[Economic Report of the President (2008)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 2

Credit and Housing Markets

In the summer of 2007, the contraction in the U.S. housing market
worsened and credit markets experienced a substantial disruption.
Default rates on subprime mortgages-particularly more recent vintages
of adjustable-rate mortgages-rose rapidly. As a result, investors
became worried about how much risk they had exposed themselves to by
purchasing financial securities backed by these mortgages. Financial
disruptions rippled through the U.S. and world financial markets as
yields on many private debt securities rose sharply, while investor
demand for those securities dramatically fell. As investors sought
the safety of government securities, demand for U.S. Treasury
securities spiked upward, driving down their yields.

The Administration and the Federal Reserve independently responded to
the subprime mortgage problem and the financial market disruptions. The
Administration's policy response addressed problems in the subprime
lending market and sought to improve the long-run functioning of the
housing and credit markets through programs such as FHASecure and HOPE
NOW. FHASecure expands the Federal Housing Administration's (FHA) ability
to offer home mortgage loan refinancing options by giving it the
additional flexibility to help not only homeowners who are current on
their mortgage payments, but also borrowers in default who had made
timely mortgage payments before their loan interest rates reset. HOPE
NOW is an example of the government encouraging members of the private
sector-including lenders, loan servicers, mortgage counselors, and
investors-to identify and reach out to at-risk borrowers and help more
families stay in their homes. The Federal Reserve addressed the risks to
the economy from financial market disruptions by increasing liquidity and
lowering interest rates, and it addressed problems in the subprime
mortgage market by joining with its fellow supervisory agencies to work on
new consumer protection rules and to issue guidance to lending
institutions.

Despite the magnitude of the disruption in financial markets, the impact
on the broader real economy was, at least through the fourth quarter of
2007, largely confined to residential investment, which had been weak for
about 2 years. Nonetheless, the tightening of credit standards raises the
possibility that spending by businesses and consumers could be restrained
in the future. Declines in housing wealth may also limit consumer
spending.

The credit market disruptions appear to reflect a general repricing of
risk that was triggered, though not solely caused, by subprime mortgage
delinquencies, which were in turn a partial result of declines in housing
appreciation. New financial products, such as certain mortgage-backed
securities, also added a layer of complexity to the recent credit market
disruptions. These securities markedly expanded liquidity in the mortgage
markets and provided many Americans a previously unavailable opportunity
to own their own homes.

The key points from this chapter are:

Rising delinquencies for subprime mortgages revealed an apparent
underpricing of risk and raised concerns about which market participants
were exposed to that risk, but the subprime market was not the only cause
for the contraction in credit markets.

The Federal Reserve provided liquidity and took measures to
support financial stability in the financial markets in the wake of the
disruptions in the credit markets.

The Administration focused its response on housing markets and
helping homeowners avoid foreclosure-in particular, subprime borrowers
facing increases in the interest rate on their adjustable-rate mortgages.

Participants in the credit and housing markets are actively
addressing challenges that were revealed during the summer of 2007.
Markets are generally better suited than government to adapting to
changes in the economic environment; markets can respond quickly to new
information, while government policy often reacts with a lag or has a
delayed impact.

Financial innovations in the mortgage and credit markets have
provided a range of economic benefits, but not without some costs. Over
time, markets tend to retain valuable innovations and repair or eliminate
flawed innovations.

The macroeconomic effects of the downturn in housing and the
credit market disruptions may occur through several channels, including
the direct effect on residential investment, the reduction of wealth on
personal consumption, and tighter lending standards on business
investment.

What Are Credit Markets?

There are two primary ways to finance any economic activity: through
equity or through debt. With equity financing, investors take ownership
shares in an economic venture, such as investing in a new company, and
receive some fraction of the future returns. With debt or credit
financing, a creditor lends a debtor money today, which the debtor must
repay with interest in the future. Credit comes in many different forms:
credit cards, automobile loans, mortgages, corporate bonds, and
government bonds. Securities whose value is derived from underlying
assets are called derivatives or derivative securities. Credit markets
are the markets in which loans and their derivative securities are
traded.

Consider mortgages. Suppose a person wants to purchase a house, but does
not have enough cash on hand to buy it. The prospective borrower (the
debtor) uses his available cash as a down payment and approaches a lender
(the creditor), who lends the borrower the remaining money needed to
coverthe cost of the house. Over time, the borrower earns income from
his job and pays off the mortgage (debt). Because money today is worth
more than money tomorrow, the lender charges interest on the amount of
the loan (the principal). The interest rate must be set high enough to
compensate the lender for bearing the risks associated with the loan
but low enough to make the loan attractive to the borrower.

Mortgages, like most forms of credit, are subject to three forms of risk:
credit risk (the risk that the debtor will default on the loan), interest
rate risk (the risk that market interest rates will fluctuate), and
prepayment risk (the risk that the borrower will pay off the loan early).
Lenders make money by charging borrowers interest payments on top of the
periodic repayments of principal. Therefore, the lender is worse off if
these interest payments stop, such as when the borrower defaults on a
loan or pays off the loan early in an environment of low interest rates.
Mortgage lenders may also face the risk of a loss of principal if a
property is foreclosed upon. Loans with greater risk have higher interest
rates to compensate the lender for bearing more risk.

Recent Developments in Mortgage Markets

From 2001 to 2007, there was a substantial increase in the use of subprime
mortgages. (Box 2-1 defines "subprime mortgages" and other mortgage market
terminology.) The share of mortgage originations that were subprime
increased from 5 percent in 2001 to more than 20 percent in 2006. Subprime
mortgages carry a greater risk than prime mortgages. Many subprime
borrowers have poorer credit histories and less reliable sources of
income than prime borrowers; they may provide little or no
documentation of income or assets from which they can pay the
mortgage; and they tend to have high loan-to-value ratios. As a
result, compared with prime borrowers, subprime borrowers are more
likely to default on their loans.

