Hearing of the Joint Economic Committee - Evolution of an Economic Crisis?: The Subprime Lending Disaster and the Threat to the Broader Economy

Statement

HEARING OF THE JOINT ECONOMIC COMMITTEE
SUBJECT: EVOLUTION OF AN ECONOMIC CRISIS?: THE SUBPRIME LENDING DISASTER AND THE THREAT TO THE BROADER ECONOMY

SEN. CHARLES SCHUMER (D-NY): (Sounds gavel.) Okay, the hearing will come to order. And I'd like to welcome my fellow committee members, our witnesses and guests here today for this very important hearing on the impact of the subprime mortgage meltdown on the broader economy.

My colleagues and I on this committee have been concerned for months about the dangers to the American economy as the result of widespread unscrupulous prime -- subprime lending, and the economic news in the last six months has been -- has, disappointedly, confirmed those fears. Despite all the reassuring statements we've heard from the administration that the impact of this mess would be, quote, "contained," it hasn't been contained, but has been a contagion that has spread to too many sectors of the economy.

We've seen it most clearly in the financial markets. This summer's credit crunch was in large measure attributable to the collapse of the U.S. subprime market. It shook Wall Street and required the emergency intervention of central banks throughout the world to restore liquidity to international credit markets.

The news outside the financial markets, while not so stark, hasn't been much better. We all saw the anemic jobs report. For the first time in 40 years, the economy actually lost jobs. Consumer spending, the engine behind much of our recent economic growth, has begun to slow down. Most economists have already lowered their weak expectations about GDP growth even further. And for the first time in years, the R-word -- recession -- is being discussed far and wide as a real possibility. And we know the worst is still yet to come, as the riskiest subprime loans will begin to reset in a very weak housing market over the coming months.

This morning we heard that housing construction fell to its slowest pace in 12 years. The collapse in housing investment has already shaved nearly a full point off of GDP growth. The inventory of unsold homes already stands at record levels. Builder confidence has sunk to record lows. In many parts of the country, real home prices have declined on a year-to-year basis for the first time since 1991. If there's anyone left who doubted the repercussions of the subprime mess as the risks to the economy, they should look no further than what the Federal Reserve Open Market Committee did yesterday. In March, Chairman Bernanke came before this committee and told us that the problems in the subprime market would have little or no impact on the overall economy. Yesterday, the Federal Reserve cut the federal funds rate by 50 basis points, again primarily in response to the fallout from the subprime crisis and its ramifications.

When a conservative Fed drops the interest rate this much, it's obvious they believe the economy is in trouble. And while yesterday's rate cut is a welcome indication that the Fed realizes the real risks to our economy, it's important to recognize that a half-point reduction will do little to get at the deeper underlying problems of our overall economic health, particularly in the mortgage markets. It is a temporary solution to a bigger problem, and one that must be applied infrequently and with caution. My concern and the reason we've called this hearing is that despite all the bad news -- despite the sudden calls for action from those who just a few short months ago were assuring us there was little to worry about -- I fear that many here in Washington still don't appreciate the seriousness of the problem we are facing. Our policy responses are not matching the magnitude of the risk that still lies ahead.

And what exactly does lie ahead? An estimated 1.7 million foreclosures are predicted to occur in the next two to three years due to adjustable-rate mortgages resetting to unaffordable rates. The Center for Responsible Lending has predicted that subprime foreclosures will lead to a net loss in homeownership and a cumulative loss of $164 billion in home equity. The lost property values from the spillover effects of these foreclosures could reach up to $300 billion in neighborhoods across the country, and lost property tax revenues alone could exceed $5 billion.

These alarming statistics just refer to the direct impact of the crisis. The indirect consequences such as risks to our broader economic growth, household wealth, the health of our financial markets and our relationship with global markets, are still unknown. I hope that today's hearing will at least serve to clarify some of the dangers that cloud our economic horizon.

One of the gravest dangers we face, as we will hear from Professor Shiller, is that we're witnessing the bursting of a speculative bubble in the housing market that will impact all families, not just subprime borrowers. If, as Professor Shiller suggests, significant real nationwide housing price declines are on the horizon, we face the very real possibility that the housing market could drag the economy down with it. Our country simply can't afford a slowdown in economic growth when income inequality is at historic highs, deficits are looming and investments in critical infrastructure are drying up. Economic growth is our best hope for righting past policy wrongs and getting our country back on track.

Despite all of this bad news, the good news is that workable solutions are out there and we have time to put them in place to help limit the damage.

