Elizabeth A Duke: Rebalancing the housing market
Speech by Ms Elizabeth A Duke, Member of the Board of Governors of the Federal Reserve
System, at the Federal Reserve Board Policy Forum: "The Housing Market Going Forward:
Lessons Learned from the Recent Crisis", Washington DC, 1 September 2011.
* * *
Good afternoon. I'd like to join my colleagues in welcoming you to the Federal Reserve
Board. This policy forum, "The Housing Market Going Forward: Lessons Learned from the
Recent Crisis," has been designed to connect lessons learned from the recent past with
policy alternatives that may affect the market for years to come. Determining the key lessons
and getting this connection right are important, and as you have already heard, perhaps not
as easy as it might sound. I would like to offer some suggestions that I think could help.
Before I begin, though, I should clarify that the ideas I will be discussing do not necessarily
reflect the opinions of my colleagues on the Federal Reserve Board and that these
suggestions should not be construed as policy of the Board or the Federal Open Market
Committee.
There are many interpretations of the key factors that led to the current state of affairs, and
there are a similar number of visions of what the future should look like. But, while it is
important to learn from and avoid the mistakes of the recent past, we should not forget what
did work for many years in the housing and housing finance markets. So, in crafting
appropriate policy responses, an important starting point is to carefully analyze what we're
solving for. Certainly we want a solution based on private capital, but the role of government
in housing and mortgage markets will need to be defined before private markets will fully
reengage. Any policy solution will have to be evaluated in the context of its effect on both
owner-occupied and rental housing markets. And as the policy conversations progress, it will
also be important to maintain a focus on the demand side of the market - which is to say, all
of us, as consumers of housing. Finally, a national housing policy must also serve the needs
of the segments of our society that have been historically underserved - low-income and
low-wealth families, including disproportionate numbers of minorities and households headed
by females.
These longer-term questions are critical. But before we get to the longer-term solutions, we
need to deal with the unprecedented number of loans in or still entering the foreclosure
pipeline, the disposition of properties acquired through foreclosure, and the effect of a high
percentage of distressed sales on home prices. Regardless of how we got here, we, as a
nation, currently have a housing market that is so severely out of balance that it is hampering
our economic recovery.
To many, the story of the recent financial crisis and its aftereffects for the housing market is
one mainly attributed to subprime lending. Although problems were concentrated initially in
subprime mortgages, today about two-thirds of underwater mortgages and loans in
foreclosure are actually prime or Federal Housing Administration (FHA) mortgages. This fact
suggests that solutions aimed at righting the wrongs of previous reckless lending in the
subprime market are not sufficient to tackle the scale of current problems.
Clearly, the market is not functioning as it should. Despite near-record-low interest rates,
credit conditions remain tight for many consumers and investors interested in buying or
refinancing residential real estate. Moreover, the lack of sufficient numbers of buyers and
sellers may limit price discovery, which heightens uncertainty about the "right" price for a
given piece of real estate and further limits activity. In addition, the large number of
foreclosures and a protracted foreclosure process have led to an unprecedented level of
bank-owned homes, a level that is likely to persist for some time.
So how do we move forward in these difficult circumstances?
The economy normally has some self-correcting mechanisms. Typically, a drop in prices -
whether the price of an apple or the price of a house - stimulates demand and brings new
buyers into the market. In the case of houses, price declines often occur in the context of a
broad-based weakness in the overall economy. In response to macroeconomic weakness,
the Federal Reserve generally can lower the target federal funds rate, which would be
expected to lower mortgage rates. The combination of lower prices and lower mortgage rates
makes home purchase more affordable and helps revive the housing market. Indeed, most
recent recoveries have been led by housing. But for a variety of reasons, these mechanisms
are not working fully in today's economy. When crafting solutions, it is helpful to first identify
areas where removing some obstacles might enable these self-correcting mechanisms to
operate more productively.
Refinancing existing mortgages at lower rates
One way to reduce the flow of foreclosed homes is to ease the payment strain on borrowers,
which can be accomplished by modifying loans that are past due or by refinancing
performing loans at lower rates. The Federal Reserve has already acted to lower longer-term
interest rates, including mortgage rates, through the purchase of longer-term Treasury
securities, agency debt, and agency mortgage-backed securities. In addition to enabling
more buyers to purchase homes, low mortgage rates act to reduce the debt service cost of
existing household debt. However, while refinancing activity has picked up in response to the
lower rates, the pickup has been subdued compared with past low-rate environments. That
is, even though mortgage rates on many outstanding loans are well above current market
rates, many borrowers have not been able to take advantage of the lower rates because they
have little or no equity in their homes or face other obstacles.
