Ben S Bernanke: Housing, housing finance, and monetary policy
Remarks by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal
Reserve System, at the Federal Reserve Bank of Kansas City's Economic Symposium,
Jackson Hole, Wyoming, 31 August 2007.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
Over the years, Tom Hoenig and his colleagues at the Federal Reserve Bank of Kansas City
have done an excellent job of selecting interesting and relevant topics for this annual
symposium. I think I can safely say that this year they have outdone themselves. Recently,
the subject of housing finance has preoccupied financial-market participants and observers
in the United States and around the world. The financial turbulence we have seen had its
immediate origins in the problems in the subprime mortgage market, but the effects have
been felt in the broader mortgage market and in financial markets more generally, with
potential consequences for the performance of the overall economy.
In my remarks this morning, I will begin with some observations about recent market
developments and their economic implications. I will then try to place recent events in a
broader historical context by discussing the evolution of housing markets and housing
finance in the United States. In particular, I will argue that, over the years, institutional
changes in U.S. housing and mortgage markets have significantly influenced both the
transmission of monetary policy and the economy's cyclical dynamics. As our system of
housing finance continues to evolve, understanding these linkages not only provides useful
insights into the past but also holds the promise of helping us better cope with the
implications of future developments.
Recent developments in financial markets and the economy
I will begin my review of recent developments by discussing the housing situation. As you
know, the downturn in the housing market, which began in the summer of 2005, has been
sharp. Sales of new and existing homes have declined significantly from their mid-2005
peaks and have remained slow in recent months. As demand has weakened, house prices
have decelerated or even declined by some measures, and homebuilders have scaled back
their construction of new homes. The cutback in residential construction has directly reduced
the annual rate of U.S. economic growth about 3/4 percentage point on average over the
past year and a half. Despite the slowdown in construction, the stock of unsold new homes
remains quite elevated relative to sales, suggesting that further declines in homebuilding are
likely.
The outlook for home sales and construction will also depend on unfolding developments in
mortgage markets. A substantial increase in lending to nonprime borrowers contributed to
the bulge in residential investment in 2004 and 2005, and the tightening of credit conditions
for these borrowers likely accounts for some of the continued softening in demand we have
seen this year. As I will discuss, recent market developments have resulted in additional
tightening of rates and terms for nonprime borrowers as well as for potential borrowers
through "jumbo" mortgages. Obviously, if current conditions persist in mortgage markets, the
demand for homes could weaken further, with possible implications for the broader economy.
We are following these developments closely.
As house prices have softened, and as interest rates have risen from the low levels of a
couple of years ago, we have seen a marked deterioration in the performance of nonprime
mortgages. The problems have been most severe for subprime mortgages with adjustable
rates: the proportion of those loans with serious delinquencies rose to about 13-1/2 percent
in June, more than double the recent low seen in mid-2005.1 The adjustable-rate subprime
mortgages originated in late 2005 and in 2006 have performed the worst, in part because of
slippage in underwriting standards, reflected for example in high loan-to-value ratios and
incomplete documentation. With many of these borrowers facing their first interest rate resets
in coming quarters, and with softness in house prices expected to continue to impede
refinancing, delinquencies among this class of mortgages are likely to rise further. Apart from
adjustable-rate subprime mortgages, however, the deterioration in performance has been
less pronounced, at least to this point. For subprime mortgages with fixed rather than
variable rates, for example, serious delinquencies have been fairly stable at about 5-1/2
percent. The rate of serious delinquencies on alt-A securitized pools rose to nearly 3 percent
in June, from a low of less than 1 percent in mid-2005. Delinquency rates on prime jumbo
mortgages have also risen, though they are lower than those for prime conforming loans, and
both rates are below 1 percent.
Investors' concerns about mortgage credit performance have intensified sharply in recent
weeks, reflecting, among other factors, worries about the housing market and the effects of
impending interest-rate resets on borrowers' ability to remain current. Credit spreads on new
securities backed by subprime mortgages, which had jumped earlier this year, rose
significantly more in July. Issuance of such securities has been negligible since then, as
dealers have faced difficulties placing even the AAA-rated tranches. Issuance of securities
backed by alt-A and prime jumbo mortgages also has fallen sharply, as investors have
evidently become concerned that the losses associated with these types of mortgages may
be higher than had been expected.
