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Mortgage Markets and Financial Regulation: 

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  1. Mortgage Markets and Financial Regulation:  Past, Present and Future Prepared by Joe Vincent, General Counsel Presented by Lyn Peters, Communications Washington State Department of Financial Institutions

  2. Changes in the last 25 years

  3. FHA INSURED LOANS CONVENTIONAL CONFORMING LOANS VA INSURED LOANS BANKS Finance Companies “SUBPRIME” LOANS EQUITY LINES OF CREDIT Money used to be tight, but the lending delivery system was fairly easy to understand. • “BRICK-AND-MORTAR” BANK LENDING– Conventional, FHA and VA. • Independent FINANCE COMPANIES–“subprime”/home equity lender. • FANNIE MAEandFREDDIE MACwere the secondary market. • 3%-downFHA-INSURED LOANSand 0%-downVA-GUARANTEED LOANSfor first-time home buyers. • FIXED-RATE MORTGAGESwere the norm, while adjustable rate mortgages (ARMs) were practically unheard of.

  4. Then market, cultural and government forces combined to radically change lending practices. Enabling FEDERAL POLICIES. Federal STIMULATION OF THE ECONOMY. The “COMMODITIZATION” of mortgage lending. The explosion in DERIVATIVES – the trading in investments (ABS, CDO, and MBS) independent of their underlying assets. The revolution in INFORMATION TECHNOLOGY. Market forces – CONSUMER DEMAND and GLOBALIZATION of investment.

  5. Help from Wall Street and lax federal regulation eventually made the flow of money very loose. As of 2006, about 58% ($1.7 Trillion) of residential loans in the U.S. were originated by MORTGAGE BROKERS. The wholesale and secondary market was controlled by WALL STREET, which greatly influenced the loan products originated. As of 2007, “SUBPRIME” LENDING was at least 14% of the total U.S. mortgage market. Everyone made HOME EQUITY LOANS. Not only were ARM LOANS common, but a “flexible” interest-only payment feature called the OPTION-ARM. Private sector LOW- OR ZERO-DOWN LENDING had surpassed FHA and VA. “STATED-INCOME” and “NO DOC” loans –so-called “liar loans” – had become common. CREDIT SUPPLY SIDE Money Supply WALL STREET CMO Underwriters Hedge Funders Other Portfolio Investors Wholesale Banks Other Wholesalers Warehouse Lines of Credit Fannie Mae Freddie Mac Bank Holding Companies Other Private Secondary ORIGIINATION INTERMEDIARIES SECONDARY INTERMEDIARIES Consumer Loan Companies Retail Branch Banking MORTGAGE BROKERS CONSUMER DEMAND SIDE

  6. PRIMARY INVESTORS RATING AGENCIES Investment Bankers Hedge Funders (MBS & CDOs) INSTITUTIONAL SHAREHOLDERS Specialized Hedge Funds & Others (Sell Credit Default Protection Using Credit Default Swaps) CREDIT BUREAUS SECONDARY INVESTORS BANKERS OTHER ORIGINATORS HOMEOWNERS SECONDARY MARKET UNDERWRITERS MORTGAGE INSURERS Warehouse Lenders SPECIAL PURPOSE ENTITIES [Poolers & Re-Packagers] MORTGAGE SERVICERS THE U.S. MORTGAGE INDUSTRY Money was easy, but the delivery system had grown too complex to understand . . . or regulate. APPRAISERS HOME BUILDERS R.E. AGENTS MORTGAGE BROKERS

  7. So when the bubble burst, Wall Street and the federal government were caught short. • High rate of DEFAULTS in major areas. • Mass FORECLOSURES nationwide. • Massive LOSSES and LAYOFFS by banks. • Big mortgage companies in BANKRUPTCY. • FAILURE or MERGER of major investment banking houses. • Major WALL STREET REACTION. • ECONOMIC SPILLOVER and CREDIT CRUNCH. • Major GOVERNMENT RESPONSE – federal and state.

