The Federal Open Market Committee decided
today to establish a target range for the
federal funds rate of 0 to 1/4 percent.
Since the Committee's last meeting, labor market
conditions have deteriorated, and the available data
indicate that consumer spending, business investment,
and industrial production have declined. Financial
markets remain quite strained and credit conditions
tight. Overall, the outlook for economic activity has
weakened further.
Meanwhile, inflationary pressures have diminished
appreciably. In light of the declines in the prices of
energy and other commodities and the weaker prospects
for economic activity, the Committee expects inflation to
moderate further in coming quarters.
The Federal Reserve will employ all available tools to
promote the resumption of sustainable economic growth
and to preserve price stability. In particular, the
Committee anticipates that weak economic conditions
are likely to warrant exceptionally low levels of the
federal funds rate for some time.
The focus of the Committee's policy going forward will be
to support the functioning of financial markets and
stimulate the economy through open market operations
and other measures that sustain the size of the Federal
Reserve's balance sheet at a high level. As previously
announced, over the next few quarters the Federal
Reserve will purchase large quantities of agency debt
and mortgage-backed securities to provide support to
the mortgage and housing markets, and it stands ready
to expand its purchases of agency debt and
mortgage-backed securities as conditions warrant. The
Committee is also evaluating the potential benefits of
purchasing longer-term Treasury securities. Early next
year, the Federal Reserve will also implement the Term
Asset-Backed Securities Loan Facility to facilitate the
extension of credit to households and small businesses.
The Federal Reserve will continue to consider ways of
using its balance sheet to further support credit markets
and economic activity.
Voting for the FOMC monetary policy action were: Ben S.
Bernanke, Chairman; Christine M. Cumming; Elizabeth A.
Duke; Richard W. Fisher; Donald L. Kohn; Randall S.
Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H.
Stern; and Kevin M. Warsh.
In a related action, the Board of Governors unanimously
approved a 75-basis-point decrease in the discount rate
to 1/2 percent. In taking this action, the Board approved
the requests submitted by the Boards of Directors of
the Federal Reserve Banks of New York, Cleveland,
Richmond, Atlanta, Minneapolis, and San Francisco. The
Board also established interest rates on required and
excess reserve balances of 1/4 percent.
today to establish a target range for the
federal funds rate of 0 to 1/4 percent.
Since the Committee's last meeting, labor market
conditions have deteriorated, and the available data
indicate that consumer spending, business investment,
and industrial production have declined. Financial
markets remain quite strained and credit conditions
tight. Overall, the outlook for economic activity has
weakened further.
Meanwhile, inflationary pressures have diminished
appreciably. In light of the declines in the prices of
energy and other commodities and the weaker prospects
for economic activity, the Committee expects inflation to
moderate further in coming quarters.
The Federal Reserve will employ all available tools to
promote the resumption of sustainable economic growth
and to preserve price stability. In particular, the
Committee anticipates that weak economic conditions
are likely to warrant exceptionally low levels of the
federal funds rate for some time.
The focus of the Committee's policy going forward will be
to support the functioning of financial markets and
stimulate the economy through open market operations
and other measures that sustain the size of the Federal
Reserve's balance sheet at a high level. As previously
announced, over the next few quarters the Federal
Reserve will purchase large quantities of agency debt
and mortgage-backed securities to provide support to
the mortgage and housing markets, and it stands ready
to expand its purchases of agency debt and
mortgage-backed securities as conditions warrant. The
Committee is also evaluating the potential benefits of
purchasing longer-term Treasury securities. Early next
year, the Federal Reserve will also implement the Term
Asset-Backed Securities Loan Facility to facilitate the
extension of credit to households and small businesses.
The Federal Reserve will continue to consider ways of
using its balance sheet to further support credit markets
and economic activity.
Voting for the FOMC monetary policy action were: Ben S.
Bernanke, Chairman; Christine M. Cumming; Elizabeth A.
Duke; Richard W. Fisher; Donald L. Kohn; Randall S.
Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H.
Stern; and Kevin M. Warsh.
In a related action, the Board of Governors unanimously
approved a 75-basis-point decrease in the discount rate
to 1/2 percent. In taking this action, the Board approved
the requests submitted by the Boards of Directors of
the Federal Reserve Banks of New York, Cleveland,
Richmond, Atlanta, Minneapolis, and San Francisco. The
Board also established interest rates on required and
excess reserve balances of 1/4 percent.
| Chairman Ben S. Bernanke At the Federal Reserve System Conference on Housing and Mortgage Markets, Washington, D.C. December 4, 2008 |
| FHA Mortgage Rates |
Housing, Mortgage Markets,
and Foreclosures
The U.S. financial system has
been in turmoil during the past
16 months. Credit conditions
have tightened and asset values
have declined, contributing
substantially, in turn, to the
weakening of economic activity.
As the participants in this
conference are keenly aware, I
am sure, housing and housing
finance played a central role in
precipitating the current crisis.
As the crisis has persisted,
however, the relationships
between housing and other parts
of the economy have become
more complex. Declining house
prices, delinquencies and
foreclosures, and strains in
mortgage markets are now
symptoms as well as causes of
our general financial and
economic difficulties. These
interlinkages imply that policies
aimed at improving broad
financial and economic conditions
and policies focused specifically
on housing may be mutually
reinforcing. Indeed, the most
effective approach very likely will
involve a full range of
coordinated measures aimed at
different aspects of the problem.
I will begin this morning with
some comments on
developments in the housing
sector and on the interactions
among house prices, mortgage
markets, foreclosures, and the
broader economy. I will then
discuss both some steps taken
to date and some additional
measures that might be taken to
support housing and the
economy by reducing the number
of avoidable foreclosures. As we
as a nation continue to fashion
our policy responses in coming
weeks and months, we must
draw on the best thinking
available. I expect that the
papers presented at this
conference will add significantly
to our understanding of these
important issues.
and Foreclosures
The U.S. financial system has
been in turmoil during the past
16 months. Credit conditions
have tightened and asset values
have declined, contributing
substantially, in turn, to the
weakening of economic activity.
