Director of OTS Argues for Greater
Supervision of Mortgage Brokers

"Turmoil in the recent U.S. mortgage markets is the direct result of not enough regulatory oversight in places where it was needed most," according to John M. Reich, Director of the Office of Thrift Supervision. "Mortgage brokers driving the originations were largely unregulated and had no economic interest in the ultimate performance of the borrower. The result was that underwriting was determined not by risk assessment but by whatever would sell in the securitization markets."

Reich’s comments came in an October 3 speech before the British Bankers Association. Reich added that "while running large volumes of loans through an unregulated mortgage pipeline may have worked for a while, we need to consider bringing that business into the regulated fold to ensure the oversight, accountability and consumer protection our societies have come to expect."

After an overview of the functions of the OTS and the credit market, Reich explained that “innovative products” and practices – such as alt-A, option ARMs and teaser rates – that were invented at regulated financial institutions and closely monitored by regulators, spread quickly to the unregulated marketplace and were modified and applied without an adequate understanding or oversight of the risks. This in turn led to a housing boom in key markets.

“The continuation of this boom depended on two key ingredients: the continued uninterrupted abundance of liquidity and the continued appreciation of housing prices. As adjustable-rate mortgage payments reset, borrowers would refinance into another short-term mortgage product or flip the house for a profit, and reinvest the proceeds into another place in the housing market,” Reich explained. When housing prices leveled off and the 2004 and 2005 subprime loans began to reset, borrowers with little equity and insufficient income had nowhere to go. Housing prices began to sag further – leading some borrowers to begin handing over the keys and walking away from their mortgages rather than make the higher payments, he said.

Reich said four main lessons can be learned from that experience, namely the importance of: diversification, underwriting, transparency and a level playing field.

“Diversification is always important – both on the asset and the liability side of your balance sheets,” Reich said. Additionally, “Underwriting is fundamental. Bankers should never outsource their credit decisions to Wall Street or the investor community.”

Reich also said transparency is ”paramount to the proper functioning of markets. (The) shortage of reliable information … causes investors to leave, or pull back, neither of which is helpful during a credit crunch.” Reich added that just as transparency can protect the markets and calm investor fears, it also protects the banking system and individual institutions that may come under fire. “In this regard, the role of a transparent federal deposit insurance system in the U.S. is a tremendously stabilizing force both for our insured depository institutions and our entire banking system.”

In regards to “a level playing field,” Reich said he agrees with comments from executives at federally regulated financial institutions that a level playing field does not currently exist in the mortgage lending market. Reich pointed to a segment of the mortgage market that is outside the reach of federal regulators – and in many cases also outside the reach of the states – which allows for minimal accountability for this segment, thereby generating competitive pressure to try to play by less stringent rules.

This gap in regulatory oversight is gaining attention in Congress and in the news media. Two weeks after an August Time magazine article called the current state of regulation “a porous patchwork of state oversight,” House Financial Services Committee Chairman Barney Frank, D-Mass., wrote in an opinion article in the Boston Globe stating that, “Mortgages made and sold in the unregulated sector led to the crisis.” And just three days later, the Congressional Research service, the research arm of the U.S. Congress, released a report again focusing on this gap and outlining possible solutions.

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