  8. NOTE: This analysis of present conditions relies principally upon delinquency and foreclosure data from the Mortgage Bankers Association ® National Delinquency Survey, which comes directly from industry loan servicers and represents about 80% to 85% of the total number of residential mortgage loans in the U.S. It is considered the most reliable source of data. Present conditions

  9. Nationally, the mortgage crisis did not really hit until 2007 with “subprime ARM” defaults.

  10. U.S. market conditions, while bleak, are not nearly as bad in Washington. • Based on the 2nd Quarter 2008 MBA National Delinquency Survey, over 2.8 million of all mortgage loans reported to MBA, or 6.22% of all loans reported, were past due. • Of the total of reporting, a little over 2 million loans, or 4.5%, were seriously delinquent or in foreclosure. • Over 2.5million out of about 45.4 million loans reported to Mortgage Bankers Association®, or5.6%,were “subprime ARMs.” Of these: • Over 522,000 loans – nearly 1.15% of all loans and 20.5% of “subprime ARM” loans – were past due. • Over 682,000 loans – nearly 1.5% of all loans and over 26.77% of “subprime ARM” loans –were seriously delinquent*. *Seriously Delinquent = +90 Days Past Due or in Foreclosure. Source: Mortgage Bankers Association

  11. The U.S. and Washington have seen a recent,steady climb in defaults and foreclosures. Source: Mortgage Bankers Association

  12. And Washington does not have nearly the “subprime ARM” crisis as most other states. 2nd QTR 2008 Seriously Delinquent – All Loans 10 Worst States vs. Washington 2nd QTR 2008 Seriously Delinquent – Subprime ARMs 10 Worst States vs. Washington Source: MORTGAGE BANKERS ASSOCIATION ®

  13. This is true, even though Washington has nearly the same concentration by loan type as the U.S. Source: MORTGAGE BANKERS ASSOCIATION ®

  14. Poor Assumption.Teaser rates were never supposed to reset.  Everyone assumed that home prices would keep rising and easy credit would keep flowing, so borrowers could refinance before their loans reset. Reality Check.But very few borrowers could refinance, which led to a surge in defaults. But a wave of “resets” in rates and payment terms have yet to “kick in.”

  15. Just a Subprime Phenomenon.So far, there has been a concentration of resets insubprime ARMs, which will taper off finally at the end of 2008. But the next wave of resets is predicted to come from: Alt-A in 2010 and 2011. Prime ARMin 2009 and 2010, ending in 2011. Option ARMsbeginning in 2009, and especially in 2010 and 2011. Option ARM Conversions.With conversions to full P&I on Option ARMs, we don't know what's going to happen. But a wave of “resets” in rates and payment terms have yet to “kick in.”

  16. Immediate causes

  17. The biggest factor contributing to the crisis was the over-relaxation of credit standards. The general relaxation of credit standards in the last 25 years should not be blamed for the present mortgage situation. A lot of doors were closed 25 years ago to large numbers of would-be homeowners. But according to the 2005 U.S. Census, homeownership in the entire U.S. was at 69%, and homeownership in Washington State was at about 68%. Federal government policy helped this phenomenon. But continued relaxation without consistent, adequate safeguards is partially to blame.

  18. This included a growing lack of adequate underwriting. During the mortgage boom, lenders too often said “yes” to: Teaser interest rates on ARM loans. Permitting little or nothing down. No upfront verifications of income or employment. High debt-to-income ratios. Shoddy, inadequately reviewed property appraisals. Lax underwriting on loans made by affiliates of home builders.

  19. In addition, there was the increasing presence of predatory lending tactics. Some loan products inherently too risky. Steering of many “prime” credit borrowers into “subprime” rate loans. Unchecked greed in the market. Negligent or complicit underwriting standards. Many homeowners were stripped of their equity. Many homeowners placed into loan products whose rates and fees they could not afford.

