Communities with weak underlying economies are characterized by a long trend of population loss, gradual impoverishment, and strained municipal resources. For cities like Cleveland, Detroit, and Indianapolis the increase in foreclosures over the last few years has exacerbated a pre-existing vacancy problem. The increased rates of foreclosures and the related economic downturn have hastened a cycle of decreasing property values.

On prices of housing and the like, we're not trying to prop up the price of housing. What we're trying to do is get the credit markets working again so that the free market can begin to function in a normal way instead of in this seized-up way in which it's currently acting.

And, finally, on price fixing of so-called toxic or legacy assets, the plan that Secretary Geithner described this morning, would have as an important component private asset managers making purchases based on their own profit-maximizing analysis. So that would be true market prices that would free-up what is now a frozen market and get transactions flowing again and should restore real price discovery to those markets.

As house prices have declined, many borrowers now find themselves "under water" on their mortgages--perhaps as many as 15 to 20 percent by some estimates.  In addition, as the economy has slowed and unemployment has risen, more households are finding it difficult to make their mortgage payments.  About 4-1/2 percent of all first-lien mortgages are now more than 90 days past due or in foreclosure, and one in ten near-prime mortgages in alt-A pools and more than one in five subprime mortgages are seriously delinquent.³  Lenders appear to be on track to initiate 2-1/4 million foreclosures in 2008, up from an average annual pace of less than 1 million during the pre-crisis period.⁴

Along with the decline in construction, house prices have fallen by around 15 to 20 percent from their peak, depending on which measure you use.  Unfortunately, this is another case where the bottom is not yet in sight. First, the ratio of house prices to rents still remains high by historical standards, suggesting that further price declines are needed to bring housing markets into long-run balance. Second, the large inventories of unsold homes I mentioned—a growing share of which are foreclosures—also can be expected to continue to put downward pressure on prices. 

To reiterate, falling housing prices continue to be a significant source of down-side risk to the economy.  Previous periods of real estate problems have taken significant time to be worked out, with foreclosures remaining elevated well after their peak.  The current foreclosure problem has been exacerbated by the difficulties related to many of the problem loans being held in securities.

As noted earlier, the rapid rise in delinquencies for home equity lines and junior liens held at banks is occurring despite an unemployment rate of about 5 percent – so, should the unemployment rate rise and housing prices continue to fall, financial stresses caused by the housing correction could well spread beyond the large banks involved in complex securitizations, and the smaller banks with sizeable portfolios of construction loans, to a larger set of financial institutions. 

Smaller banks have generally not held these complicated financial instruments, so they have been more insulated from the financial turmoil.7 They also have not been liquidity providers for securities, so they have experienced less unexpected growth in their assets. As a result, there have been far fewer complaints from small and medium sized businesses – generally the clients of smaller banks – about credit availability.

However, it is important to note that the continued health of small and medium sized banks will be impacted should residential and commercial real estate prices decline in a severe manner. While that is not my forecast, it is only fair to note that for the liquidity problems to be confined it is important for collateral values to stabilize. Significant price declines will likely lead to more residential and perhaps commercial mortgage defaults not necessarily limited to the subprime market, and thus more likely linked to mortgages held in portfolio by smaller banks.8

It looks like we're in the midst of a contraction. [He said he is] expecting a contraction in economic activity
in the first half. ...

It's not over yet. I don't think it's going to end all at once.

I think the crucial variable is stability in the residential housing market in a broad number of geographies that we can have some confidence about our sense of where housing prices are going. The other major source of uncertainty that I think is consequential is non-residential construction spending. And we'll just have to see how that plays out.

From comments to press, as reported by Market News International and Reuters

The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.

In the housing area, thought will likely be needed regarding programs for those with negative as well as positive equity in their houses. As long as housing prices continue to fall, the decline increases the risks to borrowers, lenders, markets and the economy.  

A critical factor in the size of losses, and whether balance sheet constraints become more widespread, is the extent to which housing prices fall. Unfortunately, we have little historical precedent for sustained declines in national housing prices, which makes it difficult to forecast future home prices. However, one of the significant downside risks to the economy is that further declines in housing prices could depress residential investment, reduce consumer spending, generate elevated foreclosures, and contribute to financial instability. Taking appropriate monetary, regulatory, and fiscal actions to mitigate this risk seems prudent.

To date, the resulting potential capital constraints are concentrated in the largest banks with the largest exposure to securities tied to subprime mortgages. While some of the capital losses have been mitigated by new capital, the losses in combination with involuntary growth in assets can potentially restrain the willingness of these institutions to engage in activities that would further swell their balance sheet.

Because these institutions are actively engaged in structured products and loans to finance leveraged deals, it is not surprising that participants in these markets are finding tighter financial constraints. For some markets where these banks are major market makers, the unwillingness to further increase balance sheets has impacted the liquidity in those markets.

Many small and medium-sized businesses are not complaining about credit conditions. This reflects the lack of exposure that many small and medium-sized banks had to securitized products or the subprime market. However, should housing prices continue to fall, losses in prime residential mortgages and construction loans are likely to cause these institutions to be more capital constrained. Banks under $100 billion still retain significant exposure to residential mortgages and construction loans which account for 26 percent of assets or $750 billion. Should housing prices continue to fall and the housing sector get worse, it is likely that these institutions will begin being impacted more significantly.

[T]he current problems in the subprime market are heavily dependent on economic conditions particularly housing prices.[3] As a result, the outlook for how much worse this problem could become depends critically on the outlook for the economy and the housing market. We are currently expecting the economy to grow well below potential for the next two quarters, before gradually improving over the course of next year. Our research suggests that the foreclosure crisis will get worse before it gets better, but our forecast is quite dependent on how far house prices fall.

Looking ahead, two considerations suggest that conditions for subprime borrowers have the potential to get worse before they get better. First, all indications are that housing activity is continuing to weaken. Incoming data in recent weeks show that sales and new residential construction have declined further. In such an environment, house prices in the aggregate are likely to remain sluggish for some time. Second, the bulk of resets is yet to come: On average, in each quarter from now until the end of next year, monthly payments for more than 400,000 subprime mortgages are scheduled to undergo their first interest rate reset. That number is up from roughly 200,000 per quarter during the first half of 2007. Delinquencies and foreclosures are therefore likely to continue to rise for a number of quarters.

Residential investment has been a major source of weakness in the economy for a year and a half. Forecasters who were predicting a recovery in the housing sector by the end of this year have been revising down their forecasts to incorporate the effect of rising mortgage defaults, financial turmoil, and softening housing prices. Particularly notable is the decline in housing prices in many regions of the country. Consumer spending is affected by households net worth and housing equity is an important component of wealth. While the effect of the problems in housing on consumption has been muted to date, further and more widespread deterioration in housing prices would increase the risk of a more adverse impact on consumption.