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Searching for a Voice

As mortgage loan quality weakened and foreclosures began to mount in 2006, regulators finally got their bearings. Federal agencies jointly issued the October 2006 guidance cracking down on nontraditional mortgage lending, and followed in June 2007 with a statement on subprime loans. The Federal Reserve, now under the leadership of Chairman Ben Bernanke, began a series of hearings about protecting mortgage borrowers. HOEPA had given the Fed the authority for this in the mid-1990s, but not until the housing bust was the central bank willing to take on the job in a comprehensive way.

Finally, in December 2007, the Fed proposed some commonsense lending rules. Firms that made "higher-priced" (mostly subprime) loans would have to consider the borrower's ability to repay, and verify the borrower's income and assets.

Prepayment penalties were barred if a homeowner refinanced within 60 days after an adjustable loan reset, and borrowers would have to establish an escrow account for taxes and insurance. Lenders could not compensate mortgage brokers for steering borrowers to higher-rate loans, nor coerce appraisers to overstate home values. Mortgage services would have to credit borrowers as of the date they receive payments. None of these rules were radical; indeed, it is hard to imagine that lending standards had eroded so badly that they were even necessary. The Fed also began working to reestablish its leadership in mortgage and financial regulation.

The central bank issued guidance in early 2007 along with other regulators, encouraging lenders to work with borrowers who were struggling to make their payments, particularly those facing steep adjustable-rate interest resets. Later in the same year, Chairman Bernanke threw his support behind expanding Fannie and Freddie's mortgage-lending authority, then still a politically controversial idea. The Bush administration and Congress eventually followed.

In early 2008, Bernanke also supported helping homeowners whose homes' value had fallen below the amount of their mortgages a situation called "negative equity." Bernanke argued that such mortgages might have to be written down, reducing the principal until the homeowner no longer owed more than the home was worth. This was a particularly unpopular view in many parts of the mortgage industry, and in Washington, D.C.

Some mortgage holders had agreed to help troubled borrowers by freezing interest rates or extending the term of their loans, but few were willing to shrink the amount of a borrower's debt. Much of the Bush administration, and some in Congress, also argued that such writedowns would amount to a bailout of bad borrowers and lenders. Bernanke countered that negative equity makes borrowers much more likely to default, and that writedowns might be necessary to keep foreclosures from spreading uncontrollably like dominoes, dragging down housing and the wider economy.

Some regulators were particularly forthright in their responses to the subprime shock. FDIC Chairwoman Sheila Bair was one of the first to advocate freezing interest rates for subprime adjustable-rate mortgage (ARM) borrowers facing payment resets; she also proposed writing-down borrowers' mortgage debts. John Reich, Director of the federal Office of Thrift Supervision, put forward a plan addressing some of the same concerns. Not only did such efforts illustrate the severity of the subprime shock and its implications for the nation's financial system, they also testified to the leadership void left over many years by dormant regulators at the Federal Reserve.

Regulators didn't create the subprime financial shock, but they did nothing to prevent it. This was a result of, first, policymakers' distrust of regulation in general, their enduring belief that markets and financial institutions could effectively police themselves; and second, of the nation's antiquated regulatory framework. The institutions guiding the nation's financial system were fashioned during the Great Depression, and as finance evolved rapidly, they remained largely unchanged. An overhaul was indisputably overdue.