Bull by the Horns

by Sheila Bair

  So we organized three roundtables with servicers, investors, accountants, lawyers, ratings agencies, consumer advocates, and other regulators to see if we could build consensus around the idea. The roundtables were held on April 16, May 29, and July 20, 2007. The good news was that there was general consensus that servicers had the legal authority to do wide-scale interest rate reductions of the type we suggested without compromising the favorable accounting and tax treatment of the securitization trusts. What’s more, servicers were generally supportive of our proposal to freeze the starter rate (though looking back now, I wonder if they were just telling us what we wanted to hear).

  However, we received strong pushback from some in the investment community, most notably Mark Adelson of Nomura Securities, who went public with vigorous opposition. In a scathing research note, “Modify This!,” Adelson disingenuously characterized modification efforts as geared solely toward helping borrowers at the expense of MBS investors. “The fact that a loan38 modification allows a defaulted borrower to keep his home is irrelevant—it should not be a consideration,” he railed. “The only consideration should be the lender’s/investor’s economic interest.” (Throughout our struggles to achieve wide-scale loan restructurings, our industry opponents would usually fail to acknowledge the business justification and broader economic arguments in favor of loan mods. That was a smart tactic. Focusing on assistance to borrowers, of course, inflamed popular resentment against subprime borrower bailouts.)

  In his public comments, Adelson would conveniently omit the fact that foreclosures would benefit triple-A bondholders over the interests of borrowers and investors in subordinate tranches, while modifications would cost them money. However, in a May 2007 Nomura Securities research note recounting an industry forum on subprime mortgage loss mitigation strategies, he acknowledged the “conflicts between different classes39 of investors” and that “modifications favor the interests of subordinate and residual classes.” And in a not-so-veiled threat, he suggested that that was one area “likely to spawn litigation, both between investors and servicers and among competing classes of investors.” Using assumptions that seem laughable now, he referenced research predicting a housing slump with 8 percent price declines over three to four years, with estimated losses on subprime loans originated in 2006 at 8 to 10 percent—well below the thick levels of protection then enjoyed by triple-A investors. Of course, if that had been a realistic assumption, it would have made economic sense for the triple-As to push for foreclosures over modification, as they would never have been touched by loss rates of 8 to 10 percent. But that was greed-induced la-la land. Home prices declined more than 30 percent, and bond investors took a beating40, hitting a trough of around 30 cents on the dollar in early 2009.

  We invited dozens of participants to the roundtables, and only Adelson vocally opposed our proposal to modify subprime loans on a large scale. Everyone else in the room was pretty much nodding in agreement on the need to extend the starter rate when the borrower couldn’t refinance. Some attendees were extremely helpful. For instance, Marty Rosenblatt, a senior partner at Deloitte & Touche, was invaluable in helping the group navigate the accounting issues associated with modifying loans inside securitization pools. Many of the industry representatives also made positive contributions, including Lewis Ranieri of the Hyperion Group, Mike Heid of Wells Fargo, Larry Litton of Litton Loan Servicing, and George Miller of the American Securitization Forum. We were able to establish definitively that the servicers did have the flexibility under both the tax laws and accounting rules to modify the loans. The lawyers also confirmed that the securitizations imposed a contractual obligation on servicers to maximize value for the investment pool as a whole, to address concerns that senior MBS investors might try to halt loan mods. I was delighted that there seemed to be so much support.

  Loan modifications made sense for investors as a whole, home owners, and the economy. How could we not move forward with such an obviously needed initiative? Yet, looking back, I see that I was naive. As annoyed as I was with Adelson at the time, in retrospect, with him I at least knew my enemy and the true agenda.

  As for the rest, some were probably disingenuous. Others were sincere about supporting systematic modifications, though their commitment was weak and they failed to execute with the staff training and resources necessary to make systematic modifications work. But there was another factor motivating their happy talk: at the time that we held our roundtables, efforts were gaining steam to pass legislation forcing restructuring through the bankruptcy process. The servicing industry, as well as MBS investors, were eager to create the impression in Washington that they were on top of things and government action was unnecessary. At least I wasn’t the only one who was duped. Following our efforts41, Senate Banking Committee Chairman Chris Dodd and ranking Republican member Richard Shelby held their own roundtable in May. At the end of that meeting, Dodd was able to get all the participants to commit publicly to what they had all told us privately: that they would work to restructure the loans of subprime borrowers and pursue foreclosure only as a last resort.

  We had established that the private sector had the legal tools to restructure loans, and we were told by securitization industry leaders that they would be doing so. Working with the other bank regulators, we reinforced the roundtables by issuing guidance42 on April 17, 2007, that encouraged banks and bank affiliates to work with mortgage borrowers to restructure unaffordable loans. At the FDIC, we followed that up with special training programs for our examiners to make sure a review of loan restructuring was part of the examination process. I even made a personal video for our examiners emphasizing what I viewed as the crucial importance of the effort. But we were not the primary regulator of any of the major servicers. And I do not think that the other regulators43 shared our sense of urgency in making sure banks were staffed up and ready to deal with the wave of distressed mortgages coming their way. So we received a lot of happy talk from the securitization industry, but by the fall of 2007, it was clear that the major servicers were still pursuing foreclosure as the default option. Indeed, according to a survey conducted by Mark Zandi, the chief economist of Moody’s Analytics, less than 1 percent of subprime mortgages were being restructured. The vast majority of troubled loans were going into foreclosure. The few loans that were being modified were not being done systematically but individually and laboriously negotiated with the borrowers, one by one.

