Help for Homeowners, Not a Bailout for Mortgage Pushers

It was predictable that once the outlines of the coming mortgage crisis came into view, housing activists would propose some sort of federal bailout. In the new Democratic Congress, they're likely to get a serious hearing.

This is surely the wrong way to go. The message Washington should be sending is that there will be no government bailout of the mortgage bankers, brokers, syndicators and Wall Street investment houses -- the folks who got us into this mess in the first place.

For years, they've been preaching the glories of market discipline over heavy-handed regulation, and now they're about to enjoy a full measure of that discipline. Moreover, to the degree that they participated in, or turned a blind eye to, mortgage fraud, the government will be aggressive in seeking civil penalties and, in the most flagrant cases, criminal prosecution.

That said, there are several things Washington can do to minimize the damage to the rest of the housing market and the economy, reduce the chance of another housing credit bubble, and assist the victims of predatory lending.

The most obvious is to acknowledge that mortgage finance is a national business requiring a single federal regulator with broad supervisory and rulemaking powers. One reason regulators were unable to get ahead of the rapid deterioration of credit standards was the difficulty in coordinating policy among four federal agencies, and 50 state banking commissioners, that have jurisdiction over parts of the industry -- all of them with slightly different roles, philosophies and constituencies.

Whatever the historical reasons for this balkanized setup, they are no longer valid. The industry has become particularly adept at regulatory arbitrage, moving activities wherever the rules and oversight are least restrictive and playing one regulator against the other. It does no good for federal regulators to issue "guidance" on subprime lending or exotic new mortgage products if all it accomplishes is to move the business to mortgage brokers and mortgage syndicators who are beyond their reach.

In the short term, Congress should direct the regulator with the broadest jurisdiction, the Federal Reserve, to draw up rules for all mortgage originators on their responsibility to ensure the suitability of loans they offer to customers with different incomes and financial sophistication. These rules don't necessarily have to include a right to sue if a borrower is put in an inappropriate product -- that's a big bone of contention. But they should provide a basis for regulatory review and sanctions for flagrant and repeated violations.

The industry also deserves clearer guidance on the tradeoff between sound underwriting and the need to extend more credit to households with low incomes or blemished credit records. Community activists are simply naive in arguing that there is no conflict between these goals. At the same time, it's ridiculous for the chief economist of the Mortgage Bankers Association to argue, as he did this week, that the system is working because 86 percent of subprime borrowers last month were still current in their payments.

What is the "socially optimal" delinquency rate -- the rate at which the largest number of households would obtain a mortgage without undermining the credit system, inflating a housing bubble or putting too many families through the trauma of losing their homes? It's hard to put a precise number on it, but during a period of low unemployment and modest economic growth, it's probably no higher than 5 percent -- not the 14 percent that the MBA's Doug Duncan seems so sanguine about.

The Securities and Exchange Commission also needs to look into the performance of the agencies that came up with credit ratings for pools of subprime and exotic loans. I always wondered how Fitch, Moody's and Standard & Poor's could calculate, with any precision, the likely default rate of mortgage products that had never really been tested by a serious recession or a downturn in the housing cycle. Now we know: They can't. Now that the crisis is upon us, it is likely to be of little consolation to investors that ratings downgrades are under consideration.

The most difficult issue is what to do about the prospect that lenders could foreclose on a million or more homes over the next two years, many of them in low-income neighborhoods, involving unsophisticated borrowers and inappropriate mortgage products. Getting them cash to pay those loans will only reward the lenders. Rather, what's needed is some mechanism to encourage the faceless investors who now hold those mortgages to accept less money than they were expecting, while at the same time helping homeowners to refinance their homes with more appropriate mortgages.

This, it seems to me, is a perfect assignment for Fannie Mae and Freddie Mac, which were chartered by the federal government with the express purpose of stepping in when private markets fail. They have the ability to raise and commit billions of dollars to the refinancing effort. They have active networks of lenders with necessary skills in financial counseling and loan workouts. And what better way for them to atone for their recent accounting sins and burnish their affordable-housing bona fides than to provide a market-based solution to this mess?

Even then, it won't be easy. Getting investors to forgo further interest payments and take 60 or 80 cents on the dollar they are owed may require some financial sweeteners. And to pay for those sweeteners, homeowners -- who, by the way, have some responsibility here -- would have to agree to share any profits they earn from selling or refinancing their homes in the future. Through the magic of securitization, Fannie and Freddie could turn that future stream of income into needed cash today.

But a taxpayer subsidy? No way.

Steven Pearlstein can be reached atpearlsteins@washpost.com.