A little more than a decade ago, William Brennan foresaw the financial collapse of 2008.
As director of the Home Defense Program at the Atlanta Legal Aid Society, he watched as subprime lenders earned enormous profits making mortgages to people who clearly couldn’t afford them.
The loans were bad for borrowers — Brennan knew that. He also knew the loans were bad for the Wall Street investors buying up these shaky mortgages by the thousands. And he spoke up about his fears.
“I think this house of cards may tumble some day, and it will mean great losses for the investors who own stock in those companies,” he told members of the Senate Special Committee on Aging in 1998.
It turns out that Brennan didn’t know how right he was. Not only did those loans bankrupt investors, they nearly took down the entire global banking system.
Washington was warned as long as a decade ago by bank regulators, consumer advocates, and a handful of lawmakers that these high-cost loans represented a systemic risk to the economy, yet Congress, the White House, and the Federal Reserve all dithered while the subprime disaster spread. Long forgotten Congressional hearings and oversight reports, as well as interviews with former officials, reveal a troubling history of missed opportunities, thwarted regulations, and lack of oversight.
What’s more, most of the lending practices that led to the disaster are still entirely legal.
Growth of an Industry
Congress paved the way for the creation of the subprime lending industry in the 1980s with two obscure but significant banking laws, both sponsored by Fernand St. Germain, a fourteen-term Democratic representative from Rhode Island.
The Depository Institutions Deregulation and Monetary Control Act of 1980 was enthusiastically endorsed by then-President Jimmy Carter. The act, passed in a time of high inflation and declining savings, made significant changes to the financial system and included a clause effectively barring states from limiting mortgage interest rates. As the subprime lending industry took off 20 years later, the act allowed lenders to charge 20, 40, even 60 percent interest on mortgages.
The other key piece of legislation was the Alternative Mortgage Transaction Parity Act, passed in 1982. The act made it possible for lenders to offer exotic mortgages, rather than the plain-vanilla 30-year, fixed-rate loan that had been offered for decades.
With the passage of the Parity Act, a slew of new mortgage products was born: adjustable-rate mortgages, mortgages with balloon payments, interest-only mortgages, and so-called option-ARM loans. In the midst of a severe recession, these new financial products were seen as innovative ways to get loans to borrowers who might not qualify for a traditional mortgage. Two decades later, in a time of free-flowing credit, the alternative mortgages became all too common.
The Parity Act also allowed federal regulators at the Office of Thrift Supervision and the Office of the Comptroller of the Currency to set guidelines for the lenders they regulate, preempting state banking laws. In the late 1990s, lenders began using the law to circumvent state bans on mortgage prepayment penalties and other consumer protections.
In the late 1980s and early 1990s, subprime loans were a relatively small portion of the overall lending market. Subprime loans carry higher interest rates and fees, and were supposed to be for people whose bad credit scores prevented them from getting a standard — or prime — loan. Consumer advocates at the time were mostly concerned about reports of predatory practices, with borrowers getting gouged by high rates and onerous fees. Congress responded in 1994 with passage of the Home Ownership and Equity Protection Act, or HOEPA.
The act, written by former Representative Joseph P. Kennedy, a Democrat from Massachusetts, created restrictions on “high-cost” loans, which were defined as having an interest rate that was more than 10 percentage points above rates for comparable Treasury securities. If points and fees totaled more than 8 percent of the loan amount, or $400, whichever was higher, the loan was also considered high cost.
High-cost loans were still legal, but contained some restrictions. Prepayment penalties and balloon payments before five years were banned or restricted. Also prohibited was negative amortization, a loan structure in which the principal actually grows over the course of the mortgage, because the monthly payments are less than the interest owed. But the bill did not include a ban on credit insurance — an expensive and often unnecessary insurance product packed into loans, creating substantial up-front costs. Nor did it ban loan flipping, in which a borrower’s loan is refinanced over and over again, stripping equity through closing costs and fees.
