While Wall Street financiers stoked today's financial meltdown with explosive investing in high-risk mortgage loans, politicians, federal officials and lobbyists shielded them from lawsuits that would have protected borrowers and tempered the frenzy.
A principle known as assignee liability would have allowed borrowers to sue anyone holding paper on their loan, from the originators who sold it to them to the Wall Street investment bankers who ultimately funded it.
Without the measure in place, Wall Street increased by eightfold its financing of subprime and nontraditional loans between 2001 and 2006, including mortgages in which borrowers with no proof of income, jobs or assets were encouraged by brokers to take out loans, according to statistics provided by mortgage trackers.
The Bush administration and members of Congress -- including a key Republican subcommittee chairman who was later sent to prison for political corruption -- sided with lending-industry lobbyists and free marketers who hotly and successfully opposed blanket liability for Wall Street firms selling mortgage-backed securities, according to congressional testimony, other records and interviews.
Those loans are what taxpayers will be buying under the $700 billion bailout plan approved by Congress and signed by President Bush last week.
The Seattle P-I examined the roots of today's mortgage crisis from downtown Seattle to Wall Street in New York. The research included government records, court cases, industry reports, congressional testimony and interviews with experts from all sides of the issue. Although many factors contributed to the crisis, including low interest rates, demand for housing and predatory lending, experts agree that the lack of liability played a key role.
Beginning in the 1990s, Wall Street financiers have increasingly sold investment packages known as mortgage-backed securities, which contained thousands of high-risk mortgages. In doing so, they sent gushers of money back to lenders who invented new and riskier ways to structure home loans so they could distribute the money and collect their fees. Subprime and nontraditional lending, once a niche, shattered records at more than $1 trillion in 2006. Along with that came a rise in complaints about predatory lending, according to state regulators and attorneys who represent borrowers.
Seattle-based Washington Mutual and its subsidiaries were among the biggest providers of nontraditional and subprime loans, made to borrowers with checkered credit or unconventional assets and income sources. The lending and buying frenzy ultimately led to a bank run that broke that institution's back, along with many others.
Securities investors also were at risk. Enticed by high profits, the protection against legal liability and reviews by rating bureaus that failed to forecast the dangers ahead, they flocked from every corner of the globe. But investors also included government-sponsored entities such as Fannie Mae and Freddie Mac. Originally formed to guarantee home loans and provide Americans with easier access to credit, they, too, have cracked in the fire created by mortgage-backed securities.
Other Wall Street securities are subject to assignee liability, including ones containing loans for cars, refrigerators and even home improvements.
Experts on both sides of the issue say one member of Congress stood out in his opposition to assignee liability, former Rep. Bob Ney, R-Ohio, once the powerful chairman of a subcommittee focusing on home financing. Ney even drafted legislation in 2005 with Rep. Paul Kanjorski, D-Pa., that would have more decidedly and clearly protected mortgages from both federal and state assignee liability.
Ney promoted a philosophy that protecting financial institutions was protecting the little guy, assuring an easy flow of money to lenders willing to help folks with bad credit buy houses.
"These strict (state) assignee liability laws threaten the availability of credit, frankly, in the subprime market," Ney said as he opened a June 2004 hearing focused on the subject. "Acting as a usury cap on mortgage lending, these laws effectively prevent people from receiving mortgages."
Ney's arguments were repeated by lenders, financiers and other lawmakers for years afterward, but he was removed from the debate. Because of influence peddling in a scandal involving lobbyist Jack Abramoff, Ney went to prison last year. Recently released and operating his own consulting business in Newark, Ohio, according to his father, he declined an interview request.
Those opposed to holding Wall Street legally accountable acknowledge that it would have made fewer subprime and nontraditional loans possible. What was seen as a negative then would have cooled the market.
"What we would have had happening was a drying up of the market for folks who can make payments but have blemishes on their credit," Bill Himpler, executive vice president for federal affairs for the American Financial Services Association, representing lenders, and a former HUD official, said in an interview.
