by Sheila Bair
Under our agreement, the FDIC would agree to give up the 10 percent aggregate cap, but in return, the 15 percent cap on individual banks’ capital reductions would remain in place unless and until all four banking regulators issued a public report finding that there were no “material deficiencies” in the framework. My hope was that if Basel II had the outcomes we had predicted (and that were already becoming apparent with their implementation by European banks and U.S. investment banks), there was no way that the bank regulators would issue such a report. They would likely err on the side of caution and just leave the caps in place. The important point was that the caps would not automatically come off. If the bank regulators wanted to entertain capital reductions beyond 15 percent, they would have to get all of the agencies to issue a public report defending that step before it occurred.
Ben asked me to circulate the agreement to the other regulators, which I did. Since we were removing the 10 percent aggregate cap, I assumed that the other regulators would be pleased. Instead, the agreement was met with anger by both John Dugan and Randy Kroszner, who had replaced Sue Bies21 as the Fed’s point person on Basel. Dugan insisted on language that would let the OCC move ahead with capital reductions even if the other regulators thought the accord was flawed. Since the OCC already had the legal authority to do so—the other bank regulators could not bind it—we agreed so long as the OCC agreed to publicly explain its reasons for letting bank capital drop more than 15 percent. I think the real problem with both Dugan and Kroszner was that Ben and I had worked out an agreement without them. Dugan had always viewed the FDIC as “third tier” behind the Fed and OCC, and I don’t think he liked the precedent of the FDIC chairman working directly with the chairman of the Fed. Similarly, I think that Kroszner felt I had gone around him, which I had, but at the behest of his own chairman.
In any event, the agreement broke the impasse, and we moved ahead with a final rule. But I did not let up in my public criticism of Basel II as we continued to watch capital levels at European banks and U.S. investment banks decline. In the end, we were victorious. By December 2007, the weight of market opinion had swung our way, as the subprime crisis was renewing concern about the adequacy of the banking system’s capital base. Given heightened scrutiny by both the media and financial analysts of U.S. investment banks and European banks’ increasing leverage under Basel II, the Fed and OCC decided to take it slow. To this day, not a single commercial bank or thrift has ever used Basel II to set its capital requirements, and the Dodd-Frank financial reform law essentially killed Basel II as a means of reducing big bank capital. Randy Kroszner’s term at the Fed expired in a short time, and he was eventually replaced by Daniel Tarullo, who as a professor at Georgetown Law School had been an outspoken critic of Basel II. I was not happy with the fact that it had taken an impending crisis to put the final brakes on the Basel II experiment. But the fact that the FDIC had delayed for so long meant that going into the crisis, FDIC-insured banking organizations’ capital levels stayed at about 8 percent, while investment banks and European banks implementing Basel II approached levels as low as 2 percent.
CHAPTER 4
The Skunk at the Garden Party
In the interagency discussions that occurred early in my tenure, I frequently found myself isolated in advocating for stronger regulatory standards. I never viewed myself as “regulatory.” I thought my advocacy for things such as stronger capital and better lending standards was just common sense. However, the deeper I got into interagency discussions, the more convinced I became that the OTS and OCC generally took whatever positions were most advantageous to their larger institutions. That meant that sometimes they would support stronger standards if they thought the impact would be to hurt institutions regulated by other regulators. With the Fed, it was more ideological. Though Ben Bernanke would ultimately steer the Fed toward more balanced regulatory policies, in 2006 and 2007, that agency still had a strong love affair with relying on market forces to “self-regulate.”
When I arrived at the FDIC, the banking regulators had already proposed for public comment two pieces of “regulatory guidance” designed to address increasing risks in commercial real estate (CRE) lending and so-called nontraditional mortgages (NTMs). By far the most important fights would be waged over tightening mortgage-lending standards. However, because the commercial real estate lending guidance provides insights into bank regulators’ decision making, I include a brief discussion of it here.
