Susan Schmidt Bies: Economic outlook and developments in mortgage
markets
Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve
System, at the Eller College of Management Distinguished Speaker Series, Tucson, Arizona,
18 January 2007.
* * *
To begin, I would like to thank Dean Portney and everyone at the Eller College of Management here at
The University of Arizona for the invitation to speak this evening. I know that this audience includes
both experienced business leaders as well as students preparing to apply the knowledge they have
learned in the classroom to the real world. Accordingly, my remarks will first touch on the economic
outlook. Then, I will offer some thoughts on the challenges facing consumers as they navigate today's
changing mortgage loan market.
Economic outlook
Economic activity slowed in the middle part of last year. After rising at an annual rate of 3-1/4 percent
over the previous two years, real gross domestic product (GDP) increased at an annual rate of 2.6
percent in the second quarter of last year. Real GDP growth in the second half of last year slowed
after accounting for some measurement difficulties in the automotive sector. Despite the recent
slowing in output, however, resource utilization remains relatively high by historical standards and thus
continues to be a potential source of upward pressure on inflation.
In the aftermath of the 2001 recession, the Federal Open Market Committee (FOMC) eased monetary
policy substantially. However, the degree of easing in place in 2003 and 2004 was clearly
unsustainable. Since mid-2004, the FOMC has gradually moved monetary policy from an
accommodative stance to a more neutral position. As a consequence, the elements now appear to be
in place for some easing of resource utilization rates over the next year or so and a reduction in
inflationary pressures. However, substantial uncertainty surrounds the near-term outlook. In
determining the future path of interest rates, the FOMC will be guided by the incoming data on both
output and prices, so let's begin by reviewing recent developments.
Economic activity
The slowdown in the growth of real GDP since last spring largely reflects a cooling of the housing
market: Sales of both new and existing homes dropped sharply after their peak in the summer of 2005,
the inventory of unsold homes has soared, and the number of single-family and multifamily housing
starts has fallen nearly 30 percent since the beginning of last year. At the same time, homes are
appreciating more slowly and in some markets prices are even declining.
Nonetheless, a variety of factors should help limit any remaining contraction in housing demand. For
example, despite the 4-1/4 percentage point increase in short-term interest rates over the past three
years, the interest rate on a thirty-year fixed-rate mortgage has increased only about 1/2 percentage
point, and borrowing costs continue to be relatively low. The ongoing growth in employment and real
incomes and the recent increase in the stock market wealth of households should also support the
demand for housing. Indeed, the latest data on home sales and consumer homebuying attitudes
suggest that the demand for housing may be stabilizing. While much of the downshift in the housing
market appears to have occurred already, some further softening in housing starts may yet lie ahead
as the inventory of unsold homes is reduced to appropriate levels.
That said, it is encouraging that the recent weakness in residential construction does not appear to
have spilled over to other sectors. For instance, employment has been growing nicely in nonresidential
construction, even as it has shrunk in the residential sector. In addition, consumer confidence currently
stands a good bit above its long-run average and consumption is still being fueled by past house-price
gains, which raised household wealth. This contrasts with previous slowdowns in the housing market,
which have typically coincided with widespread economic weakness.
Although the slowdown in the housing market has so far done little to reduce consumer outlays, other
factors do appear to have had a damping effect. In particular, consumption likely was restrained earlier
this year by the rise in energy prices, which took a large bite out of household budgets. The rise in
energy prices over the past few years has also affected the auto sector, most notably by reducing the
demand for gas-guzzling automobiles, such as sport-utility vehicles and trucks. As a result of this
decreased demand and other factors, inventories of these types of vehicles rose in the second half of
last year. In response, domestic automakers cut production. However, the latest data on auto sales
and scheduled new-vehicle production suggest that the drag from the inventory correction in this
sector may be easing.