  I convened our staff experts and asked them to try to explain to me what was going on. Had our roundtables accomplished nothing? How could the industry be so clueless? Couldn’t it see what was coming and the need to get ahead of it with proactive, systematic modifications? There were many factors, said our staff experts: inertia, ineptitude, skewed economic incentives, tranche warfare, they were all playing a part. But perhaps the biggest problem was a culture that frankly worked against providing relief for borrowers. The Wall Street–dominated securitization industry never left money on the table. Systematic modifications, which would give everyone an extension of the starter rate, might mean that some borrowers who could afford to pay the higher rate might get a payment lower than they could really afford. The industry clearly didn’t want to give up its chance at having those 11% to 13% rates of return from subprime home owners, notwithstanding the strong evidence presented by Rich Brown and others on our economic team that there was no way the vast majority of subprime borrowers could make the higher payments. The culture was for the servicers and the investors they worked for to squeeze every penny they could out of borrowers, and that meant that they would negotiate loan by loan. “These guys will step over44 a dollar to pick up a nickel,” said George Alexander, our most seasoned securitization expert. No truer words were ever spoken.

  I was scheduled to speak to a securitization group in New York on October 4, 2007, so I decided to engage it directly on why more borrowers weren’t being helped. I tried to take a constructive approach, noting with approval a public statement
that its trade group, the American Securitization Forum, had issued in June. It reaffirmed the conclusions we had reached in our roundtable that servicers had both the legal authority and the contractual obligation to modify loans when restructuring would maximize value for investors as a whole. But then I went on to say, “Frankly, I’m frustrated45 that the servicing restructuring has not reached the level that I had hoped it would. . . . We have a huge problem on our hands. We can’t just sit here doing this kind of case-by-case, laborious restructuring process with all these millions of subprime hybrid ARMs. . . . [S]ome categorical approaches are needed, and needed urgently.”

  I finished my speech, and the lackluster applause spoke volumes. I looked over the crowd of predominantly thirty-something white male Wall Street deal makers, and those who weren’t glaring at me were casting sideways glances at each other or rolling their eyes. I thought they were going to throw rotten eggs and tomatoes at me. Then the question-and-answer session began. A hand shot up in the back of the room. The gentleman started lecturing me about how it wasn’t possible to help “these people,” referring to subprime borrowers. “You give them a break,” he said, “and they will just go out and buy a flat-screen TV.”

  So why, I asked, if he felt that way about “these people,” did he extend mortgage loans to them to begin with? I will never forget his answer: “Bad regulation.”

  So there you had it, straight from the heart of U.S. capitalism. It had been okay for the masters of the universe who filled that conference room to shovel out millions of mortgages to people who clearly couldn’t afford them because no one in the regulatory community had told them to stop. And if there was a problem now, it was because regulators hadn’t protected these securitization whiz kids from their own greed and corruption.

  So much for the self-regulating market.

  At that same conference, I felt I was seeing the true face of the industry for the first time. Those were the folks on the ground who were driving what was really going on in the housing market, not the polished lawyers and trade association heads whom we were hearing from in D.C. I was angry, and I decided to go on the offensive. I did not have any regulatory power over them, but I could at least try to engage the other regulators, who did have direct authority, as well as ratchet up public pressure and cast a media spotlight on what was going on. On October 8, I sent an email to Dugan, Kroszner, and Reich, asking for support for our proposal to extend the starter rate on hybrid ARMs. I also directly engaged Chairman Bernanke, who was the most sympathetic among my regulatory colleagues. A few weeks later, I ran an op-ed in The New York Times calling for systematic wide-scale conversion. “The mortgage crisis is growing46,” I said, “and the mortgage industry has the ability to solve much of the problem on its own.” Much to my surprise, I received editorial endorsements47 from both The New York Times and The Wall Street Journal.

  Not everyone was complimentary, however. The op-ed led to an onslaught of negative blogs accusing me of trying to help “deadbeats” and questioning why subprime borrowers should get a break on their mortgages when others would not. Many of the bloggers obviously viewed subprime borrowers as flippers and speculators, not families trying to hold on to their homes. That was an erroneous perception. Indeed, our data showed that more than 93 percent of subprime loans had been made to individuals or families occupying their homes. Professional investors and speculators generally opted for the NTM loans—option ARMs—that provided extremely low payments for five years. Real estate professionals were too smart to take out the abusive 2/28s or 3/27s. Those, for the most part, were marketed to lower- and moderate-income people who lacked financial sophistication.

