If politicians needed any more proof that shuffling existing regulators won't fix the fundamental problems, then this week's autopsy of Washington Mutual, the largest bank failure in US history, should suffice. Over several hearings and press briefings this week, the Senate investigations subcommittee, led by Carl Levin (D-MI) and Tom Coburn (R-Okla.), has dissected how WaMu and its former subprime subsidiary, Long Beach Mortgage, created a "mortgage time bomb" and fed the voracious mortgage securitization machine on Wall Street. Moreover, Levin and Coburn's teams examined how WaMu's principal regulator, the Office of Thrift Supervision, utterly failed in every single one of its duties: OTS failed to crack down on the bank's abysmal lending practices; allowed WaMu to churn out bogus option ARM mortgages worth hundreds of billions of dollars; and treated WaMu like a buddy and not a bank to be reined in. Not only that, OTS even blocked another regulator, the FDIC, from trying to get a peek at WaMu's toxic holdings.
The Senate's investigation reads like an exercise in folly. In emails, examiner reports, and other communications, OTS repeatedly spotlighted the bank's pitiful standards and practices. Yet for years the regulator failed to do anything. No enforcement actions, fines, required board resolutions. Nothing. OTS was supposed to be a firefighter, ready to rush into action at the first sign of trouble, Levin told reporters yesterday. Instead, "it stood and watched idly while the incendiary threat grew wider and wider."
Underpinning the OTS' hands-off approach was the bank's cozy relationship with WaMu. As Levin explained, OTS derives its funding from fees it assesses on the banks it regulates; WaMu, it turns out, was a huge source of revenue for OTS, posing a blatant conflict of interest for the regulator. This led to a relationship, emails and reports cited in Levin and Coburn's report show, in which the OTS viewed WaMu not as someone to be scrutinized but as a "constituent" and a customer. "Regulations only work if regulators stay at arm's length from people they regulate," Levin said. OTS, on the other hand, worked "arm in arm" with WaMu.
The evidence dug up by the Senate subcommittee is damning, and it painfully illustrates a classic case of regulatory capture. If anything, it's proof that new financial rules crafted by Congress and the White House need to be regulator-proof; that means limits on risk levels, mandatory amounts of cash to absorb losses, and outright bans on tricky products, among others. Anything else, the Senate's findings suggest, will lead to plenty more OTS-WaMu debacles in the future.
Are the Democrats poised to ram through a new financial reform bill and recreate last month's bruising, rancorous, controversial health care battle? If Senate Majority Leader Harry Reid stands by his remarks made today, then the answer to that question could be Yes. In a press briefing today, Reid said, "We have talked about this enough. We have negotiated this enough," while suggesting that a bill overhauling Wall Street and possibly creating a new consumer protection agency could land on the Senate floor as early as next week, Huffington Post's Ryan Grim reports. And while Republicans say they want to be able to make changes to the bill before it hits the floor, the Obama administration doesn't want the GOP to have the chance to whittle away at the legislation and bog down negotiations on the bill.
If the Democrats do indeed go it alone, they're potentially setting the stage for another health-care-esque bruiser in the Senate. Already, the bill, which should theoretically garner plenty of bipartisan support (everyone wants to end too-big-to-fail, predatory lending, and dangerous financial products, right?), has divided the Senate. Since returning from recess, the debate over new financial reforms has rapidly disintegrated into a partisan shout-fest complete with old-school takedowns ("poppycock"? Really Chris Dodd?), Charlie Brown football folly references, heated floor speeches, and plenty of jabs and upper cuts thrown by each party.
Is there any hope for the Obama administration's much maligned, $75 billion homeowner relief effort, the Home Affordable Modification Program (HAMP)? Government watchdogs, consumer advocates, and lawmakers have, since its unveiling last March, repeatedly criticized HAMP and its architects over at the Treasury Department for any number of reasons—the program's paltry results, Treasury's efforts to move the goal posts for HAMP success, the disproportionate number of carrots and too few sticks in the program, and much more. In just over a year, the program, which was initially predicted to help three to four million homeowners, has provided permanent loan modifications (an agreement between the mortgage servicer and homeowner to lower monthly payments through interest rate or principal reductions, or extending the loan's life) to 228,000 homeowners, according to Phyllis Caldwell, the head of the Homeownership Preservation Office within the Treasury. By contrast, there were 2.8 million foreclosures in 2009, and some three million more are projected this year.