As the participants in this
conference are keenly aware, I
am sure, housing and housing
finance played a central role in
precipitating the current crisis.
As the crisis has persisted,
however, the relationships
between housing and other parts
of the economy have become
more complex. Declining house
prices, delinquencies and
foreclosures, and strains in
mortgage markets are now
symptoms as well as causes of
our general financial and
economic difficulties. These
interlinkages imply that policies
aimed at improving broad
financial and economic conditions
and policies focused specifically
on housing may be mutually
reinforcing. Indeed, the most
effective approach very likely will
involve a full range of
coordinated measures aimed at
different aspects of the problem.
I will begin this morning with
some comments on
developments in the housing
sector and on the interactions
among house prices, mortgage
markets, foreclosures, and the
broader economy. I will then
discuss both some steps taken
to date and some additional
measures that might be taken to
support housing and the
economy by reducing the number
of avoidable foreclosures. As we
as a nation continue to fashion
our policy responses in coming
weeks and months, we must
draw on the best thinking
available. I expect that the
papers presented at this
conference will add significantly
to our understanding of these
important issues.
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Developments in Housing and Housing Finance
As you know, the current housing crisis is the culmination of a large
boom and bust in house prices and residential construction that
began earlier in this decade. Home sales and single-family housing
starts held unusually steady through the 2001 recession and then
rose dramatically over the subsequent four years. National indexes
of home prices accelerated significantly over that period, with prices
in some metropolitan areas more than doubling over the first half of
the decade.1 One unfortunate consequence of the rapid increases in
house prices was that providers of mortgage credit came to view
their loans as well-secured by the rising values of their collateral and
thus paid less attention to borrowers' ability to repay.2
However, no real or financial asset can provide an above-normal
market return indefinitely, and houses are no exception. When
home-price appreciation began to slow in many areas, the
consequences of weak underwriting, such as little or no
documentation and low required down payments, became apparent.
Delinquency rates for subprime mortgages--especially those with
adjustable interest rates--began to climb steeply around the middle
of 2006. When house prices were rising, higher-risk borrowers who
were struggling to make their payments could refinance into
more-affordable mortgages. But refinancing became increasingly
difficult as many of these households found that they had
accumulated little, if any, housing equity. Moreover, lenders
tightened standards on higher-risk mortgages as secondary markets
for those loans ceased to function.
Higher-risk mortgages are not the only part of the mortgage market
to have experienced stress. For example, while some lenders
continue to originate so-called jumbo prime mortgages and hold
them on their own balance sheets, these loans have generally been
available only on more restrictive terms and at much higher spreads
relative to prime conforming mortgage rates than before the crisis.
Mortgage rates in the prime conforming market--although down
somewhat from their peaks--remain high relative to yields on
longer-term Treasury securities, and lending terms have tightened
for this segment as well.
As house prices have declined, many borrowers now find themselves
"under water" on their mortgages--perhaps as many as 15 to 20
percent by some estimates. In addition, as the economy has slowed
and unemployment has risen, more households are finding it difficult
to make their mortgage payments. About 4-1/2 percent of all
first-lien mortgages are now more than 90 days past due or in
foreclosure, and one in ten near-prime mortgages in alt-A pools and
more than one in five subprime mortgages are seriously delinquent.3
Lenders appear to be on track to initiate 2-1/4 million foreclosures in
2008, up from an average annual pace of less than 1 million during
the pre-crisis period.4
Predictably, home sales and construction have plummeted. Sales of
new homes and starts of single-family houses are now running at
about one-third of their peak levels in the middle part of this decade.
Sales of existing homes, including foreclosure sales, are now about
two-thirds of their earlier peak. Notwithstanding the sharp
adjustment in construction, inventories of unsold new homes,
though down in absolute terms, are close to their record high when
measured relative to monthly sales, suggesting that residential
construction is likely to remain soft in the near term.
As I mentioned earlier, the problems in housing and mortgage
markets have become inextricably intertwined with broader financial
and economic developments. For example, mortgage-related losses
have eroded the capital of many financial institutions, leading them to
become more reluctant to make not only mortgage loans, but other
types of loans to consumers and businesses as well. Likewise, some
homeowners have responded to declining home values by cutting
back their spending, and residential construction remains subdued.
Thus, weakness in the housing market has proved a serious drag on
overall economic activity. A slowing economy has in turn reduced the
demand for houses, implying a further weakening of conditions in the
mortgage and housing markets.
Reducing Preventable Foreclosures
Because developments in the housing sector have become so
interlinked with the evolution of the financial markets and the
economy as a whole, both macro and micro policies have a role in
addressing the strains in housing. At the macro level, the Federal
Reserve has taken a number of steps, beginning with the easing of
monetary policy. To the extent that more accommodative monetary
policies make credit conditions easier and incomes higher than they
otherwise would have been, they support the housing market.
The Federal Reserve has also implemented a series of actions aimed
at restoring the normal functioning of financial markets and
restarting the flow of credit, including providing liquidity to a range of
financial institutions, working with the Treasury and the Federal
Deposit Insurance Corporation (FDIC) to help stabilize the banking
system, and providing backstop liquidity to the commercial paper
market. The Federal Reserve supported the actions by the Federal
Housing Finance Agency (FHFA) and the Treasury to put the
housing-related government-sponsored enterprises (GSEs), Fannie
Mae and Freddie Mac, into conservatorship, thereby stabilizing a
critical source of mortgage credit. The Federal Reserve has also
recently announced that it will purchase up to $100 billion of the debt
issued by Fannie Mae, Freddie Mac, and the Federal Home Loan
Banks and up to $500 billion in mortgage-backed securities issued by
the GSEs.
Although broad-based macroeconomic policies help to create an
economic and financial environment in which a housing recovery can
occur, policies aimed more narrowly at the housing market are
important, too. In the remainder of my remarks, I will focus on
policy options for reducing preventable foreclosures.
