A Mortgage Regulator Speaks Out


John Dugan, the Comptroller of the Currency, suspects that lenders aren't doing enough to reduce the mortgage burden on homeowners

With some problem mortgages, it's like déjà vu all over again. Many such loans that have been modified by lenders are falling delinquent again within months.

It's too soon to tell if the problems are because of a worsening economy, and therefore deteriorating household budgets, or because lenders aren't reducing enough principal or interest. A new report issued jointly by the Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (OTS) says that some 57% of Fannie Mae (FNM) modified loans were 30 days past due after six months. More details on loss mitigation and foreclosures are in the new report.

John Dugan, the Comptroller of the Currency, suspects that lenders are not going far enough to lessen the mortgage burden on homeowners. The outspoken regulator, whose five-year term ends in October 2010, was among the first to raise concerns and bank standards for payment-option loans, those toxic mortgages that allowed home buyers to pay less than the interest cost. Now, these loans not only have huge interest rate resets, but also ballooning principal debt as buyers deferred payments for years. Dugan spoke with BusinessWeek Banking Editor Mara Der Hovanesian about the new report and the need for regulatory change. An edited version of the conversation follows:

Why are the newly modified loans going delinquent so quickly?

For the first time we are having a very good crack at the data. We have just begun within this quarter to focus more on modifications and default rates. We've never seen a problem on this scale before; we've never seen delinquencies at this rate. So there's not the wealth of industry experience with how to deal with this problem. We unfortunately have to learn as we go.

What we can't tell from the raw data is whether these high delinquency rates, which are not only high but keep going up each month, are because the modifications didn't reduce the monthly payments enough to make them sustainable, or whether the economy has just gotten worse. Particularly on the subprime side, you have people who are on the cusp of being creditworthy, so it doesn't take much to push them over the edge. Modifications won't help these people, but right now it's hard to sort that out. One thing we will be able to figure out is how many have had significant reductions in monthly payments. The more aggressive programs that were started in the fourth quarter should produce more sustainable modifications.

The FDIC [Federal Deposit Insurance Corp.] has been quite active in criticizing servicers for not having sustainable programs that produce sustainable mortgages. You will have better rates of return or fewer delinquencies if you have more significant reductions in monthly payments. But there is a lot of talk that the private sector won't be able to make the modifications stick and of course you can't just have a tidal wave of foreclosures. The government is going to be very involved in what works because it looks like they're going to start writing checks.

There's still a lot of criticism about what Treasury and the Fed are doing to alleviate this crisis. What do you think?

I completely disagree, as someone who has been involved and has a ringside seat to those issues where I haven't been involved directly. There have been various significant aggressive actions that have been taken on an unprecedented scale that haven't fixed the problem, but boy, would the problem be so much worse if [we] hadn't done those things. People are impatient. The way we look at things right now, I'm glad that banks came into this problem with more capital than their counterparts in other parts of the world.

I think that we are in a situation now where it's not as much about credit markets as it is about credit quality. That is a more familiar territory for banks and regulators. That doesn't mean it doesn't represent significant challenges. But these are problems that banks have worked through before and we think we will work through them again. There will be more bank failures and some areas where we need more [financial] assistance, but with strong supervision we can get through this.

I think the Fed has been quite creative and quite impressive and has produced solid results, but there is more to be done.

A lot of investors and politicians are upset with the banks because they're not putting the first round of TARP [Troubled Assets Relief Program] money to work via loans. What gives?

What is it that makes banks make loans? They have to have the capacity and willingness to take the risk and extend credit to creditworthy borrowers who have loan demand. Right now, in terms of capacity, new capital really helps. If you are really strained with capital given the risks you are facing, then you have to shrink and you can't make new loans. So dealing with capacity is critical. If you have capital and you are comfortable, you are willing to take more risk. If not, you will be in more of a hoarding mode.

There is less demand; you can't just shove loans out the door. Shoring up banks' balance sheets and strengthening confidence that people have in banks is critically important to providing credit to the economy.

How will regulation in the new financial order of the future work?

The banks who want government assistance will have strings attached to that. In the Citi (C) deal, it had to agree to modify mortgages and have its executive compensation approved. There will be more of that. So to those that have more direct assistance from the government, which is an increasingly larger group, there will be more strings attached.

I think that there will be more of an incentive, more efforts to have executive compensation restrictions and more efforts to cut back on dividends. Also, we'll track things in terms of, what are you doing with the money? My own belief is that we will get another $350 billion with the new Administration and there will be many more strings attached. There will be continued efforts to provide assistance and more regulation in connection with mortgage modifications.

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.


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