Elizabeth A Duke: Stabilizing the housing market - focus on
communities
Speech by Ms Elizabeth A Duke, Member of the Board of Governors of the US Federal
Reserve System, at the American Bankers Association National Conference for Community
Bankers, Phoenix, Arizona, 16 February 2009.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
It is great to be back here with community bankers. The last time I addressed this
conference, I was a community banker and also chairman of the American Bankers
Association. I never dreamed that I would be back four years later as a member of the Board
of Governors. Before I took office, I wrestled with the question of how I could contribute to the
work of the Board and how difficult it might be to change from the perspective of a banker to
the perspective of a public policy maker. So I asked a friend of mine, who had spent most of
his career as an attorney before becoming an appellate court judge, just how he had made
the transition from advocate to jurist. He told me that he found that he developed a different
framework for decisionmaking, a different mindset, but one that was enriched by his
experience and knowledge of the law. He said it happened quite naturally and predicted that
I would experience the same thing. And he was right. So I thought I would begin by talking a
little about how I approach my role at the Fed and then discuss the housing and mortgage
markets, with particular emphasis on the impact this crisis is having on communities. I want
to emphasize that any opinions I express here today are mine alone and do not represent the
opinions of anyone else within the Federal Reserve System.
The Federal Open Market Committee (FOMC), as you all know, is responsible for overseeing
open market operations, which is the principal tool of monetary policy. On a voting basis, it is
composed of all of the members of the Board of Governors, the president of the Federal
Reserve Bank of New York, and 4 of the 11 remaining Reserve Bank presidents, who vote
on a rotating basis. While only five vote, all of the Reserve Bank presidents contribute
equally to the discussion. My contributions to the discussion of current and projected
financial and economic conditions are shaped largely by my conversations with bankers, my
knowledge of bank management principles, and the Main Street perspective on the economy
that I developed in my years as a banker working with consumers and small businesses.
In the six months that I have been at the Board, actions taken by bankers have had a
tremendous influence on the economy. As part of preparing for FOMC meetings, I call a
number of bankers at different size banks around the country to get their assessments of
conditions in their banks and in their markets. My questions recently have focused primarily
on the effect of government initiatives and on lending conditions. I also think through the
actions that I might take as a banker if confronted by prevailing circumstances. For example,
in evaluating the likely impact of the Treasury's recent Capital Purchase Program, I mentally
walked through what would have been my own decision tree when trying to decide whether
to apply for capital and, if I did receive capital, how I might use it.
In addition to the FOMC, I sit on the Board's Committee on Supervisory and Regulatory
Affairs and chair the Committee on Consumer and Community Affairs. In these roles, I have
been able to use my deeply ingrained knowledge of existing regulations, including their
purposes and origins, as well as my familiarity with the examination process. And while I
have long been an advocate for reducing regulatory burden, I have never questioned the
need for strong regulation and supervision, only the efficiency of its implementation. So, now
I have the opportunity to shape the implementation of new regulations and review existing
ones, including those for safety and soundness as well as for consumer protection. But, as
you know, regulations are only one part of the Federal Reserve's role in ensuring a sound
banking industry; those regulations must be complemented by strong supervision. That is,
not only do we establish a set of rules for bankers to follow, but we also ensure that while
abiding by those rules, the banking industry remains in an overall safe and sound condition.
In fulfilling my new role as a policymaker, I find that there are some basic beliefs that I held
as a banker that continue to guide me.
• I believe that the banking business plays a special role in the economy and carries
with it special responsibilities. These responsibilities come from the role of the
financial system as the circulatory system of our economy. And with respect to
insured depository institutions, given the federal safety net provided by deposit
insurance, access to the payment system, and the availability of discount window
borrowings, bankers have a responsibility to operate in a safe and sound manner.