First, we need to do everything we can to arm the local housing nonprofit groups that are working around the clock with subprime borrowers. Last week, with the help of Senators Brown and Casey, we secured 100 million (dollars) in foreclosure prevention funding targeted to the local nonprofit groups that are pivotal in bringing subprime borrowers and lenders together to achieve loan workouts. I've asked both the administration and the main private market players in the subprime market to help us find more funding the channel these nonprofit groups, particularly as their caseload grows more and more each day.

Second, we must use the Federal Housing Administration, Fannie Mae and Freddie Mac to strategically target relief to subprime borrowers. As we all know, government-backed products -- FHA-insured mortgages, Fannie and Freddie-guaranteed loans -- are the only game in town in terms of providing liquidity to the mortgage markets and safe, sustainable products to subprime borrowers. And while my colleagues and I on the Senate Banking Committee expect to pass an FHA modernization bill today that will help thousands of families keep their homes, we can and must do more with these critical tools that we have in our arsenal to assist more of the 1.7 million families who are at-risk homeowners.

That's why I've introduced two bills -- sorry -- that's why I've introduced a bill two weeks ago, the Protecting Access to Safe Mortgages Act, that will temporarily lift the limits on Fannie and Freddie's mortgage portfolios by 10 percent, which will free up 145 billion (dollars) for the purchase of new mortgages. The unique part of this bill is that it requires that half of this total go directly to refinance mortgages for borrowers who are stuck in risky adjustable-rate mortgages. And that's because I believe that targeting the borrowers that are likely to default will help shore up the housing market in general, and assist the broader credit markets and the economy as a whole.

This morning, OFHEO announced -- that's the regulator of Fannie and Freddie -- this morning, OFHEO announced that it will adjust Fannie Mae's portfolio cap upwards by only 2 percent a year after ideologically opposing a cap increase over the past several weeks. Now that OFHEO has put its toe in the water, it's time for it to jump in. Whatever they call it, there is no doubt that this is an increase in portfolio caps that I and others have been calling for. This small increase, however, doesn't respect the magnitude of the crisis. Hopefully the ideologically driven and rigid opposition to raising caps is about to fade.

We all need to work together to adopt common-sense measures that can go a long way to help make safe, affordable refinancings possible for tend of thousands of Americans trapped in the subprime mess that never needed to be in it in the first place. In short, I truly hope the White House is paying close attention to this crisis because we're far from solving it. And I hope that this hearing will draw more attention to the real economic risks that still lay ahead and what policy actions can be taken to curb the damage.

Without further delay, get -- let's get down to business. So we can proceed quickly to the witness testimony. We in the Senate have some votes. We'll allow our House colleagues, of course, to continue while those votes go on.

I would ask that we limit opening statements to the committee's senior Republican senator -- that's Senator Brownback, and I'll reserve time for him when he comes -- and to Vice Chairwoman Maloney.

We will of course enter everybody's opening statement into the record.

So without further ado, let me call on my friend and colleague, Carolyn Maloney.

BREAK IN TRANSCRIPT

SEN. SCHUMER: Okay, good.

All right, first -- and actually Mr. Pollock has addressed this, first, I think your idea of one page is excellent. I'm going to introduce something to that effect, and maybe ask one of my Republican colleagues to join me since it is, as you say, a bipartisan idea emanating from the American Enterprise Institute. Second, I'd like to ask, just quickly, the panel's opinion of the two proposals that I have made on this. One, more money for the -- Mr. Eakes mentioned this, he thought $100 million was too little, but the basic concept of -- more money for the non-profits to help people refinance.

There are two parts to this problem. One is the means of getting somebody to refinance, since most of the people who are stuck here don't know how to do it and, as Dr. -- I can't remember Dr. Orszag or Dr. Shiller pointed out, the banker is no longer there in this securitized mortgage market. And then second, some money for the refinancing.

On the first part, we've proposed money for the non-profits, some of which would come federally, we would hope some of the banks and financial institutions would chip in as well.

Does everyone agree that that's a worthy thing to do?

Do you -- I don't need comments, just a yes or no. Do you agree, Dr. Orszag?

MR. ORSZAG: You don't want to ask me yes and no questions on policy.

SEN. SCHUMER: I know.

MR. ORSZAG: But outside --

SEN. SCHUMER: Go ahead. You can be brief.

MR. ORSZAG: -- analysts have proposed using community-based organizations as a very effective tool in this kind of setting.

SEN. SCHUMER: Right. Dr. Shiller, you agree. You nodded your head.

MR. SHILLER: Yes.

SEN. SCHUMER: Mr. Eakes proposed it --

MR. SHILLER: Yes, obviously -- plus legal assistance.

SEN. SCHUMER: -- so he does. How about you, Mr. Pollock?

MR. POLLOCK: I think this is a classic problem of information asymmetry, as the economists say, where one party knows a lot more than the other. And this is really a program -- I would see it as making up for the past lack of a clearer disclosure.

