The housing crisis may not yet have run its course, and further danger could lie ahead both for the nation and also for Texas. We may seem isolated from the rest of the nation’s woes, but we are not immune from the dangers they pose. Still, as I survey the Texan economic landscape, I sense we have an opportunity here. Our economy is growing. We’re an affordable and wonderful place to live. And we hunger for workers—as recently as this morning I heard anecdotal reports of labor shortages in parts of Texas.

To date, permanent modifications in this credit cycle episode, as in the past, have typically involved a reduction in the interest rate or an extension of the loan terms, while reductions of principal balance have been quite rare. But the current housing difficulties differ from those in the past, largely because of the pervasiveness of situations known as negative equity positions in which the amount owed on the mortgage exceeds the current market value of the property. A distressed borrower with a negative equity position may have neither the means nor the incentive to remain in the home. In this environment, servicers and investors may well find principal reductions that restore some equity for at-risk homeowners to be an effective means of avoiding delinquency and foreclosure.

Although principal write-downs may be especially germane today given the prevalence of negative equity positions, they are not necessary or appropriate for all borrowers who have negative home equity or who become delinquent on their mortgage. On the contrary, a strategy of targeting write-downs to certain groups of borrowers may provide the best path forward. For example, one possibility would be to limit the availability of write-downs to those borrowers with high debt payment-to-income ratios and loan-to-value ratios significantly in excess of 100 percent before loan modification, but with the capacity to carry a written-down mortgage. In any event, it seems clear that principal reductions should be part of the tool kit that servicers and investors bring to bear as they deal with delinquent loans.

Separately, the GSEs--Fannie Mae and Freddie Mac--could be asked to do more. Recently, the Congress has greatly expanded Fannie Mae's and Freddie Mac's role in the mortgage market by temporarily increasing the conforming loan limits for these GSEs. In addition, their federal regulator, the Office of Federal Housing Enterprise Oversight, has lifted some of the constraints that were imposed on these entities because they have resolved some of their recent accounting and operational problems. Thus, now is an especially appropriate time to ask the GSEs to move quickly to raise more capital, which they will need to take advantage of these new securitization and investment opportunities, to provide assistance to the housing markets in times of stress, and to do so in a safe and sound manner. As the GSEs expand their roles in our mortgage market, there is a strong need for the Congress to move forward on GSE reform legislation, including the creation of a world-class GSE regulator.

With modernization and expansion, the FHA could play an important role in relieving stress in the mortgage and housing markets as well as in restarting securitization markets. Securitization markets are needed to help relieve capital stresses on banks and to provide more affordable mortgages to borrowers. To this end, more consideration needs to be given to how the FHA can scale up quickly and improve its processes and underwriting systems so that they are comparable in quality with those currently being used by Fannie Mae and Freddie Mac. In addition, providing the FHA with broad authority to offer innovative products that meet market needs and to outsource loan underwriting and other program elements to private-sector providers could allow the FHA to insure more mortgage borrowers and to do so more quickly. The FHA needs to be better able to compete in today's marketplace and it needs access to the best risk-management tools available when managing the risks to the government.

Until recently, the deflating housing bubble had not spilled over to the rest of the economy. But now it has. Based on monthly data that cover most of the first quarter, 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 contract over the first half of the year.

Looking ahead, it seems likely that the period of house price declines will not be over very soon, since some models of the fundamental value of houses suggest that prices are still too high, and futures markets for house prices indicate further declines this year.

My colleagues and I have been deeply involved in assessing the impact of rising foreclosures on the financial markets and the U.S. economy, and in developing the Fed’s policy response. On the monetary policy front, we have undertaken several actions designed to stimulate demand in the face of contractions in the housing market and the tightening of credit. We have also sought to bolster market liquidity and promote orderly market functioning through several new lending facilities. We continue to carefully monitor trends in the financial markets and the economy, and we are committed to acting in a timely manner to address new developments.

While much attention has focused on interest rate resets as a trigger for delinquencies and defaults—particularly on loans with artificially low introductory rates—so far they have not played a significant role. This is not to say, however, that resets won’t matter. In 2008, about 1.5 million loans are scheduled to reset.

It's possible—given certain strengths such as strong business balance sheets and export growth—that the economy will not pass the threshold into a technical recession. In considering the current economic situation, I believe that an important policy objective at this juncture is to ensure that this slowdown is short and shallow.

A critical factor—possibly the critical factor—in the determination of the length and depth of the current slowdown is the performance of the housing sector.

Looking ahead, my forecast has been affected both by an economic slowdown that has been sharper than I had expected and the recurring spells of financial market turmoil. A few months ago our forecast at the Atlanta Fed saw growth slow in the first half of 2008, then pick up in the second half of the year. But it now appears to me that the contraction in housing and the dampening effects of financial turmoil on household and business spending could persist through the remainder of this year. The recovery in growth I had expected in the second half of this year may be delayed.

The tax rebates should provide some stimulus in the second and early third quarters of this year. But given the uncertain atmosphere I expect will continue to prevail in May and June, I do not expect full flow through of the rebates into personal consumption expenditures.

I expect it will take much of the rest of the year for house prices to bottom out and financial markets to restore the necessary preconditions of stability—that is, confidence in asset values and confidence in transaction counterparties.

Looking ahead further to 2009, my outlook becomes more optimistic. It will take longer than I earlier expected to return to solid growth, but by the fourth quarter of 2008 the conditions should be in place to support a return to healthy growth next year.

These are challenging times for our economy and financial markets. We know from studying economic history that booms are often followed by busts, and this pattern has repeated itself in our housing markets lately. However, we also know that these stressful periods will abate and that our economy will improve over time.

Taking all of this into consideration, our outlook at the Chicago Fed is for weakness in real GDP this year, particularly in the first half of the year. However, we think conditions will improve in the second half of the year.

A number of factors will likely hold back activity for some time. The strains on credit intermediation and financial balance sheets mean that credit conditions will likely restrict spending. The large overhang of unsold homes will continue to restrain residential investment. Greater caution on the part of businesses and consumers will likely limit increases in their discretionary expenditures as well. Because financial issues are being worked out against the backdrop of a soft economy, we also have to recognize the risk that interactions between the two might reinforce the weakness in the economy.

Nonetheless, other factors point to improvement later in the year. We have lowered the federal funds rate by 300 basis points since September. At 2.25 percent, the current federal funds rate is accommodative and should support stronger growth. Indeed, because monetary policy works with a lag, the effects of last fall's rate cuts are probably just beginning to be felt, and the cumulative declines should do more to promote growth going forward.

The effects of the fiscal stimulus bill also are likely to boost spending in the second and third quarters of 2008.

I was convinced at the time and am convinced now that the level of adjustable-rate mortgages . . . wasn't a serious problem for attracting people into the market who then got caught [by higher rates]. People who had taken out loans in June 2003 at adjustable rates could have converted those to long-term fixed-rate mortgages at a profit over the next 18 months. And people didn't. And the reason they didn't. . . . Put it this way: They should have. I don't know frankly why they didn't. Long-term rates were low. Refinancing would have been a good decision.

If I am guilty of encouraging people to take out adjustable-rate mortgages, I am guilty for 30 days.

On his speech of Feb. 23, 2004, in which he encouraged homeowners to take out adjustable-rate mortgages, or ARMs, saying he tried to correct those comments on March 2, 2004,

Regarding the mounting levels of debt, encouraged in part by the low cost of borrowing, Greenspan said that he was "reluctant to underestimate the ability of most households and companies to manage their financial affairs."