The Subprime Virus This page intentionally left blank The Subprime Virus Reckless Credit, Regulatory Failure, and Next Steps KATHLEEN C. ENGEL PATRICIA A. McCOY 2011 Oxford University Press, Inc., publishes works that further Oxford University’s objective of excellence in research, scholarship, and education. Oxford New York Auckland Cape Town Dar es Salaam Hong Kong Karachi Kuala Lumpur Madrid Melbourne Mexico City Nairobi New Delhi Shanghai Taipei Toronto With offi ces in Argentina Austria Brazil Chile Czech Republic France Greece Guatemala Hungary Italy Japan Poland Portugal Singapore South Korea Switzerland Thailand Turkey Ukraine Vietnam Copyright © 2011 by Oxford University Press, Inc. Published by Oxford University Press, Inc. 198 Madison Avenue, New York, NY 10016 www.oup.com Oxford is a registered trademark of Oxford University Press. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior permission of Oxford University Press. Library of Congress Cataloging-in-Publication Data Engel, Kathleen C. The subprime virus : reckless credit, regulatory failure, and next steps / by Kathleen C. Engel and Patricia A. McCoy. p. cm. Includes bibliographical references and index. ISBN 978-0-19-538882-4 1. Subprime mortgage loans—United States. 2. Financial crises—United States. I. McCoy, Patricia A., 1954– II. Title. HG2040.5.U5E54 2010 332.7’20973—dc22 2010003614 9 8 7 6 5 4 3 2 1 Printed in the United States of America on acid-free paper To the memory of Fred Rebitzer, who understood and believed in this project. (K.C.E.) To Chris, for being there for me. (P.A.M.) This page intentionally left blank Contents Acknowledgments ix 1 Prologue 3 Part I The Subprime Market Takes Off 2 The Emergence of the Subprime Market 15 3 A Rolling Loan Gathers No Loss 43 Part II Contagion 4 Prelude to the Storm 69 5 Meltdown 99 6 Aftermath 123 Part III Regulatory Failure 7 The Clinton Years 151 8 OTS and OCC Power Grab 157 9 Put to the Test: OCC, OTS, and FDIC Oversight 167 10 Blind Spot: Greenspan’s Federal Reserve 189 11 Wall Street Skirts Regulation 207 Part IV Solutions 12 Consumer Protection 227 13 Containing Contagion 237 14 Epilogue 253 Notes 259 Bibliography 295 Index 343 viii • CONTENTS Acknowledgments I n the late 1990s, we embarked on a journey to understand why high-risk loans were ravishing Cleveland’s neighborhoods. Little did we know that our voyage would last for more than a decade and eventually pay witness to the greatest fi nancial cataclysm in most Americans’ lifetimes. Along the way, countless people assisted us with their insights, critiques, and sup- port. Readers should not assume that those we thank endorse all of our ideas; many of the people we consulted had different points of view. To anyone we inadvertently for- got to mention, please accept our apologies. Any mistakes in this book are ours alone. We have worked with a number of immensely talented collaborators. We are es- pecially grateful to our coauthor, Susan Wachter, who was one of the fi rst economists to encourage our research. The knowledge and intellectual rigor of our other coau- thors, Raphael Bostic, Souphala Chomsisengphet, and Anthony Pennington-Cross, enriched our understanding of subprime lending and, in turn, this book. Recently, we have also had the pleasure of coauthoring with a talented new scholar, Thomas Fitzpatrick. Amy Dunbar and Andrey Pavlov, who have written articles with Pat, shed valuable light on subprime accounting issues and the workings of credit default swaps. Over the years, we have benefi ted from the ideas of many other academics, re- searchers, and advocates. At the top of the list are Elizabeth Renuart and Kathleen Keest, who understand credit regulation better than anyone we know and have always been willing to teach us and engage with our ideas. Many other valued colleagues advanced our work by sharing their knowledge, playing devil’s advocate, and urging us to refi ne our analyses. They include Bill Apgar, Vicki Been, Eric Belsky, Mark Budnitz, Kevin Byers, Jim Campen, Jim Carr, Mark Cassell, Ruth Clevenger, Marcia Courchane, Prentiss Cox, Steve Davidoff, Andy Davidson, Kurt Eggert, Ingrid Ellen, Keith Ernst, Ren Essene, Allen Fishbein, Linda Fisher, Jim Follain, Anna Gelpern, Ira Goldstein, Cassandra Havard, Howell Jackson, Melissa Jacoby, Creola Johnson, Adam Levitin, Alan Mallach, Cathy Mansfi eld, Joe Mason, George McCarthy, Larry Mitchell, Kathy Newman, Gail Pearson, Vanessa Perry, Chris Peterson, Katie Por- ter, Roberto Quercia, Harry Rajak, David Reiss, Kris Rengert, Steve Ross, Julia Sass [...]