Offsetting influences on consumption should support continued growth of consumer spending. The
slowing in the appreciation of house prices will likely reduce the impetus to consumer spending from
this source, while recent increases in stock market values, declines in energy prices and strong
employment and wage growth should spur consumption.
In the business sector, spending on nonresidential construction has been particularly robust.
Expenditures on drilling and mining structures have increased rapidly in response to high prices for
natural gas and crude oil. Investment in other types of structures, such as offices and commercial
buildings, has also been strong. Data for October and November indicate that although the growth rate
of nonresidential investment moderated substantially in the fourth quarter of last year, it still remained
healthy by historical standards.
Spending on equipment and software grew quite rapidly from mid-2004 to mid-2006, but appears to
have advanced at a substantially slower pace in the second half of last year. The recent stepdown in
the growth of business sales likely had a damping influence on capital spending, and, in fact, business
sentiment has moved down in the past year. However, some backlog of unfilled orders for capital
goods such as industrial machinery and other types of heavy equipment remains, which should help
support spending in the near term. Moreover, the demand for information technology equipment is
likely to be well maintained, in part because of the recent introduction of a new generation of
microprocessing chips and more-efficient large servers.
Current financial conditions are also supportive of business spending. Corporate balance sheets are
strong and flush with cash, profits are strong, and broad stock price indexes are up appreciably since
the beginning of last year. At the same time, yield spreads on corporate bonds across the ratings
spectrum have been low, supported by the strong balance sheets and robust profits.
Inflation
What are the implications of current economic activity on inflation prospects? Consumer prices
excluding food and energy accelerated through last summer - the core inflation rate was 2.4 percent
over the four quarters ending in the third quarter of last year, up from 2.0 percent for the same period a
year before.1 The more recent monthly readings have been more favorable - core prices rose 2.2
percent over the twelve months through last November, only a touch higher than the 2.1 percent rise
over the previous twelve months, and this morning's latest figures on the Consumer Price Index (CPI)
suggest that this pattern continued into December. Nevertheless, the risk to inflation continues to be
on the upside until we see further confirmation in this trend toward moderation.
In thinking about the macroeconomic consequences of inflation, it makes sense to look at the core
rate, which excludes the prices of energy and food, when the focus is on the short run. This is because
temporary shocks to food and energy prices typically don't translate into changes in inflationary
pressure. However, if these shocks persist, they may have an effect on core inflation and, more
generally, on the economic behavior of households and businesses. Core inflation can be affected
when the price changes are propagated along the production chain - say from oil prices to the prices
of chemicals and ultimately to the prices of goods made with those chemicals. In addition, shocks to
food and energy prices may affect inflation expectations. Thus, we also pay attention to broader
measures of inflation.
All things considered, the scene appears to be set for a deceleration in prices. One contributing factor
is likely to be the slowing in economic activity I already discussed, which should ease the overall
pressure on resources. Another important factor affecting the inflation outlook is household and
business expectations for inflation. As best we can judge, inflation expectations appear to be well
contained: Measures of longer-term inflation expectations, based on surveys and on a comparison of
yields on nominal and inflation-indexed government debt, have remained within the ranges in which
they have fluctuated in recent years. Finally, the recent decline in energy prices, if sustained, should
reduce cost pressures along the production chain.
But a decline in the inflation rate is not assured. Outside of the housing and automotive sectors,
growth remains sound and labor markets remain tight, especially for skilled workers. The
unemployment rate began to decline in the second half of 2003 and by the fourth quarter of last year
stood at a relatively low 4-1/2 percent. With labor markets comparatively tight by historical standards,
unit labor costs have accelerated over the past year, and firms may pass on some of these higher
costs to consumers. However, strong business profit margins, which are currently well above their
historical averages, could act as a shock absorber if cost strains were to intensify. All told, in my
judgment, inflation appears poised to decelerate in coming months as energy prices stabilize and
resource pressures ease. But the risks to that outlook seem tilted toward the upside.
