Ben S Bernanke: Housing, mortgage markets, and foreclosures
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal
Reserve System, at the Federal Reserve System Conference on Housing and Mortgage
Markets, Washington DC, 4 December 2008.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
The U.S. financial system has been in turmoil during the past 16 months. Credit conditions
have tightened and asset values have declined, contributing substantially, in turn, to the
weakening of economic activity. As the participants in this conference are keenly aware, I am
sure, housing and housing finance played a central role in precipitating the current crisis. As
the crisis has persisted, however, the relationships between housing and other parts of the
economy have become more complex. Declining house prices, delinquencies and
foreclosures, and strains in mortgage markets are now symptoms as well as causes of our
general financial and economic difficulties. These interlinkages imply that policies aimed at
improving broad financial and economic conditions and policies focused specifically on
housing may be mutually reinforcing. Indeed, the most effective approach very likely will
involve a full range of coordinated measures aimed at different aspects of the problem.
I will begin this morning with some comments on developments in the housing sector and on
the interactions among house prices, mortgage markets, foreclosures, and the broader
economy. I will then discuss both some steps taken to date and some additional measures
that might be taken to support housing and the economy by reducing the number of
avoidable foreclosures. As we as a nation continue to fashion our policy responses in coming
weeks and months, we must draw on the best thinking available. I expect that the papers
presented at this conference will add significantly to our understanding of these important
issues.
Developments in housing and housing finance
As you know, the current housing crisis is the culmination of a large boom and bust in house
prices and residential construction that began earlier in this decade. Home sales and
singlefamily housing starts held unusually steady through the 2001 recession and then rose
dramatically over the subsequent four years. National indexes of home prices accelerated
significantly over that period, with prices in some metropolitan areas more than doubling over
the first half of the decade.1 One unfortunate consequence of the rapid increases in house
prices was that providers of mortgage credit came to view their loans as well-secured by the
rising values of their collateral and thus paid less attention to borrowers' ability to repay.2
However, no real or financial asset can provide an above-normal market return indefinitely,
and houses are no exception. When home-price appreciation began to slow in many areas,
the consequences of weak underwriting, such as little or no documentation and low required
down payments, became apparent. Delinquency rates for subprime mortgages - especially
those with adjustable interest rates - began to climb steeply around the middle of 2006.
When house prices were rising, higher-risk borrowers who were struggling to make their
payments could refinance into more-affordable mortgages. But refinancing became
increasingly difficult as many of these households found that they had accumulated little, if
any, housing equity. Moreover, lenders tightened standards on higher-risk mortgages as
secondary markets for those loans ceased to function.
Higher-risk mortgages are not the only part of the mortgage market to have experienced
stress. For example, while some lenders continue to originate so-called jumbo prime
mortgages and hold them on their own balance sheets, these loans have generally been
available only on more restrictive terms and at much higher spreads relative to prime
conforming mortgage rates than before the crisis. Mortgage rates in the prime conforming
market - although down somewhat from their peaks - remain high relative to yields on
longer-term Treasury securities, and lending terms have tightened for this segment as well.
As house prices have declined, many borrowers now find themselves "under water" on their
mortgages - perhaps as many as 15 to 20 percent by some estimates. In addition, as the
economy has slowed and unemployment has risen, more households are finding it difficult to
make their mortgage payments. About 4-1/2 percent of all first-lien mortgages are now more
than 90 days past due or in foreclosure, and one in ten near-prime mortgages in alt-A pools
and more than one in five subprime mortgages are seriously delinquent.3 Lenders appear to
be on track to initiate 2-1/4 million foreclosures in 2008, up from an average annual pace of
less than 1 million during the pre-crisis period.4
Predictably, home sales and construction have plummeted. Sales of new homes and starts
of single-family houses are now running at about one-third of their peak levels in the middle
part of this decade. Sales of existing homes, including foreclosure sales, are now about
twothirds of their earlier peak. Notwithstanding the sharp adjustment in construction, inventories
of unsold new homes, though down in absolute terms, are close to their record high when
measured relative to monthly sales, suggesting that residential construction is likely to
remain soft in the near term.
As I mentioned earlier, the problems in housing and mortgage markets have become
inextricably intertwined with broader financial and economic developments. For example,
mortgage-related losses have eroded the capital of many financial institutions, leading them
to become more reluctant to make not only mortgage loans, but other types of loans to
consumers and businesses as well. Likewise, some homeowners have responded to
declining home values by cutting back their spending, and residential construction remains
subdued. Thus, weakness in the housing market has proved a serious drag on overall
economic activity. A slowing economy has in turn reduced the demand for houses, implying a
further weakening of conditions in the mortgage and housing markets.