  20. And where there was little market discipline, mortgage fraud became more prevalent. Fraud for Housing – Borrower, sometimes with help from a crooked loan officer, lies to get a mortgage loan. Fraud for Profit – Con artists are in “business” to profit from their fraud – flipping and/or asset rental. Builder Bailout – Builder employs various schemes to con his or her way out of a financial fiasco. Affinity Fraud – Con artist or crooked loan officer exploits a trust – such as shared ethnicity, religion or membership – to defraud for profit and/or help a borrower lie. Foreclosure Rescue – Where a con artist offers to “help” borrowers in default or already in foreclosure with deceptive or fraudulent “rescue” schemes. FRAUD FOR HOUSING FRAUD FOR PROFIT AFFINITY FRAUD BUILDER BAILOUT MANY TYPES OF MORTGAGE FRAUD FORECLOSURE RESCUE

  21. Wall Street not only encouraged investment in this market – it made the market what it was. Globalization and global liquidity resulted in unprecedented demand for investment. Newer secondary market players –private equity firms and hedge funds – encouraged riskier subprime loans. There were no consistent underwriting standards. Bond-rating agencies were not accountable. Wall Street hadalmost no liability for the loans it indirectly financed. Direct lenders were driven by fees and were rewarded for making riskier loans. GLOBAL INVESTMENT DEMAND WALL STREET SUPPLY OF “HIGH-YIELD” MBS & CDOs

  22. When loan quality deteriorated beyond repair, the effect on capital markets was severe. Risky subprime loans helped fuel the U.S. real estate boom. Wall Street firms profited from packaging the loans and selling them as securities – MBS and CDO – to investors like hedge funds. These investments have been widely held on Wall Street and by global investors. Bond rating services finally “woke up” and downgraded all MBS and CDO investments. The downgrading had a systemic effect, producing a general “credit crunch” – Affecting nearly all Wall Street finance deals; and Causing failures for some investment houses, mergers for others. The Federal Reserve had to finally step in to bolster market liquidity and prevent a general market meltdown. THE FED JUMPS IN TO PREVENT A GENERAL MARKET MELTDOWN

  23. Lax federal regulation and preemption of state enforcement did far from help the situation. Federal policy has emphasized disclosuresvs. products. The federal government deferred to the states in the enforcement of unfair and deceptive acts and practices. But federal banking regulators have now asserted a policy of federal preemption of state laws – that states cannot regulate national banks, federal thrifts, or their operating subsidiaries or “exclusive agents.” They even have support of a majority of the Supreme Court. This policy is reflected even in a new Treasury Plan to restructure financial regulation. This is a huge concentration of the national market – insulated from state consumer protection enforcement. National Banks & Federal Thrifts FEDERAL PREEMPTION Operating Subsidiaries & “Exclusive Agents”

  24. A “tangled web” of regulation has developed since the Depression, which is now under scrutiny.

  25. At least 12 major federal agencies have some jurisdiction over the present mortgage industry. FEDERAL TRADE COMMISSION OFFICE OF COMPTROLLER OF THE CURRENCY DEPARTMENT OF JUSTICE OFFICE OF THRIFT SUPERIVISON SECURITIES & EXCHANGE COMMISSION OFFICE OF FEDERAL HOUSING ENTERPRISE OPPORTUNITY FEDERAL RESERVE BOARD OF GOVERNORS FEDERAL DEPOSIT INSURANCE CORPORATION FEDERAL HOUSING FINANCE BOARD DEPARTMENT OF HOUSING & URBAN DEVELOPMENT NATIONAL CREDIT UNION ADMINISTRATION FEDERAL FINANCIAL INSTITUTIONS EXAMINATION COUNCIL

  26. Reaction and response

  27. The first reaction among all the players was to blame others. Bankers, non-depository lenders, mortgage brokers, Wall Street and federal agencies each had their own initial reaction as to “who” was most to blame and “what,” “why” and “how” to fix it. Eventually it becameimpossible to not admit shared responsibility for the mortgage and foreclosure crisis. Most observers admittedfinancial innovation outstripped regulation. Most observers admitted a need for uniform regulation of mortgage brokers. The federal government tried to lump all states together and blame them. But there seemed to be general consensus that a majority of states, including Washington, had vigorously enforced consumer protection over the years. There has beenless understanding that states have tried to do so despite preemption effortsby the federal government to prevent that. No, you did! You did it! You’re to blame! No, you are!

