[Joint House and Senate Hearing, 110 Congress]
[From the U.S. Government Publishing Office]
S. Hrg. 110-250
EVOLUTION OF AN ECONOMIC CRISIS?: THE SUBPRIME LENDING DISASTER AND THE
THREAT TO THE BROADER ECONOMY
=======================================================================
HEARING
before the
JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED STATES
ONE HUNDRED TENTH CONGRESS
FIRST SESSION
__________
SEPTEMBER 19, 2007
__________
Printed for the use of the Joint Economic Committee
U.S. GOVERNMENT PRINTING OFFICE
38-426 PDF WASHINGTON DC: 2007
---------------------------------------------------------------------
For sale by the Superintendent of Documents, U.S. Government Printing
Office Internet: bookstore.gpo.gov Phone: toll free (866)512-1800
DC area (202)512-1800 Fax: (202) 512-2250 Mail Stop SSOP,
Washington, DC 20402-0001
JOINT ECONOMIC COMMITTEE
[Created pursuant to Sec. 5(a) of Public Law 304, 79th Congress]
SENATE HOUSE OF REPRESENTATIVES
Charles E. Schumer, New York, Carolyn B. Maloney, New York, Vice
Chairman Chair
Edward M. Kennedy, Massachusetts Maurice D. Hinchey, New York
Jeff Bingaman, New Mexico Baron P. Hill, Indiana
Amy Klobuchar, Minnesota Loretta Sanchez, California
Robert P. Casey, Jr., Pennsylvania Elijah E. Cummings, Maryland
Jim Webb, Virginia Lloyd Doggett, Texas
Sam Brownback, Kansas Jim Saxton, New Jersey, Ranking
John E. Sununu, New Hampshire Minority
Jim DeMint, South Carolina Kevin Brady, Texas
Robert F. Bennett, Utah Phil English, Pennsylvania
Ron Paul, Texas
Michael Laskawy, Executive Director
Christopher J. Frenze, Republican Staff Director
C O N T E N T S
----------
Opening Statement of Members
Hon. Charles E. Schumer, Chairman, a U.S. Senator from New York.. 1
Hon. Carolyn B. Maloney, Vice Chair, a U.S. Representative from
New York....................................................... 4
Witnesses
Statement of Hon. Peter R. Orszag, Director, Congressional Budget
Office......................................................... 7
Statement of Dr. Robert J. Shiller, Stanley B. Resor Professor of
Economics, Yale University..................................... 9
Statement of Martin Eakes, CEO, Center for Responsible Lending... 11
Statement of Alex J. Pollock, Resident Fellow, American
Enterprise Institute........................................... 13
Submissions for the Record
Prepared statement of Senator Charles E. Schumer, Chairman....... 41
Prepared statement of Representative Carolyn B. Maloney, Vice
Chair.......................................................... 48
Prepared statement of Hon. Peter R. Orszag, Director, CBO........ 48
Prepared statement of Dr. Robert J. Shiller, Stanley B. Resor
Professor of Economics and Professor of Finance, Yale
University; Co-founder and Chief Economist, MacroMarkets LLC;
Research Associate, National Bureau of Economic Research....... 71
Prepared statement of Martin Eakes, CEO, Center for Responsible
Lending........................................................ 110
Prepared statement of Alex J. Pollock, Resident Fellow, American
Enterprise Institute........................................... 141
Prepared statement of Senator Sam Brownback...................... 149
EVOLUTION OF AN ECONOMIC CRISIS?: THE SUBPRIME LENDING DISASTER AND THE
THREAT TO THE BROADER ECONOMY
----------
WEDNESDAY, SEPTEMBER 19, 2007
Congress of the United States,
Joint Economic Committee,
Washington, DC
The Committee met at 9:37 a.m. in Room 216 of the Hart
Senate Office Building, the Honorable Charles E. Schumer, and
Vice Chair Carolyn B. Maloney, presiding.
Senators Present: Brownback and Schumer.
Representatives Present: Cummings, Hill, Hinchey, Maloney,
and Loretta Sanchez.
Staff Members Present: Christina Baumgardner, Katie Beirne,
Ted Boll, Barry Dexter, Stephanie Dreyer, Chris Frenze, Nan
Gibson, Colleen Healy, Marc Jarsulic, Aaron Kabaker, Israel
Klein, Michael Laskawy, Zachary Luck, Robert O'Quinn, Jeff
Schlagenhauf, Robert Weingart, Adam Wilson, Jeff Wrase, and
Adam Yoffie.
OPENING STATEMENT OF HON. CHARLES E. SCHUMER, CHAIRMAN, A U.S.
SENATOR FROM NEW YORK
Chairman Schumer. The hearing will come to order. I'd like
to welcome my fellow Committee members, our witnesses, and
guests here today for this very important hearing on the impact
of the subprime mortgage meltdown on the broader economy.
My colleagues and I on this Committee have been concerned
for months about the dangers to the American economy as a
result of widespread, unscrupulous subprime lending, and the
economic news in the last 6 months has disappointedly confirmed
those fears.
Despite all the reassuring statements we've heard from the
Administration that the impact of this mess would be, quote,
``contained,'' it hasn't been contained but has been a
contagion that has spread to too many sectors of the economy.
We've seen it most clearly in the financial markets. This
summer's credit crunch was, in large measure, attributable to
the collapse of the U.S. subprime market.
It shook Wall Street and required the emergency
intervention of central banks throughout the world to restore
liquidity to international credit markets.
The news outside the financial markets, while not so stark,
hasn't been much better. We all saw the anemic jobs report. For
the first time in 4 years, the economy actually lost jobs.
Consumer spending, the engine behind much of recent
economic growth, has begun to slow down. Most economists have
already lowered their weak expectations about GDP growth even
further, and for the first time in years, the R-word,
recession, is being discussed far and wide as a real
possibility.
And we know that the worst is still yet to come, as the
riskiest subprime loans will begin to reset in a very weak
housing market over the coming months.
This morning we heard that housing construction fell to its
slowest pace in 12 years. The collapse in housing investment
has already shaved nearly a full point off of GDP growth.
The inventory of unsold homes already stands at record
levels. Builder confidence has sunk to record lows. In many
parts of the country, real home prices have declined, on a
year-to-year basis, for the first time since 1991.
If there is anyone left who doubted the repercussions of
the subprime mess and the risks to the economy, they should
look no further than what the Federal Reserve Open Market
Committee did yesterday.
In March, Chairman Bernanke came before this Committee and
told us that the problems in the subprime market would have
little or no impact on the overall economy. Yesterday, the
Federal Reserve cut the Federal Funds Rate by 50 basis points,
again, primarily in response to the fallout from the subprime
crisis and its ramifications.
When a conservative Fed drops the interest rate this much,
it's obvious they believe the economy is in trouble, and while
yesterday's rate cut is a welcome indication that the Fed
realizes the real risks to our economy, it's important to
recognize that a half-point reduction will do little to get at
the deeper underlying problems of our overall economic health,
particularly the mortgage markets.
It is a temporary solution to a bigger problem and one that
must be applied infrequently and with caution. My concern, and
the reason we've called this hearing, is that despite all the
bad news, despite the sudden calls for action from those who
just a few short months ago were assuring us there was little
to worry about, I fear that many here in Washington still don't
appreciate the seriousness of the problem we are facing.
Our policy responses are not matching the magnitude of the
risk that still lies ahead. And what, exactly, does lie ahead?
An estimated 1.7 million foreclosures are predicted to
occur in the next 2 to 3 years, due to adjustable-rate
mortgages resetting to unaffordable rates.
The Center for Responsible Lending has predicted that
subprime foreclosures will lead to a net loss in home ownership
and a cumulative loss of $164 billion in home equity. The lost
property values from the spillover effects of these
foreclosures could reach up to $300 billion in neighborhoods
across the country, and lost property tax revenues alone could
exceed $5 billion.
These alarming statistics just refer to the direct impact
of the crisis. The indirect consequences, such as risks to our
broader economic growth, household wealth, the health of our
financial markets, and our relationship with global markets,
are still unknown.
I hope that today's hearing will at least serve to clarify
some of the dangers of the cloud on our economic horizon.
One of the gravest dangers we face, as we will hear from
Professor Shiller, is that we're witnessing the bursting of a
speculative bubble in the housing market that will impact all
families, not just subprime borrowers.
If, as Professor Shiller suggests, significant real
nationwide housing price declines are on the horizon, we face
the very real possibility that the housing market could drag
the economy down with it.
Our country simply can't afford a slowdown in economic
growth. When income inequality is at historic highs, deficits
are looming, and investments in critical infrastructure are
drying up, economic growth is our best hope for righting past
policy wrongs and getting our country back on track.
Despite all of this bad news, the good news is that
workable solutions are out there and we have time to put them
in place to limit the damage.
First, we need to do everything we can to arm the local
housing nonprofit groups that are working around the clock with
subprime borrowers. Last week, with help of Senators Brown and
Casey, we secured $100 million in foreclosure prevention
funding, targeted to the local nonprofit groups that are
pivotal in bringing subprime borrowers and lenders together, to
achieve loan workouts.
I've asked both the Administration and the main private
market players in the subprime market, to help us find more
funding to channel to these nonprofit groups, particularly
caseload grows more and more each day.
Second, we must use the Federal Housing Administration,
Fannie Mae, and Freddie Mac, to strategically target relief to
subprime borrowers.
As we all know, government-backed products, FHA-insured
mortgages, Fannie- and Freddie-guaranteed loans, are the only
game in town in terms of providing liquidity to the mortgage
markets, and safe, sustainable products to subprime borrowers.
And while my colleagues and I on the Senate Banking
Committee, expect to pass an FHA modernization bill today, that
will help thousands of families keep their homes, we can and
must do more with these critical tools that we have in our
arsenal, to assist more of the 1.7 million families who are at-
risk homeowners.
That's why I've introduced two bills--sorry. That's why
I've introduced a bill 2 weeks ago, the Protecting Access to
Safe Mortgages Act, that will temporarily lift the limits on
Fannie's and Freddie's mortgage portfolios by 10 percent, which
will free up $145 billion for the purchase of new mortgages.
The unique part of this bill, is that it requires that half
of this total go directly to refinance mortgages for borrowers
who are stuck in risky adjustable-rate mortgages.
And that's because I believe that targeting the borrowers
that are likely to default, will help shore up the housing
market, in general, and assist the broader credit markets and
the economy as a whole.
This morning, OHFEO announced--that's the regulator of
Fannie and Freddie--this morning, OHFEO announced that it will
adjust Fannie Mae's portfolio cap upwards by only 2 percent a
year, after ideologically opposing a cap increase over the past
several weeks.
Now that OHFEO has put its toe in the water, it's time for
it to jump in. Whatever they call it, there is no doubt that
this is an increase in portfolio caps that I and others have
been calling for.
This small increase, however, doesn't respect the magnitude
of the crisis. Hopefully, the ideologically-driven and rigid
opposition to raising caps, is about to fade.
We all need to work together to adopt common-sense measures
that can go a long way to help make safe, affordable
refinancings possible for tens of thousands of Americans
trapped in the subprime mess, that never needed to be in it in
the first place.
In short, I truly hope the White House is paying close
attention to this crisis, because we're far from solving it,
and I hope that this hearing will draw more attention to the
real economic risks that still lay ahead, and what policy
actions can be taken to curb the damage.
[The prepared statement of the Chairman Schumer appears in
the Submissions for the Record on page 41.]
Without further delay, let's get down to business, so we
can proceed quickly to the witness testimony. We in the Senate
have some votes. We'll allow our House colleagues, of course,
to continue, while those votes go on.
I would ask that we limit opening statements to the
Committee's Senior Republican Senator--that's Senator
Brownback, and I'll reserve time for him when he comes--and to
Vice Chairwoman Maloney. We will, of course, enter everybody's
opening statement into the record.
Chairman Schumer. Without further ado, let me call on my
friend and colleague, Carolyn Maloney.
OPENING STATEMENT OF HON. CAROLYN B. MALONEY, VICE CHAIR, A
U.S. REPRESENTATIVE FROM NEW YORK
Vice Chair Maloney. Good morning. I want to personally
thank Chairman Schumer for his great leadership as New York's
Senior Senator, in so many ways and in this subprime crisis
situation, and for holding this hearing to examine the subprime
lending disaster and the threat to the broader economy.
Anxiety over the state of the economy remains high, as
concerns mount that the subprime mortgage meltdown will infect
the rest of the economy.
Yesterday, RealtyTrac released the latest bad news, that
foreclosures reported in August, increased 36 percent since
July and 115 percent since this time last year. Expectations
are the next 18 months will be even worse, as many subprime
loans reset to higher rates.
The credit crunch, the worsening housing slump, market
volatility, and weak consumer confidence, point to a gathering
storm that could drag down the economy, taking thousands of
American jobs with it.
Consumer spending has been propping up the economy, but the
ability of American consumers to keep spending, may be flagging
with slowing or declining home prices, putting the economy at a
serious risk of a downturn.
Dr. Shiller worries that the collapse of home prices that
we will see, and I quote, ``might turn out to be the most
severe since the Great Depression,'' end quote.
Millions of Americans are in danger of losing their homes,
and if employers continue to pull back on hiring, their jobs
may be in danger too.
In a clear sign of the seriousness with which the Fed now
views economic conditions, yesterday the Committee moved to
lower its key short-term interest rate by 50 basis points to
4.75 percent, and left the door open to additional cuts.
The Fed's action is an effort to prevent the economy from
derailing, and to ease credit pressures, but it is no silver
bullet. In Congress, we are focusing on helping families stay
in their homes, and preventing another crisis like this in the
future.
Just yesterday, the House of Representatives passed
legislation to enable the FHA to serve more subprime borrowers
at affordable rates and terms, attract borrowers who have
turned to predatory loans in recent years, and offer
refinancing to homeowners struggling to meet their mortgage
payments.
Senator Schumer has taken several important steps. The $100
million that he's put in the budget, is very important to help
people stay in their homes.
Also, Fannie and Freddie are providing much needed
liquidity in the prime market right now. We passed a GSE Reform
Bill in the House, but we should also raise the cap on these
entities, which the Senator has called for repeatedly, on their
portfolio limits, at least temporarily, so that they can
provide additional liquidity and help with the subprime crisis.
To make servicers more able to engage in workouts, another
action that we took in Congress, for strapped borrowers, we
pushed FASB to clarify that its Standard 104 allows for
modification of a loan when default is reasonably foreseeable,
not just after default. They believe that will help keep many
people in their homes.
And I think we should also eliminate the tax on debt
forgiveness, sparing families the double whammy of paying taxes
on the lost value of their homes.
For the future, our regulatory system is in serious need of
renovation to catch up with the financial innovation that has
surpassed our ability to protect consumers and hold
institutions accountable.
Even though the Federal banking regulators have put out
interagency guidance on subprime loans to improve standards,
some three-quarters of the subprime market does not have a
Federal regulator. We need to extend the guidance to create a
uniform national standard to fight predatory lending and a
single consumer protection standard for the entire mortgage
market.
I believe regulating the brokers and other unregulated
participants, is an essential first step. Shoring up the
foundation of the American dream will help families and
strengthen the economy.
I thank the Chairman for holding a series of hearings on
this important issue, and I look very much forward to the
testimony from our distinguished panel.
[The prepared statement of Vice Chair Maloney appears in
the Submissions for the Record on page 48.]
Chairman Schumer. Thank you for your excellent testimony,
Congresswoman Maloney, and when Senator Brownback arrives,
we'll make room for his opening statement.
But now we'll turn to the witnesses. We want to thank every
one of them. It's a very distinguished and knowledgeable, and,
I would say, timely panel, given everything that's going on.
So let me introduce all four, and then we'll ask each of
you to make your statements.
On my left, is Dr. Peter Orszag. He's been Director of the
CBO, the Congressional Budget Office, since January of 2007.
Before joining CBO, Dr. Orszag was the Joseph A. Peckman
Senior Fellow and deputy director of economic studies at
Brookings. While at Brookings, he also served as director of
the Hamilton Project, director of the Retirement Security
Project, and co-director of the Tax Policy Center.
He has co-authored numerous books, and his main areas of
research include: Macro economics, tax policy, and budget
policy.
Dr. Robert Shiller is one of, if not the leading expert on
the economics of housing in America. He is the Stanley B. Resor
Professor of Economics in the Department of Economics at Yale
University, and a fellow at the Yale School of Management's
International Center for Finance.
Dr. Shiller has written extensively on financial markets
and innovation, behavioral economics, macro economics, and on
public attitudes, opinions, and moral judgments regarding
markets.
He currently writes a column, Finance in the 21st Century,
which is published around the world.
Dr. Martin Eakes is the CEO and co-founder of Self Help, a
community development lender that's provided $5 billion in
financing to more than 50,000 home buyers, small businesses,
and nonprofits.
He's also the CEO of the Center for Responsible Lending, a
research and policy center that works to protect home ownership
and family wealth. To date, the Center for Responsible Lending
has helped American families save more than $4 billion
annually.
He's also a nationally-recognized expert on development
finance.
Finally, last but not least, Mr. Alex Pollock of the
American Enterprise Institute, has been a resident fellow there
since 2004, focusing on financial policy issues.
He previously spent 35 years in banking, including 12 years
as president and chief executive officer of the Federal Home
Loan Bank of Chicago, while also writing numerous articles on
financial systems and management.
Mr. Pollock is a director of the Allied Capital
Corporation, the Chicago Mercantile Exchange, the Great Lakes
Higher Education Corporation, and the International Union for
Housing Finance.
Without objection, each of the statements will be placed,
in their entirety, into the record. We would ask each witness
to take no more than 5 minutes, so that we can have time for
questions.
Dr. Orszag, you may begin.
STATEMENT OF HON. PETER R. ORSZAG, DIRECTOR, CONGRESSIONAL
BUDGET OFFICE
Director Orszag. Thank you very much, Chairman Schumer,
Vice Chair Maloney, members of the Committee.
My testimony this morning covers three principal topics:
First, it examines the boom and then the bust in the housing
market.
As Figure 1 shows, the home ownership rate varied within a
narrow range from the 1960s to the mid-1990s, but then
increased from about 65 percent in 1995 to about 69 percent in
2006.
The housing boom stemmed from three main factors. First,
low interest rates spurred demand for houses. Second, home
buyers' expectations of continued and rapid home price
inflation, played a central role in propelling prices upward;
that is, if people believed that prices would rise, demand for
homes increased, which then put upward pressure on prices.
Thus, the expectation of higher prices can become a self-
fulfilling prophecy in the short run.
As Professor Shiller and others have noted, to the extent
that underlying fundamentals are reflected in rental prices,
however, the ratio of housing prices to rent may provide
insight into the degree to which prices are diverging from
underlying fundamentals.
That ratio tended to vary within a relatively narrow range
between 1975 and 1995, before climbing steeply between 1995 and
2005.
A third factor in the housing boom was the plentiful supply
of credit, which manifested itself most dramatically in the
expansion of the subprime mortgage industry.
As has become apparent, the underwriting standards of some
originators in that market slipped, especially over the past
couple of years. Those problems fundamentally stemmed from a
failure to provide the right incentives and oversight of
originators.
In the traditional form of mortgage financing, the
originator of the loan also holds the loan in its portfolio,
and therefore has a very strong incentive to learn about the
borrower's ability to repay.
By contrast, in the securitized form of mortgage financing,
the originator sells the mortgage to a third party and earns a
fee for origination, but receives little immediate reward for
discovering relevant information about the borrower.
As a result, the originator may not have adequate
incentives to exercise care and discretion in its underwriting,
unless the ultimate purchaser or the entity providing the
securitization, carefully structures such incentives.
Some borrowers may also not have understood the complex
terms of their mortgages. As Ned Gramlich asked in a speech
that was delivered on his behalf just before he died, why are
the most risky loan products sold to the least sophisticated
borrowers?
Over the past 2 years, prices have softened and problems in
the subprime market, in particular, have become apparent.
Although markets have weakened throughout the country, the
increase in foreclosure rates has been concentrated in a few
States, which are highlighted in red in the graph.
The second major topic of my testimony is the macro
economic consequences of the problems in the mortgage market.
There are four main channels through which problems in the
mortgage market can spread to the rest of the economy:
First, reduced housing investment. Between 1995 and 2005,
investment in residential housing directly contributed an
average of 0.3 percentage points to economic growth. The slump
in residential housing has already weakened the economy and
more weakness in the housing market could constrain growth
further by reducing that source of investment.
Second, less consumer spending could occur, because of a
reduction in housing wealth. Lower housing prices, reduce
housing wealth, which, in turn, reduces consumer spending.
We have estimated the impact of a potential 20-percent
decline in housing prices, and these first two channels, if
such a dramatic decrease in housing prices were to occur, would
reduce growth over the next 2 years, by somewhere between a
half and 1.5 percentage points per year.
So that would slow the economy significantly, but not tip
the economy into recession.
There are, however, two other factors at play, two other
channels: First, contagion in financial markets, the broader
spillover or contagion of the subprime mortgage markets into
other credit markets, which can impair economic activity
through reducing business investment, in particular.
To date, the increase in risk spreads has been concentrated
in high-yield bonds, and it is worth noting that the increase
that has occurred has returned the pricing of risk, even on
those bonds, to somewhat more normal levels, after a period in
which they were very, very low.
There's been less of an increase in risk spreads for
higher-rated bonds.
A fourth channel that could possibly occur, is a decline in
consumer and business confidence, which could also slow
economic activity as a result.
The first two channels reduce investment in housing, and
the wealth effects are easy to quantify, and they suggest
slowing of the economy, but not tipping into recession.
The other two channels depend fundamentally on perceptions
among investors, businesses, business executives, and
consumers, and are therefore harder to pin down, because
perceptions are--it's like you're trying to predict what other
people are predicting.
Nonetheless, the best available evidence suggests that
while the housing slowdown will slow the economy and the risk
of recession is elevated, the most likely scenario is continued
economic growth. That, for example, is reflected in the Blue
Chip economic forecasts that were released in early September.
Even the average of the bottom ten forecasts in that survey
suggested 2.0-percent real growth in 2008, and not a single
forecaster projected negative growth for the year.
So the risk of recession is elevated, but the most likely
scenario, at least at this point, seems to be continued
economic growth.
My testimony also covers policy proposals that could
address the financial difficulties in the subprime market, but,
in the interest of time, I will leave that for your questions.
Thank you very much.
[The prepared statement of Director Orszag appears in the
Submissions for the Record on page 48.]
Chairman Schumer. Thank you, Dr. Orszag. Dr. Shiller?
STATEMENT OF DR. ROBERT J. SHILLER, STANLEY B. RESOR PROFESSOR
OF ECONOMICS, YALE UNIVERSITY
Dr. Shiller. Thank you, Mr. Chairman and members of the
Committee. In my testimony, I wanted to reiterate the
fundamental importance of the unwinding of the housing boom.
Senator Schumer, you quoted some alarming statistics, and I
heard numbers in the hundreds of billions, but if we look at
the prospective loss in value of homes in this country, it's
actually in the trillions. We have seen, after an 86-percent
increase in home prices, we have seen a 6.5-percent loss.
If you could show my Figure 1, we've seen a huge boom and a
decline since then of about 6.5 percent. That's the blue line
on the figure.
The futures markets at the Chicago Mercantile Exchange, are
predicting another 4- to 10-percent decline in major cities in
the U.S. over the next year. If you correct this for inflation,
we're talking about a 13 percent to 20 percent in real value
that's already in the market, for a year from now.
And with $23 trillion in real estate value, that's
trillions of dollars of losses. That's the fundamental thing
that will drive it.
It will offset balance sheet, it will upset lots of our
economic institutions.
Representative Sanchez. Mr. Chairman?
Chairman Schumer. We have these charts.
[The referenced charts appear in the Submissions for the
Record on pages 73-74.]
Representative Sanchez. We can't see what chart you're
pointing to.
Dr. Shiller. It's behind you there.
Representative Sanchez. Oh, OK, thank you.
Dr. Shiller. The chart also shows real--everything is in
real inflation-corrected terms. In addition to price, it shows
the real rent from the Consumer Price Index, and real building
costs.
It shows that the price increase that we've seen since the
late 1990s, is not warranted by either costs or rent.
Now, if you recall, the appraisal industry uses three
methods of appraising homes: There's the comparable sales
approach; the cost approach; and the income approach. We're
seeing a big divergence.
The comparable sales approach has shown a big increase, but
the others, if done properly, would not have shown such a price
increase, so I think there's been a problem that we're mis-
valuing our homes.
The declines that you can see already beginning, on the
chart, are down 6.5 percent in real terms since the peak in
2006. If follows past patterns, it has a good chance of
continuing.
Home price recessions tend to last years, as you can see
from the last chart. In the last recession, which peaked in
1989--same chart--it bottomed out 7 or 8 years later, with a
total decline of 15 percent, in real terms.
This time, we're in a bigger boom and we face the
possibility of a bigger decline. It's not just an issue of a
recession coming up; it's an issue of a drag on the economy
that might extend over many years.
The credit crisis that we've seen, is one reaction, but
we're still early in the possible declines in home prices, so
we can expect more surprises like that.
So, if I go to the next chart, residential investment--
that's investment in homes and apartment buildings and
improvement--has been an important part of the business cycle
in this country, going back to World War II. You can see that
just about every recession in--the recessions are shown on the
chart as this area between the parallel vertical lines. Those
are NBER recessions.
You can see that the red line, which is residential
investment, as a fraction of GDP, peaked and then dropped
before just about every recession that we've seen.
And note that the recent peak and drop, is entirely
comparable to what we've seen before recessions.
You can also see on that chart, that it shows, with the
blue line, the Federal Funds Rate, the real Federal Funds Rate,
and you can see that it seems like it's more housing than the
Fed that has been responsible for past recessions.
It's very much a housing cycle, and it looks to me that the
probability of a recession, given other factors, like the
rising oil prices we've just seen, has a probability of maybe
over 50 percent in the next year.
Finally, I think that looking back at the issue that home
ownership is something that has been rising in this country and
it's especially important that we maintain incentives for home
ownership among low income minority people in a time with
rising income inequality, maintaining a sense of participation
in the economy that home ownership provides, is a very laudable
aim.
And so I think that--one problem with the boom, is that the
price increases that we've seen, are relatively, according to
the S&P Case-Shiller indexes, produced by FiServe, Inc., are
relatively concentrated in low-priced homes, which suggests
that it is the subprime lending that is a factor in producing
the housing boom, and it also suggests that low-income people
will be especially hard hit by the correction.
So that means that I think that it is very important that
we help--get some help for these borrowers, especially the
borrowers who got into trouble because of some problems with
our lending institutions, so, the FHA and the GSEs should be
encouraged to help low-income borrowers.
I also endorse Elizabeth Warren, who's a Harvard Law
Professor, her proposal for a financial products safety
commission, modeled after the Consumer Product Safety
Commission, so that we would have a government agency whose
duty is to protect consumers in the mortgage market.
We also, I think, need some appraisal reform. The last
major decline in housing prices in this country, was in the
1930s, and that brought us the Appraisal Institute, which is a
professional organization.
I think, though, they need to be put under somewhat more
pressure at this time, to review how appraisals are done and
rethink whether the appraisal industry could help prevent
another crisis like this.
Finally, I think there are other risk management products
that need to be encouraged, like home equity insurance, shared
equity mortgages, home price warranties, and down payment-
insured mortgages that, in the future, might help risk to be
spread more effectively, so that another crisis like this won't
develop.
[The prepared statement of Dr. Shiller appears in the
Submissions for the Record on page 71.]
Chairman Schumer. Thank you, Dr. Shiller. Mr. Eakes?
STATEMENT OF MARTIN EAKES, CEO, CENTER FOR RESPONSIBLE LENDING
Mr. Eakes. Chairman Schumer, Vice Chair Maloney and other
members of the Committee, thank you for holding this timely
hearing.
I am a lender. I've been making loans to low-income people
to become homeowners for 25 years. We've financed $5 billions
to 50,000 homeowners. We've never had more than 1-percent
losses in a year.
If you have high losses, it means, as a lender, you're
doing something wrong, not that the borrowers are wrong.
I've spent the last 8 years, trying to, starting with the
North Carolina Anti-Predatory Lending Legislation, trying to
stop the lending abuses that have been taking place in the
subprime lending marketplace, which have cost millions of
families already, their homes and the wealth that they have
spent a lifetime building up in those homes.
I spend a lot of time in my written testimony, documenting
subprime foreclosures, and that the problem is severe and real.
Today, what I'd like to talk about, is more talking about
solutions and recommendations. There really are two problems to
solve:
The first problem is to make sure that we prevent abusive
home loans from continuing in the future. The second problem is
to deal with the existing borrowers who are trapped in subprime
loans and face foreclosure immediately.
On the first issue, the Federal Reserve has promised that
they will pass rules before the end of the year, that will
address some of the continuing abuses in the subprime
marketplace.
The most critical of those are the ability to repay for the
borrower, to prohibit yield-spread premiums, which provide an
incentive for mortgage brokers to put people into higher-cost
loans; to prohibit prepayment penalties; to require escrows for
taxes and insurance, and to somehow make lenders responsible
for bad behavior of brokers.
If the Federal Reserve does not follow through on it
promise, then you, Congress, need to take the authority that is
given unilaterally to the Federal Reserve, and deploy it to
another agency who will carry it out.
The second problem is the one I really want to spend more
time on today, and that is the assistance to the 6.7 to 7.5
million families who have subprime loans as of the beginning of
this year.
The first thing I want to do, is break down the categories
of those borrowers: Of that 7 million, roughly 40 percent are
borrowers who could be refinanced into a prime loan that would
be stable, fixed-rate, going forward.
The next 20-percent slice, are borrowers who could stay in
their homes, if the ARM loan they have, which will explode in
payment amount within the next 12 to 18 months, simply
continued the payment that they started with for the first 2
years.
The next 20 percent of these borrowers, will need an
adjustment in their interest rate that lowers the overall
monthly payment. They can't afford even the payment they had
for the first 2 years.
The final 20 percent are two groups: Ten percent that are
speculative and investor properties. No one really is worried
about the policy ramifications there. They're going to lose
those houses.
The bottom 10 percent, are those homeowners who really
should have never gotten a home loan to begin with, and sadly,
there are families in that situation.
There's not a lot we can do there. What we're really going
to be trying to do, is trying to ameliorate the effects of
those foreclosures, by having municipalities be able to
purchase properties and redeploy them in some sort of lease-to-
purchase structure to get them back into circulation.
Each of these five categories have different policy
responses that are required.
The second thing I want to talk about, is the spillover
effect in neighborhoods, because, often, this is overlooked.
It is true that for every foreclosure, the lender and/or
the family, will lose somewhere between $50,000 and $80,000 on
an average $200,000 subprime mortgage loan.
But that really is just a small part of the problem. I a
study in Chicago, in low-income homeowner neighborhoods,
roughly 1.5 percent is lost in value for every one of the
neighbors within a one-eight mile radius of the foreclosure.
So what we're saying, is that for every foreclosure that
occurs, the 50 houses that surround that foreclosure, will lose
$3,000 in value, each. When you add that up, that's $150,000 of
losses for the neighbors, who obviously did nothing wrong,
other than trying to live in a neighborhood and pay their home
loan on time.
This will be utterly catastrophic. We can talk about
whether it will be a national recession or not. I tend to think
we will have one.
But I can tell you that in the neighborhoods where I have
worked for the last 25 years, it will be utterly a depression.
If you've been to Cleveland or Detroit or to the suburbs of
Charlotte, or neighborhoods that have low- or modest-income
homeowners that had a predominance of subprime loans, it will
be utterly catastrophic, the devastation, when you have 10 or
20 homes that are boarded up in a very small, concentrated
area.
What are the solutions: The first solution that I and many
others have worked on for the last 9 months, is to work with
loan servicers to modify the subprime loans that are currently
exploding payments as we speak.
We have pretty much solved the problem of the authority
that the loan servicers have, the accounting issues, and the
tax issues. Those were really major thorny issues that came up,
but they've all been resolved.
But for whatever reason, the loan modifications are not
taking place in any appreciable magnitude, so we still have
100,000 to 150,000 foreclosures each and every month, being
initiated, and for the next 12 to 18 months, we will see a
level of foreclosures that we have not seen in decades and
decades, and maybe all the way back to the Great Depression.
I think we have to do two additional things, in addition to
working with loan servicers. The first is, we need to delete
from the Bankruptcy Code, an exception that makes personal
residences the only asset that cannot be protected in a Chapter
13 bankruptcy.
So if you're rich enough to have a loan for a second home
or a vacation home, for investment real estate, a vacant lot, a
boat, or an RV, every one of those loans can be adjusted in
bankruptcy, to the current market value of that asset, and the
terms of the loan can be modified.
But, ironically, the only asset that cannot be so adjusted
in bankruptcy under Chapter 13, is a loan against your personal
residence. It makes utterly no sense whatsoever.
Finally, Congress should provide $1 billion of funding. The
$100 million is a wonderful start to provide legal
representation to the borrowers who are facing foreclosure. For
$2,000 per borrower, you can save that family.
It's not a bailout, because the investor is going to take
the loss on these loans, either way. All it does, is, it says,
let's have that loss be in an orderly, transitional way that
does not destroy the neighbors living around that house.
I know that elections are around the corner and we've got a
short window to get something done. I urge you to join together
and pass these common-sense solutions before it's too late.
There really are hundreds and hundreds of thousands of people
who will lose their homes immediately, if we don't act soon.
[The prepared statement of Mr. Eakes appears in the
Submissions for the Record on page 110.]
Chairman Schumer. Thank you, Mr. Eakes. Finally, Mr.
Pollock?
STATEMENT OF ALEX J. POLLOCK, RESIDENT FELLOW, AMERICAN
ENTERPRISE INSTITUTE
Mr. Pollock. Thank you. Mr. Chairman, Vice Chair Maloney,
members of the Committee, as others have said, the best way to
understand the severe mortgage and housing industry problems
we're experiencing, is to look at them as the deflation of a
classic credit-inflated asset bubble.
Because residential mortgages represent so large a credit
market and so large a component of total debt, and residential
real estate such a huge asset class, about a $21 trillion asset
class, and, therefore, a large component of household wealth,
the effects of a deflating bubble on macro economic growth are
sizeable and significant, of course, in a negative direction.
In addition to monetary policy and the actions we've seen
recently, possible political responses can include temporary
programs to bridge the impact of the bust and reduce the risk
of a housing sector debt deflation.
For the future, we can also take steps to fundamentally
improve the functioning of the mortgage market. Here I have
simple, but, I think, a very powerful proposal, which is a one-
page mortgage disclosure which tells borrowers what they really
need to know about their mortgage loan, in a clear and
straightforward way, this to better protect themselves and also
to make the market more efficient.
Typical estimates of credit losses involved in the subprime
mortgage bust are about $100 billion. That's the credit losses.
It doesn't count the losses in market value of securities.
A year ago, it was common to say that while house prices
would periodically fall on a regional basis, they couldn't do
so on a national basis. Well, now house prices are falling on a
national basis. With excess supply and falling demand from the
credit constraint, it's not difficult to arrive at a forecast
of further drops in house prices.
A recent Goldman Sachs forecast, for example, projects
average drops of 7 percent per year through 2008.
Now, this kind of house price decline, as others have
pointed out, would mean a large loss. Fifteen percent would be
a $3 trillion loss of wealth for U.S. households, which would,
of course, be especially painful for those who are highly
leveraged, and would certainly put a crimp in cashout
refinancing, and home equity loans. It will certainly
negatively impact consumption, although, as Peter said, because
we're talking about behavior, to make precise forecasts is
difficult.
But the deflation of a bubble centered on such large stocks
of debt and assets always causes serious macro economic drag.
On the subprime sector itself, we ought to point out that
subprime is actually about half and half--53 percent
adjustable-rate loans; 47 percent fixed, according to the
Mortgage Bankers Association numbers.
The serious delinquencies on subprime fixed-rate loans are
not too different from those on FHA fixed-rate loans, so we can
really focus the problem on the subprime ARMs, where the
serious delinquencies are much higher, about 12.5 percent in
the latest numbers.
Now, to try to bridge the bust and ameliorate a possible
downward debt-house price cycle, President Bush, numerous
Members of Congress, and the FHA itself, have suggested using
the FHA as a means to create refinancing capability for
subprime mortgages.
In my view, this makes sense, because the FHA itself is and
has been since its creation in 1934, a subprime mortgage
lender. That's what it's there for.
We see it, for example, in total FHA delinquencies, which
are about 12.5 percent. That compares to about 14.5 percent in
the subprime market.
But I believe a special program, in which the FHA could
refinance 97 percent of the current value of a house, and the
investors would accept a loss on any difference between that
and the principal owed, would be distinctly preferable to
foreclosure for investors, as well as, obviously, for
borrowers.
That's the test we have to meet to make it possible for the
mortgage servicer to fulfill its fiduciary duty, which runs to
the investors. The deal has to be better for both sides, and I
think we could create that.
Regarding Fannie and Freddie, I do not favor an increase in
the conforming loan limit, but I do favor granting Fannie and
Freddie a special increased mortgage portfolio authorization.
However, this should be strictly limited to a segregated
portfolio solely devoted to refinancing subprime ARMs.
In my view, such a special authorization might be for $100
billion each. I've got a bigger number than you do, Mr.
Chairman.
This should include the ability for them to purchase FHA-
insured subprime ARM refinancings. That way, you get two
channels of funding, one through Ginnie Mae and one through
Fannie and Freddie for the special FHA program.
Finally, it's essential to a market economy, based on
voluntary exchange, that the parties understand the contracts
they're entering into.
A good mortgage finance system, in particular, requires
that the borrowers understand how the loan will work, and
especially how much of their income it will demand. Nothing is
more apparent than that the American mortgage system is a
failure in this respect.
Instead of what we have, which is highly confusing to all
borrowers, not only subprime borrowers, but also prime
borrowers, the key information should be stated in a simple and
clear way, in regular-size type, and presented from the
perspective of the commitments the borrower is making and what
that means for the demands on household income.
To achieve this, I propose a one-page form, which we call
``Basic Facts About Your Mortgage Loan'', which accompanies my
testimony. All borrowers, in my view, should have to receive
this well before the closing.
You can actually get the key information on one page. It
wasn't easy, but you can do it.
I believe that the mandatory use of such a form would help
achieve the required clarity, make borrowers better able to
protect themselves by understanding what the mortgage really
means to them, and, at the same time, promote a more efficient
mortgage finance system.
In my view, this is a completely bipartisan idea, and along
with other things we may or may not do, I think we should
implement this form or something very much like it. Thanks very
much for the opportunity to be here.
[The prepared statement of Mr. Pollock appears in the
Submissions for the Record on page 141.]
Chairman Schumer. Thank you, Mr. Pollock. I'm glad you're
all here. I thought these were four excellent testimonies and I
recommend that people read them all. Time limited us.
What we're going to do here--Senator Brownback came, but
he's going to get an extra time to make an opening statement
when he does his questions, so I'll ask questions first, and
then we'll go to Congresswoman Maloney, who will take over
chairing the hearing at 10:30 when the Senate vote occurs, and
then we'll go to Senator Brownback, if that's OK. And if he
needs--if Senator Brownback needs to go first because of the
vote, that's OK, too.
Senator Brownback. We don't need to do that. Thank you very
much, Mr. Chairman.
Chairman Schumer. OK, good. All right, first--and,
actually, Mr. Pollock has addressed this--first, I think your
idea of one page is excellent. I'm going to introduce something
to that effect, and maybe ask one of my Republican colleagues
to join me, since it is, as you say, a bipartisan idea
emanating from the American Enterprise Institute.
Second, I'd like to ask, just quickly, the panel's opinion
of the two proposals that I have made on this--one, more money
for the--Mr. Eakes mentioned this. He thought $100 million was
too little, but the basic concept of more money for the
nonprofits to help people refinance.
There are two parts to this problem: One is the means of
getting somebody to refinance, since most of the people who are
stuck here, don't know how to do it, and--I can't remember if
it was Dr. Orszag or Dr. Shiller who pointed out that the
banker is no longer there in this securitized mortgage market,
and then, second, some money for the refinancing.
On the first part, we have proposed money for the
nonprofits, some of which would come federally, and, we would
hope, some of the banks and financial institutions would chip
in, as well.
Does everyone agree that that's a worthy thing to do? I
don't need comments, just a yes or no. Do you agree, Dr.
Orszag?
Director Orszag. You don't want to ask me yes and no
questions on policy matters.
Chairman Schumer. I know.
Director Orszag. But outside analysts have proposed using
community-based organizations as a very effective tool in this
kind of setting.
Chairman Schumer. Right. Dr. Shiller, you agree? You nodded
your head.
Dr. Shiller. Yes.
Chairman Schumer. Mr. Eakes proposed it, so he does.
Mr. Eakes. Yes, obviously, plus legal assistance.
Chairman Schumer. How about you, Mr. Pollock?
Mr. Pollock. I think this is a classic problem of
information asymmetry, as the economists say, where one party
knows a lot more than the other, and--I would see this program
as making up for the past lack of a clearer disclosure.
Chairman Schumer. But you would be----
Mr. Pollock. So I think it makes some sense, right.
Chairman Schumer. Right. Second--and you talked about this,
Mr. Pollock--raising the mortgage portfolio caps at Fannie and
Freddie, and directing--we direct half, because we think they
need some room here. You might direct all, Mr. Pollock, but the
idea of raising the portfolio cap and directing a very
significant portion of that increase to go to refinancing
subprime mortgages in foreclosure or on the edge of
foreclosure, Mr. Pollock clearly agrees. Do you agree?
Mr. Pollock. I agree, provided 100 percent goes to this.
Fannie and Freddie are making plenty money on other things, Mr.
Chairman.
Chairman Schumer. OK, fair enough. Mr. Eakes?
Mr. Eakes. I have never been in favor of portfolio caps, so
I think that----
Chairman Schumer. And how about directing them to these
markets?
Mr. Eakes. I think they should be directed, in that there
should be standards to ensure that the same protections that
currently apply to prime loans, such as no prepayment
penalties, are also applied to the refinanced subprimes.
Chairman Schumer. Dr. Shiller?
Dr. Shiller. Well, Fannie and Freddie are important
institutions promoting home ownership, and we need--they seem
like a logical conduit.
Chairman Schumer. How about you, Dr. Orszag?
Director Orszag. That would have the effect of increasing
demand for the mortgages and reducing the interest rate. I
think there are some questions that people have raised about
whether using an FHA-type of intervention is a more effective
tool, but that's for you to evaluate.
Chairman Schumer. Well, let's get that. One of the big
problems we face here, is who is going to do this? The people
I've talked to who are in foreclosure, since there's no
friendly banker around, there's an unfriendly mortgage broker,
who, as you all pointed out, one way or another, has taken
advantage of the mortgagor.
The lending institution is oftentimes not a bank, and
they're off in the sunset. They've made their big fees and
they're gone, and so the only person really left on the scene,
is the mortgage servicer, which Mr. Eakes talked a little bit
about.
And that mortgage servicer, just to inform everybody, does
have to take the mortgage payment and sort of break it up into
all the little pieces and send it to the various bond holders
and securities holders who have the pieces.
Now, my question is this, and I direct it to Mr. Eakes, but
ask anybody to chime in: Can we use these mortgage servicers,
the present ones or new ones--and it's a lucrative business--to
help with the knowledge gap we have in terms of refinancing.
You say it hasn't worked thus far, for reasons you didn't
describe in your oral testimony. Could you talk a little bit
about that, Mr. Eakes? This is an important missing piece of
the puzzle.
Mr. Eakes. For 9 months, the banking regulators and Members
of Congress, have been working to make modifications take
place. The modification path becomes more and more important
with every month that passes.
As property prices fall, refinancing becomes less and less
available, because you can't refinance if your property is
under water.
The three issues that were initially discussed, were that
servicers didn't have authority to modify loans.
Chairman Schumer. Now they do.
Mr. Eakes. So there was great research looking at the
servicing agreements of all of the agreements, and basically
have now concluded that they do have the authority.
Chairman Schumer. Right
Mr. Eakes. The second issue was looking at whether it would
violate the REMIC tax laws, and----
Chairman Schumer. And it does not.
Mr. Eakes. And there is great consensus that there is no
problem there.
Chairman Schumer. Right.
Mr. Eakes. The final one, which was a little thornier, was
the SEC FASB problem in accounting.
Chairman Schumer. And we worked on that and that's been
solved.
Mr. Eakes. And that's been solved.
Chairman Schumer. So, why isn't it happening?
Mr. Eakes. OK, the two remaining problems: Number one, 50
to 60 percent of the subprime loans made in 2006, had piggyback
second mortgages. You can't really get a resolution with a
single servicer, if you have another loan outstanding.
The second mortgage holder has no interest in basically
writing off their entire debt. They feel like, why not just
leave my loan there and see if I can be a fly in the ointment
and eventually get paid something.
So, for whatever reason, that structural reason, or just
that it is legally easier and more protected for the loan
servicer to foreclose, that is the path.
So a company like Countrywide, which has announced that
it's actively doing modifications of loans, has in its most
recent investor teleconference, admitted that virtually none of
the so-called modifications, were, in fact, real modifications.
Chairman Schumer. Right.
Mr. Eakes. They were just simply payment deferrals.
Chairman Schumer. What do we do to correct that situation
and allow the servicers--the servicer is the on-the-ground
person best suited to do this, with some kind of incentive.
Mr. Eakes. So the first thing to note, is that we have a
real absence of time. These loans that were made in 2006, are
going to come due with the 50-percent payment shock, during the
next 12 months.
Chairman Schumer. Right.
Mr. Eakes. If we don't act immediately, we're going to lose
the chance, because somewhere around 70 percent of the
borrowers who face this reset and aren't able to refinance, are
going to be foreclosed. They can't make----
Chairman Schumer. And that is going to shock--I mean,
that's going to shock the markets.
Mr. Eakes. It's going to shock. The foreclosures we see
now, are just a--you know, it's a preview of what will come
over the next 18 months.
Chairman Schumer. So you're saying that the only real
solution, is the nonprofit solution, because the servicers
either can't or won't?
Mr. Eakes. I think the primary solution, is doing this
tweak to the Bankruptcy Code. It's a very small thing that
would allow these loans to be modified after a hearing by a
Bankruptcy Judge in Chapter 13. In 2005, we encouraged
borrowers who are having trouble, to go Chapter 13 and pay back
their debt responsibly.
