No part of the nation's economic life receives more legal and regulatory oversight than housing and mortgages. Federal and state government agencies have a say in nearly every stage of mortgage lending, from determining whether a loan is appropriate to how to foreclose on a defaulting homeowner. Yet regulatory supervision all but disappeared during the housing boom. Where were the regulators?
It wasn't as if regulators didn't understand subprime lending's risks. They had dealt with the issue in the mid- and late 1990s, when home equity lenders that period's subprime pioneers were aggressively making loans. Many of those home-equity loans defaulted and many of those lenders went belly-up by the end of the decade. Regulators responded in 1999 and again in early 2001 by "issuing guidance" sending an official warning to lenders about the perils of such lending. The regulators told lenders to be sure they set aside adequate reserves to cover the potential losses on risky subprime loans and also warned lenders to avoid predatory lending.
Regulators carefully defined a "predatory" loan as one made without regard to the borrowers' ability to make timely payments.1 Lenders had to do more than make sure the borrower's house was worth more than the amount of the mortgage; they also had to determine that borrowers had enough income to stay current on the loan. Loans that appeared designed mainly to generate fees for the lender were also declared predatory. A refinancing deal that did not lower the borrower's monthly payment or allow the borrower to take cash out of the house fell into the category of predatory practices, as did lying or withholding relevant information to make a loan to unsophisticated borrowers. Yet as the subprime market heated up not long after the 2001 guidance was issued, predatory lending practices spread. Lenders appeared to be violating the rules' spirit, if not the letter. The nation's mortgage regulators largely went silent. They might slap the hand of a small lender for something particularly egregious; a few tweaks were made to the rules regarding property appraisals and mortgage fraud. But regulators had little of consequence to say during the housing bubble of the mid-2000s.
Not until late 2006, well after the bubble had begun to burst, did regulators issue their first formal guidance on what they called "nontraditional mortgage products."
Regulators had debated what to say in the guidance for more than a year, and what they finally agreed to still didn't directly address most subprime lending. Lenders limited their own definition of "nontraditional" mortgages to interest-only and negative-amortization loans, in which borrowers were allowed to pay less each month than the actual interest due, with the difference added to the principal amount of the loan. Most such deals were in fact prime not subprime loans.
The late 2006 guidance was much needed, but it was clearly too little and too late. It included some instructions that might have been considered common sense: lenders, for instance, should not qualify borrowers for a loan based on low introductory "teaser" rates, but rather ask whether a borrower had enough income to pay the higher rates that would kick in down the road. The guidance warned against making loans with no verification of income and savings, and it demanded lenders disclose whether a loan included a large prepayment penalty (as most loans did). The guidance was fashioned by federal regulators, but it quickly became national policy as mortgage-industry regulators at all levels of government adopted it. It was a laudable step; unfortunately, the mortgages whose defaults would precipitate the subprime financial shock had already been made.
Federal and state regulators finally addressed subprime lending formally in June 2007, just weeks before the financial shock hit.3 In this guidance, regulators told subprime lenders to qualify borrowers assuming a loan's full monthly cost, not just at the low initial teaser interest rate. Borrowers hit with large hikes in their mortgage payments would also have to have at least 60 days to refinance into a more favorable loan before they could be charged a prepayment penalty. By the time this guidance went out, however, subprime lending was already evaporating; the new rules applied to a type of lending that was speeding toward extinction.
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06102010
1. The debt recovery claimant receives various documents from the court
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