•
I believe that rigorous supervision and enforcement are necessary companions to
regulation. One of the lessons we have learned in the current crisis is that different
levels of supervision and enforcement can cause problems, even when institutions
are ostensibly following the same regulations. Nowhere was this more evident than
in the mortgage origination market, in which banking organizations and firms outside
the banking supervision system were all originating mortgages but were subject to
very different levels of oversight.
•
I believe in the separation of banking and commerce. The lending policies of banks
should have as their purpose the efficient channeling of savers' funds to their most
productive uses. The allowance of banks to affiliate with commercial firms threatens
the ability of banks to continue to serve as efficient and objective intermediaries of
credit and has the potential to expose banks to the operational, financial, and
reputational risks of commercial affiliates. It also has the potential to extend to
commercial affiliates the federal safety net afforded to banks in recognition of their
role in the economy.
•
I believe that a bank holding company should act as a source of financial and
managerial strength to its banking subsidiaries. That is, a bank holding company
should stand ready to use available resources to provide adequate capital funds to
its subsidiary banks during periods of financial stress or adversity, and it should
maintain the financial flexibility and capital-raising capacity to obtain additional
resources for assisting its subsidiary banks. The reasoning behind these functions is
that a bank holding company derives certain benefits at the corporate level that
result, in part, from the ownership of an institution that has access to the federal
safety net, including deposit insurance. This principle is, naturally, very familiar to
almost all bankers, since it is embedded in Federal Reserve regulation, but it is
worth repeating from time to time.
•
Finally, I believe that strict adherence to consumer protection is necessary to protect
consumers and the financial system as a whole. We have now witnessed the severe
consequences of inadequate consumer understanding of financial products and of
lending to consumers without regard to their ability to sustain the payments.
Reasonable regulations, such as the Federal Reserve's recent rule changes for
mortgages and credit cards, can help protect consumers and encourage responsible
lending.
Much of my time is currently absorbed by activities related to this last point, as well as the
broader housing and mortgage crisis. In addition to my Board committee assignments, I
represent the Fed on the oversight board of the HOPE for Homeowners (H4H) program, an
FHA program created by the Congress that allows lenders to refinance a delinquent borrower
into an FHA-insured fixed-rate mortgage if the lender and borrower agree to certain
conditions. Again representing the Fed, I also recently joined the board of directors of
NeighborWorks America, a national, congressionally chartered nonprofit organization
focused on affordable housing and, in the face of growing needs, on responses to problems
facing communities as a result of the housing and mortgage crisis.
Today I would like to share my thoughts about the problems in housing markets and
mortgage lending, with a focus on how they affect communities. Every time someone talks of
troubled mortgages on bank balance sheets, they are also talking about distressed
homeowners, distressed neighborhoods and distressed communities. I've heard many of you
say to me, "We didn't cause this problem. We didn't make any subprime mortgages. It's not
fair that we should have to pay the price." I understand that many of you may be frustrated
because you feel you have acted in a prudent manner while others have not. But additional
parties are also suffering from the imprudent actions of others, such as the homeowners in
your community who dutifully pay their mortgages but still see their houses fall sharply in
value. More broadly, the recovery of the macroeconomy and the financial system are being
inhibited by ongoing problems in the housing and mortgage markets. At this moment, we all
simply need to do whatever we can to address the enormous challenges facing our
communities, including those of us who believe we were being prudent and were not a cause
of the difficulty in the first place. With that in mind, let me delve a bit more into the details of
the current housing problems and offer some thoughts about what might be done to improve
the situation.
The current weakness in housing markets
Housing activity remains extraordinarily weak. Sales of new and existing homes have been
running at a pace that is 60 percent of that seen at the peak in 2005. Single-family housing
starts are now less than one-quarter of their peak level. With the cutbacks in construction,
inventories of unsold new homes have declined, but the months' supply - that is, inventories
relative to sales - is still very high by historical standards. The inventory of existing homes for
sale is also quite elevated - and it would be even higher if not for would-be sellers who have
withheld or withdrawn their homes from the market amid poor selling conditions.