Chairman Schumer. Mr. Eakes, it's going to take a long time
to get these hundreds of thousands of people into Bankruptcy
Court.
Mr. Eakes. Well, the truth is, if you have the provision
and anyone files, which they will, the Bankruptcy Court has
built into it, two things that are very important:
First, it has an automatic stay that stops the foreclosure
until the process can work its way through. That's really
important.
The second is that in the Bankruptcy setting, when you have
a writedown of a mortgage value, it's already determined that
that will not create a taxable gain.
Chairman Schumer. Understood. I understand the legal. I
think the practical problems are pretty large.
Mr. Eakes. I just think we must do this.
Chairman Schumer. I'll ask each of the people. This is the
greatest nut here. I mean, we need new financing, but I think
we're going to get that, one way or another. Maybe, if we go to
100 percent, as Mr. Pollock suggested, we might even get the
Administration's support.
They have not objected to directing the money; they just
don't want to raise the portfolio limit. So that's a possible
compromise that we would explore.
I proposed 50 percent, and I've spoken to Secretary
Paulson. He's not totally against this. I mean, I think he's
constrained a little bit by the previous Administration's
position.
But the real problem is, who is going to execute these?
I've met some of the people in foreclosure, and they can't do
it themselves. So it's the nonprofits, but Mr. Eakes said we
need a billion dollars there, and unless we get some private-
sector input--it was hard enough for us to get $100 million
into this, Senators Casey, Brown, and myself.
I was hopeful that the servicers might do this, somehow or
other, with some encouragement, some incentives, since they're
on the ground. Old, existing servicers, or new ones. Mr.
Pollock?
Mr. Pollock. If I could comment on the servicer issue, Mr.
Chairman, I think the core issue there--of course, there are a
number of issues--but the core issue is the fiduciary duty of
the servicer or the agent. The servicer is actually an agent
for the bondholders.
So the agent, the servicer, has a duty to do things which
are in the best long-term interest of the bondholders. This is
why I think there may be a meeting ground, if you had a readily
available subprime ARM refinancing program, for example,
through the government subprime lender, the FHA. It would be
clear, even in the case where the price of the house is less
than the mortgage--which if Professor Shiller's forecasts are
right, will be a lot more common--where there's a ground where
it's actually better for the investor to accept a refinancing
and a haircut, but a haircut that will be much less expensive
than foreclosure. As has been often pointed out, foreclosure is
very expensive.
Chairman Schumer. There are a lot of investors to deal with
each of these changes, because the mortgages are so split up.
Mr. Pollock. That's why the servicer has to be put in a
position where it's clear that he's doing something that's in
the benefit of the bondholder, as well as the benefit of the
borrower, and finding that middle ground, which seems to me, is
possible to do, is what we have to achieve.
Chairman Schumer. Would you want to comment on that, either
Dr. Shiller or Dr. Orszag, on any aspect of the servicer
conundrum here?
Dr. Shiller. I had to defer to Mr. Eakes for the--I'm
impressed, though, that this is a very rapidly changing
situation. I think some measures like those Mr. Eakes proposed,
should be urgent.
Chairman Schumer. It is urgent, and we're not reacting
urgently. And your economic forecast, Dr. Shiller, and
everything that each of the other witnesses has said, says this
ought to be on the front burner of the Administration and of
the Congress, and I can tell you that it's not. Dr. Orszag?
Director Orszag. I would just add that, in addition to the
community-based organizations and the FHA channels, one of the
things that it is important to remember about the
securitization process, is that we have not had as many
problems in the conforming market, and the reason is because of
the role of the GSEs in setting standards for the whole
process.
So, one of the other effects that expanding the efforts or
the activities of the GSEs into this market may have is to
alleviate, over time, that incentive problem that is the
trigger for a lot of this. But that, obviously, is not an
immediate solution.
Chairman Schumer. Thank you. Well, my time has more than
expired, so let me call on my colleague, Senator Brownback, to
make an opening statement and do questions, and then
Congresswoman Maloney will chair part of the hearing while we
go vote, and my other colleagues will be able to ask questions.
I'd like to return for a second round, if I can. Thank you.
Senator Brownback. Thank you, Mr. Chairman. I appreciate
that. Thank you for holding the hearing. I just will put my
full statement in the record, if that would be acceptable.
[The prepared statement of Senator Brownback appears in the
Submissions for the Record on page 149.]
Gentlemen, I want to ask this from the basis of experience,
and then I apologize that I missed your testimony. I had
another engagement that I was at.
But I would like to ask then, if I can, some ways that
maybe we can get at this. I went through the farm crisis in the
early eighties, from the position of being a lawyer, from the
position of being the Secretary of Agriculture in an
agricultural state, and from seeing what government policies
did to exacerbate it.
And my experience in looking back on that and applying it
to this situation--and you tell me if it's the wrong way to
look at it--was that we ended up having a situation where you
had a lot of people that got overly financed, because land was
inflating at 10 percent a year; people were borrowing off of
that.
I remember being offered to allow to buy some land at 100-
percent financing, because next year, it was going to be worth
10 percent more, and so this was all going to work out. I had
that personal offer to me, so I know those sorts of things
happen.
Then we had a bad spot in the market. Land prices started
falling off, then the banks went out and said we've got to
clean up all these bad loans, because the regulators were on
top of them. I actually had a small bank I was representing,
and, boy, we just--we had to go through the community and it
wasn't pretty.
That put a glut of both land and farm machinery on the
market, which then dropped those markets even further. I
remember people saying, well, we had this big confinement
facility, livestock confinement facility, and said, well, what
do you think it's worth, when we were in these negotiating
sessions.
And the lender held up zero. It's worth zero in this
market, because the local market was so saturated.
And looking back on that, my answer in this situation, if
it's similar, is that the key thing we have to do, is to try to
prevent this thing from boiling over. It can slow boil for
awhile, but the key thing that we need to do, is to try to
string this out so that you don't get too much stock on the
market too fast, so that the market itself can work this out--
if we can maintain a decent overall economy, to where the
overall economy is not dipping, that people can maintain some
income, you may be able to slow boil your way through it.
But you need something that, instead of happening in 2
years, it needs to happen over 7 or 10, is my sense of this on
the ground.
I don't know if that's your perspective or not. If it
isn't, or if I'm wrong, I'd like to know that. If it is that,
what are the key policy tools?
You probably have already covered this, but in a sentence
or two, what are the key policy tools to allow us to be able to
string this out further, so it doesn't just kill us on a local
market basis and on a national market basis?
Mr. Pollock?
Mr. Pollock. I'll try to answer that, Senator. First of
all, I think your description of the parallels between the farm
boom and bust and this one, are exactly right. All financial
booms and busts are different in detail, but exactly the same
in general pattern. They all involve the over-expansion of
credit, and then the contraction of credit. So that is exactly
right.
Jesse Jones, who ran the Reconstruction Finance Corporation
in the 1930s said, as you just did, the thing that troubled
financial markets need is time for the values to sort out and
to stop a threatened downward spiral of the kind you discussed.
I think the things we have been talking about using special
refinancing programs of the FHA, or portfolios of Fannie and
Freddie entirely limited to refinancing subprime ARMs, would be
devices to do exactly what you are suggesting, Senator, which
is to say----
Senator Brownback. And that's the primary tool that we
would have available now.
Mr. Pollock. As something to, I call it bridging the bust;
to do something that takes you on a bridge across the chasm
that you might get into in a downward debt deflation--this time
in the housing sector, obviously historically in all different
sectors, including housing before.
Senator Brownback. I want to apologize to my colleagues
because this is ground I am sure they have already heard
covered, but I would like to ask, Mr. Eakes, you think that one
of the things we need to do is change the Bankruptcy Code. That
was heavily used in that farm crisis, and we even put in a new
chapter in the Bankruptcy Code for that.
Is that your primary answer?
Mr. Eakes. Well what I would say is that the comparison to
the farm crisis is very similar, with one exception. The
product on subprime home loans has a 40- to 50-percent payment
jump in the third year, which is happening right now for the
next 12 months.
So we do not have time to stretch it out over 4 or 5 years.
If these borrowers, either through voluntary efforts by the
loan servicers or through having a bankruptcy protection, do
not get those payments adjusted, we will lose 2-plus million
families, and the spillover effects will be enormous.
I do not see the voluntary action coming from the loan
servicers any more than it did from the lenders in the farm
crisis. It is just a tweak. It is an exception in the
Bankruptcy Code now that says that personal residence loans are
the only real estate loans--as you said, for farms, for
business property, for second homes, you can protect that
property by modifying the loan after a hearing by a bankruptcy
judge.
If we do not have that, and soon, my prediction is we will
lose these 2 million homes, and there is nothing we are going
to do that will stop it.
Senator Brownback. Thank you very much.
Vice Chair Maloney [presiding]. Dr. Orszag wants to
comment.
Senator Brownback. Oh, yes.
Director Orszag. I just wanted to add, I think we can think
about the policy responses in three categories. There is
stabilizing the macro economy, which is mostly the Federal
Reserve's job.
There is helping vulnerable households, which is what most
of this discussion has been about using FHA and community-based
organizations, and what have you. And a balance needs to be
reached there between helping vulnerable households at risk for
reasons beyond their control, and the general principle that
households bear the consequences of their own decisions within
some reasonably foreseeable set of possibilities. And that is
something you all need to balance.
Then a final category is preventing future crises. That
involves things like changing, or perhaps expanding the laws
against deceptive and other practices like the Home Ownership
Equity Protection Act; possible changes to rating agencies; and
regulation of the subprime market. Those things will not help
existing homeowners but may help prevent future crises.
Senator Brownback. Chairman, thank you very much, and
thanks to my colleagues for indulging me in going back through
some things you had already covered. I appreciate it.
Vice Chair Maloney. Thank you. Thank you so much, Senator.
Dr. Shiller, you seem to think that there is a risk of an
economic downturn within the next year, yet Dr. Orszag you seem
to be saying that the economy will slow but probably not enough
for growth to turn negative.
Can each of you explain what factors you think will
contribute to or prevent an economic downturn?
Dr. Shiller. Maybe I can start.
Vice Chair Maloney. OK.
Dr. Shiller. Mr. Orszag is relying on an econometric model
that looks at repercussions of the wealth effect that we are
seeing. But I think that it is difficult for these models to
represent unusual new circumstances, especially circumstances
that effect the psychology of the market.
This is the biggest housing boom the U.S. has ever seen. In
fact, it is not just the U.S. We need a world model, as well,
because this housing boom has afflicted much of the world
economy. And the unraveling of this boom will have
repercussions abroad, and it will feed back into this country.
The real question is the effects on confidence and
psychology, and how people interpret all of this, which I think
is difficult to model. And so if you look at Dr. Orszag's
results they are showing us on the margin of a recession.
So it seems to me that it is entirely consistent with what
he has presented, that there is a significant risk at this
time.
Director Orszag. If I could just add a few thoughts. First,
we have to remember that there are some underlying drivers that
are continuing to propel economic growth, including net
exports, business investment, government spending, and other
factors. So there is some underlying momentum to the economy.
I agree with Professor Shiller that the hardest part of
analyzing the impact of the housing downturn is the perception
related third and fourth channels I talked about: contagion in
financial markets, and effects on confidence. That is just very
difficult to evaluate.
What I would say is there does seem to be a bit of a
disconnect between financial analysts and those on Wall Street
and business executives and those on Main Street with somewhat
more pessimism among the financial market players than among
the real economy players. But any way you cut it, there is an
elevated risk of recession.
The economic outlook is particularly uncertain right now,
and my only point was that the most likely scenario is one of
continued economic growth, acknowledging that again the
situation is uncertain and the risks of a recession are
elevated.
Vice Chair Maloney. Dr. Shiller, how much do you expect
housing prices to fall over the coming year? And how much of a
threat do these falling housing prices pose to the stability of
the overall economy?
Dr. Shiller. Well the Futures Markets that are trading in
Chicago are predicting, depending on the city, between 4- and
10-percent declines over the next year. I don't make forecasts,
quantitative forecasts, but those sound like reasonable
possibilities.
Vice Chair Maloney. And specifically do you expect that the
lower housing prices will cause a significant slowdown or
decline in consumer spending?
Dr. Shiller. Well the U.S. has a very low saving rate. I
think one of the factors that has--virtually zero personal
saving rate--and I think one of the factors that has encouraged
this is the housing boom and people's perception that, what's
the point of saving when my house is providing me new equity
of, you know, it could be $20,000 in 1 year.
As this perception fades, I think it is quite likely that
we will see declines in spending. And these are again things
that are difficult to model based on historical data because we
are talking about a major change in perceptions.
Vice Chair Maloney. And do you expect--and I would like Dr.
Orszag also to comment on this--do you expect the lower
consumer spending to be large enough to affect the overall
economy, our economic growth, and our employment levels?
Dr. Shiller. I think it is likely to be a drag on the
economy for years to come.
Vice Chair Maloney. How many years do you expect?
Dr. Shiller. I am saying a drag on the economy. I cannot--
the last, the weakness in the housing market in the last cycle
lasted 5 years. But this is not a catastrophe. This is----
Mr. Pollock. But there was not a 5-year recession.
Dr. Shiller. It was not a 5-year recession. The Fed has
been very responsive to these things, and they will cut
interest rates. I expect the 50 basis point cut we saw
yesterday is likely one of a series of cuts. So we will see
strong policy action. And recessions have been relatively
short-lived, and I think we will get over it.
But even after the recession, if it comes, we may see
attenuated growth for some time.
Vice Chair Maloney. Would you like to comment, Dr. Orszag?
Director Orszag. I would just add two things quickly. One
is that this sector is likely to impose a drag on the economy
for some extended period of time, and that is embodied in most
projections at this point.
The second point is this: Another lesson I think we can
learn from this experience is the fact that financial markets
are not pricing some risk--in this case having to do with
subprime mortgages--in no way means that that risk is not real.
The fact that financial markets are not pricing other risks
like our long-term fiscal imbalance in no way means that the
risks that we are running along other dimensions are not real.
We face a severe and serious long-term fiscal imbalance that
does not appear to be fully reflected in long-term bond prices,
but that does not mean that all is well in the world from a
fiscal perspective and that we are not running risks there.
Vice Chair Maloney. And very quickly, Mr. Pollock, on your
financial statement on one page, if a borrower did not
understand the underlying financial instrument, is it really
likely that a form will do that much to help them?
Mr. Pollock. Yes, I think it is, Madam Chairman. Because
unlike any other disclosure ever used in the history of
American mortgages, the one I am suggesting actually focuses on
the impact on the household finances.
We have had a lot of forms in the huge stack of papers we
all know about at mortgage closings, but they are all devoted
to describing the instrument in vast detail. And the result of
that is that there is essentially zero real information.
What I am suggesting is a form which highlights notably the
household income. Just in case you have lied about it, you get
a chance to rethink. Or if somebody else has lied about it on
your behalf, you get a chance to correct it.
And then the payments, including all the elements--
principal, interest, insurance, and property taxes--and how
much of your household income this loan is going to take up,
both at its beginning rate, and if it has adjustable rates at
its fully indexed rate.
We have never told in any straightforward way people. We
rely on the brokers, or the loan officers to explain that.
Obviously a lot of them are very diligent and responsible
people, and some are not.
So I do think this could make a difference. I do not claim
it would work in 100 percent of the cases, but I think it would
work in a large amount. And I have had the most fun testing
this informally on various people.
I think it would work. And I have had, out of the blue,
responses from a number of loan officers who voluntarily
adopted this for use with their clients because they think it
works.
Vice Chair Maloney. Thank you. I want to thank all of you.
I have been in many hearings on this issue, and you have really
been the most informative with actual ideas of what we can do
about it.
I want to thank you, and I yield to my distinguished
colleague, Congressman Hill.
Representative Hill. Thank you, Madam Chairman.
You basically asked, Madam Chairman, most of the questions
that I was going to ask. But, Mr. Pollock, I think you are the
only one that did not comment on whether or not, in your view,
we were going to move into a recession. Do you wish to comment
as to whether or not you believe that to be a reality?
Mr. Pollock. Congressman, I confess to be fully agnostic as
to the possibility of macroeconomics as a science. The reason
is, as Dr. Orszag said, you are trying to model human behavior.
And the human behavior is reacting to all of the things that
are happening, including your forecast.
I do not think there is any question but that the bursting
of a big bubble is a serious negative economic drag. Whether it
is enough to put you over the line into negative growth, I do
not know.
Representative Hill. OK. In listening to all the testimony,
one thing that is bleeding through is that the subprime
market--and correct me if I am wrong--according to the
testimony that you have given, if there is going to be a
recession, is going to be the reason why we are going to have a
recession, the decline in that market.
Is that a fair analysis?
Dr. Shiller. The housing market, more generally. It's not
just subprime. The housing market is going to continue to fall
and bring more and more people in trouble. And it will affect
confidence more generally.
Representative Hill. But it is the subprime market that is
driving the decline in the overall market?
Dr. Shiller. Well that is the focal point right now, that's
right.
Director Orszag. And the problems thus far have been
disproportionately concentrated in the subprime market. For
example, I showed you the increase in foreclosure rates by
State. Those States were also the ones that had the highest
shares of subprime mortgages extended.
So the connection that you are drawing seems to be one that
is borne out by the data, that the problems seem to be
disproportionately concentrated in the subprime market, and
that that poses macroeconomic risk because of its implications
for the rest of the housing market, and then for the rest of
the economy.
Representative Hill. OK, Mr. Eakes, you say that many
problems in the subprime market have been attributed to
unscrupulous mortgage brokers. Then you went on to indicate
that your Self-Help losses have been less than 1 percent.
I believe it was Mr. Pollock who indicated that the
national foreclosure is at 14 percent?
Mr. Pollock. That's total delinquencies.
Representative Hill. Total delinquencies. And what is your
foreclosure with Self-Help, Mr. Eakes.
Mr. Eakes. Our total losses have been 1 percent
cumulatively, so it is well under 1 percent per year. We have
had over a lifetime of loans probably 2 percent, 3 percent that
have foreclosed. But the losses have been very small.
Representative Hill. OK.
Mr. Eakes. My statement about that is: If you do common-
sense loan underwriting, what all bankers did 10 years ago, 15
years ago, you just do not get these problems. It is when you
start adding practices like stated income that says to a
borrower or to a broker you just get to state what your income
is, and we will believe it.
Or, that you do piggyback loans that are larger than 100
percent of the value of the home at day one; or you put a
prepayment penalty that says if you got stuck in a loan and you
cannot get out, when you cumulate each of the risk factors it
becomes really quite catastrophic.
Representative Hill. Well do you believe, then, that the
market ought to take care of that? Or should we in Congress be
passing laws that regulate how you are lending?
Mr. Eakes. There are two different markets that play here.
One is the investor market, the funds that flow into mortgages.
And the market will self-correct there. I mean, it is already
correcting.
On the level of individual homeowners, the market is not
going to correct for people who got sold a product they did not
understand and got put in. They are going to lose their homes.
If we call that ``correction,'' it is a very harsh sort.
I have been arguing for--I have been doing hearings since
2000 and have been saying that a market for homeowners is like
a soccer game. You do not want to have rules and referees who
run around and impinge on the players. But if you do not have
boundary rules that say this is what is an ethical marketplace
on the boundaries, you will end up with the kind of
catastrophic foreclosures that we have had.
You know, for people to say that this is a surprise to them
is mind-boggling to me, because I feel like I have been talking
about this, and hearings have been recognizing the problem
since 1994 when the Home Ownership and Equity Protection Act
was first passed.
In that bill, Congress designated that the Federal Reserve
was to be the entity to pass these boundary rules to make sure
that unfair and deceptive practices did not creep into the
mortgage marketplace.
And the Federal Reserve to date has simply not done its
job. There are really good signs. The current Board, none of
them were here in 2000, and they have promised that they will
address this problem before the end of the year with a proposed
rulemaking.
If they do not do it, then Congress must step in or we will
have this same exact problem 8 years from now just like when we
thought it was all wound out in 1999 and 2000, it came back in
an ever more virulent strain.
Representative Hill. Thank you, Madam Chairman.
Vice Chair Maloney. Thank you. The Chair recognizes the
distinguished Congresswoman from California, Congresswoman
Sanchez.
Representative Sanchez. Thank you, Madam Chair.
I heard my colleague, and I love Barron Hill, but I think I
have a little disagreement with this whole issue that maybe the
subprime has caused--the market has caused this.
I actually think that our economy, if you look at the
fundamentals of it, has been pretty lackluster in the last 6
years. And that the only bright spot in it was the housing
market.
If you had taken the housing market away, taken that piece
out, you would have seen that when you look at the Federal
deficit in Washington, some of our industries just not really
coming back, in fact contracting, that the housing market was
actually really pushing the numbers of the economy up so that
we could all be fooled in a sense that things were OK.
I mean, I started mentioning this when I got on this
Committee, that I thought we had some very, very fundamental
problems with our economy. Now it goes bust and everyone is
thinking, oh, my, the economy is going to go bad because the
housing market has gone away.
Well, yes, I think it has got a possibility to really tank
the economy. But if the economy had been stronger in other
areas, then we would not see as big an implication. That is my
personal opinion. And I know I had that discussion with
Greenspan in a couple of the hearings that we had when we was
before us.
I also think that anybody who had been asking--maybe it is
because of subprime corporations are located in Orange County
for a large part that I saw this coming way ahead of time, but
if anybody had been asking about what was going on with the
housing market and what types of loans people were taking out,
I mean the very favorite one in Orange County was a 40-year
loan at 1 percent.
And then they would borrow something to make the 10-percent
down payment first. I mean, two loans back to back. You know,
if you looked at what people were using to get into the product
that they were using, you would just say that people were
crazy, that this was a crazy market.
People actually offering these products had to have known
that this was going to get us all in trouble. So it is not a
surprise to me that we are in this situation.
The question is: Is our economy strong enough to take the
hit of this housing, what will be I hope just a short-term, by
``short-term'' I mean like 2- or 3- or 5-year sort of slow
down, reduction in prices, maybe 5 or 10 percent, I hope at the
most. I have heard economists say it could be 25 percent, or 50
percent. In some markets of course you can't give away a house
these days.
But I think we need to get back to a few things. First of
all, how do we help the people who are really losing their
homes right now, who made a mistake? They made a mistake. They
did not understand what they were getting themselves into.
Part of that can be these unscrupulous people who actually
sold it to them, but the fact of the matter is we have a lot of
people who, if they lose their homes, probably cannot even get
into an apartment because their credit will be wrecked by what
has happened. So they are going to be less likely even to find
a housing situation, let alone lose their home.
So how do we help them? I think there are a lot of things
that Congress can do, and I do not think that we can wait for
the Federal Reserve to decide that, you know, prepayment
loans--you know, I had some realtors who told me that they are
trying to unwind people out of some of these loans, and the
prepayments are, you know, 3 or 5 percent of the loan. That is
$10,000, $15,000, $20,000 for some people.
We just have got to tell these people, hey, you put them
into a bad loan. We are not going to honor that prepayment. I
think we as a Congress need to pass some legislation now rather
than wait for the Fed to come up with the rules of how we are
going to get these people out of it.
If we would pass some legislation in the next couple of
months that would actually help that set of people that I
think, Dr. Shiller, you were talking about, the ones who maybe
are in the first 60 percent of people, the 40 percent you said
can refinance, the 20 percent who have the adjustable loan,
what would be some of the things?
I mean, I have thought of maybe looking at what indexes are
these adjusted pegged to, and how do we make sure that that
index does not move up significantly? What are some of the
things that we can look at from a legislative standpoint and
also from a monetary standpoint to help these people not lose
their homes? Or move them into new product?
Dr. Shiller. Well we have a fundamental problem, which is
that market economy functions very well overall to product
wealth. But it has a chance, a tendency to go to excesses. And
so we have seen a boom in home prices which has been supported
by irrational expectations.
It has been supported by a sense that these home price
movements will go on forever. And that has caused errors to be
made both by lenders and by borrowers.
So it is not an easy thing to know how to correct these
booms and busts. So I wish I had easy answers to your
questions. It seems, though, that it is very important that we
do something in the immediate crisis because we are going to
see people in the bottom tier of our income distribution hit
and hurt badly.
So some of the proposals of Mr. Eakes and Mr. Pollock sound
very sensible in the short run, but in the longer run we also
have to prevent this kind of thing from happening. So the
particular proposal that I launched, which was not my own, was
that we should create some kind of, something analogous to the
Consumer Product Safety Commission that reviews practices in
the mortgage industry from the consumer's standpoint, and
really has as its mandate that it looks at abuses; it collects
information about abuses; and recommends changes.
That is one of a number of things. But I just hope that we
get to action fast before this crisis unravels more.
Mr. Pollock. If I could make a comment, Congresswoman,
there is nothing like a market economy for creating wealth for
ordinary people. That is the best thing there is. And as
Professor Shiller says, part of a market economy is periodic
booms and busts.
It is important to remember that the reason the boom really
gets going is because many people succeed. So if you think
about, in California for example, people early on who took what
we would now look back and say, well, those were terrible
loans, 100-percent subprime, floating rate, but they caught the
house price appreciation and their house appreciated 30, 40, 50
percent. They had a huge success. They had now big equity in
their house. Now they could refinance.
And in every boom, it is the observation by everybody else
of all of the successes and having those successes be
extrapolated in the behavior--we're talking here about behavior
and predictions--that creates the boom.
What we can do in terms of the form of loans, it is the
long-time experience, and one of the really reliable
statistical regularities about the mortgage market is fixed-
rate loans have lower defaults and losses than adjustable rate
loans.
That is true of prime loans where adjustable rate defaults
are about two or three times what fixed-rate defaults are. It
is true of FHA loans, and it is true of subprime loans.
So if we want to be a careful, conservative lender, it
helps to have loans fixed for some considerable period, and not
necessarily 30 years but let's say a minimum of 5 to 7 years.
And careful lenders like Mr. Eakes' organization who are
operating in their towns and neighborhoods, the kind of credit
record that he cited is very common among bank and thrift
lenders. And it is even more common if you are doing
predominantly fixed-rate loans.
My final note is, however, if we want fixed-rate loans we
have to have securitization. Because as we have learned from
history, there is another risk which is interest rate risk on
the long-term fixed-rate loan.
If you do not pass that on to the bond holders and you
stick it in the local institutions, they are going to get in
trouble in a different way.
Mr. Eakes. What I wanted to add was----
Representative Sanchez. Yes, Mr. Eakes.
Mr. Eakes [continuing]. The consumer financial products
commission, or financial products, or the Federal Reserve's new
guidelines will only affect borrowers going forward. So the
second question of what do we do for existing borrowers, brings
home the point that, while we can have great sport about
whether we will go into a recession or not, if you disaggregate
the data and look at specific States, or specific subgroups, we
are going to have a catastrophic recession.
Let me just break it out. In the last 2 years, 53 percent
of all mortgage loans made to African American families in the
Nation were subprime. Forty percent of all mortgage loans to
Latinos across the country were subprime. These products that
are basically foreclosure machines. We face right now--and the
same is true for mobile home owners in rural States.
Those segments are going to be catastrophically hit. If you
look at the States, break it out by states--California, Nevada,
Arizona, Florida, New York--the States that had the most rapid
rise in home prices are going to see the effects being most
catastrophic in the reverse direction.
So even if we do not tip into what would be considered a
national recession, we are going to have whole cities and whole
States that are suffering dramatically. And there are only two
ways to intervene in existing--so when I say that for Latino
and rural White and African American families, they face right
now the greatest threat to family wealth in the history of the
country. Right now over the next 2 to 3 years.
And if we do not act to help existing borrowers, which can
only happen by having some judicial intervention, either by a
foreclosure which clears title and frees up the property for
someone else, or a bankruptcy that allows the loan to be
written down to the current market value and the loan terms
modified so that it can be affordable, we are going to have at
least in these micro-economies, we are going to have
catastrophe.
Director Orszag. Could I just add very briefly on that
broader topic? We are turning to a point you made at the
beginning of your statement.
It is often much harder to deal with a mess after the mess
is made than to try to mitigate or prevent it in some way in
the first place. And you mentioned that there were aspects of
economic growth that seem unbalanced. I would just again
highlight that we as a Nation are saving 1 or 2 percent of our
national income. That is not a sustainable situation.
We are borrowing 6 percent or more from abroad. That is not
a sustainable situation. The only question is whether it
resolves itself gradually or in a more sudden way. And again,
similarly if it were to unravel more quickly than anticipated,
we could quickly wind up in a mess that would then be very
difficult to work our way out of.
So trying to take reasonable steps against that kind of
risk is an important policy objective.
Representative Sanchez. I would completely agree with you,
Doctor. It is one of the reasons I am a Blue Dog. That is one
of the reasons why, you know, we are trying to bring down the
spending at the Federal level.
I think the situation--I do not know why America has not
awakened to what is going on here in Washington, D.C., but I
think we have some serious financial considerations on our
hands for the future.
But trying to figure out what we do for these poor lower-
income families that are really going to be hit by what is
happening in this loan situation, whether it is African
American, Latino, whether it is poor White, in Utah and other
places, they are the least able to take this. And probably the
money was made by the upper half while all of this was going
on.
So we are looking--I think we need to look for real
solution now to help some of these people. So I appreciate your
comment. I mean, it is a comment I have had for a long time
about our economy. I would not do my spending plan that way,
but I am not president.
Thank you, Madam Chair.
Vice Chair Maloney. Thank you. Thank you, and my colleague
and friend from New York, Congressman Hinchey.
Representative Hinchey. Well thank you very much, Madam
Chairman.
Gentlemen, I apologize for not being here to listen to your
testimony. I was tied up with something else, and I very much
wanted to hear it, but I will still be able to read it.
I thank you very much for being here. It struck me that the
subprime mortgage initiative was a creative but also seemingly
dangerous and potentially destructive initiative which was put
forward to try to protect and preserve the contribution that
the housing industry was making to sustaining the economy when
everything else seemed to have fallen apart.
As time has gone on, that seems to be more and more the
case. And particularly the answers that I have just heard to
all the questions seem to verify that. The impacts that, as you
have said, that are going to be had on many, many people--
particularly low and moderate income people--across the country
are going to be very severe.
Those people are already facing some very dire
consequences. Most of the people in this country are
increasingly in debt as the country itself is increasingly in
debt--our National Debt has now gone up over $9 trillion, just
about doubling over the course of the last 6 years--but the
debt of ordinary people keeps going up.
The information that I saw recently is that people are
spending about 10 percent more than they are making on a
weekly, monthly, annual basis, which is something that is
seemingly unsustainable.
I understand that there are other situations like this that
are going on in other parts of the world. Great Britain I
understand recently, there's been some analysis of that as
well, how people are spending more than they are taking in, and
therefore more than they can afford.
So it seems to me that this economy that we are dealing
with now is very, very fragile. The potential impact can be
very, very destructive. And frankly, as I look at it, I cannot
understand what it is that we might be able to do in order to
deal with this immediately.
I think that there is a good possibility that we are going
to have to suffer some form of recession of some kind in order
to gin up enough attention and enough energy out of this
Congress to focus on this issue and try to create something
that would be productive.
So I am sorry that I was not here to listen to your
testimony, because in all probability you have probably already
addressed these things, but if there is something that you
would like to say about it now I would very much appreciate
hearing it, or comment on some of the things that I have just
said, I would be very grateful to hear.
Mr. Eakes. If you would do this one tweak to the Bankruptcy
Code, you will save 1,000,000 families from being foreclosed
on, and that will impact 5- to 10,000,000 of their neighboring
families. That that one little thing, like deleting 10 words
for an exception that made no sense to begin with, it will
dramatically change--it does not mean we will not have national
pain, but that by itself will do more to help the existing
homeowners facing foreclosure than any other single act that
you could take. And you could do it with a snap.
Director Orszag. If I could just add one thing about
subprime mortgages in general, I think it is important to
remember that for, although there are clearly problems--I do
not want to downplay them--that for many households this type
of product does make a lot of sense, and does help to boost
home ownership.
So for a low-income family that is expecting some
significant increase in income, for example, and then has
trouble qualifying for a conforming type mortgage, or has other
credit problems, a subprime mortgage can provide access to home
ownership in a reasonable way.
So it is important in addressing the problems that we are
facing not to throw that benefit out also. And also to remember
that at least as of now the vast majority, something like 85
percent of subprime mortgages, are not in foreclosure and are
still operating as expected.
So I do want to just make sure that we underscore that
there are benefits to this financial innovation, also.
Mr. Pollock. But 95 percent are not in foreclosure, and 85
percent, if I may correct the number, are not delinquent. That
is as of now.
If I could say something, Congresswoman, here, one of the
key things about America is people have a right to take a
chance. I think it is really important that borrowers have a
right to take chance. And lenders have a right to take a
chance, if they want to.
I point out in my testimony that the sorts of chances we
are talking about, buying a house, are very modest when
compared to the chances, say, that our ancestors took being
immigrants, or being pioneers and setting off in their covered
wagons. We are pretty soft compared to them.
But when they are taking their chance, they ought to know
what chance they are taking and really understand what it is
they are getting theirselves into.
Dr. Shiller. We have a short-term problem with the subprime
mortgage, but it is also part of a bigger long-term problem:
that we have been rather complacent over the last decade,
really, of home price appreciation. We have been living in a
boom economy, and this boom economy has helped us defer
worrying about long-term problems.
But we do have a Baby Boomer Generation that is going to
retire. We have to think about their pension, and their health
care, and these are all tied up with the sense of complacency
which we have had in this housing boom, and it is now finally
correcting.
So it will bring up all these other problems also.
Mr. Eakes. I want to engage Dr. Orszag just for a second.
When he says that 85 percent are paying on time, or 95 percent
from Mr. Pollock, that is a snapshot of one moment in time. If
you look at a year's loans, subprime loans, the way they have
currently been practiced over the last 4 or 5 years, somewhere
in excess of 20 percent of those loans will end up in a lost
home.
Of those subprime loans, no more than 10 percent created
new homeowners. So subprime lending--I've been a subprime
lender myself for 25 years, and I feel like that I can defend
the industry, done right. But the last 4 or 5 years it has not
been a help to people.
It has a short-term benefit of getting someone in a house
that 20 or 30 percent--if a large percentage of them will lose
their homes because of the product, because it is going to have
a payment shock in the third year of 50 percent, it is really a
negative drag for that.
So I agree in theory that the subprime marketplace, of
which I feel like I am a participant, could be a powerful force
for helping people have access to credit, but if it is done
poorly it will create much more harm and destruction than good.
Representative Hinchey. Well a lot of it has been done
poorly in the last few years. And I think what you have just
said, Mr. Eakes, confirms what Dr. Shiller said: That what we
are dealing with here has some potential, serious potential,
for long-term economic problems, unless this issue is addressed
constructively and the circumstances can be at least reversed
to some extent.
Mr. Eakes. I agree.
Chairman Schumer [presiding]. Well welcome, and thank you,
my colleague and friend from New York.
Representative Sanchez. Mr. Chairman, we have votes coming
up.
Chairman Schumer. OK, thank you. I want to thank both of
you and your colleagues for being here today.
I will just follow up with my second round. I would like to
go back. I know it has been touched on. The most frightening
prediction here is Professor Shiller's about the housing bubble
and its effect on the whole economy, and if we do have a
serious housing bubble all the more reason that we should be
moving with some alacrity on the mortgage problem.
Simply lowering interest rates is not going to be the main
way to solve that problem. Or simply--well, simply pushing more
money into the economy, not if the fundamentals in the mortgage
area are not being taken care of.
At the very least it is a highly inefficient way to do it,
with other ramifications. So Professor Shiller you testified
that we could see a decline--and this is astounding--in home
values between 7 and 13 percent in the next year alone; even
worse, we may see the likelihood of a great decline, and you
characterize it as the worst decline since the Depression--
first, that is frightening; that is really astounding. There is
probably no way, if they decline to that degree, that we could
avoid a recession. Is that fair to say, Dr. Shiller?
Dr. Shiller. I wouldn't go that far. I would say I think
there is probably a greater than 50-percent chance of a
recession.
Chairman Schumer. Do you agree with that, Dr. Orszag? If
his initial prediction on house prices is severe as it is?
Director Orszag. What we provided in our testimony was a
scenario in which national house prices declined by 20 percent.
So that is a very substantial decline. You get----
Chairman Schumer. One to 1.5.
Director Orszag. A half to 1.5 percentage points per year
off of growth through the channels that are sort of
quantifiable. And then there is this other stuff, the
perceptions.
It is possible that something like a 20-percent real
decline in house prices will have a significant effect on the
outlook of business executives and consumers.
I would note, though, that a reduction in interest rates,
while it may not directly offset all of that, does spur other
stuff, business investment and what have you.
Chairman Schumer. But let me ask you this, Dr. Orszag, if
there is a 20-percent decline in housing prices, what do you
estimate--I think it is in your testimony, I do not have it in
front of me--decline in consumer spending?
Director Orszag. Most of the half to 1.5 percentage point
decline in economic activity per year that would occur comes
through consumer spending. There is a little bit through
residential investment, but most of that is a wealth effect
through consumer spending.
Chairman Schumer. It is more likely to be the low end, or
high end? That is a pretty broad range. And you are dealing
with a GDP of 3-percent growth, maybe, not even 2.
Director Orszag. The reason there is a range is that this
has to do with when the value of your house goes down by $1,
how much less do you spend?
We put out a paper earlier this year on the evidence on
that, suggesting somewhere between 2 and 7 for each $1
reduction. The range I was giving you reflects the empirical
ambiguity about the size of that response.
Chairman Schumer. But let's say it's 7 percent, the decline
in consumer spending, and consumer spending is what, about 70
percent of the GDP?
Director Orszag. There's an extra step, but if it were 7
cents on the dollar for the housing wealth effect, in a 20-
percent price decline, you do then wind up with about 1.5-
percent slower growth the first year, and another 1.5-percent
slower growth----
Chairman Schumer. Oh, so it's 3 percent, the second year?
Got it.
Director Orszag. Well, in terms of growth, it's another
1.5, but in terms of the level, it's 3 percent lower.
Chairman Schumer. OK, go it. Do you want to say something
about this?
Dr. Shiller. Yes. I've done studies of the wealth effect,
too, but remember what we're doing; we're looking at past
recessions, in order to quantify the effects on wealth.
And what I think is different about this experience, is
that the last 10 years, we have been in a very unusual boom
that has led us into an unusual psychology.
And I think that it changes in unpredictable ways. I don't
trust my own past analysis of this.
It's a big event that we've been through, and with the
recent crises and the prospect of foreclosures for millions of
people, it strikes me that there could be a bigger effect than
these models predict.
Chairman Schumer. Mr. Pollock, would you like to comment?
Mr. Pollock. I'd just say, Mr. Chairman, that as many
people who inhabit the southern tip of New York City, of
Manhattan, would say, one thing about falling prices, is that
it creates buying opportunities for other people.
Chairman Schumer. It always has.
[Laughter.]
Chairman Schumer. But there's a lot of pain in between.
OK, let me ask you another question. This is about the
higher end of the market, which we haven't focused on in this
testimony.
Obviously, the ability of those at the higher ends to
securitize, has allowed a lot more money to come into the
market, and then allowed maybe the mortgage brokers--and not
all of them are unscrupulous, but too many are--to do what they
have done.
Let me ask you this: Do any of you have any thoughts on how
we improve the securitization process with mortgages, so that
this situation doesn't repeat itself? Or is the market taking
care of that well enough itself?
Usually, when we have problems in the market, they occur in
different places, you know? I was very much involved in the S&L
fix, you know, and the savings and loan industry, since 1989,
when we passed the legislation, has been pretty good. They
still remember what happened.
So, could any of you comment on that. Dr. Shiller, why
don't you go first?
Dr. Shiller. I think the biggest problem in the
securitization process, has been that the rating agencies had
not foreseen these problems, and allowed mortgage securities to
have triple-A ratings, when they shouldn't have.
I think this is a problem of transition; that when we're in
an unusual situation, it's very hard for some organization
that's assessing risks, to take that properly into account, and
it would be kind of an act of unusual intellectual courage for
them to start predicting this crisis a year or two ago, and
embodying that in their recommendations, but I do think that
they are making corrections.
Overall, I just want to say that financial innovation is
very important, and the securitization of mortgages and the
different vehicles, have a general good social purpose, which
is spreading risk and allowing people to have access to credit
that otherwise couldn't.
Chairman Schumer. So you're basically saying, Dr. Shiller,
that the place that needs most correction, is the individual
mortgage broker to the potential mortgagor and maybe the first
lender, because the rest is sort of self-correcting, or because
the rest----
Dr. Shiller. Well, we need----
Chairman Schumer [continuing]. Is self-correcting. The
credit agencies will never just stamp triple-A on things that
are all mortgages. Well, maybe for another 20 years, they
won't.
Dr. Shiller. The real issue, to me, at this time, is lower-
income borrowers and that we are a country that cares about all
people, not just the securitizers of mortgages, and we have to
do something for them.
Chairman Schumer. Well, that's what we're trying to do
here, with you help.
Go ahead, Mr. Eakes.
Mr. Eakes. I think the challenge is that you have perverse
incentives working in the mortgage market now.
Where you used to have a thrift that would make a loan and
hold the loan, their interests were completely aligned with the
borrower, went bankrupt and had a loss, the lender would have a
loss.
Now we have mortgage brokers, most of whom are honorable
people, but who have a financial incentive to close every loan
as fast as they can, without regard to whether it's a good
product for the borrower. And that's just the financial
incentives that they have operating and putting pressure on
them.
And if I told you that we were going to repeal all of the
State statutes that had it be--that held responsible, the
receiver of stolen goods, we would have a whole lot more
receiving of stolen goods.
Chairman Schumer. Sure.
Mr. Eakes. But we make those parties responsible, even
though they weren't the ones that----
Chairman Schumer. Mr. Eakes, do you disagree with--I mean,
Dr. Shiller seemed to indicate--and, I think, Dr. Orszag
earlier--that the watchdog here, according to Dr. Shiller, are
the credit rating agencies, because once they said these are
good securities, people bought them.
And you can't ask the individual investor to look into the
611,000 mortgages that are part of the large security,
especially when they're chopped up.
Mr. Eakes. I think there are two cases.
Chairman Schumer. And so my question is, is it going to be
self-correcting, or do we need to do something? Are the credit
agencies and the investors chastened?
Mr. Eakes. The gate for the credit rating agencies, has
also a perverse incentive. Somewhere near 70 percent of all of
the revenues for Moody's and S&P in recent years, was
structured finance, this product, all of which was paid to them
by the issuers.
So the ratings agency is meant to be a disclosure and an
information transparency to investors. But the investors don't
pay for that service; instead, the people who are profiting
from pushing the product, are paying the ratings agencies.
Chairman Schumer. Like the accounting profession.
Mr. Eakes. It's an inherent conflict of interest. No matter
how much firewall you put up, there ought to be SEC--that piece
of the incentive, needs to be restructured.
On the front end, the gate with mortgage brokers, the first
lender who pays a broker for delivery of a loan, should be
responsible for any bad actions taken by that broker.
Chairman Schumer. Mr. Eakes, I have legislation to do just
that.
Mr. Eakes. I know you do.
Chairman Schumer. So, I'm glad you're supportive. Would
everyone agree with that proposal?
Mr. Pollock. I do not, Mr. Chairman.
Chairman Schumer. Go ahead, Mr. Pollock. I was wondering
when your American Enterprise Institute stuff would bubble up.
Mr. Pollock. It's been there all the time.
[Laughter.]
Mr. Pollock. The argument, as you know, gets very clear,
and the experience of being in experiments of trying to pass
that liability on, is that it tends to shut off the very
funding that we're trying to create.
I think it is quite clear that in any lending operation,
you ought to have a responsibility of due care and diligence,
but somebody else's fraud that fools you, in my judgment,
shouldn't also punish you.
I do think, coming back to your first question, that the
prime market, we don't have to worry very much about. We've had
a panic.
Financial panics tend not to last very long, especially
when central banks start cutting rates, and the prime market
will, in my judgment, adjust fairly rapidly. That's why I would
be, for example, opposed to raising the conforming loan limit
for Fannie and Freddie. We don't need to.
With respect to credit rating agencies and the lessons, the
clear verdict of financial history, is that lessons are always
learned in these busts, and they last about 10 to 15 years and
then a new group of people gets to relearn them.
There is an issue with the credit rating agencies, in my
judgment, about the two possible models, the issuer-paid model,
as Mr. Eakes referred to, which is the dominant model, although
all of the original credit rating agencies were investor-paid,
in the beginning--Moody's and Poor's Rating Service and Fitch,
all got into business issuing ratings for investors, up until
the 1970s.
Chairman Schumer. That's interesting.
Mr. Pollock. Then the switch in payment basically happened.
The story is--I'm not sure it's true--it was because of the
Xerox machine, because if you were selling your book of ratings
to investors, you couldn't protect it anymore as a proprietary
property.
Chairman Schumer. Carbon paper wasn't good enough?
Mr. Pollock. Carbon paper wasn't good enough. But it's my
view that we ought to have as robust a competition as possible
between issuer-paid rating agencies and investor-paid rating
agencies.
There are some of those. It would do us well to have more.
The SEC has been a large obstacle to letting investor-paid
agencies compete, by withholding, by historically withholding
their so-called NRSRA, Nationally Recognized Statistical Rating
Agency imprimatur from them.
I think a really useful project would be to set our minds
on how we could create a more robust presence in the market by
rating agencies which are purely paid by the investors, and who
would rate, purely looking at the investors.
One of the ideas I've had on this, is that the major
institutional investors themselves, maybe ought to be willing
to fund the creation of a highly competent major rating agency,
which would work only for them.
And just a final point, Mr. Chairman, when you mentioned
the going through the individual loans, I've been told by
experts in securitization, that major institutional investors
do actually go through individual loans before they buy
securitized mortgage pools and run their own models on them.
The problem is the adequacy of any model--an investor
model, a rating agency model, and, if I may say so, colleagues,
a macro economic model--there's always a slip between the model
and the reality.
Chairman Schumer. Mr. Pollock, I appreciate what you're
saying, but knowing what I've known, even in the last 8 or 9
months, you know, the kind of stuff Mr. Eakes deals with,
what's been going on on the ground, it's hard to give much
credence to those models.