Box 2-1: Definitions of Select Mortgage Terms

Adjustable-rate mortgage (ARM): Adjustable-rate mortgages have
an initial period with a fixed interest rate, after which the interest
rate adjusts at set periods. For example, a 3/1 ARM would have a set
interest rate for 3 years, but after that the interest rate would adjust
every year. The adjusted interest rate is a function of some ''index''
market interest
rate, such as the London Interbank Offer Rate.

Conforming loan limit: The charter-required limit, as determined by
Federal regulators, placed on the size of loans that can be purchased by
Fannie Mae and Freddie Mac.

Default: A borrower defaults on a mortgage when he or she fails to
make timely monthly mortgage payments or otherwise comply with
mortgage terms. A mortgage is generally considered in default when
payment has not been made for more than 90 days. At this point,
foreclosure proceedings against the borrower become a strong possibility.


Delinquency: A borrower is delinquent on a mortgage when he or she
fails to make one or more scheduled monthly payments.

Fannie Mae: Fannie Mae is the registered service mark of the Federal
National Mortgage Association, a U.S. Government-sponsored enterprise.
Fannie Mae buys mortgage loans that meet certain criteria from
primary mortgage lenders and sells mortgage-backed securities with
guaranteed principal and interest payments. In return for this guaranty,
investors pay a fee to Fannie Mae. Fannie Mae also holds some of the
mortgages it purchases, and mortgage-backed securities it originates, in
its portfolio.

Fixed-rate mortgage (FRM): A mortgage with an interest rate that
remains the same throughout the life of the loan.

Foreclosure: A legal process in which a lender seeks recovery of
collateral from a borrower (in the case of home mortgages, the home
itself is the collateral), with several possible outcomes, including that
the borrower sells the property or the lender repossesses the home.
Foreclosure laws are based on the statutes of each State.

Freddie Mac: Freddie Mac is the registered service mark of the Federal
Home Loan Mortgage Corporation, a U.S. Government-sponsored enterprise.
Freddie Mac buys mortgage loans that meet certain criteria from
primary mortgage lenders and sells mortgage-backed securities with
guaranteed principal and interest payments. In return for this guaranty,
investors pay a fee to Freddie Mac. Freddie Mac also holds some of the
mortgages it purchases, and mortgage-backed securities it originates, in
its portfolio.

Jumbo loan: A loan that exceeds the conforming loan limit.


Prime loan: Loans made to borrowers that meet stringent lending and
underwriting terms and conditions. Prime borrowers have good credit
records and meet standard guidelines for documentation of debt-toincome
and loan-to-value ratios.

Reset: An interest rate on an adjustable-rate mortgage is said to have
reset whenever it is adjusted, or moved, in the direction of the market
interest rate that it tracks.

Subprime loan: Loans that meet less stringent lending and underwriting
terms and conditions. Subprime borrowers may have weaker
credit histories characterized by payment delinquencies; previous
charge-offs, judgments, or bankruptcies; low credit scores; high debt-
burden ratios; high loan-to-value ratios; or little to no documentation
to prove income.

Workout: An adjustment to, or renegotiation of, a loan a lender
makes with a borrower, usually with the purpose of avoiding a default
or foreclosure on the loan. Types of workouts include modifications to
the original loan contract, forbearance agreements (agreements that
postpone payments), forgiveness of some debt, and short sales (the
lender accepts the proceeds from the home's sale as settlement for the
debt even if the proceeds do not cover the entire mortgage amount).


Strong house price appreciation in much of the country beginning in 2003
provided confidence that riskier borrowers could easily refinance
mortgages,using their built-up equity, should they be unable to keep up
with their monthly mortgage payments. This expectation of house price
appreciation, coupled with an increasingly competitive lending
environment, led lenders to relax their underwriting standards and offer
products with features that lowered monthly payments. Loans with low
initial payments, including subprime loans, helped further feed house
price appreciation, and increased the risk of eventual default and
foreclosure due to their future interest rate resets. Some subprime loans
were traditional fixed-rate mortgages (FRMs) that specified a fixed
interest rate throughout the life of the loan, while others were
adjustable-rate mortgages (ARMs), with interest rates that followed a
market interest rate, such as the London Interbank Offer Rate (LIBOR),
the interest rate at which banks lend to one another using the London
market. About 70 percent of subprime ARMs were 2/28 or 3/27 hybrid ARMs.
A 2/28 hybrid ARM, for example, has 2 years of payments at a fixed
introductory interest rate, after which it resets to a higher floating
rate, and then floats for the remaining 28 years.

At the same time, the dollar volume of private mortgage-backed securities
issued by private sector entities grew rapidly beginning in 2001.
Investors were attracted to these securities because of their seemingly
high risk-adjusted returns; ARMs apparently shifted interest rate risk
from the lender to the borrower, whose mortgage payments would vary
according to market interest rates. This provided continued liquidity
support for the further expansion of mortgage lending, including poorly
underwritten subprime lending. Lenders sold loans on the secondary
market, passing risks on to investors who relied primarily on ratings
of the securities provided by third-party rating agencies.

There are two important caveats to keep in mind when thinking about
credit risk in the mortgage markets. First, defaults and foreclosures
are expected even in the best of times. Some individual borrowers will
experience difficulties-such as job loss-that may lead them to default
on their mortgages. Eliminating defaults and foreclosures caused by such
difficulties would be nearly impossible, and efforts to do so by raising
credit thresholds would have the unfortunate effect of restricting access
to credit-and, therefore, to home ownership-for many prospective
borrowers. Second, in well-functioning markets, risks are priced. There
is nothing wrong or unnatural about the possibility of higher default
and delinquency rates, provided the borrower and lender enter the
transaction fully informed. Lenders and investors can compensate for
increased risk by setting an appropriately high interest rate. Of course,
if information on credit risk is imperfect, the demand for loans in the
secondary market will be affected. For example, if credit rating
agencies or investors underestimate the default risk of subprime
securities, the market may underprice subprime risk, leading to an
excess quantity of subprime credit. See Box 2-2 for background on the
credit rating agencies.