  28. Congress has now enacted the Housing and Economic Recovery Act of 2008 (H.R. 3221). • GSE Reform • The creation of a strong independent regulator for Fannie Mae and Freddie Mac. • Permanent conforming loan limits up to the greater of $417,000 or 115% local area median home price, capped at $625,500. • GSE Stabilization • Authorizes the Treasury Department to make loans to and buy stock from the GSEs to make sure that Freddie Mac and Fannie Mae could not fail.

  29. In addition to GSE reform and stabilization, H.R. 3221) strengthens the FHA and VA programs. • FHA Reform • Permanent FHA loan limits at the greater of $271,050 or 115% of local area median home price, capped at $625,500. • Streamlined processing for FHA condos. • Reforms to the HECM (Reverse-Mortgage) program. • Reforms to the FHA manufactured-housing program. • The down payment requirement on FHA loans will go up to 3.5% (from 3%). • VA Loan Limits • Temporarily increases the VA home loan guarantee loan limits to the same level as the Economic Stimulus limits through December 31, 2008.

  30. H.R. 3221 provides stimulus for the housing and mortgage markets which benefits homebuyers. • Homebuyer Tax Credit • $7500 tax credit available for any qualified purchase between April 9, 2008 and June 30, 2009. • The credit is repayable over 15 years (making it, in effect, an interest free loan). • FHA Risk-Based Pricing Moratorium • Moratorium on FHA using risk-based pricing for one year. • Effective from October 1, 2008 through September 30, 2009. • National Affordable Housing Trust Fund • Develops a Trust Fund funded by a percentage of profits from the GSEs. • In its first years, the Trust Fund would cover costs of any defaulted loans in FHA foreclosure program. • In later years, the Trust Fund would be used for the development of affordable housing. • Low Income Housing Tax Credits • Modernizes the Low Income Housing Tax Credit program to make it more efficient.

  31. H.R. 3221 also takes immediate remedial action to address the mortgage foreclosure crisis. • FHA Foreclosure Rescue (10/1/2008) • Refinance program for homebuyers with problematic subprime loans. • Lenders would write down qualified mortgages to 85% of the current appraised value and qualified borrowers would get a new FHA, 30-year fixed mortgage at 90% of appraised value. • Borrowers would have to share 50% of all future appreciation with FHA. • The loan limit of $550,440 nationwide. • Seller-Funded Downpayment Assistance Programs (10/1/2008) • Prohibits use of downpayment assistance programs funded by those who have a financial interest in the sale. • Does not prohibit other assistance programs provided by nonprofits funded by other sources, churches, employers, or family members. • Mortgage Revenue Bond Authority • Authorizes $10 billion in mortgage revenue bonds for refinancing subprime mortgages. • CDBG Funding • Provides $4 billion in neighborhood revitalization funds for communities to purchase foreclosed homes.

  32. Title V of H.R. 3221 also includes the S.A.F.E. Mortgage Licensing Act of 2008. • S.A.F.E. Mortgage Licensing Act of 2008: • Nationwide Mortgage Licensing System and Registry (“NMLS”) for the residential mortgage industry through the Conference of State Bank Supervisors (CSBS) and the American Association of Residential Mortgage Regulators (AARMR). • Mandatory registration and state licensing of mortgage loan originators. • Federal banking agencies jointly develop and maintain a system for registering depository institution employees as registered loan originators with the Registry. • HUD Secretary has contingent backup authority to license and registration system for loan originators. • Does not preempt state law which provides greater protection to consumers. • HUD Secretary to study andreport to Congress on the root causes of default and foreclosure of home loans.

  33. Meanwhile, Treasury is advocating overhaul of the entire financial regulatory system. • President’s Work Group • First, the President’s Work Group, chaired by Treasury Secretary Paulson, published a study on remedial goals for correcting problems in the capital markets that contributed to the mortgage fallout. • The Paulson Plan • Seizing the opportunity from the mortgage fallout, Treasury Secretary Paulson issued a plan in April 2008 to restructure the entire financial servicesindustry. • Imposing Market Discipline • The Fed engineered a “soft landing” for the failed Bear Stearns because of a true crisis in the financial markets. • But Paulson and Fed Chairman Ben Bernanke have spoken in unison about market discipline – that Wall Street will not police itself if investment bankers are perceived as “too big to fail.”