Mr. Pollock. I fully agree, Mr. Chairman.
Chairman Schumer. People were just ripped off and given
mortgages they couldn't afford, for the very reason, I think,
that Dr. Shiller just mentioned; because the mortgage broker
and the initial mortgage lender, just walked off into the
sunset.
And they made huge fees. I mean, I've used this example
before, but just to share it with you, a fellow who I met, who
is a prime, just like you say, Mr. Eakes--and I'm going to come
to that as my last question--who would have qualified for a
prime loan, refinanced his home.
And the majority of people who are in these messes, are not
new homeowners. You know, with all due respect, Mr. Pollock,
the ideological view that we're really just funding new
homeowners who never would have gotten funded before, that's
happened to some people and that's good, but many people were
like this gentleman.
He had a home, he had paid about half his mortgage. He
needed $50,000, because he had diabetes and his healthcare plan
didn't pay for it. A mortgage broker calls him up and says,
I'll refinance your home and get you $50,000 in cash.
They refinanced the home, and the rate went way up, of
course, and he lost his home. But of the $50,000, do you know
how much he actually got? It was $5,700.
The mortgage broker made $22,000 as a fee, because he
landed, as Mr. Eakes has pointed out, a very high-interest loan
that this man, who's a prime candidate, prime-rating
candidate--he was a retired subway motorman. He has a pension,
he has Social Security, and a bank--it wasn't a bank, sorry--
the lender, got $11,000 as a fee, and then between the
appraiser, the lawyer, and everyone else, this poor man got
$5,700.
Mr. Eakes. And lost his house.
Chairman Schumer. And lost his house, to boot.
Mr. Pollock. May I make one comment?
Chairman Schumer. Please.
Mr. Pollock. That's a story of the very sort of thing we'd
like a well functioning market not to have happen in, if I can
put it that way.
I don't think there's any doubt that in the ideal mortgage
market design, the original lender would maintain a life-of-
the-loan credit interest in the loan.
I do a fair amount of work with emerging or developing
countries as they try to think about mortgage systems, and
that's one of the things I always advise them: make sure that
the organization that's making the loan stays on the hook in
some serious way for the credit.
It's not impossible, but it's harder to do that in a
securitization world, and for other reasons, namely, interest
rate risk, we really like securitization, and moving certain
risks to the bondholders. We're caught between these two
desires and trying to figure out how to somehow satisfy both.
Chairman Schumer. Did you want to say something, Dr.
Orszag?
Director Orszag. Yes, just briefly. I think your question
touched on and then we didn't really address, the jumbo market
above conforming limits. There is a different set of
considerations there.
Coming back to the Ned Gramlich quotation, you would think
that jumbo borrowers will often--not always, but will often
have the sophistication to understand more complicated
financial instruments, and, therefore, are somewhat less
sympathetic in terms of financial assistance--the problems in
the jumbo market, although they're there, seem to have tempered
a bit recently with spreads coming down a bit, so I think a
broad array of policy analysts believe that there's less
justification for intense intervention there, than at the
bottom.
Chairman Schumer. Right. One final question, if I might,
just one final question for me, and that is just to Mr. Eakes.
You mentioned--and this is astounding. I say this all the time.
The media never picks this astounding fact up, which is at the
core of the problem, that 40 percent of current subprime
borrowers could have qualified for prime loans. That's an
astounding statistic.
It probably means a higher--anyway, so it seems to me,
these borrowers would be the best targets for the kind of
preemptive refinancings or loan modifications that you're
talking about. Are you seeing efforts to target these specific
borrowers, to go find them and target them, or is that sort of
like finding a whole bunch of needles in a big haystack?
Mr. Eakes. Well, now, one of the few good benefits of
having a liquidity crisis, is that these borrowers who have
good credit, cannot be easily refinanced back into another
subprime loan. That was the business that's occurred over the
last 10 years.
So, now, those borrowers, their only refinancing is to a
prime loan, and that's a good thing.
Chairman Schumer. But how many of them are actually----
Mr. Eakes. Nobody really knows.
Chairman Schumer. But it's probably very few, right?
Mr. Eakes. It's not enough.
Chairman Schumer. It's hard to find them. Is that right? Am
I wrong about that?
Mr. Eakes. It's hard to find them, and the person who has
the data about that borrower, what their performance record is,
what their credit score is, is the loan servicer-lender, who
made the subprime loan to begin with, and they don't always
have an incentive or, in many case, don't even have the
capacity to originate a prime loan.
Chairman Schumer. A lot of them are bankrupt.
Mr. Eakes. A lot of them are gone.
Chairman Schumer. Congressman Hinchey?
Representative Hinchey. Mr. Chairman, I just want to thank
you for holding this hearing. I think it's been very
fascinating, listening to this discussion. I'm sorry I wasn't
here earlier to hear the testimony, but I'm awfully glad I got
here to hear these questions.
Chairman Schumer. Thank you.
Representative Hinchey. It seems to me that the evolution
of this mortgage financing process that we've seen,
particularly the way in which the subprime aspects of it have
been carried out over the last few years, is certainly kind of
devolution in the impact that it's having on so many people, on
a larger number of people. That number seems to be growing.
It's one of those good capitalism/bad capitalism
situations. If we just allow this to continue, knowing that the
housing market has been the main driving force in keeping this
economy sustained, I just wonder what the consequences are
going to be.
And in the context of that wonderment, you can't help but
being a little bit fearful that the situation is going to get
successively worse.
Chairman Schumer. Thank you, Congressman Hinchey.
I want to thank each of our four witnesses. You each were
really excellent. I hope this hearing--it was on CSPAN, so I
hope a lot of people watched. I hope it stimulates people to
talk about these issues, because this is the nub of the problem
we've talked about, and we get a lot of talk around the issue
and above the issue, if you will, but not at the issue.
And that's what I've been trying to do for the last several
months, is focus it on the issue.
I also want to thank my staff for the JEC. The reason we
have four excellent witnesses, is that they chose you, and
they're always on the ball.
So, thank you all, and, without objection, we're adjourned.
[Whereupon, at 11:39 a.m., the hearing was adjourned.]
Submissions for the Record
=======================================================================
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
I would like to welcome my fellow Committee Members, our witnesses
and guests here today for this very important hearing on the impact of
the subprime mortgage meltdown on the broader economy. My colleagues
and I on this committee have been concerned for months about the
dangers to the American economy as a result of widespread, unscrupulous
subprime lending, and the economic news in the last six months has
disappointingly confirmed those fears.
Despite all the reassuring statements we've heard from the
administration that the impact of this mess would be ``contained,'' it
has not been contained, but has been a contagion that has spread to all
sectors of the economy.
We've seen it most clearly in the financial markets. This summer's
credit crunch was in large measure attributable to the collapse of the
U.S. subprime mortgage market. It shook Wall Street and required the
emergency intervention of central banks throughout the world to restore
liquidity to international credit markets.
The news outside the financial markets, while not so stark, has
been little better. We all saw the anemic August jobs report--for the
first time in four years, the economy actually lost jobs. Consumer
spending--the engine behind much of our recent economic growth--has
begun to slow down. Most economists have lowered their already weak
expectations about GDP growth even further. For the first time in
years, the ``R word''--recession--is being discussed far and wide as a
real possibility.
And, we know that the worst is still yet to come, as the riskiest
subprime loans will begin to reset in a very weak housing market over
the coming months. This morning, we heard that housing construction
fell to its slowest pace in 12 years. The collapse in housing
investment has already shaved nearly a full point off of GDP growth.
The inventory of unsold homes already stands at record levels. Builder
confidence has sunk to record lows. In many parts of the country, real
home prices have declined, on a year-to-year basis, for the first time
since 1991.
If there is anyone left who doubted the repercussions of the
subprime mess and the risks to the economy, they should look no further
than what the Federal Reserve Open Market Committee did yesterday.
In March, Chairman Bernanke came before this committee and told us
that the problems in the subprime market would have little or no impact
on the overall economy. Yesterday, the Federal Reserve cut the federal
funds rate by 50 basis points, again primarily in response to the
fallout from the subprime crisis.
When a conservative Fed drops the interest rate this much, it is
obvious that they believe the economy is in trouble. And while
yesterday's rate cut is a welcome indication that the Fed realizes the
real risks to our economy, it is important to recognize that a half a
point reduction will do little to get at the deeper, underlying
problems to our overall economic health. It is a temporary solution to
a bigger problem, and one that must be applied infrequently and with
caution.
My concern, and the reason that I have called this hearing, is
that, despite all the bad news, despite the sudden calls for action
from those who just a few short months ago were assuring us there was
little to worry about, I fear that we still don't appreciate the
seriousness of the problem we are facing. Our policy responses are not
matching the magnitude of the risk that still lies ahead:
And what exactly does lie ahead?
An estimated 1.7 million foreclosures are predicted to occur in
the next two to three years due to adjustable rate mortgages resetting
to unaffordable rates.
The Center for Responsible Lending has predicted that subprime
foreclosures will lead to a net loss in homeownership and a cumulative
loss of $164 billion in home equity.
The lost property values from the spillover effects of these
foreclosures could reach up to $300 billion in neighborhoods across the
country, and lost property tax revenues could exceed $5 billion.
These alarming statistics just refer to the direct impact of this
crisis. The indirect consequences--such as risks to our broader
economic growth, household wealth, the health of our financial markets,
and our relationship with global markets--are still unknown. I hope
that today's hearing will at least serve to clarify some of the dangers
that cloud our economic horizon.
One of the gravest dangers we face, as we will hear today from
Professor Robert Shiller, is that we are witnessing the bursting of a
speculative bubble in the housing market that will impact ALL
families--not just subprime borrowers. If, as Professor Shiller
suggests, significant real nationwide housing price declines are on the
horizon, we face the very real possibility that the housing market will
drag the economy down with it.
Our country simply cannot afford a slowdown in economic growth.
When income inequality is at historic highs, deficits are looming, and
investments in critical infrastructure are drying up, economic growth
is our best hope for righting past policy wrongs and getting our
country back on track.
Despite all of this bad news . . . the good news is that workable
solutions are out there, and we have time to put them into place to
help limit the damage.
First, we need to do everything we can to arm the local housing
nonprofit groups that are working around the clock with subprime
borrowers. Last week, with the help of Senators Brown and Casey, we
secured $100 million in foreclosure prevention funding targeted to the
local nonprofit groups that are pivotal in bringing subprime borrowers
and lenders together to achieve loan workouts. I've asked both the
administration, and the main private market players in the subprime
market, to help us find more funding to channel to these nonprofit
groups--particularly as their case loads grow more and more each day.
Second, we must use the Federal Housing Administration, Fannie Mae
and Freddie Mac strategically to target relief to subprime borrowers.
As we all know, government-backed products--FHA-insured mortgages and
Fannie and Freddie-guaranteed loans--are the only game in town in terms
of providing liquidity to the mortgage markets and safe, sustainable
products to subprime borrowers. And while my colleagues and I on the
Senate Banking Committee expect to pass an FHA Modernization bill today
that will help thousands of families keep their homes--we can and must
do more with these critical tools that we have in our arsenal to assist
more of the 1.7 million families at-risk homeowners.
That is why I introduced a bill two weeks ago--the Protecting
Access to Safe Mortgages Act--that will temporarily lift the limits on
Fannie and Freddie's mortgage portfolios by 10%, which will free up
approximately $145 billion for the purchase of new mortgages. The bill
requires that half of this total go directly to refinanced mortgages
for borrowers who are stuck in risky adjustable rate mortgages because
I believe that targeting the borrowers that are likely to default will
help shore up the housing market and assist the broader credit markets
and economy as a whole.
This morning, OHFEO announced that it will adjust Fannie Mae's
portfolio cap upwards by only 2% a year, after ideologically opposing a
cap increase over the past several weeks. Now that OFHEO has put its
toe in the water, it is time to jump in. Whatever they call it, there
is no doubt that this is an increase in the portfolio caps that I have
been calling for. This small increase, however, doesn't respect the
magnitude of this crisis. Hopefully this ideological driven and rigid
opposition to raising the caps is about to fade.
We all need to work together to adopt common-sense measures that
can go a long way to help make SAFE, AFFORDABLE refinancings possible
for tens of thousands of Americans trapped in the subprime mess that
never needed to be in it in the first place.
In short, I truly hope that the White House is paying close
attention to this crisis--because we are far from solving it. And I
hope that this hearing will draw more attention to the real economic
risks that still lay ahead, and what policy actions we can take to curb
the damage.
Without further delay, let us get down to business. So we can
proceed quickly to the witness testimony, and to allow time for a few
rounds of questions, I would ask that we limit opening statements to
the Committee's Senior Republican Senator, Senator Brownback and Vice
Chair Maloney. We will of course enter everyone's opening statements
into the record.
______
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Prepared Statement of Representative Carolyn Maloney, Vice Chair
Good morning. I would like to thank Chairman Schumer for holding
this hearing to examine the subprime lending disaster and the threat to
the broader economy.
Anxiety over the state of the economy remains high, as concerns
mount that the subprime mortgage meltdown will infect the rest of the
economy. Yesterday, RealtyTrac released the latest bad news that
foreclosures reported in August increased 36% since July and 115% since
this time last year. Expectations are that the next 18 months will be
even worse, as many subprime loans reset to higher rates. The credit
crunch, the worsening housing slump, market volatility, and weak
consumer confidence point to a gathering storm that could drag down the
economy, taking thousands of American jobs with it.
Consumer spending has been propping up the economy, but the ability
of American consumers to keep spending may be flagging with slowing or
declining home prices, putting the economy at serious risk of a
downturn. Dr. Shiller worries that the collapse of home prices that we
will see ``might turn out to be the most severe since the Great
Depression.'' Millions of Americans are in danger of losing their
homes, and if employers continue to pull back on hiring, their jobs may
be in danger too.
In a clear sign of the seriousness with which the Fed now views
economic conditions, yesterday the FOMC moved to lower its key short-
term interest rate by 50 basis points, to 4.75 percent, and left the
door open to additional cuts. The Fed's action is an effort to prevent
the economy from derailing and to ease credit pressures, but it is no
silver bullet.
In Congress, we are focusing on helping families stay in their
homes and preventing another crisis like this in the future.
Just yesterday, the House passed legislation to enable the FHA to
serve more subprime borrowers at affordable rates and terms, attract
borrowers who have turned to predatory loans in recent years, and offer
refinancing to homeowners struggling to meet their mortgage payments.
Fannie Mae and Freddie Mac are providing much needed liquidity in the
prime market right now. We passed a GSE reform bill in the House, but
we should also raise the cap on these entities' portfolio limits, at
least temporarily, so that they can provide additional help with the
subprime crisis. To make servicers more able to engage in workouts with
strapped borrowers, we pushed FASB to clarify that its Standard 140
allows for modification of a loan when default is reasonably
foreseeable, not just after default. And I think we should also
eliminate the tax on debt forgiveness, sparing families the double-
whammy of paying taxes on the lost value of their homes.
For the future, our regulatory system is in serious need of
renovation to catch up to the financial innovation that has surpassed
our ability to protect consumers and hold institutions accountable.
Even though the federal banking regulators have put out interagency
guidance on subprime loans to improve standards, some three-quarters of
the subprime market does not have a federal regulator. We need to
extend the guidance to create a uniform national standard to fight
predatory lending and a single consumer protection standard for the
entire mortgage market. I believe regulating brokers and other
unregulated participants in the subprime market are also essential
steps.
Shoring up the foundation of the American Dream will help families
and strengthen the economy.
I thank the chairman for holding this hearing and I look forward to
the testimony of our witnesses.
__________
Prepared Statement of Hon. Peter R. Orszag, Director, CBO
Turbulence in Mortgage Markets: Implications for the Economy and
Policy Options
Chairman Schumer, Vice-Chair Maloney, Senator Brownback,
Congressman Saxton, and Members of the Committee, I appreciate the
opportunity to testify on the current turmoil in the nation's mortgage
markets and its implications for the broader macroeconomy.
Housing markets entered a period of sustained growth in the mid-
1990s--the rate of home ownership expanded rapidly, and in the early
2000s, housing prices increased dramatically. Since 2005, however, the
markets have softened substantially, and in many areas of the country,
housing has now entered a deep slump. Sales of new and existing homes
have dropped, and many forecasters expect further declines in coming
months. The construction of new single-family homes has contracted
sharply. The inventory of unsold existing homes has climbed to record
levels. At today's sales rates, it will take about nine and a half
months to clear the current inventory of existing homes on the market.
Home prices have stopped climbing in many areas of the country and have
begun to fall in some. Many forecasters now believe that the national
average home price could decline significantly before housing markets
stabilize.
Those developments have raised a number of important questions.
What factors account for the recent slump in housing markets? How will
developments in housing affect the rest of the economy? To what extent
will consumers retrench in the face of declining home values, and to
what extent will turmoil in certain parts of the mortgage markets spill
over into other credit markets and affect the intermediation of funds
between borrowers and lenders? And how should policymakers respond to
the situation?
My testimony reviews issues raised by those questions and comes to
the following conclusions:
Innovations in mortgage markets, including the development of
subprime mortgages, permitted many more people to become homeowners by
reducing credit restraints. The home ownership rate had varied within a
narrow range from the 1960s to the mid-1990s but then increased from
about 65 percent in 1995 to about 69 percent in 2006.
The boom in housing prices between 1995 and 2005 was caused by
several factors, including low interest rates, buyers' expectations of
price increases, and easier availability of credit, especially through
subprime mortgages (which played a particularly prominent role over the
past few years).
Over the past 2 years, prices have softened, and problems in the
subprime market in particular have become apparent. To date, the
problems with subprime mortgages are disproportionately concentrated in
California, Nevada, Arizona, and Florida. Other areas of the country,
however, have also been significantly affected.
The turbulence in housing markets could affect the broader
macroeconomy through four channels: reduced investment in housing; a
reduction in consumer spending because household wealth declines;
contagion in financial markets, which can impede business investment
and some household spending, especially for consumer durables; and a
lessening of consumers' and businesses' confidence about the future,
which can constrain economic activity.
The available data and evidence suggest that the first two
channels (reduced investment in housing and reduced consumer
spending because of a decline in wealth) will impose a
significant drag but are unlikely, by themselves, to tip the
economy into recession. The other two channels--contagion in
financial markets and weakened confidence--are more difficult
to predict but could pose serious economic risks.
The economic outlook is thus particularly uncertain right
now. Analysts have lowered their economic forecasts as a
consequence of this summer's turmoil in financial markets, and
the risk of a recession is heightened. But the most likely
scenario involves continued (albeit more sluggish) economic
growth, and few analysts expect an outright recession next
year. Even the average for the bottom 10 forecasts included in
the Blue Chip survey (an average of about 50 private sector
forecasts) released in early September suggested 2.0 percent
real growth in 2008, and not a single forecaster projected
negative growth in 2008.
Policy proposals for addressing the financial difficulties
originating in the subprime market could be classified into three
categories: sustaining the overall economy, helping homeowners facing
foreclosures, and preventing future crises by protecting homeowners and
reducing the chances of a recurrence of financial instability.
In evaluating policies to achieve those goals, it is
important to recognize that although significant problems have
arisen, not all current housing and credit policies are broken
and that the seeds of future crises are often sown by the
reaction to current crises.
Policy interventions need to reach an appropriate balance
between assisting people at risk from events beyond their
reasonable control and allowing people to assume responsibility
for the consequences of their own decisions.
The challenge is to find ways of correcting the abuses and
instability that are now becoming apparent while strengthening
successful institutions and continuing the benefits of market
innovation.
background
The current contraction of housing markets comes after several
years of extraordinary growth in the residential sector, and the recent
slump in housing partly reflects an inevitable correction to more
normal levels after that remarkable growth. By 2005, home sales had
climbed to record levels. The residential construction industry boomed,
and home prices soared in many areas of the country.
Many people who had previously been renters became homeowners. As a
result, the rate of home ownership, which had varied within a narrow
range from the 1960s to the mid-1990s, increased from about 65 percent
in 1995 to about 69 percent in 2006 (see Figure 1). That rise meant
that approximately 4-\1/2\ million more families that otherwise would
have been renters owned their homes. Investors and second-home buyers
also purchased a growing number of properties, accounting for more than
one-sixth of all first-lien loans to purchase one-to-four-family site-
built homes in 2005 and 2006.
The housing boom stemmed from many factors. Low interest rates,
both short- and long-term, in the early 2000s spurred demand for
houses. The Federal Reserve kept short-term rates low through mid-2004
in an effort to promote growth, as the growth of gross domestic product
(GDP) was slow to recover from the recession of 2001 and as some
analysts expressed concerns in 2003 about the possibility of deflation.
The housing sector is generally more sensitive to interest rates than
most other sectors, so the effect of monetary policy is often channeled
to the economy through housing markets. Rates for 30-year conventional
mortgages, which had averaged 7.6 percent from 1995 through 2000,
dropped to 5.8 percent in 2003 and generally remained below 6 percent
until the fourth quarter of 2005. The low rates increased the
affordability of homes, increased demand, and ultimately caused housing
prices to be bid up. More people decided to live in separate households
than would have occurred in the absence of the housing boom; that
phenomenon both reflects and partially caused that boom.
Homebuyers' expectations of continued and rapid home price
inflation also appear to have played a central role in propelling
prices upward. If people believe that prices will rise, demand for
homes increases, which puts upward pressure on prices. Thus, the
expectation of higher prices can become a self-fulfilling prophecy in
the short run. But that temporary cycle may not be tied to underlying
fundamentals (such as demographic forces, construction costs, and the
growth of household income), and in the long run, prices will
ultimately evolve back toward becoming aligned with those fundamentals.
To the extent that the underlying fundamentals are reflected in rental
prices, the ratio of housing prices to rents may provide insight into
the degree to which prices are deviating from the fundamentals. The
ratio tended to vary within a relatively narrow range between 1975 and
1995 before climbing steeply between 1995 and 2005 (see Figure 2). To
be sure, homebuyers' expectations of home prices may deviate from long-
term fundamentals for extended periods of time, as shown by evidence
that Professor Robert Shiller of Yale University and others have
developed, and the prolonged rise in the ratio of house prices to rents
between 1995 and 2005 is consistent with the possibility of such
extended deviations of prices from underlying fundamentals.
Another major factor in the housing boom was the plentiful supply
of credit, which manifested itself most dramatically in the expansion
of the subprime mortgage industry. Subprime mortgages are extended to
borrowers who for one reason or another--a low credit rating,
insufficient documentation of income, or the capacity to make only a
low down payment--do not qualify as prime borrowers. The share of
subprime mortgages rose rapidly after 2002, and more than 20 percent of
all home mortgage originations (in dollar terms) in the past two years
were for subprime loans. By the end of 2006, the outstanding value of
subprime mortgages totaled an estimated $1.2 trillion and accounted for
about 13 percent of all home mortgages.
Subprime mortgages include fixed-rate mortgages, adjustable-rate
mortgages (ARMs), and combinations of the two, such as the 2/28
mortgage, in which the interest rate is fixed for two years and then
varies for the 28 years remaining on the life of the loan. Many
adjustable-rate loans have so-called ``teaser'' rates, which offer
lower-than-market rates during the loans' early years. Subprime
mortgages may be interest-only loans and negative amortization loans,
in which the principal can actually grow during the initial years of
the loans. A common characteristic of many subprime loans is that they
offer borrowers low monthly payments in the loans' early years but
higher ones in later years. Prepayment penalties (which impose fees on
borrowers who want to pay off the remaining balance on a mortgage
early) are common on subprime mortgages that have teaser rates but
relatively uncommon on prime mortgages.\1\
---------------------------------------------------------------------------
\1\ John Farris and Christopher A. Richardson, ``The Geography of
Subprime Mortgage Prepayment Penalty Patterns,'' Housing Policy Debate,
vol. 15, no. 3 (2004), pp. 687-714.
---------------------------------------------------------------------------
Subprime mortgages have provided significant benefits to many
borrowers. The availability of subprime mortgages has expanded home
ownership, especially in minority and low-income communities. Many
borrowers in such communities have low income, have less than stellar
credit histories, or can only make down payments that are smaller than
prime lenders require. Subprime loans may be particularly appropriate
for people whose income is expected to rise--for instance, if they are
in the early stages of a career. The number of borrowers with first-
lien subprime mortgages has climbed to about 7-\1/2\ million, and many
of them would not have been eligible for a prime mortgage and might not
become homeowners in the absence of subprime mortgages. Although the
foreclosure rates on subprime mortgages have received a great deal of
attention and are higher than those on prime mortgages, over 85 percent
of the borrowers who currently hold subprime mortgages (including both
fixed-rate and adjustable-rate ones) are still making their payments on
time.
The growth of the subprime mortgage industry stemmed from three
factors. First, legislative and regulatory changes made in the 1980s
lifted constraints on the types of institutions that could offer
mortgages and the rates that could be charged. Second, the development
of new credit-scoring technology in the 1990s made it easier for
lenders to evaluate and price the risks of subprime borrowers. Third,
the expansion of the securitization of subprime mortgages allowed the
market to bear the risks of those mortgages more efficiently and at
lower costs.\2\
---------------------------------------------------------------------------
\2\ Securitization is a process whereby mortgages are pooled, and
then their cashflows are sold as securities (tranches) with different
risk characteristics. Some of the risk tranches are designed to be
relatively safe, and others can be quite risky; investors can choose
according to their preferences and objectives.
---------------------------------------------------------------------------
As has become apparent, the underwriting standards of some
originators in the subprime mortgage market slipped. Some made loans to
borrowers who put little money down--and had little to lose if they
defaulted--and to borrowers with particularly weak credit histories.
Some subprime lenders also required little or no documentation of
borrowers' income and assets, and determined borrowers' qualification
for mortgages on the basis of initial teaser rates. That approach
created opportunities for both borrowers and originators to exaggerate
borrowers' ability to repay the loans. Those problems fundamentally
stemmed from a failure of lenders to provide the right incentives to
and oversight of originating brokers. In the traditional form of
mortgage financing, the originator of the loan also holds the loan in
its portfolio and therefore has a strong incentive to learn about the
borrower's ability to repay. By contrast, in the securitized form of
mortgage financing, the originator sells the mortgage to a third party
and earns a fee for origination but receives little immediate reward
for discovering relevant information about the borrower. As a result,
the originator may not have adequate incentives to exercise care and
discretion in its underwriting unless the ultimate purchaser carefully
structures such incentives.
Some borrowers may also have not understood the complex terms of
their mortgages, and some mortgage originators may also have taken
advantage of unsophisticated borrowers. Certain adjustable-rate
mortgages may have been among the more difficult mortgages for first-
time borrowers to understand. Many of those mortgages made in recent
years included teaser rates, which may have confused some borrowers
about the eventual size of their mortgage payments when their mortgage
rates were reset. Most of those mortgages also included prepayment
penalties, which protected lenders from the potential churning of
mortgages with very low initial rates but also made it more expensive
for borrowers to refinance their loans when their monthly payments
rose. As Edward Gramlich asked in a speech that was delivered on his
behalf just before he died, ``Why are the most risky loan products sold
to the least sophisticated borrowers?'' \3\
---------------------------------------------------------------------------
\3\ Edward M. Gramlich, ``Booms and Busts, The Case of Subprime
Mortgages'' (address given at the symposium ``Housing, Housing Finance,
Monetary Policy,'' sponsored by the Federal Reserve Bank of Kansas
City, Jackson Hole, Wyoming, August 31, 2007), available at http://
www.kansascityfed.org/publicat/sympos/2007/pdf/2007.09.04.gramlich.pdf.
---------------------------------------------------------------------------
The subprime market began to experience growing problems after
2004, when delinquencies on subprime ARMs began to rise. By the second
quarter of 2007, almost 17 percent of subprime ARMs were delinquent, up
from a recent low of 10 percent in the second quarter of 2005 (see
Figure 3). In addition, the share of subprime ARMs entering foreclosure
increased from an average of 1.5 percent in 2004 and 2005 to 3.8
percent in the second quarter of 2007. Although delinquencies have also
risen for fixed-rate subprime loans, the level of delinquencies for
fixed-rate loans has been lower and its increase has been slower.
Housing markets have weakened throughout the country, but only a
few states have had significant increases in foreclosure rates (see
Figure 4).
Several factors seem to have contributed to the growing
delinquencies of subprime mortgages. Mortgage rates moved upward during
the period as monetary policy tightened, and some ARM borrowers may
have been surprised at how high their mortgage rate became. Many ARM
borrowers appear to have defaulted after the initial period of low
rates expired and their monthly payments were reset at significantly
higher levels. Such ARM borrowers often found it difficult to refinance
their mortgages to avoid increasing payments. In addition, some
borrowers who had purchased their home with little money down may have
seen their equity vanish as home prices began to decline in some areas.
In the industrial Midwest, especially in Michigan, those problems were
aggravated by the slowdown of the regional economy as the automotive
industry retrenched.
The problems have undermined investors' confidence in the
securities backed by subprime mortgages. During the boom years,
investors may not have fully appreciated the risks of subprime loans
and seem to have underpriced them. Investment managers around the globe
were seeking securities that offered higher yields but apparently did
not fully appreciate the risks that they were taking on. The price that
investors charged for taking on risk in the subprime mortgage market,
as well as other financial markets, plummeted to abnormally low levels.
The rating agencies, too, appear to have not kept up with some fast-
emerging problems in the quality of securities backed by subprime
loans, and they may have placed undue emphasis on the unusual period of
substantial price appreciation in evaluating the risks of mortgage-
related securities. This year, when the risks of subprime mortgages
were recognized, the prices for securities backed by them dropped
sharply. Liquidity in both the primary and secondary markets for
subprime mortgage-backed securities has also declined, as some of the
country's largest originators of such loans collapsed.
risks to individuals and the broader economy
The shakeout in housing markets has already affected both
individuals and the overall economy. House prices have declined in some
areas of the country, mortgage delinquencies and foreclosures have
risen, and housing investment has fallen dramatically. The effects that
have occurred to date, however, may only be the beginning. Even if the
economy manages to maintain a fairly steady pattern of growth, many
homeowners will face dramatically higher mortgage payments, which will
probably lead to additional foreclosures, and some mortgage investors
will experience further losses. Moreover, the problems in the subprime
mortgage market have spilled over into the broader financial markets,
raising borrowing costs for other mortgage and nonmortgage borrowers
and threatening to further depress economic activity. Although the
consensus forecast for the economy still indicates real growth of about
2-\1/2\ percent next year, economists generally agree that the
probability of a recession next year has risen and is now quite
elevated relative to normal conditions.
Individuals
Mortgage payments, delinquencies, and foreclosures will be a
problem for many years as interest rates are reset on prime and
subprime ARMs that were originated during the 2004-2006 period. Rates
have already been reset for some of those ARMs, and the remaining
instances (most of which will occur before the end of 2010) will
eventually add about $30 billion to annual payments.\4\ Although that
increase is not large relative to total household income of $10
trillion, many households will be hard pressed to make the higher
payments, and some will become delinquent on their mortgages.
---------------------------------------------------------------------------
\4\ See Christopher L. Cagan, Mortgage Payment Reset: The Issue and
the Impact (Santa Ana, Calif.: First American CoreLogic, March 19,
2007).
---------------------------------------------------------------------------
New foreclosures on ARMs have risen over the past year and are
likely to remain high for some time. About 1.65 percent of the 8.7
million ARMs (both prime and subprime) included in data tabulated by
the Mortgage Bankers Association (MBA) went into foreclosure in the
second quarter of this year, about twice the rate during the second
quarter of last year. Extending that percentage to all 12.4 million
ARMs that were outstanding during the second quarter of 2007 suggests
that about 200,000 may have gone into foreclosure.
The rate of new foreclosures in the future depends upon a wide
variety of factors, particularly the overall state of the economy and
housing prices, so forecasts vary widely--from an additional 1 million
over the next few years to more than 2 million. The lower estimates
suggest that the pace of foreclosures may slow next year, reflecting
the fact that many of the recent foreclosures stem from the expiration
of extremely low and very short-term (one- to six-month) teaser rates
on some ARMs. Such mortgages will not have as large an effect on the
overall foreclosure rates in the future as they have had recently. The
higher estimates, however, reflect a concern about the outlook for the
overall economy and the possibility that a negative cycle may develop--
higher rates of foreclosure may depress housing prices, undermining
efforts to refinance mortgages, pushing more homes into foreclosure,
and lowering prices further.
Individuals who owned assets that were affected by the recent
turmoil in financial markets have experienced losses as a result of the
problems in mortgage markets. No data are available about how the
losses were distributed among various categories of investors--domestic
or foreign, individuals or institutions--nor about how pension funds
may have been affected.
The Broader Economy
The problems created by mortgage markets threaten to slow economic
activity, possibly by a substantial amount. Four channels exist through
which the turbulence in housing markets could affect the broader
economy:
Reduced Housing Investment. Between 1995 and 2005, investment in
residential housing directly contributed an average of 0.3 percentage
points per year to economic growth. The slump in residential housing
has already weakened the economy, and more weakness in the housing
market could constrain growth further by reducing that source of
investment.
Less Consumer Spending Based on Housing Wealth. Lower house
prices also are likely to weaken economic activity through the housing
wealth effect: Reduced housing wealth causes a decline in consumer
spending. The effect could be somewhat larger than expected if
households have increased difficulty withdrawing equity from their
homes.
Contagion in Mortgage and Financial Markets. Higher mortgage
rates and weaker house prices, contributing to higher foreclosure rates
and losses for mortgage lenders, threaten to precipitate a spiral of
tighter mortgage standards, lower house prices, and more foreclosures.
The broader spillover, or contagion, of the subprime mortgage problems
into other credit markets, causing stricter standards and terms for
other types of borrowing, could reduce economic activity by weakening
business investment.
A Decline in Consumers' and Businesses' Confidence. A slowdown in
economic activity and employment growth triggered by the problems in
mortgage markets, especially if associated with spillover effects in
financial markets, could weaken consumers' and businesses' confidence
about income growth in the future. Such a reaction could then constrain
economic activity further.
Those various channels through which the problems in mortgage
markets could spread to the broader economy make the current situation
particularly uncertain; the potential effects involving contagion and
confidence are especially difficult to evaluate because they depend in
part on how financial market participants, consumers, and business
executives perceive the situation.
Analysts have lowered their economic forecasts as a consequence of
this summer's turmoil in financial markets. In July, the Blue Chip
consensus anticipated that real GDP would grow by 2.9 percent next
year; by September, however, the Blue Chip consensus forecast for 2008
had dropped to 2.6 percent. The average growth in the bottom 10
forecasts in the Blue Chip survey fell somewhat more--from 2.5 percent
to 2.0 percent--but even the average for the bottom 10 forecasts in the
Blue Chip does not suggest a recession next year. In other words,
although the risk of a recession is elevated relative to normal
conditions, at least as of now economists generally do not expect a
recession next year.
Residential Housing Investment. Investment in residential housing
bolstered the economy from the middle of 2003 to early last year, but
by that time, the combination of increased mortgage rates and high
prices for houses had reduced the affordability of buying a house. Home
sales and construction began to falter, and the appreciation in housing
prices subsequently slowed. By mid-2007, housing construction activity
was 32 percent lower than it had been in early 2006, and by one widely
used measure, the national average of housing prices was about 3
percent lower than it had been at its peak. The direct effect of the
fall in residential investment reduced real GDP growth in the second
half of 2006 and the first half of 2007 by about a percentage point.
The severity of the problems in mortgage markets will exacerbate
the decline in residential investment. A few months ago, before the
extent of the troubles in the subprime market was recognized, housing
analysts generally anticipated a rebound in housing construction during
2008. Now, however, they assume that increased difficulty in arranging
financing will cause housing sales and construction to fall much
further, perhaps delaying the recovery in the housing market until
2009.
The Housing Wealth Effect. The major factors influencing consumer
spending are household income and housing wealth. Greater income and
wealth provide consumers with more buying power. The amounts that
consumers spend out of their income and wealth vary over their lifetime
and vary with the actual and expected pace of economic activity, with
interest rates, and with opportunities to borrow, among other things.
In recent years, homeowners have been able to easily make use of their
housing wealth by using home equity loans and lines of credit and by
taking cash out when refinancing their mortgages. The withdrawal of
housing equity (net of mortgage fees, points, and taxes) amounted to
$735 billion in 2005 and $564 billion in 2006.
A significant amount of uncertainty exists about precisely how much
spending changes when wealth changes (known as the marginal propensity
to consume out of wealth). Estimates of that parameter range from 2
cents to 7 cents out of a dollar of wealth.\5\ So if the value of a
home drops by $10,000, the owner might reduce his annual spending by
between $200 and $700, if nothing else changes. Some studies find that
people adjust their spending more in response to changes in housing
wealth than to changes in other forms of wealth, while other studies do
not reach that conclusion.
---------------------------------------------------------------------------
\5\ See Congressional Budget Office, Housing Wealth and Consumer
Spending (January 2007).
---------------------------------------------------------------------------
The outlook for home prices is highly uncertain, but it seems
likely that house prices will continue to fall next year.
The inventory of unsold homes stands at record levels, which will
place continued downward pressure on house prices in many regions of
the country.
The futures market for the Case-Shiller composite home price
index for 10 metropolitan areas expects a decline of about 6 percent
over the coming year (see Figure 5).\6\ That expectation may not be a
reliable guide, however, because those index futures do not trade
frequently or in large numbers, so it may not represent a broad
consensus of investors. Moreover, the index covers only a relatively
few metropolitan areas and, hence, is not indicative of prices
nationwide.
---------------------------------------------------------------------------
\6\ The S&P/Case-Shiller' 10-City Composite Home Price
Index tracks changes in the value of residential real estate in 10
metropolitan regions. Futures based on that index trade on the Chicago
Mercantile Exchange.
---------------------------------------------------------------------------
Home prices are still quite high relative to rents by historical
standards, although the ratio of house prices to rents is only a very
rough guide to the magnitude of possible movements in house prices (see
Figure 2). The ratio has risen sharply over the past 10 years and now
stands about 60 percent above its average from 1975 to 1998. In the
past, when the ratio has deviated from its historical norm, most of the
adjustment has occurred in house prices rather than in rents--although
that adjustment can take many years.
Although the magnitude of the possible decline in house prices is
subject to great uncertainty, the housing wealth effect alone is
unlikely to push the economy into a recession. CBO examined two cases
(at the low end and the high end of assumptions about the marginal
propensity to consume out of housing wealth) of the potential effects
of a substantial decline of 20 percent in real house prices over 2
years. At the low end, by the third year, real output would be about 1
percent lower, implying that growth would fall by about one-half of a
percentage point per year. At the high end, those effects would more
than double; that is, growth could drop by about 1-\1/2\ percentage
points per year on average (see Figure 6). In neither case would the
decline be enough to slow the economy, otherwise growing at something
like 2-\1/2\ percent per year, into a recession. The Federal Reserve
conducted similar experiments using its model and found even smaller
effects.\7\
---------------------------------------------------------------------------
\7\ See Frederic S. Mishkin, Housing and the Monetary Transmission
Mechanism, Finance and Economics Discussion Series No. 2007-40, Federal
Reserve Board (August 2007). Both CBO's and the Federal Reserve's
analyses assume that the Federal Reserve offsets some of the negative
effects of the decline in house prices. In the Federal Reserve's
simulation, the federal funds interest rate is more than 1-\1/2\
percentage points lower by the end of the third year; in CBO's
simulation, the rate is between half of a percentage point and 2
percentage points lower at the beginning of the third year.
---------------------------------------------------------------------------
Contagion. The plausible effects of the decline in housing markets
through reduced investment in housing and the effects of reduced
housing wealth on consumption are thus negative but do not appear to be
large enough to tip the economy into recession. If those were the only
potential effects of the problems in housing markets on the economy,
the risk of a recession would probably not be as elevated as many
economists believe it currently is. The turbulence in housing markets
could have other effects on the economy, though.
For example, some economists are concerned about the adverse
impacts on growth that could occur if the problems in the subprime
mortgage market continue to spread to other credit markets. That is
indeed a serious risk to the economic outlook. The possibility of such
contagion initially upset financial markets in the spring of this year,
when the problems in the subprime market first surfaced. Markets were
further roiled in July and August following the failure of several
hedge funds that had invested heavily in subprime securities, concerns
over some European banks' contingent liabilities for similar types of
hedge funds, and the arrival of other news on the depth of the problems
in mortgage markets. Because of a lack of clear information about who
holds those subprime investments in their portfolios, investors often
do not know who has exposure to the losses in the subprime market. That
confusion has led to a repricing of risk in general, which has affected
valuations and interest rates on a wide variety of investments--prices
of risky assets fell, whereas prices of Treasury securities rose. That
repricing followed a period in which risk spreads had been unusually
low.
Price changes in the market for assets collateralized by subprime
mortgages have been dramatic. Financial institutions issue mortgage-
backed securities (MBSs) to investors with the payments of interest and
principal tied to the payments made by subprime borrowers. MBSs are
structured to create multiple classes of claims, or seniority, on the
cash-flows from the underlying mortgages. Investors holding securities
in the safest or most senior tranche (AAA) stand first in line to
receive payments from borrowers (and expect to receive a
correspondingly low return). Investors holding the least senior
securities stand last in line to receive payments after all more senior
claims have been paid. Hence, they are first in line to absorb losses
on the underlying mortgages. In return for assuming that risk, holders
of less senior, lower-rated claims expect to receive correspondingly
higher returns.
As of mid-August, the prices of the riskiest tranche of mortgages
issued in 2006 and early 2007 had fallen to 40 cents or less on the
dollar, but the prices of the safest tranche were above 90 cents on the
dollar. Prices of tranches based on mortgages issued earlier, in the
last half of 2005, ranged from 60 cents for the BBB- tranche (the
lowest investment grade) to almost 97 cents for the AAA tranche,
indicating that the worst losses seem to apply to originations made in
2006 and early 2007.
Difficulties in the subprime mortgage market spread to jumbo
mortgages, which are those that exceed the maximum size of a mortgage
that Fannie Mae and Freddie Mac are eligible to purchase. That amount,
which is also known as the conforming limit, was $417,000 in 2007. As
problems in the market for financing subprime mortgages became more
apparent, investors began to demand much higher premiums on jumbo
mortgages, raising interest rates on them. In addition, the terms of
those jumbo loans tightened, as many lenders began to require larger
down payments and higher credit scores. By contrast, mortgage rates on
conforming loans have actually declined, as they have benefited from a
``flight to quality.'' Moreover, prime borrowers are not having
significant difficulties in obtaining credit for loans under the
conforming limit.
The contagion has spread beyond mortgage markets, leading to higher
interest rates on various types of business borrowing. One indication
is the change in the differences, or spreads, between interest rates on
corporate bonds and the rate on 10-year Treasury notes. To date, the
increase in spreads on riskier bonds (those with lower credit ratings)
has been substantial and greater than the increases on less risky bonds
(see Figure 7). Much of the recent increase, though, simply brings the
spreads of risky assets back to more normal levels. That is, investors
appear to have been underpricing risk for some time, and the jump in
the riskiest rates in recent months brings them up to levels that are
still low relative to those in more serious episodes of credit
restraint, during the fall of 1998, for instance, when the Long-Term
Capital Management hedge fund failed, and at the end of 2000, when the
stock market started to fall.
Serious problems have appeared in the riskier end of the market for
commercial paper. The commercial paper market is an important source of
short-term funds for businesses; in July, the outstanding amount of
commercial paper was almost $2.2 trillion (see Figure 8). Interest
rates on the lower grade A2/P2 and assetbacked paper rose sharply
during the turmoil in financial markets in August (see Figure 9), when
holders of the asset-backed paper became concerned that the underlying
assets might include very risky subprime mortgages. The underlying
collateral was difficult to value because the market for trading
subprime loans was never liquid to begin with, and is less so now. The
amount of commercial paper outstanding fell by an unprecedented $260
billion in August, with most of the drop in asset-backed paper.
The difficulties in some segments of the credit markets are
relatively easy to observe through price spreads or ratings downgrades.
Other market segments, however, may have shifted substantial portions
of risk from subprime mortgages through private transactions that were
not evaluated by rating agencies. The publicly traded participants to
those transactions will disclose the impact on their earnings
statements, but depending on the structure of the transactions
involved, the process for valuing losses may take months.
The problems in the credit markets have resulted in a shortening of
the maturity structure of commercial paper and a big jump in term
premiums for asset-backed paper with maturities longer than a week.
Those large premiums indicate that investors are quite uncertain about
what will happen to the market for that paper. One test for the asset-
backed commercial paper market in coming weeks is the large fraction of
the outstanding paper that matures and must be rolled over. About 44
percent ($418 billion) of the asset-backed commercial paper outstanding
in early September will mature by September 21, and 73 percent ($688
billion) by October 19. If investors' demand for that paper is
insufficient, issuers will have to find other sources of funds to
finance their assets.
Consumer and Business Confidence. The turmoil in credit markets
could also affect the broader economy through a decline in consumer and
business confidence about future economic activity. To be sure, those
consumers and businesses directly affected by the turmoil may already
have lowered their expectations of the future economic activity.
Diminished expectations by other consumers and businesses, which would
show up in the aggregate data for gauging confidence, would be a signal
that a broader slowing of economic activity may be in the offing. To
date, consumer confidence has held up fairly well even though problems
in housing markets have been building up for the past year (see Figure
10). Results from the Business Roundtable's Economic Outlook Survey
appeared consistent with a broad slowing in the economy, but not with
the kind of collapse in business spending that could precipitate a
recession. Notably, the survey was conducted between August 20 and
September 5, the period of greatest disruption in the commercial paper
market. Also, the Index of Small Business Optimism, based on a survey
conducted by the National Federation of Independent Businesses, fell
slightly in August, but it is not much lower than its average of the
last 6 months. By contrast, investors' optimism, as measured by the
UBS/Gallup index, dropped sharply in August, falling 14 points, to 73,
its lowest level in 12 months.\8\
---------------------------------------------------------------------------
\8\ The UBS/Gallup Index of Investor Optimism, published monthly,
is available at www.ubs.com.
---------------------------------------------------------------------------
policy responses
Three objectives appear dominant in current policy proposals for
addressing the financial difficulties originating in the subprime
market: sustaining the overall economy; helping homeowners facing
foreclosures; and preventing future crises by reducing the chances of a
recurrence of financial instability, while keeping the subprime market
open.
