A Mortgage Regulator Speaks Out

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So where do you see that regulation fell short in catching the banks at risk?

Honestly [we thought] there were companies that weren't taking much subprime risk because they weren't making subprime loans—only to find that their securities arms were buying them from third parties. They were making and holding on to pieces which proved to be the really toxic instruments that caused the problems. And the very fact that it was a surprise tells you about how risk management was being handled.

The really complicated, structured-product instruments…they are not making them anymore. It is just unclear that the market will ever accept anything with that complexity, at least for a significant period of time. The whole paradigm of securitization as a funding vehicle is under real stress. So some of the risk that caused the biggest problems isn't likely to reappear.

Of course, you can't rely on that. Everybody is rebuilding risk management…but the danger is less about new risks and more about what they are doing with the embedded problems of the past and problems that we see over the horizon that come with a very severe recession.

The new [types of] predatory loans were underwritten without regard to the buyer's ability to repay. How will that be enforced in the future?

We have pretty strong regulatory standards about this. We expect banks not to underwrite loans unless the person can demonstrate the ability to repay. We were warning the industry not to underwrite customers to the teaser rates on mortgages, because the payments were likely to go up.

We examined all our banks for compliance. But no federal regulator can extend that same rule to state mortgage lenders that make loans and sell into the secondary market, and I think that needs to be changed. These mortgage brokers were licensed by the states, but were not subject to the same kind of regulations as commercial banks. More important, they didn't [undergo] the same kind of strict supervision, the kind of regular examinations, that commercial banks were subject to.

You're talking about companies like New Century and Countrywide…but what about Washington Mutual (WAMUQ)? They are regulated by the Office of Thrift Supervision. What will change?

I think that given all the well-publicized thrift failures, there will be a strong move afoot in Congress to do away with the OTS. There are different ways to do this, if they decide to go forward. One way is to have the thrifts convert to banks. They can choose if they want to be a national or state bank. On the other hand, you could take the OTS charter and give it to someone else like the OCC, but that would perpetuate the same business model. You would still have thrifts, engaged almost exclusively in the business of mortgage lending, without the same kind of diversification that commercial banks have. I would question why you would want to do that.

The OCC is going to start regulating the former investment bank Morgan Stanley (MS). How will that change your jobs?

They are a very different creature: a very small bank with a giant financial company. And they are very sophisticated, more of a wholesale capital market institution. We are using the people from our large bank staff and we will work closely with the Fed as well. Our suspicion is that over time the bank will get bigger and it will look like other money-center banks, but we don't know that yet.

The debate on the accounting treatment of bank losses is heating up again. How will it shake out?

There has been this inexorable march toward fair-value accounting that has been thought to be the wave of the future and a great thing to have more transparency. But with the last year when you have a truly illiquid market and you have instruments that are illiquid, you can have severe dislocations—I would say severe misrepresentations—and it doesn't work very well in many circumstances.

Unfortunately, how do you deal with that? In true book accounting. I am sympathetic to the notion that a slavish adherence to fair value is producing paper losses that are more significant than the true credit losses that the institution is likely to sustain. So I have a loan where I have every reason to believe that the borrower is going to pay off that loan. But the secondary market will only pay 80¢ on the dollar, but I'm saying wait, this is an asset that under normal circumstances is worth $1.00 and I'm going to hold on to it. Why should I be booking losses if I have no plans to sell it?

This is the big argument. The cash flows are producing one value and the market price is way, way lower because the markets are dysfunctional.

What will be the fate for Fannie Mae and Freddie Mac (FRE)?

Despite all their problems, it's a good thing that we have Fannie and Freddie as an engine to buy mortgages. It's another tool that the government can use. We can't lose sight of the benefits. There are obvious problems with their previous business model, and there will be much debate about what they will be going forward and if they will be regulated more like a public utility or on the other end of the spectrum severing ties. That's a hard debate that will unfold in the next Congress.