Regulators under fire for ignoring red flags

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Sheila Bair logged onto her e-mail account recently and got a pop-up ad offering a $175,000 home loan with monthly payments of only $400.

“I thought, ‘Oh no, it’s coming back already,’ ” said Mrs. Bair, the Federal Deposit Insurance Corp. chairman who had spotted problems with abusive and risky mortgages long before the mortgage crisis broke out last year.

The pop-up on the screen took her back several years to the time she first saw trouble brewing. The ads had been the warning flags: pop-ups, spam e-mails and junk-mail fliers offering loans at extraordinarily easy terms and low rates without explaining that the payments would eventually shoot up to unaffordable levels — a practice that will be banned in the future.

Today, federal regulators are on the firing line trying to explain why they were seemingly asleep at the switch and failed to crack down on the abusive loans that led to the worst housing bust and financial collapse in modern times.

If regulators failed to act quickly or aggressively enough, they can share the blame with most of their interrogators in Congress. Elected officials did little to deter risky lending and instead mostly sat on the sidelines between 2000 and 2006, cheering on the housing boom and the easy mortgage financing that made it possible.

Three years ago, those early signs prompted a fruitless effort by the FDIC, the Federal Reserve and other regulators to warn banks against the risky lending practices that were proliferating, including loans with teaser rates as low as 1 percent whose monthly payments could more than double once the loans adjusted to market interest rates.

While that light-handed regulatory guidance may have been heeded by a few banks it had no effect on the legions of mortgage brokers operating outside the banking system. They took their marching orders from Wall Street investors ready to throw billions of dollars into the lucrative mortgage securities derived from pools of subprime and exotic loans.

Brokers joked that anyone who could fog a mirror could get a loan, borrowers exaggerated their incomes with impunity, and the race to the bottom in lending standards went largely unchecked until the market for such loans collapsed in the middle of last year. The crisis brought on by accelerating defaults on subprime loans quickly spread to nearly every corner of the credit market.

It seemed like a win-win situation when the boom was raging. Many first-time buyers attained the American dream of homeownership while the 70 percent of Americans who already owned homes watched their household wealth soar along with house prices.

Federal and state tax coffers were filled with revenue generated by booming home sales and prices, and political leaders reaped millions of dollars in campaign contributions from the profitable real estate and mortgage businesses and Wall Street firms, all of which benefited from keeping the party going.

“Everybody was happy,” said Mrs. Bair. No one in Washington wanted to break up the financing orgy and end the housing bonanza. “So long as prices were going up, not many people were complaining. … Consumers were getting these mortgages, but they could refinance out of them” when the payments shot up, as long as the market remained strong.

As a top Treasury official in 2001 and 2002, Mrs. Bair worked with consumer groups and other regulators to try to establish voluntary “best practices” aimed at marginalizing predatory lenders, but the effort went nowhere. Legislative efforts on Capitol Hill spearheaded by leaders of the House Financial Services Committee — Reps. Barney Frank, Massachusetts Democrat, and Spencer Bachus, Alabama Republican — fared no better.

“Back then, we mainly looked at it as a consumer issue. I don’t think anybody thought it had economic implications,” Mrs. Bair said. Few people at the time had “a full appreciation of the costs of these mortgages, or [realized that] if the market stopped going up [borrowers] would lose their ability to pay.”

The result is a record level of foreclosures and a major credit crisis that likely has thrown the economy into recession. Many analysts compare it to the savings and loan crisis two decades ago, when lax federal policies allowed a proliferation of fraud and abuse in bank lending that ended in a big real estate bust and recession.

“The smart people really screwed this one up,” said Mr. Frank, now chairman of the House committee. He has spent much of the last year threatening to impose a heavy-handed legislative hammer on the financial industry if voluntary and regulatory efforts by the administration fail to make headway toward resolving the crisis and cleaning up lending standards.

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