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Regulators and Rating Agencies

Federal and state regulators may have been nervous about runaway mortgage lending, but they failed to do much about it. They certainly had reason to worry; their own surveys showed that most mortgage borrowers understood little about the financial obligations they were taking on. Many ARM borrowers did not know their mortgage payments were likely to increase, much less when they would adjust higher or by how much.

Meanwhile, hamstrung government regulators couldn’t keep up with lenders who were constantly devising ways to elude oversight. Some of the most egregious lending was done not by traditional mortgage lenders, such as commercial banks and savings and loans, but by real estate investment trusts (REITs). The Securities and Exchange Commission (SEC), the agency that regulates stock and bond sales, also regulates REITs. Yet the SEC was focused on insider trading at the time, not predatory mortgage lending. An even more important factor was a philosophical distaste for regulation that seemed to pervade the Federal Reserve, the nation’s most important banking regulator. Without Fed leadership, the agencies that monitor smaller corners of the banking system, such as the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and Office of Thrift Supervision, were deterred from taking action. State regulators also had a say, but they were no match for a globally wired financial industry.

Regulators’ reluctance to intervene in the mortgage market may have also been based on their trust in the acumen of the rating agencies. These companies provide opinions about the creditworthiness of securities and are paid by the issuers of these securities. Global banking regulators had only recently given the agencies’ opinions a quasi-official status, by making their opinions count toward determining whether banks had an appropriate amount of capital to safeguard depositors. The rating agencies were also the only institutions outside of the mortgage or banking business with enough data and information to make an informed judgment about the securities’ safety. If the agencies gave them an A-rating (meaning that they saw very little chance of default), regulators weren’t going to argue.

Yet the rating agencies badly misjudged the risks. Poor-quality data and information led to serious miscalculations. The agencies were not required to check what the originators or servicers of the mortgage loans told them, and this information was increasingly misleading. The agencies also had the difficult task of developing models to evaluate the risk of newfangled loan schemes that had never been through a housing slump or economic recession. Without that experience, the models were not up to the task they were asked to perform. The ratings were supposed to account for the range of things that could go wrong, from rising unemployment to falling house prices, but what went wrong was much worse than they had anticipated.

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