[Senate Hearing 110-976]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 110-976


    TURMOIL IN U.S. CREDIT MARKETS: EXAMINING PROPOSALS TO MITIGATE 
                             FORECLOSURES 
             AND RESTORE LIQUIDITY TO THE MORTGAGE MARKETS

=======================================================================

                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                       ONE HUNDRED TENTH CONGRESS

                             SECOND SESSION

                                   ON

 EXAMINING PROPOSALS TO MITIGATE FORECLOSURES AND RESTORE LIQUIDITY TO 
                          THE MORTGAGE MARKETS


                               __________

                        THURSDAY, APRIL 10, 2008

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


      Available at: http: //www.access.gpo.gov /congress /senate /
                            senate05sh.html




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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

               CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         WAYNE ALLARD, Colorado
EVAN BAYH, Indiana                   MICHAEL B. ENZI, Wyoming
THOMAS R. CARPER, Delaware           CHUCK HAGEL, Nebraska
ROBERT MENENDEZ, New Jersey          JIM BUNNING, Kentucky
DANIEL K. AKAKA, Hawaii              MIKE CRAPO, Idaho
SHERROD BROWN, Ohio                  ELIZABETH DOLE, North Carolina
ROBERT P. CASEY, Pennsylvania        MEL MARTINEZ, Florida
JON TESTER, Montana                  BOB CORKER, Tennessee

                      Shawn Maher, Staff Director
        William D. Duhnke, Republican Staff Director and Counsel

                      Amy S. Friend, Chief Counsel
                  Jonathan Miller, Professional Staff
          Julie Y. Chon, International Economic Policy Adviser
                Didem Nisanci, Professional Staff Member
                   Kara Stein, Legislative Assistant
                 Jayme Roth, Professional Staff Member
                   Mark Powden, Legislative Assistant
                 Jason Rosenberg, Legislative Assistant

           Mike Nielsen, Republican Professional Staff Member
          William Henderson, Republican Legislative Assistant
          Courtney Geduldig, Republican Legislative Assistant
      Jennifer C. Gallagher, Republican Professional Staff Member

                       Dawn Ratliff, Chief Clerk
                      Shelvin Simmons, IT Director
                          Jim Crowell, Editor










                            C O N T E N T S

                              ----------                              

                        THURSDAY, APRIL 10, 2008

                                                                   Page

Opening statement of Chairman Dodd...............................     1

                               WITNESSES

Lawrence H. Summers, Charles W. Eliot University Professor, 
  Harvard University.............................................     4
    Prepared statement...........................................    33
    Response to written questions of:
        Senator Shelby...........................................    72
Dean Baker, Co-Director, Center for Economic and Policy Research.     6
    Prepared statement...........................................    35
    Response to written questions of:
        Senator Shelby...........................................    73
        Senator Bunning..........................................    74
Ellen Harnick, Senior Policy Counsel, Center for Responsible 
  Lending........................................................     9
    Prepared statement...........................................    39
    Response to written questions of:
        Senator Shelby...........................................    77
        Senator Bunning..........................................    78
Scott Stern, Chief Executive Officer, Lenders One, Incorporated..    11
    Prepared statement...........................................    55
Douglas W. Elmendorf, Senior Fellow, The Brookings Institution...    12
    Prepared statement...........................................    63
    Response to written questions of:
        Senator Shelby...........................................    79
        Senator Bunning..........................................    81

              Additional Material Supplied for the Record

Letter submitted to Chairman Dodd from William H. Gross and 
  Mohamed A. El-Erian, Co-Chief Investment Officers, PIMCO.......    83

 
    TURMOIL IN U.S. CREDIT MARKETS: EXAMINING PROPOSALS TO MITIGATE 
       FORECLOSURES AND RESTORE LIQUIDITY TO THE MORTGAGE MARKETS

                              ----------                              


                        THURSDAY, APRIL 10, 2008

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 10:05 a.m., in room SD-538, Dirksen 
Senate Office Building, Senator Christopher J. Dodd (Chairman 
of the Committee) presiding.

       OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD

    Chairman Dodd. The Committee will come to order.
    Let me thank our witnesses this morning and my colleagues 
for being here. Let me just say on behalf of Senator Shelby, as 
you all might well imagine, there are a number of Committee 
hearings going on this morning, and Senator Shelby is deeply 
involved in an Appropriations Subcommittee which he is the 
Ranking Member of, so he will be moving back and forth here but 
has urged me to go forward and not wait for him to be here this 
morning.
    I am very grateful to all of you for coming out. I am going 
to make some opening comments, and with the indulgence of 
Committee members, unless you absolutely feel totally compelled 
to be heard at the outset, I am going to turn to our witnesses, 
and particularly the former Secretary of the Treasury, Larry 
Summers, who is here. And, Dr. Summers, we deeply appreciate 
your being here, and as well as Mr. Elmendorf.
    They are both hosting a conference later this morning, and 
so I am going to turn to them and urge my colleagues to focus 
any questions they have to these two witnesses.
    I have informed the audience--and our colleagues are aware 
of this--that at roughly 11 o'clock, we have two or three votes 
on the floor of the Senate, so we are going to get as much done 
as we can between now and 11, certainly regarding the two 
witnesses who have other obligations and have graciously agreed 
to be here this morning under the time constraints. And then we 
will come right back again to our other witnesses to complete 
the hearing this morning. A little complicated, but it allows 
us to get through here and have a good discussion this morning.
    Well, today the Senate Committee on Banking, Housing, and 
Urban Affairs is meeting to hold a hearing entitled ``Turmoil 
in the U.S. Credit Markets: Examining Proposals to Mitigate 
Foreclosures and Restore Liquidity to the Mortgage Market.''
    Last week, we had an excellent hearing to look at one 
result of the turmoil we are experiencing in the capital 
market: the decision of the Federal Government to commit $29 
billion in taxpayer money to rescue Bear Stearns. Today, we are 
focusing more on the other end of the spectrum: the impact of 
the crisis on homeowners themselves.
    This is the second hearing we are holding on this topic. 
The first was held in January. Since then, the crisis only 
seems to have gotten worse. It has spread from housing to other 
areas, such as student lending and municipal finance. And I 
expect that the Committee will examine these other areas in the 
weeks to come.
    This hearing could not be more timely. Today, after a week 
of intensive discussions and negotiations, the Senate later 
this morning will pass the Foreclosure Prevention Act of 2008. 
There are a number of important provisions in the legislation. 
The bill adds $150 million to the counseling budget. It 
includes an expansion and modernization of the FHA program, 
which will create a real alternative to the abusive subprime 
lending so many working families have turned to in the past 
several years--which has greatly contributed to the crisis, by 
the way. It adds about $10 billion in increased mortgage 
revenue bond authority for the States, which will help to 
provide some lower-cost credit to distressed borrowers. And it 
includes $4 billion for State and local governments to clean up 
the mess left by historic foreclosure problems we are 
experiencing.
    There are a number of other provisions in the bill, but 
those are some of the major ones that will be a part of the 
bill I hope is adopted later this morning.
    It falls far short, I would add, this legislation does, of 
the lofty title of the bill. We do not do as much as I would 
like to have seen us do with this legislation. It does not do 
enough to help families facing foreclosure. Nearly 8,000 
foreclosure filings occur every day in the country--almost 
8,000 filings every single day--according to RealtyTrac, which 
follows that information. The most significant challenge we now 
face is helping people tottering on the edge of foreclosure to 
keep them in their homes. It is all well and good to provide 
funds to help pick up the pieces, but we need to do more 
prevention so we have less need for cleanup after the fact.
    To that end, I have been working intensely with colleagues 
on this Committee, have had numerous conversations with members 
of both the Democratic and Republican side, listening to their 
ideas and thoughts about how we could develop such a proposal 
here to deal with these issues. Hope for Homeowners Act of 2008 
is sort of a compilation of those ideas. It is not the final 
word on it, but it is an opportunity for us to step up and try 
to move forward as a way of dealing with this issue.
    Briefly, the bill would create a new fund at the FHA to 
insure affordable mortgages for distressed borrowers. These FHA 
mortgages would refinance the old troubled loans at significant 
discounts. The new loans would be no larger than the borrowers 
could afford to pay and no more than 90 percent of the current 
value of the home. This formula is similar to the one laid out 
by Federal Reserve Chairman Bernanke in a speech several weeks 
ago when he noted that ``creating new equity for underwater 
borrowers may be a more effective way''--and I am quoting him 
here--``to prevent foreclosures.'' Now, apparently the 
administration has also embraced this concept, and I applaud 
and welcome their participation in this debate and discussion.
    Lenders and investors will have to take a serious haircut 
to participate in the program, but in return, they will receive 
more than what they would recover through foreclosures, 
obviously. Borrowers get to keep their homes, but they must 
share the newly created equity and future appreciation with the 
FHA program to help offset possible losses. Only owner 
occupants would be eligible for this new program, and only 
those who clearly cannot afford their current mortgages. There 
will be no investors in the program.
    In addition to helping homeowners and the communities in 
which they live, this program will help stabilize capital 
markets, put a floor under housing prices, and get capital 
flowing once again. That part of this idea is hardly ever 
talked about. That may be the most important part of this 
program. I would argue that keeping them in their homes is, but 
the fact that we are establishing a floor and that we get 
capital flowing again is what is critically missing in all that 
we are talking about, and that is one of the reasons for it.
    The big enemy of smoothly functioning capital markets is 
uncertainty. Today, nobody knows what the subprime mortgages 
underlying the alphabet soup of complex securities--CDOs, SIVs, 
RMBs, and the like--are worth. This program would help put a 
value on those mortgages.
    We have another hearing on this proposal next week when we 
will hear from a number of Government witnesses and others. 
After that, I want to work with my colleagues to see if we can 
move this legislation forward.
    As you know, Representative Barney Frank is holding 
hearings as well on this subject matter, and has I think 
yesterday and today, talking about this issue, and we welcome 
his involvement.
    I understand that some people oppose this kind of program 
on the grounds that we should not reward people who acted 
irresponsibly. As we have seen from numerous hearings we have 
held over the past 15 months, many people facing foreclosure 
today were victims of abusive and predatory lending practices. 
Most were trying to act responsibly, but they were led badly 
astray by unscrupulous mortgage brokers and lenders. They were 
victims of what Mr. Stern, one of our witnesses this morning, 
calls ``mortgage malpractice,'' and I urge my colleagues to 
read his testimony in which he talks about this phenomenon. 
This is a lender talking about mortgage malpractice that is 
going on.
    In fact, the Wall Street Journal did a study in which it 
concluded that 61 percent of subprime borrowers it reviewed had 
high enough credit scores to qualify for prime loans. We know 
that these brokers portray themselves as trusted advisors to 
unsuspecting borrowers, while steering these borrowers into 
higher-cost loans in exchange for higher commissions.
    Lenders and brokers gave these borrowers, many on fixed 
incomes, mortgages with exploding interest rate payments that 
they knew the borrowers could never, ever afford. These are 
among the homeowners that we seek to help with this 
legislation. We seek to help them because it is the right thing 
to do. To paraphrase Franklin Roosevelt, when your neighbor's 
house is burning, you do not charge him for the use of your 
garden hose. You simply lend it to him. We are not acting for 
their sakes alone. Today, hundreds of thousands of our 
neighbors' homes are figuratively burning, and like any fire, 
the damage threatens to spread. Every home that goes into 
foreclosure lowers the value of the other homes on that block 
by at least $5,000. It reduces property tax collections, which 
leaves local school revenues struggling. It hurts badly the 
ability of local governments to provide adequate police and 
fire protection and social services just as the need gets more 
pressing.
    The ripple effects are severe and widespread, so we owe 
ourselves and our communities, as well as our neighbors, our 
help in a crisis like this. We must act to put this fire out. 
That is what I would hope to do with all of you in the coming 
weeks. I look forward to hearing from our witnesses this 
morning and from our colleagues about how to draft this 
legislation that I have circulated a better document, a set of 
better ideas. We are going to hear from witnesses today, those 
who favor and oppose this ideas, because we want to have a 
balanced view of how we are looking at this as well. But my 
hope is we can put something together here that will accomplish 
the dual goals of keeping people in their homes as well as 
unleashing capital which is pent up.
    With that, I will turn to Senator Bennett, if you want to 
make any quick opening comments. And I would say to Senator 
Bunning, Jim, we are trying to--because of time constraints and 
votes this morning, if we can move right to witnesses. I 
apologize. I normally like to hear from everybody, but, Bob, 
any comments you want to make.
    Senator Bennett. Mr. Chairman, I will not presume upon 
Senator Shelby's prerogatives, and I will wait my turn.
    Chairman Dodd. I thank you very much.
    Witnesses, thank you. Larry, good to have you with us this 
morning. Welcome back to the Committee. It is an honor to have 
you here with us this morning.

