Credit market innovations have expanded opportunities for many households. Markets can overshoot, but, ultimately, market forces also work to rein in excesses. For some, the self-correcting pullback may seem too late and too severe. But I believe that, in the long run, markets are better than regulators at allocating credit. We at the Federal Reserve will do all that we can to prevent fraud and abusive lending and to ensure that lenders employ sound underwriting practices and make effective disclosures to consumers. At the same time, we must be careful not to inadvertently suppress responsible lending or eliminate refinancing opportunities for subprime borrowers.

[W]e believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system. The vast majority of mortgages, including even subprime mortgages, continue to perform well.

More recently, developments in the subprime mortgage market have raised some additional concern about near-term prospects for the housing sector. The sharp rise in delinquencies on variable-interest-rate loans to subprime borrowers and the exit of a number of subprime lenders from the market have led to tighter terms and standards on such loans. While these problems have caused undeniable hardship for many families and communities, spillovers to other segments of the mortgage market or to financial markets in general appear to have been minimal. Variable-interest-rate loans to subprime borrowers account for a bit less than 10 percent of all mortgages outstanding, and at this point the expected losses are relatively small. Moreover, because most subprime mortgages are securitized, the risks associated with these loans are spread widely. Banks and thrift institutions that hold mortgages are well-capitalized, and exposures of individual banks to possible subprime losses do not appear to be large. On the whole, some borrowers may find credit more difficult to obtain, but most borrowers are not likely to face a serious credit constraint.

The subprime situation may well be a blessing in disguise.  It reminds us that history does have the capacity to repeat itself.  The