Elizabeth A Duke: Prescriptions for housing recovery
Speech by Ms Elizabeth A Duke, Member of the Board of Governors of the Federal Reserve
System, at the National Association of Realtors Midyear Legislative Meetings and Trade
Expo, Washington DC, 15 May 2012.
* * *
Good morning. The title of this session is "Prescriptions for Housing Recovery." I wish I had
such a prescription. Problems related to mortgage debt and mortgage underwriting played a
central role in the recent financial crisis and resulted in a massive dislocation in the housing
market. It is difficult to think of a single prescription that by itself will generate a sustainable
recovery in housing. At the same time, I do see policies that I believe will help reduce the
shadow inventory of houses in the foreclosure pipeline. I also see policy actions that could be
taken to improve credit availability for potential homebuyers and, in turn, demand for houses.
I have talked at length in previous speeches about actions that I believe would help alleviate
the effects of excess foreclosure inventory on the housing market.1 In my remarks today I will
mention those possible actions only briefly and then focus primarily on policy issues that I
expect will shape the availability of credit for home purchases in the future.
Before I begin my remarks, I want to emphasize that the views that I will present today are
my own and not necessarily those of my colleagues on the Federal Open Market Committee
(FOMC) or the Board of Governors.
State of housing markets
Let me start with a review of the fallout from the boom and subsequent bust in housing. It
was only six years ago that the housing market was booming: The homeownership rate
stood at 69 percent, and aggregate housing wealth reached nearly $23 trillion. Since then,
however, the housing market has struggled, to say the least: The homeownership rate has
declined to 66 percent, and national house prices have fallen about one-third, while house
prices in hard-hit areas, such as Las Vegas, have fallen almost twice that amount. As a
result, nearly $7 trillion in housing wealth has been lost.
Housing supply
House prices have been weighed down by the large proportion of distressed sales - that is,
sales resulting from foreclosures or short sales - and the specter of the large shadow
inventory currently in the foreclosure pipeline. High levels of unemployment, weak income
growth, and negative equity have contributed to a staggering 2.2 million loans in the
foreclosure process and another 1.7 million loans that are three or more payments behind.
Moreover, due to ongoing delays in the foreclosure process, more than 40 percent of loans in
foreclosure are more than two years delinquent.
While these statistics are indicative of a historic level of homeowner stress, they are down
from their post-crisis peaks, and there are signs that further gradual improvement may lie
ahead. The share of loans entering delinquency for the first time has been trending lower for
more than two years. This decline in early-stage delinquencies has coincided with sustained
reductions in broader measures of delinquency - most notably, total loans past due. These
favorable trends likely reflect somewhat better economic conditions. But efforts to resolve
troubled mortgages through loan modification, short sales, and deeds-in-lieu of foreclosure
should also be credited. Further, mortgages that were originated using the tight underwriting
that has prevailed since 2008 would presumably have lower delinquency rates, and recent
vintage loans now make up an increasing share of outstanding mortgages.
There are some promising signs in the trend of house prices as well. Although house prices
have continued to fall year-over-year, the pace of decline has slowed notably and the
month-over-month readings have shown increases for three months now. National house
prices fell less than 1 percent for the year ending in March. With the exception of the period
around the 2010 first-time homebuyer tax credit, this year-over-year decline was the smallest
since early 2007. Moreover, according to CoreLogic data, home prices have risen in more
cities lately than they have fallen. Indeed, over 45 percent of cities saw their home prices rise
more than 1 percent in the past three months, the most since early 2006.
These modest improvements in house prices can only be sustained if the demand for homes
strengthens or the supply of homes for sale falls to meet weak demand. My Realtor friends
have taught me that when inventories of houses for sale reach a level equal to six months of
sales, then markets are usually in rough balance, meaning that levels below six months tend
to favor sellers and those above six months favor buyers. My economist colleagues talk
about much the same concept - using, as they so often do, a vocabulary that may not be
familiar to others. In particular, they think about the idea of equilibrium prevailing in a market,
so that prices are roughly stable. And, indeed, just as the inventory of existing homes for sale
nationally has approached six months of sales, we have seen a leveling of prices suggesting
that some equilibrium is being achieved, albeit at low levels. Of course, as Realtors know
very well, these national data mask some significant differences in individual markets.
