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.

In our research, we looked at what happened to homeowners who used subprime loans to buy their homes and found that five years later, 90 percent were either still in their house or had profitably sold it.  While our research also shows that number will likely be lower for the most recent vintages, which already exhibit elevated defaults, most subprime buyers have a positive experience with homeownership. So, perhaps the most critical issue is that financing that supports responsible subprime lending continues, despite recent problems. Since the broker channel has been disrupted, as described earlier, I believe there is an opportunity for commercial and savings banks to help provide liquidity in this market. Most commercial and savings banks were not involved in originating subprime mortgages and are well capitalized, and may have profitable opportunities to explore in this market.

I am hopeful that financial institutions will play an important role in providing financing for many of the borrowers facing higher rates as their mortgages reset. In the past, rate-resets may not have been as problematic as they could be now, because borrowers had an easier time refinancing or selling. As we look at the situation now, we want to see borrowers continue to have the option to refinance, and want to see lenders continue lending so that resets do not become an increasing problem. As I said a moment ago, perhaps the most critical issue is that financing that supports responsible subprime lending continue.

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.

The financial market turmoil that began in August hit hard an already struggling housing market. Financial markets appear to be stabilizing, but they have not returned to normal and are still fragile. Most forecasters have reduced their expectations for GDP growth and believe that downside risks have risen. However, the employment report for September, the latest available at this time, does not suggest that the downside risk is occurring. As an aside, the substantial upward revisions to data released in the August report remind us that it is a mistake to place too much weight on any one report.

Although this episode of financial turmoil is still unfolding, my preliminary judgment is that there are no new lessons. Weak underwriting practices put far too many borrowers into unsuitable mortgages. As borrowers default, they suffer the consequences of foreclosure and loss of whatever equity they had in their homes. It is painful to have to move, especially under such forced circumstances. Investors are suffering heavy losses. There is no new lesson here: Sound mortgage underwriting should always be based on analysis of the borrower’s capacity to repay and not on the assumption that a bad loan can be recovered through foreclosure without loss because of rising property values.

The other aspect of the current financial turmoil that reaffirms an old lesson is that it is risky to finance long-term assets with short-term liabilities.

The Federal Reserve has neither the power nor the desire to bail out bad investments. We do have the responsibility to do what we can to maintain normal financial market processes. What that means, in my view, is that we want to see restoration of active trading in assets of all sorts and in all risk classes. It is for the market to judge whether securities backed by subprime mortgages are worth 20 cents on the dollar, or 50 cents, or 100 cents. Obviously, the market will judge different subprime assets differently, based on careful analysis of the underlying mortgages. That process will take time, as it is expensive to conduct the analysis that good mortgage underwriting would have conducted in the first place. Although there is a substantial distance to go, restoration of normal spreads and trading activity appears to be under way, and we can be confident that in time the market will straighten out the problems. We do not know, however, how much time will be required for us to be able to say that the current episode is over.

Econometric models can estimate approximate effects on the overall economy from changes in real estate activity. Still, economists know that our knowledge is incomplete. It is no secret that the downturn in residential real estate activity is more severe than most forecasters expected only a few months ago.

In addition, the sharp deceleration in home prices since 2005, including outright declines in some markets, left many of these more-recent borrowers with little or no home equity.  In this situation, some borrowers (particularly owner-investors) may have found that simply walking away from their properties was their best option.  Moreover, low home equity has made refinancing--the typical way for many subprime borrowers to avoid large scheduled interest rate resets--difficult or impossible for many.  Thus, with house prices still soft and many borrowers of recent-vintage subprime ARMs still facing their first interest rate resets, delinquencies and foreclosure initiations in this class of mortgages are likely to rise further. 

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 most plausible downside risk is that financial market developments will lead to higher mortgage rate spreads and will further depress housing activity.

In the U.S., the recent reversal of the boom in housing activity and house prices has contributed to a slowdown in economic growth. But the consequences of the declines in housing activity and house prices, in my view, have so far not derailed the prospect that economic growth will return toward trend at the end of 2007 and in 2008.

Except the housing sector, I would expect economic growth to pick up.  We are a powerful economic machine.  We continue to grow.

As reported by Bloomberg News