In contrast to corporate securities, corroborating information on mortgage securities is not as readily available. There is no equivalent to equity analysts and equity prices to give investors updated market information. The information needed to analyze the individual mortgages in the pool can be expensive to obtain. So investors are more reliant on rating agencies than they are with corporate securities.

The problems in the mortgage market highlight the need for caution where there has been limited ratings history, where the underlying characteristics that drive the asset’s price may not be fully understood or anticipated, and where evaluations cannot be easily corroborated by others such as equity analysts.9 Certainly one way to highlight these differences is to differentiate ratings on corporate securities from ratings on assets like mortgage-backed securities.

Mortgage delinquencies began to rise in mid-2005 after several years at remarkably low levels.  The worst payment problems have been among subprime adjustable-rate mortgages (subprime ARMs); more than one-fifth of the 3.6 million loans outstanding were seriously delinquent at the end of 2007.¹  Delinquency rates have also risen for other types of mortgages, reaching 8 percent for subprime fixed-rate loans and 6 percent on adjustable-rate loans securitized in alt-A pools.  Lenders were on pace to have initiated roughly 1-1/2 million foreclosure proceedings last year, up from an average of fewer than 1 million foreclosure starts in the preceding two years.  More than one-half of the foreclosure starts in 2007 were on subprime mortgages.

The government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, likewise could do a great deal to address the current problems in housing and the mortgage market. New capital-raising by the GSEs, together with congressional action to strengthen the supervision of these companies, would allow Fannie and Freddie to expand significantly the number of new mortgages that they securitize. With few alternative mortgage channels available today, such action would be highly beneficial to the economy. I urge the Congress and the GSEs to take the steps necessary to allow more potential homebuyers access to mortgage credit at reasonable terms.

Given falling housing prices, many financial institutions are likely less willing to be exposed to the mortgage market. One aspect of the current situation is the high LTV ratios facing many borrowers, as low down-payments and falling housing prices have made refinancing homes difficult. A possible solution would be shared appreciation loans with FHA guarantees. This approach, variants of which are currently being discussed, would provide the FHA and the lending institution with a portion of future appreciation in return for providing the FHA insurance on high LTV loans.

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.  

I think the originate-distribute model and the securitization has a lot of value. It allows borrowers to have, essentially, direct access to capital markets.  But the recent experience shows we need to do some work on it, both the private sector and in collaboration with supervisors and regulators. We need to have more responsibility and accountability at the point of origination. We need to have better information and clarity about what securitized products contain.

If we do those things, I think we can restore this market. But at the moment, as you know, it's very dysfunctional.

From the Q&A session

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 

There will come a time when we will turn the corner on this difficult period. As long as we regulate wisely and do not suffocate our credit markets, the very real hardships of adjustment will fade, and we will all benefit from the new practices that emerge.    

...[E]ffective consumer protection can reduce uncertainty about the underwriting standards of, and hence, the value of, loans in mortgage-backed securities, thereby helping to revive and strengthen mortgage securities markets. 

Because systematic approaches to dealing with troubled loans are often likely to lead to better aggregate investor returns than foreclosures, we are encouraged by industry efforts to pursue these approaches. When servicers modify loans, however, they may face potential litigation risk from investors because of their contractual obligations under the servicing agreements. One particular source of litigation risk, we understand, may be that different asset classes have conflicting interests. Therefore, we encourage ongoing industry efforts to agree to standards for addressing these issues. We are hopeful that the industry can resolve these conflicts on a consensual basis so that they do not preclude servicers from taking actions that are in the overall best interests of consumers and the industry.

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.

As I mentioned, delinquencies will probably rise further for borrowers who have a subprime mortgage with an adjustable interest rate, as many of these mortgages will soon see their rates reset at significantly higher levels.  Indeed, on average from now until the end of next year, nearly 450,000 subprime mortgages per quarter are scheduled to undergo their first interest rate reset.  Relative to past years, avoiding the payment shock of an interest rate reset by refinancing the mortgage will be much more difficult, as home prices have flattened out or declined, thereby reducing homeowners' equity, and lending terms have tightened.  Should the rate of foreclosure rise proportionately, communities as well as individual borrowers would be hurt because concentrations of foreclosures tend to reduce property values in surrounding areas. 

So, one possibility would be, if the federal government were willing to act as guarantor. For example, suppose that the GSEs were to pay their usual mortgage insurance credit fee to the federal government, which enacted is guarantor -- so, to take away the credit risk from the GSEs, then they could process these jumbo loans and sell them into the secondary market and that would be, I think, of some assistance to the mortgage market.

From the federal government's point of view, they would be taking on some credit risk, which you may or may not be willing to do. I think that if you did that, it would be a good idea to make the GSEs ultimately responsible for some -- any excess losses or some part of excess losses, relative to the premiums that are paid, and leave it to the regulator to determine when the safety and soundness was adequate that the GSEs could make that repayment.

So, I think there might be some mechanisms that would involve federal interaction. But I think it's extremely important, as we look at these options, that we don't take actions that will endanger the safety and soundness of the underlying institutions.

From the Q&A session

Looking ahead, two considerations suggest that conditions for subprime borrowers have the potential to get worse before they get better. First, all indications are that housing activity is continuing to weaken. Incoming data in recent weeks show that sales and new residential construction have declined further. In such an environment, house prices in the aggregate are likely to remain sluggish for some time. Second, the bulk of resets is yet to come: On average, in each quarter from now until the end of next year, monthly payments for more than 400,000 subprime mortgages are scheduled to undergo their first interest rate reset. That number is up from roughly 200,000 per quarter during the first half of 2007. Delinquencies and foreclosures are therefore likely to continue to rise for a number of quarters.

The supply of funds for subprime loans is likely to remain low for some time as investors gather information and reevaluate the risks.