Elizabeth A Duke: Stabilizing the housing market - next steps
Speech by Ms Elizabeth A Duke, Member of the Board of Governors of the US Federal
Reserve System, at the Global Association of Risk Professionals' Risk Management
Convention, New York, 11 February 2009.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal Reserve
System's website.
* * *
In the summer of 2007, the U.S. and global economies entered a period of unprecedented
financial turmoil, which has since led to a significant slump in macroeconomic activity.
Problems in both the housing sector and the housing finance sector played a central role in
precipitating the crisis, and ongoing weakness in housing activity, along with persistent
strains in mortgage markets, continue to inhibit a broader recovery. In particular, we have
entered a cycle where high levels of default on mortgage debt have led to a reduction in the
availability of mortgage debt as well as a tightening of terms for it. This situation has led to
lower levels of home sales and prices paid for homes, which, in turn, contributes to yet more
defaults by borrowers. As financial risk managers, I am sure you are aware of the important
steps that have already been taken to try to break this cycle, but that you also recognize the
need to do more. My remarks today will focus on the next steps - efforts to increase demand
for homes, efforts aimed at further reducing preventable foreclosures, and efforts aimed at
limiting the costs imposed on households and communities by foreclosures that cannot be
avoided. Both the government and the private sector have important roles in these efforts.
These suggestions and recommendations are my opinion alone and do not reflect the views
of other members of the Federal Reserve Board or any other government entity.
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 that 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withheld or withdrawn their homes from the market amid poor selling conditions.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 looked to be substantially higher
than warranted by fundamentals. However, home prices at the national level are now 17
percent off their peak, with some states, such as California and Florida, seeing declines on
the order of 40 percent.1 These declines may have reversed much, or perhaps all, of the
earlier overvaluation.
Notwithstanding this correction, all indications are that the softness in housing activity is likely
to persist for some time. In normal times, population growth and the attendant formation of
new households tend to support housing demand. Indeed, by some estimates, the current
stock of housing is not high relative to the number of housing units that would be predicted
by long-run trends in household formation. However, the actual number of households has
fallen well short of trend household formation. Macroeconomic conditions no doubt explain
part of the shortfall in household formation, as, for example, younger people facing weak job
prospects defer striking out on their own. More generally, the soft economy has diminished
demand for housing among already-established households. High rates of job loss and weak
income growth are directly reducing what some individuals can spend on housing, and the
prospect of losing a job or suffering an income loss is damping the housing demand of
others.
The cost and availability of mortgage credit is also bearing critically on housing demand. With
private-label securitization markets almost completely closed, most purchases are financed
with some form of government-supported credit. Purchasers with strong credit histories and
sufficient down payments can obtain a "conforming" mortgage, one that can be sold to the
housing government-sponsored enterprises (GSEs). Loans insured through the Federal
Housing Administration (FHA) are also available to eligible borrowers, who have historically
been first-time homebuyers, borrowers without significant down payments, and higher-risk
borrowers. In addition, veterans with eligibility can obtain virtually 100 percent financing
through VA loans.
However, households without access to government-supported programs are having much
more difficulty obtaining a mortgage than in the past. One obstacle is that the private
mortgage securitization markets that previously supported most non-GSE mortgage lending
are now shut down. Subprime and near-prime mortgages - which traditionally were funded
almost exclusively through securitization - are essentially unavailable, leaving those
higherrisk households that do not qualify for FHA programs without access to mortgage credit.
Prime jumbo mortgages are still available for those seeking to finance a more expensive
home, but lenders are being more selective, and spreads to conforming rates remain very
high. In addition, the availability of products that complement conforming loans is impaired.
For example, second liens are more difficult and more expensive to obtain, which has
deterred some households from making purchases that previously would have been financed
by combining a conforming loan with a second lien that would cover some additional amount.
Access to private mortgage insurance is more restricted, which holds back some households
that lack a sufficient down payment but otherwise qualify for a conforming mortgage.
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 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 high-risk mortgages at any price.
While the high delinquency levels and subsequent pullback of credit for subprime loans was
certainly foreseeable, what was less obvious was the degree to which problems in the
subprime market would spread to the market for prime loans. Loans in the prime loan market
are going delinquent for all the traditional reasons: economic conditions and life events, such
as job loss, medical problems, and divorce. In a rising or even stable price environment,
these delinquencies would often be cured through refinance or sale of the property, which
would result in low levels of actual foreclosure. However, loss of equity and tighter standards
on all types of mortgages mean that even prime loans are more difficult to refinance, and
weak housing demand has made it difficult to sell.