We have also seen sharp drops in home prices. When home prices were at their peak three
years ago, most analysts agreed that housing valuations seemed to be substantially higher
than warranted by fundamentals. However, home prices at the national level are now 18
percent off their peak, with some states, such as California and Florida, experiencing
declines on the order of 40 percent.1 These declines may have reversed much, or perhaps
all, of the earlier overvaluation. That said, futures markets and many analysts foresee further
declines. Expectations that house price declines have not yet reached their trough are
probably deterring some prospective homeowners from making purchases and thereby
contributing to the current weakness in housing demand.
A key factor inhibiting recovery is that the adverse conditions in the housing and mortgage
markets have been, and continue to be, mutually reinforcing. As I am sure you are painfully
aware, delinquencies on mortgages have risen sharply in recent years. By way of
background, the problems began in the nonprime mortgage market. As house prices boomed
in the middle part of this decade, mortgage originators relaxed underwriting standards and
extended mortgages with low or no down payments to households with weak credit histories
or those that did not fully document their income. Many of these loans had low initial interest
rates that reset to market rates after a couple of years, which resulted in a significant
increase in the monthly payment. Had house prices continued to rise, many borrowers would
have been able to refinance to avoid higher payments and perhaps to extract accumulated
home equity to use for future payments. However, the downturn in house prices meant that
many borrowers did not have sufficient equity to refinance. Payment problems began to rise,
which, in turn, led lenders to tighten standards and made it even more difficult for borrowers
to obtain new loans, which put even more upward pressure on delinquencies. Eventually,
investors became unwilling to fund higher-risk mortgages at any price.
Although the current problems appear to be rooted in high-risk subprime lending, I would like
to dispel the notion that these problems were caused in any way by Community
Reinvestment Act (CRA) lending. The CRA is designed to promote lending in low- to
moderate-income areas; it is not designed to encourage high-risk lending or poor
underwriting. Our analysis of the data finds no evidence, in fact, that CRA lending is in any
way responsible for the current crisis. In our analysis of loan originations, we found that
approximately 60 percent of higher-priced loans went to middle- or higher-income borrowers
or neighborhoods, which are populations not targeted by the CRA. Additionally, more than 20
percent of the higher-priced loans that were extended in low- to moderate-income areas, or
to low- to moderate-income borrowers, were loans originated by lenders not covered by the
CRA. In fact, the analysis found that only 6 percent of all higher-priced loans were made by
CRA-covered lenders to borrowers and neighborhoods targeted by the CRA. This very small
share makes it hard to imagine how CRA could have caused, or even contributed in a
meaningful way, to the current crisis. Further support for this conclusion comes from our
finding that serious delinquency rates for subprime loans are high in all neighborhood-income
categories, not only those in lower-income areas, as might be thought if the CRA were a
contributing force to the subprime crisis.2
The problems in the high-risk mortgage market, together with the more general pullback in
risk-taking across virtually all financial assets, reduced the willingness of lenders to fund all
types of mortgages. We are now seeing widespread payment problems in every category of
mortgages. To be sure, the deterioration partly reflects households straining to meet their
mortgage obligations amid the broader weakening of macroeconomic conditions. However, it
also reflects the fact that reduced home equity and tighter mortgage credit have impaired
borrowers' ability to refinance their mortgages in order to cope with income loss, unexpected
expenses, or adverse life events.
According to the latest data, 25 percent of subprime loans and 13 percent of near-prime
loans are now seriously delinquent - that is, more than 90 days past due or in foreclosure.
The serious delinquency rate for prime mortgages, at between 3 percent and 4 percent, is
much lower than for nonprime loans, but it has doubled over the past year. Foreclosures
have also risen sharply. The available data suggests that lenders initiated 2-1/4 million
foreclosures last year, more than twice the number seen in 2006.3 In the past, about one-half
of foreclosures initiated were cured through a repayment plan or some other arrangement,
but the remaining one-half resulted in the loss of a home. The share resulting in home loss
could well be higher now given the large numbers of distressed households and the bleak
underlying economic conditions.