  34. Four bank holding companies control 48% of U.S. deposits.

  35. Troubled Assets Relief Program (TARP)in a Nutshell Purchases of Troubled Assets Troubled Asset Relief Program (TARP): Purchase troubled assets from financial institutions. Office of Financial Stability (OFS): Implement TARP in consultation Federal Reserve Board (FRB), FDIC, OCC, OTS and HUD. Insurance of Troubled Assets Must establish risk-based premiums for such guarantees sufficient to cover anticipated claims. Treasury Secretary must report to Congress.

  36. TARP Price Tag Provisions: What’s it going to cost? Graduated Authorization to Purchase Authorizes the full $700 billion Secretary may immediately use up to $250 billion Upon a Presidential certification of need, the Secretary may access an additional $100 billion Final $350 billion may be accessed if the President transmits a written report to Congress requesting such authority Increase in Statutory Limit on the Public Debt Raises the debt ceiling from $10 trillion to $11.3 trillion Temporary Increase in Deposit and Share Insurance Coverage Raises the FDIC and the National Credit Union Share Insurance Fund deposit insurance limits from $100,000 per account to $250,000 until December 31, 2009 Temporarily raises FDIC and NCUA borrowing limits at the Treasury Recoupment Requires that in 5 years, the President submit to the Congress a proposal that recoups from the financial industry any projected losses to the taxpayer.

  37. TARP Oversight Financial Stability Oversight Board Reports to Congress Comptroller Oversight and Audits Regulations & Guidelines to Prevent Conflicts of Interest Sunset Clause – Extension December 31, 2009 Treasury Secretary may extend the authority for an additional year upon certification of need to Congress Special Inspector General – Quarterly Report Congressional Oversight Panel Bi-Partisan Appointment – 5 Outside Experts Report every 30 days to Congress Submit a special report on regulatory reform by January 20, 2009 Judicial Review Market Transparency Must publicly disclose the details of any transaction within 48 hours

  38. TARP Major Specifics Authority to Manage, Negotiate & Modify Troubled Assets Profits from Sale Must Pay Down National Debt Waiver of Government Bidding & Hiring Process Implementation of Foreclosure Mitigation Procedures for TARP Purchased Assets Assistance to Homeowners Limit Executive Compensation and Improve Corporate Governance Suspension of Mark-to-Market Accounting Allow Banks to Deduct Losses from Fannie Mae and Freddie Mac Stock as Ordinary Losses Extension of Exclusion of Income From Discharge of Qualified Principal Residence Indebtedness Extends Tax Forgiveness on Cancellation of Mortgage Debt

  39. The “Paulson Plan” rests on the notion that the current regulatory scheme has no present utility. * Financial services regulation in the states often, though not always, bifurcated among two or more agencies. In Washington State, five of the six state financial regulatory functions are administered by one agency, the Department of Financial Institutions.

  40. The “Paulson Plan” would replace the current regulatory scheme with a far different one. * Under the Paulson Plan, you could not obtain federal deposit insurance without being a federally chartered bank or thrift, effectively undermining the state charter. † Also, because of the Federal Conduct of Business Regulatory Agency, there would be some question as to the continuing jurisdiction of State Mortgage & Consumer Finance Regulators.

  41. The “Paulson Plan” – while it looks intriguing – has several major drawbacks. • Bureaucracy – The de-centralized but functional regulation of the current system would be replaced with a centralized federal bureaucracy with a tendency to be insensitive to state and local needs. • Decreased Competition – The demise of the state banking charter would stifle competition and promote concentration, thereby undermining innovation. • Federal Preemption of State Consumer Protection – History has shown that federal banking regulators have permitted the federal charter to often be manipulated as a “safe harbor” from protection of consumer rights. • Stifling of Innovation – State regulation has shown itself to be innovative and forward-thinking in everything from the creation of the checking account in 1870 to the latest initiative actually created by the states – the National Mortgage Licensing System (NMLS) and Registry.