At the time of HOEPA’s passage, the subprime lending industry had two main elements: small, regional lenders and finance companies. The regional lenders specialized in refinancing loans, charging interest rates between 18 and 24 percent, said Kathleen Keest, a former assistant attorney general in Iowa who is now an attorney with the Center for Responsible Lending, a fair lending advocacy organization. HOEPA sought to eliminate the abusive practices of the regional lenders without limiting the lending of the finance companies — companies like Household, Beneficial, and the Associates — viewed then as the legitimate face of subprime, Keest said.
HOEPA did largely succeed in eliminating the regional lenders. But the law didn’t stop subprime lending’s rapid growth. From 1994 to 2005, the market ballooned from $35 billion to $665 billion, according to a 2006 report from the Center for Responsible Lending, using industry data. In 1998, the CRL report said, subprime mortgages were 10 percent of all mortgages. By 2006, they made up 23 percent of the market.
The loans themselves also changed during the 2000s. Adjustable-rate mortgages, which generally begin at a low fixed introductory rate and then climb to a much higher variable rate, gained market share. And over time, the underwriting criteria changed, with lenders at times making loans based solely on the borrower’s “stated income” — what the borrower said he earned. A 2007 report from Credit Suisse found that roughly 50 percent of all subprime borrowers in 2005 and 2006 — the peak of the market — provided little or no documentation of their income.
As the subprime lending industry grew, and accounts of abusive practices mounted, advocates, borrowers, lawyers, and even some lenders clamored for a legislative or regulatory response to what was emerging as a crisis. Local legal services workers saw early on that high-cost loans were creating problems for their clients, leading to waves of foreclosures in cities like New York, Philadelphia, and Atlanta.
Wall Street Changes Dynamic
Subprime loans weren’t designed to fail. But the lenders didn’t care whether they failed or not.
Unlike traditional mortgage lenders, who make their money as borrowers repay the loan, many subprime lenders made their money up front, thanks to closing costs and brokers fees that could total over $10,000. If the borrower defaulted on the loan down the line, the lender had already made thousands of dollars on the deal.
And increasingly, lenders were selling their loans to Wall Street, so they wouldn’t be left holding the deed in the event of a foreclosure. In a financial version of hot potato, they could make bad loans and just pass them along,
In 1998, the amount of subprime loans reached $150 billion, up from $20 billion just five years earlier. Wall Street had become a major player, issuing $83 billion in securities backed by subprime mortgages in 1998, up from $11 billion in 1994, according to the Department of Housing and Urban Development. By 2006, more than $1 trillion in subprime loans had been made, with $814 billion in securities issued.
Among those sounding an early alarm was Jodie Bernstein, director of the Bureau of Consumer Protection at the Federal Trade Commission from 1995 to 2001. She remembers being particularly concerned about Wall Street’s role, thinking “this is outrageous, that they’re bundling these things up and then nobody has any responsibility for them. They’re just passing them on.”
The FTC knew there were widespread problems in the subprime lending arena and had taken several high-profile enforcement actions against abusive lenders, resulting in multi-million dollar settlements. But the agency had no jurisdiction over banks or the secondary market. “I was quite outspoken about it, but I didn’t have a lot of clout,” Bernstein recalled.
Speaking before the Senate Special Committee on Aging in 1998, Bernstein noted with unease the big profits and rapid growth of the secondary mortgage market. She was asked whether the securitization and sale of subprime loans was facilitating abusive, unaffordable lending. Bernstein replied that the high profits on mortgage backed securities were leading Wall Street to tolerate questionable lending practices.
Asked what she would do if she were senator for a day and could pass any law, Bernstein said that she would make players in the secondary market — the Wall Street firms bundling and selling the subprime loans, and the investors who bought them — responsible for the predatory practices of the original lenders. That didn’t happen.
Instead, over the next six or seven years, demand from Wall Street fueled a rapid decline in underwriting standards, according to Keest of the Center for Responsible Lending. Once the credit-worthy borrowers were tapped out, she said, lenders began making loans with little or no documentation of borrowers’ income.
“If you’ve got your choice between a good loan and a bad loan, you’re going to make the good loan,” Keest said. “But if you’ve got your choice between a bad loan and no loan, you’re going to make the bad loan.”
If the loan was bad, it didn’t matter — the loans were being passed along to Wall Street, and at any rate, the securitization process spread the risk around. Or so investors thought.
