[W]ith the exception of housing, lending over the current downturn does not appear particularly weak or subdued relative to other downturns. Indeed, for all categories of lending other than home mortgage lending...there are at least two other downturns for which the paths of lending after the business cycle peak lie below that following 2007:Q4

(I)n principle, mortgage securitizations make good economic sense: By providing access to the broad capital market, securitization allows loan originators to access a wider source of funding than they can obtain directly. In addition, securitization can limit an originator's exposure to prepayment risks associated with interest rate movements, to geographic concentrations of loans, and to credit and funding risks associated with holding mortgages all the way to maturity. Effectively, securitization can significantly lower the cost of extending home loans, and some of those cost savings can be passed along to homeowners in the form of lower mortgage rates.

The paucity and inaccessibility of data about the underlying home loans was, in my opinion, one of the reasons that private-label MBS was able to expand so rapidly in 2005 and 2006 despite a deterioration in underwriting and prospective credit performance. That is not to say that better data would necessarily have led investors to completely sidestep the private-label MBS that have caused them so much difficulty. But I do think it was a significant hindrance that the information needed to infer, in real time, the extent to which subprime and alt-A mortgage underwriting was sliding simply did not exist in a form that allowed the widespread scrutiny or objective analyses needed to bring these risks more clearly into focus.

Thus, I believe that markets for private-label MBS are unlikely to recover unless comprehensive and standardized data for home mortgage pools are made widely available to market participants.

Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve's quiver--the provision of liquidity--remains effective. Indeed, there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions. First, the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand. Indeed, last week the Fed announced plans to purchase up to $100 billion in GSE debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. It is encouraging that the announcement of that action was met by a fall in mortgage interest rates.

Developing an effective securitization model is not easy--according to one economic historian, mortgage securitization schemes were tried and abandoned at least six times between 1870 and 1940.¹  Eventually, experience provided three principles for successful mortgage securitization.  First, for the ultimate investors to be willing to acquire and trade mortgage-backed securities, they must be persuaded that the credit quality of the underlying mortgages is high and that the origination-to-distribution process is managed so that originators, such as mortgage brokers and bankers, have an incentive to undertake careful underwriting.  Second, because the pools of assets underlying mortgage-backed securities have highly correlated risks, including interest rate, prepayment, and credit risks, the institutions and other investors that hold these securities must have the capacity to manage their risks carefully.  Finally, because mortgage-backed securities are complex amalgamations of underlying mortgages that may themselves be complex to price, transparency about both the underlying assets and the mortgage-backed security itself is essential.

The Boston Fed’s position has long been — despite some determined mischaracterizations — that some flexibility in underwriting criteria may be appropriate if the borrower’s willingness and ability to handle the debt can be affirmed, and such flexibility is considered in a consistent and fair manner across applicants.

We have not, and do not, advocate for irresponsible or poorly underwritten lending. That perspective, however, is not at odds with advocating that the various participants in housing markets continue to strive for fair access to credit, appropriately extended. Nor is it at odds with our belief that responsibly underwritten loans to borrowers in low- and moderate-income areas — including those whose credit situation is considered “subprime” but can document their ability to afford the loan — are welcome and indeed crucial.

I would note one -- two things. First, as a minor point, that one of the things that this program being discussed could do would be to purchase second liens, which have proved to be a very significant barrier to the resolution of -- of foreclosures.

...

Well, second liens are selling for a few cents on the dollar. I wouldn't expect them to be worth much more than that.  But I was only pointing out that -- I know this from Governor Duke, who's on the Hope for Homeowners board, that the problem with second liens is a big issue right now, because it prevents renegotiations of the first mortgage.  So I was just saying that a side effect, if we do buy them at market value, a few cents on the dollar, would be to help free up this -- this other issue.

From the Q&A session

We continue to encourage lenders and mortgage servicers to work constructively with borrowers at risk of default and to consider prudent workout arrangements to avoid unnecessary foreclosures. As you know, the Federal Reserve believes that prudent workout arrangements that are consistent with safe and sound lending practices are generally in the long-term best interest of both the financial institution and the borrower.

Furthermore, we are working to finalize the proposed amendments to the rules under the Home Ownership and Equity Protection Act that we proposed in December...Our proposal includes key protections for higher-priced mortgage loans secured by a consumer's principal dwelling and addresses concerns about a lender's assessment of a borrower's ability to make the scheduled payments, including verification of the consumer's income and assets. The proposal also addresses concerns about prepayment penalties and the adverse impact on consumers of lenders failing to escrow for taxes and insurance. Protecting consumers also has benefits for lenders because it should reduce delinquencies and defaults that can occur when consumers do not understand or cannot afford certain types of loans.

As market participants take steps to foster greater transparency and reduce the complexity of structured credit instruments, I believe that recovery and repair in the mortgage markets will take hold over time. Moreover, as financial institutions continue to attract capital and strengthen risk-management practices, and as supervisors ensure that banks take the necessary actions, institutions will become more resilient to shocks, and the overall financial system will be more robust as a result.    

What about today? Using the same rough method to approximate home equity for the same subset of homeowners, the data imply that about 10 percent of post-1987 purchasers were in a position of negative equity as of the fourth quarter of 2007. Assuming that the unemployment rate and benchmark interest rate (the 6-month London Interbank Offered Rate or LIBOR) stay at their fourth-quarter 2007 levels, the statistical default model of Gerardi, Shapiro and Willen predicts that less than 10 percent of these homeowners with negative equity will default.

Continued declines in house prices, higher unemployment, and possibly a greater willingness to default on home mortgages might raise this estimate of future defaults. Even so, many lenders will not be inclined to make concessions unless borrowers clearly lack the ability to pay.

Despite some promising proposals, these factors – the presence of piggyback loans, the desire of lenders to continue to get paid unless the borrower does not have the capacity to make payments, and the legal restrictions and tax-liability concerns surrounding securitization agreements – make any across-the-board modification of loan terms challenging. 

As long as loan modifications are taking place on a loan-by-loan basis (a time-consuming and labor-intensive process), to significantly increase the number of loan modifications and avoid significant numbers of foreclosures, many servicers will need to quickly expand the pool of staff capable of making these evaluations. 

To reiterate, falling housing prices continue to be a significant source of down-side risk to the economy.  Previous periods of real estate problems have taken significant time to be worked out, with foreclosures remaining elevated well after their peak.  The current foreclosure problem has been exacerbated by the difficulties related to many of the problem loans being held in securities.

As noted earlier, the rapid rise in delinquencies for home equity lines and junior liens held at banks is occurring despite an unemployment rate of about 5 percent – so, should the unemployment rate rise and housing prices continue to fall, financial stresses caused by the housing correction could well spread beyond the large banks involved in complex securitizations, and the smaller banks with sizeable portfolios of construction loans, to a larger set of financial institutions. 

Research suggests that it was not so much interest rate resets that triggered the rise in subprime problems, as many expected. Indeed, reductions in short-term interest rates since the onset of the crisis should diminish the danger of foreclosures from such resets going forward. Rather, the single most important determinant of the level and change in subprime delinquency rates has been the pace of house price changes.

We have taken some very strong steps to make sure that people have flexibilty thats necessary to deal with re-financing, to deal with the potential payment shock that can come from an interest rate reset.

From Q&A as reported by Market News International