 STATEMENT OF LAWRENCE H. SUMMERS, CHARLES W. ELIOT UNIVERSITY 
                 PROFESSOR, HARVARD UNIVERSITY

    Mr. Summers. Thank you very much, Mr. Chairman. The honor 
is mine. Let me do two things very briefly: summarize my view 
of where the economy stands, and offer four observations on the 
policy challenges before you.
    The economy is very likely currently in recession. If it is 
not a recession, it will certainly feel like one to the vast 
majority of our fellow citizens. The likelihood is very high 
that the downturn will continue for some time, certainly the 
next two quarters, despite the many constructive steps that 
have been taken in recent months.
    Particularly in housing markets, more distress lies ahead. 
No one can forecast where house prices are going, but the 
available evidence from futures markets, the available evidence 
on the level of inventories of unsold houses suggest that house 
prices could, on average, fall as much as 15 to 25 percent from 
current levels.
    The declines are likely to be concentrated in lower-priced 
homes and in the areas of the country where financing with 
subprime mortgages and low down payments has been especially 
prevalent.
    These declines in house prices are placing and will place 
unprecedented burdens on the mortgage finance system. It 
appears, contrary to some of the discussion, that the dominant 
determinant of how pervasive foreclosures are is the behavior 
of house prices. When house prices rise, people find ways of 
refinancing as they rise, even if they are having personal 
financial difficulties. When house prices fall, foreclosures 
take off.
    The best estimates suggest, as I read them, that we are 
likely to have as many as 15 million homes with negative equity 
over the next 2 years, and it is very difficult to gauge the 
number of foreclosures, but they could on the current path 
exceed 2 million.
    There have been some signs of repair in financial markets 
since the Bear Stearns events of mid-March, but markets remain 
quite fragile. In particular, there is, as your initial 
comments suggested, Mr. Chairman, some reason to believe that 
as serious as the situation is in the housing markets, because 
of illiquidity various securities markets are actually pricing 
in degrees of dislocation that even substantially exceed those 
associated with a serious recession.
    There is, I believe, in the context of these developments, 
no basis for assuming that the housing market will be self-
correcting. Indeed, financial markets sometimes--and at times 
like the present--do not follow the ordinary law of supply and 
demand. In economics classes, we teach that when prices fall, 
demand rises, and that tends to stabilize markets. But in 
leveraged financial markets, when prices fall, with leverage, 
people have margin calls or are unable to meet their debts and 
are forced to sell their assets, and so there is more supply, 
not more demand. Falling prices leading to reduced demand and 
increased supply means further falling prices, means vicious 
cycles, and it is interference with that type of vicious cycle 
mechanism that provides the important warrant for Government 
action.
    At the same time, it is appropriate to recognize the 
policies that serve only to delay inevitable adjustments can 
easily prove counterproductive.
    I would urge that policymakers give serious consideration 
to four areas.
    First, and critically, our policies regarding the 
Government-sponsored enterprises. The GSEs have a potentially 
critical role at a time of cyclical disturbance. Whatever one 
thinks about the GSEs as a normal matter, they exist to be in a 
position to be responsive at a time like the present.
    For them simply to expand their balance sheets without 
increased capital would be to expose the taxpayers and 
ultimately the entire financial system to very serious risks. 
The correct course is, therefore, for the Government-sponsored 
enterprises to raise capital on a very substantial scale for 
both prudential reasons and to back expanded lending. This may 
not be the first choice for their shareholders, but it is 
essential to the national interest. Robust, reasonably 
capitalized, GSEs taking an active role is probably the single 
most important step that the Government can take in bringing 
more regularity to the housing markets.
    Second, there is a strong case for Federal support for the 
writing down of mortgages in selected cases along the lines 
that you, Mr. Chairman, and Congressman Frank have suggested. 
Carefully designed measures to reduce the tremendous 
externalities associated with foreclosures can provide an 
important contribution in the current context.
    In considering such measures, it will be essential to 
ponder design issues, including the treatment of second liens, 
assuring integrity in the appraisals on which the program will 
inevitably be based, possibly adverse selection effects on 
mortgages offered by servicers, and eliminating incentives for 
opportunistic behavior by homeowners. There are also desirable 
changes in legal rules.
    Third, I support carefully designed bankruptcy reform as a 
vehicle for encouraging the writing down of mortgages where 
that is appropriate.
    Finally, and respectfully, Mr. Chairman, I would raise 
serious concerns with respect to the tax measures contained in 
the legislation the Senate is likely to pass this morning as I 
understand them. Providing tax credits conditioned on 
initiation of the foreclosure process is likely to have 
perverse effects in two respects: foreclosures may be 
encouraged in order to make the underlying sale consistent with 
the tax credit; and in any event, the benefits will flow not to 
families, but to the financial institutions that have taken 
over the foreclosed property.
    I would also suggest that experience and economic logic 
suggest that tax benefits targeted to corporations with net 
operating losses are unlikely to have major stimulative 
effects. To the extent that stimulus and responding to economic 
distress are key objectives, tax measures targeted at those who 
suffer foreclosure or at the conversion of foreclosed homes 
into rental housing would represent a substantially more 
effective public choice.
    I stand ready to respond to your questions.
    Chairman Dodd. Thank you very much, Larry. I appreciate 
your testimony immensely, and thank you once again for being 
here on short notice.
    I would say to my colleagues, I called the former Secretary 
and asked if he could be with us today, just in the last few 
days, and I am very grateful to him for making that happen. So 
I thank you for being with us.
    Good morning, Mr. Baker. How are you? Nice to have you with 
us. Are you ready to testify?

             STATEMENT OF DEAN BAKER, CO-DIRECTOR,
            CENTER FOR ECONOMIC AND POLICY RESEARCH

    Mr. Baker. Thank you very much for inviting me here. What I 
wanted to say is that I would like to recognize first that we 
have a very diverse housing market, and what may be good for 
some portions of the country may not be for other portions. In 
particular, what I am going to do is talk about the loan 
guarantee program and raise three--outline three basic 
objections to it.
    First, it will lead to many homeowners paying much more in 
housing cost than they would if they were rent a comparable 
unit.
    Second, we will end up with a situation where many 
homeowners are unlikely to accumulate any equity in their homes 
and, in fact, we are very likely to end up putting considerable 
tax dollars at risk.
    And, third, I think the effort to stabilize prices in 
bubble-inflated areas will prove unsuccessful and, furthermore, 
I would argue it is undesirable, even if it were successful. 
And I will very briefly comment on what I would argue is a 
better alternative to a loan guarantee program, what I call 
``own to rent,'' a temporary change in foreclosure rules on 
moderate-income housing that would guarantee people the option 
to remain in their house as long-term renters. I think that is 
a solution that would not cost any taxpayer dollars or require 
any bureaucracy and potentially lead to much better outcomes 
for homeowners.
    The first point, in talking about the diverse market, it is 
important to recognize we had an unprecedented housing bubble 
in the United States over the last decade, which led to an 
overvaluation of house prices on average of about 70 percent. 
We have had house prices falling very rapidly in the last year 
and a half, so the bubble is partially deflated, and in large 
parts of the country I would say prices are no longer out of 
line with fundamentals. Places like Cleveland, Detroit, 
Atlanta, large parts of the Midwest and South, prices are 
pretty much in line with fundamentals.
    On the other hand, in the bubble-inflated areas--primarily 
areas along the coasts, you still have house prices that remain 
30, 40 percent above their underlying values. That means that 
if we were to intervene at this point and try and stabilize 
prices, it would be similar to intervening in the collapse of 
the Nasdaq when it had fallen from 5,000 to about 3,500 on its 
eventual way down to 1,200. It is simply not viable and would 
not be good policy.
    OK. To go through the details, if we look at what we are 
doing for moderate-income homeowners in these bubble areas, we 
still have a situation where the ratio of house price to annual 
rent is far above 20:1. If you do the arithmetic on this, you 
would find that the annual ownership costs in such situations, 
even getting these people good mortgages, a 6-percent mortgage, 
the annual ownership cost, adding in the mortgage cost, 
insurance, property tax, maintenance costs, that will typically 
run as high as 10 percent, perhaps even higher, as a share of 
the ownership price.
    So just to take a numerical example, if we are looking at a 
home that would sell for $200,000, this home in this situation 
might rent for $10,000; we would be having a family that stays 
there as an owner paying $20,000 a year in ownership costs. 
That difference of $10,000 a year is a considerable amount of 
money for a moderate-income family that might be making 
$40,000, $50,000, $60,000 a year. This is money that is not 
available for child care expenses, health care expenses, other 
necessary expenses for that family. That simply does not seem 
to me good policy to be having moderate-income families pay way 
more than necessary by way of housing costs.
    The second point is, in terms of equity, if prices are 
falling, if they are going to fall 30, 40 percent--as I am 
quite confident they will in many of these bubble-inflated 
areas--people are not going to be accumulating equity even if 
they get a loan with a substantial writedown. Most people, 
moderate-income homeowners, only stay in their home about 4 
years. These people are not going to accumulate equity. They 
are still likely to be underwater at the time they leave their 
home, which means either a loss to them or to taxpayers or to 
both. So it simply does not seem to me like good policy.
    The third point, in terms of the price support program, I 
sort of think that when we talk about a housing price support 
program, we should think about it the same way we would an 
agricultural price support program, except that instead of 
talking about a commodity with a market of, say, $20 billion a 
year, we are talking about a commodity--housing--with a value 
of $20 trillion. It is not going to work. We are not going to 
be able to sustain bubble-markets.
    On the other hand, even if we could do it, it again strikes 
me as rather perverse policy. Why do we want to keep 
artificially high house prices? Do we want to make it 
impossible for young families to be able to afford to buy homes 
or people moving into an area to be able to afford to buy 
homes? That simply does not seem to me like good policy.
    A last point I will just say on that is that we should also 
keep in mind the considerable costs associated with this 
program in terms of implementing--creating new mortgage 
instruments. Very conservatively we would have to imagine it is 
1 percent of the cost; it might well be 2 percent. If we are 
talking about a $300 billion loan guarantee program, that is $3 
to $6 billion in costs that will either be borne by the 
taxpayers or the homeowners. Again, to my mind, that is not a 
good expenditure.
    In terms of the alternative, the own-to-rent alternative, I 
think this is a very simple proposal. It requires no taxpayer 
money, no bureaucracy. We simply have a temporary change in the 
foreclosure rules that gives moderate-income homeowners facing 
foreclosure the option to remain in their house as renters for 
a significant period of time, say 10 years or so. This provides 
homeowners with some security. They know that if they like the 
home, they like the schools, they like the neighborhood, they 
are not going to be thrown out on the street. Perhaps more 
importantly, it gives the mortgage holders a very real 
incentive to sit down and renegotiate terms that will allow the 
homeowners to remain in their home as homeowners since it is a 
safe bet that banks are not anxious to end up as landlords. I 
would urge Congress to consider this or other alternatives 
that, you know, perhaps put less taxpayer money at risk than 
some of the guarantee proposals, at least for the bubble-
inflated markets.
    In conclusion, I would just say that, to my mind, the big 
policy mistake that we are trying to deal with here is that we 
allowed for a financial bubble, a bubble in the housing market, 
to grow to very dangerous proportions. That was what created 
the situation that led to the crash that led to the recession 
that Secretary Summers was referring to. And I think it is 
unfortunate that that happened. Now that we have seen the 
crash, I have to say I find it somewhat striking that with so 
many economists that were unable to recognize the inflated 
prices during the bubble, they are so anxious to tell us that 
now prices are undervalued.
    Thank you.
    Chairman Dodd. Thank you very much.
    Ellen, thank you very much. Ellen Harnick, the Center for 
Responsible Lending. Thank you for joining us.

 STATEMENT OF ELLEN HARNICK, SENIOR POLICY COUNSEL, CENTER FOR 
                      RESPONSIBLE LENDING

    Ms. Harnick. Thank you very much for having me here.
    I think I just want to pick up on the point about the 
extent of the financial crisis we face and just to focus us on 
the details of what this really means.
    Mr. Summers said that 2 million families may end up losing 
their homes in foreclosure. This is consistent with numbers 
that we have seen from a variety of sources. What this means is 
2 million families will be put out of their homes. Some 
proportion of those families will find themselves homeless. 
Most of those families will suffer financial devastation from 
which they will never fully recover over the course of their 
working lives.
    We have talked about the declines in values that their 
neighbors will face, and we should be clear what we are talking 
about are not simply the declines that flow from home prices 
declining or the deflating of the housing bubble. What we are 
talking about are additional home price declines that will 
follow from the foreclosures themselves. And in many 
communities where the number of foreclosures in a particular 
neighborhood hit a tipping point, what families living in those 
neighborhoods will face is not merely a loss in their wealth 
and financial stability, but an actual significant decline in 
their quality of life.
    We all know what boarded-up homes on a block can do, and 
what we will start to see and some parts of the country have 
already started to see are middle-class neighborhoods that are 
now being overrun with criminal activity that makes it 
uncomfortable for families to have their children walk to and 
from school for the first time in their lives living in those 
communities.
    I think it is extremely important to take these things into 
account in deciding what can be done. Congress can avoid a 
substantial number of these foreclosures. I am not talking 
about the foreclosures that we will face from families who 
simply cannot afford a sustainable loan. I think that is off 
the table. But what I am talking about are foreclosures that 
are needless in the sense that rational economic decisions 
could prevent the homes from being lost. I think that the 
proposal that you, Mr. Chairman, have made for the FHA program 
is an excellent example of very significant work that can be 
done to avoid needless foreclosures.
    I want to pause for a minute on the moral hazard question. 
It has not been raised, but it sometimes is in other contexts. 
People say, well, we should not help these reckless borrowers, 
we should not support irresponsible lending. And I think--Mr. 
Chairman, you alluded to this in your opening remarks, and I 
think it is really important to stress that the mortgage 
malpractice or lending malpractice is an excellent point, and 
for those who doubt it, you do not have to know anything more 
about the particular borrowers at issue other than to know that 
all of these 228 hybrid ARMs, with which I know the Committee 
is familiar, these are extremely risky loans. They are not like 
your normal adjustable rate mortgages. And every single person 
who received these loans received them in preference to a 
sustainable 30-year fixed-rate loan, which even in the subprime 
market could have been obtained at a very small increase over 
the introductory rate on the loan they got. And as Mr. Chairman 
said, many of these borrowers qualified for prime loans.
    The second point on the moral hazard question has to do 
with a point that I think Secretary Paulson made very 
eloquently immediately following the rescue of Bear Stearns, 
which was, yes, we worry about moral hazard, of course we worry 
about moral hazard; but we worry more, our primary focus at the 
moment is on stabilizing the market. And I do not think it is 
too fine a point to note that the investment banks and Wall 
Street have a share of the responsibility for supporting and 
encouraging the kind of loans that led to this crisis. I think 
helping them should preclude any real anxiety about helping the 
homeowners that we are talking about.
    It is now widely said--Chairman Bernanke said this a few 
weeks ago--that the key is reducing some of these principal 
balances and setting economically rational interest rates. We 
are not talking about propping up home prices unduly. We are 
talking about putting a floor under the decline.
    I have basically three recommendations to make with respect 
to the Hope for Homeowners Act.
    The first is the 13-percent haircut--the 10-percent 
reduction over current loan value, plus the 3 percent to go to 
the insurance pool--this is essential. It is essential for two 
reasons: one, to ensure the sustainability of the program so 
that taxpayers are not unduly at risk; and, second, from our 
point of view, it is extremely important that while we are 
going to help put a floor under the problem, we are not going 
to save investors and lenders from the full consequences of 
their investing decisions. These were sophisticated actors, and 
it is important that we not take away some of the incentives to 
behave more responsibly in the future.
    The reason I raise this is that as I read the bill, it 
leaves open the possibility that this requirement could be 
waived by future administrations of the program, and I think 
that that would be a mistake.
    The second recommendation is the appreciation sharing so 
that the homeowner is sharing with the FHA some of the benefit 
of the program. We think it is extremely important and 
appropriate that the homeowner should be helping to finance 
this program. We think that extending the appreciation sharing 
indefinitely, as the bill currently does, is not appropriate 
and also will be unworkable. Most homeowners do not stay in 
their homes more than 5 years. But for those who do and who 
make improvements, for example, in the homes, having indefinite 
appreciation sharing would require very complicated 
calculations about what part of the appreciation is a function 
of the original home and what is a function of subsequent 
improvements. I think capping it at 5 years with a 3-percent 
payment thereafter, as Mr. Frank's bill does, is a very good 
approach.
    Finally, we need a mechanism for dealing with the problem 
that in many cases loan servicers will be unable to take 
advantage of this program, just as they are unable to 
voluntarily modify the loans, even where each of those options 
is far better for investors than foreclosure. And the clearest 
example of where that will arise is in the case of the loans 
that carry piggyback second mortgages. Without the consent of 
the second-lien holder, there is no--you cannot modify the loan 
and save the home. And consent of the second-lien holder has 
not been forthcoming. The only proposal that I am aware of that 
would address this problem is a mechanism for allowing courts 
to supervise a modification of those loans so that the second-
lien holder's consent is not required.
    Thank you very much.
    Chairman Dodd. Thank you very, very much. I appreciate it, 
and I appreciate your testimony.
    Mr. Scott Stern, we thank you very much for being here this 
morning.

