The credit markets are seizing up and the uncertainty recently drove up short-term interest rates for municipalities and some rock-solid institutions such as New York's Metropolitan Museum of Art to 20%. And now even so-called prime borrowers, the ones who were properly vetted, are being sucked into defaults on their mortgages. Yet it's still a relatively small number of institutions and individuals getting hurt by this not-yet-a-recession. So what's the worst that could happen?
Sorry we asked.
A number of economists and banking industry experts believe the subprime crisis could metamorphose into the biggest debacle to hit the sector since the savings and loan catastrophe of the 1980s, which caused some $500 billion in losses to the banking industry. And that means the future of a couple of name-brand financial institutions could be in jeopardy.
Much will depend on how far home prices tumble over the next few quarters, how high unemployment climbs, how many homeowners are pushed into foreclosure from rate resets, and, most importantly, how far the crisis spills into the conventional mortgage market and other parts of the credit sector. "The impact here could be far larger [than the S&L crisis] in terms of the dollar amount and the spillover effects into other parts of the economy, particularly the consumer," said Merrill Lynch economist Kathy Bostjancic.
Why? Home prices fell about 6% in 2007 and are expected to tumble another 15% in 2008, 10% in 2009 and 5% in 2010, said Bostjancic. Unemployment, which climbed to its highest level in two years in December at 5%, will hit 5.8% by year end and 6% in 2009, predicts Bostjancic. As this happens, she said, the crunch will likely expand into prime mortgages, home equity loans and credit cards, making it the worst consumer recession since 1980. The buildup of credit was "unprecedented" and is now unwinding, she said.
The Bush Administration's rate-freeze program for certain subprime homeowners and the recently passed stimulus/rebate package, along with the Federal Reserve's aggressive rate cuts, offer short-term fixes. But it won't stop the carnage. "The principal concern of the current credit crisis lies in the possibility that banks will eventually run out of capital," said Doug Duncan, chief economist with the Mortgage Bankers Association, in his updated 2008 forecast.
Many believe the government will ultimately step in with a housing industry bailout to the tune of hundreds of billions of dollars before it would allow a major bank to collapse.
Subprime horror stories have been making headlines for much of the past year as falling home prices, a pullback in housing demand, overbuilding, interest rate resets, growing defaults and tightening lending standards played havoc in the residential market. A flurry of mortgage companies, including American Home Mortgage Investment Corp., New Century Financial Corp. and Delta Financial Corp., filed for Chapter 11 bankruptcy protection.
Big banks took large write-downs, and chief executives from three of them — Citigroup's Charles Prince, Bear Stearns' James Cayne and Merrill Lynch's Stanley O'Neil — resigned. Citigroup and Merrill Lynch shook the market when Citigroup posted an $18.1 billion write-down, $9.8 billion loss, and 41% dividend cut, and Merrill Lynch posted its largest loss in the firm's 94-year history in the fourth quarter. Both warned of more write-downs ahead. "Who would have guessed the banks would have incurred the losses they've incurred already, especially on triple A investments," said Chip MacDonald, partner in the Atlanta office of Jones Day.
Experts fear this is just the tip of the iceberg. There are $1 trillion in outstanding subprime mortgages, with potential losses estimated at about $250 billion, said Bose George, an equity analyst with Keefe, Bruyette & Woods Inc. Columbia University professor Charles Calomiris pegs the losses even higher — at between $300 and $400 billion.
All of this comes as a large wave of ARM and hybrid mortgages are poised to reset this year — an event that could push the crisis into the conventional mortgage and credit markets. Once this happens, "it's almost impossible to imagine any bank or financial institution going unscathed and I would be very surprised if at least some aren't threatened," said Dean Baker, co-director of the Center for Economic and Policy Research, a Washington think tank. He believes the losses will easily exceed that of the S&L debacle.
Subprime borrowers, who had eye-poppingly low teaser rates of 7% to 8%, will see rates jump as high as 11% when they reset. Even conventional borrowers with ARM and hybrid mortgages could face a crunch, especially those who stretched their finances to buy a home, those who took advantage of loose lending standards by taking out big loans without showing documented proof they could afford it, and those whose home values have plummeted below the mortgage amount.