  42. The NMLS & Registry became one of the cornerstones of the H.R. 3221. • As an important example of innovation in state regulation through cooperation among the states, the National Mortgage Licensing System & Registry was conceived and launched by the states well before the present mortgage crisis or the present response by Congress. • Because the states were both innovative and proactive, Congress was able to incorporate the NMLS & Registry as a cornerstone of the Housing & Economic Recovery Act of 2008, rather than “reinventing the wheel.” • That system has now gone online, which creates: • A one-stop shop mortgage licensing application system. • A single database to promote cooperative examinations and investigations and prevent mortgage fraud. • DFI was a early, leading contributor to the creation of the NMLS and is an active participant.

  43. Events also finally called for rescue of Fannie Mae and Freddie Mac. • In 2005, Fannie Mae and Freddie Mac underwrote 50% of U.S. residential mortgage loans.But as of 2008,due to the general meltdown of secondary market,Fannie and Freddie’s underwriting of total originations had grown to 80%. • But Fannie and Freddie faced imminent collapse due to a combination of – • Over-optimistic financial reportingwhich led to over-investment; • Thin capitalization; and • Huge numbers ofdefaulted, non-performing loans and foreclosureson their books. • Fannie’s and Freddie’sinvestors – many of which are the largest U.S. banks and thrifts subject to their own financial risks – also faced a loss of their investmentswhich could have severely affected their balance sheets.

  44. Events also finally called for rescue of Fannie Mae and Freddie Mac. • Faced with all of these factors, the Treasury Department as of September 7, 2008stepped in and rescued Fannie and Freddie, backing the two companies with "full faith and credit" of the U.S. government. As a result: • Fannie and Freddie mortgage pools now have alow level of default risk, similar to US Treasury bonds. • This willattract more fundsto the mortgage market and alsoreduce interest rates to home buyers. • Lower interest rates should mean thatmore people can afford homes, which ought tohelp more buyers to enter the housing market. • Home valuesought to be stimulatedby this action.

  45. Innovation usually precedes regulation . . . and sometimes comes at a very steep price. • Take credit default insurance on municipal bonds, corporate debt and mortgage securities – an innovation in the last 10 years. • The buyer pays premiums over a period of time in return for the promise that losses will be covered if a default happens. • These contracts have been heavily traded by insurer and insured — that is, “swapped” from investor to investor – without anyone overseeing the trades to ensure the buyer had the resources to cover the losses if the security defaults.

  46. Innovation usually precedes regulation . . . and sometimes comes at a very steep price. • Credit swaps market is not regulated. • The CDS market is now$45-55 trillion – over twice the size of the U.S. stock market, 7 times that of the U.S. mortgage market and 10 times that of the U.S. treasuries market. • Commercial banks are among the most active in this market, with the top 25 banks holding more than $13 trillion in credit default swaps.

  47. As of 01/01/2008 As of 09/15/2008 = ? The bill is now past due and the price, though steep, has to be paid. • Earlier this year, Bear Stearns was forced to merge with JP Morgan. • The 158-year old Lehman Brothers filed for Chapter 11 bankruptcy, and its assets will be liquidated. Barclays is buying 2 units. • Merrill Lynch is being bought by Bank of America for $50 Billion at a small fraction of its former value. • And insurance giant AIG is getting loan from the Federal Reserve to restore liquidity to its operations.

  48. As of 01/01/2008 As of 09/15/2008 = ? The bill is now past due and the price, though steep, has to be paid. • It is too early to tell how many bank closures and mergers, other than IndyMac Bank, will result from the crisis. WaMu is being purchased by JP Morgan Chase. Wells Fargo and Citigroup are in court, arguing over Wachovia. • There is definitely a major re-alignment of the financial industry taking place before our eyes. • Savings of individual depositors, however, are protected by the Federal Deposit Insurance Corporation. • And the individual investments of Americans in 401Ks and the like are protected because it’s their assets – not the investment bank that collapsed.

  49. State initiatives

  50. Regulatory initiative was apparent in the Governor’s Task Force on Homeowner Security. • Governor Christine Gregoire convened in September 2007 a major government-industry-citizen task force to proactively address in Washington State concerns about the mortgage foreclosure problem nationwide. • Go to www.dfi.wa.gov for full Task Force Report.