One of the nation's biggest mortgage industry players repeatedly warned the Federal Reserve, the Federal Deposit Insurance Corp. and other bank regulators during the housing bubble that the U.S. faced an imminent housing crash.
The trade group also mapped out the 15 states which faced "sudden increases in foreclosures" and "a downward spiral," including California, Florida and Nevada.
But bank regulators not only ignored the group's warnings, top Fed officials also went on the airwaves to say the economy was "building on a sturdy foundation" and a housing crash was "unlikely."
The letters, obtained by Fox Business, were sent in 2005 and 2006 before the housing bubble burst.
As it pleaded with bank regulators to stop subprime lending abuses, the Mortgage Insurance Companies of America [MICA] pointed out the red flags in analysis from the bank regulators' own staffers as well as the likes of Bear Stearns and Lehman Brothers, three years before these two Wall Street giants collapsed under the weight of bad mortgage bets.
But the fact that these lengthy warnings did not compel bank regulators to act raises serious policy questions for Congress and the White House, as they move to make the Federal Reserve the systemic risk regulator, when the Fed didn't act to stop the biggest systemic risk of all.
The new revelations also may make it harder for Federal Reserve chairman Ben Bernanke to battle Congressional curbs on the Fed's authority over the banking system, and moves by members of Congress to have the Fed's monetary policies audited.
Disturbing Concerns Raised
Mortgage insurance companies cover lenders' loan losses when they go bad; borrowers pay for the insurance. MICA counts as its members AIG United Guaranty, Genworth Mortgage Insurance Corp., PMI Mortgage Insurance Co., United Guaranty, and Mortgage Guaranty Insurance.
Mortgage insurers are “deeply concerned about increased mortgage market fragility, which, combined with growing bank portfolios in high-risk products, pose serious potential problems that could occur with dramatic suddenness,” warned Suzanne Hutchinson, top executive at the Mortgage Insurance Companies of America, in 2005.
Failure to adjust bank underwriting, reserves and capital to account for this growing risk “means that downturns from credit and/or interest rate events–let alone shocks–will be far more severe than” if precautions are taken, Hutchinson noted, adding that what is “disturbing to us is the fact that recent trends could lead to sudden increases in foreclosures.”
MICA based its warnings on detailed analyses that came from the regulators' officials at the Federal Reserve, the OCC, FDIC and OTS. “The OCC and FRB work reinforces, we think, the urgent need for quick action on high-risk” subprime loans, Hutchinson wrote.
And MICA also backed up its red flags with data from the Basel Committee on Banking Supervision, the world's top central bank body comprising central bank governors from the Group of Ten nations.
It also backed up its predictions with Fannie Mae disclosures in filings with the Securities and Exchange Commission, as well as analysis from Standard & Poors, Fitch Ratings, Deloitte & Touche, the Mortgage Bankers Association and the National Association of Realtors.
The Federal Reserve Board, the Administrator of National Banks, the FDIC and the Office of Thrift Supervision declined repeated calls for comment. MICA said the letter only jump-started informal conversations about the problems.
Bank regulators began warning lenders in 2004 about the dangers of subprime loans, and issued guidance in 2005 advising tighter lending standards, including higher down payments and income verification.
But MICA said this didn't go far enough. It noted that there are “questions about the degree to which this guidance has in fact been reflected in industry practice,” and the government's “industry outreach statements do not address the prudential implications” of subprime loans, which demand stiffer “internal controls, regulatory capital and reserves.”
Bernanke Says Crash “Unlikely”
Despite mounting evidence, Bernanke went on TV in 2005 to say of a housing collapse, “it's a pretty unlikely possibility,” adding that “fundamentals are strong.” Right before the crash in 2007 the Fed chairman said “the subprime markets seem likely to be contained.”
Bernanke also noted in February 2008: "By later this year, housing will stop being such a big drag directly on GDP" and that "among the largest banks, the capital ratios remain good and I don't expect any serious problems.”
Former Fed chairman Alan Greenspan also testified to Congress that the Fed could do nothing to stop lending abuses. “The loan officers of those institutions knew far more about the risks involved and the people to whom they lent money than I saw even our best regulators at the Fed capable of doing,” Greenspan said.
Despite the fact that a chorus of economists around the world began raising the alarms in the mid-'90s that U.S. housing leverage on both the business and borrower level would lead to economic collapse, no moves stateside were made to enact common sense measures such as tougher loan to value ratios.
