Elizabeth A Duke: Envisioning a future for housing finance
Speech by Ms Elizabeth A Duke, Member of the Board of Governors of the US Federal
Reserve System, at the Mortgage Foreclosure Policy Conference, Chicago, 10 December
2009.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
Good afternoon. I want to thank the Federal Reserve Bank of Chicago for this opportunity to
offer my perspectives on the housing market - a topic of paramount importance to us all. The
conference theme suggests that I take you on a retrospective journey about homeownership
in the past, bring you into the present day with thoughts about the current challenging
conditions, and leave you with insights on the future state of mortgage finance and housing
policies. With the holiday season upon us, I must admit that I find this trip reminiscent of
A Christmas
Ebenezer Scrooge's journey in Carol. The Ghost of Homeownership Past might,
in retrospect, remind us of a seemingly idyllic time in our nation's history, with high and rising
homeownership rates, while the Ghost of Homeownership Present would likely describe one
of the bleaker periods in our nation's economy. But I hope that the Ghost of Homeownership
Yet to Come would be much cheerier than Dickens' spectral visitor and would show us a
future with a housing and mortgage finance system that functions efficiently and provides
adequate safeguards for consumers, lenders, and investors going forward. I'm afraid I cannot
describe for you, as assuredly as Dickens might, just what that future market will look like,
but I will share my thoughts on some general principles that, I would argue, we should look
for in new market structures or practices that may emerge.
Responsible home ownership and housing finance
responsible
Let me establish from the outset that I believe homeownership has, for many
years, proven to be good business and good public policy. The benefits derived from
sustainable homeownership - including robust local investment and household financial
stability - bring value to a community. Homeownership has been the principal means for
many families to build wealth and financial stability over time, to use this wealth as a further
investment in education and entrepreneurship, and to transfer this wealth to future
generations. Lenders who engage in safe, sensible underwriting help to ensure that
borrowers are matched with loan products that they can repay. In turn, borrowers can use
debt to buy a productive asset that they could not otherwise purchase. Although leverage
gained a bad name in the recent crisis, responsible and sustainable leverage can normally
help more individuals become homeowners sooner.
The scarcity of available mortgage lending at present - especially the lack of relatively
lowdown-payment products beyond the Veterans Administration (VA) and Federal Housing
Administration (FHA) market - most hurts modest-income households who lack other assets.
This makes it especially difficult for first-time and minority homebuyers to enter the market.
Going forward, the challenge will be to encourage responsible, well-underwritten loan
products for these segments of the market while banning lending activity that is unfair or
deceptive.
Homeownership Past
Depending on how far back you walk with the Ghost of Homeownership Past, you might
reach a seemingly idyllic world where all mortgages were simple contracts made by local
institutions lending for their own portfolios to consumers who could make a substantial down
payment and had excellent credit. But in that ostensibly happy place, many responsible
consumers were excluded from the benefits of homeownership, funds for lending were
limited, and lending institutions ultimately found themselves with unmanageable interest rate
risk. In the 1990s and the earlier part of this decade, financial engineering in the secondary
market for mortgages led to the development of more flexible products, efficient underwriting
systems, and alternatives for new borrowers to enter the market - all good outcomes when
done right. Experimentation, technological advances, and data modeling allowed for the
development of niche mortgage products that could better meet the needs of particular
subgroups of potential borrowers. These tools, when coupled with other risk mitigants,
allowed greater numbers of Americans to buy, and stay in, homes they could afford.
But not all of this innovation proved to be positive, for either borrowers or investors. The
market overheated. Mortgages became increasingly complex and opaque, as did the
mortgage-backed securities that were then offered to investors. Risk innovation became risk
layering. A speculative mentality took hold among investors and consumers who expected
limitless house price appreciation. Borrowers overreached; risk mitigation peeled away as
niche products were mass marketed; lenders made and purchased mortgage loans with lax
underwriting standards; and investors relied too heavily on what turned out to be faulty
ratings of poorly structured securities. All of this contributed to a housing price bubble that, as
we are all too aware, eventually burst. In response, the surviving lenders severely curtailed
credit availability.