Signs of a Bigger Problem
Even as subprime lending took off, the trend in Congress was to approach any issues with the new mortgages as simple fraud rather than a larger risk to the banking industry.
“In the late 1990s, the problem was looked at exclusively in the context of borrower or consumer fraud, not systemic danger,” recalls former Representative Jim Leach, a Republican from Iowa. Leach served as chair of the House Banking and Financial Services Committee from 1995 through 2000.
Some on Capitol Hill tried to address the problems in the subprime market. In 1998, Democratic Senator Dick Durbin of Illinois tried to strengthen protections for borrowers with high cost loans. Durbin introduced an amendment to a major consumer bankruptcy bill that would have kept lenders who violated HOEPA from collecting on mortgage loans to bankrupt borrowers.
The amendment survived until House and Senate Republicans met to hammer out the final version of the legislation, under the leadership of Senator Charles Grassley, the Iowa Republican who was the principal Senate sponsor of the bankruptcy bill. The predatory lending clause, along with other consumer protections, disappeared. (Staffers for Sen. Grassley at the time say they don’t remember the amendment.) Faced with opposition from Durbin as well as President Clinton, the new version of the bill was never brought to a vote.
More calls for action surfaced in 1999, when the General Accounting Office (now the Government Accountability Office) issued a report calling on the Federal Reserve to step up its fair lending oversight. Consumer groups, meanwhile, were raising concerns that mortgage companies owned by mainstream banks — so-called non-bank mortgage subsidiaries — were making abusive subprime loans, but these subsidiaries were not subject to oversight by the Federal Reserve. In fact, the Federal Reserve in 1998 had formally adopted a policy of not conducting compliance examinations of non-bank subsidiaries. The GAO report recommended that the Federal Reserve reverse course and monitor the subsidiaries’ lending activity.
The Fed disagreed, saying that since mortgage companies not affiliated with banks were not subject to examinations by the Federal Reserve, examinations of subsidiaries would “raise questions about ‘evenhandedness.’” According to GAO, the Federal Reserve Board of Governors also said that “routine examinations of the nonbank subsidiaries would be costly.”
In 2000, Congress revisited the subprime issue. Again, the concern was more about predatory lending practices than systemic risk. But, as in 1998, there were warnings about larger problems.
Ellen Seidman, director of the Office of Thrift Supervision, testified that predatory lending was an issue of serious concern to the OTS in part because it raised major safety and soundness concerns for banks. Seidman, speaking before the House Banking and Financial Services Committee in May 2000, said investors needed more education about mortgage-backed securities, because “predatory loans are not good business, not simply because they are unethical, but because they can damage reputations and hurt stock prices.”
Cathy Lesser Mansfield, a law professor at Drake University, presented the House committee with specific and alarming data on the interest rates and foreclosure rates of subprime loans nationwide. “Probably the scariest data for me personally,” Mansfield testified, “was a single pool foreclosure rate.” Mansfield had looked at the foreclosure rate for one pool of loans that had been bundled and sold on Wall Street. About a year and a half after the pool was created, almost 28 percent of the loans were in delinquency or foreclosure, she said.
“That means in that single pool, if that is symbolic for the industry, that means there might be a one in four chance of a borrower losing their home to a lender,” she told the committee.
Representative Ken Bentsen, a Democrat from Texas, found the high default rates worrying, particularly because the nation was enjoying a healthy economy. “I think you could argue that, assuming we have not repealed the business cycle and there is a downturn at some point,” he said, “you could experience even astronomical default rates… That would spill over into other sectors of the economy, both in deflating the real estate market, as well as impact the safety and soundness of the banking system.”
While acknowledging the safety and soundness concerns, banking regulators expressed only lukewarm support for new legislation to bar predatory practices. They suggested, instead, that the problem could be addressed through stepped up enforcement of existing laws and industry self-regulation.
Representatives from the lending industry said they were troubled by reports of predatory practices. But they, too, opposed new legislation, arguing that new laws would cut off credit to impoverished communities. The abuses were the actions of a few “bad actors,” said Neill Fendly, speaking on behalf of the National Association of Mortgage Brokers at the 2000 House hearing.
