Susan Schmidt Bies: A supervisor's perspective on mortgage markets and
mortgage lending practices
Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve
System, at the Mortgage Bankers Association Presidents Conference, Half Moon Bay, California,
14 June 2006.
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Good morning. It is a pleasure to be here today, and I thank you for the invitation. It almost goes
without saying that over the past several years, residential housing markets have been attracting
considerable attention, and they have been a strong contributor to the overall growth of the U.S.
economy. Today I would like to offer some thoughts on the current state of both residential and
commercial mortgage markets and then discuss some ways in which U.S. bank supervisors are trying
to ensure that bank lending in those markets is safe and sound.
Conditions in real estate markets
Residential real estate markets
Activity in U.S. housing markets is slowing. Incoming data point to a decided, but so far moderate,
cooling. Starts of single-family houses fell appreciably in March and April. Because construction had
been spurred in the preceding months by unusually mild weather, some slowing in the spring was
natural. However, the level of housing starts lately has fallen below not just the elevated winter pace
but also the pace of last fall. Indeed, construction permit issuance for single-family homes, which is
less affected by the weather, has been declining since September. Sales of new and existing homes
have dropped noticeably from their highs of last year. In addition, inventories of unsold homes have
increased, and your own MBA index of loan applications for home purchases has trended lower in
recent months.
Although a slowdown in housing activity is apparent in a wide range of indicators, it seems to be
occurring in a gradual way. Notwithstanding their recent slip, both home construction and home sales
are still at relatively high levels. The underlying fundamentals of housing demand also remain
favorable. Real disposable income is growing at a solid pace. In the aggregate, household balance
sheets appear to be in a good position, even though risks clearly exist for some households.
Longterm mortgage rates, although up substantially from last summer's level, remain low relative to their
historical experience.
The latest data on house prices from the Office of Federal Housing Enterprise Oversight suggest that
house-price appreciation has moderated but that prices in the aggregate continue to move up.
Between the first quarter of 2005 and the first quarter of this year, the price index for existing homes
sold in repeat transactions increased 10 percent - a solid gain but down a bit from the record pace for
the period mid-2004 to mid-2005. Focusing on the first quarter of 2006 alone, prices increased at an
annual rate of 7.3 percent. However, quarterly figures should be treated with a good degree of caution
given the volatility of this data series.
Given the slowing conditions in the housing market, spending for the construction of new housing is
unlikely to be an important direct source of overall GDP growth this year, after having contributed
close to 1⁄2 percentage point last year. In addition, the slackening of house-price appreciation could
hold back growth in consumption spending through the so-called wealth effect, or the effect that lower
overall housing wealth has on consumption. Estimates from various econometric models of consumer
spending suggest that each dollar of change in wealth is associated with a change in consumption of
approximately 31⁄2 cents, with roughly half of the effect occurring within a year.
Of course, these consumption estimates are just that - estimates. Beyond the usual issues of
measurement and interpretation associated with any statistical estimate, one can easily point to some
specific risks in estimating how housing wealth affects spending. First, econometric modeling has had
difficulty distinguishing between the effects of movements in housing wealth and movements in other
components of household balance sheets, even though housing may be a unique asset in a number of
ways. Thus, the estimate of change in consumption that I cited is based on the historical relationship
between spending and changes in overall wealth. Changes in housing wealth may have a somewhat
different effect. Second, the linkages between housing wealth and consumption may change over
time. For example, these linkages may be stronger now than in the past because financial innovation
has made it easier and less costly for households to tap their accumulated housing equity. Third, a
pronounced deceleration in house prices could have an outsized effect on consumer confidence, and
such a decline in confidence could be an additional damping force on consumption.
Another housing-related issue that bears watching is mortgage debt accumulation. Since the end of
2002, home mortgage debt outstanding has risen about 50 percent. The increase has substantially
pushed up homeowners' mortgage payments in relation to their income, in spite of historically low
mortgage rates, the growing use of interest-only mortgages, and the lengthening of average loan
maturities over the past few years. That said, homeowners appear to be able to manage these higher
payments: we have seen only a little deterioration in mortgage credit quality as yet, and overall
delinquency rates remain low. Going forward, I expect aggregate homeowner mortgage payments to
continue to rise, especially as adjustable-rate mortgages reach their initial reset dates. However, these
reset adjustments are expected to be gradual, and only a modest number of outstanding mortgages
are expected to reset during 2006 and 2007. To date, consumers appear to be managing changes in
their mortgage payments quite well.