Homeownership Present
The lingering effects of this recent history continue to be felt in today's housing market. We
are now seeing high delinquency rates in every category of mortgages. While defaults in
2007 and 2008 were elevated by poor underwriting practices and the use of inappropriate
mortgage products, the current deterioration reflects to a greater degree job losses and lower
house prices. In addition, reduced home equity has impaired borrowers' abilities to refinance
their mortgages or sell their homes to cope with income loss, unexpected expenses, or
adverse life events. Numerous public, private, and nonprofit efforts are underway to keep
these delinquencies from becoming a wave of foreclosures. For example, the Federal
Reserve's program of purchasing government agency mortgage-backed securities has
significantly reduced mortgage rates, which, in combination with the Administration's Home
Affordable Refinance Program (HARP), has enabled millions of families to reduce their
mortgage payments this year. Hundreds of thousands of homeowners are making reduced
payments through trial modifications under the Home Affordable Modification Program
(HAMP). While these numbers are encouraging, the real success will be in the number of
foreclosures actually averted through successful permanent modifications. At the Board of
Governors in Washington, and at the regional Federal Reserve Banks across the country, we
are providing data and bringing together different parties from the private, public, and
nonprofit sectors to encourage strategies for refinance, loan modifications, short sales, and
other alternatives to preventable foreclosures.
The Federal Reserve System also supports local and regional initiatives to address the
negative effects that large numbers of foreclosures can have on individual consumers and
their surrounding communities. Neighborhood Housing Services of Chicago is probably one
of the finest examples of such efforts. In the mid-1990s, NHS of Chicago identified predatory
lending as a threat to the neighborhoods it served. In collaboration with the City of Chicago
and many others including - I am proud to say - the Federal Reserve Bank of Chicago, NHS
formed the Home Ownership Preservation Initiative (HOPI). As other communities across the
country experienced similar problems, this initiative became a model for foreclosure
prevention and neighborhood stabilization efforts elsewhere. This is important, tireless work
and much remains to be done.
With respect to new lending, data collected under the Home Mortgage Disclosure Act
(HMDA) for 2008 tell the story of a fractured market for housing finance as private mortgage
lending came to a standstill and new lending depended heavily on government support. The
number of active mortgage companies fell 25 percent from 2006 to 2008, in part because the
warehouse lines of credit that mortgage companies depended on to fund their loans
contracted significantly. In addition, overall demand for housing slowed appreciably. Indeed,
the number of mortgage applications in 2008, 14.2 million, was about half the 2006 level and
the lowest in more than a decade. Such a low level of applications suggests that potential
borrowers were wary of entering the housing market or feared being turned down for a loan.
The 2008 HMDA data also show a dramatic increase in loans made by FHA and VA, whose
share of total mortgage originations were higher than at any time in the 19-year history of
HMDA reporting.1 These government-backed loans have been characterized as the
alternative for borrowers with a weaker credit record in the absence of a subprime market. In
addition, they are presumably attractive at the moment because they are among the few
affordable options for buyers with stronger credit records but only modest savings available
for a down payment.
In the recent past, such borrowers would have used a so-called "piggyback" mortgage -
effectively borrowing part of the down payment - or secured private mortgage insurance to
compensate for a higher loan-to-value (LTV) ratio. According to data from the National
Association of Realtors, the typical first-time homebuyer over the past several years has had
a down payment of less than 10 percent of the purchase price of the home.2 Securing even
that much has historically been a barrier to home purchase, especially among lower-income,
younger, or minority households.3 Yet higher LTV loans that help overcome this barrier also
pose higher credit risk.
Striking the right balance in loan underwriting is critically important but has proven very
difficult. The development of more flexible underwriting standards was originally hailed for the
potential to help millions of families become homeowners. But at some point, a line was
obviously crossed, standards were dangerously lowered, and loans were underwritten
without any regard for a borrower's ability to repay. When home prices fell and jobs were
lost, borrowers who did not have other assets to tap were left exposed. So the question is:
How can the market re-emerge with enough flexibility to allow more families to achieve
homeownership in a responsible way, while avoiding the mistakes of the recent past?