Foreclosures impose large costs on families who face the loss of their
homes and reduced future access to credit. But the public policy
case for reducing preventable foreclosures does not rely solely on
the desire to help people who are in trouble. Foreclosures create
substantial social costs. Communities suffer when foreclosures are
clustered, adding further to the downward pressure on property
values. Lower property values in turn translate to lower tax
revenues for local governments, and increases in the number of
vacant homes can foster vandalism and crime.5 At the national level,
the declines in house prices that result from the addition of
foreclosed properties to the supply of homes for sale create broader
economic and financial stress, as I have already noted.6
On the surface, private economic incentives to avoid foreclosure
would appear to be strong for the lender as well as the borrower.
Foreclosure dissipates much of the value of the property: Indeed,
recent losses on defaulted subprime mortgages have averaged
around 50 to 60 percent of the loan balance.7 Besides the general
decline in property values and foregone payments, fees related to
foreclosure, such as court costs, maintenance expenses, and others,
can amount to 10 to 15 percent of the loan balance; furthermore,
the discount in value due to foreclosure status can be an additional 5
to 15 percent.8
However, despite the substantial costs imposed by foreclosure,
anecdotal evidence suggests that some foreclosures are continuing
to occur even in cases in which the narrow economic interests of the
lender would appear to be better served through modification of the
mortgage. This apparent market failure owes in part to the
widespread practice of securitizing mortgages, which typically results
in their being put into the hands of third-party servicers rather than
those of a single owner or lender. The rules under which servicers
operate do not always provide them with clear guidance or the
appropriate incentives to undertake economically sensible
modifications.9 The problem is exacerbated because some
modifications may benefit some tranches of the securities more than
others, raising the risk of investor lawsuits. More generally, the
sheer volume of delinquent loans has overwhelmed the capacity of
many servicers, including portfolio lenders, to undertake effective
modifications.
During more normal times, mortgage delinquencies typically were
triggered by life events, such as unemployment, illness, or divorce,
and servicers became accustomed to addressing these problems on
a case-by-case basis. Although taking account of the specific
circumstances of each case remains important, the scale of the
current problem calls for greater standardization and efficiency. Loan
modification programs with clearly defined protocols can both help
reduce modification costs and protect servicers from the charge that
they have acted arbitrarily. The federal banking regulators have
urged lenders and servicers to work with borrowers to avoid
preventable foreclosures. The regulators recently reiterated that
position in a joint statement that encouraged banks to make the
necessary investments in staff and capacity to meet the escalating
workload and to adopt systematic, proactive, and streamlined
modification protocols to put borrowers in sustainable mortgages.10
A number of initiatives have attempted to address the problem of
unnecessary foreclosures. Working in collaboration with the
Treasury Department, the Hope Now Alliance, a coalition of mortgage
servicers, lenders, housing counselors, and investors--led by Faith
Schwartz, a member of the Fed's Consumer Advisory Council--has
produced a set of guidelines that participating servicers have agreed
to use as they work to prevent foreclosures. In addition, servicers in
the Alliance agreed to delay foreclosure proceedings if an alternative
approach might allow the homeowners to stay in their home.
Recently, in conjunction with the FHFA, the coalition announced that
its members will adopt a streamlined modification program for certain
loans that they service for the GSEs. This program will closely follow
the one that the FDIC has introduced for modifying the loans in the
portfolio that it took over from IndyMac.11
The Federal Reserve has also been actively supporting efforts to
prevent unnecessary foreclosures. Through the System's
Homeownership and Mortgage Initiative, we have conducted studies
on housing and foreclosures, provided community leaders with
detailed analyses to help them better target their borrower outreach
and counseling efforts, and convened forums like this one to facilitate
the exchange of ideas and the development of policy options. Taking
advantage of the Federal Reserve's nationwide presence, the twelve
Reserve Banks have sponsored or co-sponsored more than 100
events related to foreclosures around the country since last summer,
bringing together more than 10,000 lenders, counselors, community
development specialists, and policymakers. A particular focus of the
Fed's efforts has been the mitigation of the costs to communities of
high rates of foreclosure. For example, we have partnered with
NeighborWorks America on a neighborhood stabilization project and
helped them develop responses to community needs as well as train
local leaders.
Beyond these efforts, two government programs to facilitate loan
modifications have been authorized, both through the Federal
Housing Administration (FHA). The FHASecure program has
provided long-term fixed-rate mortgages to borrowers facing a rise
in payments due to an interest rate reset. Another, more recent
program, dubbed Hope for Homeowners (H4H), allows lenders to
refinance a delinquent borrower into a new, FHA-insured fixed-rate
mortgage if the lender writes down the mortgage balance to create
some home equity for the borrower and pays an up-front insurance
premium. In exchange for being put "above water" on the mortgage,
the borrower is required to share any subsequent appreciation of the
home with the government.
Although the basic structure of the H4H program is appealing, some
lenders have expressed concerns about its complexity and cost,
including the requirement in many cases to undertake substantial
principal write-downs. As a result, participation has thus far been
low. In response to these concerns, the board of the H4H
program--on which Governor Duke represents the Federal
Reserve--recently approved a number of changes, using the
authority granted to it under the Emergency Economic Stabilization
Act (EESA). These changes would reduce the necessary write-down
on some loans, address the complications caused by subordinate
liens by permitting up-front payments to those lien holders, allow
lenders to extend mortgage terms from 30 to 40 years to increase
affordability, and eliminate the trial modification period to expedite
loan closings. It is still too early to know what the ultimate demand
for H4H loans under this set of rules will be, but as I will discuss
further momentarily, a case can be made for further adjusting the
terms of the program to make it more attractive to both lenders and
borrowers.
Despite good-faith efforts by both the private and public sectors, the
foreclosure rate remains too high, with adverse consequences for
both those directly involved and for the broader economy. More
needs to be done. In the remainder of my remarks I will discuss,
without ranking, a few promising options for reducing avoidable
foreclosures. These proposals are not mutually exclusive and could
be used in combination. Each would require some commitment of
public funds.
To be effective, loan modifications should aim to put borrowers into
mortgages that they can afford over the longer term. During more
normal times, many homeowners could be helped with a temporary
repayment plan--for example, a deferral of interest payments for a
period. But under the current circumstances, with house prices
declining and credit tight, permanent loan modifications will often be
needed to create sustainable mortgages and keep people in their
homes. Most current proposals to reduce foreclosures incorporate
this view and thus emphasize permanent modifications.