Still, concern was substantial enough to prompt the introduction of new legislation in early 2000 — not one, but two competing bills, from Representatives John LaFalce, a Democrat from New York, and Robert Ney, a Republican from Ohio. LaFalce’s bill proposed to fill in what he called “gaps in HOEPA.” It would have lowered the interest rate and fee thresholds for HOEPA protections to kick in, and restricted loan flipping and equity stripping. The bill would also have barred lenders from making loans without regard for the borrower’s ability to repay the debt.
Ney — who years later would plead guilty to conspiracy charges in connection with the Jack Abramoff lobbying scandal and spend 17 months in federal prison — pushed a “narrowly crafted” solution to problems in the subprime lending market, calling abusive mortgage lending practices “rare.” Ney’s bill would have provided some restrictions on subprime lending by strengthening some of the thresholds under HOEPA, but would have also taken away the power of individual states to enact tougher restrictions.
While the chances of Democratic-backed, pro-consumer legislation passing in the Republican Congress seemed slim, forces from the mortgage banking and brokerage industries were taking no chances, ramping up their political contributions to federal candidates and national parties. After having given $4.2 million in contributions in the 1998 election cycle, industry contributions doubled for the 2000 campaign to more than $8.4 million, according to data from the Center for Responsive Politics. Those contributions would balloon to $12.6 million in 2002. A coalition of subprime lenders sprang into action to fight LaFalce’s bill and other attempts to impose tough restrictions.
The tougher LaFalce proposal had the support of Leach, the powerful Republican chairman of the House banking committee. But even with Leach’s approval, the bill went nowhere in a Congress run by conservative Republicans. Increased regulation, recalled Bentsen, “was against what they [the Republican House leadership] believed in.”
With that political reality as backdrop, neither LaFalce’s bill nor any other lending reform proposal came up for a vote in committee.
Two years later, Democrat Paul Sarbanes of Maryland, then chairman of the Senate Committee on Banking, Housing, and Urban Affairs, introduced another bill to curb abusive high-cost lending. The bill failed to attract a single Republican co-sponsor, and, like the LaFalce bill, never saw a committee vote. Wright Andrews, a leading lobbyist for the subprime industry, said that the LaFalce and Sarbanes proposals in this period were “never really in play.” The bills were introduced, but no one was seriously pushing for them, he explained. “The industry could and would have blocked [those proposals], but we didn’t really have to.”
States Act — And Get Shut Down
In the absence of new federal legislation, efforts to combat predatory lending were moving at the state level. North Carolina had passed the first state law targeting predatory loans in 1999, and consumer advocates were pushing state laws from Massachusetts to California. The North Carolina law barred three common provisions of predatory loans: loan flipping, prepayment penalties, and the financing of up front, “single-premium” credit insurance. In essence, the law sought to eliminate incentives for making unaffordable loans. With lenders unable to strip equity through high up-front charges, and unable to churn loans through flipping, they would have to make money the old-fashioned way, through borrowers’ monthly payments.
Two men working at the state level were in attendance at the 2000 House hearing: Andrew Celli, with the New York state Attorney General’s office, and Thomas Curry, the Massachusetts banking commissioner.
The state officials told the House committee that they were forced to push consumer protection in their states because the federal regulators were not doing enough to protect borrowers, and HOEPA was ineffective. The threshold for high cost loans to trigger HOEPA’s protections was an interest rate 10 percent above comparable Treasury securities. But “as important as this prohibition is, its powers in real world relevance are diminishing,” Celli said. Lenders were evading HOEPA, and the consumer protections it afforded, by making loans just under the law’s definition of a high-cost loan.
In response, many state laws set the trigger lower, at five percent, affording consumer protections to a broader swath of borrowers. But the efforts soon came to naught – at least when it came to federally regulated banks. The wave of anti-predatory lending laws was preempted by federal banking regulators, particularly by the Office of Thrift Supervision and the Office of the Comptroller of the Currency. OCC and OTS had effectively told the institutions they regulated that they did not, in fact, have to comply with state banking laws, thanks to the agencies’ interpretations of the Parity Act.