Box 2-2: Credit Rating Agencies

The securities credit rating industry began in 1909, but it was not until
the 1930s that regulators began mandating the use of credit ratings. For
example, banks cannot invest in bonds that are rated below investment
grade; insurance companies are required to link their capital
requirements to the ratings of the bonds they invest in; and the
Securities and Exchange Commission's capital requirements require
broker-dealers to hold investment-grade bonds in their portfolios.

In order to regulate these ratings the Securities and Exchange
Commission created the National Recognized Statistical Rating
Organization designation (NRSRO) in 1975. Since then, the NRSRO
category has become a de facto license, and like all licenses, it aims
to enforce quality but in fact restricts quantity, by granting monopoly
power to the incumbent firms. Currently, seven firms are designated
NRSROs. Critics have described the criteria for entry into the NRSRO
designation as opaque, effectively blocking new entry.

The industry came under scrutiny after a large energy company was
rated -investment grade' 5 days before its bankruptcy. In September
2006, the Credit Rating Agency Reform Act was passed to increase
transparency and competition in the rating industry. Under the new act,
a credit rating firm whose ratings have been used by at least 10
investors for 3 years can apply for registration as an NRSRO.

Although the new law is still being implemented, some contend that
barriers to entry are still high, and conflicts of interest between the
rater and the issuer persist. The President's Working Group on Financial
Markets is examining the need for reform of the credit rating agencies.


In 2006, defaults on mortgages began to increase, but, as shown in
Chart 2-1, the rise in default rates was concentrated in ARMs,
particularly subprime ARMs, while default rates for FRMs were relatively
unchanged. The performance of subprime mortgages was particularly poor
for more recent vintages. Subprime mortgages originated in 2005 and
2006 have defaulted much more quickly than those originated in 2003
and 2004, for example. By July of 2007, escalating subprime ARM
default rates led lenders to sharply curtail new originations of
subprime loans.




The current rise in defaults reflects a combination of factors,
including flat or falling home prices, weaker underwriting standards
(including higher loan-to-value ratios), regional economic weakness,
and interest rate resets on subprime ARMs. About 1.8 million owner-
occupied loans in subprime mortgage pools are scheduled to reset in
2008 and 2009. For mortgages issued in the past several years,
defaults are occurring well before interest rates reset, which
suggests soft housing prices and weak underwriting standards may be
more important factors. As housing prices began to falter, flat or
falling home prices combined with weaker underwriting standards
meant that borrowers lost their "equity cushion" and had more
difficulty refinancing or selling their homes. Borrowers who had
purchased homes (particularly homes for investment purposes) but now
owed more than the properties were worth had incentives to stop making
mortgage payments in order to minimize their financial losses. Rising
interest rates increased the probability of default and foreclosure for
borrowers with adjustable-rate mortgages because their monthly payments
grew as rates were climbing. The relative importance of these factors
may vary geographically, as discussed in Box 2-3.

Worries in late summer about exposure to risk increased in the markets
for other mortgages as well. In particular, interest rates on jumbo
mortgages (mortgages in excess of the "conforming loan limit" of
$417,000) rose, and jumbo mortgage originations slowed. Chart 2-2
shows the increase since the summer of 2007 in interest rates for
fixed-rate jumbo mortgages relative to fixed-rate conforming mortgages.

Box 2-3: Geographic Variations in Housing Markets

Home prices vary significantly from neighborhood to neighborhood,
State to State, and region to region. In 2006, for example, the median
sale price for an existing home sold in the western United States was
well over $300,000 compared with just $170,000 in the Midwest. Within
California, the median price in San Jose was $775,000, while the median
price a few hours away in Sacramento was only $375,000.

Home prices increased from 2001 to 2007 and boomed from 2003 to
2006, rising over 35 percent on average across the Nation, but those
gains also showed large regional variations. House prices rose most
dramatically in the southeastern and western United States and, to
a lesser extent, in New England and the mid-Atlantic. Likewise, the
subsequent deceleration (or outright declines) in house prices in 2007
also varied, with the largest changes occurring in those places that had
previously shown the most rapid appreciation or were experiencing
prolonged economic weakness.



Mortgage default rates have also varied substantially across regions.
Falling house prices and high loan-to-value ratios have likely lifted
delinquency rates in places that had experienced substantial run-ups in
prices (such as Las Vegas and Miami), while economic weakness has likely
lifted delinquencies in some Midwestern cities.


Concerns about risk also affected the secondary market in which mortgages
are bought and securitized, that is, bundled together and sold as a
singlesecurity (see Box 2-4). The government-sponsored enterprises
(GSEs), Fannie Mae and Freddie Mac, securitize the majority of prime
mortgages below the conforming loan limit. The secondary market for
GSE-securitized mortgages remained active through 2007, presumably
largely because some investors believe that these securities have an
implicit guarantee from the U.S. Federal Government, even though no
such guarantee exists. In contrast, the securitization of jumbo
mortgages slowed as investors shied away from securities not created
by the GSEs.




Box 2-4: Securitization and Structured Finance

Securitization is the transformation of a collection of individual
assets into tradable securities. These -asset-backed securities' are
created by financial institutions-including banks and government-
sponsored enterprises-from pools of assets, such as mortgages, car
loans, credit card loans, corporate receivables, and student loans.

Mortgages make up a large fraction of asset-backed securities.
Traditionally, a lender makes a loan to a borrower, in what is called
the primary market. In the secondary market, a financial institution
buys multiple loans, which, taken together, are essentially a bundle
of cash flows. The simplest mortgage-backed security is a pass-
through security, for which the interest and principal payments of
the individual loans pass through to the holders of the new securities.

