Ben S Bernanke: The subprime mortgage market
Remarks by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal Reserve
System, at the Federal Reserve Bank of Chicago's 43rd Annual Conference on Bank Structure and
Competition, Chicago, 17 May 2007.
* * *
The recent sharp increases in subprime mortgage loan delinquencies and in the number of homes
entering foreclosure raise important economic, social, and regulatory issues. Today I will address a
series of questions related to these developments. Why have delinquencies and initiations of
foreclosure proceedings risen so sharply? How have subprime mortgage markets adjusted? How have
Federal Reserve and other policymakers responded, and what additional actions might be
considered? How might the problems in the market for subprime mortgages affect housing markets
and the economy more broadly?
The development of the subprime mortgage market
Let me begin with some background. Subprime mortgages are loans made to borrowers who are
perceived to have high credit risk, often because they lack a strong credit history or have other
characteristics that are associated with high probabilities of default. Having emerged more than two
decades ago, subprime mortgage lending began to expand in earnest in the mid-1990s, the expansion
spurred in large part by innovations that reduced the costs for lenders of assessing and pricing risks.
In particular, technological advances facilitated credit scoring by making it easier for lenders to collect
and disseminate information on the creditworthiness of prospective borrowers. In addition, lenders
developed new techniques for using this information to determine underwriting standards, set interest
rates, and manage their risks.
The ongoing growth and development of the secondary mortgage market has reinforced the effect of
these innovations. Whereas once most lenders held mortgages on their books until the loans were
repaid, regulatory changes and other developments have permitted lenders to more easily sell
mortgages to financial intermediaries, who in turn pool mortgages and sell the cash flows as structured
securities. These securities typically offer various risk profiles and durations to meet the investment
strategies of a wide range of investors. The growth of the secondary market has thus given mortgage
lenders greater access to the capital markets, lowered transaction costs, and spread risk more
broadly, thereby increasing the supply of mortgage credit to all types of households.
These factors laid the groundwork for an expansion of higher-risk mortgage lending over the past
fifteen years or so. Growth in the market has not proceeded at a uniform pace, but on net it has been
dramatic. About 7-1/2 million first-lien subprime mortgages are now outstanding, accounting for about
14 percent of all first-lien mortgages.1 So-called near-prime loans - loans to borrowers who typically
have higher credit scores than subprime borrowers but whose applications may have other higher-risk
aspects - account for an additional 8 to 10 percent of mortgages.2
The expansion of subprime mortgage lending has made homeownership possible for households that
in the past might not have qualified for a mortgage and has thereby contributed to the rise in the
homeownership rate since the mid-1990s. In 2006, 69 percent of households owned their homes; in
1995, 65 percent did. The increase in homeownership has been broadly based, but minority
households and households in lower-income census tracts have recorded some of the largest gains in
percentage terms. Not only the new homeowners but also their communities have benefited from
these trends. Studies point to various ways in which homeownership helps strengthen neighborhoods.
For example, homeowners are more likely than renters to maintain their properties and to participate in
civic organizations. Homeownership has also helped many families build wealth, and accumulated
home equity may serve as a financial reserve that can be tapped as needed at a lower cost than most
other forms of credit.
Broader access to mortgage credit is not without its downside, however. Not surprisingly, in light of
their weaker credit histories and financial conditions, subprime borrowers face higher costs of
borrowing than prime borrowers do and are more likely to default than prime borrowers are. For
borrowers, the consequences of defaulting can be severe - possibly including foreclosure, the loss of
accumulated home equity, and reduced access to credit. Their neighbors may suffer as well, as
geographically concentrated foreclosures tend to reduce property values in the surrounding area.
The recent problems in the subprime mortgage sector
With this background in mind, I turn now to the recent problems in the subprime mortgage sector. In
general, mortgage credit quality has been very solid in recent years. However, that statement is no
longer true of subprime mortgages with adjustable interest rates, which currently account for about
two-thirds of subprime first-lien mortgages or about 9 percent of all first-lien mortgages outstanding.