With state protections limited, and federal regulation lax, the boom in subprime mortgages continued. And so did the warnings.
In 2001, Congress heard yet again about the potentially devastating impact of subprime lending, at a hearing before the Senate Banking Committee. In Philadelphia, subprime loans were devastating entire communities, Irv Ackelsberg, an attorney with Community Legal Services, told the committee. “I believe that predatory lending is the housing finance equivalent of the crack cocaine crisis. It is poison sucking the life out of our communities. And it is hard to fight because people are making so much money.”
“There is a veritable gold rush going on in our neighborhoods and the gold that is being mined is home equity,” Ackelsberg added.
And like William Brennan and Jodie Bernstein in 1998, and Cathy Mansfield, Ellen Seidman, and Ken Bentsen in 2000, Ackelsberg warned that bad subprime loans could hurt not just homeowners, but the broader economy. The ultimate consumers of the high-cost loans, he told the committee, were not individual borrowers, taking out loans they couldn’t pay back. “The ultimate consumer is my retirement fund, your retirement fund,” he said.
The Laissez-Faire Fed
Congressional inaction didn’t have to leave borrowers unprotected, say experts. The Federal Reserve could have moved at any time to rein in subprime lending through the Home Ownership and Equity Protection Act. Under the original 1994 law, the Federal Reserve was given the authority to change HOEPA’s interest rate and fees that would trigger action under the act, as well as to prohibit certain specific acts or practices. “Clearly, the Fed should have done something on the HOEPA regs,” said Seidman, the former OTS director. “I think there is little doubt.”
The Fed’s reluctance to change the law, Seidman said, reflected the philosophy of the Federal Reserve Chairman, Alan Greenspan, who “was adamant that additional consumer regulation was something he had absolutely no interest in.” Jodie Bernstein, who had tackled abusive lenders at the Federal Trade Commission, agreed. Greenspan, she said, was “a ‘market’s going to take care of it all’ kind of guy.”
Consumer advocates had pushed for lower HOEPA triggers since the law’s passage, hoping to include more loans under the law’s protections. But one problem with changing the law was that no one seemed to agree on how well it was working. In 2000, the Federal Reserve acknowledged that it did not even know how many home-equity loans were covered by HOEPA — the main federal law preventing abuses in high-cost lending.
Three government agencies said that the law was protecting staggeringly few borrowers. A joint report from the departments of Treasury and Housing and Urban Development, released in June 2000, found that during a sample six-month period in 1999, less than one percent of subprime loans had an interest rate exceeding the HOEPA trigger. The Office of Thrift Supervision estimated that based on interest rates, the law was capturing approximately one percent of subprime loans.
The American Financial Services Association, a lenders’ trade association, had very different numbers. George Wallace, the general counsel of AFSA, told the Senate in 2001 that according to an AFSA study, HOEPA was capturing 12.4 percent of first mortgages and 49.6 percent of second mortgages.
After a series of national hearings on predatory lending, the Fed made modest changes to HOEPA’s interest rate trigger in 2001. The late Ed Gramlich, a governor on the Federal Reserve Board and early critic of the subprime industry, said that in setting the new triggers the Board was “heavily influenced” by survey data provided by the lending industry — data showing that a significant percentage of mortgages were in fact just below the triggers.
The 2001 changes to HOEPA set the threshold for what constituted a high-cost first mortgage loan at 8 percent above comparable Treasury securities, down from 10 percent, but for second mortgages it was left unchanged. The Fed also added credit insurance to the law’s definitions of points and fees, meaning that lenders could no longer pack expensive insurance into loans and still evade HOEPA’s triggers.
For the first time, lenders making a high-cost loan had to document a borrower’s ability to repay the loan. The Fed also barred high-cost lenders from refinancing mortgages they made within a year.
But Margot Saunders, of the National Consumer Law Center, said the 2001 changes had little impact. Lenders simply undercut the law’s new, lower triggers, she said, continuing to make loans at just below the thresholds. Advocates said another provision, designed to stop loan flipping, also did little, because lenders could simply flip borrowers into a new loan on the 366th day, or a new lender could flip the loan at any time.