For example, Germany's legal limit on loan to value ratios is 60%; France is 75% and Denmark pegs it at 80%. In the U.S., no-money-down loans were rampant.
Subprime loans were historically given only to rich borrowers who could afford them. In 2000, just 1% of borrowers got subprime loans.
But by May 2006, about a third of all borrowers had one, according to First American LoanPerformance, which tracks mortgage lending statistics.
In September, 2005, MICA executive vice president Hutchinson wrote to the Federal Reserve, John Dugan, Comptroller of the Currency, Donald Powell, then chairman of the FDIC and John Reich, then director of the Office of Thrift Supervision.
Hutchinson acknowledged that regulators were dealing with the aftermath of Hurricane Katrina. But she pleaded with regulators to crack down on risky subprime loans because another storm was brewing, a nationwide crash due to a “growing risk in residential mortgage” business.
Mounting defaults warrant “considerable caution as lenders have rapidly increased their portfolios of high-risk subprime loans,” she said, adding, “Federal Reserve data indicate that banks say they have not yet changed their underwriting standards even as” the subprime loans “have dramatically increased.”
“We know that dealing with Hurricane Katrina is rightly your agencies' first priority,” Hutchinson warned, but “market developments call for quick supervisory action on mortgage risk,” as banks were overexposed.
Banks' Wells Running Dry
And Hutchinson foretold that the banks' wells were running dry, putting the FDIC deposit insurance fund in jeopardy.
“Combined with the fact that bank reserves are, according to the FDIC, at a 19-year low, it would appear that lenders with large” subprime portfolios “are singularly ill-prepared for the risk clearly presented by high-risk, nontraditional mortgages,” she said.
Hutchinson warned that toxic subprime loans “would, in effect, ‘pollute the residential mortgage well'--a well of profound importance to the depository institutions you regulate and to the mortgage insurance industry.”
Hutchinson also cited a “recent Federal Reserve study [that] has rightly demonstrated that many vulnerable borrowers of complex adjustable rate mortgage products do not understand their terms, may pay higher rates with complex products, and thus are more exposed to payment shock.”
Even so, lenders were selling subprime loans at “very high” loan to value ratios “to unsophisticated borrowers” who were “ill prepared” and could default, she said.
The OCC, too, had cautioned that it has seen the “first drop in overall credit underwriting standards in the 11 years of its work,” Hutchinson noted.
OCC found rampant problems, including “higher credit limits and loan-to-value ratios, lower credit scores, lower minimum payments…less documentation and verification, and lengthening amortizations—have introduced more risk to retail portfolios,” Hutchinson told regulators.
Huffing, Puffing, and Blowing Borrowers Out of Their Houses
Citing data from SMR Research, a market data firm, Hutchinson pointed out that borrowers were increasingly doing an end-run around the rules in order to get little- to zero-money down loans—or loans at 100% or more of a home's value.
Specifically, MICA's Hutchinson pointed out a soaring increase in what are called “piggy back loans,” whereby borrowers first get a loan worth 80% of a house's value, then get another loan to finance the remaining 20%.
“They may be called piggyback loans, but some analysts worry they could behave more like the big bad wolf—huffing, puffing, and blowing borrowers right out of their houses via defaults,” Hutchinson wrote, quoting Dow Jones.
Hutchinson predicted no money down loan abuses would help tank the market.
“Without equity, borrowers may have to bring money they do not have to the closing table, worsening market problems and potentially creating a downward spiral in home prices that leads to still more mortgage defaults and then still more foreclosures,” she wrote.
Shows the States Under Threat
California, Arizona, Nevada, Florida, Texas and ten other states were plagued by these loan abuses, Hutchinson said, citing an SMR survey covering 2004 and the first half of 2005, which looked at 3.1 million new loans for homes in over 334 counties.
SMR found that out of the loans in these areas, “60% were piggy back loans with LTVs above 95% in 2005, up from 52% in 2004,” Hutchinson warned. Hutchinson added that “70 counties, or a fifth of the total, had piggybacks representing more than half of all loans in 2005,” noting that “piggybacks comprise over 48% of the dollar value of all new home purchase loans.”
And Hutchinson noted government data showing that loans at 95% or more of a home's actual value actually “performed 200% worse” in terms of defaults versus loans at 80%. Loans at 100% more performed three times as poorly as loans with 20% down.
