Dugan: Public Policy Fed the Wave of Subprime Demand

Comptroller of the currency John Dugan, before the Financial Crisis Inquiry Commission (FCIC) today, said public policy favoring the American dream of homeownership, combined with lax underwriting, fed the market for subprime mortgages and related investment products. “[F]or many years, home ownership has been a policy priority,” he said in prepared remarks (download here). “As a result, when times are good, we as a nation have an unfortunate tendency to tolerate looser loan underwriting practices – sometimes even turning a blind eye to them – if they make it easier for more people to buy their own homes.” Dugan noted that the rapid increase in market share by unregulated brokers and originators put pressure on regulated banks to lower their underwriting standards. Then, low interest rates and excess liquidity spurred investors to chase yields, he said. The contagion of risk from unsustainable and unaffordable mortgages could be averted in the future through higher down payment requirements, he said. “We had a crisis in which credit was too easy and too many people got loans because of lending standards,” Dugan told the FCIC. “If  you strengthen those standards, fewer people will get loans. That is the trade-off.” He recommended that the government establish minimum, common sense underwriting standards for mortgages that can be effectively applied and enforced for all mortgage lenders, whether they are regulated banks or unregulated mortgage companies. “If we had had such basic, across the board rules in place ten years ago on income verification, down payments, and teaser rate mortgages, I believe the financial crisis would have been much less severe than it was,” he said. Former comptroller of the currency John Hawke Jr. — also testifying to the FCIC — said prior to 2000, the Office of the Comptroller of the Currency (OCC) warned banks on holding subprime loans for their portfolios. He said they needed stronger underwriting and and internal controls, better monitoring and administration and appropriate pricing in their subprime programs. Additionally, demand in the market for higher yield investments at a time of low market rates encouraged “an erosion” of underwriting standards, he said. As a result, many thousands of subprime loans eventually were put back to the originating banks. “I think it is fair to say that supervisors did not anticipate this risk, which arose from wholesale defaults on securitized loans, and if they had, the need to require banks to maintain capital commensurate with this risk would have been compelling, even if the loans had been taken off the banks’ balance sheets,” Hawke said in prepared testimony (download here). His remarks supported earlier testimony to the FCIC from former executives at Citigroup (C) who said the banks could not anticipate the coming wave of financial fallout linked to subprime mortgages. Write to Diana Golobay.

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