Inventory in some markets is reportedly quite tight, including some markets such as Miami
and Phoenix where the level of past due loans and loans in the process of foreclosure is still
quite high. For me, this calls into question the notion that housing prices cannot stabilize until
the foreclosure pipeline is worked off. I believe that this reduction in inventory, even in the
face of a steady supply of foreclosed homes, is a result of a sharp contraction in normal
homeowner activity and an equally sharp expansion of investor activity. Certainly, as prices
fell, many existing homeowners withdrew their homes from the market either because they
were unwilling to sell at low prices or because they were unable to sell if they could not
receive enough money from the sale to pay off their mortgages.
At the same time, a significant portion of the inventory has been absorbed by investors
attracted by low prices and increasing rental rates. So far, the investors purchasing
single-family properties have been primarily small investors who have had difficulties
obtaining financing to purchase more than a handful of properties. Recently, however,
anecdotes have been proliferating about investors establishing entities to purchase and
manage a larger number of properties - on the order of several hundred to several thousand
of them. In addition, pilot programs are currently under way to solicit larger-scale investor
interest in properties owned by Fannie Mae and Freddie Mac. If successful, these programs
could act to simultaneously reduce the number of distressed sales and meet the elevated
demand for rental housing.
Recent indicators of housing construction activity have also been somewhat encouraging.
Housing starts and permits have edged up from very low levels, and builders' and Realtors'
ratings of housing market conditions have stepped up a fair bit. In addition, multifamily starts
have risen steadily, likely in response to higher apartment demand and falling vacancy rates.
Demand for housing
Notwithstanding these signs of improvement in the housing market, demand for
owner-occupied housing remains stubbornly tepid. An important driver of housing demand is
household formation. Although household formation typically falls during economic
downturns, it has been especially weak this time around. Since 2007, household formation
has been running at three-fourths of its normal rate of about 1 million households per year. In
addition, many potential homebuyers are delaying home purchases because they are
worried about their income or employment prospects. Others look at declining house prices
and either conclude that they can wait and buy at a lower price or fear that if they do buy,
they might lose their home equity. Even so, the drag of these factors on housing demand
should begin to wane as the gradual recovery in the labor market progresses and house
prices stabilize.
Unfortunately, some buyers who would like to purchase a home are unable to do so because
they are unable to obtain a mortgage. According to the Federal Reserve's quarterly Senior
Loan Officer Opinion Survey on Bank Lending Practices (SLOOS), underwriting standards
for residential mortgages tightened steadily from 2007 to 2009, and they do not appear to
have eased much since then.2
This tightening of credit standards is apparent in the credit scores of borrowers who obtain
mortgages. For newly originated mortgages, the median credit score of prime borrowers rose
from about 700 in 2006 to more than 760 in 2009, where it remains today. Moreover, a large
swath of borrowers who likely had access to credit a few years ago appear to be essentially
excluded from the mortgage market under current prevailing standards. Indeed, in an
indication of the minimum credit score required to obtain credit, the credit scores of
borrowers in the bottom 10 percent of those who obtained credit have risen from around
625 in 2006 to approximately 690 today.
Tight mortgage underwriting standards make obtaining mortgage credit particularly more
difficult for first-time homebuyers. Because first-time homebuyers tend to be younger than
other homebuyers, they also tend to have lower credit scores and fewer financial assets that
can be used for down payments. As a result, tight lending standards would be expected to
constrain their demand by more than it would for other homebuyers. Indeed, research by
Federal Reserve staff finds that first-time homebuying during the past two years has been
quite weak by historical standards, and that this weakness has been particularly pronounced
among borrowers with lower credit scores.
Understanding tight mortgage credit conditions
So why is access to mortgage credit so tight? Lenders may have tightened credit standards
partly as a correction for the lax and problematic lending standards that prevailed in the
years leading up to the peak in house prices. And, given the significant consequences that
those lax lending standards had for many households, communities, financial institutions,
and the economy, some tightening of credit standards is warranted. But it seems likely that
other factors are at work as well.
