Credit crunch likely to spur reforms

But no one is sure what is the best response, short of helping people to avoid foreclosure.

from the September 14, 2007 edition

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•Home buyers often failed to understand the terms of their loans, or speculated that rising home prices would cover their rising obligations.

•Lenders, eyeing lucrative loan fees, relaxed their standards.

•The investors who bought loan-backed securities lost track of risks.

•Credit rating agencies and regulators arguably were lulled to sleep when few mortgages were in default.

Behind all this was an atmosphere of easy money, as the Federal Reserve tried to stimulate the economy after a 2001 stall-out caused, in part, by its own monetary tightening.

As they consider the right responses, many policymakers say the first priority is to do no harm.

"It always takes balance" between appropriate regulations and competitive markets, Treasury Secretary Henry Paulson said this week at a Monitor-organized breakfast with reporters.

Indeed, many analysts say the most important fixes will come from the private sector itself.

For example, a surge in subprime loans in the past few years included the rise of risky mortgages. Some required no verification of the borrower's income, while others allowed lower-than-normal interest and no payment of principal, so home "owners" were really adding to their loan balance rather than acquiring any equity in a house.

"That was really poor judgment on the part of the lenders," says Sung Won Sohn, president of Hanmi Financial Corp. in Los Angeles. "The market is not allowing those kinds of loans anymore."

Still, he hopes to see some regulatory changes, such as a licensing system for mortgage brokers.

Other analysts also see that as a likely step, as Congress reviews a regulatory system in which some sectors of the home- loan industry face much less oversight than others.

Already, some legislation is surfacing.

Last month, Rep. Christopher Murphy (D) of Connecticut introduced a measure to impose more accountability and transparency on mortgage brokers. In the Senate, Charles Schumer (D) of New York introduced mortgage-broker legislation in May.

The current turmoil could result, too, in a fresh look at bank regulation, which for years has been done by a patchwork of agencies, including the Federal Reserve, Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency. Meanwhile, nonbank mortgage finance companies, which have gained market share at the expense of banks in recent years, have no federal regulator.

Mr. Zandi says one of the most useful steps would be to expand the flow of information from lenders to regulators.

Dean Baker, a housing expert at the Center for Economic and Policy Research, says Congress needs to consider improved truth-in-lending laws, to help home buyers understand the terms of credit.

The Federal Reserve, too, must reassess its own policies, some economists say. The Fed should have become vocal earlier in sounding alarms about overly easy credit, says Mr. Baker. Though most mortgage loans aren't made by the banks the Fed regulates, such a warning would have sent a wider signal to investors to be more vigilant about the risks.

"[Alan] Greenspan really made a very serious mistake," Baker says of the former Fed chairman.

Though not everyone agrees that regulators could have slowed the boom in subprime credit, focus for now is on containing foreclosure damage.

"The last thing we want to do right now," says University of Wisconsin economist Morris Davis, "is enact regulation that just makes the downturn [in home prices] more severe."

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