Ben S Bernanke: Reducing preventable mortgage foreclosures
Speech of Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal
Reserve System, at the Independent Community Bankers of America Annual Convention,
Orlando, Florida, 4 March 2008.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
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Over the past year and a half, mortgage delinquencies have increased sharply, especially
among riskier loans. This development has triggered a substantial and broad-based
reassessment of risk in financial markets, and it has exacerbated the contraction in the
housing sector. In my remarks today, I will discuss the causes of the distress in the mortgage
sector and then turn to the key question of what can be done in this environment to reduce
preventable foreclosures.
Although I am aware, as you are, that community banks originated few subprime mortgages,
community bankers are keenly interested in these issues; foreclosures not only create
personal and financial distress for individual homeowners but also can significantly hurt
neighborhoods where foreclosures cluster. Efforts by both government and private-sector
entities to reduce unnecessary foreclosures are helping, but more can, and should, be done.
Community bankers are well positioned to contribute to these efforts, given the strong
relationships you have built with your customers and your communities.
The rise in mortgage delinquencies and foreclosures
Mortgage delinquencies began to rise in mid-2005 after several years at remarkably low
levels. The worst payment problems have been among subprime adjustable-rate mortgages
(subprime ARMs); more than one-fifth of the 3.6 million loans outstanding were seriously
delinquent at the end of 2007.1 Delinquency rates have also risen for other types of
mortgages, reaching 8 percent for subprime fixed-rate loans and 6 percent on adjustable-rate
loans securitized in alt-A pools. Lenders were on pace to have initiated roughly 1-1/2 million
foreclosure proceedings last year, up from an average of fewer than 1 million foreclosure
starts in the preceding two years.2 More than one-half of the foreclosure starts in 2007 were
on subprime mortgages.
The recent surge in delinquencies in subprime ARMs is closely linked to the fact that many of
these borrowers have little or no equity in their homes. For example, data collected under the
Home Mortgage Disclosure Act suggest that nearly 40 percent of higher-priced
homepurchase loans in 2006 involved a second mortgage (or "piggyback") loan. Other data show
that more than 40 percent of the subprime loans in the 2006 vintage had combined
loan-tovalue ratios in excess of 90 percent, a considerably higher share than earlier in the decade.3
Often, in recent mortgage vintages, small down payments were combined with other risk
factors, such as a lack of documentation of sufficient income to make the required loan
payments.
This weak underwriting might not have produced widespread payment problems had house
prices continued to rise at the rapid pace seen earlier in the decade. Rising prices provided
leveraged borrowers with significant increases in home equity and, consequently, with
greater financial flexibility. Instead, as you know, house prices are now falling in many parts
of the country. The resulting decline in equity reduces both the ability and the financial
incentive of stressed borrowers to remain in their homes. Indeed, historically, borrowers with
little or no equity have been substantially more likely than others to fall behind in their
payments. The large number of outstanding mortgages with negative amortization features
may exacerbate this problem.
Delinquencies and foreclosures likely will continue to rise for a while longer, for several
reasons. First, supply-demand imbalances in many housing markets suggest that some
further declines in house prices are likely, implying additional reductions in borrowers' equity.
Second, many subprime borrowers are facing imminent resets of the interest rates on their
mortgages. In 2008, about 1-1/2 million loans, representing more than 40 percent of the
outstanding stock of subprime ARMs, are scheduled to reset. We estimate that the interest
rate on a typical subprime ARM scheduled to reset in the current quarter will increase from
just above 8 percent to about 9-1/4 percent, raising the monthly payment by more than 10
percent, to $1,500 on average. Declines in short-term interest rates and initiatives involving
rate freezes will reduce the impact somewhat, but interest rate resets will nevertheless
impose stress on many households.
In the past, subprime borrowers were often able to avoid resets by refinancing, but currently
that avenue is largely closed. Borrowers are hampered not only by their lack of equity but
also by the tighter credit conditions in mortgage markets. New securitizations of nonprime
mortgages have virtually halted, and commercial banks have tightened their standards,
especially for riskier mortgages. Indeed, the available evidence suggests that private lenders
are originating few nonprime loans at any terms.
