The foreclosure crisis that resulted from unsustainable subprime lending has persisted largely because of high unemployment rates. Thus, in order to be successful, any effort to stabilize and revitalize lower-income neighborhoods will need to consider housing through the lens of access to jobs and educational opportunities.

We will soon give notice to the third anniversary since the onset of the global financial crisis. As we mark this occasion--and continue to witness shocks arising intermittently and unevenly--it might be worth debunking some popular views that have become part of the crisis narrative. In their stead, I will begin with what I believe are some truths, perhaps hiding in plain sight all along.

Subprime mortgages were not at the core of the global crisis; they were only indicative of the dramatic mispricing of virtually every asset everywhere in the world. The crisis was not made in the USA, but first manifested itself here. The volatility in financial markets is not the source of the problem, but a critical signpost. Too-big-to-fail exacerbated the global financial crisis, and remains its troubling legacy. Excessive growth in government spending is not the economy's salvation, but a principal foe. Slowing the creep of protectionism is no small accomplishment, but it is not the equal of meaningful expansion of trade and investment opportunities to enhance global growth. The European sovereign debt crisis is not upsetting the stability in financial markets; it is demonstrating how far we remain from a sustainable equilibrium. Turning private-sector liabilities into public-sector obligations may effectively buy time, but it alone buys neither stability nor prosperity over the horizon.

It is natural to equate the problems in our financial system with the securitization of subprime mortgages. But the securitized subprime market happened to be the epicenter, and we now see that the fault line really ran for a very long distance and spanned many markets and many kinds of financial institutions – particularly those that were the most complex and the most interconnected.

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.

Some critics of the CRA contend that by encouraging banking institutions to help meet the credit needs of lower-income borrowers and areas, the law pushed banking institutions to undertake high-risk mortgage lending. We have not yet seen empirical evidence to support these claims, nor has it been our experience in implementing the law over the past 30 years that the CRA has contributed to the erosion of safe and sound lending practices.

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Two key points emerge from all of our analysis of the available data. First, only a small portion of subprime mortgage originations are related to the CRA. Second, CRA- related loans appear to perform comparably to other types of subprime loans. Taken together, as I stated earlier, we believe that the available evidence runs counter to the contention that the CRA contributed in any substantive way to the current mortgage crisis.

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.

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. 

[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.

While much attention has focused on interest rate resets as a trigger for delinquencies and defaults—particularly on loans with artificially low introductory rates—so far they have not played a significant role. This is not to say, however, that resets won’t matter. In 2008, about 1.5 million loans are scheduled to reset.

Everyone agrees that it is long-term interest rates and mortgages that ultimately determine the demand for homes and hence the price. What became clear in the early part of this decade is that central banks, not only the Fed, . . . began to lose control over long-term interest rates. That was a major issue in 2004. The Federal Reserve started to raise short-term rates very significantly and found that instead of long-term rates rising with them in unison, it failed . . . I call it the conundrum. What the conundrum was was evidence that long-term interest rates were being dominated by long-term forces.

On the power of the Fed

The very sophisticated financial community basically decided that this was a steal. They put very significant pressure on the securitizers to produce more paper. I was aware of it at the time. Then the securitizers began to pressure the lenders and underwriting standards became egregious. It wasn't that the Federal Reserve wasn't aware of the problem. What we didn't realize was the order of magnitude of the subprime lending, which started as a niche with no macroeconomic implications to something that became excessive, a huge part of the market that . . . was sold around the world.

The crisis will leave many casualties. Particularly hard hit will be much of today’s financial risk-valuation system, significant parts of which failed under stress. Those of us who look to the self-interest of lending institutions to protect shareholder equity have to be in a state of shocked disbelief. But I hope that one of the casualties will not be reliance on counterparty surveillance, and more generally financial self-regulation, as the fundamental balance mechanism for global finance.

The problems, at least in the early stages of this crisis, were most pronounced among banks whose regulatory oversight has been elaborate for years. To be sure, the systems of setting bank capital requirements, both economic and regulatory, which have developed over the past two decades will be overhauled substantially in light of recent experience. Indeed, private investors are already demanding larger capital buffers and collateral, and the mavens convened under the auspices of the Bank for International Settlements will surely amend the newly minted Basel II international regulatory accord. Also being questioned, tangentially, are the mathematically elegant economic forecasting models that once again have been unable to anticipate a financial crisis or the onset of recession.

Credit market systems and their degree of leverage and liquidity are rooted in trust in the solvency of counterparties. That trust was badly shaken on August 9 2007 when BNP Paribas revealed large unanticipated losses on US subprime securities. Risk management systems – and the models at their core – were supposed to guard against outsized losses. How did we go so wrong?

The essential problem is that our models – both risk models and econometric models – as complex as they have become, are still too simple to capture the full array of governing variables that drive global economic reality.

Among the practices addressed by our proposal is the use of yield spread premiums (YSPs).⁶ Many consumers use mortgage brokers to guide them through a complex process and shop for the best deal. Unfortunately, consumers may believe that the broker has a responsibility to get them that best deal, which is not necessarily the case. In fact, the design of YSPs may provide the broker a financial incentive to offer a loan with a higher rate. Consumers who do not understand this point may not shop to their best advantage. Therefore, we would prohibit a lender, for both prime and subprime loans, from paying a broker an amount greater than the consumer agrees to in advance. Brokers would also have to disclose their potential conflict of interest. The combination of stricter regulation and better disclosure will not solve all the problems. We do believe, however, that this proposal will give consumers much better information and raise their awareness of brokers' potential conflict of interest while reducing a broker's incentive to steer a consumer to a higher rate.

6.  A YSP is the present dollar value of the difference between the lowest interest rate the wholesale lenders would have accepted on a particular transaction and the interest rate the broker actually obtained for the lender.  This dollar amount is usually paid to the mortgage broker.  It may also be applied to other loan-related costs, but the Board's proposal concerns only the amount paid to the broker.