Reducing preventable foreclosures
Because developments in the housing sector have become so interlinked with the evolution
of the financial markets and the economy as a whole, both macro and micro policies have a
role in addressing the strains in housing. At the macro level, the Federal Reserve has taken
a number of steps, beginning with the easing of monetary policy. To the extent that more
accommodative monetary policies make credit conditions easier and incomes higher than
they otherwise would have been, they support the housing market.
The Federal Reserve has also implemented a series of actions aimed at restoring the normal
functioning of financial markets and restarting the flow of credit, including providing liquidity
to a range of financial institutions, working with the Treasury and the Federal Deposit
Insurance Corporation (FDIC) to help stabilize the banking system, and providing backstop
liquidity to the commercial paper market. The Federal Reserve supported the actions by the
Federal Housing Finance Agency (FHFA) and the Treasury to put the housing-related
government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, into
conservatorship, thereby stabilizing a critical source of mortgage credit. The Federal Reserve
has also recently announced that it will purchase up to $100 billion of the debt issued by
Fannie Mae, Freddie Mac, and the Federal Home Loan Banks and up to $500 billion in
mortgage-backed securities issued by the GSEs.
Although broad-based macroeconomic policies help to create an economic and financial
environment in which a housing recovery can occur, policies aimed more narrowly at the
housing market are important, too. In the remainder of my remarks, I will focus on policy
options for reducing preventable foreclosures.
Foreclosures impose large costs on families who face the loss of their homes and reduced
future access to credit. But the public policy case for reducing preventable foreclosures does
not rely solely on the desire to help people who are in trouble. Foreclosures create
substantial social costs. Communities suffer when foreclosures are clustered, adding further
to the downward pressure on property values. Lower property values in turn translate to
lower tax revenues for local governments, and increases in the number of vacant homes can
foster vandalism and crime.5 At the national level, the declines in house prices that result
from the addition of foreclosed properties to the supply of homes for sale create broader
economic and financial stress, as I have already noted.6
On the surface, private economic incentives to avoid foreclosure would appear to be strong
for the lender as well as the borrower. Foreclosure dissipates much of the value of the
property: Indeed, recent losses on defaulted subprime mortgages have averaged around 50
to 60 percent of the loan balance.7 Besides the general decline in property values and
foregone payments, fees related to foreclosure, such as court costs, maintenance expenses,
and others, can amount to 10 to 15 percent of the loan balance; furthermore, the discount in
value due to foreclosure status can be an additional 5 to 15 percent.8
However, despite the substantial costs imposed by foreclosure, anecdotal evidence suggests
that some foreclosures are continuing to occur even in cases in which the narrow economic
interests of the lender would appear to be better served through modification of the
mortgage. This apparent market failure owes in part to the widespread practice of
securitizing mortgages, which typically results in their being put into the hands of third-party
5
For evidence that concentrations of foreclosures lead to lower house prices throughout the neighborhood, see,
for example, William C. Apgar, Mark Duda, and Rochelle Nawrocki Gorey (2005), "The Municipal Cost of
Foreclosures: A Chicago Case Study", Housing Finance Policy Research Paper 2005-1 (Minneapolis, Minn.:
Homeownership Preservation Foundation, February),
www.995hope.org/content/pdf/Apgar_Duda_Study_Full_Version.pdf; and John P. Harding, Eric Rosenblatt,
and Yao Vincent (2008), "The Contagion Effect of Foreclosed Properties", Social Science Research Network
working paper 1160354 (July).
6
To be sure, policy should not attempt to keep house prices from falling sufficiently to stabilize the demand for
housing. But preventing avoidable foreclosures does not block necessary adjustments. Indeed, failing to
prevent such foreclosures may heighten the risk that house prices will move lower than they would otherwise
need to go.
7
See J.P. Morgan (2008), "SOS - Summary of Subprime, Alt-A, Prime Jumbo", Global Structured Finance
Research (November 2); and Credit Suisse (2008), "Deep Dive into Subprime Mortgage Severity", Fixed
Income Research Report (June 19).
8
See "Deep Dive", note 8.
BIS Review 152/2008
servicers rather than those of a single owner or lender. The rules under which servicers
operate do not always provide them with clear guidance or the appropriate incentives to
undertake economically sensible modifications.9 The problem is exacerbated because some
modifications may benefit some tranches of the securities more than others, raising the risk
of investor lawsuits. More generally, the sheer volume of delinquent loans has overwhelmed
the capacity of many servicers, including portfolio lenders, to undertake effective
modifications.
