FDIC Chairman Sheila Bair Returns to the Isenberg School

Mon., Feb 25, 2008
On February 15, Sheila Bair, the Isenberg School professor who has served as chairman of the U.S. Federal Deposit Insurance Corporation since July 2006, returned to campus as featured speaker in the school’s Finance Seminar. Bair is on leave from the school as its Professor of Financial Regulatory Policy. Since moving to Washington, Dr. Bair has become a central figure in policy discussions focusing on the nation’s subprime mortgage crisis. Last year’s 1.7 million foreclosures in the U.S. dwarfed the 600,000 or so that we’ve come to expect, Bair told her audience of 60 academics and finance industry practitioners. Much of the tragedy, she continued, stems from the housing market’s abrupt decline combined with the groundswell of subprime mortgages issued from 2002 through 2006 and into 2007.

Those mortgages, Bair explained, offered seductive starter interest rates of 7% to 9% followed two or three years later by compulsory upward interest obligation resets of 2% to 3%. For many subprime borrowers, that meant a payment shock of 30% to 40%. “Don’t worry about the reset. You can always refinance the mortgage, lenders would tell the homeowners,” remarked Bair. Most homeowners could indeed refinance or sell as long as home prices continued to appreciate, but in 2006 the housing boom abruptly tanked, leaving subprime homeowners at risk.

That risk, noted Bair has fallen disproportionately on lower-income homeowners and their neighborhoods. Forty-eight percent of African Americans and forty-two percent Hispanics who secured mortgages in 2006 went the subprime route compared with only 17% of their white counterparts. (In contrast, a greedy subset of borrowers had earlier worked the system to secure low starter rates and low down payments [or none at all], only to subsequently flip their appreciated properties for resale.)

Mortgage-makers/lenders—servicers contracted by nonbank mortgage companies—were key enablers of the subprime mortgage mess, observed Bair. Many of them overmarketed subprime mortgages and obscured their potentially onerous costs. Many also relaxed housing loan criteria. In 2006, with the housing market free fall on the horizon, a frenzy of lax lending practices included “liar loans,” which obscured personal income or substituted variables like applicant is employed full time.

Challenges for Policy Makers. Policy makers and regulators, emphasized Bair, were also to blame. “Everyone had relied uncritically on historical data that mortgages were safe and would rise indefinitely,” she observed. “It’s amazing to me that nobody asked about the consequences of an overappreciated mortgage market. Everybody was asleep at the switch.”

What’s a policy maker to do? “In the short run there are no good options, but compassion for duped investors and their neighborhoods is preferable to defaults,” Bair insisted. (Widespread foreclosures would maximize losses for mortgage servicers as well, she added.) A wholesale government bailout, she emphasized, would be counterproductive—it would ultimately erode market discipline. At the same time, renegotiating mortgage terms one at a time would be prohibitively costly. So Bair advocates a blanket prescription for current distressed subprime mortgage homeowners: convert their reset payments to fixed-rate loans at the starter rate for at least five years. That would protect neighboring properties and hasten the recovery of markets burdened by an excess supply of houses.

For Bair, the long-term is another matter: “We need to establish new, uniform rules for the subprime mortgage markets,” she continued. Restoring confidence to the system is critical, she emphasized, because home ownership is essential to America’s social and economic fabric.

Before securitization and nonbank mortgage lenders, the quality of mortgage loans was far more transparent: banks would hold mortgages on their balance sheets. They would get to know their borrowers and be ready to work with them if need be. “In recent years, we’ve relied on ratings agencies that base their rating assignments on modeling rather than underlying assets,” observed Bair. Securitization, she insisted, is valuable because it disperses risk. We can fix securitization and the quality of lender portfolios through consistent, system-wide rules for screening potential homeowners and improving mortgage loan practices.

Bair’s proposed standards include:

• Underwriting mortgages at the fully fixed rate, which would incorporate the 2 to 4 percentage points that accompany the present practice of resets.


• Screening borrower eligibility though a stipulated debt-to-income ratio that includes taxes and insurance.


• Eliminating restrictions on prepayment penalties, which Bair characterizes as anticompetitive.

“We also need a system that licenses and upholds professional standards for nonbank mortgage originators,” added Bair. Unlike other investment professionals like securities brokers, nonbank mortgage professionals receive no industry accreditation or professional training.

“I pride myself on being a moderate Republican,” Bair told her audience. “I believe in capitalism and markets. But in free-for-all markets, capitalism doesn’t always work.”

Many in Washington on both sides of the aisle believe that housing markets will work better thanks in part to Bair’s wisdom, integrity, and resolve. We and they should also applaud Bair for her influence on public service itself.



View Daily Hampshire Gazette article: Q & A With Sheila Bair