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Thursday, March 22, 2007

The Fed's View of the Sub-Prime Mortgage Market

Robert Reich comments on the problems in the sub-prime mortgage market:

The Fed and the Sub-Prime Lending Debacle, by Robert Reich: What the Fed does or fails to do has more effect on the nation’s poor than any other policy making body. When the Fed decides to fight inflation by raising interest rates and cooling the economy, it’s the poor who are the first to be drafted into the inflation fight because their jobs are the most tenuous, and they’re the first to lose them. When the Fed decides to ease up and reduce rates, it’s the poor who are among the first to get the new jobs because employers who are most likely to hire at the start are small service businesses offering jobs at the bottom rungs of the wage scale. The best example of this occurred in the late 90s, when Alan Greenspan bucked conventional economic wisdom and decided that the economy could safely grow fast enough that unemployment dropped to around 4 percent. The result was to create more jobs for people in the bottom fifth of the income ladder – whose total income therefore began to rise for the first time in decades.

But the Fed affects the poor in another way, too. It determines their access to credit. And here as well, the Fed's decisions can either be a great boon to poorer Americans or a huge curse, depending on how responsibly the Fed manages the credit markets. In this respect, it’s done a lousy job in recent years. In the early 2000s, rates were so low that banks didn’t know what to do with all the extra money they had on hand. But instead of keeping an eye on bank lending standards, the Fed looked the other way. The result: Credit standards were disregarded in a tidal wave of sub-prime lending to the poor home buyers – often without down payments, often with mortgage interest rates that would rise if and when the prime rate went upward. Then what happened? The Fed raised short-term rates seventeen consecutive times, catching poor borrowers in the very trap the Fed allowed banks to set for them. So now millions of poorer Americans face foreclosures on their homes, and sub-prime lenders are in trouble.

Will anyone hold the Fed responsible? Answer: No. Does anyone know how to hold the Fed responsible? Answer: No.

See also "Does Debt Get Enough Credit?" for my views on this, and "Regulation of Mortgage Markets" for a summary and analysis of the regulatory structure. [Update: Tanta at Calculated Risk also comments in Cole Testimony: Cui Bono?, "I want to point out ... the one place in this document where I think the Fed has really drunk a little of the Kool Aid."]

We've all been critical of regulators to one degree or another, so I should let the Fed defend itself. This is testimony from Roger Cole, the Federal Reserve's Director of Banking Supervision and Regulation given today before the Senate Committee on Banking, Housing, and Urban Affairs:

Mortgage markets, by Roger T. Cole, Federal Reserve: Introduction Chairman Dodd, Ranking Member Shelby, members of the Committee, I appreciate the opportunity to discuss mortgage lending, the recent rise in mortgage delinquency and foreclosure rates, particularly in the subprime sector, and the Federal Reserve’s supervisory response.

The Federal Reserve is concerned about recent developments in mortgage markets and has been closely monitoring the effects of these developments on the financial health of mortgage borrowers and lending institutions. Regarding safety and soundness of the banking system, less than half of subprime loans have been originated by federally regulated banking institutions. To date, the deterioration in housing credit has been focused on the relatively narrow market for subprime, adjustable-rate mortgages, which represent fewer than one out of ten outstanding mortgages. Borrower performance deterioration in the subprime market has been concentrated in loans made very recently, especially those originated in late 2005 and 2006, and problems in those loans started to become apparent in the data during the latter half of 2006.

As in past credit cycles, market investors and lenders have begun to implement more appropriate underwriting standards and to change their risk profiles. Some borrowers are clearly experiencing significant financial and personal challenges, and more subprime borrowers may join these ranks in the coming months. We are mindful that any action we take should not have the unintended consequence of limiting the availability of credit to borrowers who have the capacity to repay. I will shortly offer some suggestions to address these challenges, including the potential for lenders to work with troubled borrowers.

We know from past cycles that credit problems in one segment of the economy can disturb the flow of credit to other segments, including to sound borrowers, creating the potential for spillover effects in the broader economy. Nevertheless, at this time, we are not observing spillover effects from the problems in the subprime market to traditional mortgage portfolios or, more generally, to the safety and soundness of the banking system.

Subprime lending has grown rapidly in recent years and has expanded homeownership opportunities for many individuals. It is important to ensure that these gains are not eroded by the recent increase in delinquencies and foreclosures in the subprime market. It is especially important to preserve homeownership for the many low- and moderate-income borrowers who have only recently been able to achieve the goal of owning a home.