In evaluating policies to achieve those goals, it is important to
recognize that not all current housing and credit policies are broken.
Some are working well. The challenge is to find ways of correcting the
abuses and instability that are now becoming apparent while
strengthening successful institutions and continuing the benefits of
market innovation.
Sustaining the Overall Economy
One of the central goals for policy is to limit the potential
effects of turmoil in the subprime market on the economy as a whole.
The Federal Reserve, as the lender of last resort, is the institution
that is best placed to take action to meet that goal.
The Federal Reserve faces two problems. The most immediate is to
stabilize credit markets, especially to avoid problems with liquidity
that could emerge if commercial borrowers (including those unrelated to
the housing industry) have difficulty refinancing their short-term debt
as it matures. That problem is short term and will diminish as
financial markets develop ways to assure investors of the quality of
borrowers. Market participants are already discussing ways to improve
such transparency.\9\ Traditionally, the Federal Reserve has provided
that liquidity for banks at times such as these. Some economists have
noted that with changes in the financial system, the Federal Reserve
may need to extend liquidity to others, although other economists have
noted that such a change would represent a fundamental shift in the
conduct of monetary policy and would need to be carefully evaluated
before being adopted.
---------------------------------------------------------------------------
\9\ See Reuters, London, ``ESF Head Sees Investors Returning to
Asset-Backed CP,'' September 13, 2007.
---------------------------------------------------------------------------
The second problem is to stabilize the economy, which the Federal
Reserve tries to do by adjusting its target for the interest rate on
federal funds. That adjustment requires an estimate of how much the
turmoil in subprime mortgages will affect the broader economy. As noted
above, such estimates are quite uncertain. Moreover, while the Federal
Reserve's actions to provide liquidity work quickly, there is a
considerable lag between changes in interest rate targets and their
effects on the economy.
The Federal Reserve and other central banks have already taken
steps to help limit the spillover of the problems in the subprime
market to other financial markets. In August, the Federal Reserve
provided liquidity for the financial system in a timely manner and
helped prevent the collapse of a few markets from quickly spreading to
other parts of the financial system: It allowed the actual federal
funds rate to move below its target level as a result of the injection
of liquidity. It lowered the discount rate, though that move initially
led to very little additional borrowing. It has also reiterated its
ongoing commitment to financial stability, suggesting in recent
statements that it might be willing to go beyond the ordinary tools of
monetary policy if the problems in the market prove recalcitrant.
(Although the Federal Reserve was not specific about what it might do,
some people have discussed providing liquidity in other parts of the
market, beyond the interbank market in which it normally operates.)
Especially in the face of the significant uncertainties in the
economic outlook, but more broadly as a matter of principle, there
appears to be significant benefit in allowing the Federal Reserve the
independence to evaluate macroeconomic tradeoffs as best it can. At its
September 18 meeting, the Federal Reserve lowered the discount rate and
its target for the federal funds rate by 50 basis points.
Aiding Borrowers Facing Foreclosure
A second major goal for policy may be to aid borrowers who are
facing the possibility of foreclosure. Because most of those
foreclosures stem from homeowners with adjustable-rate mortgages, most
of the options involve increasing opportunities for those borrowers to
restructure their debt in a manner that reduces their debt-service
burden and shares the cost among the parties to the transaction: the
homeowner, the lender, and participants in the secondary market.
Such opportunities could be created in a variety of ways. For
example, federal financial regulators have sought to encourage lenders
to consider refinancing the mortgages of troubled borrowers as an
alternative to the costly process of foreclosure. Another possibility
is to expand the use of community-based organizations, such as
community development corporations and community development financial
institutions, which provide services, counseling, and foreclosure
protection to households. In his recent book, Edward Gramlich described
the role of such organizations and the possibilities for expanding
their work given the turmoil in the mortgage market.\10\
---------------------------------------------------------------------------
\10\ Edward M. Gramlich, Subprime Mortgages: America's Latest Boom
and Bust (Washington, D.C.: Urban Institute Press, 2007).
---------------------------------------------------------------------------
In addition, the Administration has made changes to federal
regulations that govern the Federal Housing Administration (FHA) to
make such refinancing easier. Specifically, the new FHASecure plan
modifies the existing rules for the agency's mortgage insurance and
increases opportunities for some homebuyers to refinance their
mortgages on more affordable terms. For those buyers who can meet FHA's
existing underwriting standards but cannot afford to service their
existing mortgages, the policy will avoid the high cost of foreclosure.
The FHASecure policy is unlikely to be a solution for all subprime
borrowers with high-cost ARMs, however. Many of those at risk will be
unable to meet FHA's eligibility requirements, including a 3 percent
down payment and full documentation of income. In addition, refinancing
troubled ARMs may be hampered by heavy penalties for prepayment.
Finally, the ability of lenders to renegotiate and refinance existing
mortgages is restricted by tax provisions intended to limit the role of
lenders in the operation of trusts that hold the mortgage pools backing
the MBSs.
In providing assistance to vulnerable households, it is important
to strike an appropriate balance between reducing the harm to
homeowners and inappropriately signaling that the government will make
whole future borrowers who place risky bets in housing markets. As
Douglas Elmendorf of the Brookings Institution has noted, ``. . . some
struggling borrowers are the victims of predatory lending practices,
and others entered into mortgage contracts they did not fully
understand. Others knew what they were doing and deliberately took
risks, but we should still be sympathetic to low-income people who
would have their lives disrupted by losing their homes, giving up any
equity in their homes, and damaging their credit histories. That said,
our economic system of letting people make their own decisions is
sustainable only if people bear the consequences of those decisions. .
. . Moreover, helping people who took risks and lost can encourage
excessive future risk-taking.'' \11\
---------------------------------------------------------------------------
\11\ Douglas W. Elmendorf, ``Notes on Policy Responses to the
Subprime Mortgage Unraveling,'' The Brookings Institution, September
17, 2007, available at www.brookings.edu/views/papers/
elmendorf200709.htm.
---------------------------------------------------------------------------
Regulatory and Administrative Changes. The Administration and
federal financial regulators have begun to take steps to help
defaulting borrowers using the legal authorities that they already
have.
In addition, the Congress could consider a variety of legislative
approaches, most of which would probably have a budgetary cost. One
possibility is to reduce the burden on distressed borrowers by changing
the tax code. Other approaches could include facilitating refinancing
of distressed loans, either directly through government lending
programs or indirectly by guaranteeing those loans.
Eliminating the Tax on Debt Forgiveness. The Administration has
proposed a Debt Relief Liability Waiver, which would eliminate the tax
liability for debt forgiveness. Under current law, loan forgiveness is
taxable income to the recipient. Therefore, loan balances that are
forgiven as a part of a debt restructuring are taxable to borrowers.
Similarly, a shortfall between the value of a foreclosed property and
the remaining balance on the mortgage is currently considered income to
borrowers and is taxed. Legislation to waive that tax liability could
provide assistance to financially troubled borrowers, but the waiver
would need to be crafted carefully to avoid the gaming that could
result. For example, if the waiver were too general, a firm could give
a loan to a worker (rather than taxable wages) and then forgive the
principal.
Expanding FHA's Guarantees. Increasing the size limit on mortgages
eligible for FHA's guarantees to 100 percent of the conforming loan
ceiling would make it possible for some current homeowners with
mortgages up to $417,000 to refinance with a guarantee from the agency,
provided they can meet the eligibility requirements. Additional
borrowers could be assisted by easing those requirements and by
reducing the guarantee fees for those refinanced mortgages. However,
expanding the government's portfolio of loan guarantees could prove
costly to the government, even though beneficial to borrowers.
Easing Restrictions on Fannie Mae and Freddie Mac. The secondary,
or resale, market for low-risk first mortgages of $417,000 or less is
dominated by the government-sponsored enterprises (GSEs) Fannie Mae and
Freddie Mac. With the support of an implicit federal guarantee of their
debt and other liabilities, those enterprises have privileged access to
funds in the capital markets. In fact, during times of financial
turmoil and uncertainty when there is often a ``flight to quality'' by
investors, the securities issued by those entities are favored
investments.
Some legislative proposals would increase the maximum mortgage size
that housing GSEs are permitted to purchase, from $417,000 to $500,000
nationally and to $625,000 in designated high-cost areas. The aim of
the proposal is to increase demand by investors for jumbo mortgages,
for which the availability of funds has been limited and interest rates
have risen in recent months.
Another proposal would raise the maximum size of loans that could
be purchased by Fannie Mae and Freddie Mac. In addition, some
variations of that proposal would increase current limits on the dollar
volume of mortgages and mortgage-backed securities that Fannie Mae and
Freddie Mac could hold as investments rather than reselling them to
investors as guaranteed asset-backed securities. The current limits
were imposed on the housing GSEs by the federal safety and soundness
regulator, the Office of Federal Housing Enterprise Oversight, in
response to the accounting scandals at the enterprises last year.
Former Treasury Secretary Lawrence Summers has proposed expanding the
GSEs' securitization of subprime mortgages (and perhaps also expanding
their holdings of such mortgages).\12\ That approach could be
implemented in conjunction with an increase in the dollar limits on the
GSEs' portfolios.
---------------------------------------------------------------------------
\12\ Lawrence Summers, ``This Is Where Fannie and Freddie Step
In,'' Financial Times, August 26, 2007.
---------------------------------------------------------------------------
Adopting those proposals could increase the demand for mortgages
and lower interest rates on them. However, the proposals also raise
concerns about an increase in risk to the financial system (and perhaps
implicitly to the federal budget) from further concentrating mortgage
holdings in enterprises that have problems with financial controls and
accounting capabilities. Shifts in the GSEs' portfolios with a given
aggregate cap would raise the demand for some types of mortgages and
reduce the demand for other types. Creating new refinancing
opportunities directly through a federal agency such as FHA, rather
than the for-profit housing GSEs could also improve the targeting of
assistance to those families with the greatest need.\13\
---------------------------------------------------------------------------
\13\ See Elmendorf, ``Notes on Policy Responses.''
---------------------------------------------------------------------------
Encouraging Other Solutions. Federal regulators might encourage
solutions, such as renting defaulted homes back to the homeowners, that
both minimize the disruption for them and provide an income stream for
investors.\14\ That sort of solution was probably easier to achieve
when mortgages were held by the issuers; with ownership widely spread
through tranches of pooled mortgages, it might be difficult to get
agreement among all parties, absent regulatory encouragement. It may
also prove difficult to make sure that renters take proper and
sufficient care of their previous homes.
---------------------------------------------------------------------------
\14\ See Dean Baker and Andrew Samwick, ``Save the Homeowners, Not
the Hedge Funds,'' Providence Journal, September 3, 2007.
---------------------------------------------------------------------------
Preventing Future Crises
Preventing future crises is a third important goal for policy. Two
broad approaches could be taken: addressing deceptive lending practices
and improving regulation of the subprime market.
Other areas that policymakers may want to revisit, but that pose
difficult tradeoffs, involve the role of the rating agencies and
regulation of hedge funds and private equity funds. The incentives of
rating agencies may not be adequately aligned with investors purchasing
securities. Former Chairman of the Securities and Exchange Commission
(SEC) Arthur Levitt, for example, has proposed a variety of measures to
realign incentives in the rating agency market (for example, by
requiring in debt-offering documents full disclosure about consulting
advice from related parties and imposing SEC's oversight of the
agencies). Other observers have called for increased regulation of
hedge funds and private equity funds.
Although the government may need to take important and relevant
steps to reduce the risk of future crises, the private sector also has
an incentive to limit such risk. Financial losses being incurred by
lenders and investors are forceful reminders of the enduring need to
adhere to basic standards of prudence in underwriting and evaluating
risk.\15\ The consequences of the current disturbance for investors may
help to avoid a recurrence of the worst excesses of recent years.
---------------------------------------------------------------------------
\15\ Those developments have also exposed weaknesses in some
relatively new financial structures, such as structured investment
vehicles (SIVs), which are a means of deriving profit from the
difference between short-term borrowing rates and long-term rates. SIVs
may use subprime loans as collateral when issuing asset-backed
commercial paper. When banks create them, they are usually kept off the
balance sheet, adding to problems in the interbank market.
---------------------------------------------------------------------------
Addressing Deceptive Practices. For the federally chartered and
regulated financial institutions, the Federal Reserve has authority
under the Truth in Lending Act and the Home Ownership Equity Protection
Act (HOEPA) to require specific provisions in mortgage contracts and to
prohibit practices deemed ``unfair'' or deceptive.\16\ Currently, the
Federal Reserve is reviewing proposals that would require lenders to
include in monthly repayments and escrow accounts amounts sufficient to
pay taxes and insurance on mortgaged properties, as most prime lenders
do routinely. The Federal Reserve is also considering rules that would
restrict or prohibit prepayment penalties when payments under ARMs are
reset and loans are made without documentation that verifies the
borrower's income. The coverage of HOEPA could also be expanded. For
example, Edward Gramlich proposed reducing the interest rate threshold
at which HOEPA applies from 8 percentage points to 5 percentage points
above the Treasury bond rate on comparable securities; he noted that
such an expansion may partially supplant the variety of regulations
that have been adopted by about 40 states.
---------------------------------------------------------------------------
\16\ Ben S. Bernanke, ``The Sub-Prime Market'' (address at the
Federal Reserve Bank of Chicago's Annual Conference on Bank Structure
and Competition, May 17, 2007).
---------------------------------------------------------------------------
Prosecution of fraudulent lenders and mortgage brokers by federal
and state authorities under current law (including HOEPA) is likely to
reduce the recurrence of the most abusive, illegal practices in the
future. Some legislative proposals would also hold mortgage originators
and investors in mortgage-backed securities liable for loan terms
defined in legislation as ``abusive.'' Such consumer protection
initiatives can prevent some uninformed borrowers from agreeing to
disadvantageous terms and teaser rates, but they also restrict the
ability of lenders to tailor mortgage terms to the legitimate needs of
some borrowers. For example, prohibiting prepayment penalties may help
protect unsophisticated households from entering contracts that lock
them into excessively costly payments--but it may also allow higher-
quality borrowers to refinance more rapidly than lower-quality
borrowers, thereby causing a reduction in the average quality of the
mortgage pool and forcing investors to charge a higher interest rate on
the mortgages in the first place.
Improving Regulation of the Subprime Market. Over the longer term,
the subprime mortgage finance industry may require more uniform
regulation. Currently, about half of all subprime mortgages are
originated by lenders subject to federal safety and soundness
regulation. The other half of the market is made up of state-chartered
independent mortgage lenders and brokers. Some, but not all, of the
latter group are subject to effective operating oversight and consumer
protection by state regulatory authorities. Those lenders and brokers
who operate outside of effective government-imposed regulation or
industry self-regulation are the source of much, though not all, of the
fraudulent and abusive practices that have come to light as a result of
the current wave of defaults and foreclosures. More uniform regulation
of those entities would be consistent with both fair competition and
consumer protection.
Investors' interest in increasing the transparency of the
operations of structured finance entities, including the pooling of
subprime mortgages in a trust for the purpose of selling various
classes of ownership shares in the pool to investors, has been reported
in the press. To date, however, no legislation has been introduced for
that purpose. In general, the creators of structured finance vehicles
have strong incentives to meet investors' needs for information and to
maintain low-cost access to the capital markets. Current deficiencies
in the information provided by such entities to investors may be self-
correcting.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Prepared Statement of Robert J. Shiller, Stanley B. Resor Professor of
Economics and Professor of Finance, Yale University; Co-founder and
Chief Economist, MacroMarkets LLC; Research Associate, National Bureau
of Economic Research
Mr. Chairman and members of the committee, I thank you for the
opportunity to testify today. My name is Robert Shiller, and I am
Professor of Economics and Finance at Yale University, author of the
books Irrational Exuberance and The New Financial Order, Research
Associate, National Bureau of Economic Research, and Co-founder and
Chief Economist, MacroMarkets LLC.
In my lectures at Yale, my books, public appearances, and business
dealing with the financial products as a principal in the firm
MacroMarkets LLC, I have been a strong advocate for financial
innovation. Financial innovation has the potential to reduce economic
risks and promote economic growth. But at the same time I have argued
for many years that despite financial innovations, what Allan Greenspan
termed ``irrational exuberance,'' that is irrational optimism about
investments and economic prospects, can substantially disrupt financial
markets from time to time.
The roots of the current subprime crisis involve the impact of both
financial innovations and irrational exuberance. Rapid financial
innovation has been a good thing overall, but it has caused some
mistakes to be made, mistakes that are associated with the immense
speculative booms we have recently observed in the market for single
family homes.
1. The Recent Boom in Housing Prices
The most important cause of our current crisis is the housing boom
that preceded it. The U.S. has, since the late 1990s, had its biggest
national housing boom in history. I believe that the boom was driven by
the expectations of home purchasers that further price increases were
likely, if not inevitable. Thus, home buyers were willing to pay ever
higher and higher prices to participate in the perceived bonanza.
Booms tend to produce financial innovations. They also produce
excesses such as the decline in lending standards that generated the
subprime crisis.
Figure 1 shows the dimensions of the boom according to the U.S.
National S&P/Case-Shiller Home Price Index, which is produced by Fiserv
Inc using methods that Karl Case of Wellesley College and I originated.
The U.S. housing market gained 86% in real inflation-corrected value
from 1998 to the peak in early 2006. In my view, this degree of asset
value inflation was unwarranted, and driven by excessive investor
enthusiasm for housing as an investment. Since the peak, it has lost
6.5% of its real value.
Note from Figure 1 that neither the rise of home prices to 2006 nor
the fall thereafter can be attributed to changes in the rental market
for homes or to changes in building costs. That is part of the reason
why I believe that the home price changes are basically speculative,
and, I believe, driven by market psychology.
The futures market for single family homes at the Chicago
Mercantile Exchange that I and my colleagues at MacroMarkets LLC helped
establish last year has been in backwardation, that is, it has been
implying further declines in home prices. If one corrects for
inflation, it can be interpreted as predicting another 7% to 13%
decline in real value by August 2008, depending on city beyond the 6.5%
we have already experienced. Since the asset values in the housing
market are so large (approximately $23 trillion) this amounts to a real
loss of home value on the order of trillions of dollars by August 2008.
2. Impact of the Subprime Lending Fallout on the U.S. Economy
While the media has focused on lax and irresponsible lending
standards, I believe that this loss in housing value is the major
ultimate reason we see a crisis today. The decline in house prices
stands to create future dislocations, like the credit crisis we have
just seen, if home prices continue to fall. Notably, mortgages tend to
default and end in foreclosure after home prices fall, since people who
have purchased homes when prices were very high may see their houses
now have negative net worth and, perceiving further falls coming, they
no longer have the motivation to struggle to make payments. Thus, the
problem is larger than simply the group of home buyers who have
subprime mortgages.
Although mortgage bondholders and servicers may mobilize
unprecedented resources for loan work-outs, we are very likely to see
higher foreclosures in the future. Programs like FHASecure, which
appear to be focused only on assisting home owners with positive
equity, will not stem the rising tide of defaults.
Declines in residential investment have been an important factor in
virtually all recessions since 1950, as is shown in Figure 2. The last
time we saw such declines, in 1990-91, there was a U.S. and worldwide
recession, of rather short duration, but followed by a weak economy for
several years. The housing boom since the late 1990s was clearly bigger
than the one that preceded the 1990-91 recession, and the contraction
in residential investment since last year is sharper.
I am worried that the collapse of home prices might turn out to be
the most severe since the Great Depression. It is difficult to predict
the depth, duration and all of the consequences of such a decline
operating in a much more complex modern economy.
My own research, with Karl Case and John Quigley, has shown a
strong effect of housing prices on people's spending historically,
which would suggest that consumption spending would contract as home
prices fall. But, even beyond the effects that we have found in past
cycles, the bursting of the housing euphoria, and the attendant
financial crises, may bring on a further loss of consumer confidence,
given the size of the price drops and media attention the current
crisis has been generating.
There is a significant risk of a recession within the next year.
The Federal Reserve will undoubtedly take aggressive actions, which
will mitigate its severity. But, if home price deflation persists or
intensifies, they may discover that the Achille's Heel of this
resilient economy is the evaporation of confidence that can accompany
the end of boom psychology.
3. Effects on Home Ownership Levels
The promotion of homeownership in this country among the poor and
disadvantaged, as well as our veterans, has been a worthy cause. The
Federal Housing Administration, the Veterans Administration, and Rural
Housing Services have helped many people buy homes who otherwise could
not afford them. Minorities have particularly benefited. Home ownership
promotes a sense of belonging and participation in our country. I
strongly believe that these past efforts, which have raised
homeownership, have contributed to the feeling of harmony and good will
that we treasure in America.
But most of the gains in homeownership that we have seen in the
last decade are not attributable primarily due to these government
institutions. On the plus side, they have been due to financial
innovations driven by the private sector. These innovations delivered
benefits, including lower mortgage interest rates for U.S. homebuyers,
and new institutions to distribute the related credit and collateral
risks around the globe. Unfortunately, as the distance between
originators and the ultimate investors in subprime assets grew and risk
was managed more efficiently, so too did the underwriting complacency.
The layered risks and opacity of certain securities backed by
recent vintage subprime mortgages are unprecedented. Riskier mortgage
products--such as those entailing a low down-payment, negative
amortization, limited documentation, no documentation, payment options,
adjustable rates, and subprime credit--have been offered for decades by
portfolio lenders and specialty finance companies. However, in the past
few years alone, individual loans with a growing combination of these
risks have been promoted, originated, funded, and securitized in the
mainstream of mortgage finance. The housing boom and the global
appetite for outsized returns enabled a large playing field to develop
quickly. The rules of the game were loose and untested, and play was
largely unregulated.
A sharp distinction should be made between promoting home ownership
for low income individuals and promoting home ownership in general. We
do not need to feed the housing boom any more, or to bail out middle
income people who tried to make huge profits in the housing boom.
It is among lower-income Americans that the crisis is most severe.
Indeed, according to the three-tier Fiserv/Case-Shiller Home Price
Indices that track appreciation rates by price segment for major
cities, the housing boom since 1998 has been more pronounced for
affordable concentrated in low price homes than high-price homes. This
fact is consistent with our observation that the growth of subprime
loans has been an important driver of home prices. It also suggests
that lower-priced homes may therefore fall further if the contraction
continues, setting the stage for disproportionate negative wealth
effects for American making the contraction in home owners with low
incomes especially burdensome.
4. Some Recommendations
The FHA, the GSEs, private mortgage investors and mortgage
servicers should be incentivized to further assist the lower-income and
minority borrowers and others who have been victimized by fraudulent
and predatory lending practices in the recent boom. We should create,
along lines advocated by Harvard Law professor Elizabeth Warren, a
Financial Product Safety Commission, patterned after the Consumer
Product Safety Commision, to deter poor lending practices in the
future. Formal safeguards against the practices and influences that
generate systematic home appraisal inflation are also long overdue in
the mortgage lending industry. We should, at the same time, promote
other risk managing innovations in housing, such as home equity
insurance, shared equity mortgages, home price warranties, and down-
payment-insured home mortgages. All of these risk-management vehicles
will help mitigate the severity of impact on individual homeowners when
we next encounter a boom-bust cycle in home prices.
5. Attachments
I attach two recent papers of mine that expand on ideas in this
testimony. The first is ``Understanding Recent Trends in House Prices
and Home Ownership'' which was presented at ``Housing, Housing Finance,
and Monetary Policy,'' an economic symposium sponsored by the Federal
Reserve Bank of Kansas City in Jackson Hole, Wyoming, on August 31-
September 1, 2007. The second is ``Low Long-Term Interest Rates and
High Asset Prices'' which was presented at the ``Celebration of
Brookings Papers on Economic Activity'' Conference, Brookings
Institution, Washington DC, September 6 and 7, 2007.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Figure 1: Real US Home Prices, Real Owners Equivalent Rent, and Real
Building Costs, quarterly 1987-I to 2007-II. Source: Robert J. Shiller:
``Understanding Recent Trends in House Prices and Home Ownership''
Federal Reserve Bank of Kansas City Jackson Hole Symposium, September
2007 [attachment to this testimony]. Real US Home Price is the S&P/
Case-Shiller U.S. National Home Price Index deflated by the Consumer
Price Index (CPI-U) for the first month of the quarter rescaled to
1987-I=100. Real Owners Equivalent Rent is the U.S. Bureau of Labor
Statistics Owners Equivalent Rent December 1982=100 from the CPI-U
divided by the CPI-U, all items, 1982-4=100, both for the first month
of the quarter, rescaled to 1987-I=100. Real building cost is the
McGraw-Hill Construction/Engineering News Record Building Cost Index
for the first month of the quarter (except for the years 1987, 1988 and
1989 where the index is only annual) deflated by the CPI-U for that
month.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Figure 2: Residential Investment as Percent of GDP (quarterly, 1947-I
to 2007-II) and Real Federal Funds Rate (monthly January 1947 to July
2007). Source: Robert J. Shiller: ``Understanding Recent Trends in
House Prices and Home Ownership,'' Federal Reserve Bank of Kansas City
Jackson Hole Symposium, September 2007 [attachment to this testimony].
Residential Investment and GDP are nominal values from National Income
and Product Accounts. Real federal funds rate, end of month, is
computed by subtracting the rate of increase of CPI-U for the 12 months
up to and including the month. Recessions as defined by the National
Bureau of Economic Research are shown as the narrow areas between
adjacent vertical lines.
______
Understanding Recent Trends in House Prices and Home
Ownership\1\,\2\
---------------------------------------------------------------------------
\1\ This paper was originally presented at ``Housing, Housing
Finance, and Monetary Policy,'' an economic symposium sponsored by the
Federal Reserve Bank of Kansas City in Jackson Hole, Wyoming, on August
31-September 1, 2007. The author is indebted to Tyler Ibbotson-Sindelar
for research assistance, and, for suggestions and other help, to Harold
Magnus Andreassen, Terry Loebs, William Smalley, and Ronit Walny.
\2\ By Robert J. Shiller, Professor of Economics and Professor of
Finance, Yale University, and Chief Economist, MacroMarkets LLC.
---------------------------------------------------------------------------
This paper looks at a broad array of evidence concerning the recent
boom in home prices, and considers what this means for future home
prices and the economy. It does not appear possible to explain the boom
in terms of fundamentals such as rents or construction costs. A
psychological theory, that represents the boom as taking place because
of a feedback mechanism or social epidemic that encourages a view of
housing as an important investment opportunity, fits the evidence
better. Three case studies of past booms are considered for comparison:
the US housing boom of 1950, the US farmland boom of the 1970s, and the
temporary interruption 2004-5 of the UK housing boom. The paper
concludes that while it is possible that prices will continue to go up
as is commonly expected, there is a high probability of steady and
substantial real home price declines extending over years to come.
While home price booms have been known for centuries, the recent
boom is unique in its pervasiveness. Dramatic home price booms since
the late 1990s have been in evidence in Australia, Canada, China,
France, India, Ireland, Italy, Korea, Russia, Spain, the United
Kingdom, and the United States, among other countries.\3\ There appears
to be no prior example of such dramatic booms occurring in so many
places at the same time.
---------------------------------------------------------------------------
\3\ According to OECD data, in 2006 nominal home price inflation
exceeded 10 percent a year in 8 of 18 OECD member countries. Real price
increases exceeded 10 percent a year in five of these countries. Japan
was the only country to show a nominal or real price decline in 2006,
and house prices there have been declining steadily since 1992. See
OECD Economic Outlook, May 2007, Statistical Annex, Table 59, House
Prices.
---------------------------------------------------------------------------
Within the United States, the current boom differs from prior booms
in that it is much more of a national, rather than regional, event. In
the current boom, successive rounds of regional home price booms have
occurred that eventually became what can be called a national boom.
The boom showed its first beginnings in 1998 with real (inflation-
corrected) home price increases first exceeding 10 percent in a year on
the west coast, in the glamour cities San Diego, Los Angeles, San
Francisco and Seattle. The incipient boom then attracted only moderate
attention since it was confined to the west coast, and the cumulative
price gain was still not dramatic. But the boom quickly spread east,
with 10 percent 1-year real home price increases appearing in Denver
and then Boston in 1999. These cities kept on appreciating at a high
rate.
As years went by yet new cities started seeing substantial real
home price increases. Even though it was a recession year, Miami,
Minneapolis, New York, and Washington DC began to see 10 percent real
price increases in 2001. Then there arrived the late entrants, who
compensated for their delay with the intensity of their price boom. Las
Vegas first saw a 10 percent annual real home price increase in 2003,
and real home prices shot up 49 percent in 2004. Phoenix first saw a 10
percent real price increase in 2004 and then real home prices shot up
43 percent in 2005. And still, as of that date most of the other cities
were still going up at substantial rates. The result of this succession
of booms, in so many places has been a massive increase in national
home prices over a period of nearly a decade. The boom was tempered
somewhat by the fact that some cities never experienced booms. In
Atlanta, Charlotte, Chicago, Cleveland, Dallas and Detroit there was no
year since 1998 in which real home prices increased by 10 percent in a
year, though even these cities showed some increases.
Figure 1 shows, with the heavy line, the S&P/Case-Shiller National
Home Price Index for the United States, corrected for inflation using
the Consumer Price Index. This shows the market situation at the
national level. Nationally, real home prices rose 86 percent between
the bottom in the fourth quarter of 1996 and the peak 9.25 years later
in the first quarter of 2006.
This dramatic price increase is hard to explain, since economic
fundamentals do not match up with the price increases. Also shown on
the figure is an index of real owner occupied rent (thin line). Real
rent has been extremely stable when compared with price. Real rent
increased only 4 percent from the 1996-IV to 2006-I. The rent figures
indicate that there has been virtually no change in the market for
housing services, only in the capitalization of the value of these
services into price.
The boom in real home prices since 1996-IV cannot be explained by
rising real construction costs either, even though there appears to be
a common idea, among the general public, that it might. Using data from
Engineering News Record (2007), and correcting it for inflation with
the CPI-U, one finds that while the real price of 1/2-inch gypsum
wallboard rose 41 percent from the trough in real home prices in 1996-
IV to the peak in real home prices in 2006-I, the real price of 5/8-
inch plywood rose only 9 percent, and the real price of 2x4 common
lumber actually fell 32 percent. Labor costs are the single most
important component of building costs, and these showed little change
as common-labor earnings have stagnated. The Engineering News Record
Building Cost Index corrected for inflation showed relatively little
change over this interval. In fact the index corrected for CPI
inflation showed a slight decline from 1996-IV to 2006-I, as can be
seen in Figure 1, dotted line.
Note that real owners' equivalent rent and real building costs
track each other fairly well, as one might expect. But neither of them
tracks real price at all, suggesting that some other factor--I will
argue market psychology--plays an important role in determining home
prices.
The boom may be coming to an end in the United States where a sharp
turnaround in home prices can be seen in the bold line in Figure 1,
with real home prices falling 3.4 percent since the peak in the first
quarter of 2006. Anecdotal reports are also appearing within the last
year of a softening of the boom or even outright falls in home prices
in other countries as well, but the data already in do not yet show
this, and, on the contrary, some countries still seem to be
appreciating fast. The latest S&P/Case-Shiller Home Price Indices (for
May 2007) even show a slight strengthening of the housing market in a
number of cities.
When there are declines, they may be muted at first, and disguised
by noise. Home sellers tend to hold out for high prices when prices are
falling.\4\ The 17 percent decline in the volume of US existing home
sales since the peak in volume of sales in 2005 is evidence that this
is happening now.
---------------------------------------------------------------------------
\4\ Genesove and Mayer (2001) have shown with data on individual
purchases and sales that people who bought their homes at high prices
are reluctant to sell at a lower price, apparently due to regret or
loss aversion.
---------------------------------------------------------------------------
The market for homes is clearly not efficient, and shows enormous
momentum from year to year, as Karl Case and I first demonstrated in
1988. We attributed this inefficiency to the high transactions costs
associated with this market, which make exploitation of the
inefficiency prohibitively expensive. In May 2006 the Chicago
Mercantile Exchange, in collaboration with the firm I co-founded,
MacroMarkets LLC, created futures and options markets for US single
family homes that are cash-settled using the S&P/Case-Shiller home
price indices. Some day these markets may have the effect of making
home prices more efficient, but these markets still are not big enough
to affect the cash market very much. Given the tendency for long trends
in home prices, and given the downward momentum in price and high
valuation relative to rent, the possibility of a substantial downtrend
in home prices over many years into the future must be considered.
The implications of this boom and its possible reversal in coming
years stands as a serious issue for economic policy makers. It may be
hard to understand from past experience what to expect next, since the
magnitude of the boom is unprecedented. The implications of the boom
have produced difficult problems for rating agencies who must evaluate
the impact of the boom on securities such as the collateralized debt
obligations (CDOs) that have burgeoned in the U.S. from virtually
nothing at the beginning of the housing boom to approximately $375
billion issued in 2006. The trickiest problem these agencies face in
assessing these securities, many of which are backed by subprime
mortgages, is correlation risk (the risk that many of the real-estate-
backed assets will default at the same time) a risk that is directly
connected to the risk of a macro real estate bust that may or may not
follow the unprecedented boom.
In this paper, I will consider, from a broad perspective, the
possible causes of this boom, with particular attention to speculative
thinking among investors. I will argue that a significant factor in
this boom was a widespread perception that houses are a great
investment, and the boom psychology that helped spread such thinking.
In arguing this, I will make some reliance on the emerging field of
behavioral economics. This field has appeared in the last two decades
as a reaction against the strong prejudice in the academic profession
against those who interpret price behavior as having a psychological
component. The profession had come to regard all markets as efficient,
and to reject those who say otherwise. Now, however, behavioral
economics is increasingly recognized, and has developed a substantial
accumulation of literature that we can use to give new concreteness to
ideas about psychology in economics.
feedback and speculative bubbles
The venerable notion of a speculative bubble can be described as a
feedback mechanism operating through public observations of price
increases and public expectations of future price increases. The
feedback can also be described as a social epidemic, where certain
public conceptions and ideas lead to emotional speculative interest in
the markets and, therefore, to price increases; these, then, serve to
reproduce those public conceptions and ideas in more people. This
process repeats again and again, driving prices higher and higher, for
a while. But the feedback cannot go on forever, and when prices stop
increasing, the public interest in the investment may drop sharply: the
bubble bursts.
This basic notion of the underpinnings of speculative bubbles can
be traced back hundreds of years in the writings of commentators on
speculative markets. The germ of the idea seems to go back to the time
of the tulip mania in Holland in the 1630s (Shiller 2003). But academic
economists have long been cool to the idea that such feedback drives
speculative prices, and it has remained, until recently, largely in the
province of popular journalists. Academic economists who wrote about
them (Galbraith 1954, Kindleberger 1978) found that the academic
profession, while in some dimensions interested in their work, largely
distanced itself from their views. Part of the academic resistance has
to do with unfortunate divisions in the profession: the notion of a
speculative bubble is inherently sociological or social-psychological,
and does not lend itself to study with the essential tool bag of
economists.
In my book Irrational Exuberance (2000, 2005), named after a famous
remark of Alan Greenspan, I developed this popular notion of bubbles. I
argued that various principles of psychology and sociology whose
importance to economics has only recently become visible to most
economists through the developing literature on behavioral economics
help us to lend more concreteness to the feedback mechanism that
creates speculative bubbles. These principles of psychology include
psychological framing, representativeness heuristic, social learning,
collective consciousness, attention anomalies, gambling anomalies such
as myopic loss aversion, emotional contagion, and sensation seeking.
I argued that the feedback that creates bubbles has the primary
effect of amplifying stories that justify the bubble; I called them
``new era stories.'' The stories have to have a certain vividness to
them if they are to be contagious and to get people excited about
making risky investments. Contagion tends to work through word of mouth
and through the news media. It may take a direct price-to-price form,
as price increases generate further price increases.
News commentators on speculative phenomena clearly have the idea
that contagion may be at work but tend to stay away from a really
sociological view of speculative bubbles. They do not hear professional
economists refer to such feedback often, so they are not confident of
such a view. They tend to revert back to the comfortable notion that
markets are efficient or that everything that happens in speculative
markets ultimately comes from actions of the monetary authority. The
social epidemic model, with its psychological and sociological
underpinnings, is too poorly understood by economists in general to be
represented as an authoritative view in media accounts.
I argued that a new era story that has been particularly amplified
by the current housing boom is that the world is entering into a new
era of capitalism, which is producing phenomenal economic growth, and
at the same time producing both extreme winners and unfortunate losers.
The phenomenal growth seen recently in China and India is part of the
story, and the growing abundance of rich celebrities and extravagantly
paid CEOs is another. The new era story warns people that they have to
join the capitalist world and buy their homestead now, before it is
priced out of reach by hordes of wealthy new investors. I also listed a
number of other driving factors, partially or totally independent of
this story that also helped drive the housing boom.
That the recent speculative boom has generated high expectations
for future home price increases is indisputable. Karl Case and I first
discovered the role of high expectations in producing the California
home price boom in the late 1980s. We did a questionnaire survey in
1988 of home buyers in the boom city Los Angeles (as well as Boston and
San Francisco) and compared the results with a control city, Milwaukee,
where there had been no home price boom then.
The homebuyers were asked: ``How much of a change do you expect
there to be in the value of your home over the next 12 months?'' For
Los Angeles in 1988, the mean expected increase was 15.3 percent and
the median expected increase was 11 percent. The mean was higher than
the median in Los Angeles since about a third of the respondents there
reported extravagant expectations, creating a long right tail in the
distribution of answers. For Milwaukee in 1988 the mean expected
increase was only 6.1 percent, and the median was only 5 percent. From
this and other results from the survey we concluded that the 1980s boom
in Los Angeles relative to Milwaukee appears to be driven by
expectations.
Case and I are now, beginning in 2003, repeating the same survey
annually in the same cities. In 2003, responding to the same question
as above, the reported expectations in Los Angeles were almost as heady
as they were in 1988: the mean expected increase was 9.4 percent, the
median 10 percent. This time, however, the expectations of a good
fraction of the people in Milwaukee had converged upwards toward those
of Los Angeles: the mean expected increase was 8.6 percent. The median
expected increase remained still low, at 5 percent. Given that the
Milwaukee housing market had not boomed substantially as of 2003, one
wonders why the expectations of a good fraction of its inhabitants
matched those of people in Los Angeles. Expectations of home price
increase are probably formed from national, rather than local evidence
for many people, especially at a time of national media captivation
with the real estate boom.
By 2006, as the housing market in Los Angeles was still going up
but showed definite signs of weakening, the answers for the same
question produced a mean expected price increase of only 6.1 percent
and a median expected price increase of only 5 percent. In Milwaukee,
the mean expected increase also cooled somewhat, to 6.8 percent, while
the mean remained at 5 percent.
By 2007, after the housing market in Los Angeles dropped 3.3
percent (between May 2006 and May 2007, according to the S&P/Case-
Shiller Home Price Index), the answers for the same question
(preliminary results) produced a mean expected 1-year price increase of
-0.7 percent and a median expected 1-year price increase of 0 percent.
In Milwaukee, the answers showed a mean expectation of 6.5 percent and
a median of 3 percent.\5\
---------------------------------------------------------------------------
\5\ Our survey also asks for 10-year expectations. These remain
high in our 2007 (preliminary) results. In Los Angeles, the reported
expectation for the average annual price increase over the next 10
years was 9.6 percent and the median was 5 percent. In all the cities
we surveyed in 2007, only one respondent in 40 expects a decline over
the next 10 years. Thus, there is little alarm about the state of the
housing market for relevant investor horizons, and that perhaps
explains why consumer confidence has not been harmed by the weakening
housing market. It may also help explain why there is not panic
selling, and suggests that home prices may yet recover.
---------------------------------------------------------------------------
Thus, our expectations data show remarkable confirmation of an
essential element of the bubble story: times and places with high home
price increases show high expectations of future home price increases,
and when the rate of price increases changes, so too do expectations of
future price increases, in the same direction.
Many people seem to be accepting that the recent home price
experience is at least in part the result of a social epidemic of
optimism for real estate. But the idea that the single most important
driver of the housing boom might be such a story, and not something
more tangible like the policies of the central bank, has never really
taken hold in public consciousness. People love to exchange stories of
crazy investors or property flippers, but most just cannot seem to
integrate such stories into a view of the movements of economies and
markets. They do not accept that the market outcomes are the result of
a world view, a Zeitgeist, that is encouraged by stories and theories
whose contagion as ideas is amplified by the excitement surrounding the
price increases.
We should still be careful not to overemphasize bubble stories in
interpreting market movements. There are other factors that drive
prices. Of course, monetary policy, which has the potential to affect
the level of interest rates and hence the discount rate, is an
important factor. But, even beyond monetary policy, it must be
appreciated that there are many factors that drive decisions to
purchase long-term assets such as housing. The decision to buy a house
is a major life decision for most people, and is affected by all the
factors that people consider when deciding on their life style and
purpose. The decision is postponable, and so anything that attracts
attention to or away from housing can have a significant effect on the
state of new construction.
Housing seems not to have been a very speculative asset until the
last few decades, except in a few places where there is a story that
encourages people to think that housing may be especially scarce. The
conventional view among economists until recently has been that housing
prices are driven primarily by construction costs. For example, this
view was neatly laid out in 1956 by Grebler, Blank and Winnick.
It is not surprising that people did not view housing as a
speculative asset: almost all of the value of houses has been value of
structure, which is a manufactured good. From this view, there would be
no reason to think that one can make money by buying houses and holding
them for resale than that one can make money by buying tables and
chairs and holding them for resale. People apparently knew that home
prices were dominated by structure prices. The recent real estate boom
has changed this. According to a recent study by Davis and Heathcote,
the percent of home value accounted for by land in the United States
rose from 15 percent in 1930 to 47 percent in 2006.
Whether this higher fraction of value attributed to land is a
stable new equilibrium or is a temporary phenomenon induced by a
speculative bubble remains to be seen. Today, agricultural land sells
for less than $2000 an acre, or about $300 per lot-sized parcel, a
miniscule number compared to the cost of a structure. Of course, this
is usually land in the wrong place, far from the urban areas and jobs
and schools that people want to get on with their lives. But there is
reason to expect that as existing urban land becomes very expensive
relative to structures, there will be efforts to substitute away from
that land, and so the fraction of value attributed to land in housing
may be expected to mean-revert. Such substitution takes time.
New urban areas can be built elsewhere on land that is now cheap.
Cities can economize on land by raising the population density and
building high-rises. Already there is a movement advocating cities
which, like Manhattan, or various urban areas in Europe and Asia,
emphasize public transport, tall buildings bringing large numbers of
people together. Such cities are highly attractive to many people
because of the diversity of opportunity and entertainment there, and
also simply because of the feeling of excitement of crowds. Such cities
make very economical use of land. Many more such cities can be built in
the future, though, especially in the US, such new cities run against
conventional notions of suburbia and automobile-based life.
Christopher Leinberger (2007) has shown that there is an increasing
demand for ``walkable urban centers,'' and finds that prices of living
space in such centers goes at a premium. This premium reflects tastes
for a city with lots of attractions nearby, within walking distance.
This taste is not being rapidly fulfilled because of coordination
problems and zoning restrictions. But, some developers have been able
to crack this nut. He gives as an example Reston Town Center built on
then-cheap land in the country that surrounds Washington DC. It was
planned starting in 1961 by developer Robert E. Simon, whose initials
form the first part of the town name. He launched a campaign to get the
Fairfax County Board of Supervisors to pass an ordinance allowing high-
density housing there. The Town Center was dedicated in 1990. It is now
a cluster of high rises that mimics a city center. Values per square
foot are comparable there to those of large city centers. This and
other examples prove that the quality of life in downtown glamour
cities is reproducible, if only zoning does not stand in the way.\6\ It
is plausible, then, that the economic pressure for more such spaces
will eventually give way into the further development of such projects.
The supply of houses will increase without substantial land shortage
problem.
---------------------------------------------------------------------------
\6\ Glaeser and Gyourko (2002) present evidence that zoning
restrictions are an important reason for high prices in urban areas.
Comparing across major US metropolitan areas, they found no substantial
correlation between housing density and housing prices, as one would
expect to see if mere high demand for urban land drove home prices.
---------------------------------------------------------------------------
Concern about pollution, the environment and energy costs may also
provide an impetus to move toward such cities. But the expectation that
such new urban areas will be built is not a certainty yet, and will
unfold if it does over many years.
Concern about economic inequality, which has been growing for
decades now in most countries of the world, also has the potential to
reduce barriers to the increase in the supply of housing and to bring
prices down. For example, one of the first actions Gordon Brown took
upon becoming Prime Minister was to offer a number of proposals to
encourage the construction of millions of new homes to relieve people
priced out of the housing market.
Gyourko, Mayer and Sinai have gotten great attention for a paper
arguing that it may be reasonable to suppose that great cities will
indefinitely outperform the economy in general. They found that some
``superstar cities'' have shown long-term, that is 50-year,
appreciation above national averages. But, their study found only
relatively small excess returns to homes in those cities. They use
Census decadal owners' evaluations of the value of their homes. They
report much smaller differences across cities than people expect. Their
paper found that Los Angeles grew at 2.46 percent a year real 1950-
2000, but this is far below the kind of expectations we have seen
recently. According to our surveys, homebuyers in Los Angeles had a
mean expectation for 10-year nominal price growth of 9.4 percent and a
median of 10 percent in 2003. Moreover, in the decadal Census data
there is no correction for quality change, and yet homes have been
getting larger in the superstar cities, so the actual appreciation of
existing homes was likely even less than 2.46 percent a year.
Considering the really long term, the centuries over which these
cities persist, it is hardly reasonable to expect much more than a 1
percent a year advantage in those cities in the long term, for that
would mean doubling every 69 years relative to other cities. If New
York City were on the same price level as other cities at the time of
the American Revolution, at a 2 percent per year relative advantage in
appreciation a home there would now cost a hundred times as much as the
same home in other cities--hardly plausible.
