Wall Street and the Financial Crisis: Anatomy of a Financial Collapse


G. Preventing High Risk Lending

Washington Mutual was a $300 billion, 120-year-old financial institution that was destroyed by high risk lending practices. By 2007, stated income loans—loans in which Washington Mutual made no effort to verify the borrower's income or assets—made up 50% of its subprime loans, 73% of its Option ARMs, and 90% of its home equity loans. Nearly half of its loans were Option ARMs of which 95% of the borrowers were making minimum payments and 84% were negatively amortizing. Numerous loans had loan-to-value ratios of over 80%, and some provided 100% financing. Loans issued by two high volume loan offices in the Los Angeles area were found to have loan fraud rates of 58, 62, and even 83%. Loan officer sales assistants were manufacturing borrower documentation. The bank's issuance of hundreds of billions of dollars in high risk, poor quality loans not only destroyed confidence in the bank, but also undermined the U.S. financial system.

The consequences of WaMu's High Risk Lending Strategy and the proliferation of its RMBS structured finance products incorporating high risk, poor quality loans provide critical lessons that need to be learned to protect the U.S. financial system from similar financial disasters. A number of developments over the past two years hold promise in helping to address many of the problems identified in the Washington Mutual case history.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), P.L. 111-203, which the President signed into law on July 21, 2010, contains a number of changes in law that will be implemented over the course of 2011. The Dodd-Frank changes include banning stated income loans; restricting negative amortization loans; requiring lenders to retain an interest in high risk loan pools that they sell or securitize; prohibiting lenders from steering borrowers to poor quality, high risk loans; and re-evaluating the role of high risk, structured finance products in bank portfolios.

Ban on Stated Income Loans. Multiple witnesses at the Subcommittee's April 16, 2010 hearing on the role of bank regulators expressed support for banning stated income loans. The FDIC Chairman Sheila Bair testified: "We are opposed to stated income. … We think you should document income." |581| When asked for his opinion of stated income loans, the FDIC Inspector General Jon Rymer responded: "I do not think they should be allowed," |582| stressing the fraud risk: "I really can see no practical reason from a banker's perspective or a lender's perspective to encourage that. … That is just, to me, an opportunity to essentially encourage fraud." |583| Treasury Inspector General Eric Thorson also criticized stated income loans, explaining: "[T]he problem is, you can't assess the strength of the borrower and that has got to be at the foundation of underwriting, risk assessment, risk management." |584| Even the former head of OTS called stated income loans an "anathema" and expressed regret that OTS had allowed them. |585|

The Dodd-Frank Act essentially bans stated income loans by establishing minimum standards for residential mortgages in Title XIV of the law. Section 1411 establishes a new Section 129C of the Truth in Lending Act (TILA) prohibiting lenders from issuing a residential mortgage without first conducting a "good faith and reasonable" determination, based upon "verified and documented information," that a borrower has a "reasonable ability to repay the loan" and all applicable taxes, insurance, and assessments. Subsection 129C(a)(4) states the lender "shall verify" the borrower's income and assets by reviewing the borrower's W-2 tax form, tax returns, payroll receipts, financial institution records, or "other third-party documents that provide reasonably reliable evidence" of the borrower's income or assets. In addition, Section 1412 of the Dodd-Frank Act adds a new Subsection 129C(b) to TILA establishing a new category of "qualified mortgages" eligible for more favorable treatment under federal law. It states that, in all "qualified mortgages," the "income and financial resources" of the borrower must be "verified and documented."

These statutory requirements, by prohibiting lenders from issuing a residential mortgage without first verifying the borrower's income and assets, essentially put an end to stated income loans. |586|

Restrictions on Negative Amortization Loans. Witnesses at the Subcommittee's April 16 hearing also criticized WaMu's heavy reliance on Option ARM loans. These loans provided borrowers with a low initial interest rate, which was followed at a later time by a higher variable rate. Borrowers were generally qualified for the loans by assuming they would pay the lower rather than the higher rate. In addition, borrowers were allowed to select one of four types of monthly payments, including a "minimum payment" that was less than the interest and principal owed on the loan. If the borrower selected the minimum payment, the unpaid interest was added to the unpaid loan principal, which meant that the loan debt could increase rather than decrease over time, resulting in negative amortization.

