Foreclosed: The Failure to Regulate Abusive Lending Practices

An Interview with Debbie Goldstein

Debbie Goldstein is an executive vice president of the Center for Responsible Lending, a nonpartisan research and policy organization committed to eliminating abusive lending practices.

Multinational Monitor: What's the scale of the foreclosure epidemic in the United States?

Debbie Goldstein: It's growing rapidly, and it has expanded substantially into the real economy as foreclosures have continued to put pressure on falling home prices and job losses and declining incomes. We have now created a perfect storm. Foreclosures continue to grow at an alarming rate and home prices are expected to continue to fall until late 2009.

Our latest figures are that since 2007, more than two million families have already lost their homes. Credit Suisse has projected that more than eight million families will lose their homes over the next four years.

MM: What is the community impact of foreclosure?

Goldstein: Every family that loses their home is hit very hard by a significant loss in their major source of savings. Beyond the family, every time there is a foreclosure it causes the property values of every surrounding home to fall as well. That in turn leads to more foreclosures in the community, as well as significant lost tax revenue for local and state governments. So the impact goes far beyond the families that are losing their homes, and affects all of us - our own property values and services we count on that are paid for by property taxes.

MM: What proportion of foreclosed homes had subprime loans?

Goldstein: That's a good question at this point. A year or two ago, subprime accounted for as much as half of all foreclosure starts, but by the end of this year, we're expecting to see foreclosures in the subprime market level off. Meanwhile, many more foreclosures are creeping into the alt-A market and even the prime markets. Those foreclosures are growing as property values continue to decrease, and also as some of the riskier loans in those markets start to adjust to reset to higher payments that borrowers can't afford.

MM: Is it fair to say that the foreclosure epidemic can be traced to two reinforcing problems: the overall housing bubble, and the especially risky and bad loans?

Goldstein: I think that is a very fair characterization.

Initially, lenders aggressively marketed subprime loans that were designed to fail. The subprime loans had low introductory rates that significantly increased at the end of year two, when the monthly payment could go up by as much as 30 or 50 percent. So the product was designed badly, and lenders counted on borrowers being able to refinance at the end of year two into another loan. But as housing prices started to fall, borrowers couldn't refinance (or resell), and instead they defaulted on their mortgages.

A lot of borrowers were misled into these loans when they probably could have afforded a better product. And weaker and weaker underwriting standards meant that more and more borrowers received those types of subprime loans.

Now all of that is coming to a head as the foreclosures drive home prices down, which causes even more foreclosures.

MM: From the lender point of view, these predatory loans made a kind of sense, even if they weren't going to succeed, on the theory that the borrower would be able to refinance because the underlying home value would go up.

Goldstein: I think that's part of it. The other important part is that lenders didn't have much to worry about, because they were selling the vast majority of these loans to Wall Street.

Wall Street's appetite for risky mortgages encouraged mortgagers to loosen their underwriting standards and aggressively go for volume.

Once they made the loan, they sold it off and the investors were left holding the bag, not the lenders who originally made the loan.

MM: Obviously the big investment banks had major portfolios of mortgage-based securities. Why didn't they sell off the assets that are now dragging them down?

Goldstein: I think at some point they reached the point where they were unable to sell off the securities any more. Investors withdrew from the market as they lost confidence in the underlying mortgages.

MM: What were the regulators doing while this kind of lending was going on?

Goldstein: Unfortunately, I think the regulators were much more focused on making sure there was access to credit, and didn't take the steps that they needed to curb abusive lending practices.

Just to give a couple of examples, the Federal Reserve has had the authority for over 14 years to issue rules regulating unfair and deceptive mortgage practices. They failed to issue any rules on that topic until the middle of 2008. The Office of the Comptroller of the Currency, which regulates national banks, focused most of its attention on preempting state laws - which were actually doing a pretty good job of addressing predatory lending abuses - instead of working with state regulators to address mortgage abuses. Probably worst of all, the Office of Thrift Supervision (OTS), which regulates savings and loan institutions, ignored clear warning signs of risky lending by institutions the OTS supervised like IndyMac, which failed on a regular basis to document income on large numbers of loans. As we note in a recent report we published, in some cases IndyMac actually went out of its way to exclude income information in its loan files. This allowed IndyMac to make some loans that shouldn't have been made and sell them on the secondary market, which paid more for loans that didn't document income.

Regulators really missed addressing these problems. They waited a very long time to put in place rules that prevented these abuses, and they didn't do enough as supervisors to stop lending institutions from making these loans.

MM: How well did the states do as regulators?

Goldstein: Some of the states did very well. North Carolina was one of the first states to enact a predatory lending law. Its 1999 law was able to curb a lot of the abuses that it focused on. Unfortunately, some of the new practices, like the failure to underwrite based on the borrowers' ability to pay, came about in the middle of this decade, and the North Carolina law didn't anticipate some of those abuses.

North Carolina, New Jersey, New Mexico, Massachusetts and Georgia are examples of states that took a lot of action to try to curb predatory lending abuses. New York did a lot as well to address what they were seeing and had some significant impact. But the states were certainly hamstrung by federal regulators who wanted to protect federally supervised institutions and made a significant effort to preempt those states laws.