Last month, the Treasury rolled out its most comprehensive changes to HAMP yet. The new rules, the Treasury said, could pave the way toward fewer foreclosures by urging more principal reductions, providing relief to unemployed homeowners, and letting homeowners convert their mortgage to a federally-backed, more secure loan. But will these changes really do much good, salvaging what some say has become a $75 billion boondoggle? That's the question the House financial services committee took up on Wednesday, bringing together top administration and industry officials, academics, and other experts to weigh in on HAMP's new look. Unfortunately, what the majority of those experts had to say didn't bode well for Obama's flagship program.
A common refrain among those who testified yesterday was that HAMP remains a mostly voluntary program; that Treasury has yet to force mortgage servicers, who are the boots-on-the-ground connection to homeowners, and investors to make tough but necessary changes. Take principal writedowns, the reduction of how much someone owes on their mortgage. While HAMP's new changes encourage principal writedowns, they still don't make them mandatory, but rather dangle yet more incentives over servicers to get them to write down principal. "The new principal reduction approach (which will not even be implemented until close to the end of this calendar year) is unlikely to coax many servicers into reducing principal," said Alys Cohen, an attorney with the National Consumer Law Center.
Moreover, coaxing servicers to decrease principal and offering more money to do so reflects the Treasury's insistence on incentives over requirements. "Unfortunately, as HAMP has been implemented, Treasury has largely relied on large carrots to get servicer participation and has generally, if not entirely, eschewed sticks," said Andrew Jakabovics, of the Center for American Progress. "Borrowers and their advocates frequently find servicers are making mistakes on a range of program elements but there is no consistent, independent mechanism for redress, despite calls for developing a robust appeal process since the program’s beginning." Treasury's avoidance of mandatory principal requirements—or what's called "cramdown," in which bankruptcy courts are allowed to rewrite the terms of a mortgage—aligns with the position of the mortgage industry, as evidenced by the testimony yesterday of Robert Story, the chairman of the Mortgage Bankers Association, which opposes these tougher provisions.
Several experts yesterday also doubted the administration's plan to help unemployed homeowners by reducing their mortgage payments for a period of up to six months while they try to find work. The NCLC's Cohen, for instance, doubted whether six months was a sufficient period of time to find a new job; indeed, the Bureau of Labor Statistics reported earlier this month that 6.55 million workers had been out of work for more than 26 weeks, a national record. If so many workers are jobless for more than six months, will this addition to HAMP do that much good?
Big question marks remain in the structure of HAMP, Wednesday's hearing showed. The net present value test—used by mortgage servicers to determine whether someone gets a modification or not—has yet to be made public, which means there's no transparency or accountability for a core element of HAMP. Moreover, Treasury has yet to announce any kind of penalties or corrective actions for servicers who don't comply with HAMP's guidelines, said Cohen.
And as Valparaiso law professor Alan White described, HAMP's overall impact has actually been to decrease the total number of modifications, both public and private. Before March 2009, when HAMP came out, permanent modifications numbered around 120,000 a month; soon after, that figure dropped to 80,000 or so a month. Now, a year after HAMP's release, White said, those modification numbers were returning to pre-HAMP levels. "There is still no overall increase in modifications, or reduction in foreclosures, resulting from HAMP," White said. What's more, data released by the Treasury this week showed that the number of homeowner defaults by those who'd received a permanent modification nearly doubled in March. And in a report released Wednesday, the Congressional Oversight Panel stated that 75 percent of homeowners in HAMP remained underwater, meaning they owe more than their house is worth.
In his testimony, White questioned the entire premise of HAMP. He dubbed the program's philosophy "extend and pretend," suggesting that the program merely moves homeowners' debt a bit further into the future, kicking the can down the road, rather than addressing the issue of negative equity and out of whack mortgage payments right now. The only way to truly address the foreclosure crisis, he said, was to mandate principal reductions for homeowners—not use small incentive payments and other carrots to lure servicers into helping people.
In all, most of the testimonies reflected a widely held skepticism about HAMP, new provisions or not. Those experts essentially suggested that, unless the program is largely reimagined, it won't do much at all to help the millions of homeowners still clinging to their houses.
A day after the Senate's top Republican, Mitch McConnell of Kentucky, blasted the Senate's current draft of financial reform legislation, saying it would lead to "endless taxpayer-funded bailouts," three Senate Democrats fired back at McConnell today by painting GOPers as too cozy with Wall Street. The senators—Jack Reed of Rhode Island, Jeff Merkley of Oregon, and Sheldon Whitehouse of Rhode Island—stressed that the bill would force big banks and other financial institutions to fund their own future bailouts, through a $50 billion resolution fund, and that Republicans like McConnell were merely playing political games. "This is one of many recent cases in which Republican rhetoric has become completely unhinged from reality," Whitehouse said at a press conference today, "in which words are used for their effects and are totally disconnected from the truth."