The Coldwell-Banker Home Price Comparison Index compares the price
of a standard home across cities. They price ``a single-family dwelling
model with approximately 2,200 square feet, 4 bedrooms, 2\1/2\ baths,
family room (or equivalent) and 2-car garage . . . typical for
corporate middle-management transferees.'' They report that Beverly
Hills, California, the home of movie stars, was the study's most
expensive market in 2006, with the price of the standard home there at
$1.8 million. The average price of their standard home, averaging over
all cities in 2006, was $423,950. Thus, the home in Beverly Hills is
only 4 times more expensive than the average home. If we can assume
that Beverly Hills emerged into maximum movie-star status over the
space of a hundred years, this amounts to only a little over 1 percent
a year excess return. Thus, a 1 percent a year advantage is about the
reasonable limit. For most investors in the recent boom environment,
this is way under their expectations. Moreover, as Gyourko, Mayer and
Sinai themselves pointed out, even the small advantage in appreciation
that they claimed to find for the superstar cities has been offset by a
lower rent-price ratio in those cities.
home ownership and consumption of housing
Speculative booms in houses are unusual because purchasing a house
is both an investment decision and a consumption decision. Moreover,
the decision to purchase rather than rent is a decision not only to
consume different kinds of housing services but also to lead a
different kind of life; this difference has political ramifications,
and so the purchase decision enters the arena of politics.
In the United States, the home price boom since the late 1990s was
accompanied by a substantial increase in the home ownership rate (the
percent of dwelling units owned by their occupants, as recorded by the
U.S. Census). As can be seen from Figure 2, in the U.S. there were
actually two time periods in the last century over which the home
ownership rate increased, from 1940 to 1960, and again during the
recent home price boom, since the mid 1990s. Between these two periods
the homeownership rate was fairly constant. The first period of
increase, between 1940 and 1960, showed the more dramatic increase;
this increase was substantially the result of new government policies
to encourage home ownership after the surge of mortgage defaults during
the Great Depression of the 1930s.
The increase since 1994 in home ownership appears to be due in
large part to the remarkable housing boom. The boom psychology
encouraged potential homeowners and encouraged lenders as well. Home
buyers were encouraged by the potential investment returns. Mortgage
lenders were encouraged since the boom reduces the default rate on
lower-quality mortgages. The subprime mortgage market was virtually
nonexistent before the mid 1990s, and rose to account for a fifth of
all new mortgages by 2005. Denial rates for mortgage applications
plunged after around 2000. The new loans went disproportionately to
lower income borrowers, and to racial and ethnic minorities.\7\
---------------------------------------------------------------------------
\7\ Gramlich, Edward M., Subprime Mortgages, 2007.
---------------------------------------------------------------------------
The change appears to be the result of changes in public
expectations for the real estate market, rather than changes in
government policy. Unlike the 1940s-60s boom in homeownership, the
current boom is not largely due to government initiatives to increase
the homeownership rate. Instead, there has been a uniform background of
government approval for homeownership over a long time period.
There has long been a popular view that homeownership is a thing to
be encouraged, and as a result philanthropists and government officials
have tried to do so.
The U.S. Civil War 1860-65 was blamed by contemporaries on a low
level of home ownership in the South: ``Ownership of real estate by its
citizens is the real safeguard for the government. Where such a
condition is almost universal, as in the Northern States, a revolution
to destroy the government which guarantees that title is next to an
impossibility. Had the system prevailed in the South, the people would
not have been dragooned into rebellion . . .'' \8\
---------------------------------------------------------------------------
\8\ ``The Renovation of the South,'' Liberator, 35:32, p. 126,
August 11, 1865.
---------------------------------------------------------------------------
The cooperative bank movement of the 19th and 20th centuries was
motivated by a similar view. This movement was lauded in 1889 for its
effects on poor people: ``It has taken them out of the tenement houses
and freed them from the baneful influences which are apt to exhale
therefrom.\9\
---------------------------------------------------------------------------
\9\ ``Cooperative Banks in Massachusetts,'' The Bankers Magazine
and Statistical Register, 43(8):610, February 1889.
---------------------------------------------------------------------------
There is some empirical support for the view. DiPasquale, Forslid
and Glaeser (2000) have found that homeowners tend to be more involved
in local government, are more informed about their political leaders
and join more organizations than renters do, even after controlling for
other factors. The evidence for this view has led to widespread
political support for policies that encourage homeownership over much
of the world.
On the other hand, contrary to expectations suggested by much of
the literature on homeownership, homeownership rates across countries
are not well explained in terms of any economic or demographic
variables. Fisher and Jaffe (2002) could explain only 50 percent of the
cross-country variability of homeownership rates. They found that in
cross-country studies the homeownership rate is negatively correlated
with GDP per capita.
There is, however, likely to be a limit on how far public policy
should attempt to encourage homeownership. There are many sensible
reasons for people to rent rather than own: people who cannot currently
bear the responsibilities of household management, who are likely to
move soon or who have other plans for their time, should rent rather
than own. Renting rather than owning encourages a better
diversification of investments; many homeowners have very undiversified
investment portfolios, and these investments are often highly
leveraged. Moreover, creating too much attention to housing as
investments may encourage speculative thinking, and therefore,
excessive volatility in the market for homes. Encouraging people into
risky investments in housing may have bad outcomes. It is possible that
some countries have overreached themselves in encouraging homeownership
(UN-Habitat 2002).
One might suppose that the increase in home ownership is associated
with an increased share of consumption allocated to housing. However,
as can also be seen from the figure, which shows housing as a
percentage of personal consumption expenditures from 1929 to 2007, the
share of consumption expenditures allocated to housing has stayed
fairly constant at about 15 percent over the time interval, except for
a temporary dip during World War II.\10\ Housing expenditures include
both the rent of tenant-occupied housing and the imputed rental value
of owner-occupied housing. The U.S. Bureau of Economic Analysis
computes the latter based on rents of similar tenant-occupied
housing.\11\ Thus, their calculations indicate that the amount of
housing consumed has not increased as a fraction of total consumption;
the increase in the homeownership rate reflects merely the switch from
renting to owning of comparable-valued properties. Their numbers are
not affected by the home price boom since the numbers are based on
rents, not prices, of homes.
---------------------------------------------------------------------------
\10\ Corresponding to this, the PCE deflator gave the price of
housing shelter a weight of 15.0 percent in December 2004. The consumer
price index, in contrast, gave housing shelter a weight of 32.7 percent
in that month. See Brian C. Moyer, ``Comparing Price Measures--The CPI
and the PCE Price Index, National Association for Business Economics,
2006, http://www.bea.gov/papers/pdf/Moyer_NABE.pdf.
\11\ Mayerhauser and Reinsdorf 2006.
---------------------------------------------------------------------------
residential investment
Residential investment is a volatile component of GDP in the U.S.
and it has had a highly significant relation to the business cycle.
Residential investment represents essentially all economic activity
directly related to housing structures. It is comprised of three main
components: construction of new single family homes, construction of
new housing units in multifamily structures, and ``other structures,''
which includes improvements as well as brokerage commissions.
Figure 3, which was inspired by the work of Edward Leamer, as
presented in his paper at the 2007 Jackson Hole conference, shows
residential investment as a percent of GDP (quarterly 1947-I to 2007-
II). We see that residential investment has gone through cycles that
correspond closely to the ten recessions since 1950, as marked on the
figure by business cycle dates computed by the NBER. Notably,
residential investment as a percent of GDP has had a prominent peak
before almost every recession since 1950, with a lead varying from
months to years. There are only a couple of examples of such peaks that
are not accompanied by recessions. Most striking from the figure is
that ends of recessions were always marked by sharp upturns in
residential investment, within months of the end of the recession. The
latest recession (2001) shows the least drop in residential investment
as compared with all prior recessions shown, suggesting that the
relation between housing investment and the business cycle may be
changing.
Figure 3 also shows the real federal funds rate (end of month,
monthly) computed by subtracting the rate of increase of the CPI-U for
the latest twelve months. Note that the relation of the real funds rate
to recessions is rather more ambiguous than the relation of residential
investment to recessions.
The extraordinary behavior of residential investment in recent
years, especially since 2000, stands out. Residential investment rose
to 6.3 percent of GDP in the last quarter of 2005, the highest level
since 1950. We will consider the year 1950 as a case study below. But,
we can note at first here that the 1950 economy was of course very
unusual, for it followed World War II, a period when residential
construction had been sharply curtailed for the war effort. After the
war, there was a phenomenal baby boom, which translated into a sharply
increased demand for housing after the war had decreased the supply. No
fundamental shock approaching the magnitude of the World War II shock
appears to have been at work in the post-2000 residential investment
boom.
The right-most part of the figure can be used to illustrate a
popular story for the latest home price boom, a story that it was all
caused by the Fed. The real funds rate was cut sharply after 2000, and
the housing boom (as measured by investment) took off. Then, in 2003,
the Fed started raising real interest rates, and, following that, with
a lag of a couple years, residential investment fell sharply. This
story, which one repeatedly hears casually suggested, puts the full
blame for the housing boom and bust on the Fed. The accuracy of this
story in corresponding to the data since 2000 can be visualized in the
chart by noting the almost mirror-opposite of the two series since
2000.
But, the story is clearly an oversimplification at best as a model,
because the same relation between residential investment and the funds
rate had never been seen before in the entire period since 1950. In
fact, before 2000, one sees rather more a positive, not negative
relation between the real funds rate and residential investment as a
percent of GDP. From the figure, it appears that just as good a story
for a number of recessions would be that the Fed cut rates in response
to weakening housing investment prior to the recession than that it
caused the declines in housing investment by raising rates.\12\
---------------------------------------------------------------------------
\12\ In his remarks at the Jackson Hole Symposium (2007), John B.
Taylor discussed a model of U.S. housing starts in terms of just the
federal funds rate, involving lags, estimated with quarterly data 1959
to 2007. He concluded that the model ``tracks historical data on
housing starts very closely'' for the period 2000 to 2007, though he
did not present an analysis of the model's success in the period before
2000.
---------------------------------------------------------------------------
broad historical comparisons
There have been many real estate booms in history and real estate
cycles that may be variously described as speculative booms or mere
construction booms without any speculative enthusiasm.
Figure 4 shows the unusualness of the boom in a broad historical
perspective using three series of home prices, series for the
Netherlands, Norway and the United States, countries for which long
historical price indices are available that make some attempt to
control for changing size and quality of homes. The Dutch series was
created by Piet Eichholtz at Maastricht University, and applies to
Amsterdam only. The Norwegian series, created by yvind Eitrheim
and Solveig Erlandsen, covers Bergen, Oslo and Kristiansand, and, from
1897, Trondheim, through 2003. The series was updated to 2006 and
deflated by Harald Magnus Andreassen of First Securities in Norway. In
all three countries the same general observations emerge: there has
been an enormous home price boom since the 1990s, which dwarfs anything
seen before.
case studies of booms
Let us pursue here three case studies that illustrate the dynamics
of real estate booms, with special attention to the psychology of the
activity. We will consider here the 1950 home construction boom, which
stands out in the figure above, the 1970s U.S. farmland boom, and the
sudden reversal in the market for homes in the United Kingdom in 2005,
when a speculative market that was generally recognized as finished and
in decline suddenly reversed and began booming again.
The 1950 U.S. Construction Boom
The only time when construction activity in the U.S. was higher as
a percent of GDP than it was in 2005 was the year 1950, when
residential investment rose to 7.3 percent of GDP. Construction
activity was described at the time as at record levels in all major
regions of the United States. Why? It is not enough to dismiss this as
a boom to correct shortages induced by World War II, since 1950 was
already five years after the end of the war. In 1947, two years after
the war, construction as a percent of GDP was as low as 4.3 percent,
well below the postwar average of 4.8 percent. Moreover, in the
following year, 1951, residential investment as a percent of GDP fell
to 5.0 percent, just a little above the historical average.
Throughout this time, around 1950, there was no boom in real home
prices, as can be seen from Figure 4. Home prices were rather flat,
after having increased a lot at very end of World War II. It appears
also that there were not expectations, at least at the beginning of the
year, for further home price increases. A Washington Post opinion
survey of builders, realtors and bankers in the greater Washington DC
area published January 22, 1950 found 126 persons who thought that
prices would remain the same in 1950, 46 who expected a price rise, and
38 who expected a price decline. Expectations of increase were about
matched by expectations of decrease, and, in fact, given inflation,
people effectively were expecting a fall in real prices. This was no
speculative bubble. So, why were home sales setting all time
records?\13\
---------------------------------------------------------------------------
\13\ ``Prices on 1950 Homes to Level, Survey Shows,'' Washington
Post, Jan 22, 1950, p. R3.
---------------------------------------------------------------------------
The press in 1950 offered a number of reasons for the boom. First
there were the concrete reasons. The Housing Act of 1950 reduced
interest rates on FHA-insured loans by 0.25 percent and raised the
guarantee of VA loans from 50 percent to 70 percent. ``Increased
competition'' from these government-subsidized loans was said to have
led private lenders to improve their terms: offering 30-year mortgages
where once they had offered only 20-year, and offering no-down-payment
loans, controversial new products that were seen as necessary to stay
competitive.\14\
---------------------------------------------------------------------------
\14\ ``Easier Money for Homes,'' Wall Street Journal, June 2, 1950,
p. 2.
---------------------------------------------------------------------------
This stimulus to housing demand appeared to come from Congress and
mortgage lenders, not monetary policy. Fed policy at the beginning of
1950 was described as ``neutral'' with fears of rekindling inflation
offset by evidence of weakness in the business situation and slumping
commodity prices.\15\
---------------------------------------------------------------------------
\15\ ``Uncertainty Felt by Money Market,'' New York Times, January
3, 1950, p. 52.
---------------------------------------------------------------------------
But, beyond these concrete factors, the newspaper accounts refer to
other psychological factors that are suggestive of the kind of things
that affect general public thinking, and are hard for most of us to
remember later. First of all, even though expectations of price
increases did not seem to be a factor, there was repeated mention of
people giving up waiting for price declines in housing (after the
immediate postwar inflation) and a spreading feeling that ``used house
prices are not going down much more.'' \16\
---------------------------------------------------------------------------
\16\ ``Rising Costs, Easy Financing, Spur Home Sales,'' Washington
Post, July 16, 1950, p. R4.
---------------------------------------------------------------------------
The flight to suburbia was underway, and this flight was associated
with a new American life style and a new sense of community: ``nobody
worries about keeping up with the Joneses and everybody becomes a good
neighbor.'' \17\ To the extent that the 1950 construction boom was
associated with a change of consumer tastes toward suburban living away
from center city living, there would be no reason to expect the surge
in demand to boost existing home prices over all.
---------------------------------------------------------------------------
\17\ ``Life in the New Suburbia,'' New York Times, Jan 15, 1950, p.
SM9.
---------------------------------------------------------------------------
The beginnings of the war in Korea, with North Korea's surprise
invasion of South Korea on June 25, and the first clash between North
Korea and the US on July 5, led many to war fears, even fears of a
``third world war.'' The possibility seemed very real that government
restrictions on prices and construction might be in place again.
Indeed, President Truman warned of possible rationing and price
ceilings in July and asked for limited powers to control production and
credit. Congressional debate began to consider price ceilings on real
estate transactions. By December, with CPI inflation rapidly building,
price and production controls were seen as ``inevitable'' and the
beginnings of price controls were put in place.\18\ It is hard to know
exactly what people expected, but we do know that in 1950, according to
a number of contemporary observers, buyers were ``now resigned to the
fact that if they are ever going to have a home, they hadn't better
wait any longer.'' \19\
---------------------------------------------------------------------------
\18\ ``Wage, Price Controls Seen by Top Aides: Snyder, Valentine
Feel Time is Nearing for Application,'' Washington Post, December 5,
1950, p. 1.
\19\ ``Rising Costs, Easy Financing, Spur Home Sales,'' Washington
Post, July 16, 1950, p. R4.
---------------------------------------------------------------------------
The new war against communists, coupled with the 1949 Soviet atomic
bomb and the possible involvement of the Soviet Union in the war, led
to an atomic bomb scare. Columnist Drew Pearson wrote:
However, in this year 1950, half way through this modern and
amazing century, we are in real danger of bogging down in an
`age of fear.' Faced with the awful knowledge that others have
the atomic bomb, faced with fear of the hydrogen bomb, of
bacteriological warfare, of new trans-oceanic submarines and
transatlantic rockets, we are in definite danger of relapsing
into an age of fear, an age when we do not go forward because
we are paralyzed with fright.\20\
---------------------------------------------------------------------------
\20\ ``Dangers Noted in `Age of Fear,' Drew Pearson,'' The
Washington Post, June 26, 1950, p. B 11.
The fear led to concerted plans for civil defense, the construction
of bomb shelters, and much talk about where the bombs might hit. It
also led to a boom of new construction in the suburbs and countryside
which allowed people to escape the risk of a possible nuclear attack on
the center city, a powerful force that reshaped the country away from
center cities.\21\ One contemporary observer wrote of the suburban
developers: ``They're cashing in on the steady trek of city families to
the suburbs, a trend that may be getting a little extra push from the
war scare and atom bomb developments.'' \22\
---------------------------------------------------------------------------
\21\ ``Country Homes: War in Korea Boosts City Dwellers' Demand for
Rural Residences,'' Wall Street Journal, August 23, 1950, p. 1.
\22\ ``Suburban shopping: More Centers Going Up on the Outskirts,
Lure Trade from Downtown,'' Wall Street Journal, August 15, 1950, p. 1.
---------------------------------------------------------------------------
It is difficult to capture all the thinking that goes into people's
decision to buy a home this year rather than another year. One gets a
sense that those who were writing in 1950 were having as much
difficulty in understanding mass thinking about real estate as we have
today. One realtor who was interviewed in 1950 said simply ``I also
believe there is a psychological factor in home buying which is now
expressing itself in a mass desire to buy homes.'' \23\
---------------------------------------------------------------------------
\23\ ``Prices on 1950 Homes to Level, Survey Shows,'' Washington
Post, Jan 22, 1950, p. R3.
---------------------------------------------------------------------------
This psychological factor in 1950 may bear some resemblance to the
psychological factors at work in the early 2000s, even though in 1950
there was no classic speculative boom, and there apparently was little
enthusiasm for housing as ``the best investment.'' There are still
similarities with 1950, in a sense that home prices are not going down,
that one may have to buy now or miss out on an opportunity to buy at
all, and a war and a general feeling of anxiety about personal safety.
The 1970s Boom in U.S. Farmland Prices
Farmland prices went through an extraordinary boom in the 1970s.
Figure 5 shows real US farmland prices since 1900. Two big events stand
out in this century-plus of data: a boom in the 1970s, a bust in the
1980s, and a renewed boom in the 2000s.
The farmland boom of the 1970s was sometimes attributed at the time
to rising food prices. In fact, the farm products component of the US
Producer Price Index rose a total of 9 percent relative to the Consumer
Price Index from 1970 to 1980, and then leveled off. These movements
are not big enough to justify the farmland boom and bust.
More important than the food prices may be the ``great population
scare'' of the 1970s. In 1972, a Club of Rome study Limits on Growth,
authored by Donella H. Meadows and her colleagues at MIT predicted that
expanding population growth would soon lead to exhaustion of resources,
and a prominent scenario in their analysis was mass starvation around
the world. The book received extraordinary attention, even though it
was criticized by the economics establishment as alarmist and without
substantial evidence. The effects of this scare were felt all over the
world. For example, China instituted her one-child policy in 1979.
Changes in the behavior of institutions were part of the boom
phenomenon. Tax institutions changed in the direction of support for
the boom. US federal tax law was changed in 1976 to allow farm estates
left to a member of the immediate family to be valued at a
capitalization of rents, rather than the high market prices, for
computation of estate taxes, and to be paid over 15 years. Thus, it
appears that the boom stimulated Congress to place farmland in a
special privileged category for capital-gains tax purposes.
In the high-inflation years of the late 1970s, a theory began to
take hold among institutional investors that farmland is a good
inflation hedge. In 1980, the New York Times wrote:
Investment funds, traditionally leery of investment in
farmland, are starting to flow more rapidly into agriculture.
Several major insurance companies have stepped up their
purchase of farmland in the past two years and a number of
other institutions ``are beginning to express greater interest
in farmland,'' according to Irving S. Wolfson, executive vice
president of the Phoenix Mutual Life Insurance Company of
Hartford.\24\
---------------------------------------------------------------------------
\24\ Ann Crittenden, ``Farmland Lures Investors,'' New York Times,
November 24, 1980 p. D 1.
Meanwhile, investment funds specializing in farmland investments
were set up, such as the American Agricultural Investment Management Co
and Oppenheimer Industries.
Newspaper accounts of the time described the 1970s as due in part
to speculative foreign investors:
Although much of the foreign money is hard to trace, European
Investment Research Center, a private consulting firm based in
Brussels, estimates that foreigners invested some $800 million
in farmland last year. That would come to a startling 30
percent of all foreign direct investment in the U.S., according
to the Commerce Dept. ``What we are witnessing,'' says Kenneth
R. Krause, a senior economist for the Agriculture Dept., ``is
the biggest, continuing wave of investment in American farmland
since the turn of the century.'' . . . Amrex Inc., a San
Francisco-based real estate firm, is holding a meeting in
Zurich next week to introduce buyers to sellers who represent
as much as $750 million worth of U.S. farmland. Some observers
warn that the industry is attracting its share of hucksterism
as well. West German newspapers are being flooded with real
estate advertisements, apparently from small U.S. brokers, that
often offer only an anonymous post office box number for an
address.\25\
---------------------------------------------------------------------------
\25\ ``Foreign investors flock to U.S. farmlands,'' Business Week,
March 27, 1978, p. 79.
The boom period coincided with a common theme in newspapers of the
time that there was concern that farmland was rapidly shrinking as it
was converted to homes, shopping centers and parking lots, thereafter
likely never to return to cultivation. It seemed like a brand new idea:
who had ever thought that a farm, once converted, would never again
revert back to farmland? Eventually, a 1980 federal study ``National
Agricultural Lands Study'' sounded this alarm. In describing this
study, US Agriculture Secretary Bob Bergland noted then that the idea
that farmland was being consumed was a new one: ``This question never
has been seriously addressed because, for as long as I can remember,
all of us thought we had land to spare.'' \26\
---------------------------------------------------------------------------
\26\ ``Shortage of U.S. Farmland Predicted; Land Shortage, Higher
Cost of Food Foreseen,'' Washington Post, January 17, 1981, p. B1.
---------------------------------------------------------------------------
This boom even had a hit song associated with it, Joni Mitchell's
``Big Yellow Taxi,'' which had the refrain:
They paved paradise
And put up a parking lot
With a pink hotel, a boutique
And a swinging hot spot.
Don't it always seem to go
That you don't know what you've got
Till it's gone
They paved paradise
And put up a parking lot.
Joni Mitchell's song Big Yellow Taxi had an unusual appeal to
thinking people, and had a very long life, issued in 1970, it reached a
peak of #24 on the Billboard chart in 1975, just before the most rapid
price increases of the farm price boom. (Curiously, the same song was
recorded by the Counting Crows in 2003, near the peak of the recent
farmland boom, and reached 42 on the Billboard chart.)
The end of the boom coincides with President Carter's Soviet grain
embargo, which lowered the price of grains that farms produced, as well
as the sharp rise in interest rates during Volcker's term, and the
recessions of 1980 and 1981-2.
After the correction following 1980, the 1970s explosion of farm
prices was described as a dramatic bubble. One account, in 1983, wrote
that values ``overexpanded in the belief that inflationary runups in
land prices would never end.'' \27\ It does appear that it was a
bubble, and spurred by stories and lore that emphasized the emerging
scarcity of farmland. It was perhaps a more rational one than the
housing bubble we appear to be in recently, for at least farm land is
not reproducible, as housing structures are.
---------------------------------------------------------------------------
\27\ ``Debt Still Plagues Farmers,'' Business Week, March 21, 1983,
p. 109.
---------------------------------------------------------------------------
The Turnaround in London Home Prices in 2005
Figure 6 shows an index of real greater-London existing house
prices, for a case study that concerns the downturn in real prices from
the second quarter of 2004 to the second quarter of 2005. That downturn
is not the most striking feature of the figure. It is much more
striking that real home prices more than doubled from 1983 to 1988 and
then fell 47 percent, came almost all the way back down, by 1996,
producing an almost-perfect inverted-V pattern in home prices over a
period of thirteen years. Also very striking is the boom in home prices
from 1996 to the present, which shows real home prices nearly tripling.
But here, we are focusing instead on the much smaller 6 percent
downturn in real home prices over the year from 2004-II to 2005-II.
This downturn was quickly reversed: real home prices resumed heading up
at a rate of 9 percent a year from 2005-II to 2007-I, not so much
smaller than the 12 percent a year real price increase from 1996 to
2004.
This small downturn is interesting now because it looks very much
like the downturn that we have seen in U.S. prices in the last year. If
one places a piece of paper over the figure positioned so as to block
out all data after the second quarter of 2005, one will see a price
path that closely resembles that seen in figure 1 for the US above. The
decline in London home prices was interpreted by many as the end of the
home price boom, but the downdraft was suddenly and decisively
reversed. It is very common to hear forecasts that the U.S. home market
is near a bottom now, and will resume its upward climb soon. These are
forecasts for a repeat of the London experience after 2005.
The Bank of England had begun tightening rates in November 2003
when the base rate was 3.5 percent and completed the tightening in
August 2004, when the base rate reached 4.75 percent. The decline in
home prices began about 6 months before they stopped tightening. But it
is hard to see why this modest tightening should have been responsible
for the decline in home prices. Similar interest rate increases in 1997
and 1999 had not stopped the housing boom, and interest rates were
still lower in 2005 than at the ends of these prior tightening cycles.
Despite the tightening, 2016 index-linked gilt yields fell over the
same interval, from 1.93 percent to 1.79 percent, which, if anything,
would suggest that home prices should rise, not fall. After home prices
bottomed, index-linked gilt yields continued essentially the same
downward trend until September 2006, and then began to rise. Thus, it
is hard to see an explanation for the price behavior at this time in
terms of interest rate changes.
The 2004-5 downturn in UK home prices was the subject of thousands
of newspaper articles at the time. Some of these articles spoke of the
``end of the housing boom'' or ``the last desperate gasp of a defunct
housing boom'' as if this end were self-evident. Even those that were
relatively optimistic did not predict the strong recovery that actually
transpired. One reporter wrote that ``even optimists forecast prices
will rise by no more than 2 per cent annually in the next few years--
and pessimists expect an outright fall.'' \28\
---------------------------------------------------------------------------
\28\ ``Buyers Beware: Britain's Buy-to-Let Boom May Turn Out to Be
a Bust,'' Financial Times, May 30, 2005, p. 14.
---------------------------------------------------------------------------
An important theme in these articles was comparison with other
countries. In an article in The Independent entitled ``Property Market
Cools in Britain, But in US It's the Latest Gold Rush'' it was noted
that ``Just as in Britain, dinner party conversations that used to be
about schools or sports now have one constant topic: property prices,
and the outrageous price the neighbours got for their house across the
street.'' \29\ Continuing housing booms in France, Ireland and Spain
(where the boom was still strong) and the Netherlands (where a boom had
converted into a soft landing of slower price increases) were also
noted. Since the Bank of England had raised rates, while other central
banks had not, blame for the weakening housing market was often
attributed to the temporary effects of these rate increases, rather
than to any change in market psychology, thereby discouraging any
sudden change in expectations about long-run home price increases.\30\
---------------------------------------------------------------------------
\29\ The Independent, June 1, 2005, p. 56.
\30\ Jane Padgham, ``Britain Slips Down House Price League as Rate
Rises Kick In,'' The Evening Standard (London) January 28, 2005, p. 45.
---------------------------------------------------------------------------
There is a sort of coordination problem with psychological
expectations in a time of a boom. If people infer their expectations
from recent price changes not just at home but in other places, then it
may be hard for sharply changed expectations ever to take root. People
believe that a change in market psychology drives the housing market,
and if they look both near and far to gauge the psychology of others,
then it will be hard to see a change.
Moreover, the kind of expectation for home prices that is implicit
in the common 21st century world view, that increasing home prices are
the result of our capitalist institutions and the phenomenal economic
growth that the adoption and perfection of these institutions around
the world has brought about, is not likely to be changed suddenly by
the appearance of short-run price declines.
It is hard to find in any account in the news media any objective
reason for the resurgence of the boom after the second quarter of 2005.
The Bank of England did not substantially cut the base rate: there was
only a small 25 basis point cut in August of 2005, and in fact the rate
was then increased, by over a percentage point by May of 2007. The tiny
and relatively brief rate cut could hardly be held responsible for the
massive turnaround in the housing market.
The return of the boom came as a complete surprise. An October 2005
article said: ``Between January and April sales were about 25 percent
below average. It's quite staggering how things have turned around in
the last couple of months. We are now back to average levels, and are
seeing more transactions than at this time last year.'' The best this
article could come up with as an explanation was ``house prices have
not fallen as much as some analysts were warning. This has given buyers
the confidence to re-enter the market as the fear of losing money on a
property purchase is eroding.'' \31\ From a behavioral economics
perspective, that explanation is not silly, as it is part of a broader
story of speculative feedback.
---------------------------------------------------------------------------
\31\ ``Doomsters May Be Wrong,'' Sunday Times (London), October 23,
2005, p. 5.
---------------------------------------------------------------------------
This London case study should caution any who feel that a
substantial decline in home prices in the US is inevitable, given the
recent declines, but not really offer much comfort for real estate
optimists either, given the isolation, and special character, of the
brief London downturn.
conclusion
The view developed here of the boom in home prices since the late
1990s has it operating as a classic speculative bubble, driven largely
by extravagant expectations for future price increases. As such, the
situation may well result in substantial declines in real home prices
eventually.
The case studies above suggest that there are a wide variety of
considerations and emotions that impact on a decision whether or not to
buy a house. If there are fears of war or terrorism (as we saw in the
case of the 1950 boom) or fears of environmental destruction (as we saw
in the case of the farmland boom of the 1970s) then there may be major
changes in home prices or construction activity even if there is no
change in the traditional list of fundamentals.
Institutional changes tend to come in connection to the speculative
psychology, not just as exogenous advances in financial or bureaucratic
technology. Thus, we saw the lengthening of mortgage maturities during
the real estate boom of 1950, the development of real estate investing
institutions and changes in the tax law during the farmland boom of the
1970s. From these examples, it should be no surprise that we have seen
the proliferation of new mortgage credit institutions, the
deterioration of lending standards, the growth of subprime loans, and
the rapid expansion of the CDO market, in the real estate boom of the
2000s.
Monetary policy does not come out as central in the case studies
examined here. Monetary policy is in an important sense concentrated on
the extreme short-term. The fundamental target variable in the U.S. is
the federal funds rate, an overnight rate. And yet, economic decision
makers are focused on a lifetime decision problem. Economic decision
makers have to decide on the long-term, 50-year-plus, value of their
investments. The difference of maturities is a factor on the order of
10,000 to one. Using monetary policy to manage such decisions is a
little bit like adding a grain of sand a day to a scale that is
weighing a car.
People's opinions about long-term decisions, notably how much
housing to buy and what is a reasonable price to pay, change in the
short term only because their opinions about the long-term change. But,
these opinions about the long-term are hard to quantify because they
are usually not expressed. They are usually expressed only in story
form, in attention given to homespun theories, and the like.
People base life decisions upon vague expectations for the future,
and if they have the false impression that they have a unique property
that is going to become extremely valuable in the future, then they may
consume more, driving the economy, and they may drive up prices today.
That is what we have seen happening over much of the last decade.
The psychological expectations coordination problem appears to be a
major factor in explaining the extreme momentum of home price
increases. Investors who think that home prices will continue to go up
because they perceive prices as going up generally around the world may
not change this expectation easily since they will have trouble
coordinating on a time to make the change. A housing supply response to
high prices will tend to bring prices down, but the increment to
housing supply in any one year is necessarily tiny given the nature of
construction technology, and that supply can be absorbed easily if
expectations are still strengthening. If, however, price declines
continue in the United States, there could be a more coordinated
response to enforce declining expectations around the world. If the
United States shows substantial price declines, then the underlying
popular story of the boom, related to the perception of a triumph of
capitalism and the explosive growth of the world's economies, may
become old. The United States, the premier example of a capitalist
economy, has the potential to lead price expectations downward in many
countries.
The example, considered above, of the recovery from decline in
London in 2005 serves as a good reminder that speculative markets are
inherently unpredictable, and that the incipient downturn in the United
States could reverse and head back up. No one seems to have a good
understanding what causes these reversals. Still, the examples we have
of past cycles indicate that major declines in real home prices--even
50 percent declines in some places--are entirely possible going forward
from today or from the not too distant future. Such price declines have
happened before. In the last cycle in the United States, as shown in
figure one, real home prices fell only 15 percent from the peak in the
third quarter of 1989 to the fourth quarter of 1996, but some cities'
real prices fell much more. Los Angeles real home prices fell 42
percent from the peak in December 1989 to the trough in March 1997. We
saw from Figure 6 that real home prices in London fell 47 percent from
the third quarter of 1988 to the fourth quarter of 1995.
The boom cycle that followed these declines, after the late 1990s,
was even bigger than that preceded them, and so it is not improbable
that we will see such large real price declines extending over many
years in major cities that have seen large increases. Since the number
of cities involved in the recent boom is so much higher than in the
last boom, we could see much more than the 15 percent real drop in real
national home price indices that we saw last time.
References
Brown, Lynn E., ``National and Regional Housing Patterns: History of
Residential Investment in the U.S.'' New England Economic Review,
July/August, 2000.
Case, Karl E., and Robert J. Shiller, ``The Efficiency of the Market
for Single Family Homes,'' American Economic Review, 79:1, 125-37,
March, 1989.
Case, Karl E., and Robert J. Shiller, ``Home Buyer Survey Results 1988-
2006,'' unpublished paper, Yale University, 2006.
Davis, Morris A., and Jonathan Heathcote, ``The Price and Quantity of
Residential Land in the United States,'' unpublished paper,
University of Wisconsin, Madison WI, 2006.
DePasquale, Denise, Rikard Forslid, and Edward L. Glaeser, ``Incentives
and Social Capital: Are Homeowners Better Citizens?'' Journal of
International Economics, 50(2):497-517, 2000.
Eichholtz, Piet, ``A Long Run House Price Index: The Herengracht Index,
1628-1973, Real Estate Economics, 25:175-92, 1997.
Eitrheim, yvind, and Solveig Erlandsen, ``House Price Indices for
Norway, 1819-2003, in yvind, Eitrheim, Jan T. Klovland and F.
Qvigstad, editors, Historical Monetary Statistics for Norway, pp.
341-375.
Engineering News Record, Second Quarterly Cost Report, McGraw Hill
Construction 2007.
Fisher, Lynn M. and Austin J. Jafee, ``Determinants of International
Home Ownership Rates,'' unpublished paper, Smeal College of
Business Administration, Pennsylvania State University, 2002.
Galbraith, John Kenneth, The Great Crash 1929, Boston: Houghton
Mifflin, 1954.
Genesove, David, and Christopher Mayer, ``Loss Aversion and Seller
Behavior: Evidence from the Housing Market,'' Cambridge MA:
National Bureau of Economic Research Working Paper No. 8143, 2001.
Glaeser, Edward L., and Joseph Gyourko, ``The Impact of Zoning on
Housing Affordability,'' NBER Working Paper #8835, March 2002.
Gramlich, Edward M., Subprime Mortgages: America's Latest Boom and
Bust, Washington D.C.: The Urban Institute Press, 2007.
Grebler, Leo, David M. Blank, and Louis Winnick, Capital Formation in
Residential Real Estate, Princeton NJ: National Bureau of Economic
Research and Princeton University Press, 1956.
Gyourko, Joseph, Christopher Mayer, and Todd Sinai, ``Superstar
Cities,'' Cambridge MA: National Bureau of Economic Research
Working Paper No. 12355, July 2006.
Kindleberger, Charles Poor, Manias, Panics and Crashes: A History of
Financial Crises, New York: Basic Books, 1978.
Leamer, Edward E., ``Housing and the Business Cycle,'' paper presented
at the Federal Reserve Bank of Kansas City Symposium ``Housing,
Housing Finance, and Monetary Policy,'' Jackson Hole, Wyoming,
August 31, 2007.
Leinberger, Christopher B., ``Financing Walkable Urbane Projects,''
Urban Land, January 2007.
Mayerhauser, Nicole, and Marshall Reinsdorf, ``Housing Services in the
National Economic Accounts,'' U.S. Bureau of Economic Analysis,
August, 2006.
Meadows, Donella H., Dennis L. Meadows, Jorgen Randers, and William W.
Behrens III, Limits on Growth: a report for the Club of Rome's
project on the predicament of mankind, New York: Universe Books,
1972.
Poole, Robert, Frank Ptacek, and Randal Verbrugge, ``Treatment of
Owner-Occupied Housing in the CPI,'' Office of Prices and Living
Conditions, Washington DC: Bureau of Labor Statistics, 2005.
Shiller, Robert J., ``From Efficient Markets to Behavioral Finance,''
Journal of Economic Perspectives, 17(1):83-104, 2003.
Shiller, Robert J., Irrational Exuberance, 2nd Edition, Princeton:
Princeton University Press, 2005.
Shiller, Robert J., ``Low Real Interest Rates and High Asset Prices,''
unpublished paper, for presentation at Brookings Panel on Economic
Activity, Washington DC, September 2007.
Taylor, John B., ``Housing and Monetary Policy,'' remarks presented at
the Federal Reserve Bank of Kansas City Symposium ``Housing,
Housing Finance, and Monetary Policy,'' Jackson Hole, Wyoming,
August 31, 2007.
UN-Habitat, Rental Housing: An Essential Option for the Urban Poor in
Development Countries, 2002, http://www.unhabitat.org/downloads/
docs/3588_62479_655.pdf.
Van den Noord, Paul, ``Are Housing Prices Nearing a Peak? A Probit
Analysis for 17 OECD Countries,'' OECD Economics Working Paper No.
488, June 2006.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Figure 1: Real US Home Prices, Real Owners Equivalent Rent, and Real
Building Costs, quarterly 1987-I to 2007-II. Source: authors
calculations. Real US Home Price is the S&P/Case-Shiller U.S. National
Home Price Index deflated by the Consumer Price Index (CPI-U) for the
first month of the quarter resealed to 1987-I=100. Real Owners
Equivalent Rent is the U.S. Bureau of Labor Statistics Owners
Equivalent Rent December 1982=100 from the CPI-U divided by the CPI-U,
all items, 1982-4=100, both for the first month of the quarter,
resealed to 1987-1=100. Real building cost is the McGraw-Hill
Construction/Engineering News Record Building Cost Index for the first
month of the quarter (except for the years 1987, 1988 and 1989 where
the index is only annual) deflated by the CPI-U for that month.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Figure 2: Home Ownership and Housing as a Share of Consumption. Source:
The home ownership rate, percentage of homes that are occupied by their
owner (decadal 1900 to 1960, annual 1965 to 2007) is from the U.S.
Census. Housing/Consumption (annual 1929 to 1946, quarterly 1947-I to
2007-I) is calculated by the author as the ratio of housing
expenditures to personal consumption expenditures, National Income and
Product Accounts, Table 2.3.5.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Figure 3: Residential Investment as Percent of GDP (quarterly, 1947-I
to 2007-II) and Real Federal Funds Rate (monthly January 1947 to July
2007). Source: author's calculations. Residential Investment and GDP
are nominal values from National Income and Product Accounts. Real
federal funds rate, end of month, is computed by subtracting the rate
of increase of CPI-U for the 12 months up to and including the month.
Business cycle dates from the National Bureau of Economic Research are
shown by vertical lines.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Figure 4: Home price indices deflated for consumer prices and rescaled
to 1890=100, Netherlands, Norway and USA. The Netherlands index (semi-
annual 1890-1973 then annual 1974-2004) is produced by Piet Eichholtz
of Maastricht University; it is for the Herengracht region of Amsterdam
1900-1973, which he updated to 2004 using other data for the city of
Amsterdam. The Norway index (annual) is a Norges Bank series (Eitrheim
and Erlandsen, http://www.norges-bank.no/Pages/Article_42332.aspx)
1890-2003 updated to 2006 and deflated by Harold Magnus Andreassen of
First Securities ASA, Oslo. The USA index (annual 1890-2007) is from
Robert Shiller, Irrational Exuberance, Princeton, 2005, updated using
the S&P/Case-Shiller National Home Price Index for the United States.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Figure 5: Real farmland values, in US 2006 dollars, per acre, decadal
1900 to 1910, annual 1911-2006. Source: author's calculations. The
nominal USDA-NASS is divided by the CPI-U for the first month of the
year and rescaled to 2006 dollars.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Figure 6. Greater London real home price index, quarterly, 1987-I to
2007-II. Source: author's calculations. The Halifax Greater London
existing house price index is divided by the U.K. retail price index
and rescaled to 1987-I=100.
______
Low Long-Term Interest Rates and High Asset Prices\1\,\2\
---------------------------------------------------------------------------
\1\ For ``Celebration of BPEA'' Conference, Brookings Institution,
September 6 and 7, 2007. The author is indebted to Tyler Ibbotson-
Sindelar for research assistance.
\2\ By Robert J. Shiller, Professor of Economics and Professor of
Finance, Cowles Foundation, Yale University, and Chief Economist,
MacroMarkets LLC.
---------------------------------------------------------------------------
It is widely discussed that we appear to be living in an era of low
long-term interest rates and high long-term asset prices. Long rates
have been commonly described as low in the 21st century, both in
nominal and real terms, when compared with long historical averages,
though increasing somewhat in the last few years, and especially in the
past few weeks as the financial markets have been in their subprime
turmoil. Asset prices have also fallen somewhat in recent months, but
often remain almost at their peaks.
Stock prices, home prices, commercial real estate prices, land
prices, even oil prices and other commodity prices, are said to be very
high.\3\ The two phenomena appear to be connected: if the long-term
real interest rate is low, elementary economic theory would suggest
that the rate of discount for present values is low, and hence present
values should be high. This pair of phenomena, and their connection
through the present value relation, is often described as one of the
most powerful and central economic forces operating on the world
economy today. Low interest rates seem to be viewed by many as a very
powerful force of nature all over the world that guarantees that we
will be in an era of high asset prices just as global warming
guarantees rising sea levels all over the world.
---------------------------------------------------------------------------
\3\ See also Shiller (2007).
---------------------------------------------------------------------------
Our conference organizers suggested that papers for this conference
could consider ``common beliefs about the way the world works, that, in
the author's view, are not so.'' I thought, then, that for this paper I
would critique the common view about interest rates and asset prices. I
will question the accuracy and robustness of the ``low-long-rate-high-
asset-prices'' description of the world. I will also evaluate a popular
interpretation of this situation: that it is due to a worldwide regime
of easy money. Among the business population, at least, it is clear
that there is a common story about the causes of the current situation:
monetary authorities around the world have encouraged low long-term
interest rates and that these low rates have boosted asset prices all
over the world, and have spurred both stock market booms and real
estate booms. The catch phrase is a world ``awash with liquidity.''
Sometimes the phenomenon is referred to as the ``liquidity glut.''
I will consider a theme that perhaps monetary policy has indeed
been at least a small factor in promoting the high asset prices that we
have seen evolving over the last decade, but that the factor's
importance and reliability is overrated. The high asset prices are
probably not a permanent feature of a new monetary policy regime.
Perhaps, then, there is rather more instability to the high asset
values that we have seen recently than some accounts have indicated.
Another, related, theme here is that changes in long-term interest
rates and long-term asset prices seem to have been tied up with
important changes in the public's ways of thinking about the economy.
Rational expectations theorists like to assume that everyone agrees on
the model of the economy, which never changes, and that only some truly
exogenous factor like monetary policy or technological shocks moves
economic variables. Economists then have the convenience of analyzing
the world from a stable framework that describes consistent public
thinking. I propose that often the popular models, the models of the
economy believed by the public, change frequently through time, and
this has driven both long rates and asset prices.\4\
---------------------------------------------------------------------------
\4\ See also Shiller (1990).
---------------------------------------------------------------------------
This paper will begin by presenting some stylized facts about the
level of interest rates (both nominal and real) and the level of asset
prices in the world since 1950. Next, I will consider some aspects of
the public's understanding of the economy, including common
understandings of liquidity, the significance of inflation, and real
interest rates, and how their thinking has impacted both asset prices
and interest rates. This will lead to a conclusion that there is only a
very tenuous relation between asset prices and either nominal or real
interest rates, a relation that is clouded from definitive econometric
analysis by the continual change in difficult-to-observe popular
models.
Low Long-Term Interest Rates
Figure 1 shows nominal long-term (roughly 10-year) interest rates
for eight countries and the Euro Area. With the exception of India, all
of them have been on a massive downtrend since the early 1980s. Even
India has been on a downtrend since the mid 1990s. The lowest point for
long term interest rates appears to have been around 2003, but, from a
broad perspective, the up-movement in long rates since then is small,
and one can certainly say that the world is still in a period of low
long rates relative to the last half century. Long rates are not any
lower now than they were in the 1950s, but the high rates of the middle
part of the period are gone now.
Economic theory has widely been interpreted as implying that the
discount rate used to capitalize today's dividend or today's rents into
today's asset prices should be the real, not nominal, interest rate.
This is because dividends and rents can be broadly expected to grow at
the inflation rate. However, as Franco Modigliani and Richard Cohn
argued nearly 30 years ago, it may, because of money illusion, be the
nominal rate that is used in the market to convert today's dividend
into a price.\5\
---------------------------------------------------------------------------
\5\ Modigliani and Cohn (1979). The authors also stressed that
reported corporate earnings need to be corrected for the inflation-
induced depreciation of their nominal liabilities, and investors do not
make these corrections properly.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Figure 1. Long-Term (approximately ten-year) Nominal Interest Rates, 8
countries and Euro Area, monthly, 1950-2007. Source: Global Financial
---------------------------------------------------------------------------
Data.
The cause of the downtrend in nominal rates since the early 1980s
is certainly tied up with a downtrend in inflation rates over much of
the world over the period since the early 1980s. So, it is interesting
and important to look also at real long-term interest rates. Figure 2
shows real ex-post real long-term interest rates based on a 10-year
maturity for the bonds. The annualized 10-year inflation rate that
actually transpired was used to correct the nominal yield. For dates
since 1997, the entire 10-year subsequent inflation is not yet known,
and so for these the missing future inflation rates were replaced with
historical averages for the last 10 years. Note that there has been a
strong downtrend in ex-post real interest rates over the period since
the early 1980s as well.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Figure 2. Ex-Post Real Long-Term (approximately ten-year) Bond Yields,
9 countries, 1950-2007. Source: author's calculations using data from
Global Financial Data.