To facilitate refinancing for borrowers who are current on their mortgages but whose equity
has eroded as home prices have fallen, the Administration's Home Affordable Refinance
Program, or HARP, provides streamlined refinancing for low- or no-equity mortgages if the
borrowers meet certain qualifications and if their existing mortgages are already guaranteed
by Fannie Mae or Freddie Mac. So far, more than 800,000 borrowers have refinanced their
mortgages through HARP.
One question, however, is why more borrowers have not benefited from this program. We
estimate that 4 million borrowers appear to meet the basic eligibility for HARP refinancing.1
Of course, some of these borrowers may be ineligible for reasons that we cannot observe,
and others may be uninterested in refinancing. However, given the potential savings to
households, the relatively low take-up on this program warrants another look at the frictions
that may be impeding these refinancing transactions.
Responses to our inquiries regarding impediments to HARP refinancing have revealed four
possible frictions:
1. LLPAs are upfront fees that are added
Loan-level pricing adjustments (LLPAs).
to the refinancing costs of loans that are judged to have higher risk characteristics,
such as high loan-to-value ratios. The fees can increase the cost of refinancing by
thousands of dollars and thus discourage borrowers from participating in the HARP
program. Risk-based pricing is a standard risk-management tool for lenders in
evaluating new risk. However, when the lender or guarantor already owns the credit
risk, refinancing a low- or no-equity loan can actually reduce risk because it reduces
payments and thus makes default less likely.
2. Limited lender competition for HARP refinance loans due to lender concerns
about taking on "putback" risk from previous underwriting. Putback risk is the
possibility that the loan originator will have to repurchase the loan from the
government-sponsored enterprises (GSEs) because the underwriting violated GSE
guidelines. Although the streamlined HARP guidelines do not require lenders to
verify all aspects of a borrower's application, lenders who process the HARP
refinancings have putback risk both from the refinance and from the original
underwriting, even if the refinancing lender did not underwrite the original loan. This
risk may make lenders reluctant to refinance loans originated by other lenders and
so limits participation in the program. Perhaps competition among potential lenders
could be increased if a minimum number of timely payments could be used as a
proxy for sound original underwriting to relieve the liability of the refinancing lender
for the mistakes of previous lenders.
3. Junior lienholders. In some cases, holders of junior liens are refusing to allow their
loans to remain subordinate to a proposed new refinance loan, thus holding up the
HARP process.
4. Mortgage insurers. Similarly, some mortgage insurers will not agree to
reunderwrite their policies despite presumably diminished default risk after the
refinancing.
The common theme in all of these frictions is that, in each case, the parties to the transaction
are applying standard risk-management tools that would normally apply to low- or no-equity
loans - but they are applying them to risk they already own. The economics of the situation
suggests that if the first mortgage becomes more affordable, the existing risk exposure of all
credit risk holders actually decreases. Moreover, to the extent that more widespread
refinancing reduces the overall volume of distressed mortgages, it likely reduces pressures
on house prices which would, in turn, lead to lower losses on sales of foreclosed properties
across all mortgage portfolios. And finally, removal of barriers to refinancing would boost the
impetus to recovery provided by lower long-term interest rates. Thus, finding different
approaches to the policies that are hindering refinancing would likely provide some support
to the economic recovery while improving the circumstances of homeowners and reducing
the overall level of credit risk borne by the various holders of the risk.
Converting real estate owned to rental
Let me turn now to the effect on the housing market of properties acquired by creditors
through foreclosure, commonly called real estate owned, or REO. An estimated 1 million or
more properties will likely pass through REO inventory in 2011, with another million or so per
year expected in both 2012 and 2013.
REO properties are weighing heavily on the market for owner-occupied houses in at least
three ways. First, REO properties increase the total inventory of properties for sale. While the
numbers are difficult to measure precisely, we estimate that in the second quarter of 2011,
roughly 500,000 to 600,000 of the 2 million vacant homes for sale in the United States were
REO properties. This extra supply is particularly problematic because demand is quite low.