William Brennan, who is still at the Atlanta Legal Aid Society, said the Fed’s failure to act more forcefully on HOEPA was a key missed opportunity. “That bill had potential to put a stop to all this,” he said. “That one bill in my opinion would have stopped this subprime mortgage meltdown crisis.”
Former Federal Reserve Chairman Alan Greenspan declined to be interviewed for this story, but his recent congressional testimony gives some insight into his perspective on the meltdown and its origins.
In October 2008, Greenspan appeared before the House Committee on Oversight and Government Reform to answer questions about the financial crisis and his tenure at the Fed. In his testimony, Greenspan wrote that subprime mortgages were “undeniably the original source of [the] crisis,” and blamed excess demand from securitizers for the explosive growth of subprime lending.
Greenspan also acknowledged that after forty years, he had “found a flaw” in his ideology. “Those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity, myself especially, are in a state of shocked disbelief,” he said.
In other words, in this case, the market proved unable to regulate itself.
Eight years after the Fed failed to step in, skyrocketing foreclosure rates have wrecked the banking industry, requiring a $700 billion bank bailout. Investors that bought mortgage-backed securities, including many retirement funds, have lost untold billions.
One in 33 homeowners in the United States, 2.26 million people, may lose their homes to foreclosure in the next two years — a staggering foreclosure rate directly attributed to subprime mortgage loans made in 2005 and 2006, according to a recent report from the Pew Charitable Trusts.
Had the legislative efforts to curb abusive practices in the high-cost lending market succeeded — at the state or federal level — those loans might never have been made. But the proposals didn’t succeed, and many of the troubling mortgage provisions that contributed to the foreclosures are still legal today.
“Prepayment penalties, yield spread premiums, flipping, packing, single premium credit insurance, binding mandatory arbitration — they’re all still legal under federal law,” said Brennan. Some of those provisions are prohibited under July 2008 changes to HOEPA’s implementing regulations, but lenders can still include them in loans below that law’s thresholds.
A bill now moving through the House would change that. The bill, sponsored by Democratic Representatives Brad Miller and Mel Watt, both of North Carolina, and Barney Frank of Massachusetts, includes a ban on yield-spread premiums — which reward brokers for steering borrowers into costly loans — and lending without regard for a borrower’s ability to repay the mortgage. The bill would also create what are known as “assignee liability provisions,” which would make mortgage securitizers more responsible for abuses in the original mortgages. The bill was approved by the House Financial Services Committee on April 29, and is expected to receive a vote on the House floor.
Keest, of the Center for Responsible Lending, said such assignee liability provisions could have helped to avert the crisis. The provisions would not just have given borrowers the ability to defend themselves from foreclosure, Keest said, but would have protected investors as well.
Several state laws included the assignee liability provisions, but were preempted by federal regulators. If those provisions had stayed in the law, investors might have been more attentive to the questionable actions of lenders and brokers. When investors are responsible for abuses in the loans they buy, Keest said, “they have some skin in the game,” and are more likely to closely scrutinize the loans in a securitized pool. Investors might have noticed sooner that the subprime loans they were gobbling up were going bad, fast.
As it was, the demand for securities backed by subprime loans was insatiable.
“The secondary market, it was Jabba the Hutt — ‘feed me, feed me,’” Keest said. It was a “two-demand market,” she said, with borrowers seeking credit on one side, and investors clamoring for securities on the other.
Ira Rheingold, executive director of the National Association of Consumer Advocates, asserts that the financial industry’s lobbying power shut down efforts to help consumers, both during the early 2000s and more recently, when advocates were pushing for foreclosure assistance in the bailout bill. “People were making lots of money,” Rheingold said. “Congress was dependent upon their money.”
The industry is, indeed, among the biggest political forces in Washington. Between 1989 and 2008, the financial services sector gave $2.2 billion in federal campaign contributions, according to the Center for Responsive Politics. Since 1998, the sector spent over $3.5 billion lobbying members of Congress — more than any other single sector, again according to the Center.
Meanwhile, Brennan worries about his city, which sees 4,000 to 7,000 foreclosures filed each month in the metropolitan area, concentrated in African-American communities.
“Atlanta is a disaster,” he said. And the same might be said for the American economy.