In any event, my view is that we should regard recent events in the mortgage market as reflecting the normal process of innovation. The lessons have been expensive and painful, and the pain is not yet over. As with the dot-com bust, where many firms went bankrupt but some sound business models survived, we should expect that successful innovations behind the subprime market will also survive. In time, I believe, we will find that the subprime sector of the mortgage market will be as normal as any other part of the mortgage market.

The public policy problem is the danger that, with the sad record of so many mistakes and abuses in recent years, regulatory burdens designed to end the abuses will do so but only at the cost of making subprime lending so costly and risky to lenders that they will have no interest in restoring this market. We should not forget that market discipline imposed by lenders who have suffered extremely large losses is already making it very difficult for anyone to originate subprime mortgages. In time, if new regulatory burdens do not become too great, we should expect to see new practices become standard.

Although I am aware, as you are, that community banks originated few subprime mortgages, community bankers are keenly interested in these issues; foreclosures not only create personal and financial distress for individual homeowners but also can significantly hurt neighborhoods where foreclosures cluster.  Efforts by both government and private-sector entities to reduce unnecessary foreclosures are helping, but more can, and should, be done.  Community bankers are well positioned to contribute to these efforts, given the strong relationships you have built with your customers and your communities.

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.

In cases where refinancing is not possible, the next-best solution may often be some type of loss-mitigation arrangement between the lender and the distressed borrower.  Indeed, the Federal Reserve and other regulators have issued guidance urging lenders and servicers to pursue such arrangements as an alternative to foreclosure when feasible and prudent.  For the lender or servicer, working out a loan makes economic sense if the net present value (NPV) of the payments under a loss-mitigation strategy exceeds the NPV of payments that would be received in foreclosure... The magnitude of, and uncertainty about, expected losses in a foreclosure suggest considerable scope for negotiating a mutually beneficial outcome if the borrower wants to stay in the home. 

Unfortunately, even though workouts may often be the best economic alternative, mortgage securitization and the constraints faced by servicers may make such workouts less likely.  For example, trusts vary in the type and scope of modifications that are explicitly permitted, and these differences raise operational compliance costs and litigation risks.  Thus, servicers may not pursue workout options that are in the collective interests of investors and borrowers.  Some progress has been made (for example, through clarification of accounting rules) in reducing the disincentive for servicers to undertake economically sensible workouts.  However, the barriers to, and disincentives for, workouts by servicers remain serious problems that need to be part of current discussions about how to reduce preventable foreclosures.

...

Lenders tell us that they are reluctant to write down principal.  They say that if they were to write down the principal and house prices were to fall further, they could feel pressured to write down principal again.  Moreover, were house prices instead to rise subsequently, the lender would not share in the gains.  In an environment of falling house prices, however, whether a reduction in the interest rate is preferable to a principal writedown is not immediately clear.  Both types of modification involve a concession of payments, are susceptible to additional pressures to write down again, and result in the same payments to the lender if the mortgage pays to maturity.  The fact that most mortgages terminate before maturity either by prepayment or default may favor an interest rate reduction.  However, as I have noted, when the mortgage is "under water," a reduction in principal may increase the expected payoff by reducing the risk of default and foreclosure.  

I would argue that root causes of problems in the subprime market brought into question some fundamental practices, incentives, and even institutions of other markets. By fundamentals, I mean the integrity of origination (that is, the quality of assets that went into securitization pools), the structure of the securities into which loans and individual securities were packaged, and the value of these securities as collateral for margin financing.

Also, rating agencies had greatly underestimated the risk of many mortgage-backed securities. This led to a loss in confidence in the ratings assigned to other complex financing structures with further reductions in liquidity and increases in the volatility of prices across a variety of debt markets.

Through this spread of suspicion, subprime losses exposed related problems elsewhere, such as the syndication market for leveraged loans. Some leveraged lending underwriting was in its own way very aggressive in the period before the markets turned rocky starting last summer.

Finally, the subprime crisis generated a thicket of doubts concerning counterparties. Uncertainty about valuations of securitized debt fed uncertainty regarding the exposure of large banks and other market participants, which led to concerns about executing trades with these counterparties.

The credit rating agencies got it wrong. Badly. I think some of the investors didn't understand that a triple-A (rating) for a corporate bond really has a different meaning. A corporate bond that's triple-A will act in a different way than a triple-A tranche of subprime mortgages will act, and so when markets moved and markets changed, people got surprised by the extent to which there was downgrading.

From audience Q&A, as reported by Market News International

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 

Subprime lending is going to come back. Right now, subprime lending is as dead as a doornail.  The informational idea that changed things is still around. Without human beings interacting you can actually get a lot of information about whether someone is going to pay you back. This is data mining.

The problem was they said, `Oops, we made a mistake with the business model.'

From the audience Q&A, as reported by Bloomberg News

"The worst is just beginning" for sub-prime loan re-sets.

At Treasury-HUD press conference, as reported by Bloomberg News

There is a great deal of soul-searching that's going on all over the place and that's entirely appropriate. We're doing soul-searching within the Federal Reserve system, asking ourselves whether or not there are things we should have known or should have done and should do going forward.

For the past few years, we have had a raucous party of economic growth fueled by an intoxicating brew of credit market practices that financed a housing boom of historic, and late in the cycle, hysteric, proportions. With the benefit of perfect hindsight, some have argued that the Fed failed to take away the punchbowl as the subprime party spun out of control, leaving rates too low for too long and not using our regulatory powers to restrain excessive complacency in the pricing and monitoring of risk. But that is beside the point.

Now we are faced with the consequences of a process that lawyers would call the “discovery phase”: As big banks and other financial agents confess their acts of fiduciary omission and excesses of commission, credit markets have effectively de-leveraged important segments of the economy, slowing growth suddenly and precipitously. Instead of taking the punchbowl away, the Federal Reserve is now faced with the task of replenishing the punch.

...[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. 

Let’s review the five major mistakes creating the subprime mess.

First, too many borrowers took on mortgages they could not afford...

Second..., mortgage brokers put too many borrowers into unsuitable mortgages...

Third, it is surprising to me that investment banks jeopardized their reputations by securitizing these mortgages when the underlying loans were backed by inadequate or spurious information.

Damaged reputations are also casualties of the fourth major mistake: rating agencies that placed AAA ratings on many securities backed by subprime mortgages...

The final entry on our major mistake list is investors who bought those securities without conducting an adequate analysis of the underlying investments.

It is interesting, and a bit depressing, that investment professionals made four of the five mistakes.

Clearly, recent Fed policy actions have not protected investors in subprime paper. The policy objective is not to prevent losses but to restore normal market processes. The issue is not whether subprime paper will trade at 70 cents on the dollar, or 30 cents, but that the paper in fact can trade at some market price determined by usual market processes. Since August, such paper has traded hardly at all. An active financial market is central to the process of economic growth and it is that growth, not prices in financial markets per se, that the Fed cares about.