Fed President Adds Own Suggestions to Housing White Paper

In remarks prepared for delivery to the
New Jersey Bankers Association Economic Forum on Friday, Federal Reserve Bank
of New York President and Chief Executive Officer William C. Dudley
focused on
what he referred to as “only one factor behind the frustratingly slow economic
recovery,” the nation’s housing market.  He
elaborated on the framework presented in a Fed “white paper” earlier this week and
advocated for further Fed intervention in the housing market.

Among the new suggestions put
forward by Dudley in his remarks are an earned principal reduction program for
underwater but performing homeowners, freeing lenders from employment-related
credit risks, expanded bridge financing for the unemployed, and a “home for heroes”
program.

Dudley outlined the current status
of the housing market;

  • Housing prices down from the peak by
    30 to 40 percent (depending on location) and still declining;
  • Home construction now at a negligible
    425,000 annual units from the 1.75 million unit peak.
  • Mortgage delinquencies, while
    declining, remain very elevated. Currently there are 1.5 million seriously delinquent
    mortgages and 2 million in some stage of foreclosure;
  • Without improvements in housing and
    labor markets, more loans will become delinquent and the flow of loans into
    lender-owned real estate (REO) could rise from the current 1.1 million per year
    to as many as 1.8 million this year and next.
  • Increasing REO will continue to
    exert downward pressure on prices and housing activity.

These
negative benchmarks, Dudley said, have inhibited economic activity through a
number of channels.   First,
the usual driving power of residential investment has been absent from this
recovery.  In the nine quarters following
the ends of the mid-1970s and early 1980s recessions, residential investment
had climbed by 65 percent and 55 percent above their respective troughs.  There has been no rebound in this cycle.

Since the peak homeowners have lost
about $7.3 trillion in home equity – about one-half the total.  This decline has eroded household wealth and
contributed to greater weakness in consumption. 
It has also reduced credit availability as financial institutions are
less willing to lend on collateral when prices could fall further.  Problems in the foreclosure process and
obstacles to efficient modification of loans in securitizations exacerbate this
reluctance.  This has reduced the amount
of credit available for households, including for small business formation.

Finally, the resulting decline in refinancing
 deprives borrowers of a channel through
which lower interest rates support spending and employment. This has undercut
to a degree the ability of monetary policy to support demand.

Other systemic problems in housing are
contributing to the lack of recovery despite the fact that housing no longer
appears overvalued.  Items on Dudley’s list
include:

  • Supply and demand are not correcting
    efficiently because of lagging household formation and that housing is a
    long-lived asset.  The feedback loop from
    prices to demand also indicates this is not the time to own a home.
  • Factors that affect demand and home
    prices are not immutable and can be affected by the legal and operational
    structure of the mortgage market which has been inadequate for dealing with the
    recent systemic shock and is amplifying bad outcomes.
  • Conflicts of interest between first
    and second lien-holders are undermining remediation efforts.
  • There are too few mortgage
    modifications and short sales and too much emphasis on foreclosures to resolve
    difficulties.
  • Much damage is caused by inefficient
    foreclosures to families, neighborhoods, communities and the tax base.
  • The potential of “defaults by choice”
    could significantly swell REO if home prices continue to fall.

These factors, Dudley said, imply
that there are many potential equilibrium outcomes in terms of housing demand
and home prices and some are considerably more desirable than others. Housing
policy should seek to break adverse feedback loops, promote more economically
efficient outcomes in housing and support growth.

He restated the features of a
comprehensive approach to stabilize housing as was outlined in the Fed white
papers:  measures to improve access to
mortgage credit, reduce obstacles to refinancing, lessen the flow of homes into
foreclosure through bridge financing and accelerated principal reduction, and
to facilitate the absorption of REO back into use as owner- or renter- housing.

Many of these policies, he said, “simply
seek to solve or bypass the legal and incentive problems in the market today
and mimic efficient private actions that might be taken if mortgage loans were
all held in portfolio and accounting rules did not discourage net present value
maximization.” 

Several steps should be taken to offer
opportunities for new mortgages
to creditworthy borrowers on reasonable terms. Only
30 percent of originations now go to borrowers with credit scores under 720
even though they represent 52 percent of the population.  Lenders are applying tougher restrictions than
the GSEs formally require, limiting their take-back risks. While lenders should
be accountable for the representations they make, blanket repurchase
requirements lead to bad outcomes in a period of high job loss risk.  It would be better to establish alternative
ways to penalize lenders for misrepresentation that are not so closely tied to
the risk of job loss.  For example, a
better balance between encouraging for sound underwriting and credit availability
could be a materiality test in the rep and warranty agreement.   Another possibility is to explore whether
reps and warranties should have a finite duration supplemented by a rigorous
check of a random sample of the mortgages being securitized.

Dudley said he did not advocate for
a return to the lax standards and under-pricing of credit risk of the boom
period, but a review leading to guarantee fees for new mortgages should be
based on the expected losses on those mortgages, not what actually happened to
earlier vintages

There is also a strong case for
tackling the downward bias on appraisals, which are voiding many transactions
between willing buyers and willing sellers. Incentives for individual
appraisers favor conservatism today-just as they favored over-optimism during
the boom.  The industry also needs
standards to establish benchmark prices in slow markets with disproportionate
distressed sales. 

Increasing refinancing would create
additional cash flow for borrowers to absorb any adverse income shocks,
reducing the likelihood of default, distress sales and foreclosures.  However, declines in equity, tighter
standards, high fees, burdensome processes and legal risks to lenders are
hindering this goal.