This situation calls for a vigorous response. Measures to reduce preventable foreclosures
could help not only stressed borrowers but also their communities and, indeed, the broader
economy. At the level of the individual community, increases in foreclosed-upon and vacant
properties tend to reduce house prices in the local area, affecting other homeowners and
municipal tax bases. At the national level, the rise in expected foreclosures could add
significantly to the inventory of vacant unsold homes - already at more than 2 million units at
the end of 2007 - putting further pressure on house prices and housing construction.4
Helping distressed borrowers
Policymakers and stakeholders have been working to find effective responses to the
increases in delinquencies and foreclosures. Steps that have been taken include initiating
programs designed to expand refinancing opportunities and efforts to facilitate and increase
the pace of loan workouts. Troubled borrowers will always require individual attention, and
the most immediate impacts of foreclosures are on local communities. Thus, the support of
counselors, lenders, and organizations with local ties is critical.
Of course, care must be taken in designing solutions. Measures that lead to a sustainable
outcome are to be preferred to temporary palliatives, which may only put off foreclosure and
perhaps increase its ultimate costs. Solutions should also be prudent and consistent with the
safety and soundness of the lender. Concerns about fairness and the need to minimize moral
hazard add to the complexity of the issue; we want to help borrowers in trouble, but we do
not want borrowers who have avoided problems through responsible financial management
to feel that they are being unfairly penalized.
Let me turn now to some recent efforts to help distressed borrowers refinance. The
FHASecure plan, which the Federal Housing Administration (FHA) announced late last
summer, offers qualified borrowers who are delinquent because of an interest rate reset the
opportunity to refinance into an FHA-insured mortgage. Recently, the Congress and
Administration temporarily increased the maximum loan value eligible for FHA insurance,
which should allow more borrowers, particularly those in communities with higher-priced
homes, to qualify for this program and to be eligible for refinancing into FHA-insured loans
more generally. These efforts represent a step in the right direction. Not all borrowers are
eligible for this program, of course; in particular, some equity is needed to qualify. In addition,
second-lien holders must settle or be willing to re-subordinate their claims for an FHA loan,
which has sometimes proved difficult to negotiate. Separately, some states have created
funds to offer refinancing options, but eligibility criteria tend to be tight and the take-up rates
appear to be low thus far.
In cases where refinancing is not possible, the next-best solution may often be some type of
loss-mitigation arrangement between the lender and the distressed borrower. Indeed, the
Federal Reserve and other regulators have issued guidance urging lenders and servicers to
pursue such arrangements as an alternative to foreclosure when feasible and prudent.5 For
the lender or servicer, working out a loan makes economic sense if the net present value
(NPV) of the payments under a loss-mitigation strategy exceeds the NPV of payments that
would be received in foreclosure.6 Loss mitigation is made more attractive by the fact that
foreclosure costs are often substantial. Historically, the foreclosure process has usually taken
from a few months up to a year and a half, depending on state law and whether the borrower
files for bankruptcy. The losses to the lender include the missed mortgage payments during
that period, taxes, legal and administrative fees, real estate owned (REO) sales
commissions, and maintenance expenses. Additional losses arise from the reduction in value
associated with repossessed properties, particularly if they are unoccupied for some period.
A recent estimate based on subprime mortgages foreclosed in the fourth quarter of 2007
indicated that total losses exceeded 50 percent of the principal balance, with legal, sales,
and maintenance expenses alone amounting to more than 10 percent of principal. With the
time period between the last mortgage payment and REO liquidation lengthening in recent
months, this loss rate will likely grow even larger. Moreover, as the time to liquidation
increases, the uncertainty about the losses increases as well. The low prices offered for
subprime-related securities in secondary markets support the impression that the potential
for recovery through foreclosure is limited. The magnitude of, and uncertainty about,
expected losses in a foreclosure suggest considerable scope for negotiating a mutually
beneficial outcome if the borrower wants to stay in the home.
Unfortunately, even though workouts may often be the best economic alternative, mortgage
securitization and the constraints faced by servicers may make such workouts less likely. For
example, trusts vary in the type and scope of modifications that are explicitly permitted, and
these differences raise operational compliance costs and litigation risks. Thus, servicers may
not pursue workout options that are in the collective interests of investors and borrowers.