With securitization impaired, some major lenders have announced the cancellation of their
adjustable-rate subprime lending programs. A number of others that specialize in
nontraditional mortgages have been forced by funding pressures to scale back or close
down. Some lenders that sponsor asset-backed commercial paper conduits as bridge
financing for their mortgage originations have been unable to "roll" the maturing paper,
forcing them to draw on back-up liquidity facilities or to exercise options to extend the
maturity of their paper. As a result of these developments, borrowers face noticeably tighter
terms and standards for all but conforming mortgages.
As you know, the financial stress has not been confined to mortgage markets. The markets
for asset-backed commercial paper and for lower-rated unsecured commercial paper market
also have suffered from pronounced declines in investor demand, and the associated flight to
quality has contributed to surges in the demand for short-dated Treasury bills, pushing T-bill
rates down sharply on some days. Swings in stock prices have been sharp, with implied
price volatilities rising to about twice the levels seen in the spring. Credit spreads for a range
of financial instruments have widened, notably for lower-rated corporate credits. Diminished
demand for loans and bonds to finance highly leveraged transactions has increased some
banks' concerns that they may have to bring significant quantities of these instruments onto
their balance sheets. These banks, as well as those that have committed to serve as back-up
facilities to commercial paper programs, have become more protective of their liquidity and
balance-sheet capacity.
Although this episode appears to have been triggered largely by heightened concerns about
subprime mortgages, global financial losses have far exceeded even the most pessimistic
projections of credit losses on those loans. In part, these wider losses likely reflect concerns
that weakness in U.S. housing will restrain overall economic growth. But other factors are
also at work. Investor uncertainty has increased significantly, as the difficulty of evaluating
the risks of structured products that can be opaque or have complex payoffs has become
more evident. Also, as in many episodes of financial stress, uncertainty about possible forced
sales by leveraged participants and a higher cost of risk capital seem to have made investors
hesitant to take advantage of possible buying opportunities. More generally, investors may
have become less willing to assume risk. Some increase in the premiums that investors
require to take risk is probably a healthy development on the whole, as these premiums have
been exceptionally low for some time. However, in this episode, the shift in risk attitudes has
interacted with heightened concerns about credit risks and uncertainty about how to evaluate
those risks to create significant market stress. On the positive side of the ledger, we should
recognize that past efforts to strengthen capital positions and the financial infrastructure
place the global financial system in a relatively strong position to work through this process.
In the statement following its August 7 meeting, the Federal Open Market Committee
(FOMC) recognized that the rise in financial volatility and the tightening of credit conditions
for some households and businesses had increased the downside risks to growth somewhat
but reiterated that inflation risks remained its predominant policy concern. In subsequent
days, however, following several events that led investors to believe that credit risks might be
larger and more pervasive than previously thought, the functioning of financial markets
became increasingly impaired. Liquidity dried up and spreads widened as many market
participants sought to retreat from certain types of asset exposures altogether.
Well-functioning financial markets are essential for a prosperous economy. As the nation's
central bank, the Federal Reserve seeks to promote general financial stability and to help to
ensure that financial markets function in an orderly manner. In response to the developments
in the financial markets in the period following the FOMC meeting, the Federal Reserve
provided reserves to address unusual strains in money markets. On August 17, the Federal
Reserve Board announced a cut in the discount rate of 50 basis points and adjustments in
the Reserve Banks' usual discount window practices to facilitate the provision of term
financing for as long as thirty days, renewable by the borrower. The Federal Reserve also
took a number of supplemental actions, such as cutting the fee charged for lending Treasury
securities. The purpose of the discount window actions was to assure depositories of the
ready availability of a backstop source of liquidity. Even if banks find that borrowing from the
discount window is not immediately necessary, the knowledge that liquidity is available
should help alleviate concerns about funding that might otherwise constrain depositories
from extending credit or making markets. The Federal Reserve stands ready to take
additional actions as needed to provide liquidity and promote the orderly functioning of
markets.