One area of potential concern relates to the portion of home sales accounted for by investors, as
opposed to owner-occupants. Historically, only around 5 percent of U.S. homes were purchased each
year by investors; in 2005, it appears that figure was considerably higher. In many cases, investors
purchased homes because they believed prices were going to rise further, not necessarily because
they wanted to retain the property over time for rental income. As prices level off or even decline, it will
be important to see whether this investor activity subsides significantly, and if so, the impact on
mortgage markets more broadly.
Commercial real estate markets
In addition to monitoring residential markets, the Federal Reserve keeps a close watch on
developments in commercial real estate markets. Overall, conditions in this sector appear to be
improving. Demand for commercial space has been growing moderately, while the construction of new
space has generally remained tame, restrained in part by steep land prices and high construction
costs. The result has been a widespread decline in vacancy rates over the past few years. Reflecting
this improved balance between demand and supply, rents on commercial properties have been
increasing after a prolonged period of softness.
Although the level of commercial construction remains well below its peak in 2000, the latest data
indicate what may be the beginning of a pickup. Census Bureau data on nonresidential construction
put in place suggest that real spending rose in April for the sixth consecutive month. Leading
indicators of commercial construction spending, such as billings by architectural firms for design work,
point to further increases in activity in coming months. An upturn in commercial construction could
offset part of what is anticipated to be a waning contribution to GDP growth from the housing sector.
The performance of commercial real estate loans has generally been very good, due in large part to
the low interest rates of recent years and the substantial appreciation of property values that has
resulted in sizable equity positions for building owners. Delinquency rates on loans held by commercial
banks and life insurance companies remain low by historical standards, and delinquencies on
commercial mortgage-backed securities have reversed the modest increase that occurred from 2000
to 2003. The latest information on property prices hints at some moderation in price increases in the
first quarter from the rapid price appreciation of last year. But, as in the housing market, commercial
real estate prices are continuing to rise in the aggregate.
Recent supervisory guidance relating to real estate lending
The Federal Reserve will continue to monitor developments in the residential and commercial real
estate markets very closely. In addition to scrutinizing the effect of these developments on the
economy, we are also, in our role as bank supervisors, monitoring banks' mortgage lending practices.
Last year, the federal bank regulatory agencies issued draft guidance on both residential and
commercial mortgage lending. The agencies have received many comments on the proposed
guidance, including comments from your association, which we will consider as we discuss what steps
to take next. I will address the guidance on residential mortgage lending first.
Nontraditional mortgage products
Over the past few years, the agencies have observed an increase in the number of residential
mortgage loans that allow borrowers to defer repayment of principal and, sometimes, interest. These
loans, often referred to as nontraditional mortgage loans, include interest-only (IO) mortgage loans, for
which the borrower pays no loan principal for the first few years of the loan, and payment-option
adjustable-rate mortgages (option ARMs), for which the borrower has flexible payment options - and
which could result in negative amortization.
IOs and option ARMs are estimated to have accounted for almost one-third of all U.S. mortgage
originations in 2005, compared with fewer than 10 percent in 2003. Despite their recent growth,
however, it is estimated that these products still account for less than 20 percent of aggregate
domestic mortgages outstanding of nearly $9 trillion. Although the credit quality of residential
mortgages generally remains strong, the Federal Reserve and the other banking supervisors are
concerned that banks' current risk-management techniques may not fully address the level of risk
inherent in nontraditional mortgages, a risk that would be heightened by a downturn in the housing
market.
Mortgages with some of the characteristics of nontraditional mortgage products have been available
for many years; however, they have historically been offered to higher-income borrowers. More
recently, nontraditional mortgages have been offered to a wider spectrum of consumers, including
subprime borrowers, who may be less suited for these types of mortgages and may not fully recognize
their embedded risks. These borrowers are more likely to experience an unmanageable payment
shock during the life of the loan, meaning that they may be more likely to default on the loan. Further,
nontraditional mortgage loans are becoming more prevalent in the subprime market at the same time
risk tolerances in the capital markets have increased. Banks need to be prepared for the resulting
impact on liquidity and pricing if and when risk spreads return to more "normal" levels and competition
in the mortgage banking industry intensifies.
Supervisors have also observed that lenders are increasingly combining nontraditional mortgage loans
with weaker mitigating controls on credit exposures - for example, by accepting less documentation in
evaluating an applicant's creditworthiness and not evaluating the borrower's ability to meet increasing
monthly payments when amortization begins or when interest rates rise. These "risk layering"
practices have become more and more prevalent in mortgage originations. Thus, although some
banks may have used some elements of nontraditional mortgage products successfully in the past, the
recent easing of traditional underwriting controls and the sale of nontraditional products to subprime
borrowers may contribute to losses on these products.