Later in my testimony, I will discuss the recent activity in mortgage markets and the possible causes for the increases in delinquencies and foreclosures in the subprime market. I will discuss the Federal Reserve’s ongoing efforts as a banking supervisor to ensure that the institutions we supervise are managing their mortgage lending activities in a safe and sound manner, including assessing the repayment capacity of borrowers.  ...

I will also discuss our efforts in the area of consumer protection, including guidance to ensure that lenders provide consumers with clear and balanced information about the risks and features of loan products at a time when the information is most useful, before a consumer has applied for a loan. The Federal Reserve Board has significant responsibilities as a rule writer for several consumer protection laws, and I will discuss our efforts to date to improve the effectiveness of our regulations in this area as well as our plans to continue this work in the near and longer term.

Mortgages and the Role of the Capital Markets The banking system has changed dramatically since I first joined the Federal Reserve Bank of Boston in the mid-1970s. Back then, banks and savings and loans used their deposit bases and other funding sources to finance, originate, and hold loans to maturity. These financial institutions were highly exposed to any problems that might emerge in residential markets, and their analysis of credit risk was generally limited to making sure that each loan was underwritten properly. Home mortgages had fixed rates and few bells and whistles.

Today, the mortgage lending business has changed dramatically. With the remarkable ... in securitization, that simple book-and-hold model has evolved to incorporate an alternative and more complex originate-to-distribute model. While commercial banks still play a significant role in the mortgage origination and distribution process, they are no longer the only originators or holders of residential mortgages. Securitization has had profound effects in financial centers, where investment bankers use a broad array of approaches to package and resell home mortgages to willing investors, and in local communities, where mortgage brokers and mortgage finance companies compete aggressively with banks to offer new products to would-be homeowners.

These innovations in housing finance have brought many benefits to lenders, investors, and borrowers. Much more so than in the past, insured depository institutions are now able to manage liquidity and control risks by adjusting credit concentrations and maturities through the use of financial instruments such as mortgage-backed securities. For capital market investors, securitization has reduced transaction costs, increased transparency, and increased liquidity. The market has become very proficient at segmenting cash flows of mortgage portfolios into risk tranches targeted at investors with differing risk appetites.

Homebuyers have also benefited in this environment of financial innovation and market liquidity. More lenders are actively competing in the mortgage market, product offerings have expanded greatly, the underwriting process has become more streamlined, borrowing spreads have decreased, and obtaining a mortgage loan has become easier. In short, securitization has helped to expand homeownership, which recently reached a record 69 percent.[1] Not surprisingly, there have also been significant gains in homeownership for low- and moderate-income individuals. The development of the subprime mortgage market has been an integral factor in creating these homeownership opportunities for previously underserved borrowers.

Recent Trends in the Subprime Market ...While still only a relatively small part of outstanding mortgages, the subprime sector grew rapidly over the past three years and accounted for an outsized share of originations in 2006. The roots of this increase can be traced back to the low levels of market interest rates that existed in the early part of this decade which, in turn, spurred significant volumes of mortgage refinancing, as well as new originations. To meet this demand, financial institutions significantly increased their mortgage origination and securitization infrastructures. New entrants in the mortgage industry ... also ramped up their origination capacity. With the rise in short-term market interest rates beginning in 2004, the cost burden of such infrastructures came under increasing pressure as both mortgage refinance and new origination volumes declined.

In this environment of high liquidity, rising home prices, and competition, some lenders that had an originate-to-distribute model responded to the capital market’s demand for new products by easing their credit standards and increasing risks through “risk-layering” practices such as simultaneous second liens, no- or low-income documentation, and high loan-to-value ratios. Some borrowers were actually investors utilizing the ease in terms to purchase investment and rental properties. In the latter part of 2005 and in 2006, risk-layered loans were originated in greater numbers and, increasingly, to borrowers with lower credit scores. An additional layer of risk was embedded in the subprime market since subprime borrowers are more likely to use adjustable-rate mortgages, or ARMs, because these loans generally carry lower interest rates at origination, particularly if a promotional or “teaser” rate is offered for the loan’s introductory period. While these loans contribute to more manageable payments early in the life of the mortgage loan, borrowers can be exposed to payment shock when rates adjust. ARMs account for only about one in eight prime mortgages, but they account for between one-half and two-thirds of subprime mortgages.