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 almost doubled over the past year.
Foreclosures have also risen sharply. The available data suggest that lenders initiated 2-1/4
million foreclosures last year, more than double the number seen in 2006.2 While the
percentage of mortgages entering foreclosure is likely to increase further, the decline in the
number of subprime loans means that this percentage will be applied to a smaller base of
loans, which will tend to damp the overall number of foreclosures. 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. So, even if the number of foreclosures initiated begin to
drop, we are still likely to see higher levels of property taken into real estate owned (REO) as
foreclosures initiated earlier are completed and the share of those foreclosures resulting in
the loss of a home increases.
Addressing the problems in housing and mortgage markets
Several considerations underscore the need for policymakers to take further actions to
address the problems in housing and mortgage markets. 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. 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.
In addition, foreclosures 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 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.
The effects of foreclosures extend beyond these immediate families. 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. In areas where foreclosures are concentrated, communities will suffer. Clusters
of vacant properties can foster vandalism and crime, and studies have shown that they lead
to lower house prices throughout the neighborhood.3 Municipal governments may have to
spend more on maintaining properties and preventing crime, such as vandalism and arson,
just when resources are stretched thin, in part because of the lower 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. In designing such measures,
we must consider the 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 borrower and 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 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. For example, the industry-led
Hope Now Alliance - a coalition of mortgage servicers, lenders, housing counselors, and
investors - has produced loss mitigation guidelines for servicers. In addition, Hope Now
members have agreed to adopt a streamlined modification program for certain loans that
they service for the GSEs. Among government efforts, the FHASecure program provided
long-term fixed-rate mortgages to borrowers facing a rise in payments due to an interest rate
reset. The more recent FHA "HOPE for Homeowners" (H4H) program, on whose oversight
board I sit, allows lenders to refinance a delinquent borrower into an 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 equity created through the
refinancing and any subsequent appreciation of the home with the government.
Although the pace of loan modification has picked up over the past year, more needs to be
done. Indeed, many cases still seem to be appearing in which foreclosure is occurring even
though both the borrower and lender would benefit from avoiding that outcome. There are
several potential ways that the Congress and policymakers could help expand the number of
at-risk borrowers who can obtain assistance and reduce the incidence of preventable
foreclosures. For example, the impact of the H4H program has so far been limited because
of the terms and conditions for program loans mandated by the authorizing legislation and
because of the general reluctance of servicers and lenders to write down the principal of
delinquent mortgages. The Congress is currently considering several modifications to the
H4H program that have the potential to make the program more attractive to both servicers
and homeowners. These modifications include eliminating the upfront mortgage premium
that must be paid by the owner of the current mortgage and the requirement that borrowers
share with the government a portion of any future appreciation in the property. Among other
options that the Congress or the government might consider is reducing the interest rate that
H4H borrowers pay, either through a direct subsidy or through Treasury purchases of the
relatively illiquid Ginnie Mae securities to which the borrowers' interest rate is tied. The
government might also consider purchasing delinquent or at-risk mortgages in bulk and then
refinancing them into the H4H or other FHA programs.
In addition, government funds might be used to offer some general inducement for servicers
to modify loans at risk of default. For example, the Federal Deposit Insurance Corporation
(FDIC) has proposed that, for loans modified in accordance with a streamlined process
adapted from the protocol that the FDIC has used for IndyMac loans, the government would
agree to absorb some of the losses on the modified loans that redefault. Another approach
would have the government share with the servicer the cost of a reduction in the borrower's
monthly payment. Alternatively, the government might make payments directly to
homeowners who - because of temporary job loss or a similar event - need help meeting
their mortgage obligations.4 Because institutional and legal obstacles may be holding back
modifications by servicers, these plans could be effective ways to deliver assistance to some
distressed homeowners.5
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 will 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.
Although it is encouraging that so many policymakers are focused on the issue of loan
modifications and making thoughtful proposals, I think it is equally important that the
government decide how it wishes to move forward, and then do so. As long as uncertainty
exists as to the scope and terms of the additional steps that likely will be offered, borrowers,
lenders, and servicers will continue to hold out in hope of securing a better deal. In this case,
the cost of delay could easily outweigh the differences in outcome between the proposals.
