Fed White Paper Offers Advice on Restoring Housing Market


In a letter to the chairs and ranking members of the
Senate Banking and House Financial Services Committees on Wednesday, Federal Reserve
Chairman Ben S. Beranke said “Restoring the health of the housing market is a
necessary part of a broader strategy for recovery.
”  The letter accompanied a white paper developed
by the Fed which Beranke called a “framework for thinking about certain issues
and tradeoffs that policymakers might consider.”

In its opening pages the white paper titled The U.S. Housing Market: Current Conditions and Policy Considerations
acknowledges that much of the weakness in the housing market is related to poor
labor market conditions and will take time to be resolved but outlines three
dimensions along which policymakers could take
action to ease some of the pressures on the housing market:

1. Moderating the
inflow of properties into the large inventory of unsold homes

    The large
    inventory of foreclosed or surrendered properties (REO), perhaps representing
    one-quarter of the 2 million vacant homes for sale in the second quarter of
    2011, is putting downward pressure on house prices, and exacerbating the loss
    in household wealth.  The continued
    influx of new REO, perhaps as many as 1 million properties per year in 2012 and
    2013, will continue to weigh on house prices for some time.  To the extent that REO holders discount
    properties in order to sell them quickly, the near-term pressure on home prices
    might be even greater.

    At the same
    time, strengthening rental markets in some areas are reflecting the decline in
    homeownership with vacancy rates falling and rents rising in many markets.  The price signals in the markets, that is the
    decline in house prices and the rise in rents, suggest that it might be
    appropriate in some cases to convert foreclosed homes into rental properties
    and, at this time, with no indication that the downturn in homeownership being
    likely to reverse in the immediate future, there are indications of a
    longer-term need for expanded rental housing stock.

    Although small
    investors are currently buying and converting foreclosed properties to rentals,
    this is a limited solution and larger-scale conversions have not occurred for
    at least three interrelated reasons.  First,
    it can be difficult for an investor to assemble enough properties within a
    sensible geographic area to achieve efficiencies of scale.  Second, attracting investors to bulk sales
    has typically required REO holders to offer significantly higher discounts
    relative to those given owner occupants, in part because it can be difficult to
    investors to obtain financing for such sales, and third, the supervisory policy
    of GSE and banking regulators has generally encouraged sales of REO properties
    as early as practicable.

    Intertwined in these issues is the
    unresolved role of the government sponsored enterprises (GSEs) Fannie Mae and
    Freddie Mac which, because of their outsized presences, affect not only their
    own holdings but the larger market with their actions.  Despite the mandate of the Federal Housing
    Finance Agency (FHFA) as conservator of the GSEs to minimize taxpayer losses,
    some actions that cause greater losses to the GSEs in the near term might be
    advantageous if they lead to a quicker and more vigorous recovery.  The paper presents a number of suggestions
    for dealing with inventory held by the three principal government related
    agencies while suggesting it will discuss properties held by federally
    regulated banks at a later date.

    An REO to rental
    that relies on sales to third-party investors will be more viable if
    the cost-pricing differential can be narrowed which might be done by (a)
    structuring sales as competitive auctions; (b) making sales packages more
    attractive to a variety of investors, or (c) providing investors with the debt
    financing.  In the latter case REO
    holders could probably increase sales prices by providing financing but this
    may be at the cost of reducing their future income stream.

    The paper also
    suggests some innovations for reducing the amount of time that a vacant
    property remains in inventory such as auctioning the rights to acquire a future
    stream of properties that might be foreclosed in a given neighborhood rather
    than auctioning existing REO holdings or to encourage deed-for-lease programs which
    circumvent the REO process entirely by exchanging a deed-in-lieu for a
    rent-back arrangement.

    Another solution
    might be for the REO holder to convert the properties to rentals
    themselves.  The value of this suggestion
    may become more apparent as the inventories increase.  The paper also suggests that land-banking,
    perhaps with the assistance of federal subsidies, could be an option for
    low-value properties.

    2. Remove some of
    the obstacles preventing creditworthy borrowers from accessing mortgage credit.

      The paper
      touches only lightly on this topic, saying that the regulators have been in
      consultation with the GSEs and originators about the sources of the apparent
      tightness in lending standards and that balance is needed between prudent
      lending and appropriate consumer protection on one hand and not unduly
      restricting credit on the other.

      3. Limit the number of homeowners who are pushed into
      an inefficient and overburdened foreclosure pipeline.

        Beyond the
        personal suffering, foreclosures can be a costly and inefficient way to resolve
        mortgage payment obligations because they can result in “deadweight losses”,
        i.e. costs that do not benefit anyone such as neglect and deterioration of
        properties and neighborhoods and the impact of that in putting additional
        downward pressure on prices.  Some
        foreclosures might be avoided if loan modifications are pursued more
        aggressively and servicers given greater incentives to do so.  Where modifications are not feasible there
        should be more expedient ways to exit from homeownership.

        Many homeowners who could benefit from
        refinancing are unable to do so, and the paper credits recent changes in HARP
        with helping in this area but suggests possible further expansion to borrowers
        whose existing mortgages are not guaranteed by the GSEs even though this raises
        a host of risk management issues.

        The Fed suggests changes to the HAMP
        loan modification program as well.  One
        would be to eliminate the 31 percent debt-to-income (DTI) floor that currently
        exists in the program.  Another is
        eliminating the focus on modifications for borrowers who have become
        unemployed, concentrating instead on payment deferment through the period of
        unemployment which might avoid permanent foreclosures arising out of a
        temporary situation.

        The paper also suggests that the focus of HAMP on
        net present value to the lender is short sighted and there may be other types
        of modifications which may be socially beneficial even if not in the best
        interests of the lender.  This, they
        concede, may be a tough sell to lenders and likely to involve more taxpayer

        Large scale modifications involving principal
        reduction may be too costly to consider. 
        The paper calculates that the 12 million underwater mortgages in the
        country represent about $425 billion in negative equity and targeting
        underwater borrowers who are likely to default raises issues of fairness in
        addition to expenses.  An alternative
        would be aggressively facilitating refinancing for underwater borrowers who are
        current on their loans, expanding modifications for borrowers who are
        struggling with payments, and providing a streamlined exit from homeownership
        for borrowers who want to sell their homes.

        Expanding short-sale and deed-in-lieu opportunities
        have many advantages but the barriers to short sales include willing buyers at
        prices acceptable to the REO holder and a timeline that allows the transaction
        to close before the foreclosure.  Deeds-in
        lieu are often not pursued because of complications such as junior liens, dealing
        with deficiency claims, and the burden of additional REO.  On the other hand, borrowers may not even
        realize the existence of such an alternative and instead remain in their homes through
        the entire drawn-out foreclosure process. 
        Figuring out ways to surmount these obstacles is crucial.

        The paper also addresses the shortfalls in loan
        that have been widely discussed and some of the solutions that have
        been proposed such as changing the compensation structure, making changes to
        the MERS registry, and better monitoring the servicers.

        It is clear from the conclusion to the paper that
        the Fed is not just searching for short-term solutions to the current market
        disruptions, but a fundamental restructuring of the system so that these
        problems are better packaged for management in the future.  “The challenge for policymakers is to find
        ways to help reconcile the existing size and mix of the housing stock and the
        current environment for housing finance. 
        Fundamentally, such measures involve adapting the existing housing stock
        to the prevailing tight mortgage lending conditions or supporting a housing
        finance regime that is less restricting than today’s while steering clear of
        the lax standards that emerged during the last decade.”

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