The downtrend in the ex-post real interest rate since the early
1980s is nearly as striking as with nominal rates. In some countries,
ex-post real long-term rates became remarkably close to zero in 2003.
Just as with nominal rates, real rates have picked up since then, and
yet still remain relatively low.
However, ex-post real interest rates may not correspond to ex-ante
or expected real interest rates. It seems unlikely that investors
expected the negative ex-post real long rates of the 1970s which
afflicted every country except stable-inflation Germany. It is equally
unlikely that they expected the high real long rates of the 1980s.
After the very high inflation of the 1970s and the beginning of the
1980s, inflation in the United States, and elsewhere, came crashing
down, see Figure 3. It may be that people did not believe that
inflation would stay down over the life of these long-term bonds.
Tabulated inflation expectations have referred to the short term, and
it may be difficult to elicit on a questionnaire long-term
expectations.
Marvin Goodfriend and Robert King argued that the public rationally
did not believe in the 1980s that the lower inflation would continue.
They point out that the Fed under Chairman Paul Volcker (who served
from 1979 until Alan Greenspan took over in 1987) announced its radical
new economic policy to combat inflation in 1979, and then promptly blew
their credibility at the time of the January-July 1980 recession. US
CPI inflation reached an annual rate of 17.73 percent in the first
quarter of 1980, and the Fed's policy had the effect of reducing that
to 6.29 percent by the third quarter of 1980. But the Fed apparently
lost its resolve to combat inflation with that recession, and inflation
was quickly back up to 10.95 percent in the fourth quarter of 1980.
Given the fact that postwar Fed efforts to tame inflation before 1980
were followed in the space of a number of years with yet higher
inflation, a rational public would likely assume that inflation would
again head back up in future years. Hence the expected long-team real
interest rates were not as high in the early 1980s as Figure 2 would
suggest. Goodfriend and King pointed out that at the time Paul Volcker
himself regarded the nominal long rate as an indicator of inflationary
expectations, and so implicitly assumed that the expected long-term
real rate was essentially constant.\6\
---------------------------------------------------------------------------
\6\ Goodfriend and King (2005).
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Figure 3. Annual Consumer Price Inflation, 8 countries and Euro Area,
Monthly Data, 1951-2007. Source: author's calculations using Global
---------------------------------------------------------------------------
Financial Data.
Figure 3 suggests that Goodfriend and King's focus on Paul Volcker
as the stimulus for change in worldwide policy stance toward inflation
may be misplaced, for, on a worldwide basis, the major turning point
toward lower inflation looks more like 1975 than 1981. This was before
Volcker's term as Federal Reserve Board Chairman began, so he is
unlikely to be the thought leader behind this change.
The Brookings Papers on Economic Activity certainly played a major
role in the 1970s in the change of thinking among policy authorities on
monetary policy. The very first article in the very first issue, by
Robert Gordon in 1970, was about the costs of monetary policy aimed at
reducing inflation. In the early 1970s, the theme of dealing with the
rising inflation without inducing excessive costs on the economy seemed
to be the most significant theme of the Brookings Papers, where some of
the most authoritative new thinking about this problem appeared. It
seems more likely that it was the combined effect of such scholarship
and discourse that changed thinking on inflation policy than that Paul
Volcker single-handedly led the world into a new policy regime.
There were also opinion leaders who appealed directly to the broad
public to propose strong policies to deal with inflation. Irving S.
Friedman, a former chief economist at the International Monetary Fund,
and then, at the behest of Robert McNamara, Professor in Residence at
the World Bank, wrote a book in 1973 Inflation: A Growing Worldwide
Disaster that may be representative of the kind of thought leadership
that brought down inflation.\7\ He wrote:
---------------------------------------------------------------------------
\7\ Curiously, I knew of this book because it was in the library of
books left behind by the previous owners of our summer home, the only
economics book in their collection. I did not accurately notice the
year of publication when I first found the book, and was surprised to
see my suspicion confirmed that it was first published just before the
apparent inflation turning point in the mid 1970s.
The social scientist no longer enjoys the luxury and leisure to
theorize and ruminate about society, economics, institutions
and interpersonal relations. He is being called to act as he
was during the Great Depression of the 1930s. . . . The
inflation is clearly eroding the fabric of modern societies.\8\
---------------------------------------------------------------------------
\8\ Friedman (1975), p ix and xi.
Another Friedman was probably far more influential in arguing,
effectively, for consistently tighter monetary policy. Milton Friedman
made a career out of criticizing monetary policy and arguing that the
growth rate of the money stock should be targeted, no matter what
effects that has on interest rates or any other economic variable. It
was a plausible-sounding, though radical, recipe for stopping
inflation. He won the Nobel Prize in economics in 1976 and chose to
give his Nobel lecture on the inflation problem, which was published as
Inflation and Unemployment: The New Dimension of Politics, in 1977. He
---------------------------------------------------------------------------
said that:
On this analysis, the present situation cannot last. It will
degenerate into hyperinflation and radical change; or
institutions will adjust to a situation of chronic inflation;
or governments will adopt policies that will produce a low rate
of inflation and less government intervention into the fixing
of prices.\9\
---------------------------------------------------------------------------
\9\ Milton Friedman (1976). http://nobelprize.org/nobel_prizes/
economics/laureates/1976/friedmanlecture.pdf
It is plausible that Milton Friedman was of all these people the
most important thought leader who led the historic break to lower
inflation. His views on inflation had real worldwide resonance. When
the Volcker Fed made its momentous announcement of a new monetary
policy regime on October 6, 1979, the Federal Open Market Committee in
---------------------------------------------------------------------------
its official announcement described this as:
A change in method used to conduct monetary policy to support
the objective of containing growth in the monetary aggregates .
. . This action involves placing greater emphasis in day-to-day
operations on the supply of bank reserves and less emphasis on
confining short-term fluctuations in the federal funds
rate.\10\
---------------------------------------------------------------------------
\10\ Board of Governors of the Federal Reserve System, Press
Release, October 6, 1979.
These words clearly ring, in sound if not fully in substance, as an
acceptance of the Friedman formula, and willingness to accept the
consequences of following it.
It is easy to forget today that Milton Friedman's initial fame
derived primarily from his ``monetarist'' solution to the inflation
problem, not from his free-market ideas. A Proquest Historical
Newspapers count of ``Milton Friedman'' scaled by the database size
shows that his public prominence rose and fell with the inflation
problem. Scaled references to Milton Friedman in newspapers rose 15-
fold from the late 1950s to a dramatic peak in the early 1980s, just as
inflation peaked, and then fell gradually back to 20 percent of the
peak by the early 2000s. But, even as Milton Friedman's prominence in
public discourse faded, he left behind an important change in the
popular model of the economy. He created an association in the public
mind between a belief in monetary policy that tolerates large swings in
interest rates to preserve monetary targeting and a general belief in
the importance of free markets, even though there is no logical
connection between these two beliefs. By tying a belief that long-run
price stability is the paramount objective for monetary policy with the
emerging worldwide faith in free markets, he assured that this time the
efforts to control inflation would not fail.
Perhaps it was thought leaders like these, now sometimes forgotten,
who argued persuasively enough that inflation must be controlled that
gave Volcker and other central bankers the political power to take
important steps to do so. The view, as enunciated by Arthur Okun in
1978, had been that reducing inflation by monetary policy alone entails
a ``very costly short-run tradeoff'' in increased unemployment and lost
output. But the rise of inflation led to a sense of alarm, and the
failure of other measures to control inflation (in the United States,
the Lyndon Johnson 1968 tax surcharge on corporations and higher income
individuals, the Richard Nixon Phase I price controls of 1971 and the
Gerald Ford ``Whip Inflation Now'' plan of 1974 to reduce energy
demand, expand agricultural acreage and invigorate antitrust policy)
led to a increasingly widespread conventional view that the nations of
the world have no choice but to tighten monetary policy considerably.
It was like going on a painful diet after all the attempts at easy
schemes to lose weight failed, and then feeling a smug satisfaction, as
long as the diet lasts, that one had finally exerted the willpower.
But, the change in thinking influencing policymakers may not have
been so clearly palpable to the public that they brought down their
inflationary expectations. Thus, ex-post real rates may have shot up
very high even though ex-ante real rates did not.
Market real interest rates, that is, inflation-indexed bond yields,
Figure 4, have a shorter history in major countries than do ex-post
real rates. In the United Kingdom, where the series begins in 1985,
there is a distinct downtrend until the past few years. In the United
States the path has been irregular, but the general direction has been
downward since they were first created in 1997. This seems to confirm
in a very rough sense that the downtrend in ex-post real interest rates
might also be a downtrend in ex-ante real interest rates.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Figure 4. Ten-Year Inflation-Indexed Bond Yields, Monthly, United
Kingdom, January 1985-July 2007, United States, January 1997 to July
2007. Source: Global Financial Data.
But these inflation-indexed markets are still small and not central
factors in the economy and their yields may reflect inessential
features of the participants in these markets. Most of these bonds are
still held by institutions, not individuals.
Moreover, the path of real interest long-term rates are
substantially different across the two countries since 1997 even though
their asset price movements are fairly similar, as we shall see in the
next section.
High Long-Term Asset Prices
Figure 5 shows real (inflation-corrected) stock prices for the same
list of countries. The period around 1980, when long term interest
rates were most high, was often a slow period for stock prices in many
countries. In fact, with the exception of the two economic-miracle
countries Japan and Germany, one could say that real stock prices were
just about the same in the early 1980s, when long-term interest rates
were highest, as they were in 1950.
In most countries, real stock prices have been on a major uptrend
since the long-term interest rate peak in the early 1980s, as the
theory would suggest, though not exactly in phase with the decline in
long-term interest rates.
There was however a major downward correction in stock prices
between 2000 and 2003 unexplained by any rise in long-term interest
rates. In the US, real stock prices fell in half from peak to trough. A
good part of the downward correction has been reversed since 2003, even
though over this period long-rates have generally risen, not fallen.
Hence, one could say that the simple story that long-rates should
move opposite stock prices is consistent with these data but only in a
very rough sense. Stock prices were abnormally low just when long-rates
had their enormous peak in the early 1980s, however, shorter-run
movements in the series do not match up well.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Figure 5. World Real Stock Prices, 1950-2007. Source: author's
calculations using Global Financial Data.
A remarkable boom in home prices has appeared since the peak in
long rates in the early 1980s. Figure 6 shows real (inflation
corrected) home prices for seven countries. Five of the seven countries
have shown booms. In the United States, the boom is, for the Nation as
a whole, the largest since 1890. Prior home price booms seem to have
been relatively contained geographically (for example, to Florida or
California). The fact that the boom has become so pervasive leads one
to wonder if it is indeed tied up with the trend in interest rates.
However, the uptrend in home prices clearly does not begin until the
late 1990s, after most of the downtrend in interest rates had passed.
It seems that, although it might seem at first that there is a
substantial negative correlation historically between asset prices and
interest rates, this correlation is actually very weak. However, a
perception that there is such a relationship may have an influence on
the market; it may help frame today's market as justifiably high.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Figure 6. Real (Inflation-Corrected) House Prices, 7 of the 8 Countries
Shown in Figure 1, 1994=100. Source: OECD Economic Outlook 2007,
Statistical Annex, Table 59, ``House Prices''.
Awash with Liquidity
The idea that the world is ``awash with liquidity'' is part of the
lore of the market recently, and that this notion may itself help
support asset high asset prices. I tabulated the occurrence of the
phrase ``awash with liquidity'' in English language newspapers with a
Lexi-Nexis search. I found that the use of the phrase exploded upwards
in 2005, and has continued high ever since. The term was also used
rather frequently in the late 1990s, during the stock market boom, and
also somewhat in the mid 1980s, just before the stock market crash of
1987. So, the term may be something that is just trotted out whenever
the markets are rising fast.
There has been some ambiguity what a ``liquidity glut,'' or that
the world is ``awash with liquidity'' might be and what might be used
to measure it. Reading some of the many recent newspaper accounts of
this supposed phenomenon, it seems clear that some of these popular
writings are confused about some of the most basic principles of
economics. It definitely seems that the popular model is that when
people buy stocks their money goes ``into'' the stock market and sits
there, and so higher stock prices mean that there must be more money
(liquidity) to pay for them. Probably most of these people have never
heard of the economists' notion of the ``demand for and supply of
money,'' and just do not understand that asset prices can be tipped
upward if everyone thinks that they should be higher even with
virtually no transactions involving money. For these people, evidence
that we are awash with liquidity appears to be just the high stock
prices, bond prices and real estate prices lately. Monetary aggregates
have not shown unusual behavior, and they do not usually seem to be
referring to these.
An example of the kind of thinking appears in a recent Wall Street
Journal article:
``Lenders have been doling out increasingly large sums of money
and accepting increasingly crummy conditions and meager returns
on their loans. Remember those ``low-doc'' loans that got
subprime home buyers in trouble--the ones that required minimal
proof of ability to repay? These are their corporate cousins.
Waves of money are coming at the markets from investors around
the world. Bond and loan buyers have to put this money to work,
even if the deals are shoddy.'' \11\
---------------------------------------------------------------------------
\11\ Dennis K. Berman, ``Sketchy Loans Abound: With Capital
Plentiful, Debt Buyers Take Subprime-Type Risks,'' Wall Street Journal,
March 27, 2007, p. Cl.
But, all this description of the phenomenon does not seem to offer
anything more than just some colorful language to frame the observation
that bond prices are higher.
Some economists have tried to give a more sensible interpretation
of what these writers might be saying. Adrian and Shin (2007) argued
that the phenomenon that those who use these terms might be interpreted
as describing is that there is a feedback mechanism operating within
investment banks and to a lesser extent commercial banks that causes
them to demand more investments when asset inflation has inflated the
assets on their balance sheets, so that higher asset prices tend to
create through this mechanism yet higher asset prices. But, even if
such a feedback is operative, it would merely mean that shocks to asset
prices will tend to be amplified, whether up shocks amplified upward or
down shocks amplified downward, and the theory does not tell us the
source of the shocks. Their basic idea is not altogether new; the basic
idea was discussed, for example, by Charles Kindleberger and Robert
Aliber in 2005.
According to Financial Times columnist Martin Wolfe, there are two
contrasting explanations for the low real interest rates around the
world today: a ``savings glut'' and a ``money glut.'' According to
Wolfe, the savings glut theory, associated with Ben Bernanke and stock-
market analyst Brian Reading, is that there has been an upward shock to
the national savings of China, Japan, and the oil-exporting countries,
which has caused them to export capital to the rest of the world and
have the effect of flooding their markets with capital, lowering real
interest rates and lowering saving there. In the ``money glut'' theory,
which Wolfe attributes to stock market analyst Richard Duncan, the
cause of the low real interest rates is the US Federal Reserve, which
has held real interest rates low.
Past Scholarly Interpretations of Major Asset Pricing Movements
Economic research has noted for some time that the relation between
asset prices and interest rates is not as straightforward as popular
accounts often suggest. Many factors have been noted that would prevent
interest rates from feeding directly into asset prices.
James Tobin inveighed against the common assumption of abstract
theorists that there is perfect substitutability between risky long-
term assets and bonds and that the return on capital is identical to
the interest rate: ``Among the relevant properties with which the
theory must deal are: costs of asset exchanges; predictability of real
and money asset values at various future dates; correlations--positive,
negative and zero--among asset prospects; liquidity--the time it takes
to realize full value of an asset; reversibility possibility and cost
of simultaneously buying and selling an asset; the timing and
predictability of investors' expected needs for wealth.'' \12\ Tobin on
other occasions also referred to Keynes' ``beauty contest'' analogy for
the determination of prices in the stock market. These lines of thought
led Tobin to something other than the yield on bonds to measure of the
stimulus to investment demand. These ideas led to his work with William
Brainard that singled out q--the price of capital relative to its
replacement cost--as such a measure.\13\
---------------------------------------------------------------------------
\12\ Tobin (1961) p. 28.
\13\ Brainard and Tobin (1968).
---------------------------------------------------------------------------
William Brainard, John Shoven and Laurence Weiss estimated present
discounted values of future after-tax cash-flows for a panel of 187
firms for the 1958 to 1977 period. They found that over this period
there was a massive decline in the value of stocks relative to the
present value of predicted real cash flows using an inflation-adjusted
bond yield. They found that firms whose present value was relatively
more concentrated beyond 5 years in the future declined in value more
relative to the present value, suggesting that ``general pessimism
about the future'' was at work in producing the stock market
decline.\14\
---------------------------------------------------------------------------
\14\ Brainard, Shoven and Weiss (1982), p. 502.
---------------------------------------------------------------------------
William Brainard, Matthew Shapiro and John Shoven calculated for a
panel of US firms a ``fundamental return'' equal to the after tax net
of depreciation cash flow divided by the net replacement cost of its
physical assets and compared that to actual return in the market,
finding only a 0.05 correlation between the two using aggregate US data
1963-85. The correlation between fundamental return and bond return
over this period was minus 0.28.\15\
---------------------------------------------------------------------------
\15\ Brainard Shapiro and Shoven, Table 5 p. 41. They also
calculated a ``fundamental beta'' and found that it helped explain
expected return across stocks above and beyond market beta.
---------------------------------------------------------------------------
Olivier Blanchard constructed a world real medium-term interest
rate 1978-93 using a present value of inflation forecasts, and compared
this to a world dividend-price ratio--the two had opposite trends and
no significant short-term correlation. The short-run movements in the
equity premium were found to correlate with inflation, suggesting a
possible element of truth to the Modigliani-Cohn theory of money
illusion and the stock market.\16\
---------------------------------------------------------------------------
\16\ Blanchard (1993).
---------------------------------------------------------------------------
The Dynamic Gordon Model and Dividend Yields
The model one hears most often in connection with the level of
asset prices is the Gordon Model\17\:
---------------------------------------------------------------------------
\17\ Gordon (1962).
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Where P is price, D is dividend, R is the long-term interest rate,
---------------------------------------------------------------------------
and g is the expected growth rate of dividends. Or,
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Where D is dividend per share, P is price per share, R is the long-
term interest rate, and g is the expected long-term growth rate of
dividend. R and g can be either both nominal or both real. Of course,
nominal interest rates are most commonly used, but the idea that g is
expected to be constant might better be used if we suppose it is a real
growth rate.
Gordon himself derived this equation as a steady state relation,
and did not have time subscripts, but it is common today to assume that
the model holds at each point of time. John Campbell and I proposed a
``dynamic Gordon model'', based on a log-linearization of the present
value relation. In an efficient market as we defined it, the dividend
yield should be given by:
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Figure 7. World Stock Market Dividend Yields, 1950 to 2007. Source:
Global Financial Data.
Notably, the very high real interest rates in the late 1970s to
early 1980s do seem to correspond to somewhat to high dividend yields,
at least when compared with recent years. But the correspondence with
interest rates is not compelling, and seems to apply only in
comparisons with the relatively brief period of anomalously high
interest rates and inflation in the late 1970s to early 1980s. And the
high dividend yields then were not so high as interest rates would
suggest. In the US, for example, dividend yields in the early 1980s
were at about the same level as in the early 1950s. This fact was noted
by Blanchard and Summers, who, in their Brookings paper in 1984 wrote
``One would expect that a sharp increase in real interest rates at long
maturities, caused by fiscal and monetary policies, would depress stock
prices significantly. Yet in all major countries, real stock prices
have been surprisingly strong. Dividend-price ratios have in no way
followed real rates on long-term bonds.'' \18\
---------------------------------------------------------------------------
\18\ Blanchard and Summers (1984) p. 274.
---------------------------------------------------------------------------
The Real Interest Rate in the Public Mind
The theory presumes that real interest rates are natural concepts
to use to describe public decisions. However, in fact, the real
interest rate is not even a concept that many people use to frame their
decision-making when they think about asset prices.
The concept of the real interest rate dates back to 1895 with
Columbia University economics professor John Bates Clark whose name is
memorialized in a prestigious economics medal that the American
Economic Association awards today. In describing the concept, he seemed
to be presenting it as a strikingly original new idea that he needed to
explain at some length. He wrote about a widespread confusion, that he
discerned in the then-current debate about bimetallism, about the
interpretation of interest rates. Discussing the example of a debtor in
an environment with 1 percent deflation, he noted that ``If he pays a
nominal rate of five percent in interest, he may pay a real rate of
six.'' \19\ But, his use of ``real rate'' was apparently not convincing
enough to coin a new popular term. In the following year, 1896, Yale
University's Irving Fisher wrote about the same popular confusion, but
did not use the term ``real rate'' but instead ``virtual interest in
commodities.'' He also noted the lack of public understanding of the
basic concept: ``It is an astonishing fact that the connection between
the rate of interest and appreciation has been almost completely
overlooked, both in economic theory and in its bearing upon the
bimetallic controversy.'' \20\ He was right to be astonished, for
indeed the significance of any interest rate depends critically on the
inflation rate, and quoting nominal interest rates alone may be
regarded as almost meaningless.
---------------------------------------------------------------------------
\19\ Clark (1895) p. 62.
\20\ Fisher (1896) p. 4.
---------------------------------------------------------------------------
Clark's long discourse on the elementary concept of real interest
rates and Fisher's astonishment at the lack of public understanding
reflect their recognition of the importance of what today are
classified as behavioral biases in popular economic thinking, notably a
bias called ``money illusion,'' a term coined by Fisher in 1928. But,
failure to think in terms of real interest rates rather than nominal
rates, while it may be described as an ``illusion,'' is perhaps better
described as just an abject failure to understand the concept. The
concept of real interest rate remains totally absent from the popular
model of the economy.
Indeed, long after they first discussed it, the concept of the real
interest rate still did not even enter the language. People need to
understand the concept of real interest rate if they are to make the
dynamic Gordon model work. If they cannot grasp the concept, then it is
hard to see how they will immunize themselves from the money illusion
described by Modigliani and Cohn.
Modigliani and Cohn made it part of their argument in 1979 that
stock prices are determined by nominal, not real rates, that few news
media or business people ever refer to the concept of real interest
rates for the discounting of future corporate cash flows or to the
correction that must be made to corporate earnings for the real value
of the interest owed by the corporation:
. . . the financial press kept asserting that earnings-price
ratios had to be compared with nominal interest rates, while
not even mentioning the fact that profits of firms with large
debts should be adjusted for the inflation premium. To be sure,
the financial press may not be the best source of information
about how investors value equities. We therefore endeavored to
secure recent memoranda from large brokerage firms advising
institutional investors; in virtually every case, it was clear
that analysts did not add back to earnings the gain on debt,
and that they also relied at least partly on the capitalization
of earnings at a nominal rate.\21\
---------------------------------------------------------------------------
\21\ Modigliani and Cohn (1979) p. 35.
With modern day search procedures, we can do a more thorough job of
discovering how often nominal interest rates are corrected for
inflation. Based on a Proquest search of major newspapers, we found
that the term ``real interest rate'' was first used in the popular
press in the modern meaning, quoting an Institute of Life Insurance
study, in 1946, fifty years after the concept was established in
professional economics journals.\22\ The words ``real interest rate''
were occasionally used before that to refer to other things (for
example in criticizing bad lending practices that calculated interest
rates from a fictitious base).
---------------------------------------------------------------------------
\22\ Christian Science Monitor, `` `Real Return' on Saving Found 43
P. C. below 1939,'' November 26, 1946, p. 15.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Figure 8. Number of US newspaper articles that mention ``real interest
rate'' as percent of number of newspaper articles that mention
``interest rate,'' annual data, in two databases, Proquest historical
and Proquest modern. Also shown are the inflation rate (CPI-U change
from December of preceding year to December of year, except for 2007
which shows annualized six-month change for first half of year), and
the ten-year government bond yield. Source: author's calculations using
data from Proquest, U.S. Bureau of Labor Statistics, and U.S. Federal
---------------------------------------------------------------------------
Reserve.
Figure 8 shows the relative incidence of the term ``real interest
rate'' when used in its modern meaning in US newspapers in the Proquest
Newspapers data bases (historical and modern) relative to ``interest
rate'' since 1960. Between 1890 and 1960 there was only one reference
to real interest rates (as noted above, in 1946). The frequency of
references to real interest rates has been extremely low, never more
than a few percent of references to interest rates. Even those levels
of references to real interest rates have been dropping off
precipitously. The concept of ``real interest rate'' appears to have
had its day and is dying. Note that the frequency of use of ``real
interest rate'' picked up with the inflation of the 1970s, but can
hardly be described as an automatic response to high inflation since
there were earlier high inflation periods that had no use of the term.
It was suggested that perhaps the term ``real interest rate'' has
merely been replaced over time by ``interest rate adjusted for
inflation'' and so that Figure 8 might misrepresent the actual use of
the concept of real interest rate. But the term ``interest rate
adjusted for inflation'' is self explanatory, does not assume reader
knowledge of any concept and so does not seem to be as relevant to
search on as ``real interest rate.'' Nevertheless, I did a search among
newspapers in the Proquest Modern data base for ``interest rate
adjusted for inflation'' or ``inflation adjusted interest rate'' or
``inflation-adjusted interest rate.'' These terms together are indeed
much rarer than ``real interest rate,'' and articles that mentioned any
of these terms never amounted to 0.25 percent of the number of articles
that mentioned ``interest rate.'' Moreover, the pattern of the usage of
these terms is much the same as shown in Figure 1, declining in recent
years, though usage of these terms as a fraction of usage of ``interest
rate'' peaked somewhat later, in 1990.
Figure 9 shows the use of the term real interest rate in annual
reports in the Proquest data base of corporations' annual reports,
within 5-year time periods at 5-year intervals. The same spike in usage
of the term appears in these reports in 1980-4. Remarkably, not a
single annual report used the term ``real interest rate'' in 1995-9 or
2000-4, among over 2000 annual reports in the database in both of those
5-year intervals.\23\ As with the newspaper data set, the number of
annual reports that used the term ``real interest rate'' peaked at only
1.8 percent of the number of annual reports that used the term
``interest rate.'' Note also that the word ``interest rate'' has grown
dramatically over this sample, from 17.7 percent of annual reports in
1960 to 93.5 percent in 1980, and has stayed at around 90 percent ever
since. The effect of the 1980 interest rate peak had its effect on both
``real interest rate'' and ``interest rate,'' but the effect was
permanent only on the latter.
---------------------------------------------------------------------------
\23\ A search was done in the same annual report database for
``interest rate adjusted for inflation,'' or ``inflation adjusted
interest rate,'' or ``inflation-adjusted interest rate.'' Amazingly,
none of these terms was ever used in any annual report in this
database.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Figure 9. Number of annual reports in which real interest rates are
mentioned as a percent of the number of annual reports in which
interest rates are mentioned. Also, number of annual reports which
mention interest rates as a percent of the number of annual reports in
the database, five-year intervals from 1960-64 to 2000-2004. Source:
author's calculations using Proquest Annual Report Database. [9/9/07
---------------------------------------------------------------------------
revision]
We have been unable to find any single thought leader who was
particularly associated with the explosion around 1980 in the use of
the ``real interest rate.'' It appears that the term sprang into sudden
popularity after 1980, peaking in 1983, when there was a major jump in
the real interest rate after the aggressive Volcker monetary policy,
which resulted in the early years of the 1980s in a sharp fall in
inflation even as nominal interest rates were kept high. The real
interest rate concept became suddenly interesting because real interest
rates has moved so much so fast, and because the movement was
associated with aggressive actions by the monetary authority. Perhaps
too it got some interest because of the story-quality of the dramatic
figure of Paul Volcker on his mission to break the cycle of inflation,
although Volcker was never quoted in the news media from 1979 to 1981
using the term himself. But the abstract concept of real interest rates
fell out of public consciousness after its movements turned into a
gradual fall with no dramatic story connected with it.
The real interest rate concept still seems highly relevant in
judging the high asset prices we observe, but the public won't buy it.
I know this from personal experience, when I talk with news reporters
and attempt to refer to the concept. They listen patiently and change
the subject, and sometimes even offer that their readers don't relate
to such a concept.
The Treasury Inflation-Protected Security (TIPS) market started in
the US in 1997. The term ``real interest rate'' did not take off with
the development of this market. The US Treasury does not use the term
``real interest rate'' in association with their sale and marketing,
instead they refer just to ``yield'' on the Inflation-Indexed Security.
The stark reality and central importance suggested by John Bates
Clark's term was never suggested by the words that surround TIPS. Part
of the relative lack of popularity of TIPS (only 8 percent of the US
Federal national debt) is that they have not been marketed as solving
fundamental problems or providing important price discovery.\24\
---------------------------------------------------------------------------
\24\ According to Treasury Bulletin, federal debt securities held
by the public first passed $5 trillion in February 2007 (Table FD-1),
and in that month TIPS amounted to $411 billion (Table FD-2). Federal
Reserve Flow of Funds Accounts, Table B100, show household net worth at
$56.2 trillion in the first quarter of 2007, and hence TIPS amount to
well under 1 percent of net worth, and even that held largely by
institutions and foreigners.
---------------------------------------------------------------------------
In my book New Financial Order: Risk in the 21st Century (2003) I
argued that governments around the world should adopt new units of
measurement for real values, indexed units of account, like the Unidad
de Fomento that Chile adopted in 1967, and educate their publics to use
these units for contracts instead of currency. I proposed that the
units be called ``baskets'' so that people can appreciate that by
trading in these terms, they are trading in the market baskets that
underlie the consumer price index. Only a major step like this could
eliminate money illusion. Needless to say, no country has taken my
advice.
The Recent Quietness of Markets
Stock markets in many countries of the world have been
extraordinarily quiet during the current boom. Figure 10 shows the 100-
day moving standard deviation of 1-day stock market returns using the
S&P 500 (composite before 1957) index from January 4, 1950 to August
10, 2007. The period since 2003 stands out for its low standard
deviations. Even the big stock market moves of February 27 2007 and
August 9 2007 did not bring the standard deviation up very much. There
was a tremendous buildup of volatility during the 1990s boom, followed
by an enormous letdown in volatility.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Figure 10. Moving average 100-day (ending on date shown) standard
deviation of the percentage change in the S&P 500 (Composite before
1957) Stock Price Index. Source: author's calculations using data from
Standard & Poor's.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Figure 11. One-hundred day moving standard deviations of daily price
changes, daily data December 19, 1984 to August 10, 2007, seven
countries. Source: author's calculation using closing prices nominal
stock price indices, S&P 500, ASX All-Ordinaries, BSE 30, Nikkei 100,
Dax, CAC 40, Bovespa, FTSE 100.
The decline in volatility is a striking reminder that factors other
than the discount rate stand a good chance of playing a major role in
producing high asset prices. For the Gordon model if anything suggests
just the opposite from quietness in the markets, since if interest
rates used to discount in present value formulas are low, then unless
there is less variability in the news about future dividends,
volatility should be higher. Fluctuations in g in Gordon's formula will
have a bigger impact on price if r is smaller. This point was stressed
recently by Gyourko, Mayer and Sinai to explain the higher volatility
of home prices, but it works the wrong way in explaining the lower
volatility of stock prices.\25\
---------------------------------------------------------------------------
\25\ Gyourko Mayer and Sinai (2006).
---------------------------------------------------------------------------
Conclusion
We have seen here that the big movements in stock prices and real
estate prices in the last decade or so do not line up with movements in
long-term interest rates over the same time period. This appears to
confirm the 1988 results of Campbell and Shiller that stock prices
relative to dividends or earnings are not well explainable in terms of
present value models with time-varying interest rates. Yet if we are
doing very broad comparisons of the present time with another time,
comparing the early 1980s when interest rates were very high with
today, we might say that lower nominal interest rates are indeed a
factor in the relatively higher asset prices we see today.
The Modigliani and Cohn (1979) money-illusion theory of stock
prices has always seemed a little unsatisfactory since it describes
people as understanding enough about inflation so as to push nominal
rates up in high inflation periods but not understanding it well enough
that they should realize that these high nominal rates should not be
used to discount today's dividend into a low price. It may not seem
like a sound approach to economic theorizing to assume that people
understand some applications of a concept and not others.
But we have seen above that people do not even talk about the
concept of real interest rates today, and so it certainly stands as
plausible that they would be vulnerable to errors in handling all
ramifications of the concept equally well. The natural framing of stock
market reports involves dividend-price ratios and earnings-price
ratios, which are already framed so that they can easily be compared
with nominal interest rates. Moreover, public understanding about a
world ``awash with liquidity'' may be reinforced by their perception of
an era of low nominal rates, and may help reinforce errors in pricing.
Behavioral economics has always had to confront a public's partial
understanding of economic concepts, of mental compartments, of framing
effects that distort judgment.
This paper has discussed one simple explanation of the asset booms
since the mid 1990s, that they are a direct consequence of falling
long-term interest rates. I have not offered another theory of the high
asset prices. Presumably, as I discussed in Irrational Exuberance,
there are many factors, including speculative feedback, that have
contributed to high asset prices today.
This paper began by considering a certain common belief about the
way the world works which was motivation for this paper. We see that
the idea that we should think of the level of long-term real interest
rates as the dominant force in driving long-term asset prices up or
down is not supported by the evidence.
References
Adrian, Tobias, and Hyun Song Shin, ``Liquidity and Financial Cycles,''
presented at 6th BIS Symposium: Financial System and Macroeconomic
Resilience, Brunnen, Switzerland, June 18, 2007.
Blanchard, Olivier J., and Lawrence H. Summers, ``Perspectives on High
World Real Interest Rates,'' Brookings Papers on Economic Activity,
1984-2 pp. 273-324, 1984.
Blanchard, Olivier J., ``Movements in the Equity Premium,'' Brookings
Papers on Economic Activity, 2-1993, pp. 75-118.
Brainard, William C., Matthew D. Shapiro and John B. Shoven,
``Fundamental Value and Market Value,'' Money, Macroeconomics and
Economic Policy: Essays in Honor of James Tobin, Cambridge MA: MIT
Press, 1991.
Brainard, William C., John B. Shoven and Lawrence Weiss, ``The
Financial Valuation of the Return to Capital'' Brookings Papers on
Economic Activity, 2:453-511, 1980.
Brainard, William C., and James Tobin, ``Asset Markets and the Cost of
Capital,'' in Richard Nelson and Bela Balassa, Editors, Economic
Progress, Private Values and Public Policy: Essays in Honor of
William Fellner, Amsterdam: North Holland, 1977.
Brainard, William C. and James Tobin, ``Pitfalls in Financial Model
Building,'' American Economic Review Papers and Proceedings, 58:99-
102, May 1968.
Brunnermeier, Markus, and Christian Julliard, ``Money Illusion and
Housing Frenzies,'' unpublished paper, Princeton University, June
7, 2007.
Campbell, John Y., Kermit Schoenholtz and Robert J. Shiller, ``Forward
Rates and Future Policy: Interpreting the Term Structure of
Interest Rates, Brookings Papers on Economic Activity, pp. 173 224,
1 1983.
Campbell, John Y. and Robert J. Shiller, ``Stock Prices, Earnings, and
Expected Dividends,'' Journal of Finance, 43:661-76, 1988.
Clark, J. B., ``The Gold Standard of Currency in the Light of Recent
Theory,'' Political Science Quarterly, 10(3):383-97, September
1895.
Fisher, Irving, ``Appreciation and Interest,'' Publications of the
American Economic Association, 11(4):1-98, July 1896.
Fisher, Irving, The Money Illusion, New York: Adelphi, 1928.
Friedman, Irving S., Inflation: A Growing World-Wide Disaster, Garden
City: Anchor Books, 1975.
Friedman, Milton, Inflation and Unemployment: The New Dimension of
Politics, Transatlantic Arts, 1977.
Goodfriend, Marvin, and Robert King, ``The Incredible Volcker
Disinflation,'' NBER Working Paper No. 11562, August 2005
Gordon, Myron, The Investment, Financing and Valuation of the
Corporation, Homewood Illinois: Irwin, 1962.
Gordon, Robert J., ``The Recent Acceleration of Inflation and Its
Lessons for the Future,'' Brookings Papers on Economic Activity, I-
8-47, 1970.
Gyourko, Joseph, Christopher Mayer and Todd Sinai, ``Superstar
Cities,'' Cambridge MA: National Bureau of Economic Research
Working Paper No. 12355, July, 2006.
Kindleberger, Charles P., and Robert Z. Aliber, Manias, Panics and
Crashes: A History of Financial Crises, Fifth Edition, Palgrave-
MacMillan, 2005.
Modigliani, Franco, and Richard Cohn, ``Inflation, Rational Valuation,
and the Market,'' Financial Analysts Journal, pp. 22-44, March-
April 1979.
Okun, Arthur M., ``Efficient Disinflation Policies,'' American Economic
Review, 68:348-52, May 1978.
Shiller, Robert J., Irrational Exuberance, 2nd Edition, Princeton:
Princeton University Press, 2005.
___, ``Speculative Prices and Popular Models,'' The Journal of Economic
Perspectives, 4(2):55-66, Spring 1990.
___, ``Stock Prices and Social Dynamics,'' Brookings Papers on Economic
Activity, pp. 457 98, 2 1984.
___, ``Understanding Recent Trends in House Prices and Home
Ownership,'' paper presented at the Federal Reserve Bank of Kansas
City's Jackson Hole Symposium, August 31-September 1, 2007
Tobin, James, ``Money, Capital, and Other Stores of Value,'' American
Economic Review, 51:26-37, 1961.
Wolf, Martin, ``Who are the Villains and the Victims of Global Capital
Flows?'' Financial Times, June 13, 2007, p. 11.
__________
Prepared Statement of Martin Eakes, CEO, Center for Responsible Lending
Chairman Schumer, Ranking Member Saxton, Vice Chair Maloney, and
members of the Committee, thank you for holding this hearing to focus
on how the alarming rate of losses on subprime mortgages is affecting
consumers, the U.S. economy, and global financial markets. We commend
you for focusing on the problem and seeking positive solutions.
I testify as CEO of Self-Help (www.self-help.org), which consists
of a credit union and a non-profit loan fund. For the past 26 years,
Self-Help has focused on creating ownership opportunities for low-
wealth families, primarily through financing home loans. Self-Help has
provided over $5 billion of financing to over 55,000 low-wealth
families, small businesses and nonprofit organizations in North
Carolina and across the country.
Self Help is a subprime lender, and our loan losses have been less
than one percent per year. We are small compared to the commercial
finance companies that have produced most subprime loans, but we, too,
provide mortgages to people who have lower incomes and credit
blemishes. The biggest difference is that we avoid making loans that
begin, from the first day, with a high chance of failing; we assess
whether the borrower can pay the loan back; and we structure the loan
in a way that promotes sustainability. This is Risk Management 101, a
course that lenders in the prime market have followed for decades.
In addition to my experience with Self Help, I am also CEO of the
Center for Responsible Lending (CRL) (www.responsiblelending.org), a
not-for-profit, non-partisan research and policy organization dedicated
to protecting homeownership and family wealth by working to eliminate
abusive financial practices. We work with many other concerned groups
to eliminate predatory lending practices and encourage policies that
protect family wealth.
During these past few months--as subprime foreclosures shot up to
alarming levels, as over 100 mortgage companies closed their doors and
laid off tens of thousands of employees, as investments collapsed and
banks on several continents felt compelled to take action--the mortgage
industry has tried to downplay the enormous damage caused by reckless
subprime lending.
I. State of the Market
Today I want to make these points:
The rate of foreclosures on subprime loans is severe.
The problem of foreclosures on subprime mortgages is widespread,
and has already had a significant negative impact on people with and
without subprime mortgages, as well as the economy at large.
Subprime foreclosures will get much worse in the near future.
Tightening of credit has been caused by an industry that has run
too loosely and without sufficient regulation.
Market forces are not correcting the situation.
The impact on homeowners is devastating. We provide one real-life
example out of millions.
II. Policy Recommendations
The good news is that workable solutions exist. On the most basic
level, we need to ensure that lenders return to common-sense lending
that is likely to produce sustainable homeownership. At the same time,
we need to do all we can to minimize the damage to families who are
struggling today. Our policy recommendations focus on two major areas.
a. protecting homeowners in the future
First, we need strong predatory lending protections to protect
homeowners in the future. These include a number of measures that have
already been incorporated into state laws and/or guidance issued by
regulators.
Require lenders to determine that their customers have the
ability to repay the loan at the fully indexed rate, assuming fully
amortizing payments.
Require lenders to verify a customer's income using tax
documents, payroll or bank records, or other reasonable documentation.
Require lenders to escrow for real estate taxes and property
insurance.
Ban prepayment penalties and yield-spread premiums on subprime
loans.
Eliminate steering families into unnecessarily expensive loans.
Hold lenders responsible for abusive lending practices,
regardless of whether the loan was originated by the lender or mortgage
brokers.
Hold mortgage brokers accountable for abusive lending practices
by establishing rigorous affirmative duties to serve the best interests
of their customers.
Through assignee liability, hold investors accountable for the
loans they support.
Allow the states to continue to take actions to prevent predatory
lending.
b. protecting homeowners now threatened with foreclosure
Second, we need to employ sensible strategies to minimize the
devastation caused by bad loans that have already been made by helping
families avoid foreclosure. In recent weeks, some have tried to frame
sensible solutions as a ``borrower bail-out.'' This is absurd. First,
any effective measures for addressing the foreclosure crisis will not
only help homeowners, they will help entire communities and the
nation's economy as a whole. Second, no one is proposing to remove all
debt obligations from homeowners--families will still need to make
timely mortgage payments. We and other concerned groups are proposing
policy solutions that center on these actions:
Direct servicers and lenders to make meaningful and sustainable
modifications to existing loans.
Eliminate an anomaly in the Bankruptcy Code, which currently
allows judges to modify unaffordable mortgages on a vacation home or
investment property, but not on the homeowner's primary residence.
III. State of the Market--Discussion
a. the foreclosure problem is severe.
Every credible quantification of subprime foreclosures reveals that
the problem is severe. The 2nd Quarter National Delinquency Survey,
recently released by the Mortgage Bankers Association (MBA), shows that
foreclosures on all types of loans have increased, but, as expected,
foreclosures in the subprime market are most severe. New foreclosures
on subprime adjustable-rate loans in the second quarter 2007 are 90%
higher than the same time last year, compared with a 23% increase on
prime fixed-rate loans.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
At the same time, the MBA's ``point in time'' foreclosure
statistics mask the extent of the foreclosure problem, because their
figures fail to include the high number of subprime loans that were
originated recently and have yet to enter their peak foreclosure years.
CRL issued a study in December 2006 (``Losing Ground'' \1\) estimating
that one out of every five subprime mortgages made in 2005 and 2006
ultimately will end in foreclosure. This projection refers to actual
homes lost, not late payments or foreclosures started but not
completed.
When we released our report on subprime foreclosures, the lending
industry claimed that our findings were overly pessimistic. Even today,
the Mortgage Bankers Association continues to insist that the
foreclosure problem is relatively small, and that only about 250,000
households with subprime mortgages will lose their homes. Their figure
comes from a mis-reading of the research described in the Losing Ground
report. As shown here, CRL's estimate is in line with other credible
projections:
----------------------------------------------------------------------------------------------------------------
Projected # Projected
Loans Analyzed # Loans in Analysis Foreclosure Rate Foreclosures
----------------------------------------------------------------------------------------------------------------
MBA.............................. Not disclosed...... Not disclosed...... Not disclosed...... 250,000
CRL.............................. Subprime loans, 5,800,000.......... 19.4%.............. 1,125,000
owner-occupied
properties, 2005 &
3Qs 2006.
First American Real Estate All adjustable rate 7,700,000.......... 14.3%.............. 1,100,000
Solutions. mortgages issued
in 2004 & 2005\2\.
Lehman Brothers.................. Subprime loans, 4,000,000\4\....... 30%................ 1,200,000
2006 vintage
only\3\.
Moody's Economy.com.............. All loans\5\....... Not disclosed...... Not disclosed...... 1,700,000
----------------------------------------------------------------------------------------------------------------
By any measure, these estimates represent an epidemic of home
losses. These foreclosures will not only harm the families who directly
lose their homes, but the ripple effects have already begun to extend
to the wider local, national and international communities.
b. the foreclosure problem is widespread.
The MBA's recent delinquency report also shows that mortgage loans
entering foreclosure have increased in 47 states since this time last
year. On average, the increases were 50% higher. Only four states--
North Dakota, South Dakota, Utah and Wyoming--did not experience
increases in new foreclosures. Less than two percent of the American
population live in those states.
When releasing the survey, the MBA downplayed new foreclosures by
focusing only on changes between the last two quarters. But any minor
changes from one quarter to the next are largely meaningless. The
foreclosures occurring today are the worst they've been in at least 25
years. In essence, the MBA's defense of a dismal situation is, ``The
house is on fire, but the temperature has dropped by three degrees in
most rooms.''
The MBA has also been quick to claim that the performance of
subprime loans is primarily a result of local economic conditions, not
loan products or underwriting practices. In fact, it is not an either-
or proposition. Local economic conditions can affect house prices
appreciation and unemployment levels, which affect foreclosure rates.
However, subprime loans have typically included features that are known
to increase the rate of foreclosure. Economic studies and empirical
research also have shown that the incidence of foreclosure escalates
quickly due to ``layered risk'' factors (e.g. low downpayments, high
debt-to-income ratios, adjustable interest rates, etc.)--exactly the
types of loans that have dominated the subprime market in recent years.
Furthermore, if local economic conditions were the dominant factor
in subprime loan performance, then there would be little distinction
between the performance of subprime loans and FHA loans, which are also
aimed at riskier borrowers. However, the MBA's own statistics show
subprime loans perform worse than FHA loans in the same market:
----------------------------------------------------------------------------------------------------------------
% of Outstanding Loans in Foreclosure at end of
2Q 2007
-------------------------------------------------
Subprime FHA
----------------------------------------------------------------------------------------------------------------
Northeast..................................................... 5.76 2.42
North Central................................................. 8.76 3.45
South......................................................... 4.50 1.76
West.......................................................... 4.40 1.23
United States................................................. 5.52 2.15
----------------------------------------------------------------------------------------------------------------
Source: MBA National Delinquency Survey, 2Q 2007
Lastly, the MBA has claimed that defaults on non-owner occupied
properties are the major driver for increased subprime foreclosures.\6\
However, 88% of foreclosures are suffered by people living in their
primary residence.\7\ A higher rate of foreclosures on investor
properties is not a new development--default risks have always been
significantly higher for investor properties compared with owner-
occupied homes.\8\ We question why the MBA is surprised by this result,
if lenders were making subprime loans with loose underwriting standards
to this even-riskier class of borrower. Moreover, this type of lending
did nothing to increase homeownership, and instead fueled speculative
home-buying, short-term run-ups in house prices, and now increased
foreclosures and falling home values that are hurting all the families
in these neighborhoods.