Achieving credit quality and availability
Some would argue that most of the really risky behavior is now out of the market. But,
unfortunately, the backlash has restricted a lot of perfectly responsible lending as well. Banks
are reluctant to put any but the lowest possible risk loans in their portfolios. And the market
for new private mortgage loan securitizations is essentially closed. Thus, borrowers face tight
underwriting requirements, even if their own risk profile looks relatively "safe" by historical
standards. Moreover, even homebuyers with the requisite down payment realize that their
home equity is much less liquid than in the past. Once, borrowers could count on cash-out
refinancing or home equity lines of credit as a means of cheaply accessing their home equity;
these avenues are now much more restricted. A risk-averse renter might prefer to keep his
assets readily available rather than lock them up in a house. On balance, even taking into
account the excesses of the bubble period, it appears that lenders have now tightened
underwriting terms so much that the lack of credit availability is at least partially an
impediment to homeownership.
As we work to correct the problems of the recent past, we must keep in mind the importance
of access to credit. If anything, the recent mortgage meltdown and sharp pullback in lending
only demonstrates how critical it is for the economy to have a well-functioning housing
finance market. With the old mortgage system in disarray, we are, one hopes, within sight of
a new and stronger system. While there are many structural permutations that might
characterize the new system, I would suggest we focus on four core principles for evaluating
proposals:
Adequate consumer protection. First and foremost, any new system must contain
adequate protections for consumers. In the aftermath of widespread abuses, consumers
need to feel confident that they can satisfactorily negotiate a reasonable mortgage.
Transparency. Second, there must be transparency at all levels. Retail products should be
as transparent as possible, so that consumers find it easy to understand the terms and risks
of their mortgages. Lenders and servicers should also make as much information as is
reasonably feasible available to investors. Indeed, adequate information for due diligence is
likely a prerequisite to attract capital back to the mortgage market.
Simplicity. Third, the new system should encourage simplicity. Retail mortgage contracts
ought to be as simple as possible. Too often, the complexity of mortgages has served to
confuse borrowers and make it more difficult to make informed decisions.
Similarly, the complexity of the securitizations into which mortgages were packaged made
analysis difficult for investors. These structures turned out to be especially fragile when
stressed with high defaults and subsequent losses. After the crash, with delinquencies rising,
investors found modeling the cash flows under alternative scenarios confusing and uncertain.
While complexity may prove to be an inevitable byproduct of financial innovation, investors
will likely demand much simpler instruments going forward.
Properly aligned incentives. Finally, the new system should feature clear roles and
properly aligned incentives for all players. Too often in the recent turmoil, we saw examples
of misaligned interests and competing objectives. For instance, there is evidence that some
loan officers and mortgage brokers may have been as concerned about whether loans were
profitable to them personally as they were about whether the borrower could actually repay.4
Servicers, too, turned out to have interests that were not always aligned with investors, and
different tranches of investors themselves had competing interests that they tried to impose
onto servicers. Certainly, greater clarity about roles and responsibilities, and the associated
compensation of participants in the origination chain, will help all parties understand, and
properly align, incentives.
Homeownership yet to come
Under these guiding principles, what would a new mortgage market look like?
Lending practices
The Federal Reserve has already taken steps to implement and enforce safeguards to shield
consumers from hazards in the market. In recent years, we have created a blanket of new
protections for consumers under the Home Ownership and Equity Protection Act, adding
layers of defenses for borrowers as they participate in the economy.5 The new rules, most of
which went into effect on October 1, target higher-priced loans, where borrowers are most
vulnerable to abuse. Our new rules require that lenders verify borrowers' abilities to repay
these "riskier" mortgages, ban prepayment penalties if payments may increase in the loan's
early years, require escrows for taxes and insurance, and prohibit a range of misleading
advertising practices.
Under Truth in Lending we also have recently proposed revised mortgage disclosure forms
for all loans. These new forms were developed through consumer testing to ensure that they
provide information that is useful and understandable to consumers. These disclosures are
designed to focus consumer attention on mortgage features, such as variable rates, that
might be appropriate for some consumers, but potentially risky for others. And we have
proposed to ban compensation that gives originators incentives to steer borrowers to loans
with higher rates or disadvantageous terms. We would encourage comments on these
proposals; the public comment period is open until December 24.6
Despite efforts to improve disclosures and ban egregious practices, obtaining a mortgage
and purchasing a home is still a significant and complex transaction. Evidence indicates that
consumer counseling, whether for pre-purchase or foreclosure prevention, leads to better
outcomes for consumers.7 This is likely to remain true even if we do a better job of providing
much-needed financial education. So it would make sense to include strong incentives to
obtain counseling and strong support for housing counselors in our toolkit of the future.
