[The mortgage crisis] is bad and it's getting worse.

As reported by Bloomberg News

We have been pushing [mortgage servicers] to help more struggling homeowners avert foreclosure. It is our feeling, I will state very bluntly, that not enough is being done.

[The Fed is] pushing the industry to consider principal writedowns on these loans, and we have met with a lot of resistance.

As reported by Bloomberg News

In retrospect, the breakdown in underwriting can be linked to the incentives that the originate-to-distribute model, as implemented in this case, created for the originators. Notably, the incentive structures often tied originator revenue to loan volume rather than to the quality of the loans being passed up the chain. This problem was exacerbated by the bubble in house prices: Lenders began to ease standards as further appreciation in house prices was expected to ensure that risk was low, and investors failed to perform the research necessary to fully appreciate the risks in their investments, instead relying on further house price appreciation to prevent losses. The interaction between lenders' and investors' views and house prices illustrates the pernicious feedback loop I highlighted earlier.

As the Federal Reserve builds on  its consumer protection efforts in order to mitigate foreclosures for current homeowners, we are also concerned about the impact current mortgage market problems are having on individual communities.  The challenges of rising foreclosures are significant at the state and local level and the nature of the problem varies by location.  Through its structure, the Federal Reserve System is attuned to local issues, which both informs its national policymaking and allows for responses tailored to local conditions. 

Because many of our current financial problems can be tied to asset-backed securities, beginning with the subprime market, we should ask ourselves what can be done to strengthen the regulatory framework surrounding securitization and to address the asymmetric information problems in this market. This is a particularly important question given the benefits that securitization can bring to our credit markets in terms of attracting new funding sources and distributing risk across a broader marketplace.

Among the ideas now being suggested are: (1) tighter registration requirements for loan originators; (2) improved disclosures by originators and securitizers on the underlying loans; (3) new limits on the types of asset-backed securities regulated institutions can hold; (4) greater liability, risk exposure or equity positions for originators and securitizers; and (5) new regulations for the agencies rating these securities.

Other regulatory steps may be necessary.

Most Americans are paying their mortgages on time and are not at risk of foreclosure.  But high rates of delinquency and foreclosure can have substantial spillover effects on the housing market, the financial markets, and the broader economy.  Therefore, doing what we can to avoid preventable foreclosures is not just in the interest of lenders and borrowers.

As my listeners know, conditions in mortgage markets remain quite difficult, and mortgage delinquencies have climbed steeply.  The sharpest increases have been among subprime mortgages, particularly those with adjustable interest rates:  About one quarter of subprime adjustable-rate mortgages are currently 90 days or more delinquent or in foreclosure.¹  Delinquency rates also have increased in the prime and near-prime segments of the mortgage market, although not nearly so much as in the subprime sector. 

Many foreclosures are not preventable.  Investors, for example, are unlikely to want to hold onto a property whose value has depreciated significantly, and some borrowers--perhaps because they were put into an inappropriate loan or because personal circumstances have changed--cannot realistically sustain homeownership.  However, if a foreclosure is preventable, and the borrower wants to stay in the home, the economic case for trying to avoid foreclosure is strong. 

Nationally, as of the fourth quarter of 2007, the rate of serious delinquency, as measured by credit records, stood at 2 percent of all mortgage borrowers, up nearly 50 percent from the end of 2004.²  The fourth quarter of 2004 is a useful benchmark, because general economic conditions were fairly normal and the lax underwriting that emerged later was not yet evident.

 To be effective, such programs must be tightly targeted to borrowers at the highest risk of foreclosure, as measured, for example, by debt-to-income ratio or by the extent to which the mortgage is "underwater."  Finding the right balance--particularly the need to avoid programs that give borrowers who can make their payments an incentive to default--is difficult.  But realistic public- and private-sector policies must take into account the fact that traditional foreclosure avoidance strategies may not always work well in the current environment.

Clear disclosures of loan modifications will not only make it easier for regulators, the mortgage industry, and homeowners to assess the effectiveness of foreclosure-prevention efforts, but they will also foster greater transparency, and hence greater confidence, in the securitization market.

[W]e certainly cannot rule out the possibility of continued market difficulties. We cannot be sure how long it will take for financial intermediaries to complete the process of re-evaluating the risks in their portfolios and restructuring their balance sheets accordingly. Moreover, further mortgage defaults due to declines in house prices and the fact that many sub-prime adjustable rate mortgages will see their rates rise over the next few months could have negative feedbacks onto housing and financial markets. Furthermore, there remains a good deal of uncertainty about the creditworthiness of many key market participants.

There is a striking parallel with the challenges for the re-emergence of the subprime mortgage market and the adoption of innovations in the community development investments market. To overcome the unease of the current financial markets and attract a new source of capital, new market entrants must make particular efforts to reduce the uncertainty associated with their investment opportunities. For the CDFI industry, the challenges that need to be addressed are improving information about these products, developing models of risk and pricing, and standardizing these contracts. Addressing these issues will be critical to jump-start sustainable private CDFI investments as well as to revive the subprime mortgage market.

Liquidity risk is a familiar risk to banks, but it has appeared in somewhat new forms recently. While the originate-to-distribute model aims to move exposures off of banks' balance sheets, the risk remains that a sudden closing of securitization markets can force a bank to hold and fund exposures that it had originated with the intent to distribute. ...

Concentration risk is another familiar risk that is appearing in a new form. Banks have always had to worry about lending too much to one borrower, one industry, or one geographic region. But as smaller banks hold more of their balance sheet in types of loans that are difficult to securitize, concentration risks can develop. Concentrations of commercial real estate exposures are currently quite high at some smaller banks. This has the potential to make the banking sector much more sensitive to a downturn in the commercial real estate market.

In the mortgage area, the PWG [President's Working Group] recommended action at both the federal and state levels, including, for example, stronger nationwide licensing standards for mortgage brokers and more consistent government oversight for all originators. In particular, the PWG recommended that the Federal Reserve use its authority to strengthen consumer protection rules and enhance required disclosures for mortgage originations.

I strongly support this recommendation, and its implementation is well under way.