SEN. SCHUMER: Yes, but you would be supportive.

MR. POLLOCK: So I think it has to make some sense yes.

SEN. SCHUMER: Right.

Second -- and you talked about this, Mr. Pollock -- raising the mortgage, temporarily, the portfolio caps at Fannie and Freddie and directing -- we direct half, because we think they need some room here. You might direct all, Mr. Pollock, but the idea of raising the portfolio cap and directing a very significant portion of that increase to go to refinancing subprime mortgages in foreclosure or on the edge of foreclosure. Mr. Pollock clearly agrees. Do you agree with that, Mr. Eakes?

MR. POLLOCK: I agree, provided it's 100 percent goes to this. Fannie and Freddie are making plenty of money on other things, Mr. Chairman.

SEN. SCHUMER: Okay, fair enough.

Mr. Eakes?

MR. EAKES: I have never been in favor of portfolio caps. So I think that --

SEN. SCHUMER: And how about directing them to these markets?

MR. EAKES: I think they should be directed and that there should be standards to ensure that the same protections that currently apply to prime loans -- such as no prepayment penalties -- are also applied to the refinance subprime.

SEN. SCHUMER: Dr. Shiller?

MR. SHILLER: Yeah, well, Fannie and Freddie are important institutions promoting homeownership and we need -- they seem like a logical conduit.

SEN. SCHUMER: Right.

How about you, Dr. Orszag?

MR. ORSZAG: And that would have the effect of increasing demand for the mortgages and reducing the interest rate. I think there are some questions that people have raised about whether using an FHA type of intervention is a more effective tool, but that's for you to evaluate.

SEN. SCHUMER: Well, let's get to that, because one of the big problems we face here is who's going to do this? The people I've talked to who are in foreclosure, since there's no friendly banker around there's an unfriendly mortgage broker who, as you all pointed out one-way or another, is taking advantage of the mortgagor. The lending institution is often times not a bank and they're off into the sunset. They've made their big fees and they're gone. And so the only person really left on the scene is the mortgage servicer, which Mr. Eakes talked a little bit about. And that mortgage servicer, just to inform everybody, does have to take the mortgage payment and sort of break it up into all the little pieces and send it to the various bondholders and securities holders who have the pieces.

Now, my question is this -- and I direct it at Mr. Eakes, but ask anybody to chime in: Can we use these mortgage servicers, the present ones or new ones -- and it's a lucrative business -- to help with the knowledge gap we have in terms of refinancing? You say it hasn't worked thus far for reasons you didn't describe in your oral testimony. Could you talk a little bit about that, Mr. Eakes, because this is an important missing piece of the puzzle?

MR. EAKES: For nine months the banking regulators and members of Congress have been working to make modifications take place. The modification path that comes more and more important with every month that passes, as property prices fall, refinancing becomes less and less available because you can't refinance if your property's underwater.

The three issues that were initially discussed were that servicers didn't have authority to modify loans.

SEN. SCHUMER: Now they do.

MR. EAKES: There was great research looking at the servicing agreements of all of the agreements and basically have now concluded that they do have the authority.

The second issue was looking at whether it would violate the REMEC tax laws. And --

SEN. SCHUMER: Right. It does not.

MR. EAKES: -- there's great consensus that there's no problem there.

The final one, which was a little thornier, was the SEC/FASB problem and --

SEN. SCHUMER: And we worked on that and that's solved.

MR. EAKES: -- that's been solved.

SEN. SCHUMER: So why isn't it happening?

MR. EAKES: Okay. The two remaining problems -- number one is that 50 to 60 percent of the subprime loans made in 2006 had piggyback second mortgages. You can't really get a resolution with a single servicer if you have another loan outstanding. The second mortgage holder has no interest in basically writing off their entire debt. They feel like, why not just leave my loan there and see if I can be a fly in the ointment and eventually get paid something?

So for whatever reason -- that structural reason or just that it is legally easier and more protected for the loan servicer to foreclose -- that is the path. So a company like Countrywide, which has announced that it's actively doing modifications of loans, has in its most recent investor teleconference admitted that virtually none of the so-called modifications were in fact real modifications. They were just simply payment deferrals or --

SEN. SCHUMER: How do we -- what do we do to correct that situation and allow the servicers -- the on-the-ground person who's best suited to do this with some kind of incentive?

MR. EAKES: The first thing to note is that we have a real absence of time. These loans that were made in 2006 are going to come due with the 50 percent payment shock during the next 12 months.

SEN. SCHUMER: Right.

MR. EAKES: If we don't act immediately, we're going to lose the chance because somewhere around 70 percent of the buyers who face this reset and aren't able to refinance are going to be foreclosed. They can't make --

SEN. SCHUMER: And that is going to shock -- I mean, that's going to shock the markets.

