[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

                               __________

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                        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

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    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.

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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.

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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.
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    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 
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    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, 
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    Economic Policy: Essays in Honor of James Tobin, Cambridge MA: MIT 
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Brainard, William C., and James Tobin, ``Asset Markets and the Cost of 
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Brainard, William C. and James Tobin, ``Pitfalls in Financial Model 
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    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
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    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 
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    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, 
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___, ``Speculative Prices and Popular Models,'' The Journal of Economic 
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___, ``Stock Prices and Social Dynamics,'' Brookings Papers on Economic 
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                               __________
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.
  

                                  
