Embassy of the United States

Current US Economic Policy

How Will Washington Prevent Another Financial Crisis?   Experts expect new rules to ban credit card companies from offers with hidden or unjustified interest fees.   Everything from abusive lending to unregulated derivatives may be curbed By Burton Bollag Special Correspondent October 1, 2008 Washington — Whatever the impact of the federal government's gigantic rescue plan for the country's financial system, observers say, new rules governing the system will surely follow. Treasury Secretary Henry M. Paulson Jr. indicated as much to a 60 Minutes reporter in a September 28 interview. “We don't have the regulatory authorities and structure in place to protect the American people,” he said. Officials will seek new regulations in two areas: the way housing loans, credit cards and similar financial products are sold to consumers — the “primary market” — and how banks and other institutions invest the money they raise from these operations — the “secondary market.” The crisis, the worst since the Great Depression of the 1930s, has already brought down a half-dozen major banks and other financial companies. But at its core, the debacle was caused by the fairly recent practice of selling to more and more homebuyers larger loans than they could afford. Observers expect new regulations to rein in some lending practices, such as “teaser rates” that make loans look more attractive. The loan carries a low interest rate for the first two years that can increase at a fast rate thereafter. The loan can carry a ban on early payoff, so borrowers would be obligated to pay above-market rates for years. Observers say borrowers who took such teaser rates often did not understand what they were signing up for. With housing prices rising steadily until 2006, borrowers were often persuaded that they could sell their house at a profit. But as housing prices fell, many were left with homes worth less than their mortgages. Sometimes borrowers were required to present little or no documentation that they earned enough money to make the monthly payments they agreed to. “That was just an invitation for brokers to say, ‘Who cares, I'll write the mortgage and then sell it on,’” said Barry P. Bosworth, a senior fellow in economics at the Brookings Institution. Such practices were made possible by changes in the housing market at the beginning of the decade that made it easier for people with low or moderate credit scores to buy homes. A significant change in the home-loan business also contributed. Before, mortgages were made by local savings banks, to which the borrower made payments until the loan was repaid. In recent years, more and more loans have been “securitized” — pooled and then sold to other financial institutions, and then traded further as investment vehicles. “Banks had an incentive to make sure borrowers could repay,” said Barbara Roper of the Consumer Federation of America. “With securitization, banks lost that incentive.” Mark Tenhundfeld of the American Bankers Association expects Congress to pass laws against so-called predatory lending. Additionally, he said, it may require a federal license for mortgage lenders. “But enforcement will probably be left to the states,” he said. In September 2008 the House of Representatives passed a first-ever law against abusive practices by credit card companies — practices such as charging hidden or unjustified interest fees, which have forced some Americans to go into debt and default on their home loans, said the Consumer Federation. The Senate is expected to consider similar legislation. Mark Perlow, a securities attorney with the law firm K&L Gates LLP, thinks the government will require companies to keep a financial stake in all the mortgages, credit cards and similar consumer products they sell. “The originators of debt will have to keep some skin in the game,” he said. A key factor that made the mortgage defaults so damaging was the growth of so-called credit-default swaps. These abundant but exotic financial instruments function like an insurance policy that the holder of a pool of mortgages buys from another financial institution as protection against the mortgages defaulting. The problem has been that these instruments are complicated — often traders did not understand their risk — and they were spread among many financial institutions in a complex, interlocking web. The market in credit-default swaps and other complex instruments known collectively as derivatives has become huge and lucrative in recent years, but is unregulated. Observers expect Congress and the regulators to make the field more transparent and to introduce new regulations. Reserve requirements could be established. Commercial banks, for example, are generally required to keep on hand $1 of cash for every $10 they owe to account holders or they loan out. (Investment banks typically have no such requirements, and keep only $1 for every $30 or more they borrow to invest. They have made fortunes. But when investments go bad, they have few reserves to cover their losses.) Perlow, the attorney, expects Congress to debate amending the Commodity Futures Modernization Act of 2000, which kept derivatives unregulated. But, he said, such an attempt will face stiff opposition. Bosworth said officials will want to create rules to prevent a repeat of the current crisis, without burdening the financial markets with overregulation. “It's hard to strike a balance,” he said. “You don't want to stop innovation, which has brought many benefits.”