For these mortgages, the rate of serious delinquencies - corresponding to mortgages in foreclosure or
with payments ninety days or more overdue - rose sharply during 2006 and recently stood at about
11 percent, about double the recent low seen in mid-2005.3 The rate of serious delinquencies has also
risen somewhat among some types of near-prime mortgages, although the rate in that category
remains much lower than the rate in the subprime market. The rise in delinquencies has begun to
show through to foreclosures. In the fourth quarter of 2006, about 310,000 foreclosure proceedings
were initiated, whereas for the preceding two years the quarterly average was roughly 230,000.4
Subprime mortgages accounted for more than half of the foreclosures started in the fourth quarter.
The sharp rise in serious delinquencies among subprime adjustable-rate mortgages (ARMs) has
multiple causes. "Seasoned" mortgages - mortgages that borrowers have paid on for several years -
tend to have higher delinquency rates. That fact, together with the moderation in economic growth,
would have been expected to produce some deterioration in credit quality from the exceptionally
strong levels seen a few years ago. But other factors, too, have been at work. After rising at an annual
rate of nearly 9 percent from 2000 through 2005, house prices have decelerated, even falling in some
markets. At the same time, interest rates on both fixed- and adjustable-rate mortgage loans moved
upward, reaching multi-year highs in mid-2006. Some subprime borrowers with ARMs, who may have
counted on refinancing before their payments rose, may not have had enough home equity to qualify
for a new loan given the sluggishness in house prices. In addition, some owners with little equity may
have walked away from their properties, especially owner-investors who do not occupy the home and
thus have little attachment to it beyond purely financial considerations. Regional economic problems
have played a role as well; for example, some of the states with the highest delinquency and
foreclosure rates are among those most hard-hit by job cuts in the auto industry.
The practices of some mortgage originators have also contributed to the problems in the subprime
sector. As the underlying pace of mortgage originations began to slow, but with investor demand for
securities with high yields still strong, some lenders evidently loosened underwriting standards.
Socalled risk-layering - combining weak borrower credit histories with other risk factors, such as
incomplete income documentation or very high cumulative loan-to-value ratios - became more
common. These looser standards were likely an important source of the pronounced rise in "early
payment defaults" - defaults occurring within a few months of origination - among subprime ARMs,
especially those originated in 2006.
Although the development of the secondary market has had great benefits for mortgage-market
participants, as I noted earlier, in this episode the practice of selling mortgages to investors may have
contributed to the weakening of underwriting standards. Depending on the terms of the sale, when an
originator sells a loan and its servicing rights, the risks (including, of course, any risks associated with
poor underwriting) are largely passed on to the investors rather than being borne primarily by the
company that originated the loan. In addition, incentive structures that tied originator revenue to the
number of loans closed made increasing loan volume, rather than ensuring quality, the objective of
some lenders. Investors normally have the right to put early-payment-default loans back to the
originator, and one might expect such provisions to exert some discipline on the underwriting process.
However, in the most recent episode, some originators had little capital at stake and did not meet their
buy-back obligations after the sharp rise in delinquencies.5 Intense competition for subprime mortgage
business - in part the result of the excess capacity in the lending industry left over from the refinancing
boom earlier in the decade - may also have led to a weakening of standards. In sum, some
misalignment of incentives, together with a highly competitive lending environment and, perhaps, the
fact that industry experience with subprime mortgage lending is relatively short, likely compromised
the quality of underwriting.
The accuracy of much of the information on which the underwriting was based is also open to
question. Mortgage applications with little documentation were vulnerable to misrepresentation or
overestimation of repayment capacity by both lenders and borrowers, perhaps with the expectation
that rising house prices would come to the rescue of otherwise unsound loans. Some borrowers may
have been misled about the feasibility of paying back their mortgages, and others may simply have not
understood the sometimes complex terms of the contracts they signed.