During more normal times, mortgage delinquencies typically were triggered by life events,
such as unemployment, illness, or divorce, and servicers became accustomed to addressing
these problems on a case-by-case basis. Although taking account of the specific
circumstances of each case remains important, the scale of the current problem calls for
greater standardization and efficiency. Loan modification programs with clearly defined
protocols can both help reduce modification costs and protect servicers from the charge that
they have acted arbitrarily. The federal banking regulators have urged lenders and servicers
to work with borrowers to avoid preventable foreclosures. The regulators recently reiterated
that position in a joint statement that encouraged banks to make the necessary investments
in staff and capacity to meet the escalating workload and to adopt systematic, proactive, and
streamlined modification protocols to put borrowers in sustainable mortgages.10
A number of initiatives have attempted to address the problem of unnecessary foreclosures.
Working in collaboration with the Treasury Department, the Hope Now Alliance, a coalition of
mortgage servicers, lenders, housing counselors, and investors - led by Faith Schwartz, a
member of the Fed's Consumer Advisory Council - has produced a set of guidelines that
participating servicers have agreed to use as they work to prevent foreclosures. In addition,
servicers in the Alliance agreed to delay foreclosure proceedings if an alternative approach
might allow the homeowners to stay in their home. Recently, in conjunction with the FHFA,
the coalition announced that its members will adopt a streamlined modification program for
certain loans that they service for the GSEs. This program will closely follow the one that the
FDIC has introduced for modifying the loans in the portfolio that it took over from IndyMac.11
The Federal Reserve has also been actively supporting efforts to prevent unnecessary
foreclosures. Through the System's Homeownership and Mortgage Initiative, we have
conducted studies on housing and foreclosures, provided community leaders with detailed
analyses to help them better target their borrower outreach and counseling efforts, and
convened forums like this one to facilitate the exchange of ideas and the development of
policy options. Taking advantage of the Federal Reserve's nationwide presence, the twelve
Reserve Banks have sponsored or co-sponsored more than 100 events related to
foreclosures around the country since last summer, bringing together more than 10,000
lenders, counselors, community development specialists, and policymakers. A particular
focus of the Fed's efforts has been the mitigation of the costs to communities of high rates of
foreclosure. For example, we have partnered with NeighborWorks America on a
neighborhood stabilization project and helped them develop responses to community needs
as well as train local leaders.
Beyond these efforts, two government programs to facilitate loan modifications have been
authorized, both through the Federal Housing Administration (FHA). The FHASecure
program has provided long-term fixed-rate mortgages to borrowers facing a rise in payments
due to an interest rate reset. Another, more recent program, dubbed Hope for Homeowners
(H4H), allows lenders to refinance a delinquent borrower into a new, 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 subsequent appreciation of the home
with the government.
Although the basic structure of the H4H program is appealing, some lenders have expressed
concerns about its complexity and cost, including the requirement in many cases to
undertake substantial principal write-downs. As a result, participation has thus far been low.
In response to these concerns, the board of the H4H program - on which Governor Duke
represents the Federal Reserve - recently approved a number of changes, using the
authority granted to it under the Emergency Economic Stabilization Act (EESA). These
changes would reduce the necessary write-down on some loans, address the complications
caused by subordinate liens by permitting up-front payments to those lien holders, allow
lenders to extend mortgage terms from 30 to 40 years to increase affordability, and eliminate
the trial modification period to expedite loan closings. It is still too early to know what the
ultimate demand for H4H loans under this set of rules will be, but as I will discuss further
momentarily, a case can be made for further adjusting the terms of the program to make it
more attractive to both lenders and borrowers.
Despite good-faith efforts by both the private and public sectors, the foreclosure rate remains
too high, with adverse consequences for both those directly involved and for the broader
economy. More needs to be done. In the remainder of my remarks I will discuss, without
ranking, a few promising options for reducing avoidable foreclosures. These proposals are
not mutually exclusive and could be used in combination. Each would require some
commitment of public funds.
To be effective, loan modifications should aim to put borrowers into mortgages that they can
afford over the longer term. During more normal times, many homeowners could be helped
with a temporary repayment plan - for example, a deferral of interest payments for a period.
But under the current circumstances, with house prices declining and credit tight, permanent
loan modifications will often be needed to create sustainable mortgages and keep people in
their homes. Most current proposals to reduce foreclosures incorporate this view and thus
emphasize permanent modifications.