MR. EAKES: It's going to shock -- the foreclosures we see now are just a, you know, it's a preview of what will come over the next 18 months.

SEN. SCHUMER: So you're saying the only real solution is the nonprofit solution, because the servicers either can't or won't --

MR. EAKES: I think the primary solution is doing this tweak to the bankruptcy code.

SEN. SCHUMER: Yep.

MR. EAKES: It's a very small thing that would allow these loans to be modified after a hearing by a bankruptcy judge in Chapter 13. In 2005, we encouraged borrowers who were having trouble to go to Chapter 13 and pay back their debts responsibly.

SEN. SCHUMER: But Mr. Eakes, very few -- it's going to take a long time to get these hundreds of thousands of people into bankruptcy court.

MR. EAKES: Well, the truth is, if you have the provision and anyone files -- which they will -- the bankruptcy court has built into it two things that are very important. First, it has an automatic stay that stops the foreclosure until the process can work its way through. That's really important. The second is that in the bankruptcy setting, when you have a write-down of a mortgage value, it's already determined that that will not create a taxable gain.

SEN. SCHUMER: Understood. I understand the legal. I think the practical problems are pretty large.

MR. EAKES: I just think --

SEN. SCHUMER: Mr. Pollock --

MR. EAKES: I think we must do this.

SEN. SCHUMER: Yep.

I'll ask each of the people to -- this is the greatest nut here. I mean, we need new financing, but I think we're going to get that one way or another. Maybe if we go to 100 percent, as Mr. Pollock suggested, we might even get the administration's support, because they have not objected to directing the money. They just don't want to raise the portfolio limit. So that's a possible compromise that we would explore.

I proposed 50 percent and Paulson -- I've spoken to Secretary Paulson and he's not totally against this. I mean, I think he's constrained a little bit by the previous administration position. But the real problem is who is going to execute these? I've met some of the people in foreclosure and they can't do it themselves, so it's the nonprofits. But Mr. Eakes said we need $1 billion there and unless we get some private sector input -- it was hard enough for us to get 100 million (dollars) into this -- Senators Casey, Brown and myself. I was hopeful that the servicers might do this somehow or other with some encouragement, some incentive, since they're on the ground -- existing servicers or new ones.

Mr. Pollock and then --

MR. POLLOCK: If I could comment on the servicer issue, Mr. Chairman.

SEN. SCHUMER: Yep.

MR. POLLOCK: I think the core issue there -- of course, there are a number of issues -- but the core issue is the fiduciary duty of the servicer or the agent. The servicer is actually an agent for the bondholders. So the agent -- the agent, the servicer, has the duty to do things which are in the best long interest of the bondholders.

This is why I think there may be a meeting ground if you have a readily available subprime ARM refinancing program -- for example, through the government subprime lender, the FHA -- where it would be clear, even in the case where the price of the house is less than the mortgage, which will be a -- is already, I guess, and if Professor Shiller's forecasts are right, will be a lot more common -- where there's ground where it's actually better for the investor to accept a refinancing and a haircut, but a haircut that will be much less expensive than foreclosure, as has been often pointed out. Foreclosure is very expensive.

SEN. SCHUMER: A lot of investors to deal with each of these changes, because the mortgages are so split up.

MR. POLLOCK: That's why the servicers has to be put in a position where it's clearly -- he's doing something that's in the benefit of the bondholder's will -- is the benefit of the borrower. And finding that middle ground, which seems to me is possible to do, is what we have to achieve.

SEN. SCHUMER: Do you -- would you want to comment on that, either Dr. Shiller or Dr. Orszag on any aspect of the servicer conundrum here?

MR. SHILLER: I wish -- I had to defer to Mr. Eakes for the -- I'm impressed, though, that this is a very rapidly changing situation and I think that some measures like those Mr. Eakes proposed are -- should be urgent.

SEN. SCHUMER: Yeah. It is urgent and we're not reacting urgently. And your economic forecast, Dr. Shiller and everything that each of the other witnesses has said said this ought to be on the front burner of the administration and of the Congress. And I can tell you it's not.

Dr. Orszag.

MR. ORSZAG: I would just add in addition to the community-based organizations and the FHA channels -- one of the things that it is important to remember about the securitization process is we have not had as many problems or -- problems in the conforming market. And the reason is because of the role of the GSEs in setting standards for the whole process. So one of the other facts that expanding the efforts or the activities of the GSEs into this market may have is to alleviate over time that incentive problem that is the trigger for a lot of this. But that obviously is not an immediate solution.

SEN. SCHUMER: Thank you.