"Liability just creates an additional risk to the investor, risk that is difficult to manage," said Steven O'Connor, senior vice president for government affairs at the Mortgage Bankers Association.
But proponents said a slowdown was just what the doctor should have ordered. Wall Street needed to be careful with subprime lending, and shun the most toxic loans.
With civil liability threatening them, "I have no doubt the industry would not have made those (risky) loans. They would have put controls in place," said University of Connecticut law professor Patricia McCoy, a former securities and banking attorney and a recognized expert on that type of liability.
"There was a lot of legal talent hired by the industry to try to figure out ways to make sure that nobody along the chain (including Wall Street) had to suffer legal accountability," said Kathleen Keest, a former Iowa assistant attorney general who now studies lending activity for the Center for Responsible Lending.
The battle for and against assignee liability was hotly waged starting in 2002 in Congress, state legislatures and city council chambers, though it received scant publicity. Some 20 states and a few cities passed anti-predatory lending laws that contained assignee liability provisions, but federal law and the federal agencies that charter banks and thrifts such as Washington Mutual shielded them from the state laws.
What the states were worried about turned out to be an issue at the heart of today's debate over the financial crisis. Free markets are one thing; unfettered greed is another.
"History is clearly working out right in front our eyes telling us the total laissez faire operations of the last couple of decades have some consequences," said Scott Jarvis, director of the Washington State Department of Financial Institutions. "And they are substantial."
The Great Depression forged the underpinnings of today's mortgage-lending system but Wall Street fomented a significant change starting with small steps decades ago, said University of Utah law professor Chris Peterson, who wrote an award-winning law review article last year linking the sale of Wall Street securities to predatory lending.
Since the 1930s, prime mortgages have been guaranteed by government-sponsored entities that then reinvest the money and provided more funds down the pipeline for more loans. Fannie Mae, and later Freddie Mac, accepted only certain loans, creating more sober -- and some say stifling -- mortgage-underwriting standards for decades, Peterson said.
In 1977, Lewis Ranieri, a self-taught bond seller at Salomon Brothers, invented with colleagues an alternative -- the private mortgage-backed security. Each contains hundreds of mortgages arranged in subcategories known as "traunches" that provide diversity of payout and maturity. Ranieri, a company owner on Long Island, didn't respond to interview requests.
The subprime loan business grew slowly to $34 billion in originations in 1993, the Mortgage Bankers Association says.
Then in 2002, an unstable mixture of high housing demand, deregulation, avarice, technical know-how and low interest rates detonated the market. Subprime and nontraditional lending grew fivefold from $215 billion to $1 trillion between 2003 and 2006, and the percentage of those loans sold in private securities went from nearly half to 80 percent, said Guy Cecala, publisher of Inside Mortgage Finance, a newsletter.
Like smoke after an explosion, mortgage delinquencies and foreclosures rose to record heights in 2007, followed by a collapse of housing prices and mortgage-backed securities.
Looking back, Cecala thinks Wall Street wizards would have searched for ways around assignee liability, but if it was imposed he wonders: "We certainly wouldn't have had Wall Street blindly securitizing whatever was thrown at them."
Predatory lending and reckless borrowing seemed to rise in parallel with Wall Street's financing of subprime and "creative" loans, said several regulators and attorneys. Loan originators were inventing new ways to indebt people, increasing product menus tenfold, said Cecala. A huge borrower population was refinancing homes over and over again to the tune of $200 billion, he said, turning mortgaged dwellings into "ATM machines."
Congress passed an anti-predatory lending law in 1994 that contained extremely limited assignee liability. It had a threshold that covered a tiny minority of the highest-priced mortgage loans. Congress empowered the Federal Reserve board to lower the threshold to include more loans. It slightly lowered it in 2001, without capturing a significant number of additional loans, and again in July announced another lowering that will take place next year.
Too little, too late, said McCoy. "That barn door's been open for a while."
During congressional and legislative debates around the country, misleading information was circulated, the P-I found in records and testimony.