It is not the responsibility of the Federal Reserve - nor would it be appropriate - to protect
lenders and investors from the consequences of their financial decisions. But developments
in financial markets can have broad economic effects felt by many outside the markets, and
the Federal Reserve must take those effects into account when determining policy. In a
statement issued simultaneously with the discount window announcement, the FOMC
indicated that the deterioration in financial market conditions and the tightening of credit
since its August 7 meeting had appreciably increased the downside risks to growth. In
particular, the further tightening of credit conditions, if sustained, would increase the risk that
the current weakness in housing could be deeper or more prolonged than previously
expected, with possible adverse effects on consumer spending and the economy more
generally.
The incoming data indicate that the economy continued to expand at a moderate pace into
the summer, despite the sharp correction in the housing sector. However, in light of recent
financial developments, economic data bearing on past months or quarters may be less
useful than usual for our forecasts of economic activity and inflation. Consequently, we will
pay particularly close attention to the timeliest indicators, as well as information gleaned from
our business and banking contacts around the country. Inevitably, the uncertainty
surrounding the outlook will be greater than normal, presenting a challenge to policymakers
to manage the risks to their growth and price stability objectives. The Committee continues to
monitor the situation and will act as needed to limit the adverse effects on the broader
economy that may arise from the disruptions in financial markets.
Beginnings: mortgage markets in the early twentieth century
Like us, our predecessors grappled with the economic and policy implications of innovations
and institutional changes in housing finance. In the remainder of my remarks, I will try to set
the stage for this weekend's conference by discussing the historical evolution of the
mortgage market and some of the implications of that evolution for monetary policy and the
economy.
The early decades of the twentieth century are a good starting point for this review, as
urbanization and the exceptionally rapid population growth of that period created a strong
demand for new housing. Between 1890 and 1930, the number of housing units in the United
States grew from about 10 million to about 30 million; the pace of homebuilding was
particularly brisk during the economic boom of the 1920s.
Remarkably, this rapid expansion of the housing stock took place despite limited sources of
mortgage financing and typical lending terms that were far less attractive than those to which
we are accustomed today. Required down payments, usually about half of the home's
purchase price, excluded many households from the market. Also, by comparison with
today's standards, the duration of mortgage loans was short, usually ten years or less. A
"balloon" payment at the end of the loan often created problems for borrowers.2
High interest rates on loans reflected the illiquidity and the essentially unhedgeable interest
rate risk and default risk associated with mortgages. Nationwide, the average spread
between mortgage rates and high-grade corporate bond yields during the 1920s was about
200 basis points, compared with about 50 basis points on average since the mid-1980s. The
absence of a national capital market also produced significant regional disparities in
borrowing costs. Hard as it may be to conceive today, rates on mortgage loans before World
War I were at times as much as 2 to 4 percentage points higher in some parts of the country
than in others, and even in 1930, regional differences in rates could be more than a full
percentage point.3
Despite the underdevelopment of the mortgage market, homeownership rates rose steadily
after the turn of the century. As would often be the case in the future, government policy
provided some inducement for homebuilding. When the federal income tax was introduced in
1913, it included an exemption for mortgage interest payments, a provision that is a powerful
stimulus to housing demand even today. By 1930, about 46 percent of nonfarm households
owned their own homes, up from about 37 percent in 1890.
The limited availability of data prior to 1929 makes it hard to quantify the role of housing in
the monetary policy transmission mechanism during the early twentieth century.
Comparisons are also complicated by great differences between then and now in monetary
policy frameworks and tools. Still, then as now, periods of tight money were reflected in
higher interest rates and a greater reluctance of banks to lend, which affected conditions in
mortgage markets. Moreover, students of the business cycle, such as Arthur Burns and
Wesley Mitchell, have observed that residential construction was highly cyclical and
contributed significantly to fluctuations in the overall economy (Burns and Mitchell, 1946).
Indeed, if we take the somewhat less reliable data for 1901 to 1929 at face value, real
housing investment was about three times as volatile during that era as it has been over the
past half-century.
During the past century we have seen two great sea changes in the market for housing
finance. The first of these was the product of the New Deal. The second arose from financial
innovation and a series of crises from the 1960s to the mid-1980s in depository funding of
mortgages. I will turn first to the New Deal period.
The New Deal and the housing market
The housing sector, like the rest of the economy, was profoundly affected by the Great
Depression. When Franklin Roosevelt took office in 1933, almost 10 percent of all homes
were in foreclosure (Green and Wachter, 2005), construction employment had fallen by half
from its late 1920s peak, and a banking system near collapse was providing little new credit.