Well, my time is more than expired, and so let me call on my colleague, Senator Brownback, to make an opening statement and do questions. And then Congresswoman Maloney will chair part of the hearing while we go vote, and my other colleagues will be able to ask questions. I'd like to return for a second round, if I can.

Thank you.

BREAK IN TRANSCRIPT

SEN. SCHUMER: Okay. Thank you.

Well, I want to thank both of you and your colleagues for being here today. And I'll just follow up with my second round.

I'd like to go back -- I know it's been touched on. I mean, the most frightening prediction here is Professor Shiller's about the housing bubble and its affect on the whole economy. And if we do have a serious housing bubble, all the more reason that we should be moving with some alacrity on the mortgage problem. Simply lowering interest rates is not going to be the main way to solve that problem -- or simply pushing more money into the economy -- not if the fundamentals in the mortgage area are not being taken care of. At the very least it's a highly inefficient way to do it -- with other ramifications.

So Professor Shiller, you testified that we could see a decline -- and this is astounding -- in home values of between 7 and 13 percent last year -- this next year -- next year alone. Even worse, we may see the likely of a greater decline that you say -- characterize it as the worst decline since the depression. First, that's frightening. That's really astounding. There's probably no way, if they decline to that degree that we could avoid a recession. Is that fair to say, Dr. Shiller?

MR. SHILLER: I wouldn't go that far. I'd say I think there's probably a greater than 50 percent chance of recession.

SEN. SCHUMER: Do you agree with that, Dr. Orszag, if his initial prediction on house prices is severe as it is?

MR. ORSZAG: What we provided in our testimony was a scenario in which national house prices declined by 20 percent. So that's a very substantial decline.

You get --

SEN. SCHUMER: One to 1.5 --

MR. ORSZAG: A half to 1.5 percentage points per year off of growth through the channels that are sort of quantifiable. And then there's this other stuff -- the perception. It is possible that something like a 20 percent real decline in house prices will have a significant effect on the outlook of business executives and consumers. I would note, though, that a reduction in interest rates -- while it may not directly offset all of that -- it does spur other stuff -- business investment and what have you.

SEN. SCHUMER: But let me ask you this, Dr. Orszag. If there's a 20 percent decline in housing prices, what is the -- who you do estimate? I think it's in your testimony -- I don't have it in front of me -- a decline in consumer spending.

MR. ORSZAG: Most of the half to 1-and-a-half percentage point decline in economic activity per year that would occur comes through consumer spending. There's a little bit through residential investment. But most of that is a wealth effect through consumer spending.

SEN. SCHUMER: It's more likely to be the low end or high end. That's a pretty broad range. And you're dealing with a GDP of 3 percent growth, maybe not even 2 --

MR. ORSZAG: There is a big question about -- the reason there's a range is this has to do with when your -- the value of your house goes down by $1, how much less do you spend? We put out a paper this -- earlier this year, the evidence on that suggesting somewhere between 2 cents and 7 cents for each dollar reduction. That -- the range I was giving you reflects that -- the empirical ambiguity about the size of that response.

SEN. SCHUMER: But if -- let's say it's 7 percent decline in consumer spending, and consumer spending's what, about 70 percent of the GDP?

MR. ORSZAG: Oh, it's not -- there's an extra step. But you would wind up in that case with a one -- with -- if it were 7 cents on the $1 for the housing wealth effect, you'd wind up with about -- and a 20 percent price decline, you then do wind up with about 1-and-a- half percent slower growth the first year and another 1-and-a-half percent slower growth --

SEN. SCHUMER: Oh, so it's 3 percent the second year. Got it.

MR. ORSZAG: Well, in terms of growth it's another 1-and-a-half. But in terms of level, it's 3 percent lower.

SEN. SCHUMER: Yep. Got it.

Do you want to say something about this --

MR. SHILLER: Yeah, I've done studies of the wealth effect, too. But remember, what we're doing is we're looking at past recessions in order to quantify the effects of wealth. And what I think is different about this experience is that the last 10 years, we have been in an unusual -- very unusual boom that has led us into an unusual psychology and I think that it changes in unpredictable ways. And I don't trust my own past analysis of this. It's a big event that we've been through, and with the recent crises and the prospect of foreclosures of millions of people, it strikes me that there could be a bigger effect than these models predict.

SEN. SCHUMER: Do either -- Mr. Pollock, would you like to --

MR. POLLOCK: I'd just say, Mr. Chairman, that as many people who inhabit the southern tip of New York City, Manhattan would say, one thing about falling prices is that it creates buying opportunities for other people.

SEN. SCHUMER: It always has. That's our economy. But there's a lot of pain in between.