During the years of exceptionally strong growth in housing prices and low, stable interest rates, most borrowers did not face large payment shocks and many of those that did could later take advantage of home price appreciation to refinance. These conditions changed in 2006, when mortgage interest rates hit four-year highs, the volume of home sales declined, and the rate of house price appreciation decelerated, leaving the most recent subprime borrowers vulnerable to payment difficulties. Subprime borrowers with hybrid ARMs have experienced the largest recent increase in delinquency and foreclosure rates.[3] Meanwhile, an unusual number of subprime loans have defaulted shortly after origination; these “early payment defaults” are further evidence of laxer underwriting standards by subprime lenders, especially during 2006. Based on anecdotal evidence, it seems possible that fraud has also been a factor in the recent increase in early payment defaults.

Undiversified subprime finance companies have been hit especially hard... This consolidation in the subprime sector of the mortgage finance industry began several months ago and has likely not yet run its course. These changes in market conditions may assist the industry as investors become more focused on risk-reward tradeoffs and as lenders become more prudent. However, over the next one to two years existing subprime borrowers, especially those with more recently originated hybrid ARMs, may continue to face challenges.

Supervisory Guidance Over the past several years, the Federal Reserve has been monitoring these developments and has adjusted our supervisory activities accordingly. ... Since the early 1990s, the Federal Reserve and the other banking agencies have issued a number of guidance statements on residential real estate lending that focus on sound underwriting and risk-management practices, including the evaluation of a borrower’s repayment capacity and collateral valuation. 

[...Summary of regulations issued since 1990...]

Supervisory Activities Regulators became concerned in the late 1990s about certain subprime lending activities that had become the primary or sole business activity of some institutions. As regulators increased their scrutiny, it became clear that risk-management practices were deficient at some institutions. ... Supervisors took actions to address identified deficiencies, including formal enforcement actions...

[...Summary of actions taken by regulators...]

Regulatory Action to Protect Consumers The Federal Reserve also has significant rule-writing responsibilities for consumer protection laws such as the Truth in Lending Act (TILA) and for laws designed to assist in consumer protection efforts such as the Home Mortgage Disclosure Act (HMDA) of 1975.

[...Summary of actions taken by regulators...]

Responding to the Challenge The Federal Reserve believes that the availability of credit to subprime borrowers is beneficial and that subprime loans can be originated in a safe and sound manner. We continue to focus on institutions’ sound underwriting and risk-management practices and to promote clear, balanced, and timely consumer disclosures.

The proposed Interagency Statement on Subprime Mortgage Lending specifies that an institution’s analysis of a borrower’s repayment capacity should include an evaluation of the borrower’s ability to repay the debt by its final maturity at the fully indexed rate, assuming a fully amortizing repayment schedule. In proposing the guidance, the agencies specifically asked whether the subprime guidance would unduly restrict the ability of subprime borrowers to refinance their loans in order to avoid payment shock. We are mindful of unintended consequences that may affect credit availability to otherwise sound borrowers and are prepared to make changes in response to constructive comments.

Lenders and investors should take an active role in working through the current problems in the subprime market. They should not manage subprime and nontraditional mortgage portfolios in the same way as they manage more traditional portfolios that do not contain the same level of risks. Lenders, portfolio managers, and mortgage servicers should be examining how interest rate increases, real estate price fluctuations, and future payment resets can affect delinquencies, default rates, foreclosures, and losses. Strategies should be developed to minimize the effect of deteriorating conditions on segments of the portfolio identified as at-risk. Lenders should be assessing how severely a stressed environment may affect the credit quality of their portfolios, especially with respect to the large volume of subprime adjustable-rate mortgages underwritten in the last year or so. ...

Although a rising number of borrowers are having difficulty meeting their obligations, regulated institutions do not face additional supervisory scrutiny if they pursue reasonable workout arrangements with these borrowers. Existing regulatory guidance does not require institutions to immediately foreclose on the underlying collateral when a borrower exhibits repayment difficulties. Working constructively with borrowers is typically in the long-term best interests of both financial institutions and the borrowers.  Capital markets investors in securitizations have the same motivation as direct lenders in maximizing recoveries on defaulted loans. Thus, mortgage servicers will have an important role to play in working with delinquent borrowers. ... [O]ptions could include modification of interest rates, payment restructuring, and extension of maturities. ...

As I mentioned previously, the principles of sound lending have been with us for generations.  From a supervisory perspective, the Federal Reserve believes those principles need to be part of any risk-management approach to new and emerging products such as subprime lending and risk-layered loans, as well as the securitization of such loans.  We also believe that consumer education efforts to explain both the benefits and risks of new financial products are important, including disclosures that borrowers who are not fully conversant with financial products can easily understand.  ...

    Posted by on Thursday, March 22, 2007 at 12:34 PM in Economics, Financial System, Housing, Regulation | Permalink  TrackBack (0)  Comments (23)

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