Slow Building of a Rescue Plan
For Struggling Homeowners

WASHINGTON -- In April, a little-known federal regulator named Sheila Bair floated a proposal at a meeting with mortgage executives: Could the industry freeze adjustable interest rates for needy individuals before they lost their homes?

The reaction was scornful, recalls Michael Stevens, senior vice president of regulatory policy at the Conference of State Bank Supervisors. "Everyone hated it," he says. "It went nowhere. Within 15 seconds, it was dead."

Seven months later, President Bush announced an industry plan to tackle the housing meltdown, under which hundreds of thousands of struggling borrowers might get a five-year freeze on their interest rates. In many ways, it looks a lot like Ms. Bair's initial idea.

During those seven months, the Bush administration struggled to reconcile its distaste for meddling in markets with the clear signs the housing mess was turning into a financial crisis. In pushing for a resolution, Ms. Bair, chairman of the Federal Deposit Insurance Corp., was a key agitator amid hostile investors, a reluctant Treasury secretary and nervous colleagues.

"She gets a lot of credit for raising this issue and highlighting the appropriateness of a more-systematic approach," says Robert Steel, undersecretary of the Treasury for domestic finance.

The debate in Washington now isn't about whether the administration went too far, but about whether it went far enough, quickly enough. Mr. Bush said yesterday that the government will "consider all options" to stimulate the U.S. economy.

Years of lax lending by banks and other institutions has led to a surge in mortgage defaults over the past year as home prices have fallen. Moody's Economy.com forecasts that unless lenders greatly step up efforts to restructure loans, three million of the 50 million U.S. home loans will go into default in the 30 months ending in mid-2009, and about two-thirds of those will result in foreclosures.

The 53-year-old Ms. Bair is a Republican prairie populist, a veteran bureaucrat and failed congressional candidate. She started her campaign to draw attention to the burgeoning mortgage crisis in the spring. With home prices falling and costs on adjustable-rate mortgages rising, the number of homeowners entering the foreclosure process in the fourth quarter of 2006 had broken a 37-year-old record. At the April gathering of executives at the FDIC -- known best for insuring bank deposits -- one attendee raised the possibility that the mortgage problems were "Katrina-like."

Investors -- who had bought up billions of dollars in subprime mortgages packaged into securities -- balked at giving borrowers a break en masse. One problem: Loan-servicing companies are under contract to collect payments on behalf of disparate groups of investors. Forgiving interest payments might open them up to lawsuits. Industry representatives assured Ms. Bair they knew it was in their own interest to prevent foreclosures and that they didn't need federal mandates.

The Bush administration was struggling to get a grip on possible solutions. In early 2007, Treasury Secretary Henry Paulson was concerned about the practices of the subprime lenders, who often didn't even demand proof of income from their borrowers. But he and his team worried that prudent steps might worsen the situation in the short term even if they helped prevent a future crisis, says a senior Treasury official. In June, for instance, federal regulators forced banks to tighten lending criteria, making it harder for on-the-edge borrowers with adjustable-rate loans to refinance into cheaper fixed-rate mortgages.

Mr. Paulson was also instinctively wary of intervening in markets. When he and Housing and Urban Development Secretary Alphonso Jackson laid out options for Mr. Bush at the White House at the end of August, according to a senior official who was present, the Treasury secretary recommended pressing Congress to expand the ability of the Federal Housing Administration to guarantee mortgages, extend the reach of credit counselors and bring industry representatives together to work out how to fend off foreclosures.

No one at that meeting pushed for an industrywide solution, the official said. "The recent disturbances in the subprime-mortgage industry are modest -- they're modest in relation to the size of our economy," Mr. Bush told reporters soon after.

In late September, however, Ms. Bair noticed a Moody's Investors Service report revealing that lenders, investors and loan-servicing companies had softened terms on just one out of every 100 subprime loans. She emailed her counterparts at Treasury and the Federal Reserve, among others, warning she planned to go public to demand more sacrifices from the industry. She didn't get a single response, she recalls.

In early October, Ms. Bair appeared at an investor conference in New York and urged the industry to convert large groups of adjustable subprime loans into 30-year, fixed-rate mortgages at their original rates. "Make it permanent, and get on with it," she told the investors.

"I wouldn't say that jaws dropped, but there was a lot of unhappiness in the room," says Brian Gardner, vice president of Washington research for investment firm Keefe, Bruyette & Woods Inc.

The Bush administration was equally cool. On Oct. 10, Mr. Paulson announced the creation of the Hope Now Alliance, made up of lenders, mortgage servicers, investors and credit counselors. Taking questions afterward, he rejected a mass modification of loan terms.

In the days that followed, as Wall Street banks suddenly started running aground, Mr. Paulson changed his mind. Citigroup's losses mounted during October and its chief executive resigned. The stock market gyrated.

Treasury officials say there was no eureka moment. But by the time Mr. Paulson gave a speech at Georgetown University on Oct. 16, he was coming around to the idea that the mortgage industry wasn't moving fast enough to prevent foreclosures, according to a Treasury spokeswoman.

Others were moving faster. Inspired by Ms. Bair's ideas, an economic adviser to California Gov. Arnold Schwarzenegger asked for FDIC help. An FDIC official flew to California in late November and sat in on negotiating sessions with loan-servicing companies. Four days later, Mr. Schwarzenegger announced a deal under which several servicers would agree to delay interest-rate increases for vulnerable borrowers.

Iowa Attorney General Tom Miller, who also says he was inspired by Ms. Bair's ideas, led a group representing more than 35 states to pressure mortgage servicers.

Treasury officials say they were heading toward an industrywide rescue plan before the California deal was announced. Many in the business believe that action by states raised the pressure for a national accord.

"Gov. Schwarzenegger -- I think that was the real breakthrough," Ms. Bair says.

On Dec. 6, Mr. Bush unveiled a plan under which 1.2 million subprime homeowners might get expedited refinancing packages or have their adjustable rates frozen for up to five years. "There are many American homeowners who could get through this difficult time with a little flexibility from their lenders, or a little help from their government," Mr. Bush said, with Secretaries Paulson and Jackson at his side.

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