US Diluted Loan Rules Before Crash
WASHINGTON - The Bush administration backed off proposed crackdowns on
no-money-down, interest-only mortgages years before the economy
collapsed, buckling to pressure from some of the same banks that have
now failed. It ignored remarkably prescient warnings that foretold the
financial meltdown, according to an Associated Press review of
"Expect fallout, expect foreclosures, expect horror stories,"
California mortgage lender Paris Welch wrote to U.S. regulators in
January 2006, about one year before the housing implosion cost her a
Bowing to aggressive lobbying - along with assurances from banks that
the troubled mortgages were OK - regulators delayed action for nearly
one year. By the time new rules were released late in 2006, the
toughest of the proposed provisions were gone and the meltdown was
"These mortgages have been considered more safe and sound for portfolio
lenders than many fixed rate mortgages," David Schneider, home loan
president of Washington Mutual, told federal regulators in early 2006.
Two years later, WaMu became the largest bank failure in U.S. history.
The administration's blind eye to the impending crisis is emblematic of
its governing philosophy, which trusted market forces and discounted
the value of government intervention in the economy. Its belief
ironically has ushered in the most massive government intervention
since the 1930s.
Many of the banks that fought to undermine the proposals by some
regulators are now either out of business or accepting billions in
federal aid to recover from a mortgage crisis they insisted would never
come. Many executives remain in high-paying jobs, even after their
assurances were proved false.
In 2005, faced with ominous signs the housing market was in jeopardy,
bank regulators proposed new guidelines for banks writing risky loans.
Today, in the midst of the worst housing recession in a generation, the
proposal reads like a list of what-ifs:
-Regulators told bankers exotic mortgages were often inappropriate for buyers with bad credit.
-Banks would have been required to increase efforts to verify that buyers actually had jobs and could afford houses.
-Regulators proposed a cap on risky mortgages so a string of defaults wouldn't be crippling.
-Banks that bundled and sold mortgages were told to be sure investors knew exactly what they were buying.
-Regulators urged banks to help buyers make responsible decisions and
clearly advise them that interest rates might skyrocket and huge
payments might be due sooner than expected.
Those proposals all were stripped from the final rules. None required congressional approval or the president's signature.
"In hindsight, it was spot on," said Jeffrey Brown, a former top
official at the Office of Comptroller of the Currency, one of the first
agencies to raise concerns about risky lending.
Federal regulators were especially concerned about mortgages known as
"option ARMs," which allow borrowers to make payments so low that
mortgage debt actually increases every month. But banking executives
accused the government of overreacting.
Bankers said such loans might be risky when approved with no money down
or without ensuring buyers have jobs but such risk could be managed
without government intervention.
"An open market will mean that different institutions will develop
different methodologies for achieving this goal," Joseph Polizzotto,
counsel to now-bankrupt Lehman Brothers, told U.S. regulators in a
Countrywide Financial Corp., at the time the nation's largest mortgage
lender, agreed. The proposal "appears excessive and will inhibit future
innovation in the marketplace," said Mary Jane Seebach, managing
director of public affairs.
One of the most contested rules said that before banks purchase
mortgages from brokers, they should verify the process to ensure buyers
could afford their homes. Some bankers now blame much of the housing
crisis on brokers who wrote fraudulent, predatory loans. But in 2006,
banks said they shouldn't have to double-check the brokers.
"It is not our role to be the regulator for the third-party lenders,"
wrote Ruthann Melbourne, chief risk officer of IndyMac Bank.
California-based IndyMac also criticized regulators for not recognizing
the track record of interest-only loans and option ARMs, which
accounted for 70 percent of IndyMac's 2005 mortgage portfolio. This
summer, the government seized IndyMac and will pay an estimated $9
billion to ensure customers don't lose their deposits.
Last week, Downey Savings joined the growing list of failed banks. The
problem: About 52 percent of its mortgage portfolio was tied up in
risky option ARMs, which in 2006 Downey insisted were safe - maybe even
safer than traditional 30-year mortgages.
"To conclude that 'nontraditional' equates to higher risk does not
appropriately balance risk and compensating factors of these products,"
said Lillian Gavin, the bank's chief credit officer.
At least some regulators didn't buy it. The comptroller of the
currency, John C. Dugan, was among the first to sound the alarm in
mid-2005. Speaking to a consumer advocacy group, Dugan painted a
troublesome picture of option-ARM lending. Many buyers, particularly
those with bad credit, would soon be unable to afford their payments,
he said. And if housing prices declined, homeowners wouldn't even be
able to sell their way out of the mess.
It sounded simple, but "people kind of looked at us regulators as
old-fashioned," said Brown, the agency's former deputy comptroller.
Diane Casey-Landry, of the American Bankers Association, said the
industry feared a two-tiered system in which banks had to follow rules
that mortgage brokers did not. She said opposition was based on the
banks' best information.
"You're looking at a decline in real estate values that was never contemplated," she said.
Some saw problems coming. Community groups and even some in the
mortgage business, like Welch, warned regulators not to ease their
"We expect to see a huge increase in defaults, delinquencies and
foreclosures as a result of the over selling of these products," Kevin
Stein, associate director of the California Reinvestment Coalition,
wrote to regulators in 2006. The group advocates on housing and banking
issues for low-income and minority residents.
The government's banking agencies spent nearly a year debating the
rules, which required unanimous agreement among the OCC, Federal
Deposit Insurance Corp., Federal Reserve, and the Office of Thrift
Supervision - agencies that sometimes don't agree.
The Fed, for instance, was reluctant under Alan Greenspan to heavily
regulate lending. Similarly, the Office of Thrift Supervision, an arm
of the Treasury Department that regulated many in the subprime mortgage
market, worried that restricting certain mortgages would hurt banks and
Grovetta Gardineer, OTS managing director for corporate and
international activities, said the 2005 proposal "attempted to send an
alarm bell that these products are bad." After hearing from banks, she
said, regulators were persuaded that the loans themselves were not
problematic as long as banks managed the risk. She disputes the notion
that the rules were weakened.
In the past year, with Congress scrambling to stanch the bleeding in
the financial industry, regulators have tightened rules on risky
Congress is considering further tightening, including some of the same proposals abandoned years ago.