Secondary market
While these important consumer protections will help restore borrower confidence,
restoration of investor confidence may not come as easily. Whether the ultimate vehicle is
covered bonds, loan securitizations, or some other model, a mechanism for channeling
investment funds into housing finance will be critical to meeting the demands of a normally
functioning housing market. Restoration of the residential housing finance market will require
more than liquidity. At a minimum, it is likely to require access to information, standardized
contracts, and simplified structures.
In the past, potential investors found it difficult to access loan-level data on the deals they
were investing in. At best, market participants had access to underwriting and performance
information only after the deal had been issued. Even then, complete information on
borrower leverage - such as through "silent seconds" or junior liens obtained after the
origination of the first - was difficult, or expensive, to come by.
Some of the security structures that proliferated late in the credit boom contained features
that, whatever their initial purpose have served to obfuscate the relationship between loan
performance and security cash flow. Securities also differed markedly in the governing
contracts, notably the pooling and servicing agreements, or PSAs. These crucial documents
were hundreds of pages long, differed across deals, and the agreements themselves,
despite being obsessively detailed, failed to address a scenario of rapidly mounting credit
losses.
Future securities will benefit from as much standardization as possible across contracts, and
the contracts will have to spell out clearly how they can be amended to deal with
unforeseeable circumstances. Recognizing that no contract will ever be able to specify rules
for all possible contingencies, contracts should specify a governance structure for
decisionmaking in extreme circumstances.
Servicers
Servicers have not always been the most visible part of the mortgage business. Responses
to this current crisis, however, including attempts to make large-scale loan modifications,
have pointed to the critical role that servicers play through their direct interaction with
borrowers. Yet, there have been problems. Many servicers did not have - and some may still
not have - adequate systems and personnel in place to deal with the sheer scale of the
foreclosure crisis. Servicers are concerned about the competing interest of investors and the
threat of litigation for pursuing alternatives to foreclosure. In turn, some investors have
questioned servicers' incentives.
In the future, servicer contracts will need to provide clear guidance and incentive structures
that lead to transparency and certainty in loan modifications and other loss mitigation tools.
Performance under such contracts will require servicers to make investments in staffing and
information technology infrastructure. And finally, in the future, compensation for servicers
likely will need to recognize the different resources required for loss mitigation as opposed to
simple payment accounting and forwarding.
Fannie Mae and Freddie Mac
It would be unrealistic to expect the private mortgage market to rebound without defining the
ongoing role of Fannie Mae and Freddie Mac. These government sponsored enterprises
(GSEs) have continued to issue large quantities of securities even as private securitization
faltered, apparently because investors have continued to believe that the government stands
behind them. That experience suggests that, at least under the most stressed conditions,
some form of government backstop may be necessary to ensure continued securitization of
mortgages. However, restarting the GSEs in their old forms would do nothing but ask for a
repeat of recent history. Without getting into specific proposals today, I'll simply say that
whatever is the ultimate future for Fannie and Freddie, market participants will need to see a
clear roadmap for both the individual institutions and the role of government in housing
finance before private markets can begin to map a course for themselves.
Conclusion
Today I have attempted to outline a framework for a better-functioning mortgage market that
protects consumers and provides transparency to lenders, investors, and all market
participants. This is the housing finance market we need to create if responsible
homeownership is to return as a safe and viable option for the majority of consumers. It is a
market that would be attractive and profitable for lenders, servicers, and investors who are
prepared to engage in prudent, responsible, and transparent business practices.
Lending, when done responsibly, is good for business. Homeownership, when sustainable, is
good for consumers. Leverage, when used judiciously, is critical to a functioning market. It
would be hard to overestimate the damage that has been done to the housing market in
recent years, and especially to the millions of families that are suffering the devastating
consequences of foreclosure. It would be equally difficult to overestimate the damage that
would be done in the future if we must live with a chronically impaired mortgage market. We
absolutely need to change our systems so that they function properly, support the
emergence of simpler, more transparent markets, ensure aligned incentives among all
parties, and, above all, protect consumers. That, I would hope, is the market of
Homeownership Yet to Come.