Securitization has two major economic benefits: increased risk
diversification and increased available capital. With securitization, an
investor with $400,000 can own 1 percent portions of 100 $400,000
mortgages rather than having to purchase a single such mortgage. If a
single mortgage defaults, the investor bears a $4,000 loss instead of
a full $400,000 loss. If investors are risk-averse, this
diversification makes them better off. A security can also include
portions of diverse types of mortgages, which further spreads risk if
the payment performance on the individual mortgages is not perfectly
correlated. Securitization benefits lenders by enabling them to sell
loans to those investors who can better handle the risks associated
with mortgage borrowers. The sale of mortgages provides lenders with
cash that they can then use to supply more mortgages. Investors
benefit from the availability of additional securities.

The second economic benefit of securitization is an increase in
available capital. More risk-diversified securities draw additional
investors into the market, expanding the amount of capital in the
market. This increased supply of credit may result in a lower cost
of credit for borrowers, which, everything else remaining equal,
makes home ownership more accessible.


Credit Market Disruptions in 2007

There were significant disruptions in financial markets in the summer of
2007. Problems became evident in June and July, when several hedge funds
reported large losses and a large mortgage lender faced mounting
problems. In late July, demand for U.S. Treasury securities jumped due
to a "flight-to-quality" as investors shied away from mortgage-related
assets, and to a lesser degree, corporate bonds and other relatively
riskier assets. The shift away from corporate bonds resulted in a
wider spread between interest rates on U.S. Treasuries and those on
corporate bonds, following several years of narrow spreads. Conditions
in financial markets worsened in early August, when several hedge
funds experienced large losses. One European fund even stopped investor
redemptions, saying that it was not possible to value certain
securities. The disruptions led investors to try to maintain highly
liquid positions and to focus on assets that were perceived as less
risky and more easily priced.

Credit Market Link to Mortgages

The housing and credit markets are linked through the securitization of
mortgages. The resulting mortgage-backed securities are often further
packaged into other, more complicated, financial securities. Originations
of mortgages that could not be purchased and securitized by Fannie Mae
and Freddie Mac slowed sharply in the summer, as investors worried about
exposure to risk. This contraction in the secondary market for mortgages
had implications for mortgage originations: When banks are unable to sell
mortgages they originate, they have fewer funds available for further
originations. In addition, banks may be unwilling to hold some of the
mortgages they originate because their appetite for risk may differ from
that of the investors who previously bought their loans. Securitization
problems also emerged for jumbo mortgages, which are not purchased by
Fannie Mae and Freddie Mac.

Flight to Quality

When credit markets became disrupted, investors engaged in a "flight to
quality," as indicated by the large increase in demand for U.S. Treasury
securities. Because investors have high confidence that the U.S.
Government will not default on its debt, the demand for U.S. Treasury
securities-which include a variety of bills, notes, and bonds-tends to
rise during periods of increased financial uncertainty. This increased
demand pushes down Treasury yields (which move inversely with prices)
relative to private lending rates such as the London Interbank Offered
Rate, as shown in Chart 2-3.



Corporate bond yields also rose relative to U.S. Treasury securities.The
higher yield on a corporate bond reflects, among other things, the
relatively higher likelihood of default (credit risk), the risk of not
being able to find a buyer for the bond (liquidity risk), and the
potential for default to be correlated with other macroeconomic factors
(systemic risk). The spread between the interest rates on corporate bonds
and U.S. Treasury notes is therefore a barometer of risk in the market.
In late July 2007, these credit spreads spiked upwards, even though they
still remained low by historical standards, as Chart 2-4 illustrates.

Financial market participants also showed a preference for making
shorter-term, rather than longer-term, loans to one another. This
preference reflected a concern among some participants that they might
unexpectedly need cash and therefore did not want to have it wrapped up
in longer-term loans. Some participants also worried about the potential
risk of default among their borrowers. As a result, the costs of
borrowing for longer terms rose relative to overnight borrowing.



Contraction of the Asset-Backed Commercial
Paper Market

Another credit market that contracted in 2007 was the asset-backed
commercial paper (ABCP) market. As of January 16, 2008, the ABCP market
was an $800 billion market, roughly 45 percent of the $1.8 trillion U.S.
commercial paper market, which itself is roughly one-fifth the size of
the $9 trillion U.S. corporate bond market. Corporations issue short-term
loans, called commercial paper, to smooth temporary fluctuations in cash
flows; the commercial paper market is one market for short-term financing
for firms. For example, suppose a firm needs to make certain seasonal
payments and has a current cash flow constraint. The firm issues
commercial paper into the market in exchange for cash, then repays the
loan in 30 or 60 days. This loan is unsecured in that it does not specify
collateral in case of default. For blue-chip firms, default is unlikely.
However, any firm that defaults on a commercial paper loan is almost
surely on the brink of bankruptcy because the default signals to the
market that it doesn't have enough cash to pay off the most immediate of
its financial obligations.

Commercial paper that is secured by assets (such as a firm's receivables,
auto loans, or mortgage-backed securities) is known as asset-backed
commercial paper. For example, if an automobile manufacturer sells cars
but does not receive payment for the cars for 1 month, its receivables
account will document the expected cash flow 1 month into the future.
Therefore, a bank can issue to the market commercial paper backed by the
receivables of the firm. If the firm defaults on its obligations, the
holder of the ABCP can receive some payment from the receivables of the
firm.

Usually, ABCP is issued by a special-purpose vehicle or conduit sponsored
by a bank that buys assets-such as receivables from multiple
corporations-and issues commercial paper backed by these assets to the
outside market. Because ABCP conduits issue short-term debt to finance
longer-term assets, they must continue to issue new commercial paper to
repay maturing commercial paper (a process called rolling).
Special-purpose vehicles can provide corporations with relatively
low-cost access to the short-term financing available in commercial
paper markets. These vehicles are not subject to the regulatory capital
charge that is mandated for banks that extend credit directly to
borrowers. For example, a bank that makes a direct loan to an automobile
manufacturer would have to hold capital against that loan. But a bank
that sponsored a special-purpose vehicle (which it did not own) could
keep the manufacturer as a customer (and earn some fees) without
bearing the credit risk of a direct loan and without facing a capital
charge. Structured investment vehicles (SIVs) are a type of conduit
that issues both commercial paper and medium-term notes to finance the
purchase of assets. SIVs differ from ABCP conduits in that SIVs have
less access to backup credit facilities (called liquidity support) in
case they are unable to meet their short-term debt obligations.