John Dugan had spearheaded both pieces of guidance and had come in for his share of criticism from many in the industry who were content with the status quo. I respected John for trying to tighten regulatory standards in those two key areas and was offended by the heat he was taking both in the media and on Capitol Hill. However, as I became more deeply involved in interagency negotiations to finalize both documents, I came to realize that both documents had been drafted in a way that would not have much of an impact on the big national banks the OCC regulated. Rather, the primary impact of the CRE guidance would fall on small community banks, while large West Coast thrifts regulated by the OTS were the primary target of the NTM guidance. So the OCC was pushing tougher regulatory standards, but the standards did little to address risk taking by the biggest national banks.
To be sure, the OCC was correct in focusing on CRE lending. Commercial real estate was overheating in tandem with the overheated housing market. Far too many banks, large and small, were funding speculative residential housing developments, as well as strip malls and office buildings tied to those developments. CRE loan balances had grown22 from about 7 percent of bank assets in 2002 to nearly 15 percent of bank assets in 2006. The quality of that type of lending had deteriorated markedly, with lending decisions being based too often on inflated land values rather than a developer’s documented ability to pay.
However, the CRE guidance that had been proposed for comment before I arrived focused primarily on CRE lending concentrations, as opposed to underwriting quality. That is, it discouraged banks from making commercial real estate loans that exceeded 300 percent of a bank’s capital. It had a tougher requirement for construction and development (C&D) loans: 100 percent of capital. The lower threshold on C&D loans made sense to me. They were typically made on high-risk, speculative land developments where the bank had to wait until the project was built and sold or leased out before it knew whether the loan would be repaid. However, loans on income-producing commercial real estate—hotels, office buildings, shopping malls, multifamily apartment buildings, and so on—were far less speculative and generally performed well.
Bank examiners do not like concentrations for the same reason that you do not put all of your retirement savings into a single stock or a single sector. For instance, you wouldn’t invest your entire 401(k) in Google, nor would you put it all into technology stocks (at least I hope you wouldn’t). If Google or the technology sector gets into trouble, you could lose most or all of your savings. In contrast, if you have your retirement money spread among a diversified group of investments, your risk of taking a big loss on a single investment goes down. That is why index funds and well-diversified stock mutual funds are so popular with retirement investors.
For similar reasons, bank regulators put fairly strict limits on a bank making a lot of loans to a single borrower. That makes sense. However, it gets trickier when regulators try to limit concentrations in a category of assets such as CRE loans. There are many different types of developments that count as commercial real estate, and just because one sector might get into trouble, e.g., housing developments, that doesn’t mean that another sector, e.g., hotels, will also suffer problems. Moreover, because thousands of community banks tend to specialize in commercial real estate lending, any limits based on the size of their portfolios relative to their capital will impact them disproportionately. A large bank may be making the same number of commercial real estate loans, and in fact its loans might be higher risk. But if the regulatory approach is to focus more on
concentrations than loan quality, the large bank will escape scrutiny. That is because it has huge portfolios of other loans—credit cards, home mortgages, and commercial and industrial loans, to name just a few—so that the proportion of its commercial real estate loans in relation to its capital will be relatively small.
In retrospect, I wish we had focused less on concentration and more on loan quality. Once the crisis hit, the myth that large banks were less risky because they had diversified loan portfolios proved to be just that: a myth. All of their portfolios suffered losses. And as it turned out, the quality and performance23 of the commercial real estate loans made by the smallest community banks were better than those originated by larger institutions.
That was a prime example of how regulatory policy can have a disproportionate competitive impact on the industry. As examiners began enforcing the guidance, smaller banks were required to either reduce their CRE concentrations or put in better risk management controls. Meanwhile, the larger banks with which they had to compete for CRE loans did not come under the same scrutiny because they did not have CRE concentrations. The guidance did at least focus examiners on weaknesses in commercial real estate and probably averted some CRE-driven failures among smaller, weaker institutions. But we could have accomplished a better result with a heavier focus on loan quality for all banks, large and small.