The Federal Reserve and consumer protection
My remarks on the economic outlook discussed developments in housing markets, but now I would
like to delve into a specific area of mortgage lending: consumer awareness and understanding of
changes in mortgage markets. Given its role as the central bank, a banking supervisor, and a
consumer protection regulator for financial services, the Federal Reserve takes a multifaceted
approach to understanding the consumer financial services market. Thus, we recognize the
importance of homeownership in building household wealth and we monitor the safety and soundness
of mortgage underwriting practices. We also write regulations that help ensure consumers understand
the characteristics of financial services and products and that they receive the protections available for
these services and products.
Since the 1960s, Congress has enacted several laws to ensure that consumers receive
comprehensive information and fair treatment in a broad range of financial transactions. These laws
protect consumers in transactions involving credit and debit card accounts; automated teller machine
transactions and other electronic fund transfers; deposit account activities; automobile leases;
mortgages and home equity loans; and lines of credit and other unsecured credit. Congress has
assigned the Federal Reserve a considerable role in ensuring that consumers are protected under
these laws. For example, the Federal Reserve writes rules to implement the Truth in Lending Act,
which Congress enacted to ensure that consumers receive clear information about credit terms and
costs. The Federal Reserve is also responsible for rules that implement fair lending laws, such as the
Equal Credit Opportunity Act, which prohibits discrimination in credit transactions. In addition, we work
with other federal agencies to write joint rules, for example, to ensure that consumers' financial privacy
is protected.
The Federal Reserve also examines state member banks and foreign banking organizations and
exercises its umbrella supervisory authority with respect to bank and financial holding companies to
address compliance with consumer protection laws and regulations. The Federal Reserve is
committed to vigorous enforcement of those laws.
Further, the Federal Reserve develops consumer education materials, recognizing that well-educated
consumers are better able to protect themselves in financial transactions. Clearly, to choose wisely
from the variety of products and providers available, consumers must have the financial knowledge to
navigate today's increasingly complex financial services marketplace.
For example, the Federal Reserve and the Office of Thrift Supervision just revised the Consumer
Handbook on Adjustable Rate Mortgages (CHARM) to include additional information about
nontraditional mortgage products. The CHARM booklet is an important means for delivering
information about alternative adjustable rate mortgage products to consumers because creditors are
required to provide a copy of the booklet to each consumer who receives an application for an ARM.
Because the booklet is provided at this early stage in the process, it can be useful in encouraging
consumers to ask brokers and lenders the right questions to decide if this type of loan is right for them.
The booklet explains such features as payment shock and negative amortization. It also provides
numerical examples that illustrate how consumers' payments can change and how their loan balances
may increase over the term of the loan.
The Federal Reserve also published a consumer education brochure titled: Interest-Only Mortgage
Payments and Option-Payment ARMs --Are They for You? The brochure is designed to assist
consumers who are shopping for a mortgage loan and is available in printed form and in electronic
form on the Federal Reserve's website, along with other consumer mortgage information
Finally, the Federal Reserve engages in numerous outreach activities and conducts research to help
us better understand the financial services market and consumer behavior and the best approaches
for assisting consumers. We sponsor consumer and industry surveys, hold public hearings, discuss
issues with our Consumer Advisory Council, and conduct consumer focus groups and other types of
consumer testing, in addition to considering the public comments on proposed rules.
Recently, the Federal Reserve has engaged in outreach to a broad group of interested parties
regarding nontraditional mortgages. Our Consumer Advisory Council, which includes consumer
advocates and industry representatives, provided us with valuable information about nontraditional
mortgage products during development of the interagency guidance. In addition, the Federal Reserve
held a series of four public hearings on home-equity lending during the summer of 2006. One of the
principal purposes of the hearings was to gather information to inform the Federal Reserve's review of
its Truth in Lending rules. A significant portion of the hearings was devoted to discussing nontraditional
mortgage products, and in particular, whether consumers receive adequate information about these
products. The hearings explored research on consumer behavior in shopping for mortgage loans and
included discussions about the challenges in designing disclosures to more effectively communicate
loan terms and risks to consumers. We will consider this information in developing plans and
recommendations for revising the Truth in Lending rules, which require all creditors to provide
consumers with disclosures about loan terms.
