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.

The most plausible downside risk is that financial market developments will lead to higher mortgage rate spreads and will further depress housing activity.

"If I started to see some of the spillovers occur in some of the prime mortgages, I’d get more nervous...You’d start to look for higher delinquency rates on auto loans and credit card loans and they haven’t materialized yet."

"From the Fed’s point of view, the real issue is not to stop or contain adjustments in markets, our prime concern needs to be whether there are systemic effects of what’s going on… that create more aggregate type of effects."

He said in the past, slumping housing markets had broader consequences because they led to impaired loans at banks, which then reined in lending, creating a "credit crunch." But in the last 10 to 20 years, financial innovation has enabled banks to distribute much of that risk through the financial system, he said.

"Does that say nothing bad can happen? Of course not. But it means I’m a little more sanguine that that whole view of a credit crunch is probably not as applicable now as it might have been 10 or 20 years ago…. Banks in this district are pretty healthy…Their biggest complaint is not housing mortgage defaults and credit crunch, it’s the yield curve. They’ve got money to lend."

As reported by the Wall Street Journal

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.  

Currently, however, concern is growing over the increase in foreclosures.   ... [But] nontraditional mortgages have resulted in increased delinquencies because they have been used by consumers with higher risk profiles who may not fully recognize the risks inherent in these mortgages.  Some of the more exotic mortgages, which have payments that start low but can increase sharply in certain situations, may not be suitable for the average borrower.  

I think the ideal situation would be one in which the portfolios did exactly what you said, they were to be the way station for securitized mortgages and they would contain mostly liquid assets for the purpose of purchasing mortgages and then selling them back to the market. I would like to see a bill. I think we need to have a strong regulator in this arena. And we need to find some way that we can limit the growth of the portfolios.

As a practical matter, I think that restricting portfolios to mortgages related to affordable housing might be an appropriate compromise, appropriate approach that would provide some limitation.

But the Federal Reserve has always been concerned about the size of the portfolios. It never has found a substantial benefit to homeowners from large portfolios.

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.

Also, as to the extent that bank borrowing and funds provision are forecast to drop, the bankers I talked with said that they aren’t going to let the amount of loans that they extend drop as much as I think is in that forecast. So I really believe that the drop in housing is actually on net going to make liquidity available for other sectors rather than being a drain going forward and that will also get the growth rate more positive than the current Greenbook forecasts.

Homeowners appear to be able to manage these higher [mortgage] payments: we have seen only a little deterioration in mortgage credit quality as yet, and overall delinquency rates remain low. Going forward, I expect aggregate homeowner mortgage payments to continue to rise, especially as adjustable-rate mortgages reach their initial reset dates.

Historically, only around 5 percent of U.S. homes were purchased each year by investors; in 2005, it appears that figure was considerably higher. In many cases, investors purchased homes because they believed prices were going to rise further, not necessarily because they wanted to retain the property over time for rental income. As prices level off or even decline, it will be important to see whether this investor activity subsides significantly, and if so, the impact on mortgage markets more broadly.

Leading indicators of commercial construction spending, such as billings by architectural firms for design work, point to further increases in activity in coming months. An upturn in commercial construction could offset part of what is anticipated to be a waning contribution to GDP growth from the housing sector.

On a macro level I believe the housing adjustment most likely will be orderly and with a limited impact on the overall economy...For one thing, depository institutions in the United States are well capitalized and hence well positioned to absorb any housing lending losses they may incur...More and more of the credit- and interest-rate-related risks associated with mortgage finance can be easily traded and have gravitated to those institutions best positioned to manage the risks.

The last recession was a mild one partly because these financing innovations continued to facilitate the growth in mortgage lending and refinancing, supporting growth in residential investment and household consumption during the downturn and early recovery.

I just wonder about the consumer’s ability to absorb shocks. The buildup of home equity and the ability to borrow against it have helped individual homeowners when they have had layoffs, medical problems, divorces—all the things in life that create month-to-month problems for cash flow. With the growth of negative amortization, home equity is not being built up anymore. Negative amortization clearly helps consumer spending because consumers, in effect, have a smaller amount of their take-home pay that has to go to the mortgage payment every month, and so it is available to be spent elsewhere. It is probably a more pernicious type of home equity withdrawal because you don’t take an action to withdraw it. Now it is planned that you will have negative amortization. It clearly changes the way we look at the role of savings as a precautionary balance to get the consumer through bad times, and it also has long-run implications regarding the importance of asset values vis-à-vis default rates both for the banking sector and for the household sector. So the growing ingenuity in the mortgage sector is making me more nervous as we go forward in this cycle, rather than comforted that we have learned a lesson. Some of the models the banks are using clearly were built in times of falling interest rates and rising housing prices. It is not clear what may happen when either of those trends turns around.