Merrill Lynch's Bostjancic said the biggest impact of rate resets, from a dollar perspective, will come in the third quarter of 2008. She sees losses from all loan defaults exceeding $500 billion in 2008.
There are already signs the turmoil is creeping into the conventional mortgage market and other credit areas. Indeed, 5.6% of all loans were at least 30 days overdue in the third quarter — the highest rate in 20 years , according to the Mortgage Bankers Association. Mark Greene, chief executive of credit analysis firm Fair Isaac Corp., warns that "losses on prime mortgages can easily be two to three times what they were on subprime mortgages." Delinquencies are also ticking up among credit cards and home equity loans, said Dennis Moroney, an analyst with TowerGroup Research.
"It kind of reminds me of the old cartoon of the little Dutch boy with his finger in the dyke, and while he's trying to plug up the subprime hole, there are leaks sprouting all around him," said Mark Fitzgibbon, director of equity research at Sandler O'Neill & Partners. "Subprime is just one small piece of of it."
Bostjancic said the credit crunch is already affecting consumer spending as U.S. retailers experienced the worst holiday sales season since 2001, and consumer confidence hit its lowest level in 20 years. "The amount of debt that's likely to go bad is virtually certain to be in the high hundreds of billions of dollars, and it wouldn't surprise me if it ends up crossing a trillion," said Baker.
Steve Persky, managing partner and chief executive of Dalton Investments LLC, believes the federal government would step in with a heavy-handed bailout before allowing a major bank to blow up. "I don't think the Fed will let a major bank fail," he said.
Still, some industry analysts and investors see opportunity in the beaten-down financial stocks and battered mortgage-backed securities market. "There are double-A and triple-A subprime-backed securities that have a 25% or 30% collateral cushion below them that are trading at 50 cents on the dollar," Persky said. "This presents one of the best distressed opportunities I've seen in years."
Sharon Haas, managing director of Fitch Ratings, admits investors "started to panic" and randomly slashed values on virtually all mortgage-backed securities, even those that aren't at risk. "The market just doesn't know how to value those securities," she said. It had better learn soon, or the price of that education will become astronomical.
By Janet Morrissey
Sunday, October 5, 2008
FBI saw threat of mortgage crisis
WASHINGTON -- Long before the mortgage crisis began rocking Main Street and Wall Street, a top FBI official made a chilling, if little-noticed, prediction: The booming mortgage business, fueled by low interest rates and soaring home values, was starting to attract shady operators and billions in losses were possible.
"It has the potential to be an epidemic," Chris Swecker, the FBI official in charge of criminal investigations, told reporters in September 2004. But, he added reassuringly, the FBI was on the case. "We think we can prevent a problem that could have as much impact as the S&L crisis," he said.
Today, the damage from the global mortgage meltdown has more than matched that of the savings-and-loan bailouts of the 1980s and early 1990s. By some estimates, it has made that costly debacle look like chump change. But it's also clear that the FBI failed to avert a problem it had accurately forecast.
Banks and brokerages have written down more than $300 billion of mortgage-backed securities and other risky investments in the last year or so as homeowner defaults leaped and weakness in the real estate market spread.
In California alone, lenders have foreclosed on $100 billion worth of homes over the last two years and are foreclosing at a rate of 1,300 houses every business day, according to a recent report from ForeclosureRadar.com.
Most observers have declared the mess a gross failure of regulation. To be sure, in the run-up to the crisis, market-oriented federal regulators bragged about their hands-off treatment of banks and other savings institutions and their executives. But it wasn't just regulators who were looking the other way. The FBI and its parent agency, the Justice Department, are supposed to act as the cops on the beat for potentially illegal activities by bankers and others. But they were focused on national security and other priorities, and paid scant attention to white-collar crimes that may have contributed to the lending and securities debacle.
Now that the problems are out in the open, the government's response strikes some veteran regulators as too little, too late.
Swecker, who retired from the FBI in 2006, declined to comment for this article.
But sources familiar with the FBI budget process, who were not authorized to speak publicly about the growing fraud problem, say that he and other FBI criminal investigators sought additional assistance to take on the mortgage scoundrels.
They ended up with fewer resources, rather than more.
In 2007, the number of agents pursuing mortgage fraud shrank to around 100. By comparison, the FBI had about 1,000 agents deployed on banking fraud during the S&L bust of the 1980s and '90s, said Anthony Adamski, who oversaw financial crime investigations for the FBI at the time.