Okay, let me ask you another question. This is the higher end of the market, which we haven't focused on in this testimony. But obviously the ability of those at the higher ends to securitize has allowed a lot more money to come into the market, and then allowed maybe the mortgage brokers, some of the -- not all of them are unscrupulous, but too many are -- to do what they've done. Let me ask you this. Do any of you have any thoughts on how we improve the securitization process with mortgages so that the -- this situation doesn't repeat itself? Or is it -- is the market taking care of that well enough in itself? Usually, when we have problems in the market, they occur in different places, you know. I was very much involved in the S&L fix, you know. And the savings and loan industry since 1989, when we passed the legislation, has been pretty good. They still remember what happened.

So could any of you comment on that? Dr. Shiller, why don't you go first?

MR. SHILLER: I think the biggest problem in the securitization process has been that the rating agencies had not foreseen these problems and allowed mortgage securities to have triple-A ratings when they shouldn't have. And I think this is a problem of transition, that when we -- when we're in an unusual situation, it's very hard for some organization that assessing risks to take that properly into account. And it would be kind of an act of unusual intellectual courage for them to start predicting this crisis a year or two ago and embodying that in their recommendations. But I do think that they're making corrections.

And overall, I wanted to just say that I think financial innovation is very important in the securitization of mortgages and the different traunches and the different vehicles have a general good social purpose, which is spreading risk and allowing people to have access to credit that otherwise couldn't.

SEN. SCHUMER: So you're basically saying, Dr. Shiller, that the place that needs most correction is the individual mortgage broker to the potential mortgager --

MR. SHILLER: Right.

SEN. SCHUMER: -- and maybe the first lender, because the rest is sort of self-correcting or because the rest --

MR. SHILLER: Well, we need --

SEN. SCHUMER: -- yeah, is self-correcting. Credit agencies will never just stamp triple-A on things that are all mortgages -- well, maybe for another 20 years, they won't.

MR. SHILLER: The real issue of this is -- to me at this time is lower-income borrowers, and that we are a country that cares about all people, not just the --

SEN. SCHUMER: Yes,

MR. SHILLER: -- the securitizers of mortgages, and we have to do something for them.

SEN. SCHUMER: Well, that's what we're trying to do here with --

MR. EAKES: I wanted to add --

SEN. SCHUMER: -- your help.

Go ahead, Mr. Eakes.

MR. EAKES: I think the challenge is you have perverse incentives working in the mortgage market now where you used to have a thrift that would make a line, hold the line. Their interests where completely aligned with the borrower.

SEN. SCHUMER: Yes.

MR. EAKES: If the borrower went bankrupt and had a loss, the lender would have a loss. Now we have mortgage brokers, most of whom are honorable people but who have a financial incentive to close every loan as fast as they can without regard to whether it's a good product for the borrower. And that's just the financial incentives that they have --

SEN. SCHUMER: Right.

MR. EAKES: -- operating and putting pressure on them. And if I told you that we were going to repeal all of the state statutes that had it be -- that held responsible the receiver of stolen goods --

SEN. SCHUMER: Mm-hmm.

MR. EACKES: -- we would have a whole lot more receiving of stolen goods.

SEN. SCHUMER: Sure.

MR. EAKES: But we make those parties responsible, even though they weren't the ones who --

SEN. SCHUMER: So, Mr. Eakes, do you disagree with -- I mean, Dr. Shiller seemed to indicate -- and I think Dr. Orszag earlier -- that the watchdog here, according to Dr. Shiller, are the credit rating agencies because once they -- you know, once they said, "These are good securities," people bought them. And you can't ask the individual investor to look into the 611,000 mortgages that are part of a large security, especially when they're chopped up.

MR. EAKES: I think there are two --

SEN. SCHUMER: And so my question is, is it going to be self- correcting or do we need to do something? Will -- are the credit agencies and the investors chastened?

MR. EAKES: To -- the gate for the credit rating agencies has also a perverse incentive, somewhere near 70 percent of all of the revenues for Moodys and S&P in recent years was structured finance -- this product, all of which was paid to them by the issuers. So as the ratings agency is meant to be a disclosure and an information transparency to investors -- but the investor don't pay for that service. Instead, the people who are profiting from pushing the product --

SEN. SCHUMER: Yes.

MR. EAKES: -- are paying the ratings agencies --

SEN. SCHUMER: Sort of like the accounting profession.

MR. EAKES: It's an inherent conflict of interest --

SEN. SCHUMER: Yep.

MR. EAKES: -- no matter how much firewall you put up, there ought to be SEC -- that piece of the incentive needs to be restructured. On the front end -- the gate with mortgage brokers, the first lender who pays a broker for delivery of a loan should be responsible for any bad actions taken by that broker.

SEN. SCHUMER: Mr. Eakes, I have legislation to do just that --

MR. EAKES: I know you do.