STATEMENT OF SCOTT STERN, CHIEF EXECUTIVE OFFICER, LENDERS ONE, 
                          INCORPORATED

    Mr. Stern. Thank you, Chairman Dodd. My name is Scott 
Stern, and I am the CEO of Lenders One Mortgage Cooperative in 
St. Louis, Missouri. Since this is our first appearance before 
the Committee, I would like to say a few words about the unique 
role that Lenders One plays in the mortgage industry.
    As the country's largest mortgage cooperative, Lenders One 
represents the Nation's ``Main Street'' lenders, like William 
Raevis Mortgage in Shelton, Connecticut, and probably lenders 
in the great States that you all represent. Our 110 shareholder 
mortgage companies have originated over 1 million home loans, 
almost exclusively prime loans, in the past 5 years, and we 
make homeownership possible in communities across the United 
States.
    This Committee, this Congress, and the administration have 
taken important steps to address today's mortgage crisis. 
However, the mortgage storm is far from over, and the Federal 
Government's work is not done. More needs to be done to address 
the root of the problem: looming foreclosures caused by 
defective subprime loans. These loans represent a toxin in the 
mortgage system that has spread far beyond the subprime sector 
to infect liquidity in the prime mortgage market, accelerate 
home price depreciation, and cause ripple effects throughout 
the Nation's economy.
    As FDIC Chairman Sheila Bair testified recently, negative 
housing trends are likely to continue at least through this 
year. The bulk of subprime hybrid ARM resets are still ahead of 
us. Over 1 million such loans valued in the hundreds of 
billions of dollars will reset in 2008. A similar volume of 
payment option ARMS and interest-only loans are also on the 
horizon. Many of these loans are foreclosures waiting to 
happen.
    I would also like to add that, in my expert opinion, these 
loans would not be foreclosure candidates had they been FHA 
loans in the first place.
    Loan modification efforts to date have fallen short of the 
scale necessary to make a significant reduction in 
foreclosures. The main Federal effort, FHASecure, while well 
intentioned, is simply not serving enough borrowers. Credit 
Suisse has estimated that only 44,000 delinquent borrowers 
would be eligible for a refinance under the program. And the 
latest numbers directly from HUD indicate that since the 
inception of the program in September 2007, just 1,500 
FHASecure conversions have been made.
    We believe that an enhanced federally assisted effort to 
cleanse the market of distressed subprime loans will contribute 
to stabilizing the mortgage finance system. Chairman Dodd's 
bill, the Hope for Homeownership Act, is carefully drawn to 
achieve that goal. The concept is simple: lenders and investors 
would take a loss by marking down the loan to market value. 
Borrowers would refinance at a higher yet stable rate than 
their initial teaser rate. No one gets a free ride.
    In my remaining time, I would like to address the three 
fundamental objections to Government action.
    No. 1, restructuring a troubled loan is not fair to other 
homeowners who are not in troubled loans. We are not 
unsympathetic to that view. However, the fact is that 
foreclosures create home equity losses, tighter credit, and a 
strained tax base for all homeowners, not just the family 
losing their home. By reducing foreclosures, all homeowners 
will see the benefits of market stability.
    No. 2, borrowers who take out risky loans deserve what they 
get. As a mortgage practitioner who has personally originated 
over $300 million in home loans, I respectfully disagree. 
Disclosures were often less than adequate, and faced with a 
bewildering array of loan terms, borrowers tended to trust 
their banker or broker, who in turn broke that trust. I liken 
the situation to that of a doctor and patient dealing with a 
medical procedure. The patient bears some reasonable risk. But 
they do not bear the risk of malpractice by the doctor. In our 
industry, we have frankly seen too much mortgage malpractice.
    And third, that this creates a burden on the taxpayer. 
Again, I respectfully disagree. The new loans would have 
positive equity; they would be fixed-rate stable mortgages; and 
the new borrowers would qualify under terms that made them safe 
loans.
    ``Curing'' a loan that had a high risk of failure creates 
no moral hazard. Just the opposite. Modifying a loan which 
probably should not have been made in the first place is the 
kind of action that can help restore integrity in the market.
    Finally, while we support the overall approach for the Hope 
for Homeowners Act, we do have some suggestions for improving 
the proposed legislation which can be found in our written 
testimony.
    Once again I would like to thank the Committee for today's 
opportunity to share the views of the Nation's independent 
mortgage bankers, and we look forward to continuing to work 
with this Committee to ensure stability and fairness in the 
mortgage market.
    Chairman Dodd. Mr. Stern, thank you. That was excellent 
testimony. I appreciate immensely your comments.
    Mr. Elmendorf, welcome. Mr. Elmendorf is a Senior Fellow at 
Brookings, and we appreciate your being back with the 
Committee.