High unemployment and tight credit standards are currently precluding many families from
buying homes, and other potential buyers may be staying out of the market due to
uncertainty about their incomes. Even ignoring the potential inventory represented by the
large backlog of distressed loans that have not yet been foreclosed upon, the current
inventory of existing homes for sale represents approximately nine months of sales
compared with a norm of five to six months, suggesting additional pressure on house prices
as the market struggles to clear the excess inventory. Second, the downward pressure on
prices is compounded by the high proportion of sales considered to be distressed sales.
Currently, around 40 percent of sales transactions are considered to be distressed sales -
that is, short sales or sales of REO properties. And third, high vacancy rates and the low
level of maintenance that often characterize foreclosed properties make a neighborhood a
less desirable place to live and thus depress the value of surrounding homes.2
In contrast to the market for owner-occupied houses, the market for rental housing has been
strengthening of late. For example, apartment rents have turned up in the past year, and
vacancy rates on multifamily rental properties have dropped noticeably. The relative strength
of the rental market reflects increased demand as families who are unable or unwilling to
purchase homes because of tight mortgage conditions or income uncertainty are renting
properties instead. Rental demand has also been supported by families who have lost their
homes to foreclosure. The majority of these families move to rental housing, most commonly
to single-family rentals.3 Unfortunately, these conditions supporting rental demand may
persist for some time.
The weak demand in the owner-occupied housing market and the relatively high demand in
the rental housing market suggest that transitioning some REO properties to rental housing
might benefit both markets. Such conversions might also be in the best interests of
lienholders and guarantors if recoveries from renting out properties exceed those from
outright sales. Over time, as financing conditions ease and the number of REO properties to
be sold declines, the share of properties sold to owner-occupants and sold to investors for
rental will adjust commensurately.
Small investors are already converting some foreclosed properties to rental units on a limited
scale. Larger-scale conversion, however, has been hindered by at least two factors. First,
managing single-family rental homes is expensive unless the properties are concentrated
within a geographic area and investors can be certain of acquiring a critical mass of
properties. Second, regulatory guidance and standard servicing practices have typically
encouraged GSEs, FHA, servicers, and financial institutions to actively market REO
properties for sale and to consider rentals only as a short-term income generator while the
properties are being marketed.
In August, the Federal Housing Finance Agency (FHFA), working with the Treasury
Department and the Department of Housing and Urban Development, issued a request for
information seeking ideas for the disposition of REO owned by Fannie Mae, Freddie Mac,
and the FHA, including ideas for turning these properties into rental housing. Together, the
GSEs and the FHA hold about half of the outstanding REO inventory and so may be able to
aggregate enough properties to facilitate a cost-effective rental program in many markets.
In thinking through how a rental program might be structured, I want to highlight three
possible design considerations. First, as I noted earlier, achieving a cost-effective program
may require obtaining a critical mass of properties - perhaps a couple hundred or more -
within a limited geographic area. In this respect, the comparative advantage of government is
in solving the aggregation problem. The combined portfolios of the GSEs and the FHA are
large enough to achieve the necessary scale in a number of markets. However, the
structuring of such a program might require the flexibility for a pooling entity to acquire
properties from more than one seller or to contract for the acquisition of a minimum number
of properties over time. With such flexibility, the scale potential of the GSE-FHA portfolios
could be supplemented with properties from servicer or financial institution portfolios.
Second, it is important to ensure that such rental conversions are executed in a responsible
manner and in the best interests of renters and local communities. Replacing the blight of a
foreclosed home with the blight of a rundown rental property would provide little assistance to
the affected neighborhoods. Examining how best to ensure that landlords keep their
properties well maintained will be crucial.
Third, in many markets, house prices have fallen to such an extent that better recoveries
may result from renting properties rather than selling them. However, in other markets,
converting REO properties to rentals may not be in the narrow best interest of financial
institutions or mortgage investors but may be in the best interest of local communities. For
these markets, it may be useful to consider the possible role of new incentives and, if so,
what form those incentives might take.
