First published Aug. 19, 2007:
In 2002, Washington state's then-Attorney General Chris Gregoire came to Bellingham to announce what was billed as a historic legal settlement with mortgage giant Household International that would curb nationwide abuses in subprime mortgage lending.
Today, subprime mortgage defaults have set off a chain reaction of financial losses that are roiling stock markets around the world. Families in default could lose their homes, and others who had once expected to get a loan may find they can no longer qualify.
After the Household International episode and several similar cases gave clear evidence of the risks, many are wondering why subprime lending excesses were allowed to go on unchecked until the mortgage system went into a tailspin.
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Kathleen Keest, a former Iowa assistant attorney general involved in the Household International case, said today's financial mess could have been avoided if regulators and major financial institutions had heeded the lessons of that case.
"It's not that it wasn't foreseen, because it was foreseen," Keest said. "In this era of 'the market is god,' people just didn't want to listen."
Joseph Mason, associate professor of finance at Drexel University, has done extensive research into the financial underpinnings of the subprime mortgage industry. As he sees it, the potential for disaster in the subprime lending arena should have been obvious before, during and after the Household International affair.
"Household was among a number of aggressive players," Mason said. "It was not unique in its business model. ¼ By not cracking down after seeing this kind of behavior, regulators allowed it to grow and become standard industry practice."
Gregoire announced the 2002 settlement in Bellingham because about 400 Whatcom County homeowners were among those who said they had been misled into refinancing their mortgage loans on ruinous terms with Household International. A private lawsuit filed on behalf of those local homeowners was one of the factors that led Gregoire and other state attorneys general to negotiate a nationwide settlement in which Household agreed to make $484 million in restitution payments to homeowners.
At the time, Gregoire acknowledged that even $484 million would not come close to undoing the estimated billions in damages done to hundreds of thousands of homeowners struggling to keep their homes. But she said the settlement also forced Household to adopt a sweeping consumer protection system.
"They can be a model for how this industry ought to do business," Gregoire said.
Since then, many firms in the mortgage industry have developed different models.
Mortgage companies discovered that they could tap into the many billions of dollars in the hands of investors and hedge funds around the world who wanted safe investments - but investments with a higher return than a bank CD or a U.S. Treasury bill.
The lending firms made loans to homeowners, and then converted those loans into bonds that investors could buy. Those investors, not the lending companies, wound up assuming the risk. Investors thought that risk was low, because after all, the loans were secured by homes.
The availability of all that investment money enticed mortgage companies to concentrate on making as many loans as possible, without worrying about borrowers' ability to repay. Brokers collected commissions, their employers collected fees, and if the loans never got paid back, it was some unknown investor's problem.
"Mortgage brokers and their employers were making the most money selling the most complicated and opaque mortgage products ¼ to the least sophisticated borrowers in order to generate maximum fees," said Stijn Van Nieuwerburgh, assistant professor of finance at New York University, in an e-mail. "The mortgage lenders did not care. They passed on all the risk to Wall Street."
Chuck Cross, vice president of mortgage regulatory policy for the Conference of State Bank Supervisors, agreed. Cross was the Washington Department of Financial Institutions' lead investigator in the Household International case.
"We had all these dollars coming off Wall Street, looking for these high-return investments," Cross said. "Sound underwriting was just thrown out the window. ¼ Wall Street wasn't asking the questions. Nobody was doing due diligence. You had greed meeting up with naivety."
Washington Attorney General Rob McKenna said the burgeoning subprime mortgage business fed on itself.
"Credit was too easy," McKenna said. "The sale and resale of mortgages accelerated."
Easy credit helped to push up the price of homes across the country, he added. Lenders and buyers, confident that prices would keep rising, agreed to ever-riskier types of loans that left homeowners with little or no equity. That courted disaster if prices flattened or dropped, making refinancing impossible.
Keest, who is now senior policy analyst with the Center for Responsible Lending in North Carolina, said regulators in many states did what they could to curb abuses. But state agencies lack the resources as well as the legal authority to supervise lenders' behavior.
"They can't be proactive," Keest said. "They have to wait until problems appear."
As she sees it, federal regulators should have moved sooner to curb excesses, and the big Wall Street investment firms that provided the money for reckless mortgage lending should have known better.
"Wall Street and Washington (D.C.) refused to see the structural problems," Keest said. "Nobody wants to put the brakes on, because household spending is driving the economy."
Defenders of the subprime mortgage industry have argued that the availability of these loans has helped some families achieve the American dream of home ownership, and too much regulation could make it harder for those families to get their own homes. Keest's research indicates that is a myth.
Most subprime mortgage loans are made to people who already have homes, not to first-time homebuyers, Keest said. When those people get into financial trouble, they lose those homes. As a result, subprime loans take away more homes than they provide, Keest said.
Now, with investors yanking their money out of the subprime financing system, would-be homeowners with less than great credit histories may find it harder than ever to get a loan.
"There is nothing that regulation could have done that would have impeded access to credit more than this has done," Keest said.
Bob Parlette, the Wenatchee attorney who sued Household International on behalf of Whatcom County clients, agreed.
"The music has stopped," Parlette said. "The people without a chair are going under."