STATEMENT OF DOUGLAS W. ELMENDORF, SENIOR FELLOW, THE BROOKINGS 
                          INSTITUTION

    Mr. Elmendorf. Thank you, Chairman Dodd and Members of the 
Committee. I appreciate the opportunity to appear before you 
today.
    The American economy, as we all know, now faces serious 
challenges. The economy is very likely in recession. Neither 
housing construction nor house prices show any sign of reaching 
bottom. The financial system is reeling, and lending to 
households and businesses is impeded. In the absence of further 
policy action, several million families will default on their 
mortgages in the next few years and lose their homes to 
foreclosure.
    Congress, the administration, and the Federal Reserve have 
responded to the broader problems, with forcible fiscal and 
monopoly actions. But less has been done to tackle the housing 
and mortgage mess directly. It is neither feasible nor 
appropriate for the Government to ensure that all families, 
regardless of their mortgages or their overall financial 
situations, can remain in their homes. However, it is both 
feasible and appropriate for the Government to reduce the 
number of families that will lose their homes in the next few 
years. Moreover, policy actions in this direction will have 
favorable effects on the broader economic problems that we 
confront.
    The first part of my remarks presents the case for greater 
Government involvement, and the second part turns to specific 
policies.
    Some have argued that mortgage borrowers and lenders should 
be left to work out their problems themselves. With the sharp 
deterioration in underwriting standards over the past several 
years, many families have indeed ended up in mortgages that are 
unsustainably large. In addition, the argument goes, it is 
unfair to help homeowners facing foreclosure while not helping 
people who chose to remain renters or who are stretching to 
meet their mortgage payments. And helping borrowers and lenders 
will create a moral hazard of excessive risk taking in the 
future.
    These arguments contain some truth, in my view, but they 
are not the whole truth. Despite these reasonable concerns, the 
Government has a crucial part to play.
    First, the Government has long had an active role in 
housing finance. With large mortgage lenders suffering massive 
losses, and many mortgage-backed securities viewed especially 
negatively in financial markets, the private supply of mortgage 
credit is now severely hampered.
    Second, Government policy never does, nor should, follow 
free market principles absolutely. We are always balancing the 
need for people to bear responsibility for their decisions with 
the goal of protecting the vulnerable members of our society.
    Third, mortgage problems have consequences that go well 
beyond the families and institutions directly involved. 
Foreclosures lower property values. Gyrations in financial 
markets pose risks to everyone's savings. And the weakening of 
the overall economy hurts many, many people.
    Fourth, the legal complexities and coordination challenges 
created by mortgage securitization imply that fewer loans will 
be modified than would be in the interests of even the lenders.
    The compromise housing bill being debated in the Senate 
this week includes several valuable provisions, as the Chairman 
has noted, including the appropriation of additional funds for 
mortgage counseling and the augmenting of funds for State and 
local governments. However, the bill falls short of what is 
needed, in my view. The further proposals of Chairman Dodd and 
Chairman Frank in the House to expand eligibility for FHA 
guaranteed loans would be an appropriate and important step 
forward for several reasons.
    First, the FHA's traditional mandate is to assist 
individuals underserved by the traditional mortgage market. 
Given the pullback in private mortgage lending and 
securitization, it is natural to increase the FHA's presence as 
a counterweight.
    Second, the proposals on the table are appropriately 
selective in the families they help. The proposals recognize 
the hard truth that not every family can afford to stay in its 
current home, so eligibility is limited to owner-occupiers who 
satisfy underwriting standards and represent good credit risks 
at the new mortgage levels.
    Third, the plans do not simply throw open taxpayers' 
wallets. Instead, they keep any cost to taxpayers quite low, 
again, by limiting eligibility to cases where existing 
principal amounts are written down, also by collecting 
insurance premiums, and by recapturing future appreciation.
    Fourth, these proposals encourage servicers to modify 
existing mortgages by providing a safe harbor against legal 
liability for doing so and by facilitating the issuance of new 
mortgages so that the old mortgagors do not need to remain in 
the market if they would prefer to leave it. As other panelists 
have noted, finding ways for the Government to help 
resubordinate second liens would be a valuable further step.
    In conclusion, I would emphasize that all of the policy 
options available to the Congress at this time are unsatisfying 
in many ways, but the cost of inaction is also very high. I 
urge this Committee and the Congress to go beyond the 
compromise Senate bill by expanding the role of the FHA. 
Addressing the mortgage mess can help families and reduce the 
scale of our broader economic problems, and it can do so with 
limited effects on future mortgage lending and future risk 
taking, and at fairly low cost to taxpayers.
    Thank you very much. I would be happy to answer any 
questions you may have.
    Chairman Dodd. Well, thank you very much, Mr. Elmendorf. I 
think you may be hearing the buzzers going off here, so we will 
be running in and out voting. So let me address, if I can, to 
both you and to Secretary Summers, a question, if I may. And I 
think, Larry, you sort of alluded to this in talking about the 
negative cycle of foreclosures. I think others have called it 
the ``negative feedback loop,'' and maybe other economists make 
reference to that. Would you expand on that a little bit, 
because I think it goes to the heart of why there is a 
justification for some intervention here. If you get this 
constant domino effect which drives this problem even further 
and deeper, creating additional problems, it may provide some 
light as to why this particular fact situation warrants 
something like the suggestion we are making.
    Mr. Summers. You have two different possible vicious cycle 
mechanisms going on. One, which is abundantly clear, is with 
respect to mortgage-backed securities where, as you put it in 
your opening statement, Mr. Chairman, there was an issue of 
finding--there was an issue of finding a floor and reducing 
uncertainty. And you have the problem that there are leveraged 
holders of those securities. As those securities decline in 
value, they get a margin call; they have to put up more money. 
They are either unable or unwilling to put up more money, as a 
consequence of which they sell them, as a consequence of which 
they go further down in value. And I think it is quite clear 
that that mechanism is present and is pervasively present with 
respect to mortgages, and anything that involves purchasing 
mortgage-backed securities, as your proposal would, or as the 
involvement of the GSEs does, serves to limit that.
    Second, there is the similar mechanism operative in the 
market for houses. The more house prices fall, the more people 
walk away; the more they walk away, the more house prices fall; 
and then more people walk away, and you have the same kind of 
vicious cycle. There is also a desirability of containing a 
vicious cycle of that kind.
    With respect to the second mechanism, though, I would 
caution that while I do not think I would go quite as far as he 
did, the point that Dean Baker made I thought was right, that 
one has to be very careful in stabilizing markets and 
preventing overreactions. But at the same time, one needs to be 
very careful of not trying to prop up markets at artificially 
inflated values. And I do not think we can say at this point 
that there are large parts of the country where house prices 
have fallen significantly below fundamentals, and, therefore, 
by reducing the effective supply of housing, we are making the 
adjustment process better.
    So while as you know, I am very sympathetic to the broad 
structures that you have put forward in your legislation, my 
enthusiasm derives from two sources, and quite explicitly does 
not derive from a third. It derives from the sense that this 
would be constructive with respect to the mortgage market in 
providing stability in that financial market. It derives from 
the sense that it would bring about more efficient outcomes 
that the person who is living in many of these houses is the 
right person to continue to live in that house, but needs to be 
living in that house with the value of the house written down. 
And I believe your legislation will support that taking place 
more efficiently and effectively than it otherwise would.
    But I become uncomfortable when--and I also believe related 
to that that in certain neighborhoods preventing an epidemic of 
foreclosures would avoid a disaster. But I think it is very 
important to be clear that it is not and should not be the 
objective of public policy to prevent house price deflation as 
a macro phenomenon. Moreover, in some sense, one of our 
concerns is that what we have to want is that both housing 
markets and financial markets find a level where it is 
attractive to be a buyer. And the longer the Government--if the 
Government were to become a dragging anchor, slowing the 
process of adjustment, you would delay the day when it was 
attractive to be a genuine buyer, and in some ways repeat the 
mistakes of what the Japanese did.
    So, yes, but the case is based on the micro of the housing 
market and the macro of the mortgage financial market, and not 
based on a desire to artificially prop up housing prices. And I 
think it is--I am glad you asked the question because I think 
it is important to be clear about, at least for me, where the 
case lies.
    Chairman Dodd. Well, I think that is a very good point, and 
I--other members can speak, obviously, for themselves here. I 
agree with your conclusion; hence, while we are trying to do 
this carefully, understanding there are hazards in how we craft 
something like this, there is a hazard in not crafting anything 
at all. And so how you try and manage this intelligently--one 
of the objectives, obviously, is to have a limited timeframe we 
are talking about for exactly the last point you are making, so 
that this is a very--we are talking about a brief period with a 
sunset provision in a sense, so it is not an ongoing program, 
not setting up a separate bureaucracy, utilizing the platforms 
that presently exist with FHA, for instance. There is a 
tendency in this town, obviously, if you establish something, 
it does not go away, and the danger of what that could do to 
your macro point.
    Mr. Summers. I think a danger--If I might?
    Chairman Dodd. Yes.
    Mr. Summers. I think a danger which you will need to be 
attentive to--and I believe it can be addressed--that actually 
Dean Baker's comments highlighted for me is the following: You 
are going to do one of your transactions where you buy the 
mortgage and then the FHA gives a 90-percent mortgage, and you 
are going to do it hypothetically in some community where there 
has not been a lot of turnover in the housing market, where 
there are 15 months of normal demand for houses being supplied. 
And some appraiser is going to come along and say what the 
value of the house is, and then you are going to write a 
mortgage for 90 percent of that, and that is what the guy 
holding the mortgage is going to have.
    Well, in an illiquid market with a very large inventory, 
doing that appraisal is not an easy thing to do accurately, and 
everyone that appraiser is going to meet is going to tend to 
have an interest in a higher appraisal. And the people who are 
going to bear the burden if there are misappraisals are going 
to be the taxpayers when the appraisal turns out to be wrong 
and 2 years from now, gosh, the house is worth 20 percent less 
than it was appraised and we are seeing this movie again.
    And so I would urge that there be very considerable 
attention given to the incentives in the appraisal process as 
this takes place, and to what I might think of as forward-
looking appraisals. It is very easy in down markets to do--I 
mean, I have been misled myself in this on a number of 
unfortunate occasions, where you are told what your house is 
worth on the basis of somebody who did comparables when houses 
like yours were sold 6 months before, and that becomes the 
basis for the appraisal, and that is not realistic in the 
context where the market is falling.
    I think one of the things that you will need to give 
careful thought to is the incentives governing the appraisals 
as this process goes down.
    Chairman Dodd. Thank you very much.
    Mr. Elmendorf, do you want to comment on this as well? I 
know you have time constraints.
    Mr. Elmendorf. I agree with much of what Larry said about 
not trying to prevent an aggregate correction in house prices. 
I do not think your proposed legislation would or could do 
that. I think our goal is to try to avoid an overshooting, and 
particularly in those cases where house prices rose very 
dramatically and are now coming back down very dramatically. 
And in those areas, particularly those where subprime lending 
was very prevalent, I think there is a risk of an overshooting 
in a way that would be very damaging to the people in those 
areas, those in the subprime mortgage houses and those in all 
other houses or rental housing as their neighborhoods and 
communities are hurt. And I think trying to avoid that 
overshooting is a legitimate goal and one that your legislation 
would help to achieve by providing a way to help people get 
into new mortgages.
    Chairman Dodd. Thank you very much.
    Let me turn to Senator Bunning.
    Senator Bunning. Thank you, Mr. Chairman.
    Welcome all, good testifiers and experts in this field. We 
have a major problem, as you well know, and there are many 
solutions, one of them being on the floor today. I happen to 
think it is inadequate. But we have an awful lot of other 
people who are proposing changes like Chairman Frank, Chairman 
Dodd, and others.
    Can anybody answer this question: How many people who are 
in trouble today took second mortgages or refinanced to tap 
their home equity?
    Mr. Stern. I will be happy to answer this question.
    Senator Bunning. Go ahead, Scott.
    Mr. Stern. Thank you for the question. Our experience is 
that where there were second loans, they were originated as 
part of a single transaction, perhaps an 80-percent first and a 
20-percent second, not----
    Senator Bunning. To get the whole house covered?
    Mr. Stern. To get to 100-percent loan-to-value, most likely 
on the suggestion of a lender. I do not know a lot of mortgage 
lenders who walk into a lender and say, ``I would like an 80:20 
piggyback loan.'' These are often at the suggestion of the 
lender.
    Your question is perhaps to question were these 
irresponsible lenders who just borrowed too much. I would 
respectfully say I do not think so. The majority of the time 
where these were second loans, I think they were part of an 
overall single transaction of a first and second mortgage 
combined on the recommendation of lenders.
    Senator Bunning. Would that be because of the total overall 
cost not being able to be afforded by a single mortgage so they 
could borrow enough to cover the entire mortgage with a second 
loan?
    Mr. Stern. Over the past 5 to 7 years, the mortgage 
industry has done a variety of things to expand homeownership 
opportunities, most of them well intentioned. Some of these 
involved minimizing documentation, some of them involved 
lowering credit standards, and some of them involved reducing 
down payment of any borrowers who borrowed 100 percent of their 
home's value did so because they needed to. Many of the 
borrowers did so because they had to. But at the end of the 
day, there were also competent underwriters, typically seasoned 
underwriters, who looked at these transactions and erroneously 
concluded that the overall risk of the loan was accurate.
    What we now know is that there was a significant layering 
of risk that is resulting in the challenges that they have 
today. They do not have enough money. They cannot afford the 
ARM resets. But now, of course, the big challenge is they 
cannot refinance, even if they want to, because their home has 
negative equity.
    But in answer to your question, I do think there are cases 
where borrowers put little down because they needed to, but now 
it is the result of the negative equity in their home that is 
causing the challenges, not the fact that they put no money 
down to begin with.
    Mr. Baker. If I could just throw in one more thing.
    Senator Bunning. Sure.
    Mr. Baker. A lot of the people that took out additional 
equity when they refinanced, in many cases these were people 
who wanted to refinance to take advantage of lower interest 
rates where they were subject to resets in 2005-06, and there 
had been appreciation in the interim, and they were actually 
encouraged in many cases by lenders to take out some of the 
additional equity to meet needs, whatever. So it was very often 
at the urging of the lenders that they would have refinanced 
for more than the original value of their mortgage.
    Senator Bunning. Can any of you see what incentives there 
would be for second mortgage holders to release their mortgage 
so borrowers can refinance?
    Mr. Baker. In many of these cases, they have--I mean, as 
things stand now, their second mortgage is going to be almost 
worthless, you know, because the home is underwater. They 
already----
    Senator Bunning. Well, I understand that, but to actually 
have a chance for the first mortgage to get changed, you have 
got to get a release from the second mortgage. So----
    Mr. Baker. That is right. You are absolutely right, 
Senator. I am sorry. But, I mean, at this point they 
essentially are giving up nothing except their right to 
obstruct.
    Mr. Elmendorf. Can I amend that a bit? I think the problem 
is they are not quite worth nothing because in some cases house 
prices may rise, people may stay in the homes. Second-lien 
holders may get something. It is not very much. It is probably 
pennies on the dollar of what the mortgage--of what they hoped 
to get in an ideal world. But it is not quite zero, and I think 
that is the complication. It is not just they will not sign the 
form. They want to get a little something out of this, and I 
think that is the reason why coordination in the refinancing is 
important and why the second-lien holders may need--do need to 
be brought into this process, and they may need to get 
something out of the deal--not very much, I think, but perhaps 
something.
    Senator Bunning. Maybe anyone--go ahead, Larry.
    Mr. Summers. I wish I had a clear way forward for you on 
this issue. I think it is a very difficult one. There is what I 
would call a long and undistinguished tradition of hold-up 
artists in financial life. And just as the guy who figures out 
that somebody wants to build a mall in a certain area and he 
figures out to own half an acre, half an acre is not really 
worth very much to him, but he feels himself to have an asset 
of considerable importance because of his blocking right, that 
is the nature of the problem that one has with these second 
mortgages.
    On the other hand, as I suspect those on your side of the 
aisle will point out, rightly, one does need to be rather 
careful about being cavalier about what, after all, are legal 
rights that people acquire.
    Senator Bunning. Well, especially if we throw it into a 
bankruptcy court, or something like that.
    Mr. Summers. I personally am of the view--and I know this 
is controversial--that carefully structured bankruptcy reform 
that does it in the context of bankruptcy would be 
constructive. There are others who would go further--and I 
would not--in allowing as part of a comprehensive solution some 
broad-gauged writing down of second mortgages with somebody's 
discretion outside of the bankruptcy context. I find that to be 
somewhat--I find that to be a problematic approach. But I think 
the question of how one works through the second mortgages is a 
crucial one.
    I would just add one other thing. I would, if I could be so 
presumptuous, commend to Committee staff the recent work that 
has been done by the Boston Fed where they have followed every 
mortgage and every home in Massachusetts over the last 20 
years. And one finds a variety of quite interesting patterns. 
Much more common than I would have imagined, for example, is 
the pattern where somebody takes out a prime mortgage and 
subsequently refinances as a subprime mortgage in order to get 
more out in appreciation. And we think of these mortgages that 
are being restructured all as the mortgage that the person used 
in order to buy the home. And it is that in many cases, and 
most cases probably particularly the egregious 2006 and 2007 
subprime cases. But there are a variety of other phenomena here 
involving refinancing, and I think there is really a great deal 
of experience that is calibrated in that data that could 
usefully inform the design of this legislation.
    Senator Bunning. Thank you.
    Chairman Dodd. Thank you, Senator.
