WASHINGTON — One of the toughest questions facing Congress as it tries to address the meltdown in the subprime mortgage market, which caters to borrowers with poor credit, is deciding whether Wall Street is part of the problem or part of the solution.
Twenty years ago, mortgages were primarily issued and held for their entire loan life by banks, credit unions or savings and loan associations.
Today, almost as soon as the ink is dry from closing on a home, the mortgage is sold by the loan originator, often to a Wall Street company that pools loans together and packages them as a mortgage-backed security, essentially a mortgage bond.
When homeowners make their monthly payments, their payments combine with those on other loans in the package. Together, these payments are the cash flow that repays the investors who bought the mortgage bonds. These bonds are divided into a range of risk categories, with the safest bonds paying the lowest returns and the riskiest, a combination of subprime loans, offering the highest returns.
This process is known as securitization. It's brought a lot more capital into the mortgage business, which has made more lending possible, and enabled more Americans, nearly 70 percent now, to buy homes. Last year, outstanding mortgage bond debt—$6.5 trillion—was almost three times the debt issued by municipalities and exceeded the outstanding debt of all U.S. corporations.
Who owns mortgage bonds? Your 401(k) retirement plan most likely does. So do foreign central banks, oil-rich countries, state government pension funds, big banks and private investors big and small. Mortgage bonds pay a higher return than most conventional bonds and until recently they were considered safe bets because most were issued by government-sponsored enterprises, such as Freddie Mac.
Since late 2005, however, the issuance of private-sector mortgage bonds—called private label—surpassed the safer Freddie Mac bonds. And subprime loans are the underbelly of the fastest-growing segment of mortgage-bond issuances. Mortgage bonds backed by subprime loans have grown from $95 billion in 2001 to $450 billion last year, according to financial industry statistics. About 38 percent of private-label issuance of mortgage bonds was backed by subprime loans.
Most home loans remain in good standing. But the delinquency rate on subprime loans is approaching 15 percent. Some consumer groups predict that by early next year, one in five subprime home loans could be delinquent.
Most delinquencies involve adjustable lending rates that reset after two years to sharply higher rates.
Lawmakers believe that a large number of these delinquent loans involve predatory or unsound lending. Now the Democrat-run Congress is studying whether to hold sellers of mortgage-backed securities liable for enabling unsound or predatory lending.
These Democrats believe that the packaging of mortgages masks—or at least provides an incentive to—predatory or unsound lending by allowing the consequences to get kicked far enough up the investment chain so that bad lenders escape unpunished.
"Yes, it provides a lot more money, but it also meant that if you made the loan and you sold the loan, you weren't so much on the hook. And if you bought the loan, you were never on the hook," said Rep. Barney Frank, D-Mass., the chairman of the House Financial Services Committee, which will draft legislation this year to address problems in the subprime mortgage market. "That's why ... there needs to be some responsibility all the way through the (investment) chain."
Federal Reserve Chairman Ben Bernanke, in a speech Thursday on the subprime mortgage market, suggested that Frank is on the mark. The Fed chairman acknowledged that "the practice of selling mortgages to investors may have contributed to the weakening of underwriting standards," but he neither endorsed nor rejected greater regulation of mortgage-bond sellers.
Frank wants to create some liability for the assignee, the person who takes control of the loan. That way, if a borrower feels he was the victim of fraudulent or predatory lending, he can sue not only the loan originator, but also the entity that now controls the loan. At least five states now allow this.
Wall Street and mortgage bankers warn that such a change could sour investors on mortgage bonds, making them seem uncertain and risky.
"Who does one sue? Do you sue the consumer who owns a piece of a pension fund because they have a strip of a MBS (mortgage-backed security) that has in it a loan that has at least been alleged to have been predatory?" asked Kurt Pfotenhauer, the senior vice president for government affairs at the Mortgage Bankers Association.
"These mortgage (bonds) are investment commodities. To try and slap on liability would ... really take a lot of market efficiency away, which up to now has resulted in savings that have gone into the pockets of homeowners everywhere."
A better solution, argues the Securities Industry and Financial Markets Association, is tougher enforcement of predatory lending laws at the point of loan origin and a national standard and licensing system for mortgage brokers. They originate 71 percent of mortgages, yet are regulated by state governments with varying laws and enforcement budgets.
The president of the association, George Miller, said, "We think it's only appropriate that the focus of regulation, enforcement and oversight be at the point of sale ... involving the parties directly involved in making the loans."
The Center for Responsible Lending, a consumer advocacy group, wants Congress to thrust on Wall Street a clear regulatory framework that requires sellers of mortgage bonds to know more about who they're buying mortgage loans from and what their track records are.
"It's just the most effective way to get the market to behave," said Deborah Goldstein, the executive vice president of the center, based in Durham, N.C. "The only way they will create that due diligence framework is if they are held accountable."
When the state of Georgia tried to assign liability to the mortgage-bond market in 2002, all three of the major bond-rating agencies refused to rate any mortgage-backed securities that contained loans subject to Georgia law. Loans to subprime borrowers dried up immediately, and the state quickly revised its laws.
Since then, several states—including New Jersey, New Mexico, Rhode Island, Illinois and Massachusetts—have assigned some liability to sellers of mortgage bonds without serious consequences.
"It's possible to achieve balance, and to ensure that investors are ... taking responsibility for the investments they are funding," Goldstein said.