A more difficult design question turns on the extent to which the
probability of default or redefault depends on the borrower's equity
position in the home, as well as on the affordability of the monthly
payment. Although not conclusive, the available evidence suggests
that the homeowner's equity position is, along with affordability, an
important determinant of default rates, for owner-occupiers as well
as investors. If that evidence is correct, then principal write-downs
may need to be part of the toolkit that servicers use to achieve
sustainable mortgage modifications.12
If one accepts the view that principal write-downs may be needed in
cases of badly underwater mortgages, then strengthening the H4H
program is a promising strategy, as I have noted. Beyond the steps
already taken by the H4H board, the Congress might consider
making the terms of H4H loans more attractive by reducing the
up-front insurance premium paid by the lender, currently set in law
at 3 percent of the principal value, as well as the annual premium
paid by the borrower, currently set at 1-1/2 percent. The Congress
might also grant the FHA the flexibility to tailor these premiums to
individual risk characteristics rather than forcing the FHA to charge
the same premium to all borrowers.
In addition, consideration might be given to reducing the interest
rate that borrowers would pay under the H4H program. At present,
this rate is expected to be quite high, roughly 8 percent, in part
because it is tied to the demand for the relatively illiquid securities
issued by Ginnie Mae to fund the program. To bring down this rate,
the Treasury could exercise its authority to purchase these
securities, with the Congress providing the appropriate increase in
the debt ceiling to accommodate those purchases. Alternatively, the
Congress could decide to subsidize the rate.
A second proposal, put forward by the FDIC, focuses on improving
the affordability of monthly payments. Under the FDIC plan,
servicers would restructure delinquent mortgages using a
streamlined process, modeled on the IndyMac protocol, and would
aim to reduce monthly payments to 31 percent of the borrower's
income. As an inducement to lenders and servicers to undertake
these modifications, the government would offer to share in any
losses sustained in the event of redefaults on the modified
mortgages and would also pay $1,000 to the servicer for each
modification completed.13 The strengths of this plan include the
standardization of the restructuring process and the fact that the
restructured loans remain with the servicer, with the government
being involved only when a redefault occurs.
As noted, the FDIC plan would induce lenders and servicers to
modify loans by offering a form of insurance against downside house
price risk. A third approach would have the government share the
cost when the servicer reduces the borrower's monthly payment.
For example, a servicer could initiate a modification and bear the
costs of reducing the mortgage payment to 38 percent of income,
after which the government could bear a portion of the incremental
cost of reducing the mortgage payments beyond 38 percent, say to
31 percent, of income. This approach would increase the incentive of
servicers to be aggressive in reducing monthly payments, which
would improve the prospects for sustainability. Relative to the FDIC
proposal, this plan would pose a greater operational burden on the
government, which would be required to make payments to servicers
for all modified loans, not just for loans that redefault. However, this
approach could leverage existing modification frameworks, such as
the FDIC/IndyMac and Hope Now streamlined protocols, and in this
respect would build on, rather than crowd out, private-sector
initiatives.
Yet another promising proposal for foreclosure prevention would
have the government purchase delinquent or at-risk mortgages in
bulk and then refinance them into the H4H or another FHA program.
This approach could take advantage of the depressed market values
of such mortgages, and buying in bulk might help avoid adverse
selection problems. In addition, scale efficiencies could be achieved
by contracting with specialty firms (perhaps including the GSEs)
capable of re-underwriting large volumes of loans to make them
eligible for H4H or another program. The Treasury has already
considered how to undertake bulk purchases as part of its work
under EESA, and the Federal Reserve has submitted to the Congress
an analysis of bulk purchases per a legislative requirement in the H4H
bill. Even so, this program could take some time to get up and
running, and the re-underwriting required for H4H loans would likely
take more time and incur greater operational costs than other plans.
But such an approach could result in many homeowners being
refinanced into sustainable mortgages.
Conclusion
The housing market remains central to the economic and financial
challenges that we face. Because housing and mortgage markets are
tightly interlinked with the rest of the economy, actions to
strengthen financial markets and the broader economy are important
ways to address housing issues. By the same token, steps that
stabilize the housing market will help stabilize the economy as well.
In this regard, reducing the number of preventable foreclosures
would not only help families stay in their homes, it would confer
much wider benefits. Significant efforts have been taken in this
direction, but more can be done. Today I have briefly discussed a
few promising options, which are not necessarily mutually exclusive.
As we as a country consider ways to address our financial and
economic challenges, policy initiatives to reduce the number of
preventable foreclosures should be high on the agenda.
----------------------------------------------------------------------
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Footnotes
1. Estimates for specific metropolitan areas are based on
Case-Shiller Home Price Indexes. Return to text
2. See Kristopher Gerardi, Andreas Lehnert, Shane Sherlund, and
Paul Willen (forthcoming), "Making Sense of the Subprime Crisis,"
Brookings Papers on Economic Activity (Washington: Brookings
Institution Press). Also see Chris Mayer, Karen Pence, and Shane
Sherlund (2008), "The Rise in Mortgage Defaults," Finance and
Economics Discussion Series 2008-59 (Washington: Board of
Governors of the Federal Reserve System, November). Return to text
3. Estimates of delinquencies are based on data from the Mortgage
Bankers Association and from First American LoanPerformance.
Return to text
4. Foreclosure starts are based on data from the Mortgage Bankers
Association, adjusted to reflect the limited coverage of their sample.