    Senator Reed.
    Senator Reed. Thank you, Mr. Chairman. Thank you for your 
excellent testimony.
    Secretary Summers, one of the assumptions that everyone is 
operating under, and I know I am, is that if you adjust the 
price of the property down to a realistic value, then the 
homeowner will be able to carry on. But the question then is 
the continued viability of homeowners given declining wages in 
some places, stagnant wages, unemployment going up, commodity 
prices going up, and family budgets. This is not the best time 
to try to work out a real estate crisis.
    So any thoughts on the other side of the equation, that if 
this continued, price increases in commodities and unemployment 
growth, classic recession, where are we?
    Mr. Summers. I think it is a serious concern, Senator Reed. 
I am inclined to think that the further decline in house prices 
risk that I described is, if anything, slightly greater than 
the risks you describe, but I do not minimize the risks that 
you describe.
    The HOLC program in the Depression that the Chairman has 
referenced in designing his legislation has an approximately 
20-percent foreclosure rate, even though the program was put in 
at the bottom of the Depression, things were getting better, 
and equity levels were rather higher than what we contemplate 
today.
    So I think we need to be realistic in recognizing that 
whatever we do with the FHA, there is going to be a significant 
re-foreclosure rate. On the other hand, there are going to be a 
very large number of families who are going to have been 
benefited and who are going to have been enabled to stay in 
their homes.
    Now, some suggest, as Dean Baker did, that, one, cut past 
all that problem by turning the potential victims of 
foreclosure into long-term renters. And I see a merit of that 
approach in the sense that you would avoid some of these 
problems--not all of these problems. They might not be able at 
a certain point to afford the rent.
    For me, at the present time, the problematic aspect of that 
is the almost entirely involuntary character of what is 
happening vis-a-vis the contract that underlay the mortgage and 
vis-a-vis the bank.
    So I do not support that and would oppose it fairly 
vigorously, but going in that direction is the direction one 
goes if the problem one is most focused on is the ability of 
people to continue to stay in their homes indefinitely.
    Senator Reed. Dean Baker, do you have a comment?
    Mr. Baker. Yes, just a couple of things. I think any sort 
of program like the Hope Act would be most successful if we are 
very careful about the prices for reasons Secretary Summers had 
said and I had said earlier. And I think one way in which we 
could do that is if you try to anchor the guarantee price in 
rents, because rents are ongoing in the market, they have not 
fluctuated in as radical a pattern as sale prices. So if we 
were to set a guarantee price of, say, some multiple, 15:1 or 
something like, of rent, we would do two things. One, we would 
ensure ourselves that we are not setting ourselves up, setting 
up the taxpayers for large losses; and, second, we would 
minimize the subsequent foreclosure because that would be a 
situation where you would not anticipate large subsequent 
declines in the house price.
    So I would suggest that, you know, when we are looking to 
appraisals, again, as Secretary Summers said, it is very hard 
to find a reliable appraisal in a very irregular market. We 
could get a reliable rental appraisal because there is a large 
amount of rents in the market, and that could be a very good 
anchor. And, again, insofar as we are using money, using some 
of this guarantee to guarantee overpriced homes in bubble 
areas, that is money that is not going to stabilize markets 
where it could have a beneficial effect.
    Senator Reed. We all make reference back to the experience 
of the 1930s and the Depression, but there seems to be some--
there are differences, obviously, and one is that--and maybe 
this is more folklore than reality, but it seems to have some 
currency. It is that back then most of the mortgages were owned 
by a financial institution that could go in and make this deal 
pretty directly. The securitization process, which is very 
sophisticated, how will that complicate or what should we be 
particularly looking at in terms of the obstacles to getting 
anything done given these very sophisticated securitization 
products that have been cut up in tranches and defy some 
people's understanding? Secretary Summers.
    Mr. Summers. I apologize for having lost sight of precisely 
where the legislation Senator Carper has discussed in the past 
currently is. But the proposals to give legal liability--to 
give relief of legal liability from servicers for renegotiate 
strike me as being close to the lowest hanging fruit in this 
whole area.
    I think there is room for debate as to just how much of the 
problem they will solve. I think there is no room for--I think 
there is almost no room for rational debate that they represent 
a constructive step in the right direction.
    Senator Reed. Any other comments? Yes, Ellen. Ms. Harnick.
    Ms. Harnick. I would add that one other difference that 
flows from the fact that these loans are securitized is that 
different incentives are at play, so that back in the 1930s, 
the lender was the holder of the note and was the person 
negotiating. Today, when you have the servicer negotiating on 
behalf of different tranches of investors, sometimes the 
servicer's own incentives are quite different from what is good 
for the note holder. So that, for example, there has been a lot 
written about this, but servicers actually earn more themselves 
from foreclosing than they do from some of these cost-intensive 
alternatives like modification. And I assume that that would be 
in play with the FHA proposal as well. They will incur costs in 
going through the process for which they will not be reimbursed 
under their pooling and servicing agreement; whereas, if they 
foreclose, all their costs would be covered.
    So this is a problem that would have to be worked through. 
There would need to be a way to make the rational outcome--
realize the rational outcome even where the servicer's 
incentive might run to the contrary.
    Senator Reed. Do you have a proposal?
    Ms. Harnick. Well, the best proposal I am aware of is the 
one that allows a court to supervise the process and ensure 
that the rational solution is imposed where the servicer cannot 
or will not agree, and that is the bankruptcy conversation that 
has been raised in other quarters.
    Mr. Stern. If I----
    Senator Reed. Yes, please.
    Mr. Stern. I am happy to just add very, very quickly that 
the No. 1 thing we hear from Wall Street and from securitizers 
is they do not know where the bottom is. And I assure you that 
when they say we do not know where the bottom is, they are not 
talking about credit quality. They are talking about value.
    On a recent call I was on, we discussed the fact that this 
is the best quality of loans--the applications of March of 2008 
are the best quality of loans many of us have ever seen. They 
are high credit, they are low loan to value, and yet we cannot 
make the loans because simply the properties are not appraising 
out.
    If we had a bottom of the appraisal market, of the 
valuation market, these loans could be refinanced. Many of 
these borrowers need to refinance. Their ARMs are resetting. 
They come to us. We cannot help them because the simple reason 
is their loans are underwater. Securitizers need a bottom.
    Senator Reed. Thank you very much, Mr. Chairman.
    Bob, I think you are next.
    Senator Bennett. Senator Dodd as he left said he was going 
to have to recess the headquarters because of the votes, and 
since I am the only one who has voted, he said, ``You recess 
the hearing.'' [Laughter.]
    So I am prepared to do my presentation now--Senator Bayh.
    Senator Bayh. Mr. Chairman, if I could just briefly 
apologize to our panelists for the votes intruding upon this 
panel. We are all grateful for your time. Secretary Summers, it 
is particularly good to see you, and I could not help but think 
about the echoes to some of the challenges that you dealt with 
very ably in the 1990s currency crises in East Asia or in 
Mexico, and the countervailing risks of contagion and moral 
hazard. And it seems to me that there are some analogies to 
this situation where we need to deal with the systemic risk of 
the day, but then look very carefully at how we got into this 
mess and put into place mechanisms to make sure--you mentioned 
the incentives that are misaligned in some cases--to make sure 
we do not get into it again to deal with the moral hazard 
potentially down the road.
    So I would not help but be struck by that, and, again, 
thank you all. I apologize for having to run, but it is one of 
the few things as Senators, you know, they actually pay us to 
do here is to vote. So thank you all very much.
    Thank you.
    Senator Bennett. Thank you.
    I want to combine some of the things I would have said in 
an opening statement with my questioning period, and I have 
found this panel to be very, very helpful, not necessarily in 
terms of the solutions you proposed--that might disappoint 
you--but in terms of the problems you have exposed that are 
helpful to us.
    Secretary Summers, I applaud you and your final statement 
where you say, ``It is essential to recognize that policies 
that serve only to delay inevitable adjustments can easily 
prove counterproductive.'' And in our effort to be seen as 
doing something, the Congress inevitably moves in that 
direction, and I appreciate that warning.
    I want to show you a chart--I should have had it blown up, 
but I think it is big enough you can at least see the 
divergence between the two lines, and let me tell you what they 
are. The blue line is estimated price change since January 
2006, according to Case-Shiller, and it goes from the baseline 
point, a peak here in price appreciation occurring in July of 
2006, and then down 10.8 percent now.
    The red line is cumulative estimated price change since 
January 2006 according to OFHEO's Monthly Purchase Price Index 
USA. They are dramatically different. OFHEO shows a one-tenth 
of 1 percent increase in housing prices over that period, with 
the peak occurring in May 2007. And in May 2007, Case-Shiller 
had it already underwater.
    And as I have talked to Mr. Lockhart at OFHEO and asked him 
why the discrepancy, the answer is: We went to different places 
to gather data. Case-Shiller gathered the data in the 20 
largest cities in the United States, and OFHEO tried to gather 
data over a much broader scale. Point one for you, Dr. Baker, 
that there is a difference between prices in one place and 
prices in another, which makes it more difficult for us to come 
up with a nationwide system, and if we try to do our nationwide 
system based on the blue line, we may very well do damage to 
people who are living in cities that contribute to the red 
line, because the differential is fairly strong.
    My own observation is that in addition to the differential 
that you talk about, Dr. Baker, where some cities have reached 
equilibrium and others are in bubble condition, even within the 
same market there are differences, depending on the price band. 
In my own city of Salt Lake City, I know there is a glut of 
$400,000 homes, because my daughter has one that she has been 
trying to sell for over a year and can't. There is a shortage 
of homes under $200,000. And the law of supply and demand says 
that we should be building homes in that area. Why is there a 
shortage in that price band? Because homeowners in the period 
when the peak occurred, regardless of where you put it on the 
chart, could make more money building $400,000 homes and so 
they did not build homes in an area where there would be a 
greater demand because they could sell homes in the higher 
area, because people were buying them with the kinds of 
practices that you have been talking about. And also--let's not 
rule this out or turn our backs to it--people were buying homes 
for the purpose of selling them. And the homeowners were 
meeting that demand, and the market was there for it. And when 
that collapsed, everybody involved in it got hurt, and I 
frankly think most of them who were involved in the speculation 
deserved to get hurt.
    These are not struggling working families who got 
schnookered into something by an improper mortgage activity, 
Mr. Stern. I fully agree that that went on. There is no 
question that what you have described is accurate. But it was 
not accurate for the whole market, and this is my point. 
Depending on which city you go to, depending upon which price 
band you go to, depending on what kind of buyers you go to, you 
get an entirely different kind of dynamic and an entirely 
different motive for getting into this, and solving it with a 
single Federal program is extremely difficult.
    Now, Mr. Stern, you said the solution--I wrote down the 
phrase--is you ``mark to market value.'' Who determine what is 
market value? You have described loans that are good loans that 
fully meet all the needs of the lender, but the market value is 
not there because the appraisal is not there. Is the 
appraisal--market value, the economists tell you, is when a 
willing buyer and a willing seller sit down and come to a 
price. And at many parts of the there, again, at the lower end, 
a willing buyer and a willing seller could very easily come to 
a price because there is a shortage. And to arbitrarily have 
some Government agency or someone backed by a Government agency 
try to determine market value is going to be very, very 
difficult. And if all public policy flows from that kind of 
determination, we run the risk of doing what Secretary Summers 
warned us against of delaying an inevitable shake-out here.
    One final comment--well, no, two. This chart is harder for 
you to see at that distance. There is a bottom line that looks 
flat on both charts. It is in dark blue. It is not flat. It is 
loans in foreclosure, all mortgages. And in 2001, it was at 1 
percent, and by 2008, it is at 2 percent. So it is not flat. It 
has doubled in that time period.
    Now, the swooping red line is subprime adjustable rates in 
foreclosure. And in 2001, it was at 8 percent. It fell to 3.5 
percent in 2006, and then skyrocketed to 14 percent, and it is 
still going up.
    The somewhat more complicated chart above it has a third 
line on it in dark maroon. It is between the two. Very 
interestingly, it in 2008 is below where it was in 2001. It is 
foreclosures of subprime fixed-rate mortgages. Subprime fixed-
rate mortgages hit their peak in foreclosures in 2002 and have 
been coming down ever since.
    Further underscoring the point that hits me out of all of 
this testimony is that this is not a monolithic market. And 
most of the conversation, both by you and by the reporters who 
have chased me as I have walked up and down the halls, is, 
``What are you going to do about `the' housing crisis?'' As if 
it were a single, monolithic problem.
    We have differences in--repeat, differences in location, we 
have differences in price band, we have differences in style of 
mortgages. We have all kinds of differences that we are trying 
to solve by a single Federal law.
    My final point, you talk about the resets. I have a 
mortgage that just got reset. It went from 6.25 percent to 5.25 
percent. I just got the notice yesterday. I ripped it open as I 
came home from the day in the Senate, and I said, ``This is 
great. I love reset in this market.'' It just cut one full 
percentage point, 100 basis points off of the amount that I am 
paying here. We cannot automatically assume that reset means 
disaster.
    Now, I have gone on too long. That is my opening statement, 
and I am going to have to leave in 2 minutes. But, Secretary 
Summers, you wanted to respond.
    Mr. Summers. Senator, I take your point about 
heterogeneity, but I think is exactly right, but I would 
qualify--I would at least make three points.
    First, I think if you look at the study carefully, the 
difference between the OFHEO index and the Case-Shiller index, 
you will discover that different places is part of the story, 
but another very large part of the story is that the OFHEO 
index covers homes that are supported by conforming mortgages, 
not the homes that are supported by the nonconforming mortgages 
of various kinds, including subprime, where much of the problem 
lies.
    Second, there is, as you say, heterogeneity, and at least 
as I understand it, that is why voluntarism is at the center of 
Senator Dodd's proposal and proposals like it. Homeowners like 
you and mortgage owners of your mortgage will have no 
motivation whatsoever because of the circumstances--the part of 
the country you live in, the nature of your creditworthiness, 
and so forth--to bring their mortgage forward. The available 
evidence suggests that foreclosures are vastly 
disproportionately concentrated in categories of homes that 
have fallen way off in price.
    And so if you make available a universal foreclosure 
program, the people who will take it up will be those who are 
facing the problems of falling house prices and securitization.
    It is an unfair observation, but it is not a completely 
unfair observation, to suggest that if a proposal were made to 
help the victims of heart disease that an argument that that 
was an unwise proposal because there was enormous heterogeneity 
in health and many people did not have heart disease and had 
other diseases would probably not be a very strong argument. 
And while this situation is not--the analogy is not really 
right, and so what I just said is a bit of----
    Senator Bennett. I will agree with you that the analogy is 
not----
    Mr. Summers. As a bit of a cheap shot, it does capture 
something which I think is important to recognize, which is the 
place where these national programs will have their impact will 
be in the segments that are caught by the kinds of distress 
that we have been discussing.
    Senator Bennett. I vastly apologize, but Harry Reid keeps 
the time rule vigorously, and if I do not leave, I will not get 
there in time for the vote. Respond if you want to in writing, 
anything you want to send to my office. And, again, it has been 
a very valuable panel, and I have learned a great deal from it.
    The Committee is adjourned.
    Let me correct that. The Committee is in recess.
    [Recess.]
    Chairman Dodd. The Committee will come back to order. My 
apologies. You are very patient. We will have to get you a very 
good mortgage someplace.
    [Laughter.]
    You cannot plan these things. You set up a hearing, and 
then everything happens at once. Last evening, we spent all day 
trying to resolve some 16, 18 different amendments as a 
managers' amendment as part of the housing proposal we just 
voted on. And I had also agreed and accepted a wonderful 
invitation several weeks ago to speak to the midshipmen at the 
Naval Academy last evening. And I wonder who was working 
against me that all of a sudden the final vote on the housing 
package was going to occur on the very night that I was going 
to address the corps of midshipmen in Annapolis, and then this 
morning holding this hearing and having the votes occur at the 
same time.
    So to the three of you here, I appreciate immensely your 
willingness to stay around a little bit and respond more to 
some Members' questions and some thoughts, and your testimony 
has been excellent this morning. So I thank you for that as 
well.
    Given the short time we have, let me turn to Senator 
Carper. I have had a chance already to raise some questions, 
and he has not, and then what we will probably do is leave the 
record open and allow Members to submit additional questions as 
well for you.
    Senator Carper.
    Senator Carper. Thank you, Mr. Chairman. Let me just 
congratulate you and Senator Shelby on the work that culminated 
with the vote on the floor. Do you recall what the final vote 
was?
    Chairman Dodd. 84 to 12.
    Senator Carper. 84 to 12. It is pretty hard around here to 
get--I could introduce a resolution that says today is 
Thursday, and I would be lucky to get 84 votes for it. So that 
is pretty impressive.
    [Laughter.]
    I would echo the Chairman's thoughts. Thank you so much for 
your patience, for waiting for us, and for your testimony and 
responses.
    One of the things that Secretary Summers mentioned before 
we started our series of votes, he talked a little bit about 
the safe harbor legislation, and he sort of complimented me on 
my safe harbor legislation, which actually is going to be 
introduced by Delaware's Congressman, Mike Castle, also a 
Banking Committee member and, like me, a former Governor. 
People confuse us all the time, including in Delaware. But it 
is an issue that I have some real interest in, and I think the 
notion is if we are going to have this voluntary program where 
we get borrowers, lenders, servicers, mortgage servicers to 
agree to take a haircut, a financial haircut, then there may 
have to be some protection against lawsuits against the 
servicer.
    And what I think Secretary Summers was saying is he agrees 
with that notion, and I just want to ask each of you to comment 
on the value of that proposal by my colleague from Delaware, 
Congressman Castle, the safe harbor proposal.
    Mr. Stern. I am happy to start. On my way over here today, 
when we were pondering whether Government action was necessary, 
