Regulators Explain Crisis

Speaking before the House Committee on Financial Services, Treasury Under Secretary Robert K. Steel said subprime borrowers gained access to real estate credit in the early 1990s, according to a transcript of his prepared remarks. The increase drove the subprime share from 5 percent of total mortgage originations in 1994 to nearly 20 percent in 2005. Subprime originations went from $35 billion to $625 billion during that same period.

The growth was fueled by a surge in the activity of residential mortgage-backed securities, Steel said. Last year, securitizations, which are bundled pools of individual loans that are sliced up based on varying levels of risk for sophisticated investors, funded 55 percent of mortgage originations and 70 percent of subprime originations.

The transcript indicated collateralized debt obligations have further fueled the growth — with 40 percent of the $500 billion CDO market being mortgage-backed in 2006.

Growing investor appetite helped push annual mortgage originations from $1 trillion during most of the 1990s to $4 trillion in 2003 — when mortgage rates reached record lows, the Treasury official explained. But a subsequent decline in production had originators lowering their underwriting standards and boosting 2/28 teaser rate activity. And mortgage originators may have had less incentive to keep up due diligence because loan risk was transferred through securitization.

The declining quality of originations has led to rising defaults, hedge fund losses and ratings downgrades, Steel said. The current reappraisal of risk typically follows periods of widely available credit when markets have undervalued risk.

“The recent volatility in the credit and mortgage markets reflects a reassessment of risk across a broad spectrum of securities,” the under secretary concluded. “I do want to caution policymakers that this process is far from over. It will take more time to play out and certain segments of the capital markets are stressed. Risk is being repriced.”

Federal Deposit Insurance Corp. Chairman Sheila C. Bair confirmed much of what Steel said, adding that low rates helped push home prices higher — with double digit appreciation rates during 2004 and 2005. She noted Alt-A activity also expanded.

“While nontraditional mortgages, subprime mortgages, and home equity loans were not new to the marketplace in 2004, they had never been originated on such a wide scale prior to this time,” Bair said in an FDIC transcript of her testimony. “The end result of this process was the creation of trillions of dollars in investment grade mortgage-backed securities that were purchased by a range of domestic and international investors, along with a smaller volume of higher-risk securities that were better suited to hedge funds and other investors with an appetite for yield and a greater tolerance for risk.”

Bair explained the easy access to funding contributed to a deterioration in underwriting, an increase in mortgage fraud and a jump in speculative residential investments. The subsequent meltdown has led to the downgrade of more than 2,400 tranches of RMBS since June.

“While the resulting loss of credit capacity is expected to be temporary, it is important that during this period the banking industry is well-positioned to supply credit, especially for home mortgages,” Bair concluded.

Comptroller of the Currency John C. Dugan testified that commercial banks have participated little in the subprime market, a statement from the OCC indicated. In addition, bank default rates have been lower than the U.S. average.

“Unlike many non-bank lenders, national banks generally have strong levels of capital, stable sources of liquidity, and well diversified lines of business, all of which have allowed them to weather adverse market conditions,” he said. “While legitimate concerns remain about the pendulum swinging too far and too suddenly in the opposite direction, we remain hopeful that markets will stabilize at an equilibrium where lending standards are more rational and pricing more accurately reflects risk.”

U.S. Department of Housing and Urban Development Secretary wrote in a letter to the chairmen of the Senate Banking Committee and the House Financial Services Committee that over 200,000 mortgages could be saved from foreclosure if the lawmakers pass reform legislation for the Federal Housing Administration.

“If Congress enacts legislation to reform this critical mortgage insurance program, FHA will be able to better adapt to today’s marketplace and serve as a more viable solution to predatory lending and the exotic loan market,” HUD said in a statement.

Sam Garcia worked in mortgage lending for twenty years prior to becoming publisher of MortgageDaily.com.

e-mail: mtgsam@aol.com