Historically, about half of foreclosure starts resulted in the borrower
losing the home, but recent rates appear higher. Return to text
5. For evidence that concentrations of foreclosures lead to lower
house prices throughout the neighborhood, see, for example, William
C. Apgar, Mark Duda, and Rochelle Nawrocki Gorey (2005), "The
Municipal Cost of Foreclosures: A Chicago Case Study," Housing
Finance Policy Research Paper 2005-1 (Minneapolis, Minn.:
Homeownership Preservation Foundation, February),
www.995hope.org/content/pdf/Apgar_Duda_Study_Full_Version.pdf;
and John P. Harding, Eric Rosenblatt, and Yao Vincent (2008), "The
Contagion Effect of Foreclosed Properties," Social Science Research
Network working paper 1160354 (July). Return to text
6. To be sure, policy should not attempt to keep house prices from
falling sufficiently to stabilize the demand for housing. But
preventing avoidable foreclosures does not block necessary
adjustments. Indeed, failing to prevent such foreclosures may
heighten the risk that house prices will move lower than they would
otherwise need to go. Return to text
7. See J.P. Morgan (2008), "SOS--Summary of Subprime, Alt-A,
Prime Jumbo," Global Structured Finance Research (November 2);
and Credit Suisse (2008), "Deep Dive into Subprime Mortgage
Severity," Fixed Income Research Report (June 19). Return to text
8. See "Deep Dive," note 8. Return to text
9. Servicers of mortgages in securitized pools must abide by the
pooling and servicing agreements, which state what modifications
may be prohibited but provide limited guidance about what types of
modifications investors would consider to be appropriate. See Larry
Cordell, Karen Dynan, Andreas Lehnert, Nellie Liang, and Eileen
Mauskopf (2008), "The Incentives of Mortgage Servicers: Myths and
Realities," Finance and Economics Discussion Series 2008-46
(Washington: Board of Governors of the Federal Reserve System,
November). Return to text
10. See Board of Governors of the Federal Reserve System, Federal
Deposit Insurance Corporation, Office of the Comptroller of the
Currency, and Office of Thrift Supervision (2008), "Interagency
Statement on Meeting the Needs of Creditworthy Borrowers," joint
press release, November 12. Return to text
11. In addition, Hope Now has been an important source of data on
loss-mitigation activity. The loan-level data that they plan to provide
in the future will be useful for analyzing the relative effectiveness of
alternative strategies for loan modifications. Return to text
12. Studies tend to find that equity positions matter most for
default rates when they interact with other contributing factors; for
example, numerous studies have found that borrowers are more
likely to default when house prices have fallen and incomes decline.
At the household level, such "double triggers" may induce defaults
because of cash flow constraints or because continuing to make
payments on a mortgage whose balance significantly exceeds the
value of the house is more difficult to justify when the family budget
is strained. See Shane Sherlund (forthcoming), "The Past, Present,
and Future of Subprime Mortgages," Finance and Economics
Discussion Series (Washington: Board of Governors of the Federal
Reserve System); Kristopher Gerardi, Christopher L. Foote, and Paul
S. Willen (2008), "Negative Equity and Foreclosure: Theory and
Evidence (354 KB PDF)," Public Policy Discussion Papers 08-3
(Boston: Federal Reserve Bank of Boston, June); and Haughwout,
Andrew, Richard Peach, and Joseph Tracy (forthcoming), "Juvenile
Delinquent Mortgages: Bad Credit or Bad Economy?" Journal of
Urban Economics. Return to text
13. The original plan would have had the government share half of
any loss incurred by the lender, regardless of how far underwater the
loan might have already been by the time of modification. The latest
version of the plan modifies this provision by offering lower
loss-sharing rates for loans that have loan-to-value (LTV) ratios
above 100 percent at the time of the modification. Under the
modified plan, the loss-sharing rate declines from 50 percent on a
loan with an LTV of 100 percent at the time of modification to 20
percent on a loan with a LTV of 150 percent. Loans with LTVs of
more than 150 percent at the time of modification do not qualify for
loss-sharing. An alternative way to address this concern would be to
base the amount of the government insurance payment on the loss
in value relative to the appraised value of the property at the time of
the loan modification. Return to text
As you know, the current housing crisis is the culmination of a large
boom and bust in house prices and residential construction that
began earlier in this decade. Home sales and single-family housing
starts held unusually steady through the 2001 recession and then
rose dramatically over the subsequent four years. National indexes
of home prices accelerated significantly over that period, with prices
in some metropolitan areas more than doubling over the first half of
the decade.1 One unfortunate consequence of the rapid increases in
house prices was that providers of mortgage credit came to view
their loans as well-secured by the rising values of their collateral and
thus paid less attention to borrowers' ability to repay.2
However, no real or financial asset can provide an above-normal
market return indefinitely, and houses are no exception. When
home-price appreciation began to slow in many areas, the
consequences of weak underwriting, such as little or no
documentation and low required down payments, became apparent.
Delinquency rates for subprime mortgages--especially those with
adjustable interest rates--began to climb steeply around the middle
of 2006. When house prices were rising, higher-risk borrowers who
were struggling to make their payments could refinance into
more-affordable mortgages. But refinancing became increasingly
difficult as many of these households found that they had
accumulated little, if any, housing equity. Moreover, lenders
tightened standards on higher-risk mortgages as secondary markets
for those loans ceased to function.
Higher-risk mortgages are not the only part of the mortgage market
to have experienced stress. For example, while some lenders
continue to originate so-called jumbo prime mortgages and hold
them on their own balance sheets, these loans have generally been
available only on more restrictive terms and at much higher spreads
relative to prime conforming mortgage rates than before the crisis.
Mortgage rates in the prime conforming market--although down
somewhat from their peaks--remain high relative to yields on
longer-term Treasury securities, and lending terms have tightened
for this segment as well.
As house prices have declined, many borrowers now find themselves
"under water" on their mortgages--perhaps as many as 15 to 20
percent by some estimates. In addition, as the economy has slowed
and unemployment has risen, more households are finding it difficult
to make their mortgage payments. About 4-1/2 percent of all
first-lien mortgages are now more than 90 days past due or in
foreclosure, and one in ten near-prime mortgages in alt-A pools and
more than one in five subprime mortgages are seriously delinquent.3
Lenders appear to be on track to initiate 2-1/4 million foreclosures in
2008, up from an average annual pace of less than 1 million during
the pre-crisis period.4
Predictably, home sales and construction have plummeted. Sales of
new homes and starts of single-family houses are now running at
about one-third of their peak levels in the middle part of this decade.