and we were thinking about medical malpractice, we said, well, 
when something happens to you in the hospital, you sue your 
doctor. You do not ask the Government for help. And why is this 
situation different? And I said, you know what? If I had been 
the victim of a bad loan, I would go sue my lender. And it is 
very relevant, I think, because I think if I am a servicer, a 
large servicer, and several of these companies have hundreds of 
billions, if not trillions, of dollars of loans, I think they 
have to be concerned about consumer lawsuits--not investor 
lawsuits, but from the very borrowers to whom they made the 
loans.
    I do think it is an outstanding trade-off or compromise to 
say that in exchange for writing down the loan we will provide 
a safe harbor from a private right of action, because I do 
think if you are a servicer right now, you have to be concerned 
about lawsuits on behalf of borrowers who ended up with loans 
with the very features that are causing the financial pressure. 
I think it is an excellent outcome.
    Senator Carper. All right. Thank you.
    Others, please.
    Ms. Harnick. Well, the safe harbor that I think is a really 
terrific idea and that I think Dr. Summers was supporting is 
the idea of protecting servicers from lawsuits by investors, 
because I believe that that fear is, in fact, one of the 
significant barriers both to voluntary loan modifications and I 
would imagine it would be a barrier to accepting a short 
refinancing under the FHA proposal. So I think that that would 
be really essential. And it is essential in part because it 
would address--there is nothing unfair about it, I think, from 
the point of view of investors, because what it is attempting 
to do is address the very significant problem that servicers 
are in a position where they often cannot make the economically 
rational choice. If the economically rational choice is accept 
a short refinance or modify the loan and thereby recover more 
for the mortgage holder than the inevitable consequence of 
foreclosure, that is a very good choice. And if servicers--to 
the extent that servicers are--and I have heard repeatedly that 
they are--hampered by the fear that some investors will say, 
well, the way you modified the loan or the way you structured 
the new refinancing disadvantaged me, even though it was better 
for the collective. So I do think it is an excellent idea.
    I have to say I would not be supportive of the idea of 
providing a safe harbor from consumer lawsuits, and I do not 
know if that is something that needs to be discussed further. I 
could expand on it if necessary, but for investor lawsuits, I 
think it is an excellent idea.
    Senator Carper. Mr. Stern, in your comments were you 
referring to investor lawsuits?
    Mr. Stern. I am suggesting that if a consumer receives a 
short payoff from a servicer, one of the things they should 
offer in exchange is, yes, to not sue the servicer who provided 
them the short payoff.
    Senator Carper. OK. Fair enough. Thank you.
    Dr. Baker.
    Mr. Baker. I do not have too much to add on that. I would 
agree very strongly that I think it is a step in the right 
direction because, you know, you sort of have this asymmetry 
that, you know, again, it may very well be in the investor's 
best interest, but from the standpoint of the servicer, they 
want to take the cautious path. I do not think any servicer has 
ever been sued for not doing a short sale or a writedown. So, 
you know, the cautious thing for them is just sit there, go 
ahead with the foreclosure. That is a well-trodden path, and 
that is very safe.
    So I think, you know, giving them symmetry that they do not 
have to fear either way so that they can make what is the best 
decision, I think that is the good way to go. And, again, I 
would agree with Ellen that I do not--I would not want to give 
any sort of carte blanche. I am not familiar with the 
legislation, the details of the legislation. I would not want 
to give some carte blanche immunity in consumer lawsuits 
because there were improper actions in cases, and, you know, 
you might want to hold those servicers responsible. So I would 
be hesitant on that.
    Senator Carper. All right. Thank you.
    The Hope for Homeowners proposal allows a mortgage to be 
refinanced and insured by FHA, as you know. In return for 
accepting the risk, FHA receives, I think, 50 percent of all 
future profits. I think that is the way it reads. The FHA 
should, in my opinion, share some of the future profit to help 
pay for the program, and the House bill allows FHA to share--I 
think a lot during the first few years, maybe 100 percent in 
the first year, down to 0 in the fifth year of a refinance. 
But, in any event, it is less over time.
    How much should FHA receive for accepting this risk?
    Mr. Stern. I would be happy to address that, and it might 
surprise you to know that there are State-run mortgage programs 
that currently allow for the State program to participate in 
the appreciation of a home. I would be surprised if you did 
know that.
    In the State of Missouri, there is an organization known as 
the Missouri Housing Development Commission, and specifically 
they supply first-time homebuyer funds for borrowers with a 
median--who have an income below the median level in the area 
where they buy. In exchange for receiving those funds--they are 
subsidized interest rate and down payment funds. In exchange 
for receiving those funds, the buyer agrees to a concept called 
a ``recapture tax,'' and that recapture tax agreement says: If 
you sell your house in the future and you make money on the 
home investment, and your income has increased above the median 
level, you must pay a percentage of those profits back to the 
Missouri Housing Development Commission. And what happens in 
that case is that money is used to then replenish the system so 
that future buyers have the benefit of the first-time homebuyer 
system.
    I just thought it would be helpful to you to know that it 
is not unprecedented. It works extremely well in Missouri, so 
the concept is called the ``recapture tax,'' and they do have 
the benefit of the appreciation of the property in exchange for 
providing a subsidy.
    Senator Carper. All right. Thank you.
    Ms. Harnick.
    Ms. Harnick. Thank you, Senator. I think it is a good idea 
for the homeowner to share some of the appreciation with the 
program, both for the soundness of the program and because as a 
fairness issue.
    I think that my recommendation, our recommendation would be 
that we track more closely to what the House bill does. What 
the House bill does is it allows shared appreciation over 5 
years, and, by the way, it tracks both shared appreciation and 
also making sure that the borrower can't immediately get the 
benefit of the 10-percent haircut. And the proposal here does 
the same. I think that is an excellent idea.
    At the end of the 5 years under the House bill, the 
recapture tax, as it were, is capped at 3 percent, and I think 
that that is a more appropriate mechanism than having an 
indefinite 50/50 sharing of appreciation. I was saying earlier, 
quite apart from whether it is wise social policy to deprive 
the homeowner of 50 percent of the wealth-building value of a 
home indefinitely--I think that that is a real question. And I 
also think it is hard to administer. If the homeowner invests 
in a new kitchen, redoes the kitchen, and 15 years later the 
home is appraised at a value that exceeds both the refinance 
price and the value of the kitchen, how much of that 
appreciation is attributable to the work that they did and how 
much is attributable to the refinancing?
    So for that reason, I would say I think it would be better 
to cut it off and cap it.
    Senator Carper. Well, we all know that when people want to 
raise the value of their home for sale, they improve those 
kitchens. And what do they do next? The bathrooms. At least 
that is what I am told.
    Dean Baker.
    Mr. Baker. Yes, I would very much agree with that. I think 
the basic point here is that we do not want someone to be able 
to cash in, you know, at the FHA's expense with the initial 10 
percent. So something like 100 percent to start and then 
phasing down close to 0 over 5 years, I think that is a 
reasonable framework we are talking about. And once you get 
further out, again, the value of that home is going to reflect, 
to a large extent, how much people have maintained it, what 
they have put into it, so it does make sense that that be, you 
know, a much lower tax, or however you want to put it, at some 
future point.
    So something like what you have in the House bill I think 
makes a lot of sense.
    Senator Carper. All right. Great.
    Mr. Chairman, thanks for the chance to ask these questions, 
and again to each of you for--I missed your testimony. I am 
told it was just a terrific panel. I am glad I got to ask you 
some questions.
    Chairman Dodd. It was very, very good.
    We have a safe harbor provision in our bill, as does the 
suggestion of the House. The difference is the safe harbor 
that--in fact, the counseling provision is to protect the 
servicer from investor lawsuits. It is not to protect the 
servicer from consumer lawsuits. And there is more of a 
concern, I think, from that side of the equation.
    In fact, I was curious. I know there are not many examples 
of this, but I was curious as to whether or not if you did not 
do something--if I am an investor and I discovered that a 
servicer refused to have a workout and the option was losing 
everything, I would be curious if there wasn't more of an 
action, a possibility of action there, why didn't you take that 
50 cents on the dollar? I would be at least 50 percent better 
off than I am now if I end up losing everything. Again, I do 
not know if there is any precedent for any of this at all or 
not, but it would seem to me that might be a more likely 
outcome in some ways than the likelihood you are going to be 
sued because I am getting less than 50 cents--or 50 cents less 
than I would have otherwise gotten under the circumstances.
    Mr. Stern. Yes, I would say--Dr. Baker said he has never 
heard of a servicer being sued for not doing a short sale, 
except I would say this is a very unusual time. If you have a 
chance to do a short sale for 50 cents on the dollar and you do 
not, and you do lose everything, I agree, this is a very 
unusual time. You could be sued for not doing the workout, 
where they might not have in the past.
    Chairman Dodd. Exactly, so it is interesting. Thank you, 
Senator Carper, very much.
    Just going back over--and I am going to--not to keep you, 
just an additional point here. As I mentioned, Larry Summers 
and Doug Elmendorf had to attend a conference they are hosting 
today, and as I said at the outset, the proposal that I have 
suggested--back in January, in fact--raised this idea and then 
met--it is not a new idea, either. These are ideas that have 
been tried, as you point out. There are States that have tried 
variations of this. I was in Pennsylvania with Bob Casey, 
Senator Casey, the other day for a hearing, and I think it is 
the HEMAP program in the State of Pennsylvania, something very 
similar to what we are talking about here. In fact, they go 
further. They have another program, a HERO program, which 
really does take these underwater--completely underwater 
programs to try and salvage something out of them as well. So, 
again, people have identified the program in the Depression 
era, which was a more direct participation, a direct, I guess, 
acquisition and purchasing of these discounted mortgages.
    I am told historically that the Federal Government actually 
made some $14 million. I do not know what that was in today's 
dollars, what it would be at the end of the day.
    But I want to emphasize the point, I think there are some 
very, very good points. I think, Dean Baker, you raised, along 
with Larry, some cautionary notes, so as you start down this 
path, understand and think about them. That is why it is very 
important to me. This ought not to be an ideological debate. 
This ought to be a discussion about if we are going to do 
something, do it well, and make sure you are not going to do 
more harm. I guess to use your medical analogy, we ought to 
apply the Hippocratic oath here as well. The first rule is do 
no harm. In a sense, while we are talking about mortgage 
malpractice, I want to make sure that we do no harm, that as we 
try to fashion ideas that can limit the number of foreclosures 
that are being filed every day in the country, as I mentioned, 
close to 8,000 a day; 240,000 people went into foreclosure in 
the month of February. And there is always a normal amount of 
this. I think one of the things that--maybe some people would 
assume we never had any foreclosures, and there are always a 
certain level of them occurring. But this time it is compounded 
in a way because of the liquidity issues that have arisen, and 
I want to underscore Larry Summers' suggestion. I do not know 
if any of you have any views on this or not, but the notion of 
the GSEs seeking more capital, and while there is a legitimate 
shareholder interest in all of this, they are called 
Government-sponsored enterprises for a reason, and there is 
something called a ``Mission Statement,'' and the Mission 
Statement should reflect circumstances not unlike the ones we 
are in, as unprecedented as they are in many ways, but they 
exist, in effect, for dealing with moments like this.
    And so I support his underlying idea of having them go out 
and raise more capital at this point, and the shareholders 
certainly have to be considered. But they, it would seem to me, 
have to take a secondary position considering what is the 
rationale for the existence of Fannie and Freddie anyway.
    I do not know if you have--does anybody have any views on 
that? Do you have any view on that, Dean, what Larry talked 
about earlier?
    Mr. Baker. Yes. I did not quite agree with him on that 
because then we are asking Fannie and Freddie to take on, you 
know, more risk. And if you do not increase the capitalization, 
then that is putting--it is coming out of the taxpayer's 
expense. So the question is: How do you balance that, the 
shareholders versus the taxpayer? As they are taking on more 
risk, that is all going on the taxpayer side. It seems 
reasonable to say, OK, there also ought to be more on the 
shareholder side; therefore, there has to be more capital 
there.
    So I think that is going in the right direction. How much, 
you know, what is the magic number there, I do not know. But I 
think certainly increasing their capitalization is the right 
thing to do now.
    Chairman Dodd. Ellen or Scott, any views on this?
    Mr. Stern. Well, I will share with you that right now there 
are only four reliable sources of capital in the mortgage 
market today: Fannie Mae, Freddie Mac, FHA, and VA. There is no 
reliable private source of capital from anyplace else, from 
Wall Street to insurance companies, even to banks lending their 
own money. And the reason for the reliability is the implied 
guarantee of the GSEs.
    So I would suggest that especially now, the liquidity of 
the GSEs is important. It probably has been never more 
important. And as long as they remain the most reliable source 
of funding for an average borrower who needs a home for a 
purchase or refinance, I would encourage liquidity of the GSEs.
    Chairman Dodd. Ellen.
    Ms. Harnick. I do not have anything to add on that point, 
Mr. Chairman, but I did want to come back to a point that was 
made just before the break. May I do that?
    Chairman Dodd. Sure.
    Ms. Harnick. Because it goes to the----
    Chairman Dodd. What was the point?
    Ms. Harnick. The point is the issue of how difficult--the 
suggestion is that we have to be careful to make sure that 
appraisals are properly done in figuring out the current value. 
And I think what Larry Summers had said is we need to ensure 
that appraisers don't have the wrong incentives, that 
appraisers are not linked to the lender in any way or to the 
servicers, that the lenders do not have an incentive to 
overstate home values.
    But I think what got lost when the conversation got broken 
off is the fact that appraisers do this sort of thing all the 
time. There is nothing unusual about the effort to appraise a 
property, even in markets where sales have been slow, even in 
illiquid markets. I mean, this is something that could be 
done--Dean Baker suggested various mechanisms that could be put 
in place to ensure that we are getting good appraisals.
    So I think that any concern that was raised about that is 
certainly worth taking into account in shaping the kind of 
appraisals we do. But I think that is as far as the concern 
needs to go.
    Chairman Dodd. OK. Well, again, I wanted to come back and 
just suggest--these ideas and thoughts are very, very valuable 
to us as we try to fashion some good ideas, and I think Doug 
Elmendorf made a good point. He said, and I am quoting him, `` 
. . . we must choose between messy policy options and 
inaction--and the cost of inaction is very high.'' And I agree 
with him on that. And he particularly said, ``. . . a measured 
expansion in the role of the Federal Housing Administration as 
proposed by [myself] and Chairman Frank would contribute 
importantly to reducing the size of the coming foreclosure 
wave.'' I do not know if that was raised in my absence, this 
second tranche that we are approaching.
    Larry Summers said careful consideration should be given to 
the type of measures that we are proposing, and I agree with 
him on that. He noted last week that the administration has put 
together programs and policies but have not really come to very 
much. We need a much more activist set of responses to maximize 
the chance that the current crisis is contained. I think he was 
speaking as well about the capitalization issue of Fannie and 
Freddie, as well as possibly the idea we are talking about 
here.
    I want the Committee to know that I am committed to 
considering recommendations by our colleagues here, the 
witnesses. I invite your even further consideration as you look 
at these proposals, unless you just have an underlying total 
disagreement with the thrust altogether. But if you see that at 
least the thrust may be going in the right direction but it 
needs to be handled in a more balanced approach, I would be 
very interested in hearing your suggestions and thoughts on all 
of this. As I said, there is no silver bullets, but this 
proposal would provide both lenders and borrowers an additional 
tool to avoid unnecessary foreclosures--in a sense, unnecessary 
foreclosures.
    You have two constituencies, one that I am sympathetic 
about. I do not want to see anybody lose money. But I feel 
absolutely no obligation whatsoever with the speculator 
community. I am sorry they lost money, but that is the nature 
of investment here. Those things happen.
    The second group of people I feel very sympathetic about, 
and they never should have gotten a mortgage in the first 
place, and there probably is not a structure that we can come 
up with that they are going to be able to meet. Now, we ought 
to think about ways to help people in that category. But I do 
not see how these proposals are necessarily going to work for 
those people in that situation. I regret deeply the problems 
they have, but realistically it is going to be impossible in 
some cases to provide help at all.
    And then there is that third group that plays such a 
critical role in all of this, and to the extent we are able to 
do something about that is where my interest is and my focus 
is, and so I am holding this hearing today, and we will have 
one again next week, and I will be in consultations with those 
of you here. And I really do--this is not a gratuitous comment. 
You are talented, you are knowledgeable, you understand these 
things very, very well. And it will be very, very helpful to 
share your ideas and thoughts with the Committee on how we can 
do a better job at this.
    I am going to ask as well that we include an editorial from 
this morning--I believe it was this morning--in USA Today, 
which raises legitimate concerns about some of the things in 
the bill we just passed. And I will be the first to admit that 
there are some things in that bill that, had I been writing it 
alone, would not have been in there. There are lot of things 
that would have been in that bill had I had a chance to write 
it alone. And there are many things in there that I think are 
very good and can be very, very helpful. And I am grateful to 
Senator Shelby and his staff and others for allowing us to work 
through here, now allowing us to be in a position to work with 
the House of Representatives to fashion a more comprehensive 
set of thoughts on all of this in the coming weeks. And we will 
have markups in this hearing on GSE, on related matters, on the 
reform ideas that need to be considered as well. And I am going 
to be working with Senator Shelby and his staff and other 
Members of the Committee as we prepare for those to see if we 
cannot reach some strong bipartisan approval of some of these 
ideas.
    But I am very grateful, again, for your testimony today. We 
will leave the record open because I know some other people 
have some questions. But I am very impressed with your 
testimony and very grateful for your presence.
    The Committee will stand adjourned.
    [Whereupon, at 12:49 p.m., the hearing was adjourned.]
    [Prepared statements, responses to written questions, and 
additional material supplied for the record follow:]