SEN. SCHUMER: -- so I'm glad you're supportive.

Does -- would everyone agree with that proposal?

MR. POLLOCK: (I do not, Mr. Chairman.

SEN. SCHUMER: Go ahead, Mr. Pollock.

I was wondering when your American Enterprise Institute --

MR. POLLOCK: It's been there all the time. (Laughter.)

The argument, as you know, is very clear. And the experiences have been -- and experiments in trying to pass that liability on that it tends to shut off the very funding that we're trying to create. I think it's -- it is quite clear in any lending operation, you have to -- you ought to have a responsibility of due care and diligence. But somebody's fraud that fools you, in my judgment, shouldn't also punish you. I do think, coming back to your first question, that the prime market -- we don't have to worry very much about. The prime market -- we've had a panic.

Financial panics tend not to last very long, especially when central banks start cutting rates. The prime market will, in my judgment, adjust fairly rapidly. And that's why I would be, for example, opposed to raising the conforming loan limit for Fannie and Freddie. We don't need to.

With respect to credit rating agencies and the lessons, the clear verdict -- the financial history is, lessons are always learned in these busts and they last about 10 to 15 years. And then a -- then a new group of people gets to relearn them.

There is an issue with the credit rating agencies, in my judgment, about the two possible models. The issuer-paid model, as Mr. Eakes referred to, which is the dominant model -- although all of the original credit-rating agencies were investor-paid in the beginning, Moody's and Poor's Rating Service, and Fitch all got into business issuing ratings for investors up until the 1970s --

SEN. SCHUMER: Interesting.

MR. POLLOCK: -- and then the switch in payment basically happened -- the story is, I'm not sure it's true, because of the Xerox machine, because if you were selling your book of ratings to investors, you couldn't protect it anymore as a proprietary property.

SEN. SCHUMER: Carbon paper wasn't good enough.

MR. POLLOCK: Carbon paper wasn't good enough. But it's my view that we ought to have as robust a competition as possible between issuer-paid rating agencies and investor-paid rating agencies. There are some of those. It would do us well to have more. The SEC has been a large obstacle to letting investor-paid agencies compete by withholding -- by historically withholding their so-called NRSRO, Nationally Recognized Statistical Rating Agency imprimatur from them.

I think a really useful project would be to set our minds on how we could create a more robust presence in the market by rating agencies which are purely paid by the investors, and who would rate purely looking at the investors. One of the ideas I've had on this is that the major institutional investors themselves maybe ought to be willing to fund the creation of a highly-competent, major rating agency which would work only for them

Just a final point, Mr. Chairman. When you mentioned the -- the going through the individual loans, I've been told by experts in securitization that major institutional investors do actually go through individual loans before they buy securitized mortgage pools, and run their own -- run their own models on them. The problem is, the adequacy of any model -- an investor model, a rating agency model -- if I may say so, colleagues, a macroeconomic model. There's always a slip between the model and the reality.

SEN. SCHUMER: Mr. Pollock, I appreciate what you're saying, but knowing what I've known, even in the last eight-nine months -- you know, the kind of stuff Mr. Eakes deals with, what's been going on on the ground -- it's hard to give much credence to those models.

MR. POLLOCK: I fully agree, Mr. Chairman.

SEN. SCHUMER: People were just ripped-off and given mortgages they couldn't afford for the very reason I think Dr. Shiller just mentioned -- because the mortgage broker and the initial mortgage lender just walked off into the sunset. And they made huge fees.

I mean, I've used this example before, but just to share it with you. A fellow who I met, who's a prime -- just like you say, Mr. Eakes, and I'm going to come to that as my last question -- who would have qualified for a prime loan, refinanced his home. And the majority of people who are in these messes are not new homeowners. You know, the -- with all due respect, Mr. Pollock, the ideological view we're really just funding new homeowners who never would have gotten funded before, that happened to some people, and that's good, but many were like this gentleman.

He had a home, he had paid about half his mortgage. He needed $50,000 because he had diabetes and his health care plan didn't pay for it. A mortgage broker calls him up and says, I'll refinance your home and get you $50,000 in cash. They refinanced the home and the rate went way up, of course, and he lost his home.

But of the $50,000, do you know how much he actually got? Fifty- seven hundred (dollars). The mortgage broker made $22,000 as a fee because he got -- he landed, as Mr. Eakes has pointed out, a very high-interest loan, that this man who was a prime candidate, prime- rating candidate -- he was a retired subway motorman, he has a pension, he has Social Security. A bank -- it wasn't a bank, sorry, the lender got $11,000 as a fee. And then between the appraiser, the lawyer, and everyone else, this poor man got $5,700.

