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Fed Backs New Rules Aimed at Curbing Risky Home Loans

December 18, 2007 at 6:10 PM EST
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The Federal Reserve proposed new mortgage regulations Tuesday that would help protect home buyers from shady lending practices following losses suffered in the risky "subprime" home loan category. A Wall Street Journal reporter looks at the recent mortgage crisis and how the new Fed rules may prevent future subprime problems.
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JIM LEHRER: The mortgage crisis and today’s action by the Federal Reserve. Greg Ip covers the Fed for the Wall Street Journal.

Greg, welcome.

GREG IP, Wall Street Journal: Hi, Jim.

JIM LEHRER: The Fed’s rules today, they’re designed to stop what have been called “shady practices,” correct?

GREG IP: Yes.

JIM LEHRER: What were those practices that they are now designed to do away with?

GREG IP: Let’s touch on a few of these, Jim. It was very common in the heyday of the subprime mortgage market that a person would take out a mortgage at, say, 7 percent, and that seemed like a good rate, except that it was going to adjust higher to, say, 11 percent a few years later. And when that time came for adjustment, they actually would have to pay a very large penalty in order to get out of that mortgage. The new rules say: No penalties for getting out of that mortgage before the rate goes up.

It was also very common for brokers who were very anxious just to generate a lot of volume to give mortgages to people who really couldn’t afford them out of the income they were earning. And they reasoned, “Well, if they have trouble repaying the loan, they’ll just refinance, because after all home prices always go up.”

Well, since then, we’ve learned that, in fact, home prices also go down. And we want to — or, I should say, the Fed wants to make sure that people can pay the whole mortgage out of their income.

JIM LEHRER: And before there was no real restriction on anybody’s income. In other words, they didn’t match person’s income with what their payments were going to be.

GREG IP: That was quite common, yes, to issue mortgages that would consume 60 percent of a person’s income, which is far higher than would normally be permitted, say, for example, a prime customer.

And not only that, Jim, but it was also common to not even require the borrower to provide any documentation, like a W-2, proving what income they earned. These were so-called no-doc or low-doc loans.

JIM LEHRER: So if somebody said, “Hey, I make $75,000 a year,” they just took their word for it?

GREG IP: That’s right. The broker said, “No problem. If you’re lying, not my problem. That’s the problem of the person who ends up owning the mortgage.” And that will no longer be…

Disclosing hidden fees

Greg Ip
Wall Street Journal
It was very possible to not only lend money that was very difficult for the borrower to repay under normal circumstances, but to be not very upfront about all these terms.

JIM LEHRER: And what will happen now under these rules?

GREG IP: Well, anybody -- essentially, all lenders -- that includes banks, finance companies, mortgage brokers -- will be held to these new rules. They are to adhere to them.

And, also, one other thing I'll add. It also is common. Most prime customers, when they take out a mortgage, their payment is also included in that payment, is their property tax and their home owner's insurance. And that can often add a few hundred dollars to your monthly payment. And it's important to take that into account when you're deciding if a mortgage is affordable.

It became quite common not to include those payments in the subprime world. And, in fact, that was one reason people found that they were having trouble making their payments. From now on, lenders will have to -- escrow is the word we use for it -- the property and insurance.

JIM LEHRER: So, in other words, it was permissible for people to borrow money and not be told by the lender that your payment is going to be more than -- we say the payment is going to be $100 a month. It's actually going to be $125 a month, because it doesn't include insurance or whatever figures makes sense.

GREG IP: That's right, Jim. It was very possible to not only lend money that was very difficult for the borrower to repay under normal circumstances, but to be not very upfront about all these terms.

Now, there were many reputable lenders who were upfront about this, and people still got into trouble, perhaps, because they were too ambitious or too enthusiastic. But there were also many cases of outright fraud, where the broker and the lender were simply motivated to generate a lot of fees, generate a lot of loans, and then sell that loan in the capital markets to somebody else.

It might have been a pension fund in Germany or a hedge fund in Australia, when, if the loan eventually defaulted, that was somebody else's problem.

JIM LEHRER: But for the most part, the things we're talking about here that made up this so-called subprime mortgage crisis were permissible and legal, is that correct?

GREG IP: That is correct. And, in fact, for many years, Jim, in this country we encouraged the extension of credit to low-income people, people who didn't normally qualify for prime loans, because we thought it was a good thing that they had access to credit. This would permit them to buy homes for the first time.