  Notwithstanding the public misunderstanding, I understood the popular resentment. My husband and I have never had anything but fixed-rate mortgages and have always made our payments on time. But the larger point was this: if all of those loans went into foreclosure, it would create a tremendous downward pressure on the housing market, hurting home values for all of us. That, of course, was exactly what happened.

  But the political backlash was real, and it hampered our efforts to convince the Bush Treasury Department to support our position. As usual, there were differences in views among the bank regulators. I had reached out to Ben Bernanke, and the Fed was the most supportive of our position. Surprisingly, the OCC appeared to be coming our way; in a November interview with American Banker, John Dugan was quoted as saying that “there’s been a realization48 that maybe the best way to do [loan restructuring] is some kind of systematic approach.”

  Up until that point, I had had very few dealings with Treasury Secretary Hank Paulson. My early requests for a courtesy meeting with him after I became FDIC chairman had been unsuccessful. It had taken months before he finally agreed to a meeting and then, when I had arrived at his office, I had been redirected to Robert Steel’s office down the hall. Hank had stopped by for about five minutes to say hello. Clearly, the former CEO of Goldman Sachs didn’t think the head of an agency that insured $100,000 bank deposits was worth his time. That would later change, but in 2007, he still had better things to do.

  Bob, Hank’s undersecretary for domestic finance, was, however, highly accessible as well as interested in what we had to say on loan mods. Bob had worked with Hank for years at Goldman Sachs. He was friendly and personable, a good counterpoint to Hank’s abrupt, no-nonsense way of doing business. I found him easy to work with, funny, and disarmingly charming (in contrast to his somewhat cutthroat reputation on Wall Street). David Nason, who held my old job as the assistant secretary for financial institutions and reported to Bob, was also extremely helpful. Bob had participated in our roundtables, and we had been conversing regularly on the need for a government program for systematic loan modifications.

  Our efforts to convince49 Treasury to launch such a program were given a tremendous boost when, in November 2007, California Governor Arnold Schwarzenegger picked up on our proposal and convinced all of the major servicers in California to commit to extending the starter rate on subprime hybrid ARMs for a “sustainable period” of five to seven years. We had been pushing for a permanent extension of the starter rate, but the five years did give borrowers significant payment relief. At Governor Schwarzenegger’s request, I had sent Mike Krimminger to California to provide technical assistance to the governor’s staff, and the governor had asked Mike to speak at the press conference he held announcing the program. My chief of staff, Jesse Villarreal, and I watched the press conference on TV and had a good laugh when Schwarzenegger introduced Chairman Bair’s representative, Michael Kreeeeemeenger.

  That agreement was a major step forward, given California’s large and hard-hit subprime mortgage market. With California leading the way, we were sure that other states would start following suit with systematic loan modifications. Bob Steel seized on the opportunity and convinced Hank and the White House that the Treasury should get ahead of piecemeal state efforts by coming up with a national agreement to restructure subprime loans. By the end of November, other regulators were also giving our ideas public support. To his credit, Hank got on the phone with the heads of all the major banks and told them he wanted their participation. Once the secretary of the Treasury became personally involved, things started to happen. By December, we had a national agreement. Dubbed the Hope Now alliance, the program would qualify up to 1.8 million home owners for a streamlined loan modification process.

  But the agreement50—like almost all of our reform efforts—was a watered-down compromise among the various bank regulators and industry. John Reich, the head of the Office of Thrift Supervision, was a particularly vocal critic of our proposal, arguing for a loan-by-loan approach and starter rate extensions of only three years. We ended up with five years. I also felt that the criteria to qualify borrowers were far too complicated (a nod to the industry), and, most troubling, they required servicers to determine whether individual borrowers could afford the steep reset before they could be given the modification. My fe
ar was that that particular provision would be used as a ruse to engage in borrower-by-borrower negotiations, instead of the faster, more efficient systematic approach. But perhaps the biggest defect was the lack of detailed reporting on loan modification activity. Without detailed public reports, there would be no way to hold servicers accountable for complying with the agreement, which was crucial, given that the agreement was voluntary. I wanted the FDIC to have operational oversight of the program, but the other regulators would never agree to that, so program administration rested with the Treasury, which—as experience has shown—was ill-equipped to run a program of this nature.

  For those reasons, Hope Now never lived up to expectations. Hundreds of thousands of subprime borrowers did receive modifications under it, and I take pride in that, though many more went into foreclosure. I will never forget participating in a foreclosure-prevention town meeting in southern Los Angeles at Exposition Park a few months after Hope Now was announced, at Governor Schwarzenegger’s invitation. We arrived a little before 9 A.M. and saw thousands of people lined up outside the building, notwithstanding the stifling heat and humidity, waiting to talk with a servicer. I provided brief remarks to a standing-room-only crowd, explaining the Treasury program to them and how we expected it to work. In stark contrast to the arrogance and disdain I confronted on Wall Street, there I saw families with young children, elderly people, working people in their denims or uniforms. No Armani suits in that room. I saw fear, confusion, and exhaustion in their faces. They were caught in mortgages they could not afford, dealing with a complex loan-servicing process they could not understand. There were no flippers or speculators in that room, just people terrified about losing their homes.