The cost of the subprime problem extends far beyond lost homes and
ruined neighborhoods with dropping property values. Over 100 mortgage
lenders already have gone out of business and thousands of workers have
lost their jobs. It's harder for mortgage lenders and firms in other
business lines to get credit from once-burned, twice-shy investors. The
stock market is increasingly volatile and the housing market is facing
its first national decline since house prices started being measured in
the 1950s. All these factors spell slower (or even negative) economic
growth in the U.S and--with German banks worried about subprime loans
made in Chicago--bleak prospects for help from players in other global
financial markets.\9\ (See Appendix 1 for a list of mortgage firms
sold, closed, or bankrupt as of the end of August, as well as a list of
other financial transactions affected by the credit crunch.\10\)
c. subprime foreclosures will get much worse in the near future.
It is important to recognize that while the rate of subprime
foreclosures is alarming today, the worst is still ahead. With as many
as 1.7 million foreclosures predicted to occur in the next two to three
years,\11\ it is imperative that Congress take action to assist
homeowners struggling today, not just protect future subprime
borrowers.
Even with the recent modest cut in interest rates, many subprime
borrowers will face 40 percent or greater increases in their monthly
mortgage payments once their initial ``teaser'' rates expire and their
fixed interest rates reset into higher-rate variable rates. As the
chart below shows, a large majority of these rate resets will occur in
early 2008.\12\
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
d. tightening of credit has been caused by an industry that has run too
loosely and without sufficient regulation.
The mortgage industry has argued for years that regulation of
subprime lending would have the unintended consequence of restricting
credit. Today it is apparent that the current tightening of credit has
been caused by the lack of adequate regulation and the reckless lending
that followed. If subprime lenders had been subject to reasonable
rules--the kind of rules that responsible mortgage lenders in the prime
market have always followed--it is safe to say we would have avoided
the massive problems we are seeing today.
It is possible to structure subprime loans in such a way that
homeowners have a high chance of achieving sustainable ownership.
Unfortunately, that's not what most subprime lenders have done in
recent years. In fact, they have done the opposite. Typical subprime
mortgages have been refinances that include adjustable interest rates,
prepayment penalties, and little or no documentation of the borrower's
income. In the ``Losing Ground'' study, we examined subprime mortgages
made from 1998 through 2003 to assess the relationship between specific
loan characteristics and the loan's performance. As shown in the chart
below, the typical features on subprime mortgages are strongly linked
with higher rates of foreclosure:
% Increase in Foreclosure Risk for Specific Loan Features by Annual Loan Cohort\13\
(Positive numbers indicate higher risk, after controlling for borrower credit scores)
----------------------------------------------------------------------------------------------------------------
1998 1999 2000 2001 2002 2003
----------------------------------------------------------------------------------------------------------------
ARM vs. Fixed-Rate Loan........... 123.31*** 86.03*** 72.03*** 61.80*** 77.85*** 117.11***
Balloon vs. Fixed-Rate Amortizing 75.67*** 51.77*** 36.02*** 21.66*** 14.08* 85.92***
Loan.............................
Loan with Prepayment Penalty vs. 70.4*** 65.0*** 52.4*** 35.8*** 25.8*** 18.7***
Loan with No Prepayment Penalty..
Loan with No or Low Documentation 5.57** 19.02*** 29.00*** 25.75*** 44.72*** 63.69***
vs. Full-Doc Loan................
Purchase Money Loan vs. Refinance 19.3*** 20.7*** 28.5*** 37.9*** 61.0*** 102.0***
Loan.............................
----------------------------------------------------------------------------------------------------------------
Confidence levels: * = 95%, ** = 99%, *** = 99.9%. Detailed results available upon request.
This table shows that, even after controlling for a homeowner's
credit score, typical subprime loans increase the chance of loan
failures. For example, on adjustable-rate mortgages compared with
fixed-rate mortgages, the foreclosure rate was 62-123% higher. Loans
with prepayment penalties carried a higher foreclosure risk ranging
from 19% to 70%.
Some of these loan characteristics can work fine for homeowners
when their lenders have carefully evaluated the loan's risk. For
example, adjustable-interest rates are a reasonable option for families
that are not already stretched to make their payments or those who
expect a future increase in income. But in recent years, the subprime
market became dominated by adjustable rate mortgages that allowed
families no chance to sustain them: they were set only to go up, could
not go down, and had such high margins (6% to 6.5%) over a cost of
funds index (LIBOR) that they quickly jumped to highly unaffordable
levels (currently 12% plus). Further, typical subprime loans included
multiple higher risk features that became even more lethal when packed
together in one loan. The 2-28 subprime ``exploding ARMs'' comprised
``nearly 80% of subprime originations in 2006.'' \14\
For the past decade, subprime lenders have been aggressively
marketing these dangerous loans and touting the easy availability of
mortgages. Now, because of their actions, the market is tighter for
everyone.
e. market forces are not correcting the situation.
Normal market forces are not correcting the subprime crisis. That's
because the subprime mortgage market as currently structured doesn't
have adequate incentives to police itself; in fact, subprime lenders
continue to have strong incentives to make harmful loans. Consider
these facts:
Mortgage brokers, who make approximately 70% of subprime
mortgages, are not required to offer loans that are in the borrowers'
best interests.
Subprime mortgage lenders provide financial incentives
(compensation for interest rate bumps, called ``yield-spread
premiums'') to mortgage brokers for putting borrowers in higher
interest loans than they deserve. Lenders also provide brokers
incentives to include prepayment penalties costing thousands of dollars
and carrying significantly higher chances of foreclosure.
Lenders, until recently, reaped huge profits by ignoring a
homeowner's ability to repay the loan and/or neglecting to document the
homeowner's income.
Unscrupulous lenders gain a competitive advantage over honest
lenders when they exclude the costs of taxes and insurance from monthly
mortgage payments.
Lenders make more money when they steer people into subprime
loans--even when those people are qualified for a lower-cost prime
loan.
Since loans typically pass from brokers to lenders to investors,
it has been easy to avoid accountability for abusive mortgages.
All of these market incentives point in one direction: If the
subprime market continues running without any rules, borrowers will
continue to receive abusive loans that lead to foreclosure. The market
may tighten up temporarily, but with these perverse incentives firmly
in place, future abuses are inevitable.
We support responsible subprime lending, in fact, we've done it
since 1985, but we are opposed to the reckless way that subprime
lending has been conducted in recent years. When subprime mortgages are
made with care, they are a valuable tool for giving families a secure
foothold in the middle class. Sustainable homeownership is one of the
best options for helping struggling families. But offering a false
promise of homeownership is like serving tainted water. If we care
about sustainable homeownership, and if we want good credit to be more
abundant in the future, then we need to require lenders to return to
common-sense loan assessments.
f. the impact on homeowners is devastating.
The subprime meltdown has affected markets around the world, but
the markets are likely to recover faster and more completely than
families who lose their homes to foreclosure. Consider the case of the
McGowan family in Gastonia, North Carolina, who recently lost their
home to foreclosure in spite of all their best efforts to make payments
on a loan they never should have received. Butch McGowan worked as a
fire fighter for many years and his wife, Cynthia, was a police
dispatcher. They have two children, including a daughter who has had
multiple brain surgeries. They have no credit card debt, but because of
their health issues, they have carried debts related to medical
expenses.
The McGowan family desperately wanted a home of their own, and in
2006, they were very excited when they were told they qualified for
financing. When they went to close on the loan, they were expecting to
receive a fixed-rate mortgage with an interest rate of 6.75%. Instead,
the lender rushed in late and said, ``9.75% is the best we can do. Oh,
and by the way, the rate will go up even higher in six months--but
don't worry you can refinance.''
``You can refinance'' became the refrain of subprime lenders during
the lending frenzy we have experienced during the past few years.
Homeowners were told not to worry about loans that would have
unaffordable increases in interest rates because ``you can refinance.''
Lenders continued to say this even when concerns about an overheated
housing market were pervasive and even when it was doubtful that
borrowers would have enough equity to support a refinance. Subprime
lenders didn't have anything to lose. If they could refinance the
borrower, they made more money. If a refinance wasn't possible--which
is often the case when prices flatten or drop--well, it was
unfortunate, but it didn't really affect the lender, since they had
long ago sold the loan to Wall Street. These practices eventually
caught up with virtually all stand-alone subprime lenders over the past
several months, but that is small consolation to the McGowans and
millions more like them.
To make matters worse for the McGowans, they were told their
mortgage payment included property taxes and hazard insurance, but it
did not. Even knowing that the McGowans were on a limited, fixed
income, the lender failed to escrow for costs the family would be
required to pay. The McGowans closed on their mortgage thinking they
could somehow find a way to manage a loan at 9.75% until the promised
refinance came through. But adding taxes and insurance on top of an
expensive loan tipped them over the edge, and even though Mr. and Mrs.
McGowan tried their best, they simply couldn't make the payments. The
McGowans have used up all their retirement funds, and they are never
sure from one week to the next they will have enough money for
groceries.
Mrs. McGowan sums up the situation when she says this: ``The only
thing I wanted to do is to try to fix something for my children to have
after we are gone. And now that we've used all of our 401Ks and 457s,
there is not much left if we can't hold on to something.'' \15\
IV. Policy Recommendations--Discussion
It is not too late to help families such as the McGowans, and also
to prevent abusive subprime mortgages in the future. Both the Federal
Reserve Board and Congress have authority to make lenders accountable
for reckless lending that harms homeowners, businesses, and investors.
As described earlier, the market is structured in a way that encourages
brokers and lenders to ignore the quality of mortgage loans and their
likelihood of success. These perverse incentives call for reasonable,
common-sense interventions.
Our policy recommendations focus on two major areas. First, we need
strong predatory lending protections to help homeowners in the future.
These items, listed in our summary, include a number of measures that
have already been incorporated into state laws and/or guidance issued
by regulators.
Second, we need to employ sensible strategies to minimize the
devastation caused by bad loans that have already been made by helping
families avoid foreclosure. In recent weeks, some have tried to frame
sensible solutions as a ``borrower bail-out.'' This is absurd. First,
any effective measures for addressing the foreclosure crisis will not
only help homeowners, they will help entire communities and the
nation's economy as a whole. Second, no one is proposing to remove all
debt obligations from homeowners--families will still need to make
timely mortgage payments. We and other concerned groups are proposing
policy solutions that center on these actions:
We discuss these recommendations in more detail in the following
sections.
a. avoiding tomorrow's crisis: preventing future foreclosure epidemics
and associated losses.
Today's crisis in the subprime market was driven by three core
market failures. First, the subprime industry forgot the fundamentals
of its own business-it failed to underwrite the loans, and failed to
assess whether there was an ability to pay the loan. Second, this
market lacked competition in the traditional sense. Rather, there were
perverse incentives to compete for the business of the middlemen, and
for the middlemen to deliver to investors higher-priced and more
dangerous products. Finally, the subprime mortgage market lost
accountability. Both legal accountability and the accountability
resulting from market discipline disappeared into a vacuum created by
lack of regulation and securitization. Here we propose reforms that
would address each of these issues.
To restore common sense underwriting and assure ability to pay:
Require lenders to determine that the borrower has the ability to
repay the loan at the fully indexed rate, assuming fully amortizing
payments. The payment shock associated with adjustable rate or non-
fully amortizing loans must be taken into account.
At a minimum, underwriting on adjustable rate mortgages must assess
ability to pay on a fully-indexed interest rate, assuming fully
amortizing payments.\16\ Common public understanding of the mortgage
system assumes that lenders underwrite loans and would not make loans
to borrowers who do not have the ability to repay them. In the face of
an increasingly complicated market and complex products, this reliance
on the expertise of the originator and underwriter is not only
understandable, it is important for the efficiency and credibility of
the industry. This is the case whether the loan is originated by the
lender or by a broker.
Federal banking regulators issued strong guidance requiring
depositories and their affiliates to underwrite loans at the fully
indexed interest rate to ensure that borrowers will be able to repay
their mortgages. We need a clear standard in place that applies that
same concept to the whole subprime market. Congress should provide a
clear guideline for lenders by setting a rebuttable presumption that a
debt-to-income ratio (encompassing a family's housing expenses and all
other monthly obligations) of 50% or higher is unaffordable. Without a
debt-to-income ratio presumption, lenders can simply increase their
debt-to-income ratio lending standards commensurately to underwriting
to the fully indexed rate, to a clearly unaffordable level, and then
argue that they met the fully indexed standard.\17\
Legislation requiring the determination of a borrower's ability to
repay should be based on these principles:
(1) Lenders must consider an applicant's ability to repay the loan
according to its terms and based on a fully-amortizing repayment
schedule.
(2) The debt-to-income ratio must include all debt payments,
including total monthly housing-related payments such as principal,
interest, taxes, and insurance, and both first and subordinate liens.
(3) Lenders can, on a case-by-case basis, rebut the debt-to-income
presumption by showing that the consumer has other verified resources
for making loan payments, and/or that there is a specific basis for
lowering the consumer's expenses, and that there are adequate resources
available to cover family living expenses after deducting debt service
requirements from monthly income. When underwriting its home loans, the
Veterans Administration uses a similar approach that allows lenders to
consider a number of factors to justify decisions that would normally
fall outside established guidelines.\18\
Require lenders to verify borrower income using tax documents,
payroll or bank records, or other reasonable documentation.
Most people can readily document their income using W-2s, 1099s or
tax returns, but there are strong incentives for all parties involved
to avoid documentation and inflate a loan applicant's income: Borrowers
are able to qualify for bigger loans;\19\ brokers receive higher yield-
spread premiums for pushing the higher interest rates that comes with
stated income mortgages and by not having to do the work to verify
incomes;\20\ and lenders and brokers both collect hefty fees with each
later refinancing of these unaffordable loans.\21\ Inadequate
documentation compromises a lender's ability to assess the true
affordability of a loan and makes any reported debt-to-income ratio
meaningless. For the small minority of people who can't use standard
documentation, lenders should require bank records or other reasonable
verification.
Require lenders to escrow for real estate taxes and property
insurance.
Failing to escrow for taxes and insurance on a subprime loan is an
unfair and deceptive practice that contributes to high rates of
foreclosure.\22\ Requiring such escrows is the norm in the prime
market\23\ and is rare in subprime.\24\ This has distorted the subprime
market by making it difficult for responsible lenders to compete. By
creating artificially low monthly payment figures, the failure to
escrow deceives consumers about the actual cost of these mortgages
relative to those offered by competitors that do escrow. Consumers are
frequently lured into higher cost or unaffordable loans by misleading
comparisons of lower payments that exclude taxes and insurance with
payments that include those costs.\25\ Non-escrowing lenders have
benefited financially from the deception.
To correct distorted pricing incentives and encourage a truly
competitive marketplace:
Ban prepayment penalties and yield-spread premiums on subprime
loans.
Prepayment penalties--the ``exit tax'' for refinancing or otherwise
paying off a loan-are a destructive feature of the subprime market that
lock borrowers in to high-cost loans, and make it difficult for
responsible lenders to refinance them into lower-cost loans. Today
prepayment penalties are imposed on about 70 percent of all subprime
loans,\26\ compared to about 2% of prime loans.\27\ This disparity
belies any notion that subprime borrowers freely ``choose'' prepayment
penalties. All things being equal, a borrower in a higher-cost loan, or
in an unpredictable, adjustable rate loan with a very high margin,
would not choose to be inextricably tied to that product by a high exit
tax.\28\ With common formulations of six months' interest, or amounts
of approximately 3% of the principal, the amount of equity lost is
significant. For a $200,000 loan, a 3% prepayment penalty costs
borrowers $6,000, eating almost entirely the median net worth for
African American households.\29\
It has long been recognized that prepayment penalties trap
borrowers in disadvantageous, higher cost loans. Indeed, this is the
penalty's purpose--in industry parlance, to ``build a fence around the
borrower'' or ``close the back door.'' Less well known is the fact that
these penalties also increase the cost of the loan at origination
because they are linked to higher rates on loans that pay higher so-
called ``yield-spread premiums'' to brokers.\30\ Thus, contrary to the
claims of some lenders, prepayment penalties do not decrease, but,
rather, frequently increase the cost of subprime loans.
Yield-spread premiums are a bonus paid by the lender to the
mortgage broker as a reward for placing the borrower into a higher cost
loan than the borrower qualifies for. Lenders are willing to pay the
premium only where they are sure that the borrower will remain in the
higher-cost loan long enough to enable the lender to recoup the cost of
the premium from the borrower. This is not a theoretical concept; the
evidence is clear from examining ``rate sheets,'' information lenders
distribute to mortgage brokers showing which loan products the lender
is willing to offer at different interest rate levels for borrowers
that represent different credit risks. These sheets also indicate the
yield-spread premium the lender is willing to pay.
We provide an example of a recent rate sheet (September 2007) in
the appendix. As you can see, the rate sheet shows that the broker
collects a 50 basis point (0.50%) yield spread premium (called a
``rebate'' on this rate sheet) for adding 1% to the borrower's interest
rate. The broker collects an additional 75 basis point yield-spread
premium for adding an additional 1% to the borrower's interest rate.
Thus, with a $200,000 subprime loan, for the broker to receive a 2%
yield-spread premium, or $4,000, the borrower pays 1.25% more than she
actually qualified for, or $10,000 in excess interest expense if he or
she stays in the loan for four years. The broker maximizes his
compensation by seeking the lender and the loan that allow for the
maximum return to him.
It is important to note that this lender reduces the yield-spread
premium if the borrower pays a higher interest rate to ``buy out'' the
prepayment penalty--in many cases lenders do not allow the broker to
get any yield-spread premium if the loan has no prepayment penalty.
Yield-spread premiums and prepayment penalties are intertwined in a way
that is harmful to consumers and detrimental to competition (for a
fuller discussion of these issues, please refer to our recent comment
letter to the Federal Reserve Board, submitted on August 15).\31\
Thus, the yield-spread premium puts the broker in a direct conflict
of interest with the client borrower. Yield-spread premiums and
prepayment penalties both substantially undercut the benefits of
homeownership by stripping equity from the borrower. Prepayment
penalties lock the borrower into a higher-cost loan, strip further
equity upon refinance, and have been documented to increase the
borrower's vulnerability to foreclosure.
Eliminate steering homeowners into unnecessarily expensive loans.
The subprime market has long cited ``riskier borrowers'' or
``credit-impaired borrowers'' as its justification for the higher
prices on these loans. The argument is that investors need the higher
prices to justify their risk, yet that extra price burden for the
subprime loan puts credit-strapped borrowers that much closer to the
edge.
That is one reason why, as we can now see, it serves the interest
not only of homeowners, but of the world economy, to assure that all
families seeking loans who qualify for lower cost prime mortgages
should receive a prime mortgage, not a subprime loan. We know that far
more people have been placed in high-cost loans than should have
been.\32\ Since it is now abundantly clear that ``risky loans,'' as
much or more than ``risky borrowers,'' are a threat, market
professionals--loan originators, whether brokers or retail lenders--
should be required to assure that borrowers are put into the rate they
qualify for. Market incentives that encourage originators to put as
many people as possible into the priciest (and most dangerous) loans
possible helped make this problem; prohibiting those incentives is a
necessary part of the solution.
Eliminating the practice of steering borrowers to pricier and
riskier loans is also critical to assuring a fair marketplace that does
not impose a discrimination tax on borrowers of color. We know that for
borrowers of color, the odds of receiving a higher-cost loan are
greater, even after controlling for legitimate risk factors.\33\ We are
long past the time when we can--or should--close our eyes to this.
Finally, to restore accountability to the process, we recommend:
Hold lenders responsible for abusive lending practices,
regardless of whether the loan was originated by the lender or mortgage
brokers.
As the market operates today, lenders can benefit from abusive
loans made by brokers without any adverse consequences. We believe the
subprime market will remain a dangerous place for families until
lenders are responsible for abusive subprime loans, regardless of
whether they originated the loan directly, or whether they acquired the
loan through a broker. The lack of accountability for lenders leaves
homeowners without adequate remedies. Brokers are commonly thinly
capitalized and transitory, leaving no assets for the borrower to
recover against. Unclear lender liability means that homeowners face
nearly insurmountable legal hurdles in trying to defend their home
against foreclosures caused by broker lending abuses.
Lenders, who are mortgage professionals themselves, as well as
repeat users of brokers' services, have the expertise, the leverage and
the capacity to exercise oversight of the brokers with whom they do
business. Consumers do not. Indeed, the agencies have acknowledged that
lenders must engage in just such oversight. The costs of their failure
to do so should therefore be borne by lenders, not borrowers.
Hold mortgage brokers accountable for abusive lending practices.
Nor should mortgage brokers be allowed to shirk responsibility for
their actions. The broker has specialized market knowledge that the
borrower lacks and relies on. And brokers hold themselves out to
borrowers as a trusted adviser for navigating the complex mortgage
market; why otherwise would a person engage and pay for one? Merely
licensing mortgage brokers is insufficient--brokers must have
affirmative duties to their customers to turn the tide of abusive
lending practices. We commend Senators Schumer, Brown and Casey for
introducing the Borrower's Protection Act of 2007, which offers key
protections that would help hold brokers accountable for abusive
practices including establishing a fiduciary duty between brokers and
their customers, and a duty of good faith and fair dealing standard for
all originators. An additional route for Congress would be to
dramatically increase the bonding requirements for mortgage brokers.
Hold investors accountable for the loans they support through
assignee liability.
Assignee liability permits homeowners to pursue legal claims
against the assignee (the party that has purchased or otherwise taken
an interest in the loan) when the loan transaction involves illegal
actions or abusive terms. Without it, borrowers are often left without
recourse for predatory lending abuses, while retaining the risk of
losing their home to the current holder of the predatory note. Since
three-quarters of subprime home loans are sold on the secondary
market,\34\ assignee liability is a critical component of any
meaningful market reforms.\35\
All parties that benefit from subprime mortgages should be held
accountable. Without legal liability for assignees, a family that has
been the victim of a predatory loan cannot stop the foreclosure of
their home even if the originator is solvent and well-capitalized.
Instead, they end up losing their home, and then they must bring a
separate action against the originator. This separate action can take
years.
Assignee liability also protects the integrity of the market,
providing incentives to police itself, thus curbing inefficiencies. By
assuring assignee liability, the law helps to protect responsible
investors from misperceived risks and provides incentives for the
market to police itself, curbing market inefficiencies. No one is more
effective than investors who face financial and legal risk in ensuring
that loans are originated to specified standards. It cannot be stressed
too much that freeing investors from liability for the mortgages they
purchased contributed to the disregard of lending standards that
brought about the current crisis.
For example, shielding assignees from liability leads directly to a
situation where loans without documented income become more desirable
to investors than appropriately documented loans. Investors'
willingness to pay more for ``no doc'' loans led loan originators to
encourage borrowers to accept such loans rather than appropriately
document their income. As the chief executive officer of the now
bankrupt Ownit Mortgage Solutions explained when he acknowledged the
lowering of underwriting standards, ```The market is paying me to do a
no-income-verification loan more than it is paying me to do the full
documentation loans,''' he said. `What would you do?''' \36\ The reason
investors were happy to pay more for riskier loans was that they were
shielded from liability for the consequences. Restoring appropriate
assignee liability would help ensure that when investors accept
mortgages, with all the corresponding financial benefits, that they
also accept the corresponding responsibility.\37\
Buttress, but do not impede, the states' efforts to prevent
predatory lending.
It is imperative that the federal standards set the floor, not the
ceiling, on lender conduct. It is a common refrain that we have a
``national mortgage market'' so we need national standards. But we do
not have a national mortgage market. We have a national market--indeed,
we have an international market--in pieces of paper traded around the
world. But somewhere down at the bottom of many tiers of ``structured
finance,'' that paper is someone's home. And there is nothing more
local than a home and the neighborhood in which that home is located.
Different parts of the country were subjected to different aspects
of the predatory lending problem at different times. In the regions
where property values were ballooning, inflated appraisals were not a
problem; in regions where property values were stagnant, inflated
appraisals were a pervasive and serious part of the problem. Purchase
loans with low down payments or high LTV refinances were not as serious
a threat in areas where the property values were on a steeply upward
slope, since a struggling homeowner could refinance or sell. But in
areas where property values were stagnant, or appreciating only
marginally, the ``foreclosure crisis''--and the loans that caused
them--is old news.
States are more nimble and more able to accurately target specific
problems than federal policymakers and the states have served as
valuable laboratories of democracy to inform Congress' decisions. The
last time Congress addressed the predatory lending problem was 1994.
The states have been addressing the issues as they arise, all
along.\38\ Imagine how much worse the present crisis would be if many
of the states had not acted in the meantime, and how less well informed
Congress would be of what solutions to offer if the states hadn't been
implementing them. Ohio should not have to wait to respond to its
crisis until California starts feeling it. Congress should not
hamstring the ability of the states, the true ``local cops on the
beat,'' to respond to the calls of distress in their communities.
b. mitigating the consequences of today's crisis: recommendations to
help current homeowners
Direct servicers and lenders to make meaningful and sustainable
modifications to existing loans.
The best and most effective help for homeowners placed into loans
they cannot afford is for the lender or servicer to modify the loan
terms to make them sustainable. This is hardly a give-away, since even
lending industry leaders have acknowledged that many of these borrowers
qualified for sustainable, 30-year fixed rate subprime mortgages,
typically at a cost of only 50 to 80 basis points above the
introductory rate on the unsustainable exploding ARM they were
provided.\39\ In fact, a review of a broad array of lender rate sheets
establishes that those borrowers who were given ``no doc'' loans
notwithstanding their ability to document their income could have
received 30-year fixed rate fully documented loans at a lower rate than
the no-doc 2/28 adjustable-rate mortgages they received.\40\ And this
does not include the 20% or so of subprime borrowers who qualified for
conventional loans from the beginning.\41\
In our estimation, 20% of existing homeowners--those who were able
to repay their loans before their rates reset but could not refinance
to conventional loans--could save their homes if their current
``teaser'' interest rate was fixed at that rate. For another 20% of
borrowers--those unable even to pay the teaser rate because they were
placed into stated income loans they couldn't afford, or the cost of
taxes and insurance had not been factored in, for example--reducing the
principal balance or interest rate up to 50% would make it possible to
afford the lowered payments on the reduced loan balance, refinance the
loan, or sell.
We believe that, at a minimum, servicers should do such a
modification whenever the borrowers' debt-to-income ratio, including
other debts and including escrows, exceeds 50% upon reset. Reducing the
interest rate or principal by half would provide the lender with the
likely value they would obtain through foreclosure, including
foreclosure expenses. Moreover, replacing anticipated foreclosures with
modifications would avoid the rash of foreclosures that would produce
further home price declines.\42\
Some lenders have reported to policymakers that they are currently
offering loan modifications to troubled borrowers. The housing
counselors, community groups and consumer lawyers we hear from tell us
that in the vast majority of cases this is not so.\43\ We also are
hearing that in the minority of cases where modifications are offered,
they are limited to a one-year or even a six-month extension of the
introductory interest rate, a modification that is too short-term and
unsustainable to allow a family to engage in meaningful planning for
their financing, housing and children's schooling. Sustainable,
meaningful loan modifications would ideally last for the life of the
loan but certainly no shorter than five years.
A related and critical concern is that different borrowers will be
treated differently (for example, those who cannot afford legal
representation may be at a distinct disadvantage and may not be offered
the same, or any, options). One need is to standardize the loan
modification process to ensure fairness and efficiency.
Finally, when approximately two million households face the threat
of foreclosure, any case-by-case resolution will be inadequate.
Congress has the power to authorize a number of effective actions to
support sustainable homeownership and should take the following steps
to maximize the number of borrowers who receive help:
Loss Mitigation: The federal regulators have issued a call to
lenders and servicers to engage in loss mitigation efforts prior to
pursuing foreclosure. But more concrete steps are needed. To adequately
stem the tide of foreclosures Congress should act to require specific
loss mitigation efforts prior to any foreclosure filing and establish
that failure to provide such loss mitigation can be used as an
affirmative defense against foreclosure. Legislation such as Senator
Reed's Homeownership Protection and Enhancement Act (S.1386) is a step
in the right direction as it would make important inroads on
foreclosure prevention by creating an affirmative duty for lenders and
servicers to engage in some loss mitigation efforts prior to
foreclosure.
Counseling and Legal Assistance: Congress can also play a vital
role in helping homeowners navigate the complicated process as they
work to keep their homes. For example, Congress should provide
additional funding for qualified and trained counselors and legal
advocates, and lift the restraints on legal services-funded programs
from collecting attorneys' fees when defending foreclosures. There is
also an urgent need to fund for housing counselors and lawyers for low-
income homeowners to help them negotiate work-outs with lenders and
navigate tax and bankruptcy issues.
Data: To assist policymakers, industry and consumer groups in
devising meaningful policy alternatives, more data is urgently needed.
Congress should require servicers to report to a central database each
time a modification is offered, describing the nature of the
modification and how long it is effective. Servicers also should report
when lenders pursue foreclosure or collection litigation without first
offering a loan modification to the homeowner. Knowing how often
servicers modify loans, and what these modifications consist of, is at
least as important as knowing origination data reported by HMDA.
FHA support: Another important step is increasing the Federal
Housing Administration's capacity to insure abusive subprime mortgages
that can be refinanced. The President's proposals for the FHA provide a
helpful starting point, but we shouldn't be under any illusions that
they alone will substantially address problem.
However, even if we take these steps to encourage loan
modifications, the epidemic of subprime foreclosures is much too
massive to be handled by these mechanisms alone. To further mitigate
the damage caused by unsustainable subprime mortgages, we strongly
recommend two further legislative solutions--one to correct an anomaly
in the Bankruptcy Code, and another to correct an anomaly in the
Internal Revenue Code.
Most importantly, eliminate an anomaly in the Bankruptcy Code,
which currently allows judges to modify mortgages on a borrower's
vacation home or investment property, but not on the homeowner's
primary residence.
Bankruptcy has served as a safety net in the past for borrowers as
an option of last resort, but for struggling homeowners, it has become
a serious obstacle to recovering from foreclosures. The problem is that
Chapter 13 of the Bankruptcy Code--the Chapter that applies to consumer
bankruptcy reorganizations where borrowers go on a payment plan--makes
the home mortgage virtually the only debt that the court cannot modify
and therefore the home the only asset it cannot protect.\44\ Since a
home is typically the largest and most important asset a family has,
and the home mortgage loan is the family's largest single debt, the
exclusion of the principal residence from modification prevents
bankruptcy protection from reaching where it is needed most. Bankruptcy
is a critical tool to help homeowners, it is an efficient mechanism and
is, from a government perspective, a solution that does not require
direct appropriations.
The current bankruptcy language dates back to 1978. It was
indefensible policy then; a family's personal residence should be their
most protected asset in bankruptcy, not the least. This provision is
particularly harmful today, however, as exploding ARMs are the single
most important factor causing financial crisis for millions. In fact,
hundreds of thousands of families face rate resets at the same time
that their houses are worth less than the balance on their mortgage.
Thus, they cannot sell their house or refinance their loan. Some will
receive loan modifications from their servicers, but for a number of
reasons, most will not. Unless Congress passes the Act, these families
will lose their homes.
Eliminating this anomaly would not require Congress to revisit the
2005 amendments to the bankruptcy code. In fact, those amendments were
intended to encourage debtors to file under Chapter 13. But as
currently drafted, Chapter 13 has rendered Bankruptcy Courts powerless
to provide relief at a time when it is so urgently needed.
Not only is current bankruptcy policy unwise; it is unjust. Because
the home mortgage exception applies only to primary residences,
borrowers wealthy enough to own two homes can obtain relief from the
mortgage on their vacation or investment home, thereby retaining at
least one shelter for their family. Nor does the exception apply to the
homes of family farmers, who file under Chapter 12, or to commercial
real estate owned by businesses filing under Chapter 11.\45\ The law
thus deprives mostly low-wealth and middle class families of
protections available to all other debtors. If the borrowers cannot
restructure these debts, then they can neither save their home nor get
back on their feet financially.
The crux of the problem is found in section 1322 of the Bankruptcy
Code, which should be revised, very simply, as follows:
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
A narrowly-tailored amendment to the Bankruptcy Code soon to be
introduced by Senator Durbin, and under consideration by other members,
would correct this anomaly in a measured way that would provide
urgently needed relief. It could help more than 600,000 of these
financially-troubled families keep their homes\46\ by giving bankruptcy
judges the authority to modify these mortgages in Chapter 13. In
addition, it would save American families not facing foreclosure $72.5
billion in wealth by avoiding 600,000 foreclosures by their
neighbors.\47\ Finally, it would still guarantee lenders at least the
value they would obtain through foreclosure, since a foreclosure sale
can only recover the market value of the home. In addition, it would
save lenders the high cost and significant delays of foreclosure.
Eliminate an anomaly in the Internal Revenue Code, which does not
tax homeowners on the first $500,000 (for couples) they earn when they
sell their home at a gain, but does tax homeowners when the lender
declines to sue them for any balance due when the home is sold at a
loss.
Consistent with the long-standing American policy of encouraging
home ownership, the Internal Revenue Code provides a generous tax
break--even beyond the well-known mortgage interest deduction--for
homeowners fortunate enough to sell their homes at a price in excess of
what they paid. Each taxpayer can write off--that is, they are excused
from paying taxes on--$250,000 worth of profits they make on the sale
of their home. Couples get to write off $500,000 in profits.
However, while the law is extremely generous with families that
make money on their homes, it is remarkably ungenerous with those that
lose. Under current law, where a homeowner owes the bank more than the
home is worth, and is in sufficient financial trouble that the bank
relinquishes its claim for the excess balance over the home's value,
the federal government taxes the homeowner on this excess. This is so
even where the borrower loses the home in foreclosure.\48\
Given a policy that provides homeowners with a tax exemption for up
to a half-million dollars in homeownership-related gains, it is deeply
unjust to refuse a comparable exemption for families facing
homeownership losses. A recent proposal by President Bush and bills
introduced by Representative Andrews and Senator Stabenow partially
address the problem. To impact more than a minority of financially
troubled homeowners, the bills should also be revised to cover loan
balances incurred through so called ``cash-out refinancings''--
refinancings encouraged by government officials. Most subprime loans
over the last several years were cash-out refinancings, cash which
often went to pay high broker and lender fees.\49\ Additionally, the
bills need to be revised to ensure that they relate not only to tax
forgiveness upon the sale of the home, but also tax forgiveness through
modifications that enable the homeowner to keep the home.
conclusion
Not so long ago, the best interests of financial institutions and
homeowners were aligned. When a home foreclosed, it was a loss not only
to the family who lived in the home, but also to the lender who had
provided and held onto the loan. Today in the subprime market we have a
disconnect between these interests, and that needs to change. To
restore the world's confidence in our markets and recover a reasonable
expectation of integrity to our mortgage financing system, we need
decisive policy actions to realign the interests of people who buy
homes, institutions that provide the loans and the entities that invest
in those mortgages. As long as subprime lenders have little or no
incentive to make a loan successful, we will continue to set families
back financially, and rather than building our nation's prosperity
through homeownership, we will continue to lose economic ground.
The subprime lending system has failed millions of middle-class
families. These are people who were trying to do everything right: they
worked hard at their jobs, they took care of their children, and they
were seeking a more secure future. Now these families are on the verge
of losing any semblance of security, and we all will be worse off as a
result. The losses in wealth to neighbors, through the negative impact
of foreclosures on property values, is even larger.
As outlined here, policymakers have a number of tools at their
disposal to mitigate the harm caused by this situation and prevent it
from happening again in the future. We strongly urge you to take our
recommended actions to protect homeowners and promote sustainable
homeownership.
End Notes
\1\ Ellen Schloemer, Wei Li, Keith Ernst, and Kathleen Keest, Losing
Ground: Foreclosures in the Subprime Market and Their Cost to
Homeowners, (December 2006) at http://www.responsiblelending.org/
issues/mortgage/reports/page.jsp?itemID=31214551.
\2\ Christopher L. Cagan, Mortgage Payment Reset: The Issue and the
Impact, First American CoreLogic (March 19, 2007), available at
http://www.facorelogic.com/uploadedFiles/Newsroom/
Studies_and_Briefs/Studies/20070048Mortgage
PaymentResetStudy_FINAL.pdf
\3\ Mortgage Finance Industry Overview, Lehman Brothers Equity Research
(December 22, 2006).
\4\ Robert B. Avery, Kenneth P. Brevoort and Glenn B. Canner, ``The
2006 HMDA Data,'' Federal Reserve Board (September 12, 2007),
available at http://www.federalreserve.gov/pubs/bulletin/2007/pdf/
hmda06draft.pdf.
\5\ Moody's Economy.com, ``Into the Woods: Mortgage Credit Quality, Its
Prospects, and Implications,'' a study incorporating unique data
from Equifax and Moody's Investors Service (2007).
\6\ We are unable to verify the extent of this problem because the MBA
is using proprietary data to make this claim.
\7\ Mortgage Bankers Association Press Release ``Investor Loans Major
Part of Defaults in States with Fastest Rising Deliquencies'' 8/30/
2007, at http://www.mbaa.org/NewsandMedia/PressCenter/56535.htm
\8\ For example, Genworth Mortgage Insurance's ``A-Minus Rate Sheet''
dated December 1, 2005 shows a 0.5% premium for investor loans
added to a base rate of 1.66% annually for coverage on a 90% LTV A-
minus loan with a credit score of 600-619.
\9\ See, e.g., Nicola Clark, ``Bank in Germany Posts Loss Because of
Bad Stock Trades,'' New York Times (August 31, 2007); Jenny
Anderson and Heather Timmons, ``Why a U.S. Suprime Mortgage Crisis
is Felt Across the World,'' New York Times (August 31, 2007).
Indeed, the globalization of the consequences have left people on
other continents asking for an international oversight role: ``Why
should the rules of lending in the U.S. be left to U.S. regulators
when the consequences go everywhere?'' Heather Timmons and Katrin
Bennhold, ``Calls Grow for Foreigners to Have a Say in U.S. Market
Rules,'' New York Times C1, (August 29, 2007).
\10\ Also available at http://www.bloomberg.com/apps/
news?pid=20601206&sid=aQBUrPcefMtc&refer=realestate and http://
online.wsj.com/public/resources/documents/info-BondTurmoil0707-
sort.html
\11\ Into the Woods, note 5.
\12\ Source: Bank of America analyst, cited by Orange County Register
http://blogs.ocregister.com/mortgage/archives/2007/06/
bofa_analyst_mortgage_correcti_1.html
\13\ Losing Ground, note 1 at page 21.
\14\ Credit Suisse, Mortgage Liquidity du Jour: Underestimated No More,
(March 12, 2007) p. 6.
\15\ Quoted in a taped interview with the Center for Responsible
Lending, August 2007. See also Jonathan B. Cox, ``Groups: Stop
Seizing Homes--Foreclosures rising across Wake, US,'' Raleigh News
& Observer (June 20, 2007).
\16\ In a rising interest rate environment, such as we saw between 2004
and 2006, even using a fully-indexed rate is likely to understate
the risk. For that reason, some have suggested more stringent
underwriting tests, such as the fully indexed rate plus 1%, see,
e.g. AARP Comments to the Federal Reserve Board on Home Ownership
and Equity Protection Act, Dkt OP-1288 (8/15/07) p. 11 available at
http://www.federalreserve.gov/SECRS/2007/August/20070816/OP-1288/
OP-1288_51_1.pdf, AARP makes the strong argument that lenders
should underwrite the loan at the fully indexed rate plus 1%, to
provide a small cushion against interest rate increases; this would
be particularly important when short term rates are abnormally loan
and future increases could be expected. Other suggestions to
address the rising rate environment conundrum include using as the
benchmark the maximum rate to which the loan rate may rise during a
specific period, see, e.g. Comments of the National Consumer Law
Center and the National Association of Consumer Advocates to the
Federal Reserve Board Regarding the Board's Authority to Prohibit
Unfair Acts and Practices In Connection With Mortgage Lending Under
HOEPA (8/15/07), available at http://www.federalreserve.gov/SECRS/
2007/August/20070816/OP-1288/OP-1288_52_1.pdf. Particularly in view
of the unfortunate fact that subprime borrowers were never
``buying'' the opportunity to take advantage of a falling rate
environment with their ARMs, because subprime ARMs were ``up-
escalator only'' ARMS, it would not be unfair to offer an extra
cushion to protect against rising rate index exacerbating the
payment shock.
\17\ The maximum debt-to-income ratio set by the Federal Housing
Administration for FHA loans is 41%. See http://www.fha-home-
loans.com/debt_ratios_fha_loans.htm. Fannie Mae has guidelines that
describe how the debt-to-income ratio should be calculated. Fannie
Mae Selling Guide, Chapter 7, X, 703: Benchmark Ratios (Jan. 31,
2006).
\18\ ``It should also be clearly understood from this information that
no single factor is a final determinant in any applicant's
qualification for a VA-guaranteed loan. Once the residual income
has been established, other important factors must be examined. One
such consideration is the amount being paid currently for rental or
housing expenses. If the proposed shelter expense is materially in
excess of what is currently being paid, the case may require closer
scrutiny. In such cases, consideration should be given to the
ability of the borrower and spouse to accumulate liquid assets,
such as cash and bonds, and to the amount of debts incurred while
paying a lesser amount for shelter. . . . [I]t is important to
remember that the figures provided below for residual income are to
be used as a guide and should be used in conjunction with the steps
outlined in paragraphs (c) through (j) of this section.'' 38 CFR
36.4337.
\19\ However, in many cases, borrowers are unaware that the broker or
originator has inflated the income, often after the borrower
provided the documentation, such as W-2 forms, according to
attorneys and governmental investigators who have worked on such
cases. The adjective in the frequently used term ``liar's loans,''
then, should not be thought to apply just to the applicant.
\20\ See, e.g., Testimony of Ms. Delores King, Senate Banking Committee
Hearing on ``Preserving the American Dream: Predatory Lending
Practices and Home Foreclosures'' (February 7, 2007), available at
http://banking.senate.gov/_files/king.pdf.
\21\ John C. Dugan, Comptroller of the Currency, ``Remarks Before the
Neighborhood Housing Services of New York,'' (May 23, 2007) at 4-5,
available at: http://www.occ.treas.gov/ftp/release/2007-48a.pdf.
[hereafter ``Dugan''] Dugan at 4-5.
\22\ See ``Losing Ground,'' supra note at 27.
\23\ See, e.g., Fannie Mae ``Single Family Selling Guide'' Part VII,
Section 104.05 (``First mortgages generally must provide for the
deposit of escrow funds to pay as they come due taxes, ground
rents, premiums for borrower-purchased mortgage insurance (if
applicable), and premiums for hazard insurance and flood insurance.
. . . The lender may waive the escrow deposit account requirement
for an individual first mortgage, as long as the standard escrow
provision remains in the mortgage documents--however, we do not
recommend waiving it for a borrower who has a blemished credit
record because the borrower may find it difficult to maintain
homeownership if faced with the need to make lump-sum payments for
taxes and/or insurance and any other periodic payment items.'')
\24\ See, e.g., ``B&C Escrow Rate Called Low,'' Mortgage Servicing News
Bulletin (February 23, 2005), ``Servicers of subprime mortgage
loans face a perplexing conundrum: only about a quarter of the
loans include escrow accounts to ensure payment of insurance
premiums and property taxes, yet subprime borrowers are the least
likely to save money to make such payments.''
\25\ See, e.g. States' settlement agreement with Ameriquest, IV-B-5,
http://www.state.ia.us/government/ag/images/pdfs/
Ameriquest_SETTLMNT_FINAL.pdf; State of Iowa v. Household
International, Consent Judgment Para. 9(E)(1), available at http://
www.state.ia.us/government/ag/latest--news/releases/dec--2002/
hhconsent.pdf; Federal Trade Commission vs. Citigroup, et al. Civ.
No 1:01-CV-00606 (E.D. Ga., filed), Complaint, Para. 18-19, http://
www.ftc.gov/os/2001/03/citigroupcmp.pdf.
\26\ See, e.g. David W. Berson, Challenges and Emerging Risks in the
Home Mortgage Business: Characteristics of Loans Backing Private
Label Subprime ABS, Presentation at the National Housing Forum,
Office of Thrift Supervision (December 11, 2006). According to MBA
data, there was a 69.2% penetration rate for prepayment penalties
on subprime ARMs originated in 2006. Doug Duncan, Sources and
Implications of the Subprime Meltdown, Manufactured Housing
Institute, (July 13, 2007). A recent CRL review of 2007
securitizations showed a penetration rate for prepayment penalties
averaging over 70%.
\27\ See Berson, id. A recent MBA analysis shows that 97.6% of prime
ARMs originated in 2006 had no prepayment penalty, and 99% of 2006
prime FRM had no penalty. Doug Duncan, id.
\28\ Marketing jargon in the industry is more honest about the role of
prepayment penalties, along with high-LTV loans: ``Build a fence
around the customer:'' or bring them in and ``close the back door''
are phrases that surfaced during regulatory investigations of
subprime lenders in which one of the authors of this Comment was
involved.
\29\ Indeed, according to one study, it would exceed the median net
worth in 2002 for African American households ($5,988). And it
drains almost 7% of the median net worth for white households that
year ($88,651). Rakesh Kochhar, The Wealth of Hispanic Household:
1996-2002 p. 5, (Pew Center for Hispanic Studies), http://
pewhispanic.org/files/reports/34.pdf
\30\ Christopher A. Richardson and Keith S. Ernst, Borrowers Gain No
Interest Rate Benefits from Prepayment Penalties on Subprime
Mortgages, Center for Responsible Lending (January 2005).
\31\ Comment letter from the Center for Responsible Lending to the
Board of Governors of the Federal Reserve Board (August 15, 2007),
available at http://www.responsiblelending.org/policy/regulators/
page.jsp?itemID=33824187.