We finalized the CRE guidance in December 2006, but the bigger battles on mortgage-lending standards were still to be fought. The guidance on nontraditional mortgages did focus on underwriting and risk management standards, but it had a different problem. Specifically, it applied only to loans that had what is called “negative amortization” features, that is, loans where the monthly payment was not sufficient to reduce the principal. Those types of loans, also known as “option ARMs” or “pick a pay,” were popular with the major West Coast thrift institutions, including WaMu, Countrywide, and Golden West, all regulated by the OTS. The big national banks, for the most part, did not originate them. The mortgages were typically structured to provide borrowers with the option of making extremely low payments during the first five years of the mortgage term, during which time the principal balances would actually increase. At the end of the five years, they would have to start paying a higher interest rate and also have to start paying down the entire accumulated principal, so the “payment shock” of the loans was substantial.
Traditionally, NTM loans were made to borrowers with higher net worth or good credit scores; however, with the housing craze, their availability had become widespread. At the heart of the guidance was a requirement that before making that type of loan, the bank or thrift had to qualify the borrower at the fully indexed rate. That essentially meant that the lender had to determine whether the borrower’s income would be sufficient to cover the mortgage payment when the loan reset and the borrower had to start both paying a higher interest rate and paying down the accumulated principal. It was not sufficient to simply determine whether the borrower could manage the smaller payment during the introductory period.
I strongly supported this as a basic principle of good underwriting, the process of determining whether a borrower qualifies for a loan. But I questioned why we were limiting the guidance only to loans that had negative amortization. That essentially excluded the entire subprime market, which was characterized by the notorious hybrid ARMs also known as 2/28s and 3/27s. And it was with the subprime loans, not NTMs, where we were seeing the biggest problems. By the end of 200624, subprime loan delinquencies were over 13 percent, while NTM delinquencies stood at only 4 percent. Subprime loans did not have negative amortization, but they did have steep payment resets. It seemed obvious to me that we should also require originators of those products to qualify borrowers at the fully indexed rate.
Subprime hybrid ARMs were a noxious product. They were typically marketed in lower-income communities to more vulnerable borrowers. Even the “starter rates” were set significantly above market during the first two to three years, with huge interest rate resets after the starter period. In 2006 and early 2007, our data showed that the typical starter rate was 7% to 9%, with an interest rate jump of 4 to 6 percentage points after two to three years. That meant that the borrower was paying a rate of 11% to 15% on his mortgage, representing a payment increase of one-third. Our data also showed that even at the lower starter rate, borrowers could barely make the payments. The monthly payments (excluding taxes and insurance) on those loans commonly made up 40 to 50 percent of gross income, so borrowers had very little chance of making the higher payment once the interest rate reset. But that was the whole idea. Unable to afford the higher payment, the subprime borrowers would refinance over and over into another 2/28 or 3/27, generating successive rounds of high fees for the originators. It was the mortgage equivalent of churning.
Those fees included not only the usual costs associated with refinancing. In about 80 percent of hybrid ARM contracts, the fine print also imposed prepayment penalties. Those payments could be severe, typically 1 to 3 percent of the loan balance. Some of the more abusive lenders required borrowers to pay prepayment penalties even after the interest rate reset. More commonly, the prepayment penalties expired at the end of the starter period. However, if the borrower was not careful in timing the refinancing, he or she could get still get whacked with a prepayment penalty. The option ARMs addressed in the NTM guidance were bad products, but subprime hybrid ARMs were worse, and that is where we were seeing the biggest problems. But the OCC, supported by the Fed, flatly refused to amend the NTM guidance to apply to subprime mortgages. One of the reasons, I suspected at the time, was that some of the biggest national banking organizations generated a substantial number of subprime loans, though national banks typically did not originate NTMs.
