As the year drew to a close, economic prospects had dimmed considerably. The consequence is that credit conditions have tightened broadly throughout the economy and especially in the housing sector. Indeed, as I write this letter, we remain deeply concerned about the ongoing problems in the housing sector—rising delinquencies and foreclosures and falling house prices—and the distress it is causing for families and for communities. We are also concerned about the impact of these developments for the economic prospects of the national and Twelfth District economies.

Legislative initiatives that would allow the Federal Housing Administration to increase its scale to reach a wider range of borrowers and develop appropriate underwriting and pricing methodologies to deal with any increased risk and another that would strengthen the oversight of Fannie Mae and Freddie Mac are important compliments to our regulatory efforts to strengthen the housing markets.

As the Federal Reserve builds on  its consumer protection efforts in order to mitigate foreclosures for current homeowners, we are also concerned about the impact current mortgage market problems are having on individual communities.  The challenges of rising foreclosures are significant at the state and local level and the nature of the problem varies by location.  Through its structure, the Federal Reserve System is attuned to local issues, which both informs its national policymaking and allows for responses tailored to local conditions. 

Most Americans are paying their mortgages on time and are not at risk of foreclosure.  But high rates of delinquency and foreclosure can have substantial spillover effects on the housing market, the financial markets, and the broader economy.  Therefore, doing what we can to avoid preventable foreclosures is not just in the interest of lenders and borrowers.

As my listeners know, conditions in mortgage markets remain quite difficult, and mortgage delinquencies have climbed steeply.  The sharpest increases have been among subprime mortgages, particularly those with adjustable interest rates:  About one quarter of subprime adjustable-rate mortgages are currently 90 days or more delinquent or in foreclosure.¹  Delinquency rates also have increased in the prime and near-prime segments of the mortgage market, although not nearly so much as in the subprime sector. 

Many foreclosures are not preventable.  Investors, for example, are unlikely to want to hold onto a property whose value has depreciated significantly, and some borrowers--perhaps because they were put into an inappropriate loan or because personal circumstances have changed--cannot realistically sustain homeownership.  However, if a foreclosure is preventable, and the borrower wants to stay in the home, the economic case for trying to avoid foreclosure is strong. 

 To be effective, such programs must be tightly targeted to borrowers at the highest risk of foreclosure, as measured, for example, by debt-to-income ratio or by the extent to which the mortgage is "underwater."  Finding the right balance--particularly the need to avoid programs that give borrowers who can make their payments an incentive to default--is difficult.  But realistic public- and private-sector policies must take into account the fact that traditional foreclosure avoidance strategies may not always work well in the current environment.

[W]e certainly cannot rule out the possibility of continued market difficulties. We cannot be sure how long it will take for financial intermediaries to complete the process of re-evaluating the risks in their portfolios and restructuring their balance sheets accordingly. Moreover, further mortgage defaults due to declines in house prices and the fact that many sub-prime adjustable rate mortgages will see their rates rise over the next few months could have negative feedbacks onto housing and financial markets. Furthermore, there remains a good deal of uncertainty about the creditworthiness of many key market participants.

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

 Indeed, even as house prices were rising, economists in the Fed and elsewhere were analyzing how a downturn in the housing sector might affect the economy and evaluating potential policy responses. At the time, however, it was simply not anticipated that house price declines would contribute to such burgeoning delinquencies and defaults among subprime borrowers, and that those problems would set off a chain of events that would rattle the financial system, resulting in the credit crunch that is now severely restraining economic activity and employment.

 In fact, the contraction in spending on housing construction subtracted a full percentage point from U.S. real GDP growth last year, and nearly as much the year before. It seems likely that this sector will be a major drag on the overall economy through the end of this year and into 2009.

Until recently, the deflating housing bubble had not spilled over to the rest of the economy. But now it has. It appears that growth in consumption and business investment spending has slowed markedly after years of robust performance, and, as a result, the economy has all but stalled and could even contract over the first half of the year.

The factors weighing down consumer spending go beyond the effects of the credit crunch and the falling house prices. Consumers also face constraints due to the declines in the stock market, which have diminished their wealth. Furthermore, energy, food, and other commodity prices have risen sharply in recent years, essentially “taxing” their incomes. Finally, and very importantly, labor markets have weakened.

 Current indicators suggest that, starting in the fourth quarter, the national economy, at best, slowed to a crawl. I anticipate little or no growth in the first half of this year. With stimulus from monetary and fiscal policy, economic performance should improve in the second half of this year. Nonetheless, these are particularly uncertain times. I see the risks to this outcome as skewed to the downside given the ongoing turmoil in financial markets, the continued contraction in housing, and the growing caution of households and businesses.

In the mortgage area, the PWG [President's Working Group] recommended action at both the federal and state levels, including, for example, stronger nationwide licensing standards for mortgage brokers and more consistent government oversight for all originators. In particular, the PWG recommended that the Federal Reserve use its authority to strengthen consumer protection rules and enhance required disclosures for mortgage originations.

I strongly support this recommendation, and its implementation is well under way.

To a great extent, the bubble in housing was a classic case of the bigger-fool theory and efficient-market theory run amok.