As the problems in the subprime mortgage market have become manifest, we have seen some signs
of self-correction in the market. Investors are scrutinizing subprime loans more carefully and, in turn,
lenders have tightened underwriting standards. Credit spreads on new subprime securitizations have
risen, and the volume of mortgage-backed securities issued indicates that subprime originations have
slowed. But although the supply of credit to this market has been reduced - and probably
appropriately so - credit has by no means evaporated. For example, even as purchases of securitized
subprime mortgages for collateralized debt obligations - an important source of demand - have
declined, increased purchases by investment banks, hedge funds, and other private pools of capital
are beginning to fill the void. Some subprime originators have gone out of business as their lenders
have cancelled credit lines, but others have been purchased by large financial institutions and remain
in operation. Importantly, we see no serious broader spillover to banks or thrift institutions from the
problems in the subprime market; the troubled lenders, for the most part, have not been institutions
with federally insured deposits.
What about borrowers already in distress? The Board and other federal supervisory agencies have
taken actions to encourage the banks and thrift institutions we supervise to work with borrowers who
may be having trouble meeting their mortgage obligations. Often, loan workouts are in the interest of
both parties. With effective loan restructuring, borrowers facing temporary economic setbacks may be
able to work through their problems while staying in their homes, and lenders may be able to avoid the
costs of foreclosure and the losses usually associated with selling a repossessed home.
Servicers of loans aim to minimize losses, and they appear to be actively working with thousands of
individual borrowers to modify their mortgages. To some extent, the dispersed ownership of
mortgages may combine with legal and accounting rules to make successful workouts more difficult to
achieve. For example, the "pooling and servicing agreement" associated with a given securitized
mortgage pool may restrict the share of accounts that can be modified. Accounting rules that, in some
cases, require substantially modified pools to be brought back on the originator's balance sheet may
dissuade lenders from undertaking workouts. And extensive modifications that reallocate expected
cash flows across different securities associated with the pool could trigger a review of those securities
by the ratings agencies. At the same time, if workouts are economically viable, then an incentive exists
for third parties to purchase distressed pools at a discount and to undertake the workout process. We
see these purchases taking place in the marketplace, a development that should help to increase the
number of successful workouts.
Also, local community organizations that work to promote homeownership and prevent foreclosures
have stepped up their efforts. For example, NeighborWorks America advises borrowers about
restructuring their mortgages. A survey conducted by this group found that many homeowners do not
understand that lenders also want to avoid foreclosure. Thus, the simple step of encouraging
borrowers in trouble to contact their lenders can be very productive. The Federal Reserve and the
other supervisory agencies have encouraged financial institutions to identify and contact borrowers
who, with counseling and financial assistance, may be able to avoid entering delinquency or
foreclosure. Indeed, some lenders are being proactive in this regard - for example, by contacting
borrowers to discuss possible options well before a scheduled interest-rate reset.
Possible regulatory responses
Looking forward, the Federal Reserve, other regulators, and the Congress must evaluate what we
have learned from the recent episode and decide what additional regulation or oversight may be
needed to prevent a recurrence. In deciding what actions to take, regulators must walk a fine line; we
must do what we can to prevent abuses or bad practices, but at the same time we do not want to
curtail responsible subprime lending or close off refinancing options that would be beneficial to
borrowers.
Broadly speaking, financial regulators have four types of tools to protect consumers and to promote
safe and sound underwriting practices. First, they can require disclosures by lenders that help
consumers make informed choices. Second, they can prohibit clearly abusive practices through
appropriate rules. Third, they can offer principles-based guidance combined with supervisory
oversight. Finally, regulators can take less formal steps, such as working with industry participants to
establish and encourage best practices or supporting counseling and financial education for potential
borrowers.