The FBI says it now has about 200 agents working on mortgage fraud, but critics say the agency might have averted much of the problem had it heeded its own warning.
"The FBI correctly diagnosed that mortgage fraud was epidemic, but it did not come close to meeting its announced goal," said William K. Black, who was a federal regulator during the S&L crisis and now teaches economics and law at the University of Missouri-Kansas City.
"It used everyday procedures and woefully inadequate resources to deal with an epidemic," he said. "The approach was certain to bring symbolic prosecutions and strategic defeat."
The mortgage debacle has laid bare a system marked by dubious practices at every stage of the process. Lenders often made loans to borrowers who had limited ability to repay them but little desire to pass up the dream of homeownership. Many loans lacked basic documentation, such as information about borrowers' incomes.
Still, mortgage companies could hardly sell them fast enough, packaging the loans as investment securities and peddling them to eager buyers on Wall Street.
The FBI defends its handling of the crisis, with officials contending that as home prices were rising several years ago, the trouble brewing in the mortgage market -- and the potential crimes behind it -- was not immediately apparent.
Officials said they began approaching mortgage companies and others in an attempt to raise awareness about the growing fraud problem. But the lenders had little incentive to cooperate because they were continuing to make money. Black says that in many cases, they were part of the fraud.
"Nobody wanted to listen," Sharon Ormsby, the chief of the FBI's financial crimes section, said in an interview. "We were dealing with the issue as best we could back then."
Over the last three years, the FBI and other agencies have brought dozens of mortgage-fraud cases. The bureau has rooted out foreclosure rescue schemes in which homeowners are tricked into signing over the deeds to their homes to operators who buried the properties even deeper in debt. Agents have disrupted cases of identity theft in which criminals open -- and exhaust -- home equity lines of credit and leave homeowners stuck with the bill.
Many of the cases have been relatively small, however, with about half the investigations involving losses of less than $1 million -- the size of two or three loans.
But the tepid response also reflects a broad realignment of law-enforcement priorities at the Justice Department in which mortgage fraud and other white-collar crimes have been subordinated to other Bush administration priorities.
That has reflected, in part, the ramp-up in national security and terrorism investigations after the Sept. 11 attacks. But the administration has also put more support behind efforts against illegal immigration and child pornography.
In a way, the mortgage debacle could not have come onto the FBI radar screen at a worse time. Just as Swecker was making his doomsday forecast, the FBI, under pressure from Congress and the White House, was creating a crime-fighting brain drain, transferring hundreds of agents from its criminal investigations unit into its anti-terrorism program. About 2,500 agents doing criminal work -- 20% or so of the entire force -- were affected.
Even as the number of new white-collar cases started declining, the Justice Department did pursue some high-profile corporate prosecutions, such as those arising from the collapse of Enron Corp. But some former prosecutors question the administration's current commitment to pursuing complex, high-stakes cases.
"I think most sitting U.S. attorneys now staring at the subprime crisis find scant resources available to pursue sophisticated financial crimes," said John C. Hueston, a Los Angeles lawyer who was a lead federal prosecutor in the trials of Enron executives Kenneth L. Lay and Jeffrey K. Skilling.
Absent a major shift in priorities and resources, he said, it is likely that the Justice Department and the FBI will continue on their current path of focusing on simple cases "that don't go to the heart of the problem."
The FBI says it has 21 open investigations into possible large-scale fraud related to the subprime meltdown. The Times reported last month that a federal grand jury in Los Angeles had subpoenaed records from three large California lenders: Countrywide Financial Corp. (now part of Bank of America Corp.), New Century Financial Corp. and IndyMac Federal Bank.
Among other possible targets, the FBI has said, are investment firms that sold billions in securities backed by shaky subprime mortgages and credit rating agencies that gave high marks to the now-worthless securities and failed to protect investors.
But it may be hard to jump-start such probes. Trying to prove that a major mortgage company intended to defraud buyers of its securities, for example, could take years of digging into records and testimony.
Moreover, some of those involved may have special legal protection: Credit rating firms have in other cases successfully asserted that their opinions about the values of securities are protected by the 1st Amendment.