Supervisors are concerned that banks may not be fully aware of the potential risks of using
risklayering practices with nontraditional mortgage products. These practices may have become more
widespread over the past couple of years as competition for borrowers and declining profit margins
may have forced lenders to loosen their credit standards to maintain their loan volume. In the Federal
Reserve Board's most recent Senior Loan Officer Survey, conducted this past April, more than 10
percent of the surveyed institutions reported having eased their underwriting standards for residential
mortgage loans. Only one of the surveyed lenders reported having tightened standards. Additionally,
information from other sources seems to show continued growth in the number of borrowers
purchasing real estate with no equity using simultaneous second liens.
Naturally, we are watching for any signs that defaults may be on the rise. Some industry evidence
indicates that delinquencies may be on the uptick; delinquency rates for loans issued in 2005 are, in
most cases, higher than those for comparable loans issued in earlier years. Some industry observers
believe that the increase in delinquencies for loans issued in 2005 is directly related to the continued
easing of underwriting standards and the increased use of risk-layering practices.
The industry trends I have just described, taken together, were the justification for the issuance of draft
guidance on nontraditional mortgage products by the Federal Reserve and the other banking
agencies. The proposed guidance emphasizes that an institution's risk-management processes should
allow it to adequately identify, measure, monitor, and control the risk associated with these products. It
reminds lenders of the importance of assessing a borrower's ability to repay the loan, both now and
when amortization begins and interest rates rise. Nontraditional mortgage products warrant a bank
having strong risk-management standards as well as appropriate capital and loan-loss reserves.
Further, bankers should consider the impact of prepayment penalties for ARMs. Lenders should
provide enough information so that borrowers clearly understand, before choosing a product or
payment option, the terms of and risks associated with these loans, particularly the extent to which
monthly payments may rise and negative amortization may increase the amount owed above the
amount originally borrowed. Lenders should recognize that certain nontraditional mortgage loans are
untested in a stressed environment; for instance, nontraditional mortgage loans to investors that rely
on collateral values could be particularly affected by a housing-price decline. As noted, investors have
represented an unusually large share of recent home purchases. Past loan performance has indicated
that investors are more likely than owner-occupants to default on a loan when housing prices decline.
When credit standards are eased and risks are layered, institutions should compensate for the
increased risk with mitigating factors that support the underwriting decision. Among other credit
enhancements, these factors generally include requiring borrowers to have higher credit scores, lower
loan-to-value and debt-to-income ratios, and significant liquidity and net worth. Finally, lenders should
establish appropriate allowances for estimated credit losses in their nontraditional mortgage portfolios
and hold capital commensurate with the risk characteristics inherent in these products.
One final subject that is not addressed explicitly in our draft guidance, but that I believe is still
important to supervisors and bankers, is mortgage fraud. There appears to have been a substantial
upswing in suspected fraud related to residential mortgages in the past decade. Types of fraud include
falsification of loan applications, identity theft, misuse of loan proceeds, and inflated appraisals.
According to the Financial Crimes Enforcement Network, there were more than 18,000 reports of
suspected mortgage fraud in 2004 (the latest year for which we have complete data), compared with
fewer than 2,000 reports in 1997. And in the first six months of 2005 alone, there were more than
11,000 reports of suspected mortgage fraud. The increase may be attributable in part to an increase in
the number of originators required to file Suspicious Activity Reports (SARs). Notably, the more
widespread use of nontraditional loan products may present greater opportunity for fraud, as these
products sometimes lack some of the quality checks typical of more-traditional mortgages. In general,
we consider mortgage fraud to be a serious issue and one that bankers and supervisors must continue
to confront. Of course, supervisors want to hear the industry's perspective on fraud in mortgage
lending.
Commercial real estate
The U.S. banking agencies recently issued proposed guidance on commercial real estate (CRE)
lending. A major portion of that guidance focuses on CRE concentrations.
Before I discuss the importance of managing CRE concentrations, I want to emphasize that the
proposed CRE guidance relates to "true" CRE loans. It is not directed at commercial loans for which a
bank looks to a business's cash flow as the source of repayment and accepts real estate collateral as
a secondary source of repayment. The proposed guidance addresses bank loans for commercial real
estate projects for which repayment depends on third-party rental income or on the sale, refinancing,
or permanent financing of the property. The latter are "true" commercial real estate loans, in that
repayment depends on the condition and performance of the real estate market.
I also want to mention up front that the proposed guidance is not intended to cap or restrict banks'
participation in the CRE sector but rather to remind institutions that proper risk management and
appropriate capital are essential elements of a sound CRE lending strategy. In fact, many institutions
already have both of these elements in place and may not need to adjust their practices very much.