In the area of disclosure, the Federal Reserve is responsible for writing the regulation that implements
the Truth in Lending Act (TILA), known as Regulation Z. The purpose of Regulation Z is to ensure that
lenders provide borrowers or potential borrowers with clear, accurate, and timely information about the
terms and conditions of loans. The Federal Reserve is also authorized to write rules; notably, the
Home Ownership Equity Protection Act (HOEPA) gives the Board the power to prohibit acts and
practices in mortgage lending deemed "unfair" or "deceptive."6 Both the disclosures required by TILA
and the rules developed under HOEPA (which is part of TILA) apply to all lenders, not just banks. In
cooperation with the other federal banking regulators, the Board can also draft supervisory guidance
and back it up with regular examinations. Supervisory guidance applies only to banks and thrift
institutions, although state regulators of nonbank lenders can and sometimes do adopt guidance
written by the federal regulators.
In my judgment, effective disclosures should be the first line of defense against improper lending. If
consumers are well informed, they are in a much better position to make decisions in their own best
interest. However, combating bad lending practices, including deliberate fraud or abuse, may require
additional measures. Rules are useful if they can be drawn sharply, with bright lines, and address
practices that are never, or almost never, legitimate. Sometimes, however, specific lending practices
that may be viewed as inappropriate in some circumstances are appropriate in others, and the
conditions under which those practices are appropriate cannot be sharply delineated in advance. In
such cases, supervisory guidance that establishes principles or guidelines is, when applicable,
probably the better approach. Guidance can be modified as needed to apply to different situations,
and thus can be a more flexible tool than rules for accomplishing regulators' goals.
As I noted, markets are adjusting to the problems in the subprime market, but the regulatory agencies
must consider what additional steps might be needed. The Federal Reserve is currently undertaking a
thorough review of all its options under the law. Under its TILA authority, the Board last summer began
a top-to-bottom evaluation of mortgage-related disclosures with a series of four open hearings around
the country, in which we heard public concerns about various mortgage-related issues, including
predatory lending and the effectiveness of the currently required disclosures. Using consumer testing,
we will be working to improve the disclosures associated with mortgage lending and to fight deceptive
marketing practices. This effort will draw heavily on our nearly-completed review of disclosures relating
to open-end credit, including credit cards, for which we made extensive use of consumer testing to
determine which disclosure formats are most effective and informative.7
Of course, the information provided by even the best-designed disclosures can be useful only when it
is well understood. Accordingly, the Federal Reserve produces and regularly updates a range of
materials, including a booklet that lenders are required to provide to potential ARM borrowers, to help
consumers understand ARMs and other alternative mortgages; and we will continue to promote
financial education through a variety of partnerships with outside organizations. Federal Reserve
Banks around the country will also continue their cooperation with educational and community
organizations that provide counseling about mortgage products and the responsibilities of
homeownership.
We are also actively reviewing the possible use of our rule-making authority to prohibit certain specific
practices. In 2001, the Board acted under its HOEPA authority to ban several practices for high-cost
loans that were determined to be unfair or deceptive, such as loan flipping - frequent and repeated
refinancing to generate fees for lenders. The Board will consider whether other lending practices meet
the legal definition of unfair and deceptive and thus should be prohibited under HOEPA. Any new rules
that we issue should be sharply drawn, however. As lenders are subject not only to regulatory
enforcement action but possibly also to private lawsuits for redress of HOEPA violations, insufficiently
clear rules could create legal and regulatory uncertainty and have the unintended effect of
substantially reducing legitimate subprime lending. Next month, we will conduct a public hearing to
consider how we might further use our HOEPA authority to curb abuses while preserving access to
credit. We have invited people representing all sides of the debate to present their views.
