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 Economy.com, 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.”

During the housing boom, global investment banks such as Merrill Lynch and HSBC snapped up non-bank lenders such as First Franklin Financial Corp. and Household International, large mortgage-issuing finance companies that specialized in the subprime market. They weren’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, of the Brookings Institution, a liberal think tank in Washington.