Randall S Kroszner: Federal Housing Administration Housing
Stabilization and Homeownership Act
Testimony of Mr Randall S Kroszner, Member of the Board of Governors of the US Federal
Reserve System, before the Committee on Financial Services, US House of
Representatives, Washington DC, 9 April 2008.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
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Chairman Frank, Ranking Member Bachus, and other members of the Committee, I am
pleased to be here today to discuss efforts to address the current problems in the mortgage
and housing markets. In my testimony this morning, I will briefly review the current situation
in the housing market and ongoing efforts to help prevent avoidable foreclosures. Then I will
expand on what additional steps might be taken by homeowners, lenders, servicers,
investors, and the Congress to address this important issue. I will also address the need to
take the housing situation seriously and some aspects of the discussion draft of the Federal
Housing Administration (FHA) Housing Stabilization and Homeownership Retention Act of
2008.
The current situation
The mortgage market has long been a source of strength in the U.S. economy, but it is facing
very significant challenges today, especially in the subprime segment that serves consumers
who have shorter or weaker credit records. In recent years, slowing home prices and a
loosening of underwriting standards have contributed to sharp increases in delinquencies
and foreclosures. As of January 2008, the most recent month for which data are available,
about 24 percent of subprime adjustable-rate mortgages (ARMs) were 90 days or more
delinquent, twice the fraction that were delinquent by this definition one year ago. For
mortgages overall, more than 1.5 million foreclosures were started during 2007, up 53
percent from the previous year. All told, the consensus expectation is that the number of
foreclosures in 2008 will likely exceed the number in 2007.
Both delinquency and foreclosure are traumatic experiences for the families and
communities affected. Recent declines in house prices have eroded the equity that
homeowners have in their homes, which has made it difficult or impossible for many of them
to refinance their mortgage on more favorable terms compared to their current mortgage,
even if interest rates have declined since they took out their loan. Tighter lending standards
have also limited opportunities for these families to refinance. When struggling homeowners
cannot put themselves on a sustainable financial footing, neighborhoods also suffer -
properties are not maintained and foreclosures, particularly when they are clustered together,
put further downward pressure on house prices. This is bad news for investors, too, because
as property values decline, the substantial costs associated with foreclosure rise even
further. Finally, falling home prices can have local and national consequences because of the
erosion of both property tax revenue and the support for consumer spending that is provided
by household wealth.
Ongoing efforts to help struggling borrowers
Given the high cost of foreclosures to everyone involved - lenders, investors, borrowers and
their communities alike - it is in everyone's interest to develop prudent loan modification
programs and provide for other assistance to help borrowers avoid preventable foreclosures.
Indeed, policymakers and stakeholders have been working hard to find effective responses
to the increases in delinquencies and foreclosures. The steps that have been taken so far
include initiating programs designed to expand refinancing opportunities and efforts to
increase the pace of loan workouts.
One example of positive steps being taken is the effort by NeighborWorks America and the
Homeownership Preservation Foundation to offer financial counseling services through the
Homeowner's HOPE Hotline.1 With the encouragement and leadership of the Treasury
Department, the national Hope Now Alliance - a broad-based coalition of
governmentsponsored enterprises (GSEs), industry trade associations, counseling agencies, and
mortgage servicers - is working to find ways to help troubled borrowers, particularly those
facing interest rate resets, through loan modification plans.2 Recent actions by the Federal
Open Market Committee to lower the target federal funds rate and resulting decreases in
short-term interest rates also should help mitigate the problems associated with interest rate
resets.
Useful steps also are being taken by the FHA, which provides insurance on a variety of fixed-
and variable-rate mortgage products that can be used by borrowers who want to refinance
their home and who meet specified underwriting and other criteria. For example, the agency
recently established the FHASecure plan to help borrowers who are delinquent because of
an interest rate reset and who have some equity in their home. FHASecure provides such
borrowers the opportunity to refinance into an FHA-insured mortgage. Separately, the FHA's
loan limits recently were raised significantly by the Economic Stimulus Act of 2008, further
expanding the potential reach of the FHA's mortgage insurance programs. We understand
that the FHA is studying additional ways that the agency's insurance programs could be
expanded or modified, consistent with existing statutory authorities, to better help troubled
borrowers.
