The proposed requirement to assess repayment ability is intended to protect consumers from abusive practices while maintaining their access to responsible credit. We recognize that satisfying both objectives at the same time is a challenge. The proposed rule's potential for consumer actions, coupled with its careful avoidance of prescribing quantitative underwriting thresholds, could raise compliance and litigation risk. In turn, this could raise the cost of credit for higher-risk borrowers or limit the availability of responsible credit. That is why we have proposed prohibiting a "pattern or practice" of disregarding repayment ability rather than attaching a risk of legal liability to every individual loan that does not perform. Some commentators have argued that the pattern or practice requirement creates a higher standard of proof that can make it more difficult and costly for consumers to pursue litigation. We have specifically sought comment on this provision and look forward to perspectives offered by the industry and consumer groups.

The very sophisticated financial community basically decided that this was a steal. They put very significant pressure on the securitizers to produce more paper. I was aware of it at the time. Then the securitizers began to pressure the lenders and underwriting standards became egregious. It wasn't that the Federal Reserve wasn't aware of the problem. What we didn't realize was the order of magnitude of the subprime lending, which started as a niche with no macroeconomic implications to something that became excessive, a huge part of the market that . . . was sold around the world.

Among the practices addressed by our proposal is the use of yield spread premiums (YSPs).⁶ Many consumers use mortgage brokers to guide them through a complex process and shop for the best deal. Unfortunately, consumers may believe that the broker has a responsibility to get them that best deal, which is not necessarily the case. In fact, the design of YSPs may provide the broker a financial incentive to offer a loan with a higher rate. Consumers who do not understand this point may not shop to their best advantage. Therefore, we would prohibit a lender, for both prime and subprime loans, from paying a broker an amount greater than the consumer agrees to in advance. Brokers would also have to disclose their potential conflict of interest. The combination of stricter regulation and better disclosure will not solve all the problems. We do believe, however, that this proposal will give consumers much better information and raise their awareness of brokers' potential conflict of interest while reducing a broker's incentive to steer a consumer to a higher rate.

6.  A YSP is the present dollar value of the difference between the lowest interest rate the wholesale lenders would have accepted on a particular transaction and the interest rate the broker actually obtained for the lender.  This dollar amount is usually paid to the mortgage broker.  It may also be applied to other loan-related costs, but the Board's proposal concerns only the amount paid to the broker. 

I would argue that root causes of problems in the subprime market brought into question some fundamental practices, incentives, and even institutions of other markets. By fundamentals, I mean the integrity of origination (that is, the quality of assets that went into securitization pools), the structure of the securities into which loans and individual securities were packaged, and the value of these securities as collateral for margin financing.

Also, rating agencies had greatly underestimated the risk of many mortgage-backed securities. This led to a loss in confidence in the ratings assigned to other complex financing structures with further reductions in liquidity and increases in the volatility of prices across a variety of debt markets.

Through this spread of suspicion, subprime losses exposed related problems elsewhere, such as the syndication market for leveraged loans. Some leveraged lending underwriting was in its own way very aggressive in the period before the markets turned rocky starting last summer.

Finally, the subprime crisis generated a thicket of doubts concerning counterparties. Uncertainty about valuations of securitized debt fed uncertainty regarding the exposure of large banks and other market participants, which led to concerns about executing trades with these counterparties.

As has been true of many financial innovations in the past, the benefits of this disaggregated originate-to-distribute model may have been obvious, but the problems less so.  ... Originators had every incentive to maintain origination volume, because that would allow them to earn substantial fees, but they had weak incentives to maintain loan quality.  When loans went bad, originators lost money, mainly because of the warranties they provided on loans; however, those warranties often expired as quickly as ninety days after origination.  Furthermore, unlike traditional players in mortgage markets, originators often saw little value in their charters, because they often had little capital tied up in their firm.  When hit with a wave of early payment defaults and the associated warranty claims, they simply went out of business.  While the lending boom lasted, however, originators earned large profits.  