Addressing the problems in housing and mortgage markets
Several considerations underscore the need for policymakers to take further actions to
address the current problems in the housing and mortgage sectors. To begin, the weakness
in the housing sector remains a significant drag on the macroeconomy and is reinforcing the
strains in the financial system. Moreover, the wave of foreclosures has the potential to
exacerbate the problems going forward. In past housing cycles, house prices have tended to
fall below the level warranted by fundamentals, presumably as weak market conditions led
sellers to make aggressive price cuts. The potential for an overcorrection of house prices in
this cycle seems particularly acute given the potential for foreclosures to create a glut of
properties for sale. A high level of foreclosures results in lower prices, and lower prices tend
to accelerate the pace of foreclosures. And, of course, further large declines in house prices
would accentuate the broader problems in the macroeconomy and financial system through
the channels that I just discussed.
Foreclosures also cause significant distress among the families that lose their homes.
Whether the foreclosure is the result of inadequate underwriting by the mortgage lender,
irresponsibility on the part of the homeowner, or uncontrollable life events such as job loss,
the result is the same: Displaced families with depleted resources and impaired credit have
difficulty finding a new place to live. They may have to move significant distances, which may
affect their ability to retain their jobs and disrupt other aspects of their lives as well as the
lives of their family members. In addition, one in five foreclosures appears to be affecting
renter-occupied units. The families in these units may also be displaced, even if they are
paying their rent on time and abiding by the terms of their lease agreement.
Such disruptions, apart from creating personal and emotional strains, can also have
detrimental economic effects. Large numbers of displaced families will further strain
inadequate supplies of rental housing that are affordable to low- and moderate-income
families. Although the overall supply of rental housing has been slowly expanding in recent
years, new units have largely been built for the higher end of the market, with median asking
rents being 38 percent higher than average, while more-affordable units have been
demolished or permanently removed from the inventory.4 In the current environment, this
lack of new production has been exacerbated by the restricted availability of financing for
multifamily housing, reduced support by government-sponsored enterprises for multifamily
housing, and lower utilization of the Low Income Housing Tax Credit program.
In areas where foreclosures are concentrated, communities will suffer. Clusters of vacant
properties can foster crime, such as vandalism and arson, and studies have shown that they
lead to lower house prices throughout the neighborhood.5 Municipal governments may have
to spend more on maintaining properties and preventing crime just when resources are
stretched thin, in part because of the reduced tax revenue associated with lower house
prices. Such spending may well crowd out the provision of other types of public services.
Fiscal and monetary stimulus directed at improving employment conditions and federal
support for housing finance will ultimately strengthen the housing market. However, we also
need measures that directly address the foreclosure problem associated with the current
crisis. In designing such measures, we must consider that there are different types of
borrowers. First, there are distressed borrowers who can avoid foreclosure through an
appropriate modification of their loan. Second, there are some borrowers who, due to
resources or circumstance, will be unable or unwilling to sustain their mortgage payments
even with reasonable loan adjustments from the lender or support from government
programs. In such cases, foreclosures will happen, and we need to limit both the direct costs
to the lender and the borrower as well as the broader social costs. Of course, there is a third
group of borrowers - those who are still successfully meeting their mortgage obligations.
One might be tempted to view these households as a lesser concern, but we must be mindful
that they will be more likely to shift into one of the distressed groups if we do not reduce both
the number of foreclosures and the cost of the foreclosures that do occur.
Reducing preventable foreclosures
To help those distressed households for which foreclosure can be prevented, servicers must
implement effective and sustainable modifications. Key private and public steps toward
preventing unnecessary foreclosures have already been taken, but much more must be
done. While community bankers typically do not have large portfolios on which to perform
wholesale modifications, I would urge you to be sure that you are making reasonable
accommodations whenever possible to keep homeowners in their homes.