At the Subcommittee hearing, the FDIC Inspector General Jon Rymer warned that negative amortization loans are "extraordinarily risky" for both borrowers and banks. |587| The FDIC Chairman Sheila Bair testified:

    "We are opposed to teaser rate underwriting. You need to underwrite at the fully indexed rate. You should document the customer's ability to repay, not just the initial introductory rate, but if it is an adjustable product, when it resets, as well." |588|

The Dodd-Frank Act does not ban negatively amortizing loans, but does impose new restrictions on them. Section 1411 amends TILA by adding a new Section 129C(6) that requires, for any residential mortgage that allows a borrower "to defer the repayment of any principal or interest," that the lender vet potential borrowers based upon the borrower's ability to make monthly loan payments on a fully amortizing schedule—meaning a schedule in which the loan would be fully repaid by the end of the loan period—instead of evaluating the borrower's ability to make payments at an initial teaser rate or in some amount that is less than the amount required at a fully amortized rate. The law also requires the lender, when qualifying a borrower, to "take into consideration any balance increase that may accrue from any negative amortization provision." This provision essentially codifies the provisions in the 2006 Nontraditional Mortgage Guidance regarding qualification of borrowers for negatively amortizing loans.

In addition, Section 1414 of the Dodd-Frank Act adds a new Section 129C(c) to TILA prohibiting lenders from issuing a mortgage with negative amortization without providing certain disclosures to the borrower prior to the loan. The lender is required to provide the borrower with an explanation of negative amortization in a manner prescribed by regulation as well as describe its impact, for example, how it can lead to an increase in the loan's outstanding principal balance. In the case of a first-time home buyer, the lender must also obtain documentation that the home buyer received homeownership counseling from a HUD-certified organization or counselor. Finally, Section 1412 of the Dodd-Frank Act, establishing the new favored category of "qualified mortgages," states those mortgages cannot negatively amortize.

Together, these borrower qualification and disclosure requirements, if well implemented, should reduce, although not eliminate, the issuance of negative amortization mortgages.

Risk Retention. One of the root causes of the financial crisis was the ability of lenders like Washington Mutual to securitize billions of dollars in high risk, poor quality loans, sell the resulting securities to investors, and then walk away from the risky loans it created. At the April 16 Subcommittee hearing, the FDIC Chairman Bair testified:

    "[W]e support legislation to require that issuers of mortgage securitizations retain some ‘skin in the game' to provide added discipline for underwriting quality. In fact, the FDIC Board will consider … a proposal to require insured banks to retain a portion of the credit risk of any securitizations that they sponsor." |589|

Section 941(b) of the Dodd-Frank Act adds a new section 15G to the Securities Exchange Act of 1934 to require the federal banking agencies, SEC, Department of Housing and Urban Development, and Federal Housing Finance Agency jointly to prescribe regulations to "require any securitizer to retain an economic interest in a portion of the credit risk for any residential mortgage asset that the securitizer, through the issuance of an asset-backed security, transfers, sells, or conveys to a third party." |590| The retained economic interest must be "not less than 5 percent of the credit risk" of the assets backing the security, with an exception made for "qualified residential mortgages," to be further defined by the regulators. The regulators issued a proposed rule early in 2011, which is currently the subject of a public comment period.

In the meantime, the FDIC has issued a new regulation, effective September 30, 2010, that imposes a range of disclosure, risk retention, and other obligations on all insured banks that issue asset backed securitizations. |591| One of the provisions imposes a 5% risk retention requirement on all asset backed securitizations issued by an insured bank, whether backed by mortgages or other assets. The provision states that the bank sponsoring the securitization must:

    "retain an economic interest in a material portion, defined as not less than five (5) percent, of the credit risk of the financial assets. This retained interest may be either in the form of an interest of not less than five (5) percent in each of the credit tranches sold or transferred to the investors or in a representative sample of the securitized financial assets equal to not less than five (5) percent of the principal amount of the financial assets at transfer. This retained interest may not be sold or pledged or hedged, except for the hedging of interest rate or currency risk, during the term of the securitization." |592|

The provision also states that this risk retention requirement applies only until the "effective date" of the regulations to be issued under Section 941 of the Dodd-Frank Act.

The FDIC risk retention requirement, followed by the risk retention requirement to be developed under the Dodd-Frank Act, should, if well implemented, end the ability of banks to magnify risk through issuing asset backed securities and then walking away from that risk. Instead, banks will be required to keep "skin in the game" until each securitization concludes.

Ban on Steering. The Washington Mutual case history also exposed another problem: compensation incentives that encouraged loan officers and mortgage brokers to steer borrowers to higher risk loans. Compensation incentives called "overages" at WaMu and "yield spread premiums" at other financial institutions also encouraged loan officers and mortgage brokers to charge borrowers higher interest rates and points than the bank would accept, so that the loan officer or mortgage banker could split the extra money taken from the borrower with the bank.