[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]



 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM LAWRENCE 
                           H. SUMMERS

               WHAT WOULD GOVERNMENT INTERVENTION BUY US?

    Mr. Summers, you note that the policy challenge is to 
mitigate market overreactions while not interfering with 
necessary or inevitable adjustments. At the same time, we hear 
that government intervention in the housing market is needed to 
essentially set a ``floor'' to housing values.

Q.1. Can government intervention alone set a floor on housing 
values? Won't the marketplace still ultimately determine 
values?

A.1. Government intervention may not singlehandedly solve the 
turmoil in the housing markets, but the risks of inaction 
undoubtedly far outweigh the risks of action. Simply because 
government intervention will not be a sufficient solution on 
its own does not mean that it is not one important--and perhaps 
even necessary--part of the solution.

Q.2. If the government does intervene, are we effectively 
putting all the risk of further price declines on the taxpayer 
rather than leaving it in private hands who benefitted from 
what we now believe may have been a housing bubble?

A.2. As I understand the proposals, there is substantial 
protection built in for taxpayers through fees and loan limits, 
and it would be appropriate to design procedures so as to 
minimize the risk of misappraisals. Regardless, in the event 
that the current economic problems prove profound, the costs of 
current intervention are likely to be the least of the federal 
budget's problems.

Q.3. What is the long-term cost of government intervention into 
the mortgage market to provide stability? Are we encouraging 
borrowers and lenders to pay even less attention to risk in the 
future?

A.3. Any time that the federal government intervenes to protect 
borrowers and lenders, moral hazard is certainly a concern. But 
in a situation where credit problems threaten economic 
stability at a fundamental level, the risk that inaction will 
cause significant financial distress for American families 
outweighs moral hazard considerations. The same people who cite 
moral hazard as a reason that government should not act to 
minimize the threats now facing the mortgage market would 
almost certainly not claim that the prospect that people might 
smoke in bed would be a plausible argument in favor of getting 
rid of fire departments.

                      IMPORTANCE OF DOWN PAYMENTS

    A 20 percent down payment to purchase a home became 
increasingly rare in recent years as home prices accelerated. 
We now see that many of the borrowers who are in trouble made 
minimal, if any, down payment. It is not surprising that we 
would find a number of homeowners with negative equity, even 
with modest price declines in home values.

Q.4. As the Congress looks for ways to avoid repeating past 
mistakes, what should this tell us about down payment 
requirements, particularly with respect to any government-
guaranteed mortgage programs?

A.4. One would hope that any long-term response to a crisis 
caused by excessive hubris and undervaluing risk would place 
substantial value on financial responsibility. Realistic and 
responsible down-payment requirements would constitute one of 
many possible measures for restoring stability and credibility 
to the housing market.
                                ------                                


RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM DEAN BAKER

                      IMPORTANCE OF DOWN PAYMENTS

    A 20 percent down payment to purchase a home became 
increasingly rare in recent years as home prices accelerated. 
We now see that many of the borrowers who are in trouble made 
minimal, if any, down payment. It is not surprising that we 
would find a number of homeowners with negative equity, even 
with modest price declines in home values.

Q.1. As the Congress looks for ways to avoid repeating past 
mistakes, what should this tell us about down-payment 
requirements, particularly with respect to any government-
guaranteed mortgage programs?

A.1. I would be hesitant to draw conclusions that might be too 
strong about down-payment requirements. Other things equal, it 
is desirable to require that buyers have a reasonable down 
payment so that they have an equity stake in their house from 
the outset. However, I think it is reasonable to lower these 
requirements to more modest levels (3-5 percent) in cases where 
individuals have solid work histories and generally good credit 
records. It is often difficult for moderate-income families to 
save much money, and even a 3 percent down payment can be a 
burden.
    More than the down payment, I would emphasize the need to 
ensure that families are not getting into homes that they will 
not be able to afford. If a family has maintained a solid work 
history and generally good credit, then they are likely to act 
to ensure that their mortgage is paid in good faith, barring 
serious illness or family break-up.
    The housing bubble and the resulting collapse in prices are 
unusual circumstances which hopefully will not be repeated. 
When house prices fall by 25-30 percent, as we have seen in 
some areas, no reasonable down-payment requirement can prevent 
homeowners from going underwater. I think it would be a mistake 
to set down-payment requirements based on such an extraordinary 
event. Rather Congress should try to ensure that comparable 
housing bubbles do not arise in the future.

           DISCREPANCY BETWEEN HOME PRICES AND RENTAL PRICES

    Mr. Baker, your testimony notes the large discrepancies 
between home prices and rental prices in much of the country. 
It would appear that the housing market needs to adjust so that 
these two prices are more aligned, especially if we would like 
to be able to help low and moderate income working families 
purchase homes in the future.
Q.2. Please explain to the Committee how a program such as Hope 
for Homeowners would stand in the way of such a necessary 
adjustment in home prices and also, what exposure the Federal 
Government would face if we intervene in this adjustment?

A.2. The Hope for Homeowners program could interfere with the 
price adjustment process in over-valued markets if it 
guaranteed mortgages at prices that are still above trend 
levels in these markets. In effect, the program would be 
providing an artificial source of demand that would be propping 
up prices above their market levels. At least for a period of 
time, this could sustain prices at artificially high levels.
    This would place the Federal Government at risk because it 
would effectively guarantee a price on a mortgage that is above 
the trend market price for the house. If house prices 
eventually adjust to a lower level, homeowners are again likely 
to find themselves owing more than the value of their homes. 
This means they will have a temptation to default on their 
mortgage. Even if they continue making payments on the mortgage 
in spite of being underwater, many homeowners could end up 
selling their homes for less than the value of the mortgage. 
(The median period of homeownership for moderate-income 
families is just four years.) In both the cases of an outright 
default or a ``short sale,'' the Federal Government would be 
obligated to compensate the lender for the difference between 
the guarantee price and the money the lender actually collects.
    Of course, any time the government sets up a loan guarantee 
program of any type it puts itself at risk in this manner. 
However, I think it is important to distinguish between the 
type of risks that exist in a typical market, and the type that 
exist in an over-valued real estate market. As I said in my 
testimony, I think that the government can limit this risk if 
Congress bases the guarantee price on a multiple of rent (I 
suggested 15 to 1). However, if the government were to 
guarantee prices based on appraisals in a market that is still 
substantially over-valued, it is almost certain to incur losses 
on a large share of its guarantees.
                                ------                                


  RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM DEAN 
                             BAKER

Q.1. What do you suggest we do to find the $20 billion this 
bill costs to start up? What should we cut, or what should we 
raise taxes on?

A.1. Since the economy is currently facing a recession, or at 
least a period of very slow growth, it might be desirable to 
run a larger deficit, at least temporarily. This would provide 
stimulus to the economy, as Congress sought to do with the 
stimulus package it passed in February.
    Obviously any tax increases or spending cuts that Congress 
puts in place would reflect its priorities. I would first and 
foremost look to removing tax breaks which distort the tax code 
without any obvious rationale.
    The two that come to mind most immediately are the special 
treatment of carried interest which allows hedge and equity 
fund managers to have their compensation taxed at the 15 
percent capital gains rate, instead of the 35 percent rate they 
would otherwise pay. This encourages gaming of the system and 
allows some of the wealthiest people in the country to pay a 
lower tax rate on their earnings than school teachers or 
firefighters.
    The other tax break that serves no obvious purpose is the 
mortgage interest tax deduction for expensive homes. While home 
ownership is often desirable, and it is reasonable to provide 
assistance to moderate- and middle-income homeowners, it is not 
clear what public interest is served by subsidizing the 
purchase of a multi-million dollar home by a family in the top 
1 percent of the income distribution. Congress could 
substantially lower the caps on the amount of a mortgage for 
which the interest is deductible without affecting middle-class 
families at all. Moving the cap down from $900,000 to $500,000 
would inflict little pain on anyone.

Q.2. Do you have any suggestions for making sure someone did 
not lie or not tell the whole truth on their original mortgage 
application?

A.2. In the future, it would be appropriate to require that 
lenders make a good faith effort to verify the information that 
borrowers put down on application forms. The Federal Reserve 
Board has proposed regulations that would require loans be 
properly documented. I believe that Representative Frank's 
mortgage reform bill, or at least some version of it, also had 
such a requirement. There may be legitimate reasons why it is 
not always possible to get full documentation of the 
information used by borrowers to secure a mortgage, but such 
instances should be the exception.
    Clearly, issuers were anxious to issue mortgages in the 
housing boom because they made money on the issuance fees, 
whether or not there was reason to believe that the borrower 
actually could repay the loan. If issuers are made liable for 
the quality of loan, for example by requiring them to hold a 10 
percent stake of loans sold in the secondary market, then they 
will have more incentive to ensure that the information 
borrowers provide is accurate.

Q.3. If home prices continue to fall, lenders would be 
protected. But what protection do the taxpayers have if prices 
fall 10% more?

A.3. If home prices continue to decline, and the government 
issues guarantees of mortgages at prices that are near current 
levels, then the government is likely to face a substantial 
cost associated with a high default rate. The most important 
factor determining both the default rate and the cost of each 
default is the movement in house prices.
    If prices continue to fall, then many homeowners will again 
find themselves owing more than the value of their home. This 
situation leads to defaults for two reasons. First, if a 
homeowner owes more than the value of her home, then she does 
not have the option to borrow against equity in order to make 
her mortgage payments. This eliminates an important source of 
security if job loss or unusual expenses leaves the homeowner 
temporarily unable to pay his or her bills.
    The other reason why this situation increases default rates 
is that homeowners who owe more than the value of their home 
can effectively save themselves money by simply surrendering 
their house to the bank. If a homeowner owes $200,000 on a home 
that is currently worth $180,000, the homeowner can effectively 
save $20,000 by just giving the house back to the bank. While 
this move will hurt the homeowner's credit rating, if they 
don't have any special attachment to the house, a homeowner may 
choose this option.
    In addition to increasing the number of defaults and 
foreclosures, falling house prices will also increase the loss 
on each foreclosure. If the house is still valued at close to 
the amount of the mortgage, then the losses on the foreclosure 
will just be the administrative and transactions costs 
associated with carrying through the foreclosure and reselling 
the house. However, if the house sells for less than the value 
of the mortgage, then this can be a substantial source of 
additional losses for the government.
    As I argued in my testimony, the government can limit the 
risk that it will set the guarantee price on new mortgages too 
high by using an appraisal of rental price as the basis of the 
guarantee, rather than an appraisal of the sale prices. Since 
rents never rose out of line with fundamentals, an appraisal 
based on some multiple of annual rent (e.g. 15 times annual 
rent) should ensure that the government's guarantee price is 
set at a level that is close to the price that the home will 
command after the bubble has deflated.

Q.4. Should we be encouraging or subsidizing someone staying in 
a house if they would be financially better off if they were 
renting?

A.4. Homeownership can be a useful way for families to 
accumulate wealth and to provide good, secure housing. However, 
if families are buying homes at bubble-inflated prices, then 
they are not likely to accumulate any wealth in their home, 
since the price is likely to fall back to its trend level 
before they sell their home. (The median period of 
homeownership for moderate-income families is just four years.) 
Furthermore, they are likely to pay far more in housing costs 
each year, than they would to rent a comparable unit.
    In the case of moderate-income families facing serious 
budget constraints, the additional housing costs associated 
with owning an over-priced home are likely to come at the 
expense of other necessary items, such as health care and child 
care. It is difficult to see how the government will have 
helped a family by encouraging them to remain in such a 
situation. The best way to avoid this problem would be to have 
the Hope for Homeowners guarantee price grounded in the rental 
price for the unit.

Q.5. Should we require financial sacrifices for participation 
in this program, such as selling vacation homes or investment 
properties, selling second vehicles, getting a second job, not 
taking on other debts, or selling non-retirement account 
investments?

A.5. I think it would be reasonable to take steps to try to 
ensure that any government aid program helps only low- and 
moderate-income families. One obvious way to do this would be 
to limit the size of the mortgages that can be financed, which 
I believe is already the case in all of the mortgage-guarantee 
programs being considered by Congress. It is possible to put 
additional asset restrictions on participants, but my guess is 
that in the vast majority of cases, such restrictions would not 
affect eligibility.
    For example, there are not many people with vacation homes 
or investment properties who would also be living in a 
relatively modestly priced home as their primary residence. 
Furthermore, the few people who are in this situation are 
likely to find ways to hide their assets, so that they would 
still be eligible for the program.
    The other suggested restrictions also pose problems. For 
example, a two-worker family may need two cars. Similarly, 
investment accounts can be hidden in the names of relatives. My 
view is that the cost associated with trying to enforce these 
sorts of restrictions, and the additional burden imposed on 
families who are genuinely in need of help and acting in good 
faith, outweigh the benefits of excluding the relatively small 
number of scam artists that may try to take advantage of this 
sort of program. We will never be able to exclude scam artists 
altogether from such programs and we undermine the purpose of 
the program if we place too many restrictions on homeowners.
                                ------                                


  RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM ELLEN 
                            HARNICK

    A 20 percent down payment to purchase a home became 
increasingly rare in recent years as home prices accelerated. 
We now see that many of the borrowers who are in trouble made 
minimal, if any, down payment. It is not surprising that we 
would find a number of homeowners with negative equity, even 
with modest price declines in home values.

