Credit crunch likely to spur reforms

After the collapse of Enron and WorldCom, Congress passed the Sarbanes-Oxley Act to clean up corporate accounting.

After the stock market crash of 1987, regulators created a new "circuit breaker" to keep computerized stock trades from throwing share prices over a cliff.

What will be the policy fallout from the housing and mortgage meltdown of 2007?

The answers will take some time to emerge, especially since policymakers are focusing first on how to calm credit markets and to help at-risk homeowners avoid foreclosure.

But one thing seems clear: Federal fixes, when they come, are likely to be multifaceted, because of the complex web of factors that caused the current housing crunch.

In fact, the credit bust could open the door to a full-scale overhaul of the nation's financial regulatory structure – a move that some policymakers on both ends of the political spectrum say is long overdue.

Even if the responses prove to be narrower in scope, they could end up affecting everyone from home appraisers to the mortgage finance companies that now rest outside the oversight of bank regulators. And the Federal Reserve, although it enjoys wide freedom from political influence, might tinker with its own playbook after some Monday-morning quarterbacking.

"There's plenty of blame to go around," says Mark Zandi of Moody's Economy.com in West Chester, Pa. Everyone involved in originating, securitizing, and purchasing mortgage loans, he says, "had some part in the problems we're now experiencing."

Those problems are twofold. The end of the housing boom spells financial distress – and possibly foreclosure – for 1 million or more homeowners who can't afford the rising monthly payments on their adjustable-rate mortgages.

Second, global financial markets are in their own distress, as banks and other investors struggle to mark down the value of complex securities that include those tottering mortgage loans.

Many actors set the stage for the crisis, economists say.

•Home buyers often failed to understand the terms of their loans, or speculated that rising home prices would cover their rising obligations.

•Lenders, eyeing lucrative loan fees, relaxed their standards.

•The investors who bought loan-backed securities lost track of risks.

•Credit rating agencies and regulators arguably were lulled to sleep when few mortgages were in default.

Behind all this was an atmosphere of easy money, as the Federal Reserve tried to stimulate the economy after a 2001 stall-out caused, in part, by its own monetary tightening.

As they consider the right responses, many policymakers say the first priority is to do no harm.

"It always takes balance" between appropriate regulations and competitive markets, Treasury Secretary Henry Paulson said this week at a Monitor-organized breakfast with reporters.

Indeed, many analysts say the most important fixes will come from the private sector itself.

For example, a surge in subprime loans in the past few years included the rise of risky mortgages. Some required no verification of the borrower's income, while others allowed lower-than-normal interest and no payment of principal, so home "owners" were really adding to their loan balance rather than acquiring any equity in a house.

"That was really poor judgment on the part of the lenders," says Sung Won Sohn, president of Hanmi Financial Corp. in Los Angeles. "The market is not allowing those kinds of loans anymore."

Still, he hopes to see some regulatory changes, such as a licensing system for mortgage brokers.

Other analysts also see that as a likely step, as Congress reviews a regulatory system in which some sectors of the home- loan industry face much less oversight than others.

Already, some legislation is surfacing.

Last month, Rep. Christopher Murphy (D) of Connecticut introduced a measure to impose more accountability and transparency on mortgage brokers. In the Senate, Charles Schumer (D) of New York introduced mortgage-broker legislation in May.

The current turmoil could result, too, in a fresh look at bank regulation, which for years has been done by a patchwork of agencies, including the Federal Reserve, Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency. Meanwhile, nonbank mortgage finance companies, which have gained market share at the expense of banks in recent years, have no federal regulator.

Mr. Zandi says one of the most useful steps would be to expand the flow of information from lenders to regulators.

Dean Baker, a housing expert at the Center for Economic and Policy Research, says Congress needs to consider improved truth-in-lending laws, to help home buyers understand the terms of credit.

The Federal Reserve, too, must reassess its own policies, some economists say. The Fed should have become vocal earlier in sounding alarms about overly easy credit, says Mr. Baker. Though most mortgage loans aren't made by the banks the Fed regulates, such a warning would have sent a wider signal to investors to be more vigilant about the risks.

"[Alan] Greenspan really made a very serious mistake," Baker says of the former Fed chairman.

Though not everyone agrees that regulators could have slowed the boom in subprime credit, focus for now is on containing foreclosure damage.

"The last thing we want to do right now," says University of Wisconsin economist Morris Davis, "is enact regulation that just makes the downturn [in home prices] more severe."