Hutchinson spotlighted another growing abuse. “One lender brought out a mortgage that combines an 80% first lien and a 23% second for a 103% LTV. Minimum credit score: 620,” at the low end of the range, she told the bank regulators.
Hutchinson also cited a Fannie Mae disclosure in its 2003 annual report, where Fannie reported “the likelihood of default and gross severity of a loss in event of default are typically lower as the LTV decreases.”
Cites Lehman Bros. Warning
According to “a recent Lehman Bros. report,” Hutchinson said that “several large banks have significantly higher exposures, including “Wells Fargo [and] Bank of America.”
Reckless subprime lending caused “lenders to develop large concentrations of high-risk loans which, even if backed by additional capital or reserves, could pose significant credit, liquidity, operational and interest-rate risk,” she wrote.
Cites Bear Stearns, S&P Warning
And Hutchinson reported a Bear Stearns analysis whereby it's saw delinquencies more than triple in just a year on option ARMs, which dangerously let borrowers set their own payment terms, even skipping interest payments. She urged federal bank regulators to move “quickly” to curtail these loans.
“Bear Stearns estimates the percentage of skipped payment borrowers at 65%, but both estimates are significantly higher than the 20% comparable figure estimated by Bear in spring 2004,” she wrote.
She added that meanwhile, “S&P data indicate that only 16% of option ARM borrowers provide full documentation” to get their loans, and “that about 75% of these borrowers skip mortgage principal and interest payments in any given month..S&P has also noted that possible payment shock awaiting neg-am borrowers is a main concern for the ratings agency.”
And only “approximately 60% to 70%” of “borrowers make the minimum payment,” Hutchinson said, adding that "recent trends show alarming signs of on-going undue risk-taking that puts both lenders and consumers at risk."
Says Fannie and Freddie At Risk
The piggy back loan abuses were an end run around Fannie and Freddie requirements that forced borrowers to get private mortgage insurance on any loan above an 80% LTV ratio, Hutchinson said.
Piggy back loans “are often structured solely to evade this requirement, intended by Congress to ensure that [Fannie and Freddie] do not take undue risk,” Hutchinson said.
But they did get swamped with such risk. By the end of 2008, Fannie and Freddie held or guaranteed approximately 10 million subprime and Alt-A mortgages and mortgage-backed securities (MBS)—risky loans with a total principal balance of $1.6 trillion, says Peter Wallison of the American Enterprise Institute. These are now defaulting at unprecedented rates, accounting for both their 2008 insolvency and their growing losses today, he added.
Wallison also said: “New research by Edward Pinto, a former chief credit officer for Fannie Mae and a housing expert, has found that from the time Fannie and Freddie began buying risky loans as early as 1993, they routinely misrepresented the mortgages they were acquiring, reporting them as prime when they had characteristics that made them clearly subprime or Alt-A.”
And securitization, whereby banks pass the loans off as paper securities, wouldn't totally inoculate lenders from harm, MICA's Hutchinson said.
“Some have suggested that banks are not at risk because nontraditional mortgages are largely securitized,” Hutchinson said, but “as Fed data cited above, this is not the case for many banks."
She added: "Securitization does not ameliorate" the "risk" from subprime loans "because many lenders hold these" loans in their portfolios. "Lenders who rely on securitization may also be subject to liquidity risk if markets dry up unexpectedly as risks become suddenly apparent,” Hutchinson warned.
Quoting bank analyst Richard Bove, Hutchinson wrote: “There is a reason why the three largest banks that make 40% of the [option ARMs] are selling 75% of the product [in securitizations] despite its high yield. They smell the risk.”
Hutchinson added: “The question remains as to which lenders have not yet smelled the risk and which ones will still be carrying the exposure when it is too late.”
Behind the Scenes at Treasury
During the bubble, Federal Reserve and Treasury staffers considered everything but a housing crash triggered by subprime loan abuses.
In a report on what was happening behind the scenes, they considered "sudden crises such as terror attacks, natural disasters," says Phillip Swagel, former Assistant Secretary for Economic Policy in the Treasury Department, "or massive power blackouts..market-driven events such as the failure of a major financial institution..a large sovereign government default..huge losses at hedge funds, energy price shocks; ..corporate bankruptcies..or a large and disorderly movement in the exchange value of the dollar," Swagel notes.
They also considered all sorts housing data, too, he notes.
"What we missed was that the regressions did not use information on the quality of the underwriting of subprime mortgages in 2005, 2006, and 2007," Swagel says.