"I am happy to have investigations going on, but these investigations should have taken place years ago," said Blair A. Nicholas, a San Diego lawyer representing investors who lost money in the collapse of several subprime mortgage lenders. "They seem to always get involved after the horse has left the barn. It is always cleaning up the mess rather than being proactive."
Could the crisis have been averted, or at least mitigated, if the FBI had intervened more forcefully?
"Until there is a catastrophic loss, there is no incentive to investigate criminal conduct," said Cynthia Monaco, a former federal prosecutor in New York. "Nor are there people coming forward with evidence" such as angry investors or whistle-blowing corporate employees, she said.
Even now, Monaco added, it is far from clear whether the damage -- suffered by investors and homeowners alike -- was the product of clear-cut fraud.
Ormsby says the FBI is more actively working with other federal investigative agencies in the hope they will pick up the slack. The Secret Service, for example, in a departure from its traditional missions of protecting presidents and heads of state and investigating counterfeiting, has assigned more than 100 agents to examine mortgage fraud, said spokesman Edwin Donovan.
The Justice Department is also starting to mobilize. The department offered what it described as a "basic seminar" on mortgage fraud cases to about 100 prosecutors last week at its national training academy in South Carolina.
By Richard B. Schmitt, Los Angeles Times Staff Writer
"It has the potential to be an epidemic," Chris Swecker, the FBI official in charge of criminal investigations, told reporters in September 2004. But, he added reassuringly, the FBI was on the case. "We think we can prevent a problem that could have as much impact as the S&L crisis," he said.
Today, the damage from the global mortgage meltdown has more than matched that of the savings-and-loan bailouts of the 1980s and early 1990s. By some estimates, it has made that costly debacle look like chump change. But it's also clear that the FBI failed to avert a problem it had accurately forecast.
Banks and brokerages have written down more than $300 billion of mortgage-backed securities and other risky investments in the last year or so as homeowner defaults leaped and weakness in the real estate market spread.
In California alone, lenders have foreclosed on $100 billion worth of homes over the last two years and are foreclosing at a rate of 1,300 houses every business day, according to a recent report from ForeclosureRadar.com.
Most observers have declared the mess a gross failure of regulation. To be sure, in the run-up to the crisis, market-oriented federal regulators bragged about their hands-off treatment of banks and other savings institutions and their executives. But it wasn't just regulators who were looking the other way. The FBI and its parent agency, the Justice Department, are supposed to act as the cops on the beat for potentially illegal activities by bankers and others. But they were focused on national security and other priorities, and paid scant attention to white-collar crimes that may have contributed to the lending and securities debacle.
Now that the problems are out in the open, the government's response strikes some veteran regulators as too little, too late.
Swecker, who retired from the FBI in 2006, declined to comment for this article.
But sources familiar with the FBI budget process, who were not authorized to speak publicly about the growing fraud problem, say that he and other FBI criminal investigators sought additional assistance to take on the mortgage scoundrels.
They ended up with fewer resources, rather than more.
In 2007, the number of agents pursuing mortgage fraud shrank to around 100. By comparison, the FBI had about 1,000 agents deployed on banking fraud during the S&L bust of the 1980s and '90s, said Anthony Adamski, who oversaw financial crime investigations for the FBI at the time.
The FBI says it now has about 200 agents working on mortgage fraud, but critics say the agency might have averted much of the problem had it heeded its own warning.
"The FBI correctly diagnosed that mortgage fraud was epidemic, but it did not come close to meeting its announced goal," said William K. Black, who was a federal regulator during the S&L crisis and now teaches economics and law at the University of Missouri-Kansas City.
"It used everyday procedures and woefully inadequate resources to deal with an epidemic," he said. "The approach was certain to bring symbolic prosecutions and strategic defeat."
The mortgage debacle has laid bare a system marked by dubious practices at every stage of the process. Lenders often made loans to borrowers who had limited ability to repay them but little desire to pass up the dream of homeownership. Many loans lacked basic documentation, such as information about borrowers' incomes.
Still, mortgage companies could hardly sell them fast enough, packaging the loans as investment securities and peddling them to eager buyers on Wall Street.
The FBI defends its handling of the crisis, with officials contending that as home prices were rising several years ago, the trouble brewing in the mortgage market -- and the potential crimes behind it -- was not immediately apparent.