Some progress has been made (for example, through clarification of accounting rules) in
reducing the disincentive for servicers to undertake economically sensible workouts.
However, the barriers to, and disincentives for, workouts by servicers remain serious
problems that need to be part of current discussions about how to reduce preventable
foreclosures.
We now have more information about the recent pace of loss-mitigation activity than we did
just a few months ago, thanks to surveys of servicers by the Mortgage Bankers Association,
the Conference of State Bank Supervisors, the Hope Now Alliance, and others. These
surveys generally indicate that servicers substantially increased the number of loan workouts
in the latter part of last year. The Hope Now Alliance estimates that workouts of subprime
mortgages rose from around 250,000 in the third quarter of 2007 to 300,000 in the fourth
quarter, while workouts of prime mortgages rose from 150,000 to 175,000 over the same
period. The pace of workouts picked up a bit more in January.
Despite this progress, delinquency and default rates have risen quickly, and servicers report
that they are struggling to keep up with the increased volumes. Of course, not all delinquent
subprime loans can be successfully worked out; for example, borrowers who purchased
homes as speculative investments may not be interested in retaining the home, and some
borrowers may not be able to sustain even a reduced stream of payments. Nevertheless,
scope remains to prevent unnecessary foreclosures.
Lenders and servicers historically have relied on repayment plans as their preferred
lossmitigation technique. Under these plans, borrowers typically repay the mortgage arrears over
a few months in addition to making their regularly scheduled mortgage payments. These
plans are most appropriate if the borrower has suffered a potentially reversible setback, such
as a job loss or illness. However, anecdotal evidence suggests that even in the best-case
scenarios, borrowers given repayment plans re-default at a high rate, especially when the
arrears are large.
Loan modifications, which involve any permanent change to the terms of the mortgage
contract, may be preferred when the borrower cannot cope with the higher payments
associated with a repayment plan. In such cases, the monthly payment is reduced through a
lower interest rate, an extension of the maturity of the loan, or a write-down of the principal
balance. The proposal by the Hope Now Alliance to freeze interest rates at the introductory
rate for five years is an example of a modification, in this case applied to a class of eligible
borrowers.
To date, permanent modifications that have occurred have typically involved a reduction in
the interest rate, while reductions of principal balance have been quite rare. The preference
by servicers for interest rate reductions could reflect familiarity with that technique, based on
past episodes when most borrowers' problems could be solved that way. But the current
housing difficulties differ from those in the past, largely because of the pervasiveness of
negative equity positions. With low or negative equity, as I have mentioned, a stressed
borrower has less ability (because there is no home equity to tap) and less financial incentive
to try to remain in the home. In this environment, principal reductions that restore some
equity for the homeowner may be a relatively more effective means of avoiding delinquency
and foreclosure.
Lenders tell us that they are reluctant to write down principal. They say that if they were to
write down the principal and house prices were to fall further, they could feel pressured to
write down principal again. Moreover, were house prices instead to rise subsequently, the
lender would not share in the gains. In an environment of falling house prices, however,
whether a reduction in the interest rate is preferable to a principal writedown is not
immediately clear. Both types of modification involve a concession of payments, are
susceptible to additional pressures to write down again, and result in the same payments to
the lender if the mortgage pays to maturity. The fact that most mortgages terminate before
maturity either by prepayment or default may favor an interest rate reduction. However, as I
have noted, when the mortgage is "under water," a reduction in principal may increase the
expected payoff by reducing the risk of default and foreclosure.
In my view, we could also reduce preventable foreclosures if investors acting in their own self
interests were to permit servicers to write down the mortgage liabilities of borrowers by
accepting a short payoff in appropriate circumstances. For example, servicers could accept a
principal writedown by an amount at least sufficient to allow the borrower to refinance into a
new loan from another source. A writedown that is sufficient to make borrowers eligible for a
new loan would remove the downside risk to investors of additional writedowns or a
redefault. This arrangement might include a feature that allows the original investors to share in
any future appreciation, as recently suggested, for example, by the Office of Thrift
Supervision. Servicers could also benefit from greater use of short payoffs, as this approach
would simplify the calculation of expected losses and eliminate the future costs and risks of
retaining the troubled mortgage in the pool.