The credit market disruptions seriously shook the ABCP markets. Investors
began to differentiate more between the various types of ABCP and they
demanded higher returns on ABCP that had less liquidity support. As a
result of this greater investor scrutiny and investor reluctance to
purchase commercial paper issued by entities with limited or no backstop
liquidity, the volume of outstanding ABCP shrank more than 35 percent,
from $1,180 billion in early August 2007 to about $750 billion in late
December 2007 (Chart 2-5). Increased concern about risk associated with
ABCP and risk in general prompted a flight to quality as investors
shifted to low-risk short-term Treasuries. Because ABCP is used to fund
SIVs, the reduced demand for ABCP forced banks to either bring the
underlying assets (and their associated liabilities) back onto their
balance sheets or reduce the size of their SIVs by selling off the
assets.

Slower Merger and Acquisition Activity

The relatively low cost of credit contributed to a boom in mergers and
acquisitions (M&A) in recent years, but announced M&A deals slowed





sharply following the credit disruptions in mid-2007. The aggregate value
of announced M&A deals fell off sharply in late summer after having
climbed to The highest levels since 2000-2001, as shown in Chart 2-6.
Over the 12 months through August 2007, the value of M&A deals were
about $1.65 trillion, but over the following 3 months these deals
totaled just $498 billion at an annual rate. Banks that were
underwriting leveraged buyouts (LBOs)-whereby a company or investor
uses debt to finance the purchase of another company's assets-found
that buyers were no longer as willing to purchase the debt associated
with LBOs, which meant that banks had to keep more of the debt on their
own books, possibly limiting the ability of some banks to make further
loans.

Equity Markets

Equity markets continued to function amid the disruptions in the credit
markets, but implied stock price volatility-an indicator of investor
uncertainty-jumped during the summer and remained sensitive to news about
credit market developments. Unlike many credit market instruments that
trade infrequently and are hard to price, stocks trade in high volumes
and are continually repriced, making them much more transparent
financial instruments.



International Implications

A notable aspect of the disruptions in the U.S. credit and housing
markets was that it was felt globally. Subprime losses appeared not only
in the United States but also in the portfolios of banks and investors
in Europe, Australia, and Asia, demonstrating how interconnected global
capital markets have become. This international diversification provided
a clear benefit as the impact of subprime losses were shared, rather than
concentrated solely on U.S. investors and financial institutions. In some
cases, European banks were more severely affected, at least initially, by
the credit market disruptions than were U.S. banks. Lastly, both the
European Central Bank and the U.S. Federal Reserve boosted liquidity in
similar, and effectively simultaneous, actions (discussed later in this
chapter).

Policy Response to Credit Market Disruptions

The mortgage and credit market disruptions of the summer of 2007 shook
investor confidence. As in previous financial disruptions, however, these
markets again demonstrated their resilience and flexibility. The
possibility of gains from trade forces markets to adjust quickly and
self-correct. In many cases, the Federal Reserve has better tools at its
disposal for addressing certain credit market problems than do fiscal
policymakers. For example, the Federal Reserve can act to stave off
certain types of liquidity problems, such as short-term cash availability
at major banks, but not other liquidity problems, such as a lack of
trading in asset-backed commercial paper that results from investors'
doubts about the value of the paper.

The Federal Reserve took a variety of actions in the second half of 2007
to maintain financial stability and encourage continued economic growth.
In early August 2007, the Federal Reserve used open market operations to
inject large amounts of liquidity into financial markets. The Federal
Funds rate-the interest rate at which U.S. banks lend to other banks
overnight-fell below the target rate. On August 17, 2007, the Federal
Reserve made credit more easily available by enacting a 50-basis-point
eduction in the discount rate, the interest rate that banks are charged
when they borrow from the Federal Reserve's discount window. The Federal
Reserve also permitted the provision of term financing for terms as long
as 30 days, and reiterated the Federal Reserve's policy of accepting a
broad range of collateral for loans from the discount window, including
home mortgages and related assets. On September 18, 2007, the Federal
Reserve reduced the discount rate by an additional 50 basis points and
lowered the target Federal Funds rate by 50 basis points. On October 31,
2007, the Federal Funds rate and the discount rate were lowered another
25 basis points.

The Federal Reserve Bank of New York's Open Market Trading Desk announced
on November 26 that it would increase the availability of credit in
financial markets by conducting certain open market operations for terms
that extended past the end of the year. On December 11, 2007, the Federal
Funds rate and discount rate were cut another 25 basis points. The
following day, the Federal Reserve announced two new actions, in
coordination with other central banks actions, that were designed to
boost liquidity. The first action was a series of term fund auctions-
short-term loans-to depository institutions. The second action was the
establishment of temporary currency arrangements with the European
Central Bank and the Swiss National Bank that make dollars available
to these banks to alleviate dollar funding pressures in their
jurisdictions. The Federal Reserve cut rates further in January 2008.

Policy Response to Housing Market Challenges

Housing market policies have been of two types. First are policies that
are created to encourage market participants to make use of tools they
already possess and provide targeted assistance to borrowers. Second are
those that are designed to make changes to the future functioning of the
housing market. Policies should be crafted in a manner that avoids
unnecessarily restricting access to credit and financial market
innovation. Some policies encourage developing private market solutions,
such as recommending that lenders develop a mortgage workout plan with
borrowers rather than progressing through the foreclosure process. Box
2-5 discusses the challenges of workouts. Policies may also be designed
to offer targeted assistance, such as increasing access to FHA-insured
loans for subprime borrowers facing interest rate resets. To strengthen
the market for the future, other policies address fundamental problems
that markets may be slow to address themselves, such as better
disclosure of loan terms, total settlement charges, and other mortgage
characteristics. In addition, policies that require or provide
incentives for lenders and investors to perform quality due diligence
would promote true risk-based pricing in the subprime sector, and could
make this sector more competitive.