... underwriters calculated loan-to-value and debt-to-income ratios to determine whether the applicants could afford the loans In addition, underwriters drew on their knowledge of the community to assess whether the customers were “good folk” who would repay their loans Banks kept their loans in their portfolios and absorbed the loss if borrowers defaulted Knowing that they bore the risk if loans went bad, lenders... the stock market crumbled The S&P 500 dropped another 15 percent and the country slid into a recession Throughout it all, the housing and credit markets were a beacon of hope for the economy Alan Greenspan, the chairman of the Federal Reserve Board, seized on mortgage loans and other consumer credit as the way out of the slump In mid-2000, the Fed exercised its “Greenspan put” and slashed interest rates,... of the global financial system had begun to crumble The subprime story is the tale of how consumer abuses in an obscure corner of the home mortgage market spawned a virus that led to the near meltdown of the world’s financial system The virus had several strands In the first, lenders cooked up hazardous subprime loans and peddled them to people who they knew could not afford to repay the loans In the. .. up, until their equity disappeared and they could no longer qualify for loans.28 By design, these subprime loans were unaffordable The easiest loans to flip were those that borrowers couldn’t afford in the first place The higher the interest rate, the bigger the monthly payment and the more likely the borrower would default Reports abounded of subprime mortgages with fixed rates of 18 percent and adjustable... in these areas and we shouldn’t be expected to [be].”5 For part of that period, from 2002 through 2004, one of us— Pat—served on the Consumer Advisory Council (CAC) of the Federal Reserve The council was so named even though representatives from the banking industry held the majority of seats on the CAC, which was handpicked by the Fed Pat and other CAC members alerted the board to the dangers of subprime. .. standards and that fall below a certain dollar threshold are accepted for securitization by the GSEs In the industry, these loans are called “conforming loans.” Once they acquire the loans, the GSEs package them into pools Those pools then issue bonds backed by the loans As part of the bond covenants, Fannie and Freddie guarantee investors that they will receive their bond payments on time even if the borrowers... sliced and diced subprime risk and spread it to the global financial system In the third, traders bought trillions of dollars in credit default swaps with little or no margin on the bet that the whole enterprise would come crashing down In the fourth and final strand, the federal government witnessed what was happening and made a deliberate decision to desist from any meaningful action These strands combined... did not stop the subprime crisis Further, the Bush administration’s financial literacy campaign betrayed a punitive attitude toward ordinary Americans that fit comfortably with its laissez-faire ethos Behind these programs lurked the insidious question: why should the government protect people from the consequences of their bad decisions if they refuse to comparison-shop for subprime loans? The debate... underprice each other Their goal was to pinpoint likely borrowers before their competitors did and quickly induce them to agree to loans with onerous terms The complexity of subprime loans helped brokers and lenders snare their prey, by making comparison shopping difficult As long as this system worked and generated high fees, there was no reason for a subprime lender to break free from the pack and try to... obtained these loans could not afford the new rates when they reset Furthermore, many of them relied on assurances by their brokers that they could refinance if their monthly payments became unaffordable That strategy only worked if home prices continued to rise, but they did not In short, the breakdown in subprime underwriting standards was a train wreck waiting to happen The first signs of serious subprime . The Subprime Virus This page intentionally left blank The Subprime Virus Reckless Credit, Regulatory Failure, and Next Steps KATHLEEN C. ENGEL PATRICIA A. McCOY 2011 Oxford. credit, regulatory failure, and next steps / by Kathleen C. Engel and Patricia A. McCoy. p. cm. Includes bibliographical references and index. ISBN 97 8-0 -1 9-5 3888 2-4 1. Subprime mortgage loans—United. CAC, which was handpicked by the Fed. Pat and other CAC members alerted the board to the dangers of subprime loans and subprime mortgage- backed securities, and tried to convince the board to exercise