We have also used, and will continue to use, supervisory guidance to help mitigate problems in the
subprime sector. Earlier this year, the Board and other federal bank and thrift regulators issued draft
supervisory guidance to address concerns about underwriting and disclosure practices, particularly of
subprime ARMs. Many industry and consumer groups have responded to our proposal, and we are
now reviewing the comments. Regulators in 1999 issued guidance on subprime lending and in 2001
expanded that guidance. Last year, we issued guidance concerning so-called nontraditional
mortgages, such as interest-only mortgages and option ARMs. For both subprime and nontraditional
mortgages, our guidance has reminded lenders of the importance of maintaining sound underwriting
standards and of providing consumers with clear, balanced, and timely disclosures about the risks and
benefits of these mortgages.
The patchwork nature of enforcement authority in subprime lending - in particular, the fact that the
authority to make rules and the responsibility to enforce those rules are often held by different
agencies - poses additional challenges. For example, rules issued by the Board under TILA or
HOEPA apply to all mortgage lenders but are enforced - depending on the lender - by one of five
federal regulators of depository institutions, the Federal Trade Commission (FTC), or state regulators.
To ensure consistent and effective enforcement, close cooperation and coordination among the
regulators are essential. The Board remains committed to working closely with other regulators to
achieve uniform and effective enforcement. We can continue to improve the sharing of information and
the coordination of some activities, such as examiner training, through the Federal Financial Institution
Examination Council, which the Conference of State Banking Supervisors (CSBS) recently joined, as
well as through other channels, such as the CSBS's State/Federal Working Group. We will also draw
on the expertise of other regulators as we consider changes in required disclosures and rules.
Macroeconomic implications
The problems in the subprime mortgage market have occurred in the context of a slowdown in overall
economic growth. Real gross domestic product has expanded a little more than 2 percent over the
past year, compared with an average annual growth rate of 3-3/4 percent over the preceding three
years. The cooling of the housing market is an important source of this slowdown. Sales of both new
and existing homes have dropped sharply from their peak in the summer of 2005, the inventory of
unsold homes has risen substantially, and single-family housing starts have fallen by roughly one-third
since the beginning of 2006. Although a leveling-off of sales late last year suggested some
stabilization of housing demand, the latest readings indicate a further stepdown in the first quarter.
Sales of new homes moved down to an appreciably lower level in February and March, and sales of
existing homes have also come down on net since the beginning of this year.
How will developments in the subprime market affect the evolution of the housing market? We know
from data gathered under the Home Mortgage Disclosure Act that a significant share of new loans
used to purchase homes in 2005 (the most recent year for which these data are available) were
nonprime (subprime or near-prime). In addition, the share of securitized mortgages that are subprime
climbed in 2005 and in the first half of 2006. The rise in subprime mortgage lending likely boosted
home sales somewhat, and curbs on this lending are expected to be a source of some restraint on
home purchases and residential investment in coming quarters. Moreover, we are likely to see further
increases in delinquencies and foreclosures this year and next as many adjustable-rate loans face
interest-rate resets. All that said, given the fundamental factors in place that should support the
demand for housing, we believe the effect of the troubles in the subprime sector on the broader
housing market will likely be limited, and we do not expect significant spillovers from the subprime
market to the rest of the economy or to the financial system. The vast majority of mortgages, including
even subprime mortgages, continue to perform well. Past gains in house prices have left most
homeowners with significant amounts of home equity, and growth in jobs and incomes should help
keep the financial obligations of most households manageable.
Conclusion
Credit market innovations have expanded opportunities for many households. Markets can overshoot,
but, ultimately, market forces also work to rein in excesses. For some, the self-correcting pullback may
seem too late and too severe. But I believe that, in the long run, markets are better than regulators at
allocating credit.
We at the Federal Reserve will do all that we can to prevent fraud and abusive lending and to ensure
that lenders employ sound underwriting practices and make effective disclosures to consumers. At the
same time, we must be careful not to inadvertently suppress responsible lending or eliminate
refinancing opportunities for subprime borrowers. Together with other regulators and the Congress,
our success in balancing these objectives will have significant implications for the financial well-being,
access to credit, and opportunities for homeownership of many of our fellow citizens.