Addressing Current Challenges

The Administration has worked with lenders, loan servicers, mortgage
counselors, and investors to develop private sector solutions. The HOPE
NOW initiative is an effort to encourage private sector servicers,
housing counselors, and investors to work together. The goal is to
provide relief to homeowners. The Administration has encouraged market
participants who historically have not shared information, resources,
or business practices to come together to create a coordinated plan to
help homeowners. Importantly, HOPE NOW has no budgetary cost to the
Federal Government. HOPE NOW participants have agreed on a new set of
industry-wide standards designed to help streamline the mortgage
workout process for borrowers with adjustable-rate mortgages who can
afford their current mortgage payments, but will have trouble when
their interest rates rise. The standards aim to help keep these
borrowers' mortgages affordable in three ways: refinancing their
existing loans into new private mortgages, moving them into FHASecure
loans, or freezing their current interest rates for 5 years. HOPE
NOW also has an informational component, which has increased outreach
to borrowers through mailings, and has supported a toll-free hotline,
1-888-995-HOPE, to provide 24-hour mortgage counseling in multiple
languages.

Box 2-5: Mortgage Lending Today

Securitization has helped drive the expansion of home ownership,
available credit, and the selection of mortgage products throughout the
Nation. Before securitization was a prominent market force, the mortgage
industry was characterized by the portfolio lending model. Under this
model, a bank made a loan to a borrower and the loan remained on the
bank's balance sheet until the loan was paid off. The bank serviced the
loan, meaning that it collected interest and principal payments from the
borrower, throughout the duration of the loan. If the borrower became
delinquent or defaulted on the mortgage, the bank would evaluate the
economic feasibility of a mortgage workout plan with the borrower'
perhaps by modifying terms or establishing a repayment program for
missed payments-versus working through the foreclosure process.

Expanded use of mortgage securitization has partly eclipsed the
portfolio lending model and has drawn in new market participants. Now
a German businessperson can invest in a hedge fund that purchases
mortgage-backed securities, which themselves are pools of mortgages
from lenders in Minnesota. The German businessperson is investing
in mortgages and supporting the availability of credit for a teacher in
Minnesota who wants to buy her first home. Thus securitization provides
liquidity and risk diversification in an increasingly integrated world.

The rise of securitization has meant that a third party is needed to
service the bundled loans, that is, collect payments from borrowers
and distribute payments to investors. Loan servicing has developed
into a sophisticated industry. Loan servicers can be commercial banks,
community banks, investment banks, and/or third-party corporations.
Servicers typically transfer interest and principal payments to master
servicers or loan trustees before these payments reach the actual
investors. The servicer makes mortgage payments on behalf of the
borrower, and retains a portion of the payment as its own revenue.
A Pooling and Servicing Agreement (PSA) dictates the rules on loan
modifications between the lender, the investor, and the servicer.
One challenge is that PSAs often have different terms, which may
make large-scale loan modifications more difficult for servicers to
accomplish. To solve this problem, there has been a recent movement to
allow servicers more freedom to modify loans for distressed borrowers.
In the summer of 2007, a private sector group representing servicers,
lenders, and financial institutions issued guiding principles for the
securitization and servicing industries. These principles are intended to
increase the uniformity of contracts across the Nation. Less variation in
contracts allows servicers to develop uniform practices for dealing with
renegotiation, lowering the costs of modifying loans.


The Administration launched a new program at the FHA called FHASecure as
a targeted response aimed at keeping families in their homes. The FHA was
created in 1934 to insure (but not originate) mortgages for qualified
low- and moderate-income borrowers, with less-than-perfect credit and
little savings for a down payment. This insurance boosts home ownership
by enabling borrowers who may have been priced out of the mortgage
market toacquire housing on more affordable terms. The FHA works
through a networkof approved lenders and guarantees that if the
borrower defaults on the loan, the FHA will pay the lender the full
outstanding balance of the loan. Unlike many subprime lenders, most
of the FHA's risk is covered by charging mortgage insurance premiums,
not through significantly higher interest rates.

FHASecure can help some creditworthy borrowers who are affected by
subprime interest rate resets to refinance their mortgages. The FHASecure
program applies both to homeowners who are current on their mortgage
payments and borrowers who made timely mortgage payments before their
loans reset but are now in default. A borrower in default must also have
sufficient income to make future mortgage payments under a fixed-rate
FHA-insured loan, and a history of on-time mortgage payments before their
current loan reset. Making FHA mortgage refinancing options available to
more homeowners will help reduce the number of foreclosures and can help
bring greater stability to local housing markets.

The President signed a bill to temporarily change the current Federal tax
code so that cancelled mortgage debt is not treated as taxable income.
Under prior law, if the value of a home declines, and a portion of the
debt on the home is forgiven, that portion is treated like taxable income
for the borrower. For example, suppose a homeowner owes $120,000 on a
mortgage, and the home's value falls to $100,000. If the mortgage lender
agrees to take $100,000 from the proceeds of the home's sale and forgive
the rest of the debt, the old tax code treated the $20,000 of forgiven
debt as income on which the homeowner must pay taxes. Under the new law,
the homeowner need not pay taxes on the forgiven debt.

The Administration has also proposed legislation to allow State and local
governments to temporarily broaden their tax-exempt bond programs to
include mortgage refinancings. Under current law, State and local
governments are allowed to issue tax-exempt bonds, called "qualified
mortgage bonds," to finance new mortgage loans to first-time home buyers,
with some limits on which mortgages can be covered. If passed, this
legislation would reduce the cost of State and local housing agency
programs that aim to refinance borrowers facing unaffordable rate resets
into lower-cost fixed-rate mortgages.