“Because the taxpayer, via Fannie
and Freddie, is already exposed to the risk of conforming loans defaulting, it
makes no sense to make it expensive or difficult for borrowers with these loans
to refinance,” Dudley said, as after all, refinancing reduces the existing credit
risk to which taxpayers are already exposed. It is also inefficient to fully
re-underwrite applications for such refinancing.

Many of these issues have been
addressed by recent revisions to Home Affordable Refinance Program (HARP),
Dudley said, but more could and should be done. ‘I would like to see
refinancing made broadly available on streamlined terms and with moderate fees
to all prime conforming borrowers who are current on their payments.”

In a departure from the Fed’s list
of improvements, Dudley added the need to weaken the link between unemployment
and new foreclosures
because the primary reason for distress sales and mortgage
defaults today is the loss of a job. Some support for unemployed homeowners has
been provided in some states under the Hardest Hit program and Dudley favors a
broad program to “provide bridge financing for all qualified borrowers with
demonstrated ability to service their debts but who have become unemployed
involuntarily. In economic terms, this is a form of collective insurance.
 

 His staff, he said, estimates that there are 4
to 5 million “at risk” homeowners who can afford their mortgage
, but
who would struggle in the event that the primary earner in the household became
unemployed and that around 600,000 of these households will experience an
involuntary job loss that lasts longer than a month over the next year. The
average annual amount that would be required to keep the mortgage current for
these households while unemployed and receiving unemployment insurance is
around $21,000 which implies an annual bridge lending program of $15 billion
per year during the current stress period.  In the future, loan repayments would help to
offset the cost and, absent the negative externalities achieved by limiting
distress sales, the expected program cost would be even lower.  This financing would have to have features
such as requiring lenders to write down excess debt so as to assure against
another lender “bailout.”

Investment firms that purchase
delinquent mortgages routinely reduce principal in order to maximize value on
these loans. It would make sense for Fannie and Freddie to do this as well in
order to minimize loss of value on the delinquent loans they guarantee. However,
borrowers should not have to become delinquent to benefit from such
reduction.  There could be a program for
earned principal reduction for performing but underwater borrowers which would
provide an incentive to remain current, reduce defaults and ultimately REO.

One option developed by my staff is
for Fannie Mae and Freddie Mac to give underwater borrowers on loans that they
have guaranteed the right to pay off the loan at below par in the future under
certain circumstances, including that the borrowers have continued to make
timely payments. For instance, the borrower could be given an open-ended option
to pay off the loan at an LTV of 125 percent, and the right to pay off the loan
at an LTV of 95 percent after three years of timely payments.”  This would protect the borrower from further
price declines but he would give up a portion of the upside from appreciation.

Even with aggressive policies to
minimize loans flowing into foreclosure Dudley estimates that large such
volumes will continue and the growing overhang could continue to depress houses
for several years
.  Thus both incentives
for short sales and steps to facilitate the orderly disposal of properties must
be taken.  An interagency group is
working on issues relating to REO-to-rental conversations and, among other steps,
investors could be encouraged to purchase REO to be made available as rental
housing. Fannie Mae and Freddie Mac could increase the number of loans offered
to individual investors, and REO properties in a given locality could be
bundled for sale.

The government might consider a
package of tax incentives for purchases of REO that are used as rental
properties such as a reduction of the current 27½ year depreciation period
and/or a reduction of capital gains tax liability if the property is held for a
minimum period, such as five years, Dudley said.

“One idea developed by my
staff-let’s call it “homes for heroes“-would be to create a new tax
credit or other home purchase subsidy specifically for veterans of our foreign
wars that would enable these veterans to purchase such properties at a
discount. There are over 2½ million Gulf War II veterans alone, many of whom
served multiple tours of duty overseas, and a significant proportion of them
might otherwise not be able to purchase homes today.”

Dudley disputed the contention that
interventions in the real estate market would lead to moral hazard, i.e.
rewarding bad behavior.  First, he said,
programs can be designed with proper incentives to limit hazard and encourage
desirable behavior, but  today, in
contrast to the early part of the crisis, persons running into problems with
their mortgages took them under standard conditions of downpayment then ran
into an adverse life shock.  There is not
a moral hazard issue, he said; punishing misfortune accomplishes little.

He also believes his proposals are
strongly in the public interest and good for taxpayers.  The programs are not without cost, but the
payoff could be modest price increases, few defaults, and shared appreciation
as well as the avoidance of negative externalities such as reducing losses on
loans that do not default as well as the fiscal benefits generated by strong
economic growth.

In closing Dudley said the housing
policy agenda he describes would “address one factor that  has impeded the economic recovery.
Implementing such policies would improve the economic outlook and make monetary
accommodation more effective.  However,
because the outlook for unemployment is unacceptably high relative to our dual
mandate and the outlook for inflation is moderate, I believe it is also
appropriate to continue to evaluate whether we could provide additional
accommodation in a manner that produces more benefits than costs, regardless of
whether action in housing is undertaken or not. Monetary policy and housing
policy are much more complements than substitutes.”  And, he said, we have to recognize that there
is more to economic policy than just monetary policy. “Low interest rates help
housing, but cannot resolve the problems in that sector that are pressing on
wider economic activity. With additional housing policy interventions, we could
achieve a better set of economic outcomes than with just monetary policy alone.”

Article source: http://www.mortgagenewsdaily.com/01062012_housing_market_reform.asp

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