The Federal Reserve has been working with financial institutions and community groups
around the country to address the challenges posed by problem loans. For example, we
have been providing community coalitions, counseling agencies, fellow regulators, and
others with detailed analyses that identify neighborhoods with especially high concentrations
of foreclosures. Last week the Federal Reserve made available to the public a set of dynamic
maps and data that illustrate the regional variation in the condition of securitized,
owneroccupied subprime and alt-A mortgage loans across the United States.3 Armed with this
information, community organizations and leaders can better target their scarce resources
toward helping borrowers in the greatest need of counseling and for other interventions that
may help prevent foreclosure.
Communities also are searching for ways to address the challenges that foreclosed homes
can present, such as decreased home values and vacant properties that can deteriorate from
neglect. Toward this end, the Federal Reserve has recently engaged in a partnership with
NeighborWorks America to identify effective strategies to stabilize neighborhoods that have
large clusters of vacant properties due to foreclosures. Working together, we will develop
materials and tools as well as convene training sessions to help communities build local
capacity for acquiring and managing vacant properties. The ultimate goal is to return these
properties to useful purposes, whether it is to provide affordable rental housing or to supply
new homeownership opportunities in low- and moderate-income communities.
Loss-mitigation strategies to reduce foreclosures
In cases where it is not possible for the distressed mortgage borrower to refinance his or her
mortgage into a more sustainable mortgage product, the next-best solution may be some
type of loss-mitigation arrangement between the lender or servicer and the distressed
borrower. The Federal Reserve, in conjunction with the other federal banking agencies
(which include the Office of the Comptroller of the Currency, the Federal Deposit Insurance
Corporation, and the Office of Thrift Supervision), the Conference of State Bank Supervisors
and the National Credit Union Administration, has issued guidance urging lenders and
servicers to pursue such arrangements, when feasible and prudent, as an alternative to
foreclosure. For the lender, servicer, and investor, working out a distressed loan with a
struggling borrower makes economic sense if the net present value (NPV) of the payments
under a loss-mitigation strategy exceeds the NPV of proceeds that would be received in
foreclosure.
Loss mitigation can be advantageous to both the borrower and the lender because the costs
associated with foreclosure can be very substantial. Historically, the foreclosure process has
usually taken from a few months up to a year and a half, depending on state law and whether
the borrower files for bankruptcy. Anecdotal evidence suggests that the time to complete a
foreclosure has been increasing recently, as the number of foreclosures has risen and the
average time that properties remain on the market has lengthened. The losses to lenders
and investors from foreclosures include not only the missed mortgage payments during that
period, but also the costs of taxes, legal and administrative fees, real estate owned sales
commissions, and maintenance expenses. Additional losses arise from the often significant
reduction in value when a property is repossessed even in stable housing markets,
particularly if the property is unoccupied for some period. In fact, a recent estimate based on
subprime mortgages foreclosed in the fourth quarter of 2007 indicated that total losses
exceeded 50 percent of the principal balance. Whether the losses are that large in all cases
is difficult to know, but what is known is that the foreclosure process itself destroys
considerable value. The existence of such costs raises the real prospect that, by
restructuring distressed loans in those cases in which the borrower wants to stay in the
home, borrowers, lenders, servicers, and investors may all be able to achieve a better
outcome than is attainable if the foreclosure process is allowed to run its course.
Lenders, servicers, and investors have historically relied on repayment plans as their
preferred loss-mitigation technique. Under these plans, delinquent borrowers typically repay
the mortgage arrears over a few months in addition to making their regularly scheduled
mortgage payments. These plans often are most appropriate if the borrower has suffered a
reversible setback, such as a temporary illness. However, anecdotal evidence suggests that
even in the best-case scenarios, borrowers given repayment plans redefault at a high rate,
especially when the arrears are large.
Loan modifications, which involve any permanent change to the terms of the mortgage
contract, may be preferred when the higher payments associated with a repayment plan do
not result in a sustainable solution. In a loan modification, the borrower's monthly payment is
reduced through a lower interest rate, an extension of the maturity of the loan, a write-down
of the principal balance, or a combination of all three of these measures. The effort by the
Hope Now Alliance to freeze interest rates at the introductory rate for five years for eligible
borrowers with an adjustable-rate mortgage is an example of a modification, in this case
applied to a class of borrowers.