Strengthening the Mortgage Market for the Future

High default rates, which have contributed to recent market disruptions,
are more likely if consumers do not understand the terms of their loans.
Transparency in mortgage lending helps borrowers find affordable mortgages
and avoid predatory lending. Transparent markets lower the chance that
borrowers will default on loans. The Administration is working on a new
rule under the Real Estate Settlement Procedures Act (RESPA) that would
simplify shopping for loans and reduce settlement costs for consumers.
RESPA was originally passed in 1974 to protect mortgage borrowers from
unnecessarily high settlement charges. This new rule would simplify and
improve disclosure requirements for mortgage settlement costs, making it
easier for borrowers to shop for loans. The rule would establish a new
standard Good Faith Estimate form that loan originators would be required
to provide to borrowers in all RESPA-covered transactions. The aim of the
rule is to communicate complex information to borrowers so that borrowers
will be able to shop effectively for the best loan for them, and
understand the obligations they are undertaking when financing a home with
a mortgage.

The Federal Reserve is also working to improve transparency through a
review of the rules for mortgage lending under the Truth in Lending Act.
In December 2007, the Federal Reserve published proposed rules under
Regulation Z of the Truth in Lending Act to make mortgage lending more
transparent. The new rules would prohibit seven misleading advertising
practices, such as using the term "fixed" to refer to a rate that can
change, and would require truth-in-lending disclosures to borrowers early
enough to use while shopping for a mortgage.

The Federal Reserve is using its rule-making authority under the Home
Ownership and Equity Protection Act (HOEPA) to address unfair or deceptive
mortgage lending practices. In December 2007, the Federal Reserve
proposed-in addition to the rules regarding transparency discussed
above-new rules under the Truth in Lending Act that would address unfair
mortgage lending. For example, the rules would require subprime lenders to
verify income and assets before making a loan and would prohibit subprime
lenders from making loans without considering borrowers' ability to repay
them. The rules would also prohibit all lenders from paying mortgage
brokers yield spread premiums-fees paid by a lender to a broker for
higher-rate loans-without notifying the consumer in advance and from
coercing appraisers to misrepresent the value of a home.

The Administration's proposed FHA Modernization legislation aims to reform
the FHA to better reflect the way in which the private mortgage market
operates, particularly the way it prices risk. From September 2003 to
February 2005, FHA loan volume fell precipitously, from 135,000 mortgage
endorsements in September 2003 to just 40,000 in February 2005, as Chart
2-7 shows. The drop reflects several factors, including low interest rates
that made unassisted mortgages affordable for more families, the private
sector's increased use of automated underwriting that allowed the private
sector to offer loans on favorable terms to more home buyers, and the
increased use of subprime mortgages. In general, it is a positive
development when the private sector is offering favorable terms to
borrowers who previously would have turned to the FHA. Unfortunately, some
borrowers are still underserved, particularly in the subprime market. The
FHA's mission is to serve borrowers who are at the margins of home
ownership by offering safe, affordable options without compromising
underwriting standards. In recent years, the FHA's outdated statutory
authority has limited the agency's ability to keep pace with the evolving
mortgage market. As a result, borrowers opted for the innovative products
and risk-based pricing that were available in the private sector.
FHA Modernization, which was first proposed in the Administration's 2007
budget, is designed to restore a choice to home buyers who cannot qualify
for prime financing. The three major elements of FHA reform are to:
(1) Allow the FHA to price insurance premiums based on borrower risk;
(2) Raise loan limits in high-cost markets so that more families can be
served; and (3) Lower the down payment requirements.

Currently, the premiums for FHA mortgage insurance do not vary according
to a borrower's credit risk or to the expected cost from defaults. This
causes better borrowers to subsidize weaker borrowers (a process called
cross-subsidization). Charging the same price for all borrowers is a form
of average-cost pricing, while charging different prices according to cost
(here, risk) is a shift toward marginal-cost pricing, which is more
efficient. On top of this, cross-subsidization has driven lower-risk
borrowers to seek



alternatives offered in the conventional market. The proposed risk-based
pricing addresses this issue by reducing the cost of FHA mortgages for
lower-risk borrowers. Risk-based pricing will also enable borrowers to
know why they are paying certain costs and what they can do to help lower
these costs in the future. The incentives for families to improve their
credit histories or save for a down payment areimportant elements of
risk-based pricing. While full risk-based pricing requires a Congressional
act to raise the premium caps, a partial, limited version of risk-based
pricing can take place through regulation. The new flexibility under the
FHASecure program includes these regulatory changes in risk-based pricing,
and the Administration has called on Congress to pass the broader FHA
Modernization legislation to fully implement risk-based pricing.

The second piece of FHA modernization would allow the FHA to insure
higher-priced homes. Under current law, the FHA may insure loans that are
up to 87 percent of the conforming loan limit. In certain high-cost
States, this limit is below the median home price in the State. For
example, in California the median home price in 2006 was $500,000, which
is more than the current FHA cap of $363,000. Therefore in certain States,
the FHA cannot insure many of the homes in the State. The Modernization
bill broadens the reach of the FHA program by removing the 87 percent cap
and allowing the FHA to insure up to 100 percent of the conforming loan
limit.

Finally, the third piece of FHA modernization would eliminate the down
payment requirements. Currently, an FHA mortgagor is required to make a 3
percent cash contribution at settlement to be applied to the cost of
acquisition of the property. The Administration's proposal removes this 3
percent requirement. Just like risk-based pricing, the change in down
payment requirements moves away from the "one size fits all" approach and
provides the FHA with the flexibility to insure a variety of mortgage
products for different purposes and different borrowers.

