I would like to reinforce remarks made last week by Chairman Bernanke on the recent turbulence in financial markets.  In the United States we have seen a fairly sharp downturn in housing markets, and in recent weeks there have been growing investor concerns about mortgage credit performance, particularly with subprime mortgages.  If current conditions persist in mortgage markets, the demand for homes could weaken further, with possible implications for the broader economy.  And financial stress has not been limited just to mortgage markets, but has spread to other markets.  In general, a shift in risk attitudes has interacted with heightened concerns about credit risks and uncertainty about how to evaluate those risks. 

    William Poole, president of the Federal Reserve Bank of St. Louis, said there's no sign that the subprime-mortgage rout is harming the broader U.S. economy, and an interest-rate cut isn't yet needed.   ``I don't see any impact as yet on the real economy or on the inflation rate,'' he said in an interview in the bank's boardroom. ``Obviously, there could be an impact, but we have to rely on some real evidence.''
     Barring a ``calamity,'' there is no need to consider an emergency rate cut, Poole said. His comments were the first by a Fed official since the U.S. central bank joined counterparts in
Europe and Asia to inject emergency funds after a surge in money-market rates. The Fed has added $71 billion of reserves in the past five trading days.
     Poole, 70, said businesses have maintained their hiring and investment plans and banks have sufficient capital to weather the credit-market turmoil. The St. Louis Fed chief stressed that the best course is for policy makers to assess the latest economic data when they next meet Sept. 18. The comments contrast with the certainty that traders put on a rate cut next month.   ``If the data confirm the market's view that the economy is sagging, we'll have to decide whether to share that view,'' said Poole, who votes on the rate-setting Federal Open MarketCommittee this year. He cited the monthly jobs, retail sales and industrial production reports as key gauges he'll be watching.

As reported by Bloomberg News

Most recently, supervisory guidance has emphasized the added dimension of risk when higher-risk loans are combined with other features--such as the use of simultaneous second lien loans in lieu of a down payment or the use of underwriting that involves little or no documentation of income or assets. Guidance has also underscored the safety and soundness and consumer protection concerns prompted by other underwriting practices often seen in subprime and nontraditional mortgage lending, such as excluding taxes and insurance in the underwriting process and allowing deferred repayment of principal by offering interest-only loans. Finally, this supervisory tool has been used to urge creditors to work with homeowners who are unable to make mortgage payments.

"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

I believe the fundamental problems in the non-prime mortgage market amenable to improvement stem from inadequate incentives among some of the parties operating in the market to create and maintain strong reputations for quality and fair-dealing.   

It is important to emphasize that what is odd is not that there was a risk of rising short-term interest rates, as there always is, but that the market clearly expected an increase, as indicated by the shape of the yield curve. This expectation, in turn, was encouraged by the Fed’s Open Market Committee. The policy statement issued at the conclusion of the FOMC meeting of May 4, 2004, said that “the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.” A similar phrase appeared in subsequent FOMC policy statements until December 2005, when the language was changed slightly to “the Committee judges that some further measured policy firming is likely to be needed.” At its next meeting, in January 2006, the language changed from “is likely to be needed” to “may be needed,” and somewhat similar language remained in the policy statement through the FOMC meeting in January 2007.

Given these widely held expectations of rising interest rates, it is difficult to avoid the judgment that these ARM loans were poorly underwritten at the outset. It was imprudent for mortgage brokers and lenders to approve borrowers who likely could not service the loans when rates rose, and it is surprising to me that sophisticated capital-market investors willingly purchased securities backed by such poorly underwritten mortgages.

Some estimates are in the order of between $50 billion and $100 billion of losses associated with subprime credit products. The credit rating agencies have begun to try to make sure they account for those losses, and they have downgraded some of these products.  I should say that the investors, many of them recognize that even before the downgrades occurred that there were risks associated with these products, including not only credit risks, but also liquidity and interest rate, other types of risks.

I agree with you that legitimate subprime lending is beneficial. It gives people access to homeownership and access to credit, and so the real trick for us is to write rules, to write regulations that will screen out the abusive practices and the improper practices while preserving this market. And I think that's a very challenging task.

From Q&A session

[T]here's clearly less reliance on the FHA than in the past. My sense is that part of the problem is lack of flexibility, the costs of dealing with the FHA, lack of diversity of product, and so on.  So I think that modernizing the FHA, trying to make it more responsive, easier for ultimate lenders to work with and so on might reverse this trend and might give the FHA a larger share in the market, which could be a positive thing.

I guess I would point out that the FHA does have, I think, if I remember correctly, I think it still has a fairly high delinquency and default rate. It doesn't -- it hasn't solved the problem of delinquencies and so on.   And so, as those changes get made, I would suggest moving with some caution to make sure that we don't create yet another source of problems in terms of inappropriate loans for specific borrowers.

So I do see a case for trying to make the FHA more modern and to expand its role. But I would urge some caution and go slow on that.

From the Q&A session

In coordination with the other federal supervisory agencies, we are encouraging the financial industry to work with borrowers to arrange prudent loan modifications to avoid unnecessary foreclosures. Federal Reserve Banks around the country are cooperating with community and industry groups that work directly with borrowers having trouble meeting their mortgage obligations. We continue to work with organizations that provide counseling about mortgage products to current and potential homeowners. We are also meeting with market participants--including lenders, investors, servicers, and community groups--to discuss their concerns and to gain information about market developments.

We must be careful, however, not to curtail responsible subprime lending or beneficial financing options for consumers. A robust and responsible subprime mortgage market benefits consumers by allowing borrowers with non-prime or limited credit histories to become homeowners, access the equity in their homes, or have the flexibility to refinance their loans as needed.

We seek to promote the availability of consumer credit while ensuring that consumers receive the information they need to understand their options. Consumers who do not have accurate information and an understanding of what that information means will have difficulty choosing among competing products. Because information is critical to more competitive, and thus more efficient markets, more effective disclosure also has the capacity to weed out some abuses.

Tighter lending standards in the subprime mortgage market--together with the possibility that the well-publicized problems in this market may dissuade potentially eligible borrowers from applying--will serve to restrain housing demand, although the magnitude of these effects is difficult to quantify.  Subprime and near-prime mortgage originations rose sharply in 2004 and 2005 and likely accounted for a large share of the increase in the number of home sales over that period.  However, originations of nonprime mortgages to purchase homes appear to have peaked in late 2005 and declined substantially since then, and by more (even in absolute terms) than prime mortgage originations.  Thus, some part of the effect on housing demand of the retrenchment in the subprime market has likely already been felt.  Moreover, indicators such as the gross issuance of new subprime and near-prime MBS suggest that the supply of nonprime mortgage credit, though reduced, has by no means evaporated.  That said, the tightening of terms and standards now in train may well lead to some further contraction in nonprime originations in the period ahead.  We are also likely to see further increases in delinquencies and foreclosures this year and next as many subprime adjustable-rate loans face interest-rate resets.

We will follow developments in the subprime market closely. However, fundamental factors--including solid growth in incomes and relatively low mortgage rates--should ultimately support the demand for housing, and at this point, the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system.

The Board believes the rise in subprime foreclosures needs to be addressed in a way that preserves incentives for responsible subprime lenders so that borrowers with non-prime credit can become homeowners, access the equity in their homes, or have flexibility in financing their mortgages when necessary.