While speed and volume in modifications are important, in my view, it is equally essential that
the new obligations be sustainable in the long run. By "sustainable" I mean that the payment
should be fixed for the life of the loan, it should be affordable, and it should be based upon
verified income. In changing the terms of the mortgage, servicers may start with changing the
interest rate or adjusting the maturity to make the payments more affordable, but they also
need to consider whether writing down loan principal amounts make sense. Doing the latter
may be more effective at reducing the probability of redefault.6 These design principles for
modifications are all included in the Homeownership Preservation Policy recently adopted by
the Federal Reserve Board.7 The Federal Reserve announced that it would apply this policy
to the residential mortgage assets held by the special purpose vehicles established by the
Federal Reserve to facilitate the acquisition of Bear Stearns by JPMorgan Chase and to
assist the American International Group, Inc.
Reducing the costs when foreclosures cannot be prevented
Without in any way minimizing the need for continued emphasis on foreclosure prevention, I
don't believe we can fully formulate appropriate policy responses to the crisis unless we
acknowledge and address the large numbers of foreclosures that are not avoidable. We are
likely only beginning to see the serious costs of the foreclosures that have already been
initiated, both because of the often-substantial amount of time required to complete a
foreclosure and because the costs likely compound as the number of foreclosures grows
larger. Moreover, even under optimistic assumptions for the number of loan modifications
and other forms of private and public assistance that may be realized, the pace at which
foreclosures are initiated is likely to remain extremely elevated for some time. Just as public
focus, experimentation, and policy debate have informed best practices with regard to loan
modifications, we must also begin the work of developing responsible protocols for the
management of foreclosures and real estate inventory. Minimizing the amount of time that
properties remain vacant and maximizing the price at which they are sold will serve the
interests of both lenders and the communities. During the time properties do remain vacant,
servicers have a responsibility to follow local codes and ensure that the properties are
secured and maintained. At this moment, lenders and communities alike are woefully
underresourced and unprepared for the volume of real estate that will need to be processed.
Some attention has already been focused on getting renters or owners into real estate
owned (REO) and vacant properties and thus off of servicers' books - something that is in
the shared interest of servicers, investors, and communities, particularly as the inventories of
these types of properties mount. At the national level, there is some movement to enable
state and local governments, as well as nonprofits, to purchase properties from servicers'
REO inventories where sales are otherwise stagnant. Such efforts are challenging in many
areas because of a lack of financial resources and experience in the kinds of activities that
are required. Some help will be provided through the Housing and Economic Recovery Act of
2008, in which the Congress set aside $3.92 billion to assist state and local governments
with REO purchases and related efforts. The Department of Housing and Urban
Development created the Neighborhood Stabilization Program (NSP) to distribute these
funds.
Many servicers are stepping up their efforts to sell their large and growing inventories of REO
properties, although setting an appropriate price in the current environment remains difficult.
To facilitate REO sales, the National Community Stabilization Trust (NCST), a new entity
formed by four national nonprofit intermediaries, is trying to create a common platform for
servicers to efficiently sell REO properties to public entities and nonprofit organizations.
Some REO owners, such as Fannie Mae, are also creating dedicated sales channels to sell
REO properties to public entities and nonprofits, either through the NCST or through
discounted bulk sales. And some local governments are crafting comprehensive approaches
using the NSP funds to bring in private- and public-sector entities to manage and sell REO
inventories.
The Federal Reserve has also taken steps to help address the costs of foreclosures on
communities. The Community Affairs offices of the Board of Governors and all 12 Reserve
Banks held a series of forums in 2008, entitled "Recovery, Renewal, Rebuilding," that
explored the problems and highlighted promising solutions. We have also partnered with
NeighborWorks America to support its efforts to help community leaders grappling with these
issues; that effort has led to the creation of new tools, training, and the spread of information.
But current efforts are not sufficient to deal with the scale and scope of the problem, and
more needs to be done. State and local governments and nonprofits are working hard but
often lack the capacity and scale to address the magnitude of the REO disposition problem.