REP. HINCHEY: And lost his house.

SEN. SCHUMER: And lost his house to boot.

MR. POLLOCK: May I make one -- one comment on that? That's a story of the very sort of thing we'd like a well-functioning market not to -- not to have happen in, if I can put it that way -- (chuckles).

SEN. SCHUMER: No, but --

MR. POLLOCK: We're -- I don't think there's any doubt that in the ideal mortgage market design, the original lender would maintain a life-of-the-loan credit interest in the loan. I do a fair amount of work with emerging or developing countries as they try to think about mortgage systems. And that's one of the things I always advise them: make sure that whatever the organization is that's making the loan stays on the hook, in some serious way, for the credit.

It's hard to -- it's not impossible, but it's harder to do that in the securitization world. And for other reasons, namely, interest rate risks, we really like securitization and moving certain risks to the bondholders. And we're caught between these two desires and trying to figure out how to somehow satisfy both.

SEN. SCHUMER: Do you want to say something, Dr. Orszag?

MR. ORSZAG: Yeah, just briefly, because I think your question touched on, and then we didn't really address, the jumbo market above conforming limits. And there are a different set of considerations there.

Coming back to the Ned Gramlich quotation, you would think that jumbo borrowers will often, not always, but will often have the sophistication to understand more complicated financial instruments and, therefore, are somewhat less sympathetic in terms of financial assistance. The problems in the jumbo market, although they're there, seem to have tempered a bit recently with spreads coming down a bit. So I think a broad array of policy analysts believe that there's less justification for intense intervention there than at the bottom.

SEN. SCHUMER: Right.

One final question, if I might. Do you have other questions, Maurice?

Okay, just one final question for me, and that is just to Mr. Eakes. You mentioned, and this is astounding, "I say this all the time," -- the media never picks this astounding fact up, which is at the core of the problem, "that 40 percent of current subprime borrowers could have qualified for prime loans." That's an astounding statistic. It probably means a higher -- anyway.

So it seems to me these borrowers would be the best targets for the kind of preemptive finance -- refinancings or loan modifications that you're talking about. Are you seeing efforts to target these specific borrowers, to go find them and target them? Or is that sort of like finding a whole bunch of needles in a big haystack?

MR. EAKES: Well, now one of the -- one of the few good benefits of having a liquidity crisis is that these borrowers who have good credit cannot be easily refinanced back into another subprime loan. That was the business that's occurred over the last 10 years. So now those borrowers, their only refinancing is to a prime loan, and that's a good thing.

SEN. SCHUMER: But how many of them are actually --

MR. EAKES: Nobody really knows.

SEN. SCHUMER: But it's probably very few, right?

MR. EAKES: It's not enough.

SEN. SCHUMER: It's hard to find them.

MR. EAKES: And the --

SEN. SCHUMER: Is that right? Am I wrong about that?

MR. EAKES: It's hard to find them. And the person who has the data about that borrower -- what their performance record is, what their credit score is, is the loan servicer-lender who made the subprime loan to begin with. And they don't always have an incentive -- or in many cases, don't even have the capacity to originate a prime loan --

SEN. SCHUMER: A lot of them are bankrupt.

MR. EAKES: A lot of them are gone.

SEN. SCHUMER: Congressman Hinchey?

REP. HINCHEY: Well, Mr. Chairman, I just want to thank you for holding this hearing. I think it's been very fascinating listening to this discussion. I'm sorry I wasn't here earlier to hear the testimony. But I'm awfully glad I got here to hear these questions.

SEN. SCHUMER: Thank you.

REP. HINCHEY: It seems to me that the evolution of this mortgage financing process that we've seen -- particularly the way in which the subprime aspects of it have been carried out over the last few years, it's certainly had kind of a de-evolution in the impact that it's having on so many people, on a larger number of people. It seems to be -- that number seems to be growing. It's one of those "good capitalism-bad capitalism" situations.

And if we'd just allow this to continue, knowing that the housing market has been the main driving force in keeping this economy sustained, I just wonder what the consequences are going to be. And in the context of that wonderment, you can't help but being a little bit fearful that the situation is going to get successively worse.

SEN. SCHUMER: Thank you, Congressman Hinchey.

I want to thank each of our four witnesses. You each were really excellent. I hope this hearing -- it was on C-SPAN, so I hope a lot of people watch. I hope it stimulates people to talk about these issues because this is the nub of the problem we've talked about. And we get a lot talk around the issue and above the issue, if you will, but not at the issue. And that's what I've been trying to do for the last several months, is focus it on the issue.

I also want to thank my staff of the JEC. The reason we have four excellent witnesses is they chose you -- (laughter) -- and they're always on the ball. So thank you all, and without objection, we're adjourned.

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