A more difficult design question turns on the extent to which the probability of default or
redefault depends on the borrower's equity position in the home, as well as on the
affordability of the monthly payment. Although not conclusive, the available evidence
suggests that the homeowner's equity position is, along with affordability, an important
determinant of default rates, for owner-occupiers as well as investors. If that evidence is
correct, then principal write-downs may need to be part of the toolkit that servicers use to
achieve sustainable mortgage modifications.12
If one accepts the view that principal write-downs may be needed in cases of badly
underwater mortgages, then strengthening the H4H program is a promising strategy, as I
have noted. Beyond the steps already taken by the H4H board, the Congress might consider
making the terms of H4H loans more attractive by reducing the up-front insurance premium
paid by the lender, currently set in law at 3 percent of the principal value, as well as the
annual premium paid by the borrower, currently set at 1-1/2 percent. The Congress might
also grant the FHA the flexibility to tailor these premiums to individual risk characteristics
rather than forcing the FHA to charge the same premium to all borrowers.
In addition, consideration might be given to reducing the interest rate that borrowers would
pay under the H4H program. At present, this rate is expected to be quite high, roughly 8
percent, in part because it is tied to the demand for the relatively illiquid securities issued by
Ginnie Mae to fund the program. To bring down this rate, the Treasury could exercise its
authority to purchase these securities, with the Congress providing the appropriate increase
in the debt ceiling to accommodate those purchases. Alternatively, the Congress could
decide to subsidize the rate.
A second proposal, put forward by the FDIC, focuses on improving the affordability of
monthly payments. Under the FDIC plan, servicers would restructure delinquent mortgages
using a streamlined process, modeled on the IndyMac protocol, and would aim to reduce
monthly payments to 31 percent of the borrower's income. As an inducement to lenders and
servicers to undertake these modifications, the government would offer to share in any
losses sustained in the event of redefaults on the modified mortgages and would also pay
$1,000 to the servicer for each modification completed.13 The strengths of this plan include
the standardization of the restructuring process and the fact that the restructured loans
remain with the servicer, with the government being involved only when a redefault occurs.
As noted, the FDIC plan would induce lenders and servicers to modify loans by offering a
form of insurance against downside house price risk. A third approach would have the
government share the cost when the servicer reduces the borrower's monthly payment. For
example, a servicer could initiate a modification and bear the costs of reducing the mortgage
payment to 38 percent of income, after which the government could bear a portion of the
incremental cost of reducing the mortgage payments beyond 38 percent, say to 31 percent,
of income. This approach would increase the incentive of servicers to be aggressive in
reducing monthly payments, which would improve the prospects for sustainability. Relative to
the FDIC proposal, this plan would pose a greater operational burden on the government,
which would be required to make payments to servicers for all modified loans, not just for
loans that redefault. However, this approach could leverage existing modification
frameworks, such as the FDIC/IndyMac and Hope Now streamlined protocols, and in this
respect would build on, rather than crowd out, private-sector initiatives.
Yet another promising proposal for foreclosure prevention would have the government
purchase delinquent or at-risk mortgages in bulk and then refinance them into the H4H or
another FHA program. This approach could take advantage of the depressed market values
of such mortgages, and buying in bulk might help avoid adverse selection problems. In
addition, scale efficiencies could be achieved by contracting with specialty firms (perhaps
including the GSEs) capable of re-underwriting large volumes of loans to make them eligible
for H4H or another program. The Treasury has already considered how to undertake bulk
purchases as part of its work under EESA, and the Federal Reserve has submitted to the
Congress an analysis of bulk purchases per a legislative requirement in the H4H bill. Even
so, this program could take some time to get up and running, and the re-underwriting
required for H4H loans would likely take more time and incur greater operational costs than
other plans. But such an approach could result in many homeowners being refinanced into
sustainable mortgages.
Conclusion
The housing market remains central to the economic and financial challenges that we face.
Because housing and mortgage markets are tightly interlinked with the rest of the economy,
actions to strengthen financial markets and the broader economy are important ways to
address housing issues. By the same token, steps that stabilize the housing market will help
stabilize the economy as well.
In this regard, reducing the number of preventable foreclosures would not only help families
stay in their homes, it would confer much wider benefits. Significant efforts have been taken
in this direction, but more can be done. Today I have briefly discussed a few promising
options, which are not necessarily mutually exclusive. As we as a country consider ways to
address our financial and economic challenges, policy initiatives to reduce the number of
preventable foreclosures should be high on the agenda.