Officials said they began approaching mortgage companies and others in an attempt to raise awareness about the growing fraud problem. But the lenders had little incentive to cooperate because they were continuing to make money. Black says that in many cases, they were part of the fraud.
"Nobody wanted to listen," Sharon Ormsby, the chief of the FBI's financial crimes section, said in an interview. "We were dealing with the issue as best we could back then."
Over the last three years, the FBI and other agencies have brought dozens of mortgage-fraud cases. The bureau has rooted out foreclosure rescue schemes in which homeowners are tricked into signing over the deeds to their homes to operators who buried the properties even deeper in debt. Agents have disrupted cases of identity theft in which criminals open -- and exhaust -- home equity lines of credit and leave homeowners stuck with the bill.
Many of the cases have been relatively small, however, with about half the investigations involving losses of less than $1 million -- the size of two or three loans.
But the tepid response also reflects a broad realignment of law-enforcement priorities at the Justice Department in which mortgage fraud and other white-collar crimes have been subordinated to other Bush administration priorities.
That has reflected, in part, the ramp-up in national security and terrorism investigations after the Sept. 11 attacks. But the administration has also put more support behind efforts against illegal immigration and child pornography.
In a way, the mortgage debacle could not have come onto the FBI radar screen at a worse time. Just as Swecker was making his doomsday forecast, the FBI, under pressure from Congress and the White House, was creating a crime-fighting brain drain, transferring hundreds of agents from its criminal investigations unit into its anti-terrorism program. About 2,500 agents doing criminal work -- 20% or so of the entire force -- were affected.
Even as the number of new white-collar cases started declining, the Justice Department did pursue some high-profile corporate prosecutions, such as those arising from the collapse of Enron Corp. But some former prosecutors question the administration's current commitment to pursuing complex, high-stakes cases.
"I think most sitting U.S. attorneys now staring at the subprime crisis find scant resources available to pursue sophisticated financial crimes," said John C. Hueston, a Los Angeles lawyer who was a lead federal prosecutor in the trials of Enron executives Kenneth L. Lay and Jeffrey K. Skilling.
Absent a major shift in priorities and resources, he said, it is likely that the Justice Department and the FBI will continue on their current path of focusing on simple cases "that don't go to the heart of the problem."
The FBI says it has 21 open investigations into possible large-scale fraud related to the subprime meltdown. The Times reported last month that a federal grand jury in Los Angeles had subpoenaed records from three large California lenders: Countrywide Financial Corp. (now part of Bank of America Corp.), New Century Financial Corp. and IndyMac Federal Bank.
Among other possible targets, the FBI has said, are investment firms that sold billions in securities backed by shaky subprime mortgages and credit rating agencies that gave high marks to the now-worthless securities and failed to protect investors.
But it may be hard to jump-start such probes. Trying to prove that a major mortgage company intended to defraud buyers of its securities, for example, could take years of digging into records and testimony.
Moreover, some of those involved may have special legal protection: Credit rating firms have in other cases successfully asserted that their opinions about the values of securities are protected by the 1st Amendment.
"I am happy to have investigations going on, but these investigations should have taken place years ago," said Blair A. Nicholas, a San Diego lawyer representing investors who lost money in the collapse of several subprime mortgage lenders. "They seem to always get involved after the horse has left the barn. It is always cleaning up the mess rather than being proactive."
Could the crisis have been averted, or at least mitigated, if the FBI had intervened more forcefully?
"Until there is a catastrophic loss, there is no incentive to investigate criminal conduct," said Cynthia Monaco, a former federal prosecutor in New York. "Nor are there people coming forward with evidence" such as angry investors or whistle-blowing corporate employees, she said.
Even now, Monaco added, it is far from clear whether the damage -- suffered by investors and homeowners alike -- was the product of clear-cut fraud.
Ormsby says the FBI is more actively working with other federal investigative agencies in the hope they will pick up the slack. The Secret Service, for example, in a departure from its traditional missions of protecting presidents and heads of state and investigating counterfeiting, has assigned more than 100 agents to examine mortgage fraud, said spokesman Edwin Donovan.
The Justice Department is also starting to mobilize. The department offered what it described as a "basic seminar" on mortgage fraud cases to about 100 prosecutors last week at its national training academy in South Carolina.
By Richard B. Schmitt, Los Angeles Times Staff Writer
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