A potentially important step to facilitate greater use of short payoffs is the modernization of
the FHA, which I have supported. Going beyond the current proposals for modernization,
permitting the FHA greater latitude to set underwriting standards and risk-based premiums
for mortgage refinancing - in a way that does not increase the expected cost to the taxpayer
- would allow the FHA to help more troubled borrowers. A concern about such an approach
is that servicers might refinance only their riskiest borrowers into the FHA program. A
combination of careful underwriting, the use of risk premiums, and other measures (for
example, a provision that would allow the FHA to return a mortgage that quickly re-defaults
to the servicer) could help mitigate that risk.
There are, no doubt, tax-related, accounting, and legal obstacles to expanding the use of
principal writedowns. For example, investors in different tranches of mortgage-backed
securities may not benefit equally, securitized trusts may not be permitted to acquire new
equity warrants, and principal writedowns may require a different accounting treatment than
interest rate reductions. But just as market participants, with the help of regulators, obtained
greater clarity on the use of interest rate freezes through guidelines issued by the American
Securitization Forum, industry and regulator efforts could also help clarify how this alternative
type of workout might be effectively applied.
Federal Reserve System efforts
I would like to comment briefly on Federal Reserve System efforts to reduce preventable
foreclosures and their costs on borrowers and communities. The Federal Reserve can help
by leveraging three important strengths: our analytical and data resources; our national
presence; and our history of working closely with lenders, community groups, and other local
stakeholders. A major thrust of our efforts is sharing relevant and timely data analysis of
mortgage delinquencies with community groups and policymakers to efficiently target
resources to areas most in need. For example, we recently assisted NeighborWorks America
in identifying regions and neighborhoods that are at risk of higher rates of foreclosure and
could benefit from increased mortgage counseling capacity. On the basis of this analysis,
NeighborWorks recently distributed $130 million in newly granted funds from Congress to
thirty-two state housing finance agencies, eighty-two community-based NeighborWorks
organizations, and sixteen counseling intermediaries around the country.
The Federal Reserve System also is supporting efforts to reach troubled borrowers and to
raise awareness in communities about ways to prevent foreclosures. Since July, the
community affairs groups across the Federal Reserve System have sponsored or
cosponsored more than fifty events related to foreclosures, reaching more than 4,000
attendees including lenders, counselors, community development specialists, and
policymakers.
We are also concerned about the challenges of neighborhoods that have seen large
increases in foreclosures and vacant properties and have begun to work with policymakers,
lenders (including community banks) and community groups to address these problems. In
particular, we have undertaken a joint effort with NeighborWorks America to help
communities develop strategies for neighborhood stabilization.
Conclusion
Reducing the rate of preventable foreclosures would promote economic stability for
households, neighborhoods, and the nation as a whole. Although lenders and servicers have
scaled up their efforts and adopted a wider variety of loss-mitigation techniques, more can,
and should, be done. The fact that many troubled borrowers have little or no equity suggests
that greater use of principal writedowns or short payoffs, perhaps with shared appreciation
features, would be in the best interest of both borrowers and lenders. This approach would
be facilitated by allowing the FHA the flexibility to offer refinancing products to more
borrowers.
Ultimately, though, real relief for the mortgage market requires stabilization, and then
recovery, in the nation's housing sector. Modernization of the FHA would be of help on this
front as well. I am sure that the FHA and the Department of Housing and Urban
Development, given the appropriate powers by the Congress, will make every effort to
expand their operations and to help improve the functioning of the market for home-purchase
mortgages. For community bankers, FHA modernization and expansion would provide an
important opportunity - of which I urge you to take advantage - to better serve your
customers and community.
The government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, likewise
could do a great deal to address the current problems in housing and the mortgage market.
New capital-raising by the GSEs, together with congressional action to strengthen the
supervision of these companies, would allow Fannie and Freddie to expand significantly the
number of new mortgages that they securitize. With few alternative mortgage channels
available today, such action would be highly beneficial to the economy. I urge the Congress
and the GSEs to take the steps necessary to allow more potential homebuyers access to
mortgage credit at reasonable terms.