For these reasons, I am pleased that the Administration is moving ahead on this front.
4
See, for example, Chris Foote, Jeff Fuhrer, Eileen Mauskopf, and Paul Willen (2009), "A Proposal to Help
Distressed Homeowners: A Government Payment-Sharing Plan," Federal Reserve Bank of Boston (January
15).
5
For a discussion of these obstacles, 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).
6
The available evidence, though not conclusive, suggests that the homeowner's equity position is, along with
affordability, an important determinant of default rates, for owner-occupiers as well as investors. See Shane
Sherlund (2008), "The Past, Present, and Future of Subprime Mortgages," Finance and Economics
Discussion Series 2008-63 (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," Public Policy Discussion Papers 08-3 (Boston: Federal Reserve Bank of Boston, June); and
Andrew Haughwout, Richard Peach, and Joseph Tracy (forthcoming), "Juvenile Delinquent Mortgages: Bad
Credit or Bad Economy?" Journal of Urban Economics.
7
See Board of Governors of the Federal Reserve System (2009), "Board Announces Policy to Help Avoid
Preventable Foreclosures on Certain Residential Mortgage Assets Held, Owned, or Controlled by a Federal
Reserve Bank," press release, January 30; and Board of Governors (2009), "Homeownership Preservation
Policy for Residential Mortgage Assets," Board policy, January 30.
BIS Review 15/2009
Reducing 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 foreclosure and real
estate inventory management protocols. 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. At this moment, lenders and communities alike are woefully
under-resourced and unprepared for the volume of real estate that will need to be processed.
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 would release them from their obligation and avoid foreclosure. Some institutions
offer a so-called fresh start or cash-for-keys program, in which they provide a payment to
consumers in exchange for voluntarily surrendering the deed to the home. Such
arrangements reduce the cost of foreclosure and effectively provide the borrower with funds
that can help offset some of the expenses associated with relocation. Other lenders are
offering borrowers the option to remain in the house as renters rather than owners. Options
such as these could be offered in conjunction with loan modification programs as further
inducement for borrowers to engage in loan resolution discussions.
If renters occupy the property, servicers of REO properties should extend existing lease
arrangements, when 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.
Vacant properties are especially problematic for communities. Ideally, lenders would identify
early in the process whether or not property securing delinquent loans is occupied and, if
occupied, by whom. Lenders might be provided the incentive to do so if foreclosure laws
permitted lenders who agree to secure and maintain the property to accelerate foreclosure in
cases where the property has been vacated. 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. And financial institutions should look for ways to partner
with community groups and governments to support strategies to stabilize communities
affected by foreclosure. Last summer, the Congress set aside $3.92 billion through the
Housing and Economic Recovery Act of 2008 to assist state and local governments with
REO purchases and related efforts. It is likely that such efforts will require significantly more
funding. In addition, regulators should consider whether to review regulations regarding real
estate held for extended periods of time on bank balance sheets to be sure that they do not
preclude creative solutions to the foreclosure problem.
The last credit cycle primarily involved loans secured with commercial property. The
properties liquidated by banks and the Resolution Trust Corporation weighed on commercial
property values for years. This time we are talking about homes, and we are talking about
neighborhoods. Whether mortgage assets are taken off banks' balance sheets, ring fenced,
or left alone, the REO problem remains the same. Regardless of which entities actually own
the loan assets - be they financial institutions, investors, or government entities - the
servicers who represent them are going to have to deal with large real estate inventories.
Wholesale dumping of those inventories that leads to sharply lower prices and recovery rates
will not serve the interests of the public or the investors. But strategies to avoid dumping and
to maximize the ultimate value of the properties could be beyond the normal liquidity and
expertise resources of servicers. To avoid such an outcome, owners of the assets will need
to adequately fund servicers or separately engage property managers. For example, they
may need funding to repair and improve properties, which will lead to higher returns than
sale of those same properties in "as is" condition. They may need to offer seller financing.
Bulk sale or land banking strategies may offer the best likely outcome. In the most recent
credit cycle, much of the commercial inventory was sold through auction, and many of the
buyers realized a substantial profit. Using today's technology, Internet auctions could
increase the pool of potential buyers as well as price transparency.
Conclusion
In summary, broadly targeted policy is 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 policy measures that specifically address the 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 affected
families and their communities but also in the interest of the financial institutions involved and
the broader economy. Because much of the costs do not occur immediately after 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.