Sales of existing homes, including foreclosure sales, are now about
two-thirds of their earlier peak. Notwithstanding the sharp
adjustment in construction, inventories of unsold new homes,
though down in absolute terms, are close to their record high when
measured relative to monthly sales, suggesting that residential
construction is likely to remain soft in the near term.
As I mentioned earlier, the problems in housing and mortgage
markets have become inextricably intertwined with broader financial
and economic developments. For example, mortgage-related losses
have eroded the capital of many financial institutions, leading them to
become more reluctant to make not only mortgage loans, but other
types of loans to consumers and businesses as well. Likewise, some
homeowners have responded to declining home values by cutting
back their spending, and residential construction remains subdued.
Thus, weakness in the housing market has proved a serious drag on
overall economic activity. A slowing economy has in turn reduced the
demand for houses, implying a further weakening of conditions in the
mortgage and housing markets.
Reducing Preventable Foreclosures
Because developments in the housing sector have become so
interlinked with the evolution of the financial markets and the
economy as a whole, both macro and micro policies have a role in
addressing the strains in housing. At the macro level, the Federal
Reserve has taken a number of steps, beginning with the easing of
monetary policy. To the extent that more accommodative monetary
policies make credit conditions easier and incomes higher than they
otherwise would have been, they support the housing market.
The Federal Reserve has also implemented a series of actions aimed
at restoring the normal functioning of financial markets and
restarting the flow of credit, including providing liquidity to a range of
financial institutions, working with the Treasury and the Federal
Deposit Insurance Corporation (FDIC) to help stabilize the banking
system, and providing backstop liquidity to the commercial paper
market. The Federal Reserve supported the actions by the Federal
Housing Finance Agency (FHFA) and the Treasury to put the
housing-related government-sponsored enterprises (GSEs), Fannie
Mae and Freddie Mac, into conservatorship, thereby stabilizing a
critical source of mortgage credit. The Federal Reserve has also
recently announced that it will purchase up to $100 billion of the debt
issued by Fannie Mae, Freddie Mac, and the Federal Home Loan
Banks and up to $500 billion in mortgage-backed securities issued by
the GSEs.
Although broad-based macroeconomic policies help to create an
economic and financial environment in which a housing recovery can
occur, policies aimed more narrowly at the housing market are
important, too. In the remainder of my remarks, I will focus on
policy options for reducing preventable foreclosures.
Foreclosures impose large costs on families who face the loss of their
homes and reduced future access to credit. But the public policy
case for reducing preventable foreclosures does not rely solely on
the desire to help people who are in trouble. Foreclosures create
substantial social costs. Communities suffer when foreclosures are
clustered, adding further to the downward pressure on property
values. Lower property values in turn translate to lower tax
revenues for local governments, and increases in the number of
vacant homes can foster vandalism and crime.5 At the national level,
the declines in house prices that result from the addition of
foreclosed properties to the supply of homes for sale create broader
economic and financial stress, as I have already noted.6
On the surface, private economic incentives to avoid foreclosure
would appear to be strong for the lender as well as the borrower.
Foreclosure dissipates much of the value of the property: Indeed,
recent losses on defaulted subprime mortgages have averaged
around 50 to 60 percent of the loan balance.7 Besides the general
decline in property values and foregone payments, fees related to
foreclosure, such as court costs, maintenance expenses, and others,
can amount to 10 to 15 percent of the loan balance; furthermore,
the discount in value due to foreclosure status can be an additional 5
to 15 percent.8
However, despite the substantial costs imposed by foreclosure,
anecdotal evidence suggests that some foreclosures are continuing
to occur even in cases in which the narrow economic interests of the
lender would appear to be better served through modification of the
mortgage. This apparent market failure owes in part to the
widespread practice of securitizing mortgages, which typically results
in their being put into the hands of third-party servicers rather than
those of a single owner or lender. The rules under which servicers
operate do not always provide them with clear guidance or the
appropriate incentives to undertake economically sensible
modifications.9 The problem is exacerbated because some
modifications may benefit some tranches of the securities more than
others, raising the risk of investor lawsuits. More generally, the
sheer volume of delinquent loans has overwhelmed the capacity of
many servicers, including portfolio lenders, to undertake effective
modifications.
During more normal times, mortgage delinquencies typically were
triggered by life events, such as unemployment, illness, or divorce,
and servicers became accustomed to addressing these problems on
a case-by-case basis. Although taking account of the specific
circumstances of each case remains important, the scale of the
current problem calls for greater standardization and efficiency. Loan
modification programs with clearly defined protocols can both help
reduce modification costs and protect servicers from the charge that
they have acted arbitrarily. The federal banking regulators have
urged lenders and servicers to work with borrowers to avoid
preventable foreclosures. The regulators recently reiterated that
position in a joint statement that encouraged banks to make the
necessary investments in staff and capacity to meet the escalating
workload and to adopt systematic, proactive, and streamlined
modification protocols to put borrowers in sustainable mortgages.10
A number of initiatives have attempted to address the problem of
unnecessary foreclosures. Working in collaboration with the
Treasury Department, the Hope Now Alliance, a coalition of mortgage
servicers, lenders, housing counselors, and investors--led by Faith
Schwartz, a member of the Fed's Consumer Advisory Council--has
produced a set of guidelines that participating servicers have agreed
to use as they work to prevent foreclosures. In addition, servicers in
the Alliance agreed to delay foreclosure proceedings if an alternative
approach might allow the homeowners to stay in their home.
Recently, in conjunction with the FHFA, the coalition announced that
its members will adopt a streamlined modification program for certain
loans that they service for the GSEs. This program will closely follow
the one that the FDIC has introduced for modifying the loans in the
portfolio that it took over from IndyMac.11
The Federal Reserve has also been actively supporting efforts to
prevent unnecessary foreclosures. Through the System's
Homeownership and Mortgage Initiative, we have conducted studies
on housing and foreclosures, provided community leaders with
detailed analyses to help them better target their borrower outreach
and counseling efforts, and convened forums like this one to facilitate
the exchange of ideas and the development of policy options. Taking
advantage of the Federal Reserve's nationwide presence, the twelve
Reserve Banks have sponsored or co-sponsored more than 100
events related to foreclosures around the country since last summer,
bringing together more than 10,000 lenders, counselors, community
development specialists, and policymakers. A particular focus of the
Fed's efforts has been the mitigation of the costs to communities of
high rates of foreclosure. For example, we have partnered with
NeighborWorks America on a neighborhood stabilization project and
helped them develop responses to community needs as well as train
local leaders.