MM: To what extent is a well-intentioned regulator able to keep up with the evolving marketing practices? Will they always be behind the game?

Goldstein: It's definitely a challenge, particularly if you think about the many steps along the mortgage chain. You have mortgage brokers, who are then selling loans to lenders, and then lenders that are selling to Wall Street, and there are a lot of steps along the way. It's certainly a challenge for state regulators, as well as federal regulators, to see all of those steps in the transaction.

That suggests that we need more, not fewer, cops on the beat. We need those state and federal regulators to act cooperatively and do as much as they can to enforce the laws that we have.

We also need some very clear consumer protection rules at the front end to make it clear what lenders can't do, and to reduce their ability to create incentives that encourage abusive practices.

MM: What's the liability of the purchasers of mortgages, the Wall Street investors?

Goldstein: I think that's another really critical piece of the puzzle. To date, investors really are not liable for the actions of the originators of the loans that they buy. It's really important that we do more to ensure investors who buy mortgages have more skin in the game, by putting in place rules that hold them accountable for abuses in the mortgages that they buy. That will encourage investors to do a lot more due diligence before they buy loans, and make sure that they're buying loans that were legitimately made and that were affordable for the borrowers.

MM: There's certainly no question that the housing market is in free fall. Are banks agreeing to loan modifications commensurate with the situation?

Goldstein: Unfortunately, so far, most of the efforts to do loan modifications have been voluntary. Congress and the Bush administration have all promoted efforts to encourage lenders to do voluntary modifications. But all of the data suggest that these efforts have been incredibly modest.

A report from the State Foreclosure Working Group, which includes banking supervisors and attorneys general, indicates that nearly eight out of 10 seriously delinquent home owners are not on track for any loss mitigation. A lot of the modifications that are being done are not actually affordable; in some cases, borrowers actually end up with monthly payments that are higher than what they were paying before. In a lot of cases they end up with forbearance or payment plans that just extend the debt but don't actually make the loan more affordable. So many buyers that do get modifications still fail and may still lose their home.

MM: There was a highly touted federal initiative in this area, Hope Now. Does what you say apply to that as well?

Goldstein: Yes, I think Hope Now has had really limited success. The rate of foreclosures vastly outpaces the number of modifications that have occurred through Hope Now. That's certainly true as well for the FHA [Federal Housing Administration] Hope for Homeowners program created by Congress last year. There's been a paltry number of applications for that program.

MM: Don't the banks or the mortgage holders have an incentive to modify loans so money keeps coming in, rather than foreclose on a property?

Goldstein: That's certainly how it looks from the 20,000 foot level, but in actuality there are a lot of hurdles to doing modifications. They are very time consuming and time intensive, and mortgage servicers are overwhelmed by the number of borrowers that they are working with.

A servicer is typically the entity collecting payments and working with the borrower on any kind of workout arrangement on behalf of the investor. As well, there are financial incentives for servicers to foreclose, even though it might be in the best interest of the investor or the lender to work out a modification.

MM: What happens after a foreclosure? Who owns the property and is responsible for the upkeep and hypothetically selling it again?

Goldstein: Ultimately, the property will be sold for the benefit of investors. Meanwhile, the servicer would be responsible for upkeep of the property, though they typically contract that out.

MM: That has to be harder than working out a modification, isn't it?

Goldstein: In some cases, it is a common part of the business that they are set up to do. It is certainly a burden to manage those foreclosed properties, but I think it is in some ways easier for the servicers to do that than to go through the time-intensive and costly work of a loan modification.

There's also now a lot of concern about the conflicting interests of multiple investors, some of who may want different things from a loan modification. It's very difficult for servicers to balance all of those interests, and there's often concern that they will be sued by the investors if they do a loan modification that is not in the perceived interest of all the investors.

MM: Why would some investors have different interests than others?

Goldstein: Most of these mortgages have been packaged into a pool and sold on Wall Street as part of a security. There are different investors that have different tranches of those securities. Some of them may benefit, for example, on a modification that leads to a reduction on the interest rate, where another investor was counting on certain interest rate income and loses out if there's a modification to the interest rate. So while one investor may get fully paid, another at a lower tranche may not, and they may sue the servicer because they didn't get the expected benefit they had from that investment.

MM: The Federal Deposit Insurance Corporation (FDIC) has been doing things somewhat differently. What have they been doing with IndyMac?

Goldstein: The FDIC has been doing streamlined modifications of its IndyMac loans, focusing in particular on whether the borrower can afford their payment based on the borrower's debt-to-income ratio. They've also proposed doing this in a more universal way, to streamline modifications using the TARP [bank bailout] money. What the FDIC has proposed is that the government could guarantee loan modifications and share in any losses of loan modifications, as long as those loan modifications follow certain guidelines, similar to those involving IndyMac, where determination of whether a loan is affordable for the borrower is based on his or her debt-to-income ratio.

MM: The idea is that the borrower should be paying no more than 31 percent of their income?

