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Subprime Shakeout: Best Practices, Market Forces Avoid Need for Onerous Regulation

The recent subprime-lending meltdown invites comparisons with other major crises. Some liken it to the corporate-governance crisis of the early 2000s, the junk-bond crisis of the ’90s or the savings-and-loan debacle of the ’80s. Others compare it to less man-made disasters.

The ultimate effects are very much like Hurricane Katrina,” said Martin Eakes, CEO of the Center for Responsible Lending, in testimony before the Senate Banking Committee in February 2007. “Millions of citizens lose their homes and the fabric of entire communities is threatened.

Comparisons with other disasters, however, belie the complexity of the subprime-lending crisis—as well as the implications of regulatory measures being proposed to fix it. The crisis was not caused by a single factor, but a multitude of events and trends. Likewise, no silver-bullet regulation could prevent it without causing unintended consequences perhaps more damaging than the crisis itself.

“If Congress and regulators overreact to this situation by imposing onerous underwriting practices, it could price a large segment of the consuming public out of the credit market,” says Richard Gottlieb, a partner with Dykema in Chicago, and head of the firm’s national Consumer Financial Services practice. “This could have a ripple effect on spending habits, affecting the manufacturing, energy and retail industries, with a corresponding effect on stock prices.”

To better understand the causes of the meltdown, and the possible ramifications of legislative responses to it, InsideCounsel magazine teamed up with Dykema on Demand in May 2007 to produce a Podcast (www.insidecounsel.com/dykemaondemand). The Podcast features an interview with Gottlieb, who discusses the legal and regulatory fallout that financial institutions are seeing, and how they can minimize the damage.            

“Most financial institutions have a good track record of best practices and internal oversight mechanisms,” Gottlieb says. “In most cases, lenders got into trouble because they simply guessed wrong about the direction of the real-estate market and mortgage rates. This is primarily a macro-scale problem, and micro-scale regulatory solutions will offer only marginal help.”

Market Correction

While the mortgage-banking industry and its customers could benefit from federal legislation to prohibit predatory-lending practices and reduce inconsistencies among state laws, Gottlieb decries reflexive action to tighten underwriting standards. Some proposals would impose suitability standards restricting the kinds of loans offered to certain borrowers.

“Suitability tests will make it extremely difficult for some borrowers to purchase a home or refinance,” Gottlieb says. “This would be a huge mistake that would harm consumers.” Instead, he explains, lawmakers should recognize the subprime-lending meltdown was not caused by lax regulation or inadequate compliance, but by market forces.            

“The current crisis is the result of a unique combination of market forces, including the bursting of the housing bubble, and a downturn in the economy that caused loan defaults at rates not previously seen,” Gottlieb says. “There are plenty of good laws on the books, and an equally strong regulatory branch to ensure banks make loans that meet ‘safety and soundness’ considerations.”            

And the industry’s own internal systems already are working to contain the damage. Most lenders have re-examined their core underwriting practices in the current market context, and some have tightened their credit standards as a result. Further, some institutions are making the best of the situation by trying to convert troubled loans into performing ones.            

“Instead of incurring a loss, gaining possession of an over-valued asset and putting homeowners on the street, lenders should refinance or restructure defaulting loans,” Gottlieb says. “That way, borrowers can keep their homes and financial institutions can continue realizing at least some revenue stream.”           

Such an approach also saves costs in terms of attorneys’ fees, foreclosure expenses and other factors – including investors’ confidence in an institution’s ability to adapt to market difficulties.           

“In the short term, there will be an inevitable tightening of credit and increased industry scrutiny,” Gottlieb says. “But the subprime-lending industry will continue to thrive—and there will remain a steady pool of capital—because 90 percent or more of the borrowers in these markets can afford their homes under the proper conditions. If federal and state authorities resist the strong temptation to over-regulate, the market will take care of itself.”

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Featured Articles :

• Subprime Shakeout: Best Practices, Market Forces Avoid Need for Onerous Regulation
  The recent subprime-lending meltdown invites comparisons with other major crises.

• Regulating Subprime Lending
  Lawmakers at state and federal levels have responded to the subprime-lending crisis by doing whatís expected of them ñ proposing new legislation.

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