Constraints on lenders' capacity to process loan applications have reportedly been part of
the story. Since the crisis hit, some lenders have closed their doors, and others have cut
back substantially on staff. In addition, a shift to full documentation of income and assets,
along with a heightened concern that underwriting mistakes could cause lenders to be forced
to repurchase seriously delinquent loans, has lengthened the time required to originate each
mortgage. Indeed, according to Home Mortgage Disclosure Act data, the median time that
elapsed between mortgage application and closing increased from about 4 weeks in 2008 to
around 6 weeks in 2010. Moreover, empirical evidence suggests that lenders might be nearly
as capacity-constrained now as during the 2003 refinance boom, even though current
mortgage volume is only about one-third of the volume in 2003. But capacity constraints
alone are an unsatisfying answer to the question of why access to credit is so tight. It seems
reasonable to suppose that if lenders were eager to originate mortgages, they would have an
incentive to invest in staff and systems to alleviate these constraints. I believe uncertainty
about the future on the part of lenders is inhibiting these investments.
The problem of uncertainty
Just as uncertainty about job prospects or house prices has likely discouraged some
potential buyers from purchasing homes, it is likely that uncertainty has also affected
mortgage lenders. Indeed, uncertainty surrounds several key aspects of mortgage lending:
the strength of the economic recovery and the trajectory of future house prices; the costs and
liabilities associated with originating and servicing mortgage loans; the regulatory
environment; and the future structure of the mortgage market, including that of Fannie Mae
and Freddie Mac and of private-label securitization. I think the effects of these uncertainties
have an important bearing on the future strength of the housing market and would like to
discuss each in a bit more detail.
Turning first to macroeconomic uncertainty, borrowers are more likely to default when they
lose their jobs or when their houses decline in value. So long as unemployment remains
elevated and further house price declines remain possible, lenders will be cautious in setting
their requirements for credit, and rightfully so. But these factors should ease as the economic
recovery gains steam and the trajectory for house prices appears more certain.
Although house price declines have moderated notably, the continuing effects on house
prices of the large number of underwater mortgages and of the mortgages still in the
foreclosure pipeline remain unclear. Even professional forecasters diverge widely in their
views about the future path of house prices: In one recent survey, house price forecasts for
2012 ranged from a decline of 8 percent to an increase of 5 percent.
Uncertainty about house prices and the high volume of distressed sales make the job of
residential appraisers and lenders more difficult. In the current market, appraisers may tend
to have a more conservative view of a home's market value and, as long as house prices
continue to decline, lenders may lean toward more conservative underwriting. Taken
together, these factors could discourage or even disrupt sales that might otherwise happen
smoothly. Like you, we have been hearing such reports.
While macroeconomic uncertainty is likely an important contributing factor to tight mortgage
credit conditions, we also observe that lenders have tended to be conservative in making
some mortgages that are guaranteed by government-sponsored enterprises (GSEs) - loans
in which lenders do not bear the credit risk in the event of borrower default - which suggests
that issues other than macroeconomic risk are affecting lending decisions. Indeed, analysis
by Federal Reserve staff suggests that only about half of lenders currently offer mortgages to
borrowers whose credit metrics fall into the lower range of GSE purchase parameters.
In the April SLOOS, lenders were asked targeted questions about the likelihood, compared
with 2006, that they would originate mortgages with specific credit profiles. Responses
confirmed that lenders today are less likely - and often much less likely - to originate loans
to GSE borrowers with credit scores of 620 even when borrowers were making down
payments of 20 percent. In fact, the only category of borrower to have experienced no net
reduction in reported credit availability was the category with the highest credit profile asked
about in the survey - those with down payments of 20 percent and credit scores of 720.
Lenders who responded in the April SLOOS that they were less likely to originate loans were
asked to identify the reasons why. About 80 percent of the respondents reported greater
borrower difficulty in obtaining affordable private mortgage insurance, a less favorable
economic outlook, or the outlook for home prices as being at least somewhat important. But
policy concerns played a role as well. In an indication that delinquency risk is now considered
in addition to the risk of credit loss, more than half the respondents cited risks associated
with loans becoming delinquent as being at least somewhat important - in particular, higher
servicing costs of past due loans or the risk that GSEs would require banks to repurchase
delinquent loans (known as putback risk).