Beyond these efforts, two government programs to facilitate loan
modifications have been authorized, both through the Federal
Housing Administration (FHA). The FHASecure program has
provided long-term fixed-rate mortgages to borrowers facing a rise
in payments due to an interest rate reset. Another, more recent
program, dubbed Hope for Homeowners (H4H), allows lenders to
refinance a delinquent borrower into a new, FHA-insured fixed-rate
mortgage if the lender writes down the mortgage balance to create
some home equity for the borrower and pays an up-front insurance
premium. In exchange for being put "above water" on the mortgage,
the borrower is required to share any subsequent appreciation of the
home with the government.
Although the basic structure of the H4H program is appealing, some
lenders have expressed concerns about its complexity and cost,
including the requirement in many cases to undertake substantial
principal write-downs. As a result, participation has thus far been
low. In response to these concerns, the board of the H4H
program--on which Governor Duke represents the Federal
Reserve--recently approved a number of changes, using the
authority granted to it under the Emergency Economic Stabilization
Act (EESA). These changes would reduce the necessary write-down
on some loans, address the complications caused by subordinate
liens by permitting up-front payments to those lien holders, allow
lenders to extend mortgage terms from 30 to 40 years to increase
affordability, and eliminate the trial modification period to expedite
loan closings. It is still too early to know what the ultimate demand
for H4H loans under this set of rules will be, but as I will discuss
further momentarily, a case can be made for further adjusting the
terms of the program to make it more attractive to both lenders and
borrowers.
Despite good-faith efforts by both the private and public sectors, the
foreclosure rate remains too high, with adverse consequences for
both those directly involved and for the broader economy. More
needs to be done. In the remainder of my remarks I will discuss,
without ranking, a few promising options for reducing avoidable
foreclosures. These proposals are not mutually exclusive and could
be used in combination. Each would require some commitment of
public funds.
To be effective, loan modifications should aim to put borrowers into
mortgages that they can afford over the longer term. During more
normal times, many homeowners could be helped with a temporary
repayment plan--for example, a deferral of interest payments for a
period. But under the current circumstances, with house prices
declining and credit tight, permanent loan modifications will often be
needed to create sustainable mortgages and keep people in their
homes. Most current proposals to reduce foreclosures incorporate
this view and thus emphasize permanent modifications.
A more difficult design question turns on the extent to which the
probability of default or redefault depends on the borrower's equity
position in the home, as well as on the affordability of the monthly
payment. Although not conclusive, the available evidence suggests
that the homeowner's equity position is, along with affordability, an
important determinant of default rates, for owner-occupiers as well
as investors. If that evidence is correct, then principal write-downs
may need to be part of the toolkit that servicers use to achieve
sustainable mortgage modifications.12
If one accepts the view that principal write-downs may be needed in
cases of badly underwater mortgages, then strengthening the H4H
program is a promising strategy, as I have noted. Beyond the steps
already taken by the H4H board, the Congress might consider
making the terms of H4H loans more attractive by reducing the
up-front insurance premium paid by the lender, currently set in law
at 3 percent of the principal value, as well as the annual premium
paid by the borrower, currently set at 1-1/2 percent. The Congress
might also grant the FHA the flexibility to tailor these premiums to
individual risk characteristics rather than forcing the FHA to charge
the same premium to all borrowers.
In addition, consideration might be given to reducing the interest
rate that borrowers would pay under the H4H program. At present,
this rate is expected to be quite high, roughly 8 percent, in part
because it is tied to the demand for the relatively illiquid securities
issued by Ginnie Mae to fund the program. To bring down this rate,
the Treasury could exercise its authority to purchase these
securities, with the Congress providing the appropriate increase in
the debt ceiling to accommodate those purchases. Alternatively, the
Congress could decide to subsidize the rate.
A second proposal, put forward by the FDIC, focuses on improving
the affordability of monthly payments. Under the FDIC plan,
servicers would restructure delinquent mortgages using a
streamlined process, modeled on the IndyMac protocol, and would
aim to reduce monthly payments to 31 percent of the borrower's
income. As an inducement to lenders and servicers to undertake
these modifications, the government would offer to share in any
losses sustained in the event of redefaults on the modified
mortgages and would also pay $1,000 to the servicer for each
modification completed.13 The strengths of this plan include the
standardization of the restructuring process and the fact that the
restructured loans remain with the servicer, with the government
being involved only when a redefault occurs.
As noted, the FDIC plan would induce lenders and servicers to
modify loans by offering a form of insurance against downside house
price risk. A third approach would have the government share the
cost when the servicer reduces the borrower's monthly payment.
For example, a servicer could initiate a modification and bear the
costs of reducing the mortgage payment to 38 percent of income,
after which the government could bear a portion of the incremental
cost of reducing the mortgage payments beyond 38 percent, say to
31 percent, of income. This approach would increase the incentive of
servicers to be aggressive in reducing monthly payments, which
would improve the prospects for sustainability. Relative to the FDIC
proposal, this plan would pose a greater operational burden on the
government, which would be required to make payments to servicers
for all modified loans, not just for loans that redefault. However, this
approach could leverage existing modification frameworks, such as
the FDIC/IndyMac and Hope Now streamlined protocols, and in this
respect would build on, rather than crowd out, private-sector
initiatives.
Yet another promising proposal for foreclosure prevention would
have the government purchase delinquent or at-risk mortgages in
bulk and then refinance them into the H4H or another FHA program.