As in other sectors, New Deal reforms in housing and housing finance aimed to foster
economic revival through government programs that either provided financing directly or
strengthened the institutional and regulatory structure of private credit markets.
Actually, one of the first steps in this direction was taken not by Roosevelt but by his
predecessor, Herbert Hoover, who oversaw the creation of the Federal Home Loan Banking
System in 1932. This measure reorganized the thrift industry (savings and loans and mutual
savings banks) under federally chartered associations and established a credit reserve
system modeled after the Federal Reserve. The Roosevelt administration pushed this and
other programs affecting housing finance much further. In 1934, his administration oversaw
the creation of the Federal Housing Administration (FHA). By providing a federally backed
insurance system for mortgage lenders, the FHA was designed to encourage lenders to offer
mortgages on more attractive terms. This intervention appears to have worked in that, by the
1950s, most new mortgages were for thirty years at fixed rates, and down payment
requirements had fallen to about 20 percent. In 1938, the Congress chartered the Federal
National Mortgage Association, or Fannie Mae, as it came to be known. The new institution
was authorized to issue bonds and use the proceeds to purchase FHA mortgages from
lenders, with the objectives of increasing the supply of mortgage credit and reducing
variations in the terms and supply of credit across regions.4
Shaped to a considerable extent by New Deal reforms and regulations, the postwar
mortgage market took on the form that would last for several decades. The market had two
main sectors. One, the descendant of the pre-Depression market sector, consisted of
savings and loan associations, mutual savings banks, and, to a lesser extent, commercial
banks. With financing from short-term deposits, these institutions made conventional
fixedrate long-term loans to homebuyers. Notably, federal and state regulations limited
geographical diversification for these lenders, restricting interstate banking and obliging
thrifts to make mortgage loans in small local areas - within 50 miles of the home office until
1964, and within 100 miles after that. In the other sector, the product of New Deal programs,
private mortgage brokers and other lenders originated standardized loans backed by the
FHA and the Veterans' Administration (VA). These guaranteed loans could be held in
portfolio or sold to institutional investors through a nationwide secondary market.
No discussion of the New Deal's effect on the housing market and the monetary transmission
mechanism would be complete without reference to Regulation Q - which was eventually to
exemplify the law of unintended consequences. The Banking Acts of 1933 and 1935 gave
the Federal Reserve the authority to impose deposit-rate ceilings on banks, an authority that
was later expanded to cover thrift institutions. The Fed used this authority in establishing its
Regulation Q. The so-called Reg Q ceilings remained in place in one form or another until
the mid-1980s.5
The original rationale for deposit ceilings was to reduce "excessive" competition for bank
deposits, which some blamed as a cause of bank failures in the early 1930s. In retrospect, of
course, this was a dubious bit of economic analysis. In any case, the principal effects of the
ceilings were not on bank competition but on the supply of credit. With the ceilings in place,
banks and thrifts experienced what came to be known as disintermediation - an outflow of
funds from depositories that occurred whenever short-term money-market rates rose above
the maximum that these institutions could pay. In the absence of alternative funding sources,
the loss of deposits prevented banks and thrifts from extending mortgage credit to new
customers.
The transmission mechanism and the New Deal reforms
Under the New Deal system, housing construction soared after World War II, driven by the
removal of wartime building restrictions, the need to replace an aging housing stock, rapid
family formation that accompanied the beginning of the baby boom, and large-scale internal
migration. The stock of housing units grew 20 percent between 1940 and 1950, with most of
the new construction occurring after 1945.
In 1951, the Treasury-Federal Reserve Accord freed the Fed from the obligation to support
Treasury bond prices. Monetary policy began to focus on influencing short-term money
markets as a means of affecting economic activity and inflation, foreshadowing the Federal
Reserve's current use of the federal funds rate as a policy instrument. Over the next few
decades, housing assumed a leading role in the monetary transmission mechanism, largely
for two reasons: Reg Q and the advent of high inflation.