\32\ Mike Hudson and E. Scott Reckard, More Homeowners with Good Credit
Getting Stuck in Higher-Rate Loans, L.A. Times, p. A-1 (October 24,
2005). For most types of subprime loans, African-Americans and
Latino borrowers are more likely to be given a higher-cost loan
even after controlling for legitimate risk factors. Debbie
Gruenstein Bocian, Keith S. Ernst and Wei Li, Unfair Lending: The
Effect of Race and Ethnicity on the Price of Subprime Mortgages,
Center for Responsible Lending, (May 31, 2006) at http://
www.responsiblelending.org/issues/mortgage/reports/
page.jsp?itemID=29371010; See also Darryl E. Getter, Consumer
Credit Risk and Pricing, Journal of Consumer Affairs (June 22,
2006); Howard Lax, Michael Manti, Paul Raca, Peter Zorn, Subprime
Lending: An Investigation of Economic Efficiency, 533, 562, 569,
Housing Policy Debate 15(3) (2004).
\33\ Debbie Gruenstein Bocian, Keith S. Ernst and Wei Li, Unfair
Lending: The Effect of Race and Ethnicity on the Price of Subprime
Mortgages, Center for Responsible Lending (May 31, 2006). Study
finds that African-American and Latino borrowers are at greater
risk of receiving higher-rate loans than white borrowers, even
after controlling for legitimate risk factors. For example,
African-American borrowers with prepayment penalties on their
subprime home loans were 6 to 34 percent more likely to receive a
higher-rate loan than if they had been white borrowers with similar
qualifications.
\34\ Standard & Poor's Weighs in on the U.S. Subprime Mortgage Market
(April 2, 2007), cited by Sheila Bair, Chair, Federal Deposit
Insurance Corporation in a statement to the Committee on Financial
Services, U.S. House of Representatives (April 17, 2007).
\35\ An ``assignee'' is a party who purchases or otherwise takes a
financial interest in the loan. The assignee has the right to
collect payments and enforce the terms of the loan, including
foreclosing on a house if a borrower defaults.
\36\ Vikas Bajaj and Christine Haughney, ``Tremors At the Door: More
People with Weak Credit Are Defaulting on Mortgages,'' New York
Times (Fri. Jan. 26, 2007) C1, C4.
\37\ Recently Harvard issued a study that also recommended lifting
current restrictions on assignee liability--see note 7.
\38\ See, e.g., Wei Li and Keith Ernst, The Best Value in the Subprime
Market: State Predatory Lending Reforms, Center for Responsible
Lending (February 23, 2006).
\39\ See January 25, 2007 letter from the Coalition for Fair &
Affordable Lending (CFAL), an industry association, to the heads of
the federal banking regulators, urging the regulators not to apply
the October 4, 2006 Interagency Guidance on Nontraditional Mortgage
Product Risks to subprime 2-28 ARM loans.
\40\ As recently as July, 2007, even as the debacle was unfolding, that
remained the case. For example, a borrower with a 620 FICO score,
90% LTV, and 1-30 day delinquency, could get a 30-year fixed rate
mortgage at 10.25% from Option One, compared to 11.9% for a 3/27
stated doc loan. At WaMu's Long Beach Mortgage, that borrower could
get a 10.1% 30-year fixed rate loan, compared to a 10.95% 2/28
Stated income loan.
\41\ For most types of subprime loans, African-Americans and Latino
borrowers are more likely to be given a higher-cost loan even after
controlling for legitimate risk factors. Debbie Gruenstein Bocian,
Keith S. Ernst and Wei Li, Unfair Lending: The Effect of Race and
Ethnicity on the Price of Subprime Mortgages, Center for
Responsible Lending, (May 31, 2006) at http://
www.responsiblelending.org/issues/mortgage/reports/
page.jsp?itemID=29371010. See also Darryl E. Getter, Consumer
Credit Risk and Pricing, Journal of Consumer Affairs (June 22,
2006); Mike Hudson & E. Scott Reckard, More Homeowners with Good
Credit Getting Stuck with Higher-Rate Loans, Los Angeles Times p.A-
1 (October 24, 2005); Howard Lax, Michael Manti, Paul Raca, Peter
Zorn, Subprime Lending: An Investigation of Economic Efficiency,
533, 562, 569, Housing Policy Debate 15(3) (2004).
\42\ See, e.g. Nelson Schwartz, ``Can the Mortgage Crisis Swallow a
Town,'' New York Times, p. Bus 1 (Sept. 2, 2007).
\43\ See, e.g., http://sfgate.com/cgi-bin/article.cgi?f=/c/a/2007/09/
13/MNJ8S1FKC.DTL.
\44\ In 2005, the bankruptcy law was amended to treat some recent
purchase money loans for automobiles in a similar fashion, but the
dollar figures for such loans pale in comparison to the amount of a
home loan and, depending on fair market value, the amount of equity
associated with the residence. Moreover, such loans can still be
modified with respect to interest rate and payment amounts.
\45\ The family farm Chapter 12 corollary to section 1322(b)(2), found
at 11 USC 1222(b)(2), provides the bankruptcy court with power to
``modify the rights of holders of secured claims, or of holders of
unsecured claims . . .'' Similarly, the corresponding provision of
Chapter 11, found at 11 U.S.C. 1123(b)(5), contains language
identical to that in section 1322(b)(2), reaffirming the exemption
for loans secured by the debtor's primary residence, but imposing
no corresponding exemption for a company's principle place of
business or any other property.
\46\ Calculations by the CRL using data from its ``Losing Ground''
report cited above, research from the University of North Carolina,
the Home Mortgage Disclosure Act, and Bloomberg research.
\47\ Families lose 1.14% of their own house's value for every
foreclosure that occurs on their block. Woodstock Institute,
``There Goes the Neighborhood: The Effect of Single-Family Mortgage
Foreclosures on Property Values,'' June 2005, http://
www.woodstockinst.org/content/view/104/47/. Median house value of
$212,000 * 1.14% * 50 houses/block = $121,000 cost/foreclosure *
600,000 avoided = $72.5 billion saved. http://www.realtor.org/
Research.nsf/files/MSAPRICESF.pdf/$FILE/MSAPRICESF.pdf
\48\ See Geraldine Fabrikant, ``After Foreclosure, a Big Tax Bill from
the I.R.S.,'' New York Times (August 20, 2007)
\49\ Based on MBA's originations survey, cash-out refinancings
comprised 80.6% of all subprime refinances in 2006.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
[From the Bloomberg Press online, Aug. 23, 2007]
Lehman Shuts Unit; Toll of Lenders Tops 100: Subprime Scorecard
(By Rick Green)
Lehman Brothers Holdings Inc.'s shutdown of its subprime lending
unit helped push the tally of mortgage companies that have halted
operations or sought buyers since the start of 2006 to at least 100.
Lehman became the first of Wall Street's five biggest securities
firms to close its subprime business yesterday when it shut BNC
Mortgage LLC. The New York-based firm bought BNC in 2004 to expand
lending to borrowers with weak credit.
Until last year, sales of mortgage companies fetched hundreds of
millions of dollars, capped by Merrill Lynch & Co.'s $1.3 billion
purchase of First Franklin on Dec. 30. Since then, 15 have gone
bankrupt and about 50 have suspended loans or closed entirely. The
total may be higher because some defunct firms didn't make public
announcements or court filings.
``I don't think we are going to see the bottom for at least another
six months,'' Edward Resendez, ex-chief executive officer of Resmae
Mortgage Corp., said yesterday. Resendez sold Resmae to Citadel
Investment Group at a bankruptcy auction. ``The lenders that are
struggling out there are not going to survive. As soon as their
liquidity runs out, they are going to go under.''
The industry slump pushed shares of mortgage companies down 58
percent from June 14, 2005, through yesterday, according to Bloomberg's
index of mortgage real estate investment trusts, compared with a 22
percent gain for the Standard & Poor's 500 stock index. Among last
year's 20 largest subprime lenders ranked by Inside Mortgage Finance, a
trade publication, more than half have tried to sell themselves or left
the business.
late loans
Overdue payments on U.S. subprime mortgages rose to the highest
level since 2002 during the first quarter of this year, according to
the Mortgage Bankers Association. That's made investors who buy
mortgages reluctant to bid, driving down prices and cutting into the
profit of home lenders.
Subprime loans are made to borrowers with poor credit ratings or
heavy debts. The mortgages often charge higher interest rates to
compensate for the greater risk of default.
The table below tracks sales, shutdowns, bankruptcies and
transactions tied to home lenders. The list includes companies that may
have offered subprime, prime or Alternative-A loans. The latter are an
alternative for A-rated borrowers who fall just short of standards for
regular prime mortgages.
Some of the most recent developments:
Accredited Home Lenders Holding Co. will close ``substantially
all'' of its retail lending business and halt U.S. loan applications.
About 1,600 people will lose their jobs.
Capital One Financial Corp. shut its GreenPoint Mortgage unit,
eliminating 1,900 jobs.
Quality Home Loans, a California-based subprime lender, filed for
bankruptcy.
Amstar Financial Holdings Inc., a Houston-based lender, said its
mortgage division will cease operations.
----------------------------------------------------------------------------------------------------------------
BUSINESSES SOLD PARENT BUYER PRICE ($ MLN) DATE*
----------------------------------------------------------------------------------------------------------------
Centex Home Equity.............. Centex............ Fortress.......... 554(c)............ Mar. 06
Chapel Funding.................. .................. Deutsche Bank..... N/D............... May 06
Aames Investment................ .................. Accredited Home... 301............... May 06
HomEq........................... Wachovia.......... Barclays.......... 469............... June 06
MortgageIT...................... .................. Deutsche Bank..... 430............... July 06
Saxon........................... .................. Morgan Stanley.... 706............... Aug. 06
First Franklin.................. National City..... Merrill Lynch..... 1,300............. Sep. 06
Encore Credit**................. ECC Capital....... Bear Stearns...... 26................ Oct. 06
Irwin Mortgage**................ Irwin Financial... Four buyers....... 261............... Oct. 06
Irwin Mortgage**................ Irwin Financial... New Century....... N/D............... Nov. 06
Champion........................ KeyCorp........... HSBC, Fortress.... N/D............... Dec. 06
Millennium Funding Grp.......... .................. Roark Capital..... N/D............... Dec. 06
EquiFirst....................... Regions Fin'l..... Barclays.......... 76................ Jan. 07
ABN Amro Mortgage............... ABN Amro.......... Citigroup......... N/D............... Jan. 07
New York Mortgage(a)............ NY Mort. Trust.... IndyMac........... 14................ Feb. 07
New York Mortgage(b)............ NY Mort. Trust.... Franklin Credit... N/D............... Feb. 07
Senderra Funding****............ .................. Goldman Sachs..... N/D............... Mar. 07
ResMae Mortgage................. .................. Citadel........... 180............... Mar. 07
PHH Mortgage.................... PHH Corp.......... Blackstone(e)..... N/D............... Mar. 07
SB Financial.................... .................. W.J. Bradley...... N/D............... Mar. 07
MortgageTree Lending............ .................. W.J. Bradley...... N/D............... Apr. 07
Fremont(d)...................... Fremont General... Ellington......... .................. Apr. 07
Lime Financial Services......... .................. Credit Suisse..... N/D............... Apr. 07
New Century servicing........... .................. Carrington Cap.... 184............... Apr. 07
Option One Mortgage............. H&R Block......... Cerberus Capital.. 800............... Apr. 07
Opteum Fin'l retail............. Opteum............ Prospect Mortgage. 1.5............... May 07
Pinnacle Financial.............. .................. Impac Mortgage.... N/D............... May 07
Green Tree Servicing............ Fortress/Cerberus. Centerbridge...... N/D............... June 07
First NLC Financial............. Friedman Billings. Sun Capital....... 60................ July 07
Winstar Mortgage**.............. .................. Am. Sterling Bank. N/D............... Aug. 07
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
PARTIAL/POSSIBLE SALE PARENT DATE*
----------------------------------------------------------------------------------------------------------------
ACC Capital assets***........... ACC Capital Hld... Citigroup......... .................. Feb. 07
C-Bass/Sherman Fin'l............ MGIC/Radian....... .................. 750(g)............ Mar. 07
WMC Mortgage.................... General Electric.. .................. .................. July 07
CIT home lending................ CIT Group......... .................. .................. July 07
Delta Financial................. .................. Gordon / Pabrai... .................. Aug. 07
Luminent Mortgage............... .................. Arco Capital...... .................. Aug. 07
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
CUTS/CLOSED/BANKRUPT PARENT STATUS DATE*
----------------------------------------------------------------------------------------------------------------
Acoustic Home Loans.................. ....................... Halted applications.... Apr. 06
Ameriquest Mortgage.................. ACC Capital Hld........ Shut retail branches... May 06
Meritage Mortgage.................... NetBank................ Closed................. Nov. 06
Summit Mortgage...................... Summit Financial....... Closed................. Nov. 06
Sebring Capital...................... ....................... Closed................. Dec. 06
Ownit Mortgage Solutions............. ....................... Bankruptcy............. Dec. 06
Harbourton Mortgage.................. Harbourton Capital..... Closed................. Dec. 06
Alliance Home Funding................ Alliance Bankshrs...... Closed................. Dec. 06
Millennium Bankshares................ ....................... Closed mortgage unit... Dec. 06
Popular Financial.................... Popular................ Closed subprime unit... Jan. 07
Bay Capital.......................... Clear Choice Fin'l..... Closed................. Jan. 07
EquiBanc Mortgage.................... Wachovia............... Closed................. Jan. 07
Funding America LLC.................. Ocwen Financial........ Closed................. Jan. 07
DeepGreen Financial.................. Lightyear Capital...... Closed................. Jan. 07
Eagle First Mortgage................. ....................... Closed................. Jan. 07
Mortgage Lenders Network............. ....................... Bankruptcy............. Feb. 07
Lenders Direct Capital............... ....................... Halted wholesale loans. Feb. 07
ResMae Mortgage...................... ....................... Bankruptcy, revived.... Feb. 07
Central Pacific Mortgage............. ....................... Closed................. Mar. 07
FMF Capital LLC...................... FMF Capital Group...... Closed................. Mar. 07
Silver State Mortgage................ ....................... License revoked........ Feb. 07
Ameritrust Mortgage.................. ....................... Shut subprime unit..... Mar. 07
Master Financial..................... ....................... Halted originations.... Mar. 07
Investaid Corp....................... ....................... Suspended.............. Mar. 07
People's Choice...................... ....................... Bankruptcy............. Mar. 07
LoanCity............................. ....................... Closed................. Mar. 07
New Century Financial................ ....................... Bankruptcy............. Apr. 07
SouthStar Funding.................... ....................... Bankruptcy............. Apr. 07
Peoples Mortgage..................... Webster Financial...... Closed................. Apr. 07
WarehouseUSA......................... NovaStar............... Closed................. Apr. 07
Copperfield Investments.............. ....................... Bankruptcy............. Apr. 07
First Horizon National............... ....................... Halted subprime loans.. Apr. 07
Opteum Fin'l wholesale............... Opteum................. Closed unit(h)......... Apr. 07
H&R Block Mortgage................... H&R Block.............. Closed................. Apr. 07
MILA(i).............................. ....................... Bankruptcy............. Apr. 07
Texas Capital Bank................... Texas Cap. Banc........ Closed mortgage unit... Apr. 07
Millennium Funding Grp............... Roark Capital.......... Halted originations.... Apr. 07
Columbia Home Loans.................. OceanFirst............. Closed................. May 07
Lancaster Mortgage................... ....................... Halted wholesale loans. June 07
Oak Street Mortgage.................. ....................... Bankruptcy............. June 07
Starpointe Mortgage.................. ....................... Closed................. June 07
Heartwell Mortgage(j)................ ....................... Halted retail/wholesale June 07
Wells Fargo.......................... ....................... Shut correspondent unit June 07
Premier Mortgage Funding............. ....................... Bankruptcy............. July 07
Alliance Mtg Investments............. ....................... Bankruptcy............. July 07
Wells Fargo.......................... ....................... Shut subprime wholesale July 07
Entrust Mortgage..................... ....................... Halted loans........... July 07
Alternative Financing................ ....................... Halted wholesale loans. Aug. 07
Trump Mortgage....................... ....................... Closed................. Aug. 07
American Home Mortgage............... ....................... Bankruptcy............. Aug. 07
MLSG Home Loans...................... ....................... Halted loans........... Aug. 07
Impac Mortgage....................... ....................... Suspended Alt-A loans.. Aug. 07
Fieldstone........................... C-Bass................. Closed................. Aug. 07
HomeBanc Mortgage.................... HomeBanc Corp.......... Bankruptcy............. Aug. 07
Aegis Mortgage....................... Cerberus(k)............ Bankruptcy............. Aug. 07
Regions.............................. Regions Fin'l.......... Shut warehouse unit.... Aug. 07
Express Capital Lending.............. ....................... Halted acceptances..... Aug. 07
Bay Finance.......................... Commerce Group......... Halted loans........... Aug. 07
First Indiana........................ ....................... Shut wholesale unit.... Aug. 07
Guardian Loan........................ ....................... Closed................. Aug. 07
Unlimited Loan Resources............. ....................... Halted loans........... Aug. 07
Pacific American Mtg................. Golden Empire.......... Halted wholesale loans. Aug. 07
Thornburg Mortgage................... ....................... Suspended applications. Aug. 07
National Home Equity................. National City.......... Halted loans, merged... Aug. 07
NovaStar Financial................... ....................... Halted wholesale loans. Aug. 07
GreenPoint Mortgage.................. Capital One............ Shut wholesale unit.... Aug. 07
First Magnus Financial............... ....................... Bankruptcy............. Aug. 07
First Nat'l Arizona.................. 1st Nat'l Hld.......... Halted wholesale loans. Aug. 07
Quality Home Loans................... ....................... Bankruptcy............. Aug. 07
Amstar Mortgage...................... Amstar Financial....... Closing................ Aug. 07
Accredited Home...................... ....................... Halted loans........... Aug. 07
BNC Mortgage......................... Lehman Brothers........ Closed................. Aug. 07
----------------------------------------------------------------------------------------------------------------
Notes:
-- Some names have been abbreviated for space. Companies listed may
have engaged in conventional, Alternative A or subprime mortgage
lending. Status of deals and companies, prices and terms are
subject to adjustment after the announcement date.
N/D Not disclosed or not available.
* Announced date, first known disclosure or effective date if disclosed
after completion. Some announced closings have not yet been
completed.
** Asset sale
*** Citigroup obtained an option to buy ACC Capital's wholesale
mortgage origination and servicing businesses.
**** Per Goldman Chief Financial Officer David Viniar 6/14/07 in
conversation with reporters. Web site lists company name as Avelo
Mortgage LLC d/b/a Senderra Funding.
(a) Retail assets
(b) Wholesale assets
(c) Actual price before taxes, per 10-Q filing. Centex's release cited
after-tax proceeds of about $540 million.
(d) Residential subprime unit
(e) After sale of PHH Corp. to General Electric Co.
(f) Purchased in July 2007 for $188 million.
(g) Projected, after taxes, from partial divestiture. See Page 41 of
the MGIC Form S-4, March 19, 2007.
(h) Units served mortgage brokers and bought home loans from mortgage
bankers, thrifts, builders and credit unions.
(i) Formally known as Mortgage Investment Lending Associates.
(j) Confirmed by company e-mail on July 5, 2007.
(k) Owners included Cerberus Capital Management LP. Retail lending
halted in June, wholesale lending in August.
To contact the reporter on this story: Rick Green in New York at
[email protected].
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
__________
Prepared Statement of Alex J. Pollock, Resident Fellow, American
Enterprise Institute
Mr. Chairman, Ranking Member Saxton, Vice Chair Maloney and members
of the Committee, thank you for the opportunity to be here today. I am
Alex Pollock, a Resident Fellow at the American Enterprise Institute,
and these are my personal views. Before joining AEI, I spent 35 years
in banking, including 12 years as President and CEO of the Federal Home
Loan Bank of Chicago, and am a Past President of the International
Union for Housing Finance. I have both experienced and studied many
credit cycles, of which the housing and subprime mortgage boom and bust
is the latest example.
I will address three main points:
The severe mortgage and housing industry problems we are
experiencing can best be understood as the deflation of a classic asset
bubble, the asset in this case of course being houses and condominiums.
The boom is always marked by rapid and unsustainable price increases,
inducing and fueled by a credit overexpansion; the inevitable bust
follows with defaults, losses and a credit contraction.
Because residential mortgages represent so large a credit market
and component of total debt, and residential real estate such a huge
asset class and component of household wealth, while homebuilding and
its many related industries are an important element of GDP, and
because a credit contraction hurts growth generally, the negative
effects of the deflating bubble on macroeconomic growth are sizeable
and significant.
Possible political responses to the problems fall into two
categories:
First, in addition to monetary policy, temporary programs to bridge
and partially offset the impact of the bust, and to reduce the risk of
a housing sector debt deflation. I will consider some of these,
including using the use of the FHA and Fannie Mae and Freddie Mac as
sources for refinancing subprime mortgages in imminent or actual
default.
Second, long term steps to fundamentally improve the functioning of
the mortgage market. I will repeat a very simple but powerful proposal:
a one-page mortgage disclosure which tells borrowers what they really
need to know about their mortgage loan in a clear and straightforward
way. This will both better equip borrowers to protect themselves and
make the mortgage market more efficient.
1. Subprime Mortgages as a Classic Boom and Bust
Needless to say, the unsustainable expansion of subprime mortgage
credit and the great American house price inflation of the new 21st
century are both over. Former enthusiasm at rising home ownership rates
and financial innovation (now a little hard to remember) have been
replaced by large financial losses, a credit market panic, layoffs,
closing or bankruptcy of scores of subprime lenders, accelerating
delinquencies and foreclosures, a deep recession in the homebuilding
industry, tightening or disappearing liquidity, and of course,
recriminations.
It is not necessary to recite the details. Typical estimates of the
credit losses involved are about $100 billion. This does not count
losses in market value of mortgage securities or the macroeconomic
effects. Rising foreclosures are also an obvious social and political
issue.
All these elements display the classic patterns of recurring credit
overexpansions and their aftermath, as colorfully discussed by students
of financial cycles like Charles Kindleberger, Walter Bagehot and Hyman
Minsky. Such expansions are always based on optimism and the euphoric
belief in the ever-rising price of some asset class--in this case,
houses and condominiums. This appears to offer a surefire way for
lenders, investors, borrowers and speculators to make money, and indeed
they do, for a while. As long as prices always rise, everyone can be a
winner.
A good example of such thinking was the 2005 book by an expert
housing economist entitled, Are You Missing the Real Estate Boom? Why
the Boom Will Not Bust and Why Property Values Will Continue to Climb
Through the Rest of the Decade.
This time, we had several years of remarkably rising house prices--
the greatest house price inflation ever, according to our distinguished
colleague on the panel, Professor Shiller, who has certainly been
insightful in this matter. The total value of residential real estate
about doubled between 1999 and 2006, increasing by $10 trillion. The
great price inflation stimulated the lenders, the investors, the
borrowers and the speculators. If the price of an asset is always
rising, the risk of loans seems less and less, even as the risk is in
fact increasing, and more leverage always seems better.
Of course, we know what always happens next: the increased risk
comes home to roost, prices fall, and there is a hangover of defaults,
failures, dispossession of unwise or unlucky borrowers, revelations of
fraud and swindles, and the search for the guilty. You would think we
would learn, but we don't. Then come late-cycle political reactions.
With regard to the last point, since 1970 we have had the Emergency
Home Finance Act of 1970, the Emergency Housing Act of 1975, the
Emergency Housing Assistance Act of 1983, and the Emergency Housing
Assistance Act of 1988. (I do not count the Hurricane Katrina Emergency
Housing Act of 2005, a special case.) Kindleberger estimated that over
the centuries, financial crises recur about once a decade on average,
and so apparently do emergency housing acts. It seems probable to me
that, given the current problems, this fall will bring an emergency
housing act of 2007.
A year ago, it was common to say that while house prices would
periodically fall on a regional basis, they could not on a national
basis, because that had not happened in the large U.S. market since the
Great Depression. Well, now house prices are falling on a national
basis, as measured by the S&P/Case-Shiller national index.
House sales have dropped steeply, and for-sale inventories of new
and existing houses and condominiums are high. At the same time, rising
mortgage delinquencies and defaults, along with the collapse of funding
through securitization, have caused lenders to drop subprime products
or exit the business altogether and generally raise credit standards.
This has sharply reduced mortgage credit availability and thus housing
demand.
With excess supply and falling demand, it is not difficult to
arrive at a forecast of further drops in house prices. The recent
Goldman Sachs housing forecast, pointing out ``substantial excess
supply'' and that ``credit is being rationed,'' projects that average
house prices will fall 7% a year through 2008. This is along with
projected falling home sales and housing starts.
Professor Shiller has suggested that this cycle could see ``more
than a 15% real drop in national home price indicies.'' Certainly a
return to long term trends in house values would imply a significant
adjustment.
The June 30, 2007 National Delinquency Survey of the Mortgage
Bankers Association reports a total of 1,090,300 seriously delinquent
mortgages. Serious delinquency means loans 90 days or more past due
plus loans in foreclosure. Of the total, 575,200 are subprime loans.
Thus subprime mortgages, which represent about 14% of mortgage loans,
are 53% of serious delinquencies.
The survey reports 618,900 loans in foreclosure, of which 342,500
or 55% are subprime.
The ratio of subprime loans in foreclosure peaked in 2002 at about
9%, compared to its current level of 5.5%. Seriously delinquent
subprime loans peaked during 2002 at 11.9%, compared to the current
9.3%. These ratios at this point are not as bad as five years ago, but
they are still rising.
A systematic regularity of mortgage finance is that adjustable rate
loans have higher defaults and losses than fixed rate loans within each
quality class. Thus we may array the June 30, 2007 serious delinquency
ratios as follows:
------------------------------------------------------------------------------------------------------------------------------------------------
Prime fixed................................................ 0.67%
Prime ARMs................................................. 2.02%
FHA fixed.................................................. 4.76%
FHA ARMs................................................... 6.95%
Subprime fixed............................................. 5.84%
Subprime ARMs.............................................. 12.40%
------------------------------------------------------------------------
The particular problem of subprime ARMs leaps out of the numbers.
Also notice that FHA and subprime serious delinquency ratios for fixed
rate loans are not radically different. The FHA is predominately a
fixed rate lender, whereas subprime is about 53% ARMs. The total range
is remarkable: the subprime ARM serious delinquency ratio is over 18
times that of prime fixed rate loans.
A central problem is that during the boom the subprime market got
very much larger than it used to be. In the years of credit
overexpansion, it grew to $1.3 trillion in outstanding loans, up over 8
times from its $150 billion in 2000. So the financial and political
impact of the subprime level of delinquency and foreclosure is much
greater.
2. Macroeconomic Effects
The American residential mortgage market is the biggest credit
market in the world, with about $10 trillion in outstanding loans.
Residential real estate is a huge asset class, with an aggregate value
of about $21 trillion, and is of course the single largest component of
the wealth of most households. A 15% average house price decline would
mean a more than $3 trillion loss of wealth for U.S. households, which
would be especially painful for those who are highly leveraged. It
would certainly put a crimp in getting cash to spend through cash-out
refinancing and home equity loans.
The deflation of a bubble centered on such large stocks of debt and
assets always causes serious macroeconomic drag. Housing busts have
typically translated into recessions. It goes without saying that the
current bust has already been and will continue to be a significant
negative for economic growth. Moody's recently forecast that the
``unexpectedly steep and persistent downturn'' in the mortgage and
housing sector would last until 2009.
At an AEI conference last March, my colleague Desmond Lachman
predicted that the economic impact of the housing problems would be
much worse than was generally being said at the time, including what he
considered the overoptimistic view of the Federal Reserve, and that
they would become a major political issue. These were certainly good
calls.
At the beginning of September, National Bureau of Economic Research
President Martin Feldstein incisively reviewed the interrelated series
of problems stemming from the deflating housing and mortgage bubble and
pointed out ``a sharp decline in home prices and the related fall in
home building that could lead to an economy-wide recession,'' ``the
potential for a substantial decline in consumption,'' and ``a
potentially serious decline in aggregate demand.'' Note these are all
stated as risks with the objective of encouraging the Federal Reserve
to ease credit.
Aggregate consumption has been positive every quarter since 1991,
but large losses from the deflating housing and mortgage bubble have
already happened and must unavoidably work their way through the
financial and economic system. Reductions in household wealth and
tighter credit constraints on consumers might be enough to turn
consumption growth negative.
A week and a half ago, my colleague John Makin, reviewing these
factors, concluded that they ``will, very probably, produce negative
growth by the end of 2007 or early in 2008.'' The appearance of the
slowdown, he wrote, ``will hopefully get the Fed on an easing path soon
enough to escape with a mild recession.'' This would be, he suggested,
``the price we pay'' for the bubble.
3. Policy Responses
There are two categories of possible responses: temporary programs
to bridge the bust, and fundamental, long term improvements.
A. Temporary Programs
The Federal Reserve and other central banks have already provided
significant amount of liquidity support to the panicky international
credit markets, which are suffering from not knowing who is in trouble
from leveraged speculations in subprime securities and from great
uncertainty about what such securities are worth. Many voices are
calling on the Fed to lower the fed funds rate and the expectation is
that they will have taken a first step by the time of this hearing.
Lower short term rates make it cheaper to carry leveraged positions in
securities unable to be sold at prices acceptable to the seller and
help ease the panic.
In any case, panics are by nature temporary and the liquidity
crisis won't last forever. Large losses will be taken, who is broke and
who is solvent sorted out, risks reassessed, models rewritten, and
revised clearing prices discovered. Market actors will get back into
business trading with and lending to each other again. Liquidity will
return for markets in prime instruments. An astute long-time observer
of finance, Don Shackelford, has predicted that ``the panic about
credit markets will be a memory by Thanksgiving.''
He may well be right; however, the severe problems with subprime
mortgages and securities made out of them, related defaults and
foreclosures, and falling house prices will continue long past then.
Falling house prices tend to cause higher mortgage defaults,
especially if loans were made, as they were, with small or no down
payments, and especially if a substantial proportion of loans were to
speculative buyers, as they were. So the U.S. appears to risk a process
in which defaults on mortgages, and securities made of mortgages, cause
tightening credit as well as houses dumped on the market through
foreclosure, tight credit reduces demand, which induces falling house
prices, which cause more defaults, more credit tightening, lower house
prices. . . . In other words, there is risk of a self-reinforcing
downward cycle, or debt deflation, in the housing sector.
To try to bridge the bust and ameliorate the downward cycle is a
reasonable project with much historical precedent. History is clear
that governments always intervene in some fashion.
But what fashion makes sense? Intervention should be temporary,
inhibit as little as possible personal choice and the long run
innovation and efficiency of the market, and should not bail out
careless lenders and investors or speculative borrowers.
To help bridge the bust with an appropriate means of refinancing
adjustable rate subprime mortgages is a project worth pursuing. A
recent survey of mortgage brokers found that of home purchase closings
they had scheduled for August, 2007, 56% of subprime homebuyers had
canceled closings. Of subprime borrowers trying to refinance adjustable
rate mortgages with resetting interest rates, the survey found that 64%
of the subprime homeowners were unable to do so.
President Bush, numerous members of Congress, and the FHA itself
have suggested using the FHA as the means to create a refinancing
capability for subprime mortgages. This makes sense because the FHA
itself is, and has been since its creation in 1934, a subprime mortgage
lending institution. Of course, they didn't call it that, but
historically if you couldn't qualify for a prime loan, you went to the
FHA.
We noted above that the latest MBA survey shows that serious
delinquencies for fixed rate FHA and subprime loans are similar. So are
total past due loans: 14.54% of subprime loans are past due, as are
12.40% of FHA loans. The difference is in the foreclosure inventory:
although both are far over the prime foreclosure ratio of 0.59%, the
5.52% for subprime is two and a half times the 2.15% for the FHA. The
FHA, being itself the principal credit risk taker, logically has more
ability to practice forbearance and loss mitigation.
But with falling house prices, the amount the FHA could responsibly
refinance is liable to be less than the outstanding principal owed on
the subprime mortgage. Here the owners of these mortgages, typically
investors in structured MBS issued by a securitization trust, need to
take a loss for the difference. Investors in such speculative
instruments should not be bailed out, and the loss in economic value
has occurred already: it is a matter of its becoming a realized
haircut.
Here we run up against the complications of the laws, regulations
and contracts governing mortgages in securitized form and the duties of
the agents for the investors. The mortgage servicers who actually deal
with the borrower, but are not themselves the owner of the mortgage,
have the ability as agent to make loan modifications for loans in
default or imminent default. But the standard of their fiduciary duty
is to maximize the returns to the bondholders of the securitized
mortgage trust.
To accept less than full repayment in settlement of a troubled loan
from the proceeds of an FHA refinancing, the mortgage servicer would
have to be quite confident that this was a clearly better outcome for
the bondholders than proceeding to foreclosure. Fortunately, from this
particular point of view, foreclosure is an extremely expensive process
for the investors.
Thus I believe that a special program in which the FHA could
refinance 97% of the current value of the house, and the investors
would accept a loss on any difference between that and the principal
owed, would be an alternative distinctly preferable to foreclosure for
the investors, as well as obviously so for the borrowers. This would
allow the borrowers to go forward with a small positive equity in the
property and a loan of more appropriate size. That such a program would
be accompanied by risk-based FHA insurance premiums seems reasonable to
me.
Putting this in the context of the evolution of the mortgage
market, the Mortgage Bankers Association has reported that subprime
mortgages grew from 2.4% to 13.7% of total mortgage loans between 2000
and 2006. But the proportion of prime loans also increased, from 72.6%
to 76.6%. What went down? It was the market share of the government's
FHA (and much smaller VA) programs, which fell from 25.2% to only 9.7%.
The combined share of subprime plus FHA-VA stayed more or less the
same, but within that, subprime took a lot of market share away from
the government alternatives.
That was during the boom. Now in the bust, the FHA, the creation of
the great bust of the 1930s, would take that market share back.
Let me turn briefly to Fannie Mae and Freddie Mac.
Two proposals regarding Fannie and Freddie are relevant as
temporary bridge programs: to increase their conforming loan limits and
to relax their mortgage portfolio caps. Both of these represent great
profit opportunities for Fannie and Freddie, and it is the fiduciary
duty of their managements to their shareholders to push these ideas as
strongly as possible.
I do not favor an increase in the conforming loan limit, because it
would principally operate to expand the government's credit into the
prime jumbo loan market and, as discussed above, I believe the markets
for prime assets will fairly quickly recover from panic on their own.
Relaxing the portfolio caps is more interesting and capable of
being focused on the key issue of refinancing subprime ARMs. As odd as
it may seem coming from an AEI fellow, I do favor granting Fannie and
Freddie a special increased mortgage portfolio authorization, strictly
limited, however, to a segregated portfolio solely devoted to
refinancing subprime ARMs. Such a special authorization might be for
$100 billion each, and include the ability to purchase FHA-insured
subprime ARM refinancings. FHA loans would then have both a Ginnie Mae
and a Fannie-Freddie funding channel.
As a last point, actual purchase of subprime mortgages by a special
government fund has sometimes been proposed. A very interesting
historical example of such a program was the Home Owners' Loan
Corporation, created by the Home Owners' Loan Act of 1933. The HOLA
bought defaulted mortgages from lenders in exchange for its own bonds,
but would refinance not more than 80% of what it considered the long
term value of the property. It ended up purchasing 20% of all the
mortgages in the nation, from which we can see that our problems,
however serious, don't even begin to approach those of the 1930s.
B. A Simple Proposal for Fundamental Improvement of the Mortgage Market
The mortgage market, like all financial markets, is constantly
experimenting with how much risk there should be, how risk is
distributed, and how it trades off with financial success or failure.
The subprime mortgage boom obviously overshot on risk creation; it and
the economy are now paying the price. ``Risk,'' as an old boss of mine
used to say, ``is the price you never thought you'd have to pay.''
However, nothing is more apparent than that we want the long term
growth, innovation and economic well being for ordinary people that
only market experimentation can create, even though this involves boom
and bust cycles which can be avoided only in hindsight.
Should ordinary people be free to take a risk in order to own a
home, if they want to? Yes, provided they understand what they are
getting into. (This is a pretty modest risk, to say the least, compared
to those our immigrant and pioneer ancestors took!)
Should lenders be able to make risky loans to people with poor
credit records, if they want to? Yes, provided they tell borrowers the
truth about what the loan obligation involves in a straightforward,
clear way.
A market economy based on voluntary exchange and contracts requires
that the parties understand the contracts they are entering into. A
good mortgage finance system requires that the borrowers understand how
the loan will work and how much of their income it will demand.
Nothing is more clear than that the current American mortgage
system does not achieve this. Rather it provides an intimidating
experience of being overwhelmed and befuddled by a huge stack of
documents in confusing language and small type presented to us for
signature at a mortgage closing. This complexity results from legal and
compliance requirements; ironically, past regulatory attempts to insure
full disclosure have made the problem worse. This is because they
attempt full, rather than relevant, disclosure.
Trying to describe 100% of the details in legalese and
bureaucratese results in essentially zero actual information transfer
to the borrower. The FTC recently completed a very instructive study of
standard mortgage loan disclosure documents, concluding that ``both
prime and subprime borrowers failed to understand key loan terms.''
Among the remarkable specifics, they found that:
``About a third could not identify the interest rate''
``Half could not correctly identify the loan amount''
``Two-thirds did not recognize that they would be charged a
prepayment penalty'' and
``Nearly nine-tenths could not identify the total amount of up-
front charges.''
As the events of the current bust have demonstrated, this problem
is especially important in, though by no means limited to, the subprime
mortgage market.
To have informed borrowers who can better protect themselves, the
key information must be simply stated and clear, in regular-sized type,
and presented from the perspective of what commitments the borrower is
making and what that means relative to household income. The borrowers
can then ``underwrite themselves'' for the loan. They have a natural
incentive to do so--we need to ensure they have the relevant
intelligible, practical information.
I have previously proposed (in House testimony) a one-page form,
``Basic Facts About Your Mortgage Loan,'' along with brief explanations
of the mortgage vocabulary and some avuncular advice for borrowers,
which borrowers would have to receive from the lender well before the
closing. A copy of the proposed form accompanies this testimony.
I believe its mandatory use would help achieve the required
clarity, make borrowers better able to protect themselves by
understanding what the mortgage really means to them, and at the same
time would promote a more efficient mortgage finance system. This seems
to me a completely bipartisan idea, which should be implemented as a
fundamental reform, whatever else is done or not done.
Thank you again for the opportunity to share these views.
Accompanying attachment: One-Page Form (``Basic Facts About Your
Mortgage Loan'')
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
The Basic Facts about Your Mortgage Loan
This form gives you the basic facts, but some mortgage forms may
use terms not listed here. For a good, borrower-friendly information
source, try the Mortgage Professor online (www.mtgprofessor.com), which
includes detailed explanations of the technical mortgage terms in its
glossary and much other helpful information.
definitions and guidelines used in this form
The appraised value is what a professional appraisal estimates the
house could be sold for in today's market.
The type of loan determines whether and by how much your interest
rate can increase. If it can, your monthly payments will also
increase--sometimes by a lot. For example, in a thirty-year fixed rate
loan, the interest rate is always the same. In a one-year ARM, it will
change every year. Other kinds of loans have various patterns, but the
interest rate may go up a lot. Make sure you understand what type of
loan you're getting.
The beginning interest rate is the interest you are paying at the
beginning of the loan. Especially if it is a low introductory or
``teaser'' rate, it is the rate which you will hear the most about from
ads and salespeople. But how long is it good for and when will rates
increase? In many types of loans, the rate will go up by a lot. You
need to know.
The fully-indexed rate is an essential indicator of what will
happen to your interest rate and your monthly payments. It is today's
estimate of how high the interest rate on an adjustable rate mortgage
will go. It is calculated by taking a defined ``index rate'' and adding
a certain number of percentage points, called the ``margin.'' For
example, if your formula is the one-year Treasury rate plus 3 percent,
and today the one-year Treasury rate is 5 percent, your fully-indexed
rate is 5% + 3% = 8%. At the time the loan is being made, the fully
indexed rate will always be higher than a beginning ``teaser'' rate.
The index rates are public, published rates, so you can study their
history to see how much they change over time. If the index rate stays
the same as today, the rate on your loan will automatically rise to the
fully indexed rate over time. Since the index rate itself can go up and
down, you cannot be sure what the future adjustable rate will be. In
any case, you must make sure you can afford the fully-indexed rate, not
just the beginning rate, which is often called a ``teaser'' rate for
good reason.
The maximum possible rate is the highest your interest rate can go.
Most loans with adjustable rates have a defined maximum rate or
``lifetime cap.'' You need to think about what it would take to make
your interest rate go this high. How likely do you think that is?
Your monthly income means your gross, pre-tax income per month for
your household. This should be an amount which you can most probably
sustain over many years. Make sure the monthly income shown on this
form is correct!
Your monthly payment including taxes and insurance is the amount
you must pay every month for interest, repayment of loan principal,
house insurance premiums, and property taxes. Expressed as a percent of
your monthly income, this is called your housing expense ratio. Over
time, in addition to any possible increases in your interest rate and
how fast you must repay principal, your insurance premiums and property
taxes will tend to increase. Of course, your monthly income may also
increase. How much do you expect it to?
Your fully-indexed housing expense ratio is a key measure of
whether you can afford this loan. It is the percent of your monthly
income it will take to pay interest at the fully-indexed rate, plus
repayment of principal, house insurance, and property taxes. The time-
tested market standard for this ratio is 28 percent; the greater your
ratio is, the riskier the loan is for you.
A prepayment fee is an additional fee imposed by the lender if you
pay your loan off early. Most mortgages in America have no prepayment
fee. If yours does, make sure you understand how it would work before
you sign this form.
A ``balloon payment'' means that a large repayment of loan
principal is due at the end of the loan. For example, a seven-year
balloon means that the whole remaining loan principal, a very large
amount, must be paid at the end of the seventh year. This almost always
means that you have to get a new loan to make the balloon payment.
A ``payment option'' loan means that in the years immediately after
securing a mortgage loan, you can pay even less than the interest you
are being charged. The unpaid interest is added to your loan, so the
amount you owe gets bigger. This is called ``negative amortization.''
The very low payments in early years create the risk of very large
increases in your monthly payment later. Payment option loans are
typically advertised using only the very low beginning or ``teaser''
required payment, which is less than the interest rate. You absolutely
need to know four things: (1) How long is the beginning payment good
for? (2) What happens then? (3) How much is added to my loan if I pay
the minimum rate? (4) What is the fully-indexed rate?
``Points'' are a fee the borrower pays the lender at closing,
expressed as a percent of the loan. For example, two points mean you
will pay an upfront fee equal to 2 percent of the loan. In addition,
mortgages usually involve a number of other costs and fees which must
be paid at closing.
Closing is when the loan is actually made and all the documents are
signed.
The For Questions Contact section gives you the name, phone number,
and e-mail address of someone specifically assigned by your lender to
answer your questions and explain the complications of mortgage loans.
Don't be shy: contact this person if you have any questions.
Finally, do not sign this form if you do not understand it. You are
committing yourself to pay large amounts of money over years to come
and pledging your house as collateral so the lender can take it if you
don't pay. Ask questions until you are sure you know what your
commitments really are and how they compare to your income. Until then,
do not sign.
__________
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
I would like to thank Chairman Schumer for scheduling today's
hearing and thank the panel of witnesses for sharing their views on
recent developments in mortgage markets, financial markets, and the
broader economy.
We have seen continuing signs of weakness in our Nation's housing
markets and increasing delinquencies and foreclosures on mortgages,
particularly in the area of subprime mortgages with adjustable rates.
Looking forward, a large number of homeowners with adjustable rate
mortgages will be facing resets during the remainder of this year and,
at least, through next year. Difficulties in the mortgage markets have
spilled over into markets for mortgage-backed securities. More
generally, this has translated into increased risk aversion in global
financial markets as market participants face uncertainty about who is
exposed to risk from the subprime mortgage market and how much exposure
counterparties may have.
It is particularly instructive to look at the ongoing signs of
difficulties in mortgage and financial markets to assess what needs to
be done to prevent future fraudulent mortgage lending and borrowing
practices that may have occurred in the past. I am also interested in
hearing testimony from our panel of witnesses as to their views on the
broader economic implications of continued weakness in the housing and
mortgage markets as well as the present uncertainties in broader
financial markets.
As we consider various policy options to address current
difficulties, I offer a few principles that we should keep in mind:
First, policies that involve federally-guided relief to homeowners
on their mortgage debts inherently run the risk of introducing moral
hazard into future mortgage transactions. To the extent that anything
we do constitutes a bailout, it must be recognized that such policies
can lead to reckless future behavior. If borrowers and lenders are led
to believe that they may not have to carry the full burden of possible
future losses because the government might step in to bail them out,
then those people will become more inclined to take on greater risk
than they otherwise would. This should be avoided.
Second, to the extent that we consider stricter regulations on
mortgages, we have to walk a fine line. Regulators in the mortgage
market must be obliged to prevent fraud and abusive lending. At the
same time, regulators must tread carefully so as not to suppress
responsible lending or eliminate refinancing opportunities for existing
subprime borrowers and new financing opportunities for prospective
subprime borrowers through overly-stringent regulations. The expansion
of subprime mortgages has led to record homeownership that has been
significantly driven by increased homeownership among minorities.
Of course, in the current environment, we face difficulties. This
is especially so in trying to separate victims from speculators and
liars. There are homeowners who truly were victimized by fraudulent and
misleading lender practices. It is hard not to feel sympathy for the
plight of those victims and we need to act to help those people as well
as to prevent future victims. At the same time, we must acknowledge
that there were people who were recklessly taking out mortgage loans
(sometimes through misrepresentation of their actual financial
conditions) either to obtain more housing than they could reasonably
afford or as part of a speculative, get rich quick scheme. There is
some suggestion on the part of the Mortgage Bankers Association that
the latter has played a significant role in subprime defaults in
several states. Those people--those who acted imprudently with the
knowledge that they were doing so, those who were dishonest, and those
who engaged in reckless speculative activity--should bear the full
responsibility of their obligations.
I look forward to the testimony of our panelists as we examine how
best to work through the recent difficulties we have observed in
housing, mortgage, and financial markets.