The originate-to-distribute model for loans has been a successful model for some time; I think that's a very successful thing; it's worked very well in a number of areas -- consumer loans, auto loans, all kinds of things for a long time. In the case of mortgages, it just got too complicated. People made wrong assumptions. I think these instruments need to be simpler, more transparent. People need to be able to look through and make a judgment about whether the credit rating agency has done the right job or not.

From audience Q&A as reported by Market News International 

So, as we move out of the current turmoil, I see the U.S. markets headed toward a "new normal," not a return to normal. The recent turmoil has discredited the more dubious innovations of the past few years. But the foundation of earlier innovations over the past three decades delivered too much value for us to return to the "old-old" ways of finance.

I believe the contours of the new normal will be:

• a reformed, market-based system with a strong role for banks;
• the continuation of securitization more narrowly applied and with strengthened origination, structuring, and risk evaluation practices;
• better investor practices with more self-reliance, along with a substantially reformed rating agency industry;
• simplified and standardized instruments; and
• much refined risk management practices on the part of all market participants.

As I hope you detect, I am optimistic that the trauma of recent months will pass and our credit capital markets will be better for the lessons learned.

I think the recent turmoil has shown that, in fact, banks retained a central role in the originate-to-distribute credit intermediation model. ... While banks have taken hits in the recent turmoil, their central role has been reconfirmed and their inherent strengths accentuated. The scale and scope of our larger banks and their broad earnings power have cushioned the losses. And their franchise strength has aided recapitalization.

While I see banks recovering, I see little chance that we will revert to the old approach of originate-to-hold-in-portfolio model. Market-based credit intermediation provides substantial gains from diversification and transparency that are not available in the old model. And I see little chance banks in their various forms won't remain the cornerstone institutions of our financial system.

The housing sector has been and will continue to be affected by the tightening we've seen in lending standards. New home sales have fallen 64 percent from their peak in October, 2005. Home construction is unlikely to bottom out this year, and I expect housing investment to continue to be a drag on growth through at least year-end.

A second issue is the possible imposition of civil money penalties when the enforcement agencies find that there is a pattern or practice of violations. ... We would recommend that the amount of such civil money penalties, if imposed, be given a ceiling as well as a floor because of the market uncertainty that can be introduced by open-ended liability. We would also suggest that some discretion in the actual amount of the penalty, within such a range, be given to the enforcing agencies. This sort of flexibility in enforcement would help the agencies adjust the punishment to fit the infraction.

Fundamentally, we want to encourage refinancing before a problematic reset. Banks may not have viewed this market as an engaging opportunity when mortgage brokers were going aggressively after the business, but banks may now find profitable lending opportunities in the current environment perhaps, in some cases, with guarantees provided by Federal Housing Administration (FHA) loan guarantees, or state programs.

The question is, should lenders be required to offer fixed rate loans, with the borrowers needing to actively opt out of the fixed rate loan in order to be offered an adjustable rate loan (or, should borrowers always be given, and have to make, a choice). Such proposals are beginning to surface in states (such as Massachusetts) and may be an experiment worth exploring.

Over the last several decades we've seen an evolution from a bank-centered financial intermediation system to a market-centered system. As a result, lenders have become investors, loan spreads have become investment yields, and individual loans have become the feedstock of pools of like assets brought together through a process known as securitization. These changes have had significant implications both for loan underwriting and where in the system loans are ultimately held. In terms of underwriting, the old "banker-looking-borrower-in-the-eye" business model has been largely replaced by an "originate and distribute" business model.

On the lender side, the originate-to-distribute model can leave lenders with weaker incentives to maintain strong underwriting standards. In particular, originators who securitize may inadequately screen potential borrowers unless investors provide oversight and insist on practices that align originator incentives with the underlying risk. The originate-to-distribute system is thus not only a potential source of risk to the financial system but also raises concerns regarding consumer protection.