Senate Banking Committee grills regulators

NEW YORK (CNNMoney.com) -- Banking regulators came under fire in the Senate Thursday, with pointed questions on why they didn't do more in advance of the subprime lending crisis.

A senior staffer for the Federal Reserve, Roger T. Cole, was particularly singled out at the hearing of the Senate Committee on Banking, Housing and Urban Affairs.

Several senators asked why the Fed didn't do more to head off a reduction in underwriting standards and the proliferation of exotic mortgage products, such as so called "explosive ARMs" and negative amortization loans.

Robert Menendez, Democrat from New Jersey, claimed the Fed was "asleep at the switch" when it should have been using its broad regulatory power to enforce lenders to use prudent practices.

Cole admitted some responsibility lay with the Fed. "Given what we know now," he said, "we could have done more, sooner."

Cole said that the Fed has taken just three formal and three informal actions against substandard lenders during the past five years, but he added that it does engage in other actions to attempt to bring lenders in compliance with best business practices. A lot of it is in educational and outreach programs.

Florida Republican Mel Martinez was not satisfied. He wondered how bank regulators could have allowed so many bad loans to be written.

This year alone, according to the testimony of Sandra Thompson, director of the Division of Supervision and Consumer Protection, Federal Deposit Insurance Corporation, one million subprime ARMs will reset this year and 800,000 more in 2008.

Many of the borrowers of these loans will be unable to keep up with them once they reset.

Most are 2/28 or 3/27 ARMs, which have very low "teaser" rates the first two or three years before resetting to much higher rates, adding hundred of dollars to monthly payments.

The charge from the Senate committee panel is that prudent underwriting practice requires that lenders only make loans to those borrowers who are able to afford them even after the loan resets at the higher rate.

Recent surveys project that as many as 2.2 million subprime borrowers are at risk of defaulting on their loans and losing their homes.

Cole also said the Fed has not seen signs that the subprime problems are affecting other areas of the economy. "At this time we are not observing spillover effects from the problems in the subprime market to the traditional mortgage portfolios or, more generally, to the safety and soundness of the banking system."

Scott Polakoff, deputy director of the Office of Thrift Supervision, told the committee that thrifts with significant subprime lending operations were "generally well capitalized."

Joseph Smith, North Carolina's commissioner of banks, said the overall U.S. mortgage market is strong even if some large subprime lenders suffer financial losses.

A representative of the Conference of State Bank Supervisors told the Senate committee that Congress should not bail out subprime lenders and brokers who made risky mortgage loans to borrowers with bad credit.

Subprime's Scary Math: More homes, fewer buyers

Subprime risk: Most vulnerable markets