Financial Rescue Plan (HOLC II) Should Require Regulatory Reform
2/22/08 Rescues for Homeowners in Debt Weighed [Upside-Down Mortgages] NY Times. Not since the Depression has such a large share of Americans been underwater on their mortgages, i.e., owed more on the homes than they are worth - 8.8 million homeowners, or 10.3 percent. [I.e., 10.3 percent of homeowners have mortgages that are upside down - and the figure is three times as high for recently acquired mortgages]. This is more than double the percentage a year ago, estimates Moody’sEconomy.com. Administration officials say they still oppose any taxpayer bailout. But Washington is being forced to explore new ideas, among them the idea of a federal mortgage guarantee for troubled borrowers.
BANKS CHANGE THEIR TUNE
The banking lobby used to sing “My Way” (1969) to get Congress to lighten up on regulation. In 1999, the lobby succeeded – in the name of financial innovation – in rolling back the very Glass-Steagall Act (1933) that was created to stop banks from making risky investments.
Now the banks are singing “Buddy Can You Spare a Dime” (1932) again. Their ask this time, however, is for a lot more than a dime. The Bank of America has asked Congress to create a Federal Homeowner Preservation Corporation to buy up and refinance mortgages in default. The BofA estimates that $700 billion in mortgages are at risk of default in the next five years. Could we be looking at a $1 trillion bailout?
Banks have moved from a hands-off attitude toward regulation to a plea for Congress to lend a hand.
The next President of the United States will have to sort out the fiscal and financial fiasco. The proposal for a mortgage buyout fund amounts to a HOLC II, along the lines of FDR’s Home Owners’ Loan Corporation (HOLC, 1933-1951). It has been supported by Connecticut Senator Christopher Dodd and Professor Alan Blinder. An ingredient in the solution might be a domestic version of the Brady bonds. But there are two caveats:
-A bailout creates the potential for moral hazard by compensating people for imprudent behavior. Individuals and institutions that engaged in fraudulent or speculative mortgage applications should not be made whole. The original HOLC did not keep those who needed the HOLC facility from suffering losses.
-Even more important, along with the HOLC, FDR and the Congress put in place at the same time some constraints on banks such as the Glass-Steagall Act and the FDIC, and they created the SEC.
It may not be possible or desirable to restore Glass-Steagall, but here are some ideas for regulatory reform to make the HOLC more credible: 1. Establish an Affordable Housing Council. Convene a multi-stakeholder initiative, bringing together all the regulators – FRB,OCC and OTS, FDIC, SEC, HUD – and representatives of industry, consumers and local government. A law needs multiple perspectives and input or you get the contention later (as in the case of Sarbanes-Oxley). 2. Stop Predatory Lending. Some state laws aimed at predatory lending have been praised by three Wharton professors. The North Carolina Predatory Lending Law of 1999, for example, applies to mortgages of $300,000 or less that carry a rate of 8 percent above a benchmark U.S. Treasury rate. It prohibits negative amortization, interest-rate increases after a borrower default, balloon payments and other features associated with predatory loans. 3. Stop SIVs. Possibly by simply enforcing existing bank regulatory laws and FASB principles, end the dangerous Structured Investment Vehicles, which can be spun off with no capital and potentially disastrous contingent liabilities to the issuer. 4. Require the SEC to Monitor Wall Street’s New Products. Someone has to keep a risk-assessing eye on what is cooking in the Wall Street derivative kitchen. The SEC was missing in action from due-diligence oversight back in 1999 when the dot-com IPOs were cooking and then again when the toxic CDOs were on the stove. 5. Encourage the FDIC to Price Risk More Aggressively. The FDIC has some latitude in requiring higher deposit insurance premiums and it should have more. Introduce the Basel II bank capital-adequacy guidelines ahead of schedule. Financial innovation should never override the original mission of the bank regulatory agencies, which is to ensure orderly markets. The Northeast United States has not had as serious a problem with subprime loans as the rest of the country and the credit for this should go to stuffy Northeast bankers. 6. Raise the Profile of the Fed's HOEPA Consumer-Protection Activity. Make basic financial education a national priority. Free information is available online from places like Fannie Mae, Freddie Mac, and the Mortgage Bankers Association. We need financial counselors in every city whose job it is to look at documents and comment. The Mortgage Bankers Association has promised to work with the U.S. Conference of Mayors to fund such a program. The Affordable Housing Council should seek to ensure counselors are in every city that will look at mortgage terms, provide free advice to would-be borrowers and keep an eye on local credit practices. Just as a buyer of a drug at a pharmacy must sign a waiver of consultation on a prescription that is filled, every borrower should be required to sign a statement saying that they are aware of the availability of local counseling services (with addresses and phone numbers provided). States with counselors at the state and county level have helped ensure that low-income mortgages have default rates below the FHA's.
These are just a few ideas. The point is that a massive program for buying distressed mortgages will come at a cost to the taxpayer. Every effort should be made to avoid rewarding those who allowed the current situation to develop. Otherwise we will soon enough be back into yet another cycle of financial excess.