Helped by public pressure from consumer groups and key members of Congress, the FDIC was finally able to convince the other bank regulators to move forward with guidance strengthening subprime lending standards, but the OCC and Fed wanted it done separately from the NTM guidance. So we finalized the NTM guidance in September 2006, and it was not until June 2007 that we were able to finalize stronger standards for subprime lending. We wrangled with the other regulators for months on the strength of the standards. Curiously, though the OCC had insisted on a very specific standard for the NTM guidance, requiring lenders to make sure that the borrower could make the mortgage payment at the fully indexed rate, they wanted a more vague “ability to repay” standard for subprime loans. Steven Fritts, our lead negotiator, advised me in an email in January 2007 that the OCC had said it would be a deal killer if that weren’t included. In addition, the Fed was fighting us on restricting prepayment penalties. It was not uncommon for the OCC and Fed to team up against the FDIC, dividing the issues among them. So, as if fighting a hydra-headed monster, we would get agreement with one on one issue, and then the other would come out of the woodwork with a completely different concern and so on.
Also slowing down the process was heavy lobbying from nonbank mortgage lenders, which did the bulk of the subprime lending. Though they were not FDIC-insured institutions, they feared—rightly so—that once federal bank regulators tightened standards for insured banks, the state regulators that regulated them would follow course and do the same. On January 25, 2006, a whole army of them came to see me to try to convince me that we shouldn’t issue subprime guidance. Calling themselves the Coalition for Fair and Affordable Housing, they argued that the increasing delinquency rates among subprime mortgages were simply a reflection of economic conditions, not poor underwriting. They also engaged in a good deal of borrower bashing. I remember one lobbyist quite seriously saying that borrowers didn’t care as much as they used to about paying their mortgage. “If they need to buy a new washing machine, they will do that instead of paying their mortgage,” he said. I was incredulous. If borrowers were having to make such trade-offs, it might be because the lenders were giving them mortgages they could barely afford.
The lobbyist
s were right in one sense. Economic conditions were causing borrowers to default on their mortgages. But that was because they had been given loans that were unaffordable at reset and, with declining home values, refinancing was no longer an option. That was exactly why we wanted lenders to qualify borrowers based on their ability to pay at the fully indexed rate so that we could be sure the borrower could continue making payments on the loan without having to resort to refinancing.
While on the one hand bashing subprime borrowers, the lobbyists also complained that by tightening standards on hybrid ARMs, we would be constricting credit to lower-income borrowers. They argued that the lower interest rate subprime borrowers received during the two- to three-year introductory period qualified more low-income borrowers to buy homes. I had heard the same argument from the Fed and OCC, and it really sent me through the roof. We had closely analyzed the terms sheets of several of the mortgage bankers and found that the thirty-year fixed rate they offered subprime borrowers was typically lower than or about the same as the so-called teaser rate they offered on hybrid ARMs. Hybrid ARMs were not being offered to expand credit through lower introductory payments; they were purposefully designed to be unaffordable, to force borrowers into a series of refinancings and the fat fees that went along with them.
In February 2007, after months of discussions, I sent an email to Dugan, Kroszner, and Reich pleading urgency in issuing the subprime guidance and stating flatly that we would not agree to a standard that was weaker than that applied to NTMs. Driven primarily by soaring delinquency rates among subprime hybrid ARMs, late mortgage payments had reached a three-and-a-half-year high, and the foreclosure rate had more than doubled, from 2.2 percent to 4.8 percent. Twenty nonbank subprime lenders—still the smaller players at that point—had gone under. I felt that we were already falling well behind the curve. I took a page out of the playbook the OCC and Fed had used during the Basel discussions: I threatened that the FDIC would go its own way and issue separate, stronger guidance if we could not get interagency agreement to move forward. It worked. On March 2, all the regulators agreed to publish the guidance for comment, and we finalized it on June 29. That might seem like a long time, but for bank regulators, it was lightning speed.