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March 26, 2007

One cannot pick up a newspaper lately without seeing another story about the implosion of the subprime mortgage market.

Senate Banking Chairman Chris Dodd (D-Conn.) urged the Federal Reserve at a hearing last Thursday of the Committee on Banking, Housing, and Urban Affairs to clamp down on lenders who are making predatory loans to risky and low-income borrowers:

Our mortgage system appears to have been on steroids in recent years – giving everyone a false sense of invincibility. Our nation’s financial regulators were supposed to be the cops on the beat, protecting hard-working Americans from unscrupulous financial actors. Yet, they were spectators for far too long. Risky exotic and subprime mortgages – all characterized by high payment shocks – spread rapidly through the marketplace.

Almost anyone, it seemed, could get a loan. As one analyst put it, underwriting standards became so lax that “if you could fog a mirror, you could get a loan.”

Sen. Dodd described what he called a "chronology of neglect" with banking regulators who did not act quickly as lenders eased their standards to participate in the growing subprime market, targeting much of his frustration at the Federal Reserve Board. "It just seems to me that you all were asleep at the switch," Sen. Robert Menendez (D-N.J.) added during the hearing. Sen. Dodd urged the Federal Reserve to use its authority under the Home Ownership and Equity Protection Act and the FTC Act to prohibit abusive loan practices for all mortgage markets, no matter if they have a federal or state charter. "The checks and balances that we are told exist in the marketplace, and the oversight that the regulators are supposed to exercise, have been absent until recently." While Sen. Dodd added that he would push forward with legislation, Republican panel members said they would prefer to let the market work out the disruption in the $1.3 trillion subprime market, which represents 13 percent of the national mortgage debt. Banking Committee ranking member Richard Shelby (R-Ala.) said he feared problems will arise from the defaults when about 1.8 million subprime loans reset to higher interest rates by the end of 2008.

Here is what Sen. Dodd described as the "chronology of neglect" in greater detail:

  • Regulators tell us that they first noticed credit standards deteriorating late in 2003. By then, Fitch Ratings had already placed one major subprime lender on “credit watch,” citing concerns over their subprime business. In fact, data collected by the Federal Reserve Board clearly indicated that lenders had started to ease their lending standards by early 2004.
  • Despite those warning signals, in February of 2004 the leadership of the Federal Reserve Board seemed to encourage the development and use of adjustable rate mortgages that, today, are defaulting and going into foreclosure at record rates. The then-Chairman of the Fed said, in a speech to the National Credit Union Administration, said:

“American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage.”

  • Shortly thereafter, the Fed went on a series of 17 interest rate hikes in a row, taking the fed funds rate from 1% to 5.25%.
  • So, in sum: By the Spring of 2004, the regulators had started to document the fact that lending standards were easing. At the same time, the Fed was encouraging lenders to develop and market alternative adjustable rate products, just as it was embarking on a long series of hikes in short term rates. In my view, these actions set the conditions for the perfect storm that is sweeping over millions of American homeowners today.
  • By May, 2005, the press was reporting that economists were warning about the risks of these new mortgages.
  • June of that year, Chairman Greenspan was talking about “froth” in the mortgage market and testified before the Joint Economic Committee that he was troubled by the surge in exotic mortgages. Data indicated that nearly 25% of all mortgage loans made that year were interest-only.
  • Yet, in December, 2005, the regulators proposed guidance to reign in some of the irresponsible lending. And we had to wait another seven months, until September, 2006, before that guidance was finalized.
  • Even then, even now, the regulators’ response is incomplete. It was not until earlier this month – more than 3 years after recognizing the problem – that the regulators agreed to extend these protections to more vulnerable subprime borrowers. These are borrowers who are less likely to understand the complexities of the products being pushed on them, and who have fewer reserves on which to fall if trouble strikes. We still await final action on this guidance, which I urge the regulators to complete at the earliest possible moment.

Sen. Dodd explained why he thought the new rules were so important: "The subprime market has been dominated in recent years by hybrid ARMs, loans with fixed rates for 2 years that adjust upwards every 6 months thereafter. These adjustments are so steep that many borrowers cannot afford to make the payments and are forced to refinance, at great cost, sell the house, or default on the loan. No loan should force a borrower into this kind of devil’s dilemma. These loans are made on the basis of the value of the property, not the ability of the borrower to repay. This is the fundamental definition of predatory lending. Frankly, the fact that any reputable lender could make these kinds of loans so widely available to wage earners, to elderly families on fixed incomes, and to lower-income and unsophisticated borrowers, strikes me as unconscionable and deceptive. And the fact that the country’s financial regulators could allow these loans to be made for years after warning flags appeared is equally unconscionable."

Based on this heated rhetoric, it is not difficult to imagine that financial institutions may become the target of class actions brought by low-income borrowers asserting predatory lending claims. A study done by the Center for Responsible Lending estimates that up to 2.2 million families with subprime loans will lose their homes at a cost of $164 billion in lost home equity. In the words of former Federal Reserve Board member Edward Gramlich, “We could have real carnage for low-income borrowers.”

For further information, please contact Jeffrey Rosenstiel at

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