WASHINGTON (Reuters) - In January a top bank regulator voiced her biggest concerns. At the top of the list were risky home mortgages, loans that have since come to rattle financial markets and threaten economic growth.
Asked in a Reuters interview what kept her up at night, Federal Deposit Insurance Corp Chairwoman Sheila Bair said: “The subprime mortgage market.”
Just months later, U.S. regulators found themselves powerless before a storm of mortgage defaults, home foreclosures and lender losses that will continue though 2008 and likely run into 2009.
Moving to limit the threat to the economy, President George W. Bush announced on Thursday a five-year interest rate freeze plan to help some subprime borrowers.
There is no single regulator accountable for the U.S. banking system; instead, there are four main federal entities, with slightly different responsibilities. Banking experts say the complexity allows problems to fester.
“A trend toward something as questionable as subprime mortgages can easily develop because there are too many cooks, too many supervisors and no one is really coordinating,” said Michael Malloy, a former senior attorney at one regulator, the Office of the Comptroller of the Currency (OCC).
Other experts are concerned about the ability of banks to shop around for the weakest link in the regulatory framework. No regulator wants to be the toughest, lest banks gravitate to a rival watchdog, these analysts say.
Multiple regulators compete to attract banks by easing restrictions and standards, in the view of Robert Losey, chairman of the department of finance and real estate at American University’s Kogod School of Business.
“It’s called competition in laxity,” he added.
While the burgeoning crisis might be expected to spawn radical reforms, most experts say that is unlikely.
An interagency panel has a “lessons learned” study underway and the U.S. Treasury Department is doing a broad study on regulatory changes, including banking, but an election year is approaching and the banks are a powerful lobby.
“We don’t favor the idea of rolling everybody up into one big Uber-regulator,” said Wayne Abernathy, a policy expert at the American Bankers Association industry group. “I think there is value in having separate charters.”
Setting the stage for the subprime mortgage debacle was a five-year housing boom that began to run out of steam in 2005 and ended in 2006.
Fueling the boom were low interest rates stemming from 13 straight rate cuts from January 2001 to June 2003 that took the Federal Reserve’s benchmark rate down to 1 percent from 6 percent.
Lenders, ranging from big financial institutions to unregulated entities, added to the bubble by making subprime loans — loans to people with a poor record of handling credit.
Most of these loans had adjustable interest rates that often jumped from low introductory rates after a year or two.
Once interest rates began to rise in 2005 and home prices flattened or fell, many subprime borrowers were unable to make their payments and the losses were transmitted to pension funds and other investors who bought mortgage securities.
With an estimated two million subprime home loans due to reset through 2008, Bush said his plan could potentially help 1.2 million homeowners. But analysts say the figure will be much lower.
Regulators would have had to curb subprime loans years ago to head off today’s crisis.
“It was an opportunity missed a few years ago,” agrees former Fed Vice Chairman Alice Rivlin, who left the Fed in 1999.
But it was difficult to oppose subprime lending during the boom, when subprime loans were bringing the dream of home ownership to those who had thought it out of their grasp.
Critics of the subprime industry say home ownership was always illusory under the terms of many loans that included seductively low teaser rates and penalties for early payment.
Others say home buyers share the blame, sometimes lying about their income to get loans, or ignoring the risks of adjustable-rate financing.
Some banking officials may have exacerbated the problem.
In 2004, then Fed Chairman Alan Greenspan spoke favorably of the potential consumers savings from “mortgage product alternatives” in a speech to the Credit Union National Association.
Now, he admits he did not appreciate the risks of subprime lending.
“I really didn’t get it until very late in 2005 and 2006,” he said in an interview with the CBS “60 Minutes” program broadcast in September.
Fed Governor Ed Gramlich had urged Greenspan to tighten oversight of higher-risk mortgage lending.
“My late colleague Ned Gramlich certainly warned about it,” Rivlin told Reuters, adding the Fed should have convened fellow regulators to address the problem.
Banking experts say the hodgepodge of regulators, which grew over many decades, makes it hard to take swift action.
“The fact of the matter is that our regulatory structure is so unnecessarily complicated,” said Malloy, now a professor of specialty financial services at the University of the Pacific’s McGeorge School of Law.
The OCC was created in 1863 to issue standardized national bank notes to help pay for the Civil War. Now it supervises some of the largest banks, such as Bank of America Corp (BAC.N) and Citibank Inc (C.N), but their parent companies are examined by the Federal Reserve.
The Office of Thrift Supervision (OTS) was created in 1989 in response to an episode of risky real estate investments. It oversees institutions largely involving mortgage lending, from small savings and loans to giants such as Countrywide Financial Corp CFC.N and Washington Mutual Inc (WM.N).
The Federal Reserve system was established by a 1913 law that responded to a series of banking panics early in the 20th century. Its primary function is monetary policy, but it examines bank holding companies.
And the Federal Deposit Insurance Corp was created in 1933 in response to thousands of bank failures during the Great Depression. It holds $50 billion to insure deposits in the event a bank fails, examines financial institutions and supervises bank failures.
In addition, the U.S. Securities and Exchange Commission even plays a role, overseeing the holding companies of five large U.S. investment banks: Bear Stearns Co Inc BSC.N, Goldman Sachs Group Inc (GS.N), Lehman Brothers Holding Inc LEH.N, Merrill Lynch & Co Inc MER.N and Morgan Stanley
The U.S. House of Representatives voted in November to bring unregulated mortgage brokers and lenders under a federal licensing program and curtail certain predatory lending practices, but the Senate has not yet followed suit.
And there is no legislation pending to realign agencies.
But many of the experts who spoke to Reuters think the federal patchwork of regulation must be addressed.
“Each of the regulators failed to do as much as it could, but not one regulator alone could have averted the problem,” said Harvard Law School professor Elizabeth Warren.
The Treasury Department is studying combining some regulatory agencies, such as the OCC and the OTS, in an effort to make U.S. businesses more competitive globally.
American University’s Losey said it might make more sense to strip the Fed’s power to regulate bank holding companies and hand it over to the FDIC.
“The FDIC is the one that has the most at risk. In my view they should be the primary regulator,” he said.
But Anil Kashyap, who teaches finance at the University of Chicago, said the Fed, that controls interest rates on loans to banks, has good reason for wanting access to banks.
Kashyap also warns that the agencies would ardently oppose giving up power.
“So, I don’t think this is going to go very far,” Kashyap added.
It is tempting to look at the slightly simpler tripartite British model, involving the Bank of England, UK Financial Services Authority and Treasury.
But there have been calls for reform in Britain as well after depositors rushed to withdraw savings in September from Northern Rock Plc NRK.L, the nation’s fifth largest mortgage bank, after it failed to raise funds in wholesale markets.
It was the first run on a British bank in more than 140 years.
Editing by Tim Dobbyn and Andre Grenon