This approach could take advantage of the depressed market values
of such mortgages, and buying in bulk might help avoid adverse
selection problems. In addition, scale efficiencies could be achieved
by contracting with specialty firms (perhaps including the GSEs)
capable of re-underwriting large volumes of loans to make them
eligible for H4H or another program. The Treasury has already
considered how to undertake bulk purchases as part of its work
under EESA, and the Federal Reserve has submitted to the Congress
an analysis of bulk purchases per a legislative requirement in the H4H
bill. Even so, this program could take some time to get up and
running, and the re-underwriting required for H4H loans would likely
take more time and incur greater operational costs than other plans.
But such an approach could result in many homeowners being
refinanced into sustainable mortgages.
Conclusion
The housing market remains central to the economic and financial
challenges that we face. Because housing and mortgage markets are
tightly interlinked with the rest of the economy, actions to
strengthen financial markets and the broader economy are important
ways to address housing issues. By the same token, steps that
stabilize the housing market will help stabilize the economy as well.
In this regard, reducing the number of preventable foreclosures
would not only help families stay in their homes, it would confer
much wider benefits. Significant efforts have been taken in this
direction, but more can be done. Today I have briefly discussed a
few promising options, which are not necessarily mutually exclusive.
As we as a country consider ways to address our financial and
economic challenges, policy initiatives to reduce the number of
preventable foreclosures should be high on the agenda.
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Footnotes
1. Estimates for specific metropolitan areas are based on
Case-Shiller Home Price Indexes. Return to text
2. See Kristopher Gerardi, Andreas Lehnert, Shane Sherlund, and
Paul Willen (forthcoming), "Making Sense of the Subprime Crisis,"
Brookings Papers on Economic Activity (Washington: Brookings
Institution Press). Also see Chris Mayer, Karen Pence, and Shane
Sherlund (2008), "The Rise in Mortgage Defaults," Finance and
Economics Discussion Series 2008-59 (Washington: Board of
Governors of the Federal Reserve System, November). Return to text
3. Estimates of delinquencies are based on data from the Mortgage
Bankers Association and from First American LoanPerformance.
Return to text
4. Foreclosure starts are based on data from the Mortgage Bankers
Association, adjusted to reflect the limited coverage of their sample.
Historically, about half of foreclosure starts resulted in the borrower
losing the home, but recent rates appear higher. Return to text
5. For evidence that concentrations of foreclosures lead to lower
house prices throughout the neighborhood, see, for example, William
C. Apgar, Mark Duda, and Rochelle Nawrocki Gorey (2005), "The
Municipal Cost of Foreclosures: A Chicago Case Study," Housing
Finance Policy Research Paper 2005-1 (Minneapolis, Minn.:
Homeownership Preservation Foundation, February),
www.995hope.org/content/pdf/Apgar_Duda_Study_Full_Version.pdf;
and John P. Harding, Eric Rosenblatt, and Yao Vincent (2008), "The
Contagion Effect of Foreclosed Properties," Social Science Research
Network working paper 1160354 (July). Return to text
6. To be sure, policy should not attempt to keep house prices from
falling sufficiently to stabilize the demand for housing. But
preventing avoidable foreclosures does not block necessary
adjustments. Indeed, failing to prevent such foreclosures may
heighten the risk that house prices will move lower than they would
otherwise need to go. Return to text
7. See J.P. Morgan (2008), "SOS--Summary of Subprime, Alt-A,
Prime Jumbo," Global Structured Finance Research (November 2);
and Credit Suisse (2008), "Deep Dive into Subprime Mortgage
Severity," Fixed Income Research Report (June 19). Return to text
8. See "Deep Dive," note 8. Return to text
9. Servicers of mortgages in securitized pools must abide by the
pooling and servicing agreements, which state what modifications
may be prohibited but provide limited guidance about what types of
modifications investors would consider to be appropriate. See Larry
Cordell, Karen Dynan, Andreas Lehnert, Nellie Liang, and Eileen
Mauskopf (2008), "The Incentives of Mortgage Servicers: Myths and
Realities," Finance and Economics Discussion Series 2008-46
(Washington: Board of Governors of the Federal Reserve System,
November). Return to text
10. See Board of Governors of the Federal Reserve System, Federal
Deposit Insurance Corporation, Office of the Comptroller of the
Currency, and Office of Thrift Supervision (2008), "Interagency
Statement on Meeting the Needs of Creditworthy Borrowers," joint
press release, November 12. Return to text
11. In addition, Hope Now has been an important source of data on
loss-mitigation activity. The loan-level data that they plan to provide
in the future will be useful for analyzing the relative effectiveness of
alternative strategies for loan modifications. Return to text
12. Studies tend to find that equity positions matter most for
default rates when they interact with other contributing factors; for
example, numerous studies have found that borrowers are more
likely to default when house prices have fallen and incomes decline.
At the household level, such "double triggers" may induce defaults
because of cash flow constraints or because continuing to make
payments on a mortgage whose balance significantly exceeds the
value of the house is more difficult to justify when the family budget
is strained. See Shane Sherlund (forthcoming), "The Past, Present,
and Future of Subprime Mortgages," Finance and Economics
Discussion Series (Washington: Board of Governors of the Federal
Reserve System); Kristopher Gerardi, Christopher L. Foote, and Paul
S. Willen (2008), "Negative Equity and Foreclosure: Theory and
Evidence (354 KB PDF)," Public Policy Discussion Papers 08-3
(Boston: Federal Reserve Bank of Boston, June); and Haughwout,
Andrew, Richard Peach, and Joseph Tracy (forthcoming), "Juvenile
Delinquent Mortgages: Bad Credit or Bad Economy?" Journal of
Urban Economics. Return to text
13. The original plan would have had the government share half of
any loss incurred by the lender, regardless of how far underwater the
loan might have already been by the time of modification. The latest
version of the plan modifies this provision by offering lower
loss-sharing rates for loans that have loan-to-value (LTV) ratios
above 100 percent at the time of the modification. Under the
modified plan, the loss-sharing rate declines from 50 percent on a
loan with an LTV of 100 percent at the time of modification to 20
percent on a loan with a LTV of 150 percent. Loans with LTVs of
more than 150 percent at the time of modification do not qualify for
loss-sharing. An alternative way to address this concern would be to
base the amount of the government insurance payment on the loss
in value relative to the appraised value of the property at the time of
the loan modification. Return to text
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