Hearing of the House Commitee on Financial Services Subject: Recent Events in the Credit and Mortgage Markets

Interview

HEARING OF THE HOUSE COMMITTEE ON FINANCIAL SERVICES
SUBJECT: RECENT EVENTS IN THE CREDIT AND MORTGAGE MARKETS AND POSSIBLE IMPLICATIONS FOR U.S. CONSUMERS AND THE GLOBAL ECONOMY

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REP. BRAD SHERMAN (D-CA): Let's talk about these no-income verification loans. There are kind of two financial worlds out there: the world of securities that you folks represent and the world of taxation that Mr. Steel may bump into if he walks down the hall at Treasury. The question is, why have you as regulators of the financial markets turned a blind eye to the fact that those you are regulating were facilitating tax fraud or at least insulating those who chose to commit tax fraud from any inconvenience when they went to get a loan? Did you take into account in deciding to allow and to continue to allow these no-income-verification loans the effect that has on whether paying taxes continues to be the norm in our society or more and more taxpayers just begin to think that they're suckers for filling out an honest return?

I'll start with Mr. Steel. You had a chance to make it more difficult for those who chose to commit tax fraud. Did you take into consideration the decisions -- the effect of your decision on the overall tax system?

MR. STEEL: Well, at Treasury, we're not making the specific rules that the regulator --

REP. SHERMAN: Okay, then let's move on to Mr. Dugan.

MR. STEEL: Thank you.

MR. DUGAN: I just want to be clear about the question. When you say tax fraud, I'm not quite sure what you're --

REP. SHERMAN: Well, when you have a no-income-verification loan, this is basically a loan for those who've decided to commit tax fraud, those who've decided not to file, those who've decided to file phony returns, people saying "I have money to pay the mortgage, I just haven't told the IRS about it." Why do the folks who regulate the financial field, why did they not take into consideration the effect on our tax system by allowing the very kind of advertisements that Mr. Ackerman was talking about, and the general impression that those who commit tax fraud will not be impeded in their effort to get home credit?

MR. DUGAN: I guess our view on this is a little bit different. There's no obligation to collect income in order to make a loan ever. Theoretically, if someone had a million dollars and they wanted a $10,000 loan, they had it in their bank account, you'd never have to look at their income in that area.

On the other hand, there are many in most cases where income really is quite important to whether the person has the --

REP. SHERMAN: But the -- if I can interrupt -- these are all stated income loans. There's a number in the loan document. It doesn't say "income: we don't know." There's always a stated number that is not subject. I'm not asking about a no-income stated loan. I'm asking about no-income-verification loans.

MR. DUGAN: Right.

REP. SHERMAN: So the loan docs have a number and you deliberately advertise that you're not going to verify it. This is a loan packaged for those who choose not to complete an accurate tax return. Why'd you allow it?

MR. DUGAN: I think our concern is more that people would pretend -- potentially invite them to pretend that they made more income than they actually made in order to get a bigger loan that they couldn't repay, and that is something --

REP. SHERMAN: Well, that's what you also invite with this.

MR. DUGAN: And that's kind of our -- where we look at -- primary concern about will this loan get repaid. It is something we had very strong concerns about.

I gave a speech about this about six months ago.

REP. SHERMAN: Strong concerns, but --

MR. DUGAN: It's in our guidance.

REP. SHERMAN: -- did any agency here prohibit those under their umbrella from buying and holding and processing these no-income- verification loans?

MR. DUGAN: I think what we would say is that this practice began to creep into the mortgage underwriting practice as a more and more standard practice particularly in the subprime and the alt A area, and over time we began issuing stronger and stronger directives against it, culminating in the most recent subprime guidance where we said --

REP. SHERMAN: So after the hurricane hit, you decided to issue something saying the levees should be built to standard, but you could have prohibited this practice 10 years ago. It was going on 10 years ago. Why didn't you?

MR. DUGAN: I'm not sure actually that it was going on to a great extent 10 years ago. It's developed over a period of time where some lenders maintain that they can determine the repayment capacity solely from credit scores --

REP. SHERMAN: Ms. Bair, are you going to tell us that we didn't have no-income-verification loans until just the last couple of years?

MS. BAIR: Well, it's --

REP. SHERMAN: Have you been looking at this at all?

MS. BAIR: In the interest of self-defense, I'll say I've only been here about a -- (laughs) -- a little over a year in this job, but -- and John is relatively new as well. And I would say that John's been one of the leading critics of stated income and was very active in making sure we had very strong standards against stated income in our guidance.

It is my understanding --

REP. SHERMAN: Wait a minute; they were still making stated income loans four months ago.

MS. BAIR: They were. It's my understanding --

REP. SHERMAN: A strong press release is not action.

MS. BAIR: Not in banks. Not in banks, and not in our banks. If we find about it, we don't allow it, and we've cited banks and I can give you a couple C&Ds where it's been cited if you'd like. I don't think those are banks that are doing it now. It did -- as I understand the practice --

REP. SHERMAN: Then let me go on to the -- to Mr. Sirri. Why do we allow the financial markets to trade in these no-income- verification loans, and why do we allow them to be highly rated?

MR. SIRRI: Well, the one thing that we don't tolerate in these markets is fraud. So what - and this -- so what we have to be clear about is what is the disclosure that surrounds these instruments? Our authority is limited. We won't tolerate fraud and will follow through with it. But for there to be fraud, there has to be some type of a misrepresentation or omission associated with the offering of the security.

REP. SHERMAN: Well, isn't it misrepresenting a security -- or mis-rating a security -- to call it an investment-grade security when it includes and is backed by quite a number of loans issued by people -- or taken out by people who are either -- who won't verify their income and are attracted by lenders who don't -- who advertise, "If you want to lie about your income to either the IRS or to us, please come in; you're the kind of customer we want"? Why would such loans be part of A-rated pools?

MR. SIRRI: It's a difficult question. The issue revolves around facts of the particular offering. It depends upon the disclosure. For example, the underwriter may state, "We don't attempt to verify any of the traits about the collateral." They state that.

The case for fraud may be more difficult. It's -- I -- it's very, very difficult to make a general statement about this.

REP. SHERMAN: I believe my time has expired.

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