[I]t is important that new laws carefully target lending abuses without unduly restraining responsible lending.  Getting this balance right is particularly critical now, as many borrowers facing rate adjustments may need to refinance into more affordable loans.  

To the extent possible, efforts should be made to avoid foreclosure. We encourage servicers to reach out to financially stressed homeowners, to make every effort to keep them in their homes. Lenders and servicers, for example, may be able to assist troubled borrowers by modifying the loan, deferring payments, extending the loan maturities, converting an adjustable-rate mortgage to a fixed-rate or fully-indexed loan, or capitalizing delinquent amounts. The best outcome is a loss mitigation strategy that results in a mortgage obligation that the borrower can meet in a sustained manner.

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.

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.

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.

[R]egulatory changes and the ongoing growth of the secondary mortgage market increased the ability of lenders, who once typically held mortgages on their books until the loans were repaid, to sell many mortgages to various intermediaries, or "securitizers."  The securitizers in turn pooled large numbers of mortgages and sold the rights to the resulting cash flows to investors, often as components of structured securities.  This "originate-to-distribute" model gave lenders (and, thus, mortgage borrowers) greater access to capital markets, lowered transaction costs, and allowed risk to be shared more widely.  The resulting increase in the supply of mortgage credit likely contributed to the rise in the homeownership rate from 64 percent in 1994 to about 68 percent now--with minority households and households from lower-income census tracts recording some of the largest gains in percentage terms.

Markets do tend to self-correct.  In response to the serious financial losses incurred by investors, the market for subprime mortgages has adjusted sharply.  Investors are demanding that originators employ tighter underwriting standards, and some large lenders are pulling back from the use of brokers.  The reassessment and resulting increase in the attention to loan quality should help prevent a recurrence of the recent subprime problems. 

Second, in my view, we're witnessing more than just a repricing of risk. The credit markets of recent years feasted on a low cost of capital through leveraged investing and aggressive financing structures at both the retail and wholesale levels. I believe we're also seeing a broad retreat from higher-risk practices, such as

• no document/no equity mortgages,
• covenant-light leveraged buyouts, and
• the carry trade—in other words, borrowing in one currency to invest unhedged in debt instruments in another.

I believe we've been experiencing the unpleasant process of the financial world changing its ways after a prolonged period of relatively cheap credit, and in consequence, high leverage. What we've been going through is an intense adjustment in both price and practice, and this process may be continuing. 

We will not return to the days in which all mortgage lending was portfolio lending, but clearly the originate-to-distribute model will be modified--is already being modified--to provide stronger protection for investors and better incentives for originators to underwrite prudently.

Most recently, supervisory guidance has emphasized the added dimension of risk when higher-risk loans are combined with other features--such as the use of simultaneous second lien loans in lieu of a down payment or the use of underwriting that involves little or no documentation of income or assets. Guidance has also underscored the safety and soundness and consumer protection concerns prompted by other underwriting practices often seen in subprime and nontraditional mortgage lending, such as excluding taxes and insurance in the underwriting process and allowing deferred repayment of principal by offering interest-only loans. Finally, this supervisory tool has been used to urge creditors to work with homeowners who are unable to make mortgage payments.

I want to say that I think there have been some partially inaccurate stories in the press imputing to me and some others some unhappiness with the chairman over consumer inactivity. 

In fact, I have historically been concerned about the Fed's failure to do that, and particularly their failure to use the authority they've had under the Federal Trade Act to spell out unfair, deceptive practices.

But this is something that long predated the chairman and that he is in fact addressing. So I do not think it is appropriate for people to impute this unhappiness to him.

And as I read the report and saw the last -- what? -- three or four pages of the report were about this consumer issue, it just became very clear to me this is not Uncle Alan's semi-annual report. And we think we are moving forward

At the Federal Reserve, the Board of Governors is carefully considering how it might further use its rulemaking authority under the Home Ownership Equity Protection Act to curb abusive lending practices without discouraging responsible subprime lending.

We must be careful, however, not to curtail responsible subprime lending or beneficial financing options for consumers. A robust and responsible subprime mortgage market benefits consumers by allowing borrowers with non-prime or limited credit histories to become homeowners, access the equity in their homes, or have the flexibility to refinance their loans as needed.

We seek to promote the availability of consumer credit while ensuring that consumers receive the information they need to understand their options. Consumers who do not have accurate information and an understanding of what that information means will have difficulty choosing among competing products. Because information is critical to more competitive, and thus more efficient markets, more effective disclosure also has the capacity to weed out some abuses.