Many financial products are very sophisticated credit transactions, and the disclosures describing
them are also complex and highly technical; which can be difficult for some consumers to understand.
To address this issue, the Federal Reserve is focusing in a more rigorous way on determining the
effectiveness of disclosures. We conduct extensive consumer testing to determine what information is
most important to consumers, when it is most useful for consumers to receive it, what language and
formats work best, and how disclosures can be simplified, and better organized, to reduce complexity
and information overload. To that end, the Federal Reserve uses design consultants to assist in
developing model disclosures that are most likely to be effective in communicating vital credit
information to consumers. The Federal Reserve also uses consumer testing to assist in developing
model disclosure forms, and we draw from research done by respected behavioral economists.
For example, when considering some regulatory changes related to the Electronic Fund Transfer Act,
the Federal Reserve used consumer focus group testing to develop useful and timely disclosures for
employees whose pay is received in the form of a payroll card (a card that works much like a
traditional debit card). The Federal Reserve is also engaging in extensive consumer testing of credit
card disclosures required by the Truth in Lending Act, and has found those interactions with
consumers instructive in revising disclosures to be more meaningful to consumers in today's complex
and highly prolific credit card market.
Mortgage lending
I now want to discuss developments in mortgage loan products. Last September, the federal financial
institution regulators issued supervisory guidance on nontraditional mortgages. These mortgages
include interest-only loans that allow consumers to defer the payment of principal and make only
interest payments for an initial period. They also include adjustable-rate mortgages (ARMs) with a
payment option, allowing consumers to make "minimum payments" of less than the accrued interest.
The result of such a loan structure is that the amount owed can increase even as the borrower makes
payments, a circumstance known as negative amortization. Over time, the payments for these loans
must be adjusted upward to catch up with fully indexed interest rates and/or paydowns (amortization)
of the balance owed, often significantly, which sometimes results in what some call "payment shock."
Sometimes borrowers can refinance out of these loans, but that may cost them a serious prepayment
penalty and reduce the amount of equity that they have built up in their home. The complexity of these
products contrasts with traditional thirty-year fixed-rate loans, in which consumers have equal monthly
payments that are sufficient to cover the accrued interest and pay down the principal, and with which
borrowers are generally familiar.
To be clear, nontraditional mortgages certainly serve a useful purpose when used appropriately.
These products have increased the range of financing options available to consumers and have grown
in popularity over the past few years. Some consumers may benefit from these products' more flexible
payment options. For example, consumers with seasonal or irregular income or who expect their
incomes to increase are more likely to be able to absorb the increase in payments in the near term of
the loan.
But nontraditional mortgage loan products can be complex and may not be appropriate for everyone.
Concerns have been raised that consumers are not getting clear and balanced information about the
risks and features of interest-only and payment option ARMs. These products have been advertised
and promoted based on their initially low monthly payments when compared with traditional mortgage
products. By focusing on initial monthly payments without appropriate understanding of how the
payments can vary over time or that minimum payments may actually increase the amount owed,
many consumers have become financially overextended.
Mortgage lenders are no longer limited in the size of their mortgage lending activities by the amount of
available funding on their balance sheets. Mortgages are now routinely sold to institutions who
securitize mortgages by aggregating them with other loans into pools. These mortgage-backed
securities are held by banks, pension funds, mutual funds, and other investors both in the United
States and internationally. This diversity of funding sources makes it possible for lenders to structure
products that meet the various needs of borrowers, and still be able to mitigate the risks they may take
on if the loan were held on their balance sheets. As a result, the mortgage lending industry continually
adapts to consumer requirements and investor preferences for loan securitization structures.