The Democratic senators used the press conference mainly to highlight a recent meeting between top GOPers and Wall Street leaders, and to accuse the other party of caring more about Big Finance than not American families. Whitehouse pointed to a private meeting in New York between 25 Wall Street executives, including hedge fund managers, and McConnell and Sen. John Cornyn (D-Tex.), the head of the National Republican Senatorial Committee, as evidence that Republicans have aligned themselves with the interests of Wall Street. "If you look at the spectacle of Republicans running up to Wall Street to offer their services, in return for financial support, at blunting the effects of financial reform legislation...I think you can see that these charges are ill-founded" and intended to distract from the real debate around financial reform, Whitehouse said.
This partisan infighting offers a preview of what's to come as the Senate tries to pass a financial reform bill in the coming weeks. While rewriting our financial system's regulations should be an issue on which there's bipartisan support, this week's blow-by-blow suggests the debate around new financial regulation could end up looking like the ugly health care wars, with a bitter debate dividing the Senate. If this kind of blow-by-blow continues in the Senate, it will dim hopes of sending a bill to the president by Memorial Day.
Sen. Blanche Lincoln (D-Ark.) is generating plenty of buzz in financial circles for her new bill to regulate derivatives, those tricky financial products, whose value is linked to the price of commodities or interest rates, used to hedge risk and also make risky gambles. Lincoln's ambitious derivatives reform bill would require nearly all derivatives trades to take place on an exchange, where details on prices and the make-up of the deals would be transparent. (Right now, these deals take place essentially in the dark, between buyers, sellers, and brokers who privately negotiate the terms of the deal. That makes it practically impossible for, say, an airline company buying a contract to hedge against fuel price increases to look at similar deals done before and get a sense for what it should pay.)
As Felix Salmon pointed out, if derivatives will be exchange-traded, that means they'll be cleared, too, i.e., the risk of default on those deals will be distributed across the many members of the clearinghouse, instead of falling all on one counterparty. It essentially protects against another AIG-esque collapse, when billions in derivatives losses were absorbed by the global insurer leading to its near-demise.
Lincoln's bill would also call for swaps outfits to be cut out of big investment banks and essentially made into separate operations. This, of course, would prevent crippling losses on a swap desk from dragging down the rest of the firm—again, a la AIG's Financial Products division mortally wounding the entire company. Lincoln would also make a narrow exemption for specific end users of derivatives—the airlines and farmers and utility companies looking to legitimately hedge risk—without letting the speculators squeeze through that exemption.
So, that's all great, right? If you support tough new derivatives reform—like many Congressional Democrats; Gary Gensler, chair of the Commodity Futures Trading Commission and the top administration officlal overseeing derivatives; and reform advocates—then you're ecstatic. If you're Wall Street, then you're pissed. Don't be surprised to see the likes of Goldman Sachs and Morgan Stanley—whose profits would likely diminish with exchange trading and clearing (with price transparency and competition, they can't set prices to their liking and rip off clients)—lobby furiously to kneecap Lincoln's bill.
As tough as the bill is, realistically, it's even tougher to envision it surviving the gauntlet of special interests and GOP lawmakers. Here's Felix on it:
...it’s also pretty clear that none of this is going to happen. Never mind Republican support: this is going to have a hard time even getting Democratic support. It’s all a good idea, but it’s far too radical: while it might have had more of a chance if it had been introduced during the height of the crisis, at this point the banks have got their mojo working again and will quite easily be able to ensure that the beating heart of Lincoln’s proposals is surgically excised before it even gets anywhere near a vote.
That said, if Lincoln and her allies can at least preserve the exchange trading and clearing requirements, that'll amount to a major victory. Dragging these trades into the light of day is paramount because the OTC market is inherently stacked against end users. Right now, so many of these deals are opaque, and a whole host of costs bundled into the transactions aren't disclosed or well understood. If derivatives were traded in the open, however, you'd shed light on all that and compress what's called the bid-ask spread—the difference between the highest amount the buyer wants to pay and the lowest amount the seller will take to offload their product. That's good for companies using derivatives—it lowers the cost for them.
All told, there's no chance Lincoln's bill will emerge weeks or months down the road untouched. But it's laudable that she set the bar so high, and if she and her allies can preserve the transparency measures, that alone will be victory for financial reformers.