The elevated defaults we have already seen on recent vintages of subprime mortgages have resulted in losses for the highest risk tiers, and have caused investors to sell higher quality securities at a discount, reflecting uncertainty surrounding the accuracy of the investment-grade rating. If the ratings were accurate, highly rated securities containing subprime debt would have only a remote chance of default similar to investment-grade securities containing prime mortgages, home equity loans, or student loans. Unfortunately, underlying assumptions for the subprime market were inaccurate for several reasons I'll describe.

First and most importantly, most parties involved in the process assumed that house prices would continue rising nationally. This assumption seems to have had the biggest impact on the situation we see today. ... Second, the subprime market has grown very rapidly in recent years, so such widespread use of subprime mortgages is a relatively new phenomenon. This limited history made it difficult to assess the likelihood of defaults if underlying economic conditions changed. And third, the increased reliance on mortgage brokers who originated the loans but had little stake after they were securitized was a departure from the traditional buy-and-hold strategy of many financial institutions. These brokers typically are compensated based on volumes of loans made and sometimes on the rates and fees as well; as a result, the brokers have few incentives to worry about the longer-term viability of the mortgage.

Defaults in the subprime market have resulted in even the most secure tranches of subprime securitizations selling at a sizable discount. Investors are now questioning the appropriateness of surrogate securitization, contemplating more independent analysis of the securities and underlying assets and the need to distinguish between securitizations with different underlying assets. These are appropriate considerations, to be sure, but until they are more confident, investors have been shying away from even investment-grade securitization. The problems in securitization are highlighted by the impact on jumbo mortgage loans. Because of difficulties in securitization, the cost of these loans has risen significantly. This is particularly a problem in New England where the price of housing is quite high.

To better understand the subprime issue, the Federal Reserve Bank of Boston has been studying publicly-available information from the Registries of Deeds in New England states, which allows us to study the patterns of mortgages issued on a given house over time. ... A first finding is that recent foreclosures have been disproportionately related to multi-family dwellings... This highlights a potentially serious problem for tenants, who may not have known that the owner might be in a precarious financial position. Second, the Banks research shows that the duration of a subprime mortgages is on average quite short for a sample of subprime mortgages used to purchase a home between 1999 and 2004, two-thirds have prepaid within two years and almost 90 percent have prepaid within three years. Prepayment will occur if the home is refinanced or if it is sold. While some of those sales may have been under difficult circumstances, it is plausible that many borrowers who purchased homes with subprime products did benefit from the appreciation of home prices in New England that occurred over the last decade.

Current difficulties afflicting the real estate sector have, to date, been confined to the residential sector; business outlays for structures have been quite strong. Since its peak in 2005:Q4, real residential fixed investment expenditures have declined by 19 percent. Over the same interval, real business investment in structures has increased by 21 percent. If you plot these two series on a chart, they would look like scissors: one line going up and one line going down—and their slopes would be quite steep. Indeed their slopes suggest that the current rates of change are not sustainable. Housing will not continue to fall at double-digit rates, and outlays for business structures will not continue to increase at double-digit rates.

Unfortunately, recent events suggest that housing will remain weak for several more quarters; stabilization may not begin until well into 2008. Probably the most important statistics in this regard are the number of unsold new homes still on the market relative to their current sales rate and the recent trends in house prices.

 I suspect that... the causes of the swing in house prices will be seen as less a consequence of monetary policy and more a result of the emotions of excessive optimism followed by fear experienced every so often in the marketplace through the ages.   

The linkages are complex, but here is my synopsis of recent market turmoil. Since mid-2006, home price appreciation slowed, and recently prices have fallen in some markets. Earlier in 2007, markets perceived that subprime mortgage credit quality was deteriorating markedly. Delinquencies among subprime borrowers have been rising and are expected to continue to rise as many borrowers have difficulty refinancing. The initial low rates on their adjustable-rate mortgages are resetting to higher rates that imply much higher monthly payments. At the same time, stagnant housing prices have eliminated their option of refinancing at lower rates or selling their house at a profit.

Large run-ups in asset prices present serious challenges to central bankers. The analysis of the role of housing in the monetary transmission mechanism argues against a special role for house prices in the conduct of monetary policy and in favor of a policy response to them only to the extent that they have foreseeable effects on inflation and employment. Nevertheless, central banks can take measures to prepare for possible sharp reversals in the prices of homes or other assets to ensure that they will not do serious harm to the economy.   

The latest data show that prices of new and existing homes are no longer falling, and inventories of unsold homes have dropped a bit. However, a sharp decline in building permits still suggests that investment in new housing will remain weak at least through the first half of this year, as the adjustment process continues. This current housing slump is temporarily pushing overall economic growth below its longer-term growth path.

Indeed, we have already seen that the pace of house-price appreciation has clearly moderated, and there are signs that it may continue. For example, one indicator we have been following is the Case-Shiller house price index, which is based on house price data in ten large urban markets—three of which are in California, by the way. Beginning in May of this year, futures contracts on this price index began trading, and they show house prices falling at about a 6 percent annual rate by the end of this year. Though this is still a very new and pretty thin market, the results are interesting and suggestive.

Home prices, which have climbed at double-digit rates in recent years, still appear to be rising for the nation as a whole, though significantly less rapidly than before.

As home price escalation slows, consumers can be expected to feel less confident about gains in wealth and may well begin to feel inclined to save more and spend less. These indirect effects of a housing slowdown are embedded in my forecast of some slowing in the growth of consumer spending.

To be sure, we are seeing some softening in housing markets, and home prices are increasing at a slower rate. But it seems unlikely that prices will actually decline nationwide...Even if there were large price declines in some cities, there probably would be little spillover to a more general drop in prices nationwide...But if prices did decline nationwide, history suggests that the impact on overall consumer spending would be modest and gradual.

The Fed's gradual removal of monetary policy accommodation should tend to damp the pace of activity. This effect is likely to be reinforced by a related development—a significant moderation in the rate of appreciation of house prices. This could well restrict not only the pace of residential construction but also the pace of consumer spending.

While I don’t think there is much risk of a housing price collapse on a nationwide basis, we could see a decline in prices in certain markets.

It makes sense to worry about the potential impact on overall GDP growth of a combination of a reduction in housing construction and a decline in household wealth. The Bank's baseline forecast takes what might be seen as a rather conservative perspective here. We see construction diminishing somewhat and real estate prices flattening, not declining, and those assumptions are built into the solid GDP growth rate I referred to earlier. Clearly, however, we could be wrong on the magnitudes. Real estate prices could actually decline (though this has never happened for the nation as a whole at least on a nominal basis) and construction activity could retrench more than we expect. And rising mortgage rates could impede consumption more than our forecast predicts. Thus, changes in residential real estate present a source of downside risk to growth.