More dollars alone will not solve this problem. State and local governments need to do more
to partner with private-sector entities that have experience managing scattered-site housing
inventories, including rental housing. In addition, we need to make sure that we are using all
of the available public-sector capacity - such as state housing finance agencies and local
public housing authorities - that have experience managing affordable rental housing
inventories. Finally, we need to do more to explore creative solutions to speed the acquisition
of REO properties so that they do not languish vacant.
Given the likely number of properties that will enter foreclosure and the time and resources
involved in the foreclosure process, financial institutions can help minimize the cost by
developing clear policies and procedures for approval of short sales and
deeds-in-lieu-offoreclosure. For homeowners who cannot, or no longer wish to, stay in their homes, such
strategies release them from their obligation and avoid foreclosure. Some institutions already
offer a so-called fresh start or cash-for-keys program, in which they provide a small payment
to consumers in exchange for voluntarily surrendering the deed to the home. Such
arrangements reduce the cost of foreclosure and provide consumers with relocation
assistance. Other lenders are offering borrowers the option to remain in their home as
renters rather than owners. More lenders should consider these options, perhaps in
conjunction with loan modification programs, as further inducement for borrowers to engage
in discussions about loan resolution. At the same time, governments might develop policies
to accelerate foreclosure in cases where the property has been vacated and the lender has
agreed to secure and maintain the property.
If renters occupy the property, servicers of REO properties should extend existing lease
arrangements whenever possible and while tenants are abiding by the terms of their lease.
Some REO owners, including Fannie Mae and Freddie Mac, are already taking steps to
minimize the disruption and displacement to renters living in foreclosed-upon properties. If a
property is likely to sit vacant for long periods of time and create problems for the
surrounding area, servicers might consider sale of REO properties to, or partnerships with,
responsible third parties, including local governments and nonprofit groups.
Financial institutions should look for ways to partner with community groups and
governments to support strategies to stabilize communities affected by foreclosure. They can
bring invaluable technical capacity to plan and execute stabilization efforts. Banks can also
support efforts to reuse REO properties by providing home loans to new homebuyers and by
financing nonprofit entities and others for the acquisition and rehabilitation of REO properties.
In addition, they can help victims of foreclosure to rebuild their credit histories and thereby
facilitate their re-entry into the economic mainstream.
Finally, regulators should consider whether existing regulations regarding real estate held for
extended periods of time on bank balance sheets act as an obstacle to creative solutions to
the foreclosure problem.
Conclusion
In summary, broad policy measures are a central ingredient to restoring the health of the
U.S. economy and global financial system. However, as I have discussed today, there is also
a pressing need for more targeted policy measures that specifically address the current
problems in the housing sector. We need considerable public support for housing finance
until private credit and securitization markets are restarted. We need to strengthen and
augment our efforts to reduce preventable foreclosures. In addition, we need to turn far
greater attention to limiting the costs of foreclosures that do occur. Such efforts are not only
in the interest of the families who are directly affected and their immediate communities, but
are also in the interest of the financial institutions involved and the broader economy.
Because much of the cost does not occur as soon as a foreclosure has been initiated and
can grow with time, we must be forward-looking and affirmatively engage in efforts to
mitigate the consequences now.
As community bankers, you have a long history of engagement in your communities. You
have served on the boards of public and nonprofit entities focused on housing. You have
built Habitat for Humanity houses, and you have rebuilt entire neighborhoods following
natural disasters. Your financial resources will be needed as we work toward solutions for the
current crisis, but, even more important, your experience, expertise, contacts, and creativity
will be needed. If you believe in the saying that "all real estate markets are local," you also
understand that it will take local knowledge to assess community needs and craft solutions. If
you are not quite sure where to start, contact your local housing nonprofit or Federal Reserve
Bank. Contact municipal authorities or housing counselors. Partner with other banks in your
market or do it alone. But do it today. As always, your communities depend on you.