A mortgage is generally the largest financial obligation a consumer enters into. The initial costs, the
cost over the life of the mortgage, and the costs to prepay and refinance can be significant. Having a
wide variety of mortgage types assists consumers in finding a way to finance the purchase of a home
that best meets their own financial and lifestyle requirements. But the growing complexity of products
makes it a bigger challenge for borrowers to understand the characteristics of competing products.
This is where shopping among a couple of lenders and a couple of different products can help the
consumer understand the features of different loan types.
When looking at different loan products, consumers should consider how long they plan to own their
home, expectations of future income, their stage of life cycle, and broader financial obligations in
choosing among mortgage alternatives. For example, if consumers want to pay off their mortgages
before retirement, they must determine if the monthly payment will fully amortize the loan by the target
date. If homeowners plan to move in three years, then they should compare prepayment penalties, if
any, and interest rates among their mortgage alternatives.
But some consumers do not actively shop for a lender or a mortgage, and they do not compare loan
terms in light of their personal circumstances. Instead they rely on one lender and accept the
mortgage loan presented to them. Mortgages that are appropriate for one borrower, however, may
create problems for another. For example, some mortgages have low initial interest rates and monthly
payments. But increases come later as the "teaser period" ends and payments rise to begin pay down
of principal. Borrowers whose budgets make the initial payment just manageable may have difficulty
meeting these significant jumps in monthly payments and so are at risk of defaulting on their
mortgages and losing their home.
By shopping among lenders and products, consumers are also better able to determine whether a
given loan feature is really an advantage. For example, some lenders have recently been more willing
to waive proof of income when making a mortgage. But, they may charge a higher interest rate to
cover the risk that the borrower may not be able to afford the mortgage. The customer however may
save interest cost by making the effort to provide copies of tax returns and pay stubs. Another
example is that some lenders do not require their borrowers to pay their property tax and hazard
insurance premiums into an escrow account. Consumers need to ask lenders if their monthly
payments will include funds for such an escrow account. If not, borrowers need to separately set aside
savings to meet these obligations.
Lenders, for their part, should make it possible for consumers to engage in shopping for a mortgage.
As I noted, last September the federal financial institution regulators issued interagency guidance on
nontraditional mortgage products, which included both a focus on safe and sound lending practices as
well as on consumer awareness and consumer protection. The guidance focuses on the responsibility
of lenders to provide consumers with clear and balanced information at crucial decision-making points
about the benefits and risks of nontraditional mortgage products. Accordingly, the interagency
guidance describes recommended practices for financial institutions in communicating with consumers
while they are shopping, not just upon submission of an application or at loan consummation.
Specifically, the guidance recommends that institutions' promotional materials and descriptions of
these products include information about, among other things, potential increases in consumers'
payment obligations and the potential consequences of increasing principal loan balances and
decreasing home equity. The guidance also recommends that institutions alert consumers to the
amount of any prepayment penalty that may be imposed if the consumer refinances the mortgage.
Conclusion
I hope that my remarks today provided a useful snapshot of the current economic outlook. Outside of
housing and the automotive sector, the economy is strong and employment is growing. The surge in
housing construction that occurred in 2004-2005 was not sustainable, and we are now well along in
adjusting housing construction to more comfortable levels.
Inflation continues to run at a pace above my comfort level. The Federal Reserve has raised interest
rates to moderate inflation. Monetary policy works with long lags and so the economy is still reacting to
our past actions. Given the strong growth in most sectors of the economy, the risks to inflation are still
on the upside. In addition to giving some thoughts on the economy, I felt it was useful to offer a
summary of the role that the Federal Reserve plays in consumer protection, using the current example
of nontraditional mortgages. Clearly, the Federal Reserve believes in promoting consumer awareness
and maintaining consumer protection so that users of financial products fully understand those
products and their associated risks.