Under the Home Ownership Equity Protection Act (HOEPA), the Board has the responsibility to prohibit mortgage lending practices that it finds to be unfair and deceptive.

In fulfilling its responsibility to protect consumers, the Federal Reserve will do all that it can to prevent fraudulent and abusive mortgage lending practices. Because information is critical to more competitive, and thus more efficient, markets, effective disclosure also has the capacity to weed out abuses. Consumers who do not have accurate information and an understanding of what that information means will have difficulty choosing among competing products and making decisions that are in their best interest. This is true in both credit card and mortgage markets.

The Federal Reserve is also authorized to write rules; notably, the Home Ownership Equity Protection Act (HOEPA) gives the Board the power to prohibit acts and practices in mortgage lending deemed "unfair" or "deceptive."

A straightforward means of anchoring the GSE portfolios to a clear public mission would be to require Fannie and Freddie to focus their portfolios almost exclusively on holdings of mortgages or mortgage-backed securities that support affordable housing.  The evolution of mortgage markets since the GSEs were created strongly suggests that a concentration on affordable-housing products would provide the greatest public benefit.  

Our assessment, though -- while this is a very important problem and an issue, obviously, for many people who are facing foreclosure, our assessment is that there's not much indication at this point that subprime mortgage issues have spread into the broader mortgage market, which still seems to be healthy and the lending side of that still seems to be healthy.

From the Q&A session

A forward-looking view of the credit risks associated with subprime mortgages can be obtained from a new financial instrument related to these mortgages. These instruments {CDS} suggest a big increase in the risk associated with loans made to the lowest-rated borrowers, but little change in risk for other higher-rated borrowers. Based on these results, it appears that investors in these instruments expect the losses to be fairly well contained. Of course, a shift in market sentiment about the risk of some of these securities is always possible. Such a shift would have ramifications for mortgage financing and housing, likely through tighter credit standards and higher mortgage rates for certain borrowers. In fact, we already have seen some tightening among commercial banks in recent months.

There has been a surge in delinquencies and foreclosures, particularly, as I mentioned in my testimony, in sub-prime lending with variable rates, rates that adjust with short-term interest rates.

 And that is a concern to us. We certainly have been following it carefully. It's obviously very bad for those who borrowed on those circumstances, and it's not good for the lenders either, who are taking losses. We have tried, together with the other banking agencies, to address some of these concerns. We recently issued a guidance on nontraditional mortgages, which had three major themes.

The first was that lenders should underwrite properly, that is they should make sure that borrowers had the financial capacity to pay even when rates go up, and not simply underwrite based on the initial rate - deal with the possible payment shock.

Secondly, that lenders should give a full disclosure and make sure that people understand the terms of the mortgages they're getting into. And I would add that the Federal Reserve provides a number of documents, booklets and descriptions that are required to be included along with mortgage applications for adjustable rate mortgages.

 And thirdly - and this is more on the issue of the lenders rather than the borrowers - that lenders should make sure that they appropriately risk manage these exotic mortgages, which we don't have much experience with and so some caution is needed, as we're now seeing, in managing them.

Supervisors have also observed that lenders are increasingly combining nontraditional mortgage loans with "risk layering" practices--such as by not evaluating the borrower's ability to meet increasing monthly payments when amortization begins or when interest rates on adjustable rate mortgages rise due to indexing or at the end of a "teaser" rate period.  We are also seeing more frequent use of limited or no documentation in evaluating an applicant's income and assets.  Although some lenders may have used elements of nontraditional mortgage products successfully in the past, the recent easing of traditional underwriting controls and the sale of some types of nontraditional products to subprime borrowers may generate losses on these products greater than has been observed in the past.

Subprime mortgages, interest-only loans, and hybrid ARMs have opened up financing to borrowers who previously could not obtain it at all or could not borrow as much as they would like. True, these instruments are riskier than traditional mortgages. Still, to the extent that both borrowers and lenders understand the risks involved and markets have priced this risk properly, these instruments represent a net gain to society. Here there is a role for public policy. On the part of the Fed, we are supervising lenders with regard to the disclosure of terms and costs to borrowers and with regard to the risks of carrying such nonstandard loans on their books. We are also promoting financial literacy efforts for borrowers.

[I]t is the abusive end of the spectrum that has drawn so much attention and generated the discussion about discrimination in pricing and terms.