The ability of the GSEs to put back loans when lenders have misrepresented their riskiness
helps protect taxpayers from losses; however, if lenders perceive that minor errors can result
in significant losses from putback loans, they may respond by being more conservative in
originating those loans. In its recently released strategic plan, the Federal Housing Finance
Agency (FHFA), the regulator of Fannie Mae and Freddie Mac, has identified the use of
standardized data as a strategy for improving risk management for the GSEs while reducing
repurchase risk for lenders. If technology and data standardization can be used to enhance
quality control reviews at the time of purchase rather than after the loans became delinquent,
it would allow errors to be corrected much earlier, and thus should result in better outcomes
for taxpayers, borrowers, investors, and lenders. Judging from the responses to the
April SLOOS, I would expect any effort to clarify or reduce putback liability to have a
corresponding effect on the standards for underwriting GSE loans.
Reluctance to make loans because of the higher cost of servicing delinquent loans could
stem from uncertainty about future standards for delinquency servicing. Some of this
uncertainty has been resolved by the state attorneys' general settlement with the 5 largest
servicers and the consent orders that 14 large servicers have entered into with federal
regulators. However, only about two-thirds of mortgages are covered by the terms of the
settlement or are subject to consent orders.
To be sure, a number of efforts are under way to establish additional mortgage servicing
standards. The Consumer Financial Protection Bureau (CFPB) has recently declared its
intent to propose servicing rules that would apply to all mortgage loans. The FHFA strategic
plan includes an initiative already in motion to create a single set of servicing protocols for
both Fannie and Freddie loans. These new standards are being developed in consultation
with federal financial regulators who are also exploring establishing uniform servicing
standards for the institutions they supervise. However, while we hope that the prospect of
uniform national servicing standards will lead to more consistent, efficient, and fair servicing
practices, it is also generating uncertainty about the future costs of servicing mortgages and
may be a factor in decisions by servicers to delay or abandon investments in servicing
capacity.
Also affecting decisions about investing in servicing are new approaches to servicer
compensation under consideration by the FHFA. Servicers currently receive the same
compensation for loans that are up to date as they do for loans that are past due. Servicing
fees significantly exceed the cost of the administrative tasks associated with loans that pay
on time, but there is an expectation that servicers will stockpile some of this "excess profit" to
cover the cost of servicing delinquent loans. The problems associated with loan modifications
and foreclosures clearly demonstrate that servicers failed to invest enough in their
infrastructure to be able to handle the current level of delinquent loans. Furthermore, this
arrangement provides no incentive for servicers to take on loans that have a higher risk of
going past due and incurring higher servicing costs. With origination and servicing closely
linked, this incentive results in less credit offered to borrowers who have weaker credit
profiles.
Moreover, servicers subject to regulatory capital requirements are likely to be affected by
new international capital standards that change the capital treatment of the asset known as
"mortgage servicing rights" that is created from servicing compensation. These new
standards are expected to cap the amount of mortgage servicing rights that institutions can
include in regulatory capital, which could lead institutions to seek to limit or reduce the
amount of mortgage servicing rights they own. This circumstance, in turn, could reduce the
liquidity in the market for mortgage servicing rights and potentially drive their valuations
down. Thus, the final design of servicer compensation along with servicing requirements will
factor into the capital allocated to the mortgage business generally and to the relative
tightness of credit standards.
Additional regulatory uncertainty arises from the Dodd-Frank Act requirement for two
important regulatory rulemakings that could significantly influence mortgage underwriting as
well as the cost and availability of mortgage credit. First, the CFPB is required to issue rules
that will set requirements for establishing a borrower's ability to repay a mortgage. These
rules would include a definition of a "qualified mortgage" or QM. Mortgages that meet the
definition would be presumed to meet the standards regarding the ability of the borrower to
repay. These rules are important because violation of the standards could subject lenders to
penalties and, in some cases, impede their ability to collect on defaulted mortgages. In the
second rulemaking, several regulators, including the Federal Reserve, are charged with
establishing a definition for "qualified residential mortgages," or QRMs, a subset of QM that
would be exempt from risk retention requirements in mortgage loan securitizations.
