Cleanup crew is showing up to this party a little late

The subprime mortgage fallout continues. Banks have tightened lending on even credit-worthy customers. Foreclosures are at record levels.

Critics blame regulators who appeared more concerned about prolonging the housing boom in 2005-2006 than they were about the bad underwriting practices that had infected the mortgage industry.

Now, in hope of avoiding a global credit panic, the Federal Reserve essentially has indemnified Wall Street -- the guys who fueled the subprime fire. Should the big investment banks run short of cash, they can now borrow from the Fed. It's a mess that could have been avoided by outspoken federal regulators.

"We saw evidence of this coming in 2005," said Andy Winton, chairman of the banking and finance department at the University of Minnesota's Carlson School of Management. "Becoming vigilant when the boom becomes the bust isn't enough."

Winton and others charge that the Fed and the Securities and Exchange Commission ignored anecdotal evidence that parts of the housing market were rife with fraud. Bear Stearns, Merrill Lynch, Morgan Stanley and other Wall Street wizards were spreading billions in dubious mortgages as good credit and selling them as "collateralized debt obligations" that have since turned to sludge.

"The Fed lost sight of its role to take the punch bowl away from the party," Winton said last week at a forum sponsored by the Caux Round Table, a business-ethics think tank based in St. Paul. "You had newspaper articles suggesting problems. I'm not going to say I knew the housing bubble would pop in 2007, but I knew when prices turned down, some of these no-down-payment and no-documentation loans would be in trouble."

"There was no underwriting, and Wall Street was buying that trash," Wilson said in an interview. "I was in the mortgage industry for 30 years and never have I seen no underwriting. You always verified Social Security numbers, income tax filings, double-check appraisals, preapprove the borrower. ... None of that was being done in some cases."

Wilson said that the Fed regulates the big banks "so we focused on the originators [brokers] and required they have $250,000 net worth or a $250,000 bond. When we knocked on the door, they would go away, or join somebody else. They had to put up equity or work for somebody who did. We made some mortgage products illegal."

The state started or joined investigations that have led to prosecutions of bad brokers. But by then the damage was done.

Gary Stern, president of the Minneapolis Federal Reserve Bank, told the Caux Round Table forum that the Fed "would not claim perfection in the way we've done our job." He added that as much as 80 percent of subprime mortgages are performing. He said a few articles were not conclusive evidence in 2005 about the subprime threat to the financial system.

Federal Reserve Chairman Alan Greenspan said in late 2005: "In the event of a widespread cooling in house prices, these borrowers, and the institutions that service them, could be exposed to significant losses," according to the Baltimore Sun.

But Greenspan & Co. did too little to highlight unsavory lending practices, even though Congress empowered it years ago to write rules banning "unfair and deceptive practices" across a wide variety of mortgage lenders, according to the Consumer Federation of America. Little action was taken until 2006, when new Fed Chairman Ben Bernanke banned some types of loans.

Shortsighted consumers

Consumers aren't always smart. The same folks who should be attending six-month classes about homeownership were signing up with go-go mortgage brokers and they weren't reading the fine print about three-year mortgage "adjustments."

Many lenders are now trying to work them into reality-based mortgages and avoid foreclosure costs.

Ben Stein, the conservative columnist, has noted that the drive for short-term compensation at Bear Stearns and other big financial houses encouraged risky behavior. Stein, a lawyer, a Republican and an economist, asks: "Weren't fail-safe devices in place to guard against risk? Weren't government watchdogs there to make sure that catastrophes could not happen? Weren't ratings agencies on the job ... ?"

Apparently not.

This is not a rant against "securitization," the process by which home mortgages are packaged, underwritten and sold as bonds to mutual funds, insurance companies, pension funds and other investors. Most portfolios, even those targeted at marginal borrowers, perform very well and as advertised, Wilson said.

Neal St. Anthony • 612-673-7144 • nstanthony@startribune.com