The Bush administration and the U.S. Chamber of Commerce picked an awkward moment for their latest assault on financial and consumer-protection regulation. At the very moment that Treasury Secretary Hank Paulson was meeting with Wall Street bigwigs in a high-profile confab this week to call for weakening the post-Enron Sarbanes-Oxley Act and other investor and consumer protections, the stock market was tanking.
The Bush administration and the U.S. Chamber of Commerce picked an awkward moment for their latest assault on financial and consumer-protection regulation. At the very moment that Treasury Secretary Hank Paulson was meeting with Wall Street bigwigs in a high-profile confab this week to call for weakening the post-Enron Sarbanes-Oxley Act and other investor and consumer protections, the stock market was tanking.
Why is the market so nervous? Mainly thanks to the latest bitter fruit of financial deregulation: the collapsing $1.3 trillion "subprime" mortgage business, which now accounts for one mortgage in three. Here is a textbook case of why financial institutions need to be regulated, to protect both consumers and the solvency of the larger economy.
In the past decade, as regulators discarded rules, shady mortgage banking companies, financed by the bluest-chip outfits on Wall Street, calculated that they could make a lot of money offering bait-and-switch mortgages to poor credit risks. Default and foreclosure rates would be greater, but higher profits would more than compensate for the risks. So the subprime mortgage industry, enabled by the big banks, invented amazing gimmicks. These included not just variable-rate mortgages, but mortgages that were initially interest-only, mortgages with introductory teaser rates, mortgages with no down payment. No income verification required! No credit check! Subprime operators targeted people with horrific credit histories and families desperate for housing who could not afford the debt they were taking on. Last year, 60 percent of subprime loans required no meaningful documentation.
Then came the morning-after: As higher payments kicked in, people couldn't meet them. Defaults skyrocketed, to an estimated 13 percent of all such loans. At least 25 subprime lenders have gone out of business. The big dogs on Wall Street, who had invested in the subprime operators, took a big hit, too.
It's not clear where this will end. Many low-income families will lose their homes. Innocent investors will suffer the spillover effects on the stock market, and general mortgage rates may have to go up to compensate for these losses of reckless speculation.
But wait. Weren't these subprime lenders doing good works by making it easier for low-income borrowers to become homeowners? Sure -- in the same way that the Mafia helps small-business owners desperate for credit. If the goal is to promote low-income homeownership, there are far better ways that don't put financial markets at risk and don't cause people to lose their homes after a few years.
For instance, the Federal Housing Administration has long had a program of insured loans that require only a 3 percent down payment (and have a much lower default rate). Nonprofit and public programs like Neighborhood Housing Services offer long-term help to moderate-income homebuyers on credit counseling. If we were serious about promoting first-time homeownership, we would offer subsidized, low-rate mortgages, as we did in the Great Society era, before Reagan and the Bushes gutted social spending.
The subprime mortgage industry had no real commitment to the homebuyer, who was merely a handy means of making a quick buck. Ever since the Wall Street wiseguys invented "securitization" of mortgage loans, a mortgage company with little of its own capital at risk has been able to originate loans and sell them off to middlemen who turn them into bonds. Both the mortgage company and the middlemen make their money on the transactions, and some lucky investor ends up with the bonds and the risks.
Supposedly, the wizards of the private secondary mortgage market, such as Fannie Mae, vet the mortgages to make sure reasonable standards are being met. But Fannie has been reeling from her own scandals, and obviously someone was asleep at the switch.
A spectacular casualty was a subprime lender called New Century Financial, which has now suspended loans. Between 2004 and 2006 its three founders, perhaps seeing the coming abyss, realized $40 million in stock-sale profits, and are now under investigation for possible improper trading and rigged accounting.
Congress is also investigating the entire mess, while mortgage industry lobbyists hope to fend off regulation by using the low-income family as poster child for the industry's misdeeds: Regulation would just hurt the poor.
But before the mid-1970s, this kind of meltdown didn't happen, because there were regulations and prudent credit standards; low-income people got government help rather than private-market scams -- and there were hardly any defaults. How many more financial scandals will it take before we get back to that model?
Robert Kuttner is co-editor of The American Prospect. A version of this column originally appeared in the Boston Globe.
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