During a battle over proposed city ordinances in California that contained assignee liability in Oakland, Los Angeles and San Jose four years ago, George Wallace, a Virginia attorney, provided city officials with "independent" computer analyses painting a reassuring picture of the prevalence of high-risk loans in their communities, records show.
Wallace was a former registered lobbyist for the American Financial Services Association. His board members were then officers of that lender organization, although leadership has since changed. Recently deceased, Wallace explained before his death the apparent conflict in an interview with this reporter.
"I have some standards. I am retired. I am no longer working for these folks," he said. "I am basically trying to produce some reasonable stuff."
Mark Harris, a Sacramento attorney who represented AFSA at the time, said Wallace never acknowledged his affiliation to him or others in his presence. He was angry it wasn't disclosed. No longer associated with AFSA, Harris said he believes assignee liability would have saved this country from the crisis.
Other opponents argued that assignee liability would kill the subprime market completely. To bolster their argument, they frequently told lawmakers that rating agencies such as Standard & Poor's, Moody's and Fitch won't rate securities containing any loans exposed to liability.
"The rating agencies could not rate an issuance that had liability," said Chris Stinebert, president and chief executive of AFSA, in a P-I interview. "They wouldn't know how to rate it."
Not true, said officials at two rating agencies, Standard & Poor's and Moody's. They have issued written guidelines for rating mortgage-backed securities containing what they call "exposed loans," meaning they are exposed to civil liability. They have repeatedly rated loans originated by state-chartered lending institutions where assignee liability applies.
"In only a very few instances have we ever said we would not rate pools that includes those loans," said Natalie Abrams, associate general counsel for Standard & Poor's in a rare on-the-record statement regarding assignee liability.
Opponents also argued that Wall Street securitizers don't have the tools to detect predatory and reckless loans inside the huge pools of mortgages. It makes no sense for a securitizer or an investor to be responsible for something a mortgage broker did in some distant city, said Washington, D.C., attorney Laurence Platt, who represents Wall Street financiers.
"If there were assignee liability as a matter of law, there would be no assignees," said Platt, a co-leader of the mortgage finance practice for K&L Gates. "Assignees will not bear the risk of loss based on errors or legal violations of other people."
Securities handlers are fully capable of detecting bad loans, and if they were misled they can use that as a legitimate defense, said University of Minnesota law professor Prentiss Cox, former head of consumer protection for the Minnesota state attorney. He said the real reason assignee ability has gotten nowhere is a strong banking and Wall Street lobby.
Since 2001, the financial sector has given more than $2.1 billion to state and federal politicians, according to data from legislative watchdog groups. Of that, more than $900 million came from securities firms, banks and mortgage banks.
"Who is in a better position to police and be cognizant of the sales practices? The institutions that are funding this or the naïve consumer who is taking out the loan?" asked Cox. "Would that have impeded funding into the market? Yeah. Should it have been impeded? Yeah."
Without assignee liability, investors in mortgage-backed securities relied on the analysis of rating bureaus to assure the soundness of their investments. Though rating bureaus issued general warnings about the securities, today's events show the system was imperfect. As Claire Robinson, senior managing director of the rating team at Moody's, put it: "We rated mortgage-backed securities using the best information we had at the time."
With today's financial crisis blowing hot winds, changes are afoot. House Financial Services Committee Chairman Barney Frank, D-Mass., ushered a bill through the House last November containing limited assignee liability, but it died in the Senate. His spokesman, Steven Adamske, said assignee liability could have curbed the "wild, wild West behavior coming out of Manhattan."
Richard DeMong, a University of Virginia Bank Management professor who testified against assignee liability before Congress in 2004, will never advocate judicial intervention in the market. He said he prefers to think there were a "lack of critical thinking" and a failure to "challenge assumptions."
But as the market crashed around him on a recent afternoon, he reflected in an interview his growing concerns, perhaps even doubts: "You are asking the right questions," he said.
"Clearly, broadly assigning liability would have disrupted the market considerably," he said. "Could you argue that would have been a good thing? Probably. Because it turns out people were buying stuff they didn't understand."