Goldstein: Right. So they do a quick evaluation of the borrower's income and then send out a modification offer to that borrower based on their income analysis.

MM: What kind of uptake are they getting?

Goldstein: I think they are facing some of the same constraints that other lenders are facing. It is very difficult to reach borrowers at all, once they are experiencing trouble paying their mortgage. But for the borrowers they are reaching, they are having some good success in getting modifications done and helping those borrowers stay in their homes.

MM: When the FDIC modifies, the first effort is to extend the term of the loan?

Goldstein: Yes, they can do a couple of things. The two key things are to lower the interest rate - as low as 3 percent if necessary - and then to extend the term to up to 40 years. They can also forebear some or all of the principal so that you don't have to pay interest on it, and you pay it like a balloon payment at the end of the mortgage.

MM: If people owe more than the value of their homes, does it make sense to modify the interest rate or term? Don't you really have to lower the principal?

Goldstein: For a large number of people, modifying the interest rate would help make the loan affordable. And a lot of borrowers want to stay in their homes. There's some anticipation that, at some point, home prices will start to rise again, and if you can help keep borrowers in their homes long enough, they will recover.

Certainly, one of the big problems is that many families are under water. That's certainly a challenge. But all the evidence suggests that a lot of families would prefer to stay in their home with a modified, affordable mortgage, even if the house is worth less than the loan.

MM: Have the actions of the Treasury Department with the TARP money done anything to improve the condition for homeowners?

Goldstein: Part of the instructions under the TARP program directed the Treasury Department to pursue loan modifications, but they haven't used any of the TARP funds specifically for that purpose. When the Treasury has taken equity in banks, they have not systematically put in any conditions to require those institutions to do loan modifications.

We believe the Treasury could be doing a lot more under the TARP program to put in place streamlined loan modifications whenever it takes action - whether it's investing in a bank, outright taking control of loans, purchasing loans or using some kind of guarantee program. Any of those ideas could allow more families to hold on to their homes.

MM: If the Treasury Department sought to impose such conditions, could the banks make the modifications given the other obstacles that you described?

Goldstein: I think it's a challenge, but part of the power of TARP is that it would be putting in place a financial incentive to make it a better economic proposition for banks to modify more unaffordable loans. That would be helpful in overcoming some of the obstacles and saying to investors, "This is the economically rational thing to do."

MM: Are there any other steps you would like to see the federal government take to deal with these issues?

Goldstein: The other thing we have focused on is encouraging Congress to lift the ban on judicial loan modifications. Right now, the loan on a family's primary residence is the only secured debt that cannot be restructured through bankruptcy and a Chapter 13 repayment plan. If you have a loan on your vacation home, or an investment home, you can restructure that loan in a Chapter 13 bankruptcy plan.

We think it's critical that Congress move to permit bankruptcy judges to restructure mortgages on primary residences. It could prevent foreclosures for hundreds of thousands of people, and it doesn't cost any taxpayer money. And it can address the problem of underwater mortgages.

MM: Do people go into bankruptcy because they're facing foreclosure?

Goldstein: Right now, many probably do because of the current economic crisis. But there's not much that the bankruptcy court can do for borrowers who are there because of their housing debt. But many borrowers are facing a myriad of problems. They lose their home because they've lost their job, and they're under water, or the job loss compounds the problem of the mortgage that they were barely scraping by to pay.

There are families that are in bankruptcy that would benefit from this change. It would make it much more likely that they could survive the economic pressures.

In addition, if this rule were in place in bankruptcy court, it would create another reason that servicers might have a financial incentive to voluntarily modify. They would know that if they failed to voluntarily modify a loan, the borrower would have the option to file for bankruptcy.

I mentioned before that TARP offers a number of carrots that could be financial incentives for lenders and servicers to modify. Bankruptcy could serve as a stick that suggests that if lenders don't modify, there could be a financial cost.

Of course, most borrowers don't want to file for bankruptcy, but that's no reason to allow investors and people who can afford second homes to do so and not allow the same for families who are depending on their homes as their major source of wealth.

MM: What should the government do to avoid a repeat of the last five to eight years?

Goldstein: The government has to do a much better job of setting strong and clear standards for consumer protection, and to make sure that consumer protection is really a central part of how we do oversight of lending institutions.

The Federal Reserve took important steps in the middle of 2008 to put in place some clear standards for underwriting subprime mortgages. They could do a lot more to extend those standards, underwriting rules, to non-traditional mortgages - some of those products like option adjustable-rate mortgages (ARMs) and interest-only loans.

Then there are probably two areas where we need to do a lot more. One, ensuring investors of mortgages have more skin in the game by putting in place rules that hold those purchasers, the assignees of the mortgages, accountable for the abuses of mortgages that occur at the front end.

The second area is to really rein in incentives that incur and encourage abuse. One example of this is that for years lenders have paid kick-backs to mortgage brokers to place borrowers in higher-cost loans - loans with higher interest rates - when the borrower could qualify for a lower-cost, more affordable product. We really need to curb things like those kickbacks and other financial incentives that encourage abuse.