Although the line between legitimate and predatory subprime loans is often fuzzy, it is clear that some lenders make subprime loans with the intent of separating borrowers from the equity in their homes. Borrowers with good credit ratings have a dizzying array of mortgage loan products to choose from. For those with poor credit ratings or those who may be unfamiliar with financial-service providers and products, the choices are even more baffling. And because of the many different ways in which lenders might disclose information about this array of products, even knowledgeable borrowers who are familiar with the process and who have shopped diligently may not feel certain that they have gotten the loan that is best for them.

The growth of subprime mortgage lending is one indication of the extent to which access to credit has increased for all households, including those with lower incomes...

Although the emergence of risk-based pricing has increased access to credit for all households, it has also raised some concerns and questions, which are magnified in the case of lower-income borrowers.

Finally, instruments such as sub-prime mortgages, interest-only loans, and hybrid ARMs have opened up financing to borrowers who previously could not obtain it at all or could not borrow as much as they would like. True, these instruments are riskier than traditional mortgages. Still, to the extent that both borrowers and lenders understand the risks involved and markets have priced this risk properly, they represent a net gain to society. Here, there is a role for public policy: On the part of the Fed, we are promoting financial literacy efforts for borrowers and supervising lenders with regard to both the disclosure of terms and costs to borrowers and to the risks of carrying such non-standard loans on their books.

My sense is that the underwriting and pricing of mortgages has on the whole been sound, despite some individual anecdotes that suggest otherwise. The broad range of households that have taken out nontraditional mortgages are going to find them advantageous, even if, as with many financial products, a small fraction end up regretting their choice after the fact. Moreover, the banking industry looks healthy right now, with strong profitability and high levels of capital. Loan delinquencies are quite low by historical standards, as are chargeoffs of real estate loans. So it looks to me as if the end of the housing boom is unlikely to have any broader spillovers as a result of financial repercussions.

I'd like to spend a few minutes discussing the outlook for both residential and commercial real estate in the context of the current regulatory focus on the banking industry's lending to these sectors of the economy.

In fact, the San Francisco Fed has a long-standing supervisory interest in real estate conditions. We helped shape the current draft interagency guidance on commercial real estate concentrations, and our institutional memory of the devastating California real estate downturn in the early 1990s remains vivid. Frankly, it would be hard to forget that period, when California had 49 commercial bank failures between 1991 and 1996, accounting for about 11 percent of the state's banks. The vast majority—as well as many banks that survived in troubled condition—had very high construction loan concentrations for either commercial or residential properties, or both.
Of course, circumstances have changed a lot since then. For example, there is now ready access to information on real estate market conditions and active secondary markets for real estate loans; and certainly, bank underwriting practices have improved significantly. While these changes have helped to mitigate risk, we can't afford to become complacent; as history has taught us, concentrations still can prove dangerous when market conditions turn.

As you know, the performance of commercial real estate and construction loans on banks' balance sheets has been excellent, largely because of low interest rates and substantial appreciation of property values. These conditions may have encouraged banks to focus new lending towards these sectors—especially construction and land development. Although California banks no longer lead the nation in construction loan concentrations—as they did in the previous real estate cycle—more than 40 percent of the state's banks exceed the benchmark ratio contained in the draft interagency guidance, which, as you know, is 100 percent of total capital.
Construction lending causes some concern at this point in the cycle because our examiners have found that much of the recent loan growth in community and regional banks is in the softening residential market. The riskiest loans are those for land acquisition and speculative development; historically, these are the first to register the effects of a slowdown in terms of weakening demand for new loans and declining quality of existing loans. If housing markets continue to slow, such banks should watch closely for signs of trouble, such as project delays, houses not selling, price discounts, condos converting to rentals, and increasing loan renewals, extensions, and refinancings. Any of these developments could have a significant impact on revenue and growth projections as well as loan losses at some banks.

As the draft interagency guidance states, we expect banks to actively manage risk concentrations in commercial real estate and construction lending. Tomorrow, Jose will discuss some of the ways that banks are enhancing their approach to credit risk concentration management. Based on what we've seen in recent examinations, I'm pleased to say that it appears that a number of banks have already implemented most of the risk management practices outlined in the proposed guidance.

The more widespread use of nontraditional loan products may present greater opportunity for fraud, as these products sometimes lack some of the quality checks typical of more-traditional mortgages.