Dissecting the Mortgage Meltdown

After watching mortgage market turmoil steal headlines throughout the August congressional recess, House Democrats dove into the growing crisis yesterday, calling for stiffer regulation and listening as an administration official warned that the worst could be yet to come.

For the past two weeks, economists and market analysts have filled news pages and airwaves with a raging debate over the likelihood of a major economic downturn driven by the subprime-mortgage market’s implosion. Some observers argue the blaring headlines about a crisis are overblown. Others fretfully predict a slow, but not catastrophic correction. Still more worry about a full-scale recession. They all agree, though, that a major component of today’s economic landscape is changing, and quickly.

At yesterday's House Financial Services Committee hearing, the Treasury Department’s Under Secretary for Domestic Finance, Robert Steel, told lawmakers that, whatever the final fallout, we haven’t yet reached it. "The ultimate impact of these events on the economy has yet to play out," he ominously warned. The question that must be answered, however, is what the Bush administration’s deregulators did to usher in the problem in the first place?

In the 1990s, the market for subprime housing loans exploded. Its wild growth allowed new and first-time buyers to purchase property, opened lenders to increased profits down the road, and let homeowners enjoy the fruits of ever-increasing home prices across the country. Or, so the theory went.

The reality has proven much different. Lobbyists spent hundreds of millions of dollars a year in Washington to secure friendly legislation that made it easier for banks and lending companies to prey upon new and desperate borrowers—men and women of low and middle incomes or with poor credit who, without subprime loans, would not have been able to purchase homes at all, let alone at the high prices they paid.

Everybody in the game misread, or ignored, the old rules.

Some borrowers entered agreements with lenders that they didn’t understand. Others understood the stakes, but gambled on their long-term potential to make enough money to pay off their debts. Many refinanced their homes at lower rates and used the increased liquidity to buy goods and services, deceptively boosting the economy with money that didn’t exist with any certainty.

Lenders, meanwhile, believed that home prices would rise interminably, allowing borrowers to pay off their loans with the equity they’d squeeze out of their homes. The bankers and hedge-fund managers who underwrote the lenders believed they understood the markets well enough to get out of the game if and when prices stopped rising.

When that in fact happened, borrowers began to default and the market for subprime loans contracted rapidly. On April 2—with foreclosures on the rise and $1.3 trillion in subprime debt still outstanding—New Century Financial, one of the nation’s largest subprime lenders, filed for bankruptcy. Faced with the same pressures, other players reacted with concern and either followed suit or downsized their operations.

As Treasury’s Steel explained in his testimony, what comes next remains unknown. Nevertheless, federal oversight is slowly, belatedly cranking into gear. Everybody's watching on edge for what, if anything, Federal Reserve Chair Ben Bernanke will do with interest rates, and the Democrats are asking questions.

Rep. Barney Frank (D-Mass.) made the mortgage crisis the first item on his Financial Services Committee’s post-Labor Day agenda. At the hearing, he called for greater oversight of the lending industry.

"It’s clear that financial innovation outstripped regulation," Frank said, according to a Congressional Quarterly report, adding that new realities of the technologically savvy and globally spread financial industry demand new safeguards. "It’s not increasing regulation," Frank argued, but rather asking "have the markets now come up with new things that we don’t have the regulatory tools for?"

On Friday, August 31, President Bush offered his own solution, which decidedly did not include reigning in industry. He urged Congress to allow the Federal Housing Administration to insure larger loans and to suspend the practice of counting surpluses from canceled mortgages as taxable income.

Dean Baker of the Center for Economic and Policy Research dismissed the president’s plan as a "limited bailout of lenders." On his blog, Baker noted that, "the FHA will be helping moderate income homeowners to borrow $200,000 on a home that is worth $180,000. That doesn’t sound like a very good plan for the homeowner and is probably not an especially good use of government money. It essentially means paying off the current mortgage holder—who otherwise would be holding bad debt—with taxpayer money."

Still, the president’s plan is a significant step for an administration that has allowed an unfettered explosion of subprime lending. Critics point to several ways in which the administration has in fact worsened the problem.

By 2005, analysts had already alerted policy makers and investors to the risks a freewheeling subprime market presented to borrowers. Yet, the White House shoved through Congress legislation that undercut borrowers’ ability to file for bankruptcy with debt forgiveness. Subprime creditors were avid supporters of the bankruptcy legislation.

In 2001, Bush appointed James Gilleran, the regulation-averse banker, to head Treasury’s Office of Thrift Supervision and kept him aboard until April 2005—by which point lenders had issued billions of dollars in bad debt, contributing to then-surfacing fears of a housing-bubble that was poised to burst.

Frank’s committee plans to examine the president’s proposal later this month. Aides to California Rep. Linda Sanchez, chair of the Judiciary Subcommittee on Commercial and Administrative Law, have suggested that she considers it a priority to figure out how we got into this mess. They said she plans to explore the proliferation of lender-friendly laws, but offered no details on when and where the subcommittee would begin looking into the matter. The answers may not fundamentally shape the work that must be done to fix the problem, but they will at least shed light on the role industry and politicians played in a scheme that will ultimately harm millions of Americans.