January 31 2008: 9:51 AM EST
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How Congress helped create the subprime mess

Lawmakers may say they are outraged, but it was actually two key pieces of legislation that primed the pump for the housing implosion.

By Jon Birger, senior writer

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(Fortune) -- Executives in Houston high-rises can rest easy. The mortgage industry has officially replaced Big Oil as Washington's favorite political punching bag.

But before our elected officials in Congress get too preachy about the lousy lending practices that led to today's mortgage mess, first they ought to consider Congress's own role in laying the groundwork.

The fact is, neither the expansion of the subprime market nor the proliferation of exotic interest-only or option-ARM mortgages would have been possible without federal laws passed in the 1980s.

Says Patricia McCoy, a law professor at the University of Connecticut: "Congress never likes to blame themselves, but in this case there's no question they bear some of the responsibility." Indeed, only now is Congress talking about enacting some tougher regulations that they could and should have pushed through 10 or 20 years ago.

McCoy points to two key pieces of legislation that are at the root of the current mortgage crisis: the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) and the Alternative Mortgage Transactions Parity Act of 1982 (AMTPA).

The former abolished state usury caps that had limited the interest rates banks could charge on primary mortgages - and, in the process, gave banks more incentive to make home loans to folks with less-than-perfect credit.

Though DIDMCA did eventually open the door to some predatory lending in low-income communities, McCoy thinks that, on balance, the 1980 legislation was valuable in the way it deregulated the mortgage market and made home loans more available. It is AMTPA, the 1982 law, that McCoy sees as most problematic.

Prior to the passage of AMTPA, banks were barred from making anything but the conventional fixed-rate, amortizing mortgages. AMPTA lifted those restrictions, giving birth to all the new and exotic mortgages that have so many borrowers in hot water today. For instance:

  • Adjustable-rate mortgages, in which the interest rate becomes floating after a number of years.
  • Balloon-payment mortgages, which have an outsized payment when the loan comes due.
  • Interest-only mortgages, which require only repayment of interest (not principal too) during the first few years of the loan, only to hit borrowers with crushing monthly-payment resets once the new monthly payment kicks in.
  • And worst of all, the option-ARM, which allows borrowers to underpay by as much as they want during the first few years. The awful upshot is the unpaid monthly interest gets tacked onto the size of the loan. So your $300,000 mortgage can turn into a $350,000 loan in a hurry, destroying any equity you have in your home.

"One of the problems was that there were no substitute regulations to make sure these new mortgages didn't turn out to be exploitative," says McCoy.

Much of the grief being visited upon borrowers and lenders right now could have been avoided, she contends, if Congress had required that the underwriting standards on the new, adjustable-rate loans be applied not to the teaser rates but to the maximum rates.

"All of these adjustable rate mortgages have rate caps, so you figure out what the maximum the rate could be, and you underwrite to that number," she says. Had such rules been in effect a few years ago, far fewer people would have been allowed to take out mortgages they couldn't afford.

McCoy gives a bit of a pass to the 1982 Congress, as it would have been difficult for them to anticipate the growth of the subprime market (in 1982, it was hard for low-income people to get any mortgage) or the willingness of lenders to give interest-only mortgages to the borrowers in the worst position to afford such a loan. However, all the problems that are rampant today existed on a smaller scale in the 1990s, which is why McCoy faults the 1990s Congress for not acting at that time.

"Certainly by the late 1990s, Congress knew of the problems," says McCoy. "It had plenty of time over the past 10 years to do something, and it did nothing."

While it's too late for some borrowers and lenders, Congress does seem to understand what fixes are needed. An October, 2007 report put out by the Senate and House's Joint Economic Committee (which is chaired by U.S. Sen. Charles Schumer, D-NY), recommended that underwriting standards be tightened on adjustable-rate mortgages.

"At a minimum," reads the report, "the federal government should require lenders to determine that the borrower has the ability to repay a loan at the fully-indexed rate and assume fully amortized payments."

The House passed "The Mortgage Reform and Anti-Predatory Lending Act of 2007" in November, and the topic is now before the Senate. The House bill would require that mortgages be underwritten to standards that measure the borrowers' ability to pay at the fully-indexed rate.

Senate banking Committee chairman Chris Dodd introduced a Senate bill in December that includes a similar requirement. To top of page

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