I believe we are all aware of the central role that CRE lending played in the banking problems of the
late 1980s and early 1990s. One reason supervisors are proposing CRE guidance at this point is that
we are seeing high and rising concentrations of CRE loans relative to capital. For certain groups of
banks, such as those with assets of between $100 million and $1 billion, the average CRE
concentration level is about 300 percent of total capital. In the late 1980s and early 1990s, the
concentration level for this same bank group was about 150 percent, or half the current level.
Therefore, banks should not be surprised by the emphasis in the proposed CRE guidance on
concentrations and the importance of portfolio risk management.
Historically, CRE has been a highly volatile asset class. In the past, problems in CRE, even at
wellmanaged banks, have generally come at times when the broader market was encountering difficulties.
In an effort to generate cash flow, borrowers and bankers with properties in distress may disrupt their
local real estate market by cutting rents or offering leasehold improvements and other incentives to
attract or keep tenants. These actions can have a negative effect on the entire local real estate
market, including good projects. In most years, CRE credit losses are relatively low compared with
many other types of bank loans. But in times of stress, the loss rate can jump considerably higher.
Because CRE losses tend to be greater during times of stress, bankers must focus more intently on
their risk appetite as their CRE concentration grows. Bankers must consider how much capital will be
placed at risk if the CRE portfolio hits a stress period and compare that loss exposure with the relative
returns of CRE lending. In other words, bankers need to practice risk management.
While banks' underwriting standards are generally stronger than they were in the 1980s and 1990s,
the agencies are proposing the guidance now to reinforce sound portfolio-management principles that
a bank should have in place when pursuing a commercial real estate lending strategy. A bank should
be monitoring performance both on an individual-loan basis as well as on a collective basis for loans
collateralized by similar property types or in the same markets.
Some institutions' strategic- and capital-planning processes may not adequately acknowledge the
risks from their CRE concentrations. CRE lending in recent years has occurred under fairly benign
credit conditions, but those conditions are unlikely to continue indefinitely. The ability of banks with
significant concentrations to weather difficult market conditions will depend heavily on their
riskmanagement processes and their level of capitalization. From a risk-management and capital
perspective, institutions should generally focus on the emerging conditions in their real estate markets
and on the potential cumulative impact on their portfolios if conditions deteriorate; they should also
take other measures to help identify CRE vulnerabilities. Of course, these measures should vary
according to the size of the organization and the level of the concentration. All of these steps are key
elements of a sound strategy to manage concentrations.
While supervisors continue to underscore the importance of having robust risk-management practices
for CRE and other lending concentrations, we do acknowledge that banks may pursue a variety of
approaches. In some cases, such as when there is not enough market data available or the relevant
geographic market is small, banks may have to turn to less- quantitative approaches. Nonetheless,
those approaches should be robust, well documented, and transparent. This is consistent with the
broader theme that risk management should be scaled to the institution. Along those same lines, we
are not necessarily expecting smaller banks to be able to conduct regular, extensive, and
sophisticated quantitative stress tests around their lending concentrations. However, we do want
bankers at smaller organizations to have clear and coherent methods for evaluating the various
potential outcomes associated with their CRE concentrations and with all their exposures more
broadly.
Conclusion
In the past several decades, real estate markets, both residential and commercial, have affected the
U.S. economy in both negative and positive ways. Naturally, the Federal Reserve monitors these
markets to gauge their impact on broader economic activity. In addition, because banks are
substantially involved in both residential and commercial real estate markets, as a supervisor, we must
ensure that bank lending in these markets is conducted in a safe and sound manner.
One tool we use to help maintain the safety and soundness of banks is supervisory guidance, which
can point out areas requiring additional monitoring, suggest ways in which banks can improve risk
management, and remind bankers that they should continue to exercise discipline in their lending
activities to ensure that they are accounting for all their risks. The recently issued draft guidance on
nontraditional mortgage products and on CRE lending, as I have noted, is not an attempt to stifle
lending in these sectors, which, if conducted properly, can continue to be profitable businesses for
bankers. Indeed, we recognize the important role that banks play in real estate lending. That is why we
want to ensure that banks maintain good practices when operating in those markets.
As a final point, if both sets of guidance are finalized, we aim to implement them as consistently as
possible across institutions. We do understand bankers' concerns about this issue. Of course, it is
always a challenge to ensure that there is consistent application of guidance throughout the industry,
especially when bank-specific factors - such as portfolio concentrations and individual
riskmanagement practices - might affect the manner in which the guidance needs to be applied to each
bank. But if the guidance is indeed finalized, we plan to undertake considerable efforts across our
agencies, including extensive communication and coordination, so that banks are not subject to
needlessly differing treatment.