Without commenting on the specifics of any of these individual regulatory rules under
consideration, I think it is important to note that potentially each of them - servicing
requirements, capital requirements, and underwriting requirements - will affect the costs and
liabilities associated with mortgage lending and thus the attractiveness of the mortgage
lending business. The Federal Reserve is aware of this situation and will apply its best
judgment to weigh the cost and availability of credit against consumer protection, investor
clarity, and financial stability as it writes rules that are consistent with the statutory provisions
that require those rules. But regardless of what the final contours of the rules are, I think the
mortgage market will benefit from having them decided so that business models can be set
and investments calibrated.
Other uncertainties are hindering the development of a new mortgage market structure,
including the future role of the government in the mortgage market. Foremost among these
issues is the uncertainty surrounding the future of Fannie Mae and Freddie Mac. Nearly three
and a half years after the GSEs entered conservatorship, policymakers have reached no
consensus about the future structure of the GSEs and the role the government should play in
the mortgage market. Private capital might be reluctant to enter the market until the future
parameters of government support are resolved.
Collectively, these uncertainties about the future are likely contributing significantly to the
tight lending standards in the mortgage market today. Given the role that poor lending
decisions played in the financial crisis, it is appropriate that lenders have tightened their
lending standards. That said, if lenders tighten more than is warranted, it will hamper the
recovery of the housing market and, in doing so, restrain economic growth. Moreover, the
responses of lenders to these uncertainties may also have longer-term implications. If
lenders are delaying needed developments in their own infrastructure, such as servicing
systems and capacity, until they have more clarity about what the mortgage market will look
like down the road, the resulting lack of infrastructure might constrain mortgage and housing
markets in both the short term and the long term.
Choosing a path forward
I have talked quite a bit about the factors that I believe are inhibiting a recovery in housing
markets and some potential solutions to the problems I identified. We have had a severe
financial crisis with housing and housing finance playing a central role, and recovery is not
likely to be quick or easy. But I do believe there are some things that can help. So, if I were
to write a prescription for housing recovery, I would include the following items.
Most important to the health of the housing market is the strength of the economic recovery
- the labor market in particular. Potential homeowners are unwilling to buy if they are
uncertain about their income prospects. And credit standards will remain tight as long as
lenders are concerned about borrowers' ability to repay. For its part, the Federal Reserve
remains committed to fostering maximum employment consistent with price stability, which
should help reduce some of the macroeconomic uncertainty.
In addition, I think efforts under way to reduce the flow of foreclosed homes and distressed
sales in the market will help to stabilize home prices. Mortgage loan modifications, short
sales, and deeds-in-lieu of foreclosure all act to reduce the number of homes in the
foreclosure pipeline. Recent price signals - higher rental rates and falling rental vacancies
combined with low home prices and elevated single-family home vacancies - indicate that by
reallocating some of the foreclosed home inventory to rental property, investors could help
balance supply and demand in both the rental and the owner-occupied markets.
Neighborhood stabilization efforts can help alleviate some of the costs to neighborhoods of
foreclosure and allow local decisions regarding low-value and dilapidated properties. Many
borrowers are current on their payments but are still unable to refinance to take advantage of
low interest rates. Recent changes to the Home Affordable Refinance Program, or HARP,
will allow more of these borrowers to refinance and lower their payments, thus reducing the
likelihood that they will become delinquent.
But perhaps the most important solution that I am suggesting today is that policymakers
move forward with the difficult decisions that will affect the future of the mortgage market. To
be sure, important issues need to be addressed and hard questions remain to be answered.
It will not be easy to decide what to do about the GSEs, or how best to promote a robust
secondary market, or what form crucial regulations should ultimately take. And it is unlikely
that anyone will fully agree with the final decisions that are made. Nevertheless, until these
tough decisions are made, uncertainties will continue to hinder access to credit, the evolution
of the mortgage finance system, and the ultimate recovery in the housing market. I don't
want to diminish the importance of any individual policy decision, but I do believe that the
most important prescription for the housing market is for these decisions to be made and the
path for the future of housing finance to be set. It's time to start choosing that path.