To ban these compensation incentives, Section 1403 of the Dodd-Frank Act creates a new Section 129B(c) in TILA prohibiting the payment of any steering incentives, including yield spread premiums. It states: "no mortgage originator shall receive from any person and no person shall pay to a mortgage originator, directly or indirectly, compensation that varies based on the terms of loan (other than the amount of the principal)." It also states explicitly that no provision of the section should be construed as "permitting any yield spread premium or other similar compensation." In addition, it directs the Federal Reserve to issue regulations to prohibit a range of abusive and unfair mortgage related practices, including prohibiting lenders and brokers from steering borrowers to mortgages for which they lack a reasonable ability to repay.

The Dodd-Frank provisions were enacted into law shortly before the Federal Reserve, in September 2010, promulgated new regulations prohibiting a number of unfair or abusive lending practices, including certain payments to mortgage originators. |593| In its notice, the Federal Reserve noted that its new regulations prohibit many of the same practices banned in Section 1403 of the Dodd Frank Act, but that it will fully implement the new Dodd-Frank measures in a future rulemaking. |594|

High Risk Loans. Still another problem exposed by the Washington Mutual case history is the fact that, in the years leading up to the financial crisis, many U.S. insured banks held highly risky loans and securities in their investment and sale portfolios. When those loans and securities lost value in 2007, many banks had to declare multi-billion-dollar losses that triggered shareholder flight and liquidity runs.

Section 620 of the Dodd-Frank Act requires the federal banking regulators, within 18 months, to prepare a report identifying the activities and investments that insured banks and their affiliates are allowed to engage in under federal and state law, regulation, order, and guidance, and analyzing the risks associated with those activities and investments. The federal banking agencies are also asked to make recommendations on whether each allowed activity or investment is appropriate, could negatively affect the safety and soundness of the banking entity or the U.S. financial system, and should be restricted to reduce risk.

To further strengthen standards and controls needed to prevent high risk lending and safeguard the Deposit Insurance Fund, this Report makes the following recommendations.

    1. Ensure "Qualified Mortgages" Are Low Risk. Federal regulators should use their regulatory authority to ensure that all mortgages deemed to be "qualified residential mortgages" have a low risk of delinquency or default.

    2. Require Meaningful Risk Retention. Federal regulators should issue a strong risk retention requirement under Section 941 by requiring the retention of not less than a 5% credit risk in each, or a representative sample of, an asset backed securitization's tranches, and by barring a hedging offset for a reasonable but limited period of time.

    3. Safeguard Against High Risk Products. Federal banking regulators should safeguard taxpayer dollars by requiring banks with high risk structured finance products, including complex products with little or no reliable performance data, to meet conservative loss reserve, liquidity, and capital requirements.

    4. Require Greater Reserves for Negative Amortization Loans. Federal banking regulators should use their regulatory authority to require banks issuing negatively amortizing loans that allow borrowers to defer payments of interest and principal, to maintain more conservative loss, liquidity, and capital reserves.

    5. Safeguard Bank Investment Portfolios. Federal banking regulators should use the Section 620 banking activities study to identify high risk structured finance products and impose a reasonable limit on the amount of such high risk products that can be included in a bank's investment portfolio.


581. April 16, 2010 Subcommittee Hearing at 88. [Back]

582. Id. at 27. [Back]

583. Id. at 15. [Back]

584. Id. at 15. [Back]

585. Id. at 42, 142. [Back]

586. The Federal Reserve is charged with issuing regulations to implement Section 1411. Federal Reserve regulations issued in July 2008, under the authority of the Home Ownership and Equity Protection Act (HOEPA) of 1994, which took effect in October 2009, already require lenders issuing certain high cost mortgages to verify a borrower's ability to repay the loan. 73 Fed. Reg. 147, at 44543 (7/30/2008). Since the Dodd-Frank Act applies to all types of mortgage loans, the Federal Reserve is expected to issue revised regulations during 2011, expanding the verification requirement to all mortgage loans. [Back]

587. April 16, 2010 Subcommittee Hearing at 16. [Back]

588. Id. at 88. [Back]

589. Id. at 81. [Back]

590. Section 941(b) also imposes risk retention requirements on other types of asset backed securities and collateralized debt obligations. [Back]

591. 12 CFR § 360.6. [Back]

592. 12 CFR § 360.6(b)(5)(i). [Back]

593. 75 Fed. Reg. 185 (9/24/2010). [Back]

594. Id. at 58509. [Back]

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