To date, permanent modifications in this credit cycle episode, as in the past, have typically
involved a reduction in the interest rate or an extension of the loan terms, while reductions of
principal balance have been quite rare. But the current housing difficulties differ from those in
the past, largely because of the pervasiveness of situations known as negative equity
positions in which the amount owed on the mortgage exceeds the current market value of the
property. A distressed borrower with a negative equity position may have neither the means
nor the incentive to remain in the home. In this environment, servicers and investors may
well find principal reductions that restore some equity for at-risk homeowners to be an
effective means of avoiding delinquency and foreclosure.
Although principal write-downs may be especially germane today given the prevalence of
negative equity positions, they are not necessary or appropriate for all borrowers who have
negative home equity or who become delinquent on their mortgage. On the contrary, a
strategy of targeting write-downs to certain groups of borrowers may provide the best path
forward. For example, one possibility would be to limit the availability of write-downs to those
borrowers with high debt payment-to-income ratios and loan-to-value ratios significantly in
excess of 100 percent before loan modification, but with the capacity to carry a written-down
mortgage. In any event, it seems clear that principal reductions should be part of the tool kit
that servicers and investors bring to bear as they deal with delinquent loans.
Additional actions that could help reduce avoidable foreclosures
Several steps could be taken to provide further impetus to loan modifications, including
principal write-downs, in appropriate circumstances. One such step that could be taken
relatively quickly by the industry is the development of a template that would guide servicers
and others as they consider whether, and under what circumstances, to pursue various types
of loan modifications, including principal write-downs. Enhanced guidance on loan
modifications could help forge a common understanding among servicers and the investor
community on when a particular loan modification tool is most appropriate. This guidance
would help address the concern expressed by servicers that expanding the rate of principal
reductions may expose them to increased litigation risks even in situations where the
servicer reasonably determines that such action is beneficial to investors in comparison to
other available options. The Hope Now Alliance organized by the industry and the Treasury
Department successfully created guidelines dealing with interest rate resets. Leadership also
is needed to provide guidance for other loan modification tools and to clarify the "best
practices" to be followed by servicers in order to mitigate servicers' litigation risks.
The Congress can take another important step to facilitate greater use of loan modifications
by moving quickly to reconcile and enact FHA modernization legislation permitting the FHA
to increase its scale and improve the management of potential risks borne by the
government. Such legislation could improve the FHA's ability to reach a wider range of
borrowers while allowing the agency to develop appropriate underwriting and pricing
methodologies for any increased risks assumed.
Separately, the GSEs - Fannie Mae and Freddie Mac - could be asked to do more.
Recently, the Congress has greatly expanded Fannie Mae's and Freddie Mac's role in the
mortgage market by temporarily increasing the conforming loan limits for these GSEs. In
addition, their federal regulator, the Office of Federal Housing Enterprise Oversight, has lifted
some of the constraints that were imposed on these entities because they have resolved
some of their recent accounting and operational problems. Thus, now is an especially
appropriate time to ask the GSEs to move quickly to raise more capital, which they will need
to take advantage of these new securitization and investment opportunities, to provide
assistance to the housing markets in times of stress, and to do so in a safe and sound
manner. As the GSEs expand their roles in our mortgage market, there is a strong need for
the Congress to move forward on GSE reform legislation, including the creation of a
worldclass GSE regulator. As the Federal Reserve has testified on many occasions, it is very
important for the health and stability of our housing finance system that the Congress provide
the GSE regulator with broad authority to set capital standards, establish a clear and credible
receivership process, and define and monitor a transparent public purpose - one that
transcends just shareholder interests - for the accumulation of assets held in their portfolios.
Desirable characteristics of an initiative to encourage loan workouts
Going beyond the current proposals for FHA modernization and permitting the FHA greater
latitude to set underwriting standards and risk-based premiums for mortgage refinancing - in
a way that does not increase the expected cost to the taxpayer - would allow the FHA to
help more troubled borrowers. For example, an FHA-insured refinancing product with
insurance priced to reflect the risks to the taxpayers might encourage servicers to consider
providing delinquent, at-risk mortgage borrowers a principal write-down as a loan
modification alternative. The draft FHA Housing Stabilization and Homeownership Retention
Act of 2008 includes provisions designed to allow the FHA to offer such products, which
could be a useful tool in helping reduce preventable foreclosures.