The Reg Q ceilings were seldom binding before the mid-1960s, but disintermediation
induced by the ceilings occurred episodically from the mid-1960s until Reg Q began to be
phased out aggressively in the early 1980s. The impact of disintermediation on the housing
market could be quite significant; for example, a moderate tightening of monetary policy in
1966 contributed to a 23 percent decline in residential construction between the first quarter
of 1966 and the first quarter of 1967. State usury laws and branching restrictions worsened
the episodes of disintermediation by placing ceilings on lending rates and limiting the flow of
funds between local markets. For the period 1960 to 1982, when Reg Q assumed its greatest
importance, statistical analysis shows a high correlation between single-family housing starts
and the growth of small time deposits at thrifts, suggesting that disintermediation effects were
powerful; in contrast, since 1983 this correlation is essentially zero.6
Economists at the time were well aware of the importance of the disintermediation
phenomenon for monetary policy. Frank de Leeuw and Edward Gramlich highlighted this
particular channel in their description of an early version of the MPS macroeconometric
model, a joint product of researchers at the Federal Reserve, MIT, and the University of
Pennsylvania (de Leeuw and Gramlich, 1969). The model attributed almost one-half of the
direct first-year effects of monetary policy on the real economy - which were estimated to be
substantial - to disintermediation and other housing-related factors, despite the fact that
residential construction accounted for only 4 percent of nominal gross domestic product
(GDP) at the time.
As time went on, however, monetary policy mistakes and weaknesses in the structure of the
mortgage market combined to create deeper economic problems. For reasons that have
been much analyzed, in the late 1960s and the 1970s the Federal Reserve allowed inflation
to rise, which led to corresponding increases in nominal interest rates. Increases in
shortterm nominal rates not matched by contractually set rates on existing mortgages exposed a
fundamental weakness in the system of housing finance, namely, the maturity mismatch
between long-term mortgage credit and the short-term deposits that commercial banks and
thrifts used to finance mortgage lending. This mismatch led to a series of liquidity crises and,
ultimately, to a rash of insolvencies among mortgage lenders. High inflation was also
ultimately reflected in high nominal long-term rates on new mortgages, which had the effect
of "front loading" the real payments made by holders of long-term, fixed-rate mortgages. This
front-loading reduced affordability and further limited the extension of mortgage credit,
thereby restraining construction activity. Reflecting these factors, housing construction
experienced a series of pronounced boom and bust cycles from the early 1960s through the
mid-1980s, which contributed in turn to substantial swings in overall economic growth.
The emergence of capital markets as a source of housing finance
The manifest problems associated with relying on short-term deposits to fund long-term
mortgage lending set in train major changes in financial markets and financial instruments,
which collectively served to link mortgage lending more closely to the broader capital
markets. The shift from reliance on specialized portfolio lenders financed by deposits to a
greater use of capital markets represented the second great sea change in mortgage
finance, equaled in importance only by the events of the New Deal.
Government actions had considerable influence in shaping this second revolution. In 1968,
Fannie Mae was split into two agencies: the Government National Mortgage Association
(Ginnie Mae) and the re-chartered Fannie Mae, which became a privately owned
government-sponsored enterprise (GSE), authorized to operate in the secondary market for
conventional as well as guaranteed mortgage loans. In 1970, to compete with Fannie Mae in
the secondary market, another GSE was created - the Federal Home Loan Mortgage
Corporation, or Freddie Mac. Also in 1970, Ginnie Mae issued the first mortgage
passthrough security, followed soon after by Freddie Mac. In the early 1980s, Freddie Mac
introduced collateralized mortgage obligations (CMOs), which separated the payments from
a pooled set of mortgages into "strips" carrying different effective maturities and credit risks.
Since 1980, the outstanding volume of GSE mortgage-backed securities has risen from less
than $200 billion to more than $4 trillion today. Alongside these developments came the
establishment of private mortgage insurers, which competed with the FHA, and private
mortgage pools, which bundled loans not handled by the GSEs, including loans that did not
meet GSE eligibility criteria - so-called nonconforming loans. Today, these private pools
account for around $2 trillion in residential mortgage debt.