While existing statutes and regulations do not prohibit financial institutions from renting REO
properties, supervisors encourage sales as the primary disposition tool. In light of the relative
weakness of the owner-occupied market and strength of the rental market along with the
potential for a GSE-FHA program to solve the problem of insufficient scale in some markets,
conditions are unusual enough that it might also make economic sense to clarify existing
expectations to recognize that in some cases converting a portion of residential REO to
rental may be a reasonable option for financial institutions. Depending upon the conditions in
their individual markets, I believe having such an option could allow for better outcomes for
institutions - that is, a superior net present value compared with traditional disposition
approaches - and could at the same time contribute to market healing. However, to be
effective in promoting better outcomes, such an approach would require supervisors to clarify
current supervisory guidance to address how existing standards might apply to the valuation
of real estate converted to rental, the time limits applicable to such holdings, and other
aspects of managing those properties. Financial institutions with large portfolios might be
able to achieve scale in some markets on their own or possibly leverage the scale of a
GSE-FHA program if such a program was created; smaller institutions should also have the
flexibility to act in accordance with the conditions in their local markets.
Responsible REO management
In addition to the consideration of conversion strategies at significant scale, there are steps
that all REO holders can take today to ensure that they are not contributing further to the
problems. They can and should make sure that they are adequately monitoring any
thirdparty vendors with which they contract to maintain, market, or sell REO properties. Certainly,
the recent interagency review of servicers revealed the severe consequences that can result
from failing to monitor third-party vendors. Before converting REO properties to rental, REO
holders could also consider "first look" types of programs to enable owner-occupants, public
entities, and nonprofits windows of time to bid on available properties. A number of
institutions have used such programs with successful results. And REO holders who sell
large numbers of properties to investors should consider processes, such as those used by
the GSEs, to screen and monitor bulk investors to reasonably assess their probable actions
regarding maintenance and disposition after acquiring the properties.
Low-value properties
So far I've talked solely about REO-to-rental as a solution for REO properties. But that's not
going to work everywhere. In particular, some properties are too damaged, or otherwise too
low-value, to be sold as owner-occupied units or profitably converted to rental properties. In
fact, we estimate that about 5 percent of properties in the REO inventory of the FHA and the
GSEs are appraised at less than $20,000, and in some markets the share is significantly
higher. In many of these cases, the cost to repair or demolish existing structures exceeds
their fair market value, and a different type of solution may be needed.
In recent years, local governments and community-based organizations have struggled to
counter the effects of foreclosures on neighborhoods. One tool for controlling the temporary
condition and ultimate disposition of REO properties is the use of a unique kind of entity
known as a land bank.4 Land banks are typically public or nonprofit entities created to
manage properties not dealt with adequately through the private market. The lifespan of
these entities may be time-limited with sunset provisions. The notion of a land bank, as
opposed to a land trust, is that properties are brought in and moved out of a land bank's
portfolio rather than permanently preserved. Using this kind of mechanism, a community can
gain control of low-value properties that may otherwise sit vacant and cause problems for the
surrounding neighborhood. Options available for disposing of the properties include physical
rehabilitation, some period of rental, sale to new owner-occupants or responsible investors,
or, in some cases, demolition. Because it likely will take several years for the overhang of
vacant homes to be sold, such a strategy would help some communities deal with the
shortterm crisis and then ultimately allow for the disposition of properties in a manner suitable to
local market conditions in the longer term.
While few land banks currently have the resources to operate at significant scale, the land
bank model is one that has shown some success and could help many communities stabilize
troubled properties if used more extensively. However, although such an approach holds
promise, the current infrastructure for land banks is limited. First, not all states have passed
legislation that is needed to permit land banks. Second, this is difficult work, and existing land
banks have limited capacity to handle high numbers of properties at a time. More funding
and technical assistance would be needed to scale these efforts up to an adequate level. Of
course, new funds are hard to come by in the current fiscal environment, but this appears to
be an instance where relatively modest investments have the potential to yield significant
benefits, such as reduced crime stemming from vacant properties, lower municipal costs to
limit property deterioration or provide services to neighborhoods that are largely vacant,
higher property tax revenue derived from property values not being unduly depressed, and
other benefits that may be realized.
Conclusion
These are my thoughts on some of the things that can be done in the near term to help the
housing market stabilize and rebalance. An immediate priority is balancing supply and
demand in a market overwhelmed by financially stressed homeowners, tight credit
conditions, and an unusually high number of foreclosed homes. It is an important part of
rebuilding our market for housing and housing finance, but it is only a part. In addition, we
must think carefully about longer-term policy and market changes that may affect Americans'
housing options for years and even decades to come. This is important work, and I
appreciate your participation in the forum today.
Thank you.