FDIC Warns First
"This was something pointed out by staff from the Federal Deposit Insurance Corporation (FDIC), who had already (correctly) pointed out that the situation in housing was bad and getting worse and would have important implications for the banking system and the broader economy," Swagel adds.
July 1, 2005:Bernanke, then President George W. Bush's Chairman of the Council of Economic Advisers, to CNBC: “…unquestionably, housing prices are up quite a bit; I think it's important to note that fundamentals are also very strong…I don't know whether prices are exactly where they should be, but I think it's fair to say that much of what's happened is supported by the strength of the economy.
CNBC: Tell me, what is the worst-case scenario? We have so many economists coming on our air saying ‘Oh, this is a bubble, and it's going to burst, and this is going to be a real issue for the economy.'
Bernanke: Well, I guess I don't buy your premise. It's a pretty unlikely possibility. We've never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don't think it's gonna drive the economy too far from its full employment path, though.
February 15, 2006:Bernanke said: "Our expectation is that the decline in activity or the slowing in activity will be moderate, that house prices will probably continue to rise, but not at the pace that they had been rising. So we expect the housing market to cool, but not to change very sharply…The weakness in housing market activity and the slower appreciation of house prices do not seem to have spilled over to any significant extent to other sectors of the economy."
January 2007:Bernanke speech before the American Economic Association in whereby he said “to make crises less likely over the years, the Federal Reserve has worked effectively with the Congress, other supervisors, and financial market participants to develop statutory regulatory and other measures.”
March 28, 2007:Chairman Bernanke said: “The impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained.”
May 17, 2007:Chairman Bernanke said: “We do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”
February 27, 2008:Chairman Bernanke said: "By later this year, housing will stop being such a big drag directly on GDP…I am satisfied with the general approach that we're currently taking."
February 28, 2008:Chairman Bernanke said: “Among the largest banks, the capital ratios remain good and I don't expect any serious problems … among the large, internationally active banks that make up a very substantial part of our banking system.”
July 16, 2008:Chairman Bernanke said that Fannie Mae and Freddie Mac are “adequately capitalized” and “in no danger of failing.” Since then, Fannie Mae and Freddie Mac have received the largest taxpayer bailout and have been taken over by the federal government.
October 2008 testimony Congressional Testimony
Greenspan: I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms. And it's been my experience, having worked both as a regulator for 18 years and similar quantities in the private sector especially, 10 years at a major international bank, that the loan officers of those institutions knew far more about the risks involved and the people to whom they lent money than I saw even our best regulators at the Fed capable of doing.
Greenspan: Well, let me give you a little history, Mr. Chairman. There's been a considerable amount of discussion about my views on subprime markets in the year 2000. And indeed, one of our most distinguished governors at the time, Governor Gramlich, who frankly, is regrettably deceased but was unquestionably one of the best governors I ever had to deal with, came to my office and said that he was having difficulties with the problem of what really turned out to be fairly major problems in predatory lending.
Bank Crackdown Gets Lost in Fed Subcommittee
Rep. Henry Waxman (D-Calif.):Well, he urged you to move with the power that you had as the chairman of the Fed, as both the Treasury Department and HUD suggested, that you put in place regulations that would curb these emerging abuses in subprime lending. But you didn't listen to the Treasury Department or Mr. Gramlich. Do you think that was a mistake on your part?
Greenspan: Well, I question the facts that -- he and I had a conversation. I said to him I have my doubts as to whether it would be successful. But to understand the process by which decisions are made at the Fed, it's important to recognize what our lines of responsibility and lines of authority are within the structure of the system.
The Fed has incredibly professional large division that covers consumer and community affairs. It's got probably the best banking lawyers in the business in the legal department and outside counsel of expert professionals to advise on regulatory matters. And what the system actually did was to try to corral all of this ongoing information and to eventually filter it into a subcommittee of the Federal Reserve Board.
Greenspan: If I may have an extra minute. The reason basically is this that Governor Gramlich said to me that he had problems. Indeed, I agreed. I had heard very much the same thing. I, frankly, thought that when our meeting ended that the subcommittee of the board which supervises all of the various aspects of consumer and community affairs within the board of governors and the Federal Reserve system would move forward and present to the board as a whole recommendations to be made. That was not made, and I presumed at the time that essentially the subcommittee didn't think it rose to the higher level.