Q.1. As the Congress looks for ways to avoid repeating past 
mistakes, what should this tell us about down-payment 
requirements, particularly with respect to any government-
guaranteed mortgage programs?

A.1. Negative equity is a driver of foreclosure, as it deprives 
borrowers of the ability to sell the home (a particular problem 
for those who need to relocate for jobs or other reasons) or 
address short-term cash crises by tapping into home equity. 
High loan-to-value ratios or low down payments, if accompanied 
by other risk factors, can contribute to negative equity or 
elevate foreclosure risk. However, high loan-to-value ratios 
are not the primary driver of foreclosure, and do not create 
excessive foreclosure risk if the loan is properly structured. 
The most significant driver of foreclosure is the failure to 
ensure the affordability of the loan beyond an introductory 
period. Appraisal fraud, equity-stripping from successive 
refinancings, and declining home values are also important 
drivers of negative equity. For these reasons, ensuring 
affordability, utilizing reasonable debt-to-income ratios and 
residual income measurements, based on the borrower's 
reasonably documented income, are considerably more important 
than the loan-to-value ratio.
    The use of high loan-to-value loans expanded homeownership 
opportunities for individuals who lack sufficient income to 
sustain them.
    With respect to the government backed refinance loan 
program provided by the Hope for Homeowners Act, it is entirely 
appropriate to allow refinancing for up to 87 percent of the 
property's current value, and to require the lender to accept 
this payment in full satisfaction of the debt. This both avoids 
a tax-payer bailout and supports the sustainability of the 
program. For purchase money loans, in contrast, it is important 
to continue to enable government loan programs to serve 
underserved communities by making loans with low down payments, 
structured as described above to ensure sustainability.
                                ------                                


  RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM ELLEN 
                            HARNICK

Q.1. What do you suggest we do to find the $20 billion this 
bill costs to start up? What should we cut, or what should we 
raise taxes on?

A.1. The best way to cover the costs of the HOPE for Homeowners 
FHA program is to make the program self-sustaining, or as close 
as possible. As proposed, the HOPE for Homeowners Act is 
designed to accomplish this. In this regard, the essential 
aspects of the Act are those that require: (a) a loan-to-value 
ratio of no more than 90%, (b) the creation of an FHA insurance 
pool to cover losses, funded with 3% of the balance of each 
covered loan, (c) the payment by borrowers of an additional 
premium of up to 1% per year, and (d) the sharing of equity 
with the FHA. Even if the default rate on loans made under the 
HOPE for Homeowners program were twice the FHA's normal default 
rate (which would roughly correspond to the 20% default rate 
for loans made by the Depression-era Home Owners' Loan 
Corporation (``HOLC'')), the program would have sufficient 
reserves to cover the losses. (The HOLC covered its losses and 
even turned a small profit.)
    CBO estimates that the total cost of the program, as 
revised by the Committee, over a ten year period is $729 
million in order to prevent 400,000 foreclosures. (See http://
www.cbo.gov/ftpdocs/94xx/doc9480/RevHR3221Table.pdf.) That is a 
cost of $1,823 per foreclosure prevented. Given the spillover 
costs to neighbors and risks to the economy, not to mention the 
costs to the family who otherwise would face foreclosure, this 
is a modest expenditure that could be offset in a number of 
different ways, including an assessment on GSE business 
activities.

Q.2. Do you have any suggestions for making sure someone did 
not lie or not tell the whole truth on their original mortgage 
application?

A.2. It would be difficult, and administratively costly, to 
conduct a fact-finding into the truthfulness, as of loan 
origination, of data on the loan application, and would be 
harder still to discern whether the party responsible for any 
misstatement was the mortgage broker, loan originator, or 
homeowner. Given the purpose of the legislation in part to 
protect neighbors, municipalities and the economy from 
preventable foreclosures, and the necessity of acting promptly 
so that relief is available in time to accomplish its intended 
purpose, the benefits of such an exercise seem unlikely to 
outweigh the costs. However, going forward, the FHA needs to 
ensure that there is reasonable documentation of income and 
assets for any homeowner who refinances under the program.

Q.3. If home prices continue to fall, lenders would be 
protected. But what protection do the taxpayers have if prices 
fall 10% more?

A.3. A further 10% house-price decline beyond the 10% equity 
cushion created by the FHA bill could impact both the risk of 
foreclosure and loss severities in those markets experiencing 
such decline. The factors identified in answer to Question 1 
above will play an important role in minimizing the impact of 
these risks on the self-sustainability of the program, and we 
believe are sufficient to cover losses that would arise in this 
scenario. Acting expeditiously to avoid further unnecessary 
foreclosures will help avoid an over-decline in house-prices, 
and this would benefit the economy as a whole, and bolster the 
sustainability of the program.

Q.4. Should we be encouraging or subsidizing someone staying in 
a house if they would be financially better off if they were 
renting?

A.4. Losing a home to foreclosure has severe consequences for a 
homeowner's credit rating and financial stability, dramatically 
limiting the homeowner's post-foreclosure options, whether the 
homeowner seeks to buy another home, or rent. For many 
homeowners facing foreclosure the economically rational choice 
may be to avoid foreclosure by refinancing, and remain in the 
home long enough to rebuild their credit and get the benefit of 
any equity build-up over the next several years, than to 
surrender the home in foreclosure. This is so even if, in the 
same market, people who have not yet purchased their first home 
might deem it economically preferable to rent for a year or 
more, rather than purchase their first home now. Making sure 
that qualified, independent, not-for-profit housing counselors 
and lawyers are available to homeowners facing these hard 
choices, will assist troubled homeowners in making the best 
decisions given their circumstances.

Q.5. Should we require financial sacrifices for participation 
in this program, such as selling vacation homes or investment 
properties, selling second vehicles, getting a second job, not 
taking on other debts, or selling non-retirement account 
investments?

A.5. As a practical matter, lenders generally will agree to 
refinance on the terms required by HOPE for Homeowners only 
where this is preferable to other legal means of obtaining 
repayment, and likely will pursue such other means where there 
are assets available to fund the recovery.
    Moreover, some of the specific suggestions could prove more 
costly than beneficial. For example, determining how many 
vehicles are required to transport a family's wage-earners to 
work would add administrative burden and cost, and, given the 
depreciating value of used vehicles, the sale of the vehicle 
might generate less cash than the vehicle's actual value to the 
family, without materially improving the family's ability to 
repay the loan. Nor is it advisable to require families to 
further deplete their savings to repay a loan for which many 
families over-paid in the first place.
                                ------                                


RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM DOUGLAS W. 
                           ELMENDORF

                     FURTHER HOUSING PRICE DECLINES

Q.1. Mr. Elmendorf, your testimony notes that ``housing is 
overbuilt and overpriced.'' You further note that house-price 
futures and analysts' estimates point to further sizable 
declines in house prices. Assuming that is the case, I am 
concerned about what a further FHA expansion will mean for 
taxpayers.
    If the FHA guarantees a mortgage for 90 percent of a home's 
market value today and the value declines 10 percent in the 
next year, where will that leave the FHA a year from now? And 
what if there is a further decline the following year?

A.1. Substantial further declines in house prices certainly 
pose risks for the FHA, and thus for taxpayers, if new 
mortgages guaranteed under an FHA expansion do not include an 
adequate financial cushion for the FHA. In my judgment, the 
cushion built into current legislative proposals--involving a 
combination of principal writedowns, premiums, and recovery of 
a portion of any house-price appreciation--is sufficient to 
limit this risk.

                     PROBLEMS WITH SECOND MORTGAGES

Q.2. Mr. Elmendorf, you noted that the prevalence of second 
liens creates an obstacle to refinancing first mortgages into 
more affordable mortgages. Just to cite one example, data 
collected under the Home Mortgage Disclosure Act suggest that 
nearly 40 percent of higher-priced home-purchase loans in 2006 
involved a second mortgage (or ``piggyback'') loan.
    What would you suggest be done to coordinate the process of 
dealing with the second lien holders?

A.2. Much of this coordination will need to be undertaken by 
the private lien holders. However, I would also explore whether 
the government could serve as a clearing house for the relevant 
information--for example, by offering to collect from 
lienholders the addresses of properties on which they hold 
liens, and then to share that information with any other 
lienholders who report liens on properties at the same 
addresses.

Q.3. Won't there be cases where the interests of the second 
lien holder are not aligned with those of the first mortgage 
holder?

A.3. Yes, some second lien holders will likely resist 
subordinating their claims to refinanced first liens. From the 
perspective of the second lien holders, even properties with 
negative equity on the first liens alone might ultimately yield 
some mortgage payments. Moreover, the process of 
resubordinating the second liens offers those lien holders some 
leverage for extracting money from the first lien holders. In 
some cases, small payoffs from the first lien holders to the 
second lien holders is likely to be part of the refinancing 
process.

                      IMPORTANCE OF DOWN PAYMENTS

    A 20 percent down payment to purchase a home became 
increasingly rare in recent years as home prices accelerated. 
We now see that many of the borrowers who are in trouble made 
minimal, if any, down payment. It is not surprising that we 
would find a number of homeowners with negative equity, even 
with modest price declines in home values.

Q.4. As the Congress looks for ways to avoid repeating past 
mistakes, what should this tell us about down-payment 
requirements, particularly with respect to any government-
guaranteed mortgage programs?

A.4. Requiring mortgage borrowers to have some equity in their 
homes--and thus some cushion against potential house-price 
declines--is a crucial part of responsible lending. Because 
this point is being brought home so forcefully now to many 
mortgage lenders and investors, I do not expect the very high 
loan-to-value ratios seen in some mortgages during the past 
several years to be repeated in the future. Similarly, 
government-guaranteed mortgage programs need to be ensure a 
financial ``cushion'' to protect taxpayers from losses. This 
cushion depends on loan-to-value ratios, the premiums that are 
charged, and the integrity of the underwriting process.

                   RATE RESETS NOT THE ONLY PROBLEM?

    Mr. Elmendorf, at times the discussion of the mortgage 
situation has focused on how rate re-sets posed a huge problem 
as borrowers came to realize what was really in the mortgages 
they took out. Some pointed to the so-called 2/28 or 3/27 loans 
as fueling this crisis. You note in your testimony that 
declines in short-term interest rates since last year have 
reduced the magnitude of this problem.

Q.5. If the predicted foreclosure wave isn't due to rate re-
sets, what is the underlying cause?

A.5. Experience suggests that mortgage foreclosures are most 
closely linked to movements in house prices. When prices 
decline and people lose equity (sometimes all of the equity) in 
their homes, then foreclosures rise. The mechanism is 
principally that people who encounter some obstacle to making 
their mortgage payments--losing their jobs, being hit with high 
medical bills, or something else--can often find a way to keep 
making those payments when they have equity--such as 
refinancing the mortgage or borrowing from relatives--but do 
not have access to these means when they are under water.

Q.6. Can we draw something from the fact that a large number of 
borrowers went into default only a few months into their 
mortgages?

A.6. The high rate of very early defaults on recent mortgage 
vintages suggests that some borrowers had no intention of 
making mortgage payments but planned instead to re-sell the 
houses quickly and benefit from the appreciation. Of course, 
with declining rather than rising house prices, this strategy 
failed. This experience emphasizes the importance of 
restricting FHA expansion to owner-occupied homes and to 
families who demonstrate in the underwriting process the 
ability to make payments on restructured mortgages.
                                ------                                


 RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM DOUGLAS 
                          W. ELMENDORF

Q.1. What do you suggest we do to find the $20 billion this 
bill costs to start up? What should we cut, or what should we 
raise taxes on?

A.1. To my knowledge, no official cost estimate has been 
produced for the plan put forward by Chairman Dodd. The CBO 
cost estimate for the similar plan put forward by Chairman 
Frank of the House Financial Services Committee is less than $3 
billion. I agree with the spirit of the question that decisions 
to raise spending or cut taxes should be accompanied by 
decisions about how to pay for those actions, because these 
financing decisions pose the ultimate cost-benefit test. As you 
know, the CBO regularly issues a lengthy report on budget 
options. Among the options in that document that I support, 
``Eliminate the International Trade Administration's Trade 
Promotion Activities or Charge the Beneficiaries,'' ``Impose 
New Limits on Payments to Producers of Certain Agricultural 
Commodities,'' and ``Reduce Payment Acreage by 1 Percentage 
Point'' would collectively provide the amount required.

Q.2. Do you have any suggestions for making sure someone did 
not lie or not tell the whole truth on their original mortgage 
application?

A.2. In my judgment, independently verifying the honesty of 
people's initial mortgage applications is not worth the 
administrative effort involved. As with other public programs, 
designing an FHA expansion presents tradeoffs between one's 
ideal program (here, penalizing people who did not tell the 
truth) and a program that can be administered at reasonable 
cost. Many people who lied in order to buy a bigger house would 
not meet the underwriting standards imposed by the FHA and 
would not qualify for that reason. The retrospective 
underwriting required to precisely identify the others is not 
worth the cost in my view.

Q.3. If home prices continue to fall, lenders would be 
protected. But what protection do the taxpayers have if prices 
fall 10% more?

A.3. Substantial further declines in house prices pose risks 
for the FHA, and thus for taxpayers, if new mortgages 
guaranteed under an FHA expansion do not include an adequate 
financial cushion for the FHA. In my judgment, the cushion 
built into current legislative proposals--involving a 
combination of principal writedowns, premiums, and recovery of 
a portion of any house-price appreciation--is sufficient to 
limit this risk.

Q.4. Should we be encouraging or subsidizing someone staying in 
a house if they would be financially better off if they were 
renting?

A.4. People who would be better off renting than owning are 
likely to give up homeownership even under the proposed FHA 
expansion. As I mentioned in my testimony, it makes sense to 
appropriate additional funding for counseling as quickly as 
counseling organizations can build their capacity and use the 
funds effectively. One function that counselors can serve is to 
help people make informed decisions about whether to be 
homeowners.

Q.5. Should we require financial sacrifices for participation 
in this program, such as selling vacation homes or investment 
properties, selling second vehicles, getting a second job, not 
taking on other debts, or selling non-retirement account 
investments?

A.5. Again, I see tradeoffs between designing one's ideal 
program in terms of screening criteria or lending terms and 
designing a program that can be implemented quickly and 
administered efficiently. In my judgment, including these 
various penalties as a cost of borrowing would make the program 
too cumbersome to operate effectively.

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