Macroeconomic Implications

The potential macroeconomic effects of the housing market weakness and the
credit market disruptions may operate through several channels, including
residential investment, personal consumption, and business investment. In
addition, the production of some manufactured goods used in construction
has been weak, and employment in some finance-related sectors has fallen
off. Many economists would agree that the downturn in the housing market
has likely had some effects on consumption and business investment, but
the magnitude of the effects are unknown.

The effect on residential investment is the easiest to quantify. Between
the fourth quarter of 2005 and the fourth quarter of 2007, real
residential investment dropped about 29 percent and subtracted an average
of nearly 0.9 percentage point per quarter at an annual rate from real GDP
growth. Single-family housing starts peaked at more than 1.8 million units
in January 2006 and then fell more than 55 percent, to below 800,000 units,
in December 2007. Inventories of unsold homes are at elevated levels: the
inventory-to-sales ratio for existing single-family homes in December
2007-at 9.2 months' supply-was down from the previous few months but still
near highs last reached in 1991. As prices for new and existing homes
adjust to clear excess inventories, housing starts will stop declining and
the drag on GDP growth from residential investment will lessen.

A second effect of the downturn in housing is the potential effect on
personal consumption and saving. For many households, their house is their
primary asset and a significant source of wealth. A considerable academic
literature has shown that increases in wealth tend to boost consumption,
though the estimated magnitude of these so-called "wealth effects" is
imprecise and may depend upon the type of asset (such as stock market
wealth versus housing wealth). In the case of housing wealth, some
calculations suggest that a $100 billion decline in the value of the
housing stock would reduce the long-run level of annual consumption by
between $4 billion and $8 billion. Importantly, consumption responds only
gradually to such a change in wealth, which affords fiscal and monetary
policy the time to provide an offset.


A third effect of the recent credit market disruptions is that lending
standards have been tightened (Chart 2-8) for mortgages and other types of
consumer loans as well as for commercial real estate and other types of
business lending. Tighter lending standards tend to reduce residential
investment by making it more difficult to obtain mortgages. Consumption
expenditures are also likely to be lower for two reasons. First, new
homeowners may need to save more for their down payments than had
previously been the case, which reduces consumption during the period in
which they are saving. Second, existing homeowners may find it more
difficult to borrow against their home equity or to engage in cash-out
refinancings that previously might have boosted their short-term
consumption.

On the business side, tighter lending standards would tend make
investment more expensive. Historically, business fixed investment has
exceeded the internally generated funds of corporations (also known as
cash flow) by a substantial margin. The gap between these two measures is
financed by issuing equity or taking on corporate debt such as corporate
bonds or bank loans. In recent years, this gap has been considerably
smaller, which suggests



corporations have not needed to borrow funds from
other sectors as much as they did in the past. However, this gap is
reemerging and firms may need to borrow more in the future, at which point
tighter lending standards might become more limiting, though this effect
has not been apparent through the third quarter of 2007.

Conclusion

All economic activity requires flows of capital between different parties
at different times. This borrowing and lending activity takes place
constantly in the world credit markets. These markets are essential to
every well-functioning economy because they shift capital from those who
supply it (creditors) to those who demand it (debtors). Credit markets
include a wide variety of instruments, such as corporate bonds, government
bonds, and money market instruments (commercial paper, certificates of
deposit, and repurchase agreements, among others). The Federal Reserve's
monetary policies influence the general price of borrowing and lending in
the economy. Lenders can charge a higher interest payment to compensate
themselves for bearing additional risk. Like any market, the credit
markets bring together a diverse set of buyers and sellers, and the price
of the debt instrument represents an exchange between these two parties.

The summer of 2007 witnessed a contraction in the credit markets that
caused the price of borrowing to rise and the quantity of some types of
debt offered to the market to shrink. This contraction took place in
several markets, including the mortgage lending market and the
asset-backed commercial paper market. As markets evolve and adapt to
economic conditions, prices and quantities will adjust. The impact on the
nonfinancial real economy has been muted to date, notwithstanding the
decline in residential investment over the past 2 years. However, the
effects of declining home prices in some parts of the country and the
tightening of credit standards is likely to have at least some effect on
consumer and business spending as time passes.

Monetary policy actions can offset some of the weakening in aggregate
demand that results from disruptions in the housing and credit markets,
and other government policies can offer targeted assistance. FHASecure and
FHA Modernization are leading examples of targeted assistance to
homeowners and subprime borrowers facing the possibility of foreclosure on
their homes. These borrowers purchased their homes during a period in
which lenders underpriced risk and offered subprime mortgages at low
prices to too many borrowers. FHASecure can help those eligible borrowers
who were caught off guard by rapidly evolving credit markets and, in some
cases, predatory lending. FHA Modernization will encourage a more flexible
and better functioning, risk-based mortgage lending market for those with
low and moderate incomes.

Beyond such targeted responses, the best course of action is often to
simply allow markets to adjust. Financial markets are in a constant
process of pricing risk. Economic factors fluctuate daily, and the prices
of traded debt instruments reflect investors' attitudes toward the risks
associated with these fluctuations. By their very nature, markets have a
remarkable resilience and can adapt rapidly to changing economic
circumstances, as demonstrated by the response of the markets to the
credit market disruptions that began in the summer of 2007. Policies that
attempt to protect market participants from the discipline of the market
risk delaying necessary adjustments and creating a potential moral hazard
problem by giving lenders and borrowers less incentive to make prudent
financial decisions in the future.

Markets naturally self-correct, rewarding good strategies and punishing
bad ones. Government actions may be less effective at differentiating
between the two and may prevent markets from creating products that
benefit consumers. In addition, any government actions mitigating the
outcomes of risky behavior may create perverse incentives for reckless
decisions by borrowers and investors who may come to rely on government
interventions. Allowing the market to price mortgage risk will help ensure
that subprime mortgages are available to those who can afford to repay
them. With enhanced transparency, the market can weed out poor financial
products while encouraging positive financial innovations, a process that
is crucial to maintaining U.S. competitiveness in the global financial
community.