the baby out with the bathwater? Q. What’s your fix for the Wall Street side of this mess? A. Of the many things that can be said about Wall Street, few can disagree that the subprime correction started before the regulators and media became involved. The current rush of investigations and enforcement actions may be warranted. But none of this will prevent what has already happened and its future impact is questionable. The fact is that Wall Street’s present deal flow is slower than a wounded snail towing a tank. We know Wall Street will come back, but it will look and smell a whole lot different. In the meantime, lawmakers need to be careful not to hastily introduce new rules crafted for a market that no longer exists. Q. On the consumer side, what do you think of the government f ixes so far (raising conforming loan limit, getting lenders to extend introductory teaser rates on loans etc.)? Will any of them work? A. These government fixes are well-intentioned. But they don’t look like a very good bargain from the point of view of ta xpayers and responsible consumers. They’re also not very fair to responsible lenders. Raising the conforming loan limit will affect a very small number of neighborhoods. Even then, most borrowers in those neighborhoods still will not qualify for a new loan. Freezing interest or payment rates and retroactively changing bankruptcy rules will ultimately result in higher cost loans. Lawmakers and regulators should focus on enforcing existing consumer protection laws. Several existing laws afford victimized borrowers adequate remedies and protections. Enforcement provides relief to those truly aggrieved borrowers, while forcing those lenders and investors that broke the law to bear the costs. Q. Here are three key fixes suggested by columnist Jonathan Lansner: Let everyone make home loans including Wal-Mart, make brokers and lenders have as much fiduciary responsibility to consumers as stock brokers, and make the income reported by a borrower under a “stated income” loan go automatically to the IRS. What do you think? A. These suggestions are worth consideration. Not surprisingly, the mortgage industry considers “fiduciary duty” the f-word. Brokers who claim to get their clients the best rate are arguably holding themselves out as agents and should have fiduciary obligations accordingly. Imposing fiduciary duties on lenders is a tougher sell. Is it sensible to force one party to a contract to protect the interests of the other party? In any event, fiduciary standards are subjective and fact - sensitive. This makes them difficult to enforce and harder to fulfill. Regarding “low doc” loans, borrowers should be legally required to verify income or assets. If this means that a few truly well off terrorists and drug dealers are unable to obtain financing, so be it. Q. Speaking of the consumer side, consumer activists say California regulators have been too lax in their oversight of lenders and brokers. What do you think? A. Enforcement is a problem for consumers and for mortgage lenders. Lax enforcement creates an uneven playing field that benefits unscrupulous lenders and puts responsible lenders out of business. But to solve the problem it is first important to understand who it is that regulates mortgage institutions. Most mortgage institutions that were engaged in subprime lending are licensed by the state. In California, the Department of Corporations (DOC) had 25 examiners at the peak of the boom to oversee more than 4,800 state-licensed lenders. But some of the largest financial institutions are federally regulated. Wells Fargo, for instance, is a national bank regulated by the Office of the Comptroller of the Currency (OCC). The OCC has 34 examiners assigned to Wells. However, the OCC is primarily concerned with “safety and soundness” not consumer protection. In fact, the OCC has been very aggressive in preempting state consumer protection laws and blocking state attorneys’ general from investigating allegedly systemic fair and predatory lending claims. So, in some cases the enforcement problem is created by resource shortfalls and in others policy decisions. Q. Your statement that the OCC has been very aggressive in preempting state consumer protection laws echoes a recent commentary in the Washington Post by Elliot Spitzer, current governor of New York and former AG there – he basically said the same thing. The Comptroller of the Currency John Dugan responded by saying: “Almost everyone who has paid attention to the subprime lending crisis has concluded that OCC- regulated national banks were not the problem. Instead, the worst abuses came from loans originated by state-licensed mortgage brokers and lenders that are exclusively the responsibility of state regulators.” Dugan said state regulators should have done a better job. So who is right? A. I think that is an interesting story. They are both a little bit right. The national banks were not as aggressive in subprime as state licensed lenders like Ameriquest and New Century. But there were operating subsidiaries of national banks that did engage in some of this lending and national banks did fund the state licensed lenders either by providing warehouse lines or purchasing their loans for securitization. So I do think it’s a little bit of both. Q. Let’s talk more about the federal level. Critics say the Federal Reserve under Alan Greenspan was too ideological. Under his free market ideology, the Fed did not enforce consumer protection power granted to it by the Home Ownership and Equity Protection Act (HOEPA) of 1994, critics say. Your take? A. The criticism that federal regulators did little to restrain lenders and protect consumers when the boom was under way has some merit. But it only goes so far in explaining what went wro ng. The most expansive reading of HOEPA grants the Fed limited authority. It does not address deceptive broker representations or a borrower’s ability to repay. This notwithstanding, there are other federal consumer protection laws aside from HOEPA, such as the broader Truth-In- Lending (of which HOEPA is part), UDAP, RESPA and CRA. The current crisis makes clear that the federal agencies need to do a better job of balancing institutions’ “safety and soundness” with the enforcement of these laws and consumer protection more generally. Stumble it! This entry was posted on Saturday, February 23rd, 2008 at 3:00 am and is filed under Q&A. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site. 3 Responses to “Wall Street refugee examines mortgage bust” 1. mo Says: February 23rd, 2008 at 6:13 am FYI - Stock brokers are NOT held to a fiduciary standard - only Registered Investment Advisers are held to such standards. Google “Merrill Lynch Rule” to find out more.l 2. Neal Says: February 23rd, 2008 at 11:13 am “Don’t hate Louis Pizante. He worked for a Wall Street firm that made mortgage-backed securities, but he personally never touched subprime.” I’ll try not to. I would suggest, however, that the damage from this “situation” exceeds that of 9/11 in both cost and lives. Oh sure, no one has died - but how many lives have been ruined? This is a shameful episode in American history and all involved should be too embarrassed to be interviewed. 3. Rational expectations Says: February 23rd, 2008 at 12:25 pm My ears always prick up when I hear the “baby with the bath water” metaphor. Who put the baby IN the bath water? Where are they now? Any unnecessary damage that is being done now to mortgage bankers is a direct consequence of their stupidity and greed. The sad fact is that there are also externalities. Firms and individuals (our whole society, really) will suffer from this, even though many were not involved. Misguided attempts to help “homeowners keep their homes” are really helping the same entities that caused this disaster. We must do eve rything possible to help people walk away from their homes. This leaves the banks holding the bag (entirely appropriate). It clears the market more quickly, and since most people are not inclined to leave if they have equity or even out of inclination, there is not a huge need to police this. The banks will squeal like stuffed pigs, but as they have been stuffed for years with our money, a little bacon is due. Higher borrowing costs? Do you really think that this isn’t going to happen anyway? It may even draw in some new actors. Small to medium sized banks are looking to re-enter mortgage lending. The closer connection to the community is a good thing. Warren Buffet is opening a bond insurer. He is charging more, but I have yet to see anyone claim that this is bad for business. Making it more expensive to borrow may even encourage borrowers to be a bit more careful, next time. For now, if mortgage bankers suffer, good.