These developments did not occur in time to prevent a large fraction of the thrift industry from
becoming effectively insolvent by the early 1980s in the wake of the late-1970s surge in
inflation.7 In this instance, the government abandoned attempts to patch up the system and
instead undertook sweeping deregulation. Reg Q was phased out during the 1980s; state
usury laws capping mortgage rates were abolished; restrictions on interstate banking were
lifted by the mid-1990s; and lenders were permitted to offer adjustable-rate mortgages as
well as mortgages that did not fully amortize and which therefore involved balloon payments
at the end of the loan period. Critically, the savings and loan crisis of the late 1980s ended
the dominance of deposit-taking portfolio lenders in the mortgage market. By the 1990s,
increased reliance on securitization led to a greater separation between mortgage lending
and mortgage investing even as the mortgage and capital markets became more closely
integrated. About 56 percent of the home mortgage market is now securitized, compared
with only 10 percent in 1980 and less than 1 percent in 1970.
In some ways, the new mortgage market came to look more like a textbook financial market,
with fewer institutional "frictions" to impede trading and pricing of event-contingent securities.
Securitization and the development of deep and liquid derivatives markets eased the
spreading and trading of risk. New types of mortgage products were created. Recent
developments notwithstanding, mortgages became more liquid instruments, for both lenders
and borrowers. Technological advances facilitated these changes; for example,
computerization and innovations such as credit scores reduced the costs of making loans
and led to a "commoditization" of mortgages. Access to mortgage credit also widened;
notably, loans to subprime borrowers accounted for about 13 percent of outstanding
mortgages in 2006.
I suggested that the mortgage market has become more like the frictionless financial market
of the textbook, with fewer institutional or regulatory barriers to efficient operation. In one
important respect, however, that characterization is not entirely accurate. A key function of
efficient capital markets is to overcome problems of information and incentives in the
extension of credit. The traditional model of mortgage markets, based on portfolio lending,
solved these problems in a straightforward way: Because banks and thrifts kept the loans
they made on their own books, they had strong incentives to underwrite carefully and to
invest in gathering information about borrowers and communities. In contrast, when most
loans are securitized and originators have little financial or reputational capital at risk, the
danger exists that the originators of loans will be less diligent. In securitization markets,
therefore, monitoring the originators and ensuring that they have incentives to make good
loans is critical. I have argued elsewhere that, in some cases, the failure of investors to
provide adequate oversight of originators and to ensure that originators' incentives were
properly aligned was a major cause of the problems that we see today in the subprime
mortgage market (Bernanke, 2007). In recent months we have seen a reassessment of the
problems of maintaining adequate monitoring and incentives in the lending process, with
investors insisting on tighter underwriting standards and some large lenders pulling back
from the use of brokers and other agents. We will not return to the days in which all mortgage
lending was portfolio lending, but clearly the originate-to-distribute model will be modified - is
already being modified - to provide stronger protection for investors and better incentives for
originators to underwrite prudently.
The monetary transmission mechanism since the mid-1980s
The dramatic changes in mortgage finance that I have described appear to have significantly
affected the role of housing in the monetary transmission mechanism. Importantly, the easing
of some traditional institutional and regulatory frictions seems to have reduced the sensitivity
of residential construction to monetary policy, so that housing is no longer so central to
monetary transmission as it was.8 In particular, in the absence of Reg Q ceilings on deposit
rates and with a much-reduced role for deposits as a source of housing finance, the
availability of mortgage credit today is generally less dependent on conditions in short-term
money markets, where the central bank operates most directly.
Most estimates suggest that, because of the reduced sensitivity of housing to short-term
interest rates, the response of the economy to a given change in the federal funds rate is
modestly smaller and more balanced across sectors than in the past.9 These results are
embodied in the Federal Reserve's large econometric model of the economy, which implies
that only about 14 percent of the overall response of output to monetary policy is now
attributable to movements in residential investment, in contrast to the model's estimate of 25
percent or so under what I have called the New Deal system.
The econometric findings seem consistent with the reduced synchronization of the housing
cycle and the business cycle during the present decade. In all but one recession during the
period from 1960 to 1999, declines in residential investment accounted for at least 40
percent of the decline in overall real GDP, and the sole exception - the 1970 recession -
was preceded by a substantial decline in housing activity before the official start of the
downturn. In contrast, residential investment boosted overall real GDP growth during the
2001 recession. More recently, the sharp slowdown in housing has been accompanied, at
least thus far, by relatively good performance in other sectors. That said, the current episode
demonstrates that pronounced housing cycles are not a thing of the past.
My d