As you move forward in considering whether to enact a bill and, if so, what its precise design
should be, it will be important to consider a wide range of issues. In many cases, a judgment
must be made as to how to strike an appropriate balance among competing considerations.
Among the issues you will have to consider are at least the following five:
1. Mitigating moral hazard
Homeowners who can afford to pay their current mortgage should not be encouraged to
default in order to qualify for a write-down. To discourage borrowers who would otherwise
have the ability to continue making their payments from becoming delinquent, a variety of
steps could be taken. For example, eligibility for assistance under the program could be
restricted to borrowers who had relatively high debt payment-to-income ratios at some
specified date before the creation of the program. In addition, steps could be taken to make it
costly for homeowners who attempt to quickly cash-in on the equity provided through a
principal write-down. For example, participating borrowers could be required to pay an exit
fee when the refinancing loan is extinguished. As another example, borrowers could be
required to share with the government or with the holder of the borrower's existing mortgage
either the equity created through a write-down or the future appreciation in the home price, or
both, over some specified time period. In other words, the government or investor would
have what is known as a "soft-second." In addition, programs that provide for the voluntary
participation of lenders and servicers should provide a natural brake on moral hazard, as
lenders and servicers would remain free to pursue other options available to them in
situations where they believe the borrower has the ability to repay his or her existing
mortgage.
2. Mitigating adverse selection
A robust defense against adverse selection - the incentive of current servicers or lenders to
send only their worst credits to the government-insured mortgage program - is necessary to
protect the interests of the taxpayer. Mechanisms that would discourage adverse selection
include: (i) a loan seasoning requirement (for example, a period during which the new loan
could be sent back to the original servicer/lender if it redefaults) and (ii) a fee structure that
imposes costs on the servicer/lender if the new government-insured loan goes bad within a
specified period or pays a bonus if the loan continues to perform over the whole of that
period.
3. Turning the FHA into a world-class mortgage insurer
With modernization and expansion, the FHA could play an important role in relieving stress in
the mortgage and housing markets as well as in restarting securitization markets.
Securitization markets are needed to help relieve capital stresses on banks and to provide
more affordable mortgages to borrowers. To this end, more consideration needs to be given
to how the FHA can scale up quickly and improve its processes and underwriting systems so
that they are comparable in quality with those currently being used by Fannie Mae and
Freddie Mac. In addition, providing the FHA with broad authority to offer innovative products
that meet market needs and to outsource loan underwriting and other program elements to
private-sector providers could allow the FHA to insure more mortgage borrowers and to do
so more quickly. The FHA needs to be better able to compete in today's marketplace and it
needs access to the best risk-management tools available when managing the risks to the
government.
4. Protecting the taxpayer
Any government-insured mortgage offered under a refinancing program needs to be
prudently underwritten, regardless of whether a principal write-down is part of the deal. First
and foremost, this means establishing a meaningful amount of homeowner equity. Second, it
means using sound underwriting criteria to ensure that borrowers are reasonably likely to be
able to repay the government-insured loan on a sustained basis. Third, it means allowing the
FHA to engage in sensible risk-based pricing of its mortgage insurance products, including
substantial flexibility in setting its initial premium and annual premiums.
5. Negotiating junior liens
From one-third to one-half of all subprime mortgages pertain to properties that also have
junior liens. When held by an entity other than the first lien holder, these junior liens present
a variety of serious obstacles to a successful refinancing, especially one involving a principal
write-down. Typically, the junior lien holder must agree either to remove his lien in return for
a portion of the proceeds from the refinancing or re-subordinate his claim to the new loan.
The valuation of the junior lien holder's claim on the property is often difficult to negotiate.
One way of dealing with this problem in the case of a restructuring with an FHA-insured
mortgage is to offer a junior lien holder a specified share of the government's or investor's
"soft second." Another way of dealing with junior liens is to provide the servicer with financial
incentives to aggressively negotiate with the junior lien holder while capping any potential
payout available to the junior lien holder from the government program.
Elements of these considerations are already reflected in the discussion draft. For example,
Title I of the discussion draft includes exit fees and shared appreciation mortgages to
address concerns about borrower moral hazard. It also contains features to protect the
taxpayer, such as widening the range of insurance premiums and creating a meaningful
amount of borrower home equity. As for adverse selection, risk-based insurance premiums
paid by the servicer are crucial, and Title I could be clearer about the FHA's authority to use
risk-based premiums. Other steps to guard against adverse selection could include a loan
seasoning requirement or other forms of warranties given by the lender to the government
about loan performance.