And so there was, if you will, a sense on the part of regulators that they did not want to do too much to impair this market because it was doing some good things.

JIM LEHRER: And that was one of the reasons given by then-Chairman Greenspan.

GREG IP: That's right.

Criticizing past Fed practices

Greg Ip
Wall Street Journal
Greenspan's response was essentially, No. The problem that you're talking about is fraud, and the best examiners cannot find fraud.

JIM LEHRER: Fed Chairman Greenspan -- now, he is now -- tell us the story here about Gramlich, who is now deceased, who was a federal -- one of the member of the Board of Governors of the Fed seven years ago and warned about this or warned about some part of it. Now, Mr. Greenspan says, "Hey, wait a minute, it wasn't the Fed's fault." Tell us the story.

GREG IP: Well, the Fed, Jim, has two broad responsibilities in this area. One is the one we're most familiar with, which is to move interest rates up and down as the economy needs.

And the other is to basically enforce this network of protections that Congress has given it the authority to do so to protect consumers from unscrupulous practices.

On the first front, the accusations that Greenspan, in the early part of this decade, kept interest rates way too low for too long, this made homes seem artificially cheap, and that got the bubble started.

Greenspan's response to that is, "Yes, we held interest rates low. And, yes, that stimulated the housing market, but it was necessary at the time because we were facing a potentially deflationary downturn as consequence of the collapse of the tech boom."

Now, the second accusation is that the Fed had all these powers to address basically deceptive and irresponsible practices in the underwriting of mortgage loans...

JIM LEHRER: The very things that we were talking about...

GREG IP: Exactly.

JIM LEHRER: The charge is they could have stopped it earlier, right?

GREG IP: And they did not use these powers. Now, I think, in fairness, one should look at what was available to them at the time.

They did use some of their powers to address other areas, for example, issues with respect to discriminating against women or minorities in the extension both of mortgage credit and other types of loans. The Fed did, under Greenspan, move to strengthen those rules, partly at the behest of Ned Gramlich, who was a governor at the time.

Now, in 2000, Gramlich had a very brief conversation with Greenspan, saying, You know, there's a lot of really sort of like shady operators out there in the mortgage market. You know, three-quarters of subprime mortgage loans do not come out of the federally regulated banks that we at the Fed or some of the other federal regulators actually oversee. They come out of small brokers that have no oversight or very little oversight. Why don't we come up with a way to extend the Fed's oversight to those smaller operations?

And Greenspan's response was essentially, No. The problem that you're talking about is fraud, and the best examiners cannot find fraud. You know, reputable companies will make reputable loans. And the fraudulent ones will make fraudulent loans no matter who's examining them.

And he added, You can actually make matters worse, because these fraudulent operators will put in their window, "Examined by the Federal Reserve," and give borrowers, perhaps, a false sense of security.

Market self-correction

Greg Ip
Wall Street Journal
There is some feeling in Congress, both on the Senate side and the House side, that the Fed has not gone far enough. And it is possible that Congress will enact legislation that overrides some of these rules.

JIM LEHRER: Is it correct to say, as we sit here now, Greg, that most of these practices that these new rules will prohibit have -- the marketplace has already taken care of? The subprime business has pretty much gone away?

GREG IP: That's pretty much the case, Jim. There are very few subprime loans being made these days, primarily because the last few years turned out to be an anomaly. It was very easy to refinance a lot of those loans because there was a house price bubble.

House prices are now going down. A lot of those loans are going bad. Nobody wants to own them. Banks are, through their own self-interest, being much more careful about what they're underwriting.

JIM LEHRER: Now, these rules, they go into effect automatically, do they not? I mean, there's some waiting period...

GREG IP: No, they do not. There is a comment period.

JIM LEHRER: Comment period.

GREG IP: Yes. And all interested people can write to the Federal Reserve and say, "These are changes we would like."

Moreover, there is some feeling in Congress, both on the Senate side and the House side, that the Fed has not gone far enough. And it is possible that Congress will enact legislation that overrides some of these rules.

JIM LEHRER: But essentially something is going to happen sooner rather than later, right?

GREG IP: That seems likely, yes.

JIM LEHRER: All right. Greg, thank you very much.

GREG IP: Thanks for having me, Jim.