Given the magnitude of the potential foreclosures on the horizon, more steps should be
taken to modernize the FHA and to deal with the junior lien holders. The FHA needs the
resources and the incentives to manage the risks to the government well and to offer
mortgage insurance products that will be attractive to servicers. As for junior lien holders,
despite the government's best efforts, it may be difficult for servicers or lenders to negotiate
with junior lien holders on the borrowers' behalf. The FHA needs substantial flexibility to
provide incentives to servicers to negotiate with junior lien holders to address this difficult
problem.
The Congress may be concerned that the loan-by-loan approach could prove insufficient.
Title II of the discussion draft would permit substantial flexibility to expand the program if
needed by introducing a bulk-refinance mechanism if economic conditions warrant such
action. This mechanism would rely on an auction-based process to price and deliver
mortgages for refinancing. Note that an auction-based approach would still have to contend
with some of the problems mentioned above, including moral hazard, adverse selection and
the resolution of junior liens. Title II would grant authority to the implementing agencies to
build in features needed to address these and other issues. If you move forward with this
legislation, it will be important that the implementing agencies have full latitude to exercise
such authority.
In the design and details of a principal write-down program based on a government-insured
refinancing, it is critical to strike the right balance between the interests of borrowers,
servicers, investors, and taxpayers. For example, the larger the required principal reduction
on a troubled loan, the fewer loans that lenders or servicers will offer voluntarily for
refinancing into an FHA-insured product, thereby reducing the "take up" rate for the program.
However, a larger principal write-down better protects taxpayers from future losses and gives
the borrower a greater incentive to stay current on the refinanced mortgage.
As another example, the more incentives given to servicers to use an FHA refinancing
program, either through direct payments or through shared appreciation agreements, the
more they would be willing to incur the costs of refinancing borrowers. Such incentives might
increase the number of borrowers who might be considered for a government-backed
program. But such incentives also would raise the cost of the program for the borrower and
possibly for the government as well.
As a final example, providing investors with some of the benefits of any shared-appreciation
agreements might encourage them to allow servicers to write down principal and refinance
borrowers into a government-backed program. However, providing the government with such
agreements could be one means of compensating taxpayers for shouldering the risks
associated with the program.
Even if the right balance for the program can be struck, obstacles remain to the successful
implementation of a government program designed to forestall preventable foreclosures. For
example, even though workouts may often be the best economic alternative, mortgage
securitization and the constraints faced by servicers may make such workouts less likely.
Trusts vary in the type and scope of modifications that are explicitly permitted, and these
differences raise operational compliance costs and litigation risks for the servicer. So that
servicers do not try to unduly avoid litigation risks, leadership is needed to clarify their duties.
Conclusion
FHA modernization and GSE reform are needed to address the ongoing shortcomings of
current mortgage-oriented government initiatives. In addition, the GSEs should be strongly
encouraged to raise additional capital so that they can fulfill the expanded role that the
Congress has recently extended to them.
Separately, the Congress should carefully evaluate whether to take additional actions to
reduce the rate of preventable foreclosures. Properly designed, such steps could promote
economic stability for households, neighborhoods, and the nation as a whole. Although
lenders and servicers have scaled up their efforts and have adopted a wider variety of
lossmitigation techniques, more can, and should, be done.
The fact that many troubled borrowers have properties that are now worth less than the
principal amounts remaining on their mortgages suggests that lenders and servicers should
give greater consideration to the use of principal reductions as one of the loan modification
options in their tool kit. Principal write-downs would be facilitated by providing the FHA the
flexibility to insure a broad range of refinancing products for a larger number of at-risk
borrowers, including products that offer borrowers an affordable, restructured mortgage if
their lender voluntarily agrees to write-down the principal amount of the borrower's mortgage.
The voluntary nature of the program assures that only borrowers who the servicer or lender
believes cannot successfully carry their current mortgage contract would be considered for
such a program. If the Congress decides to move down this road, it should carefully consider
the steps that should be taken to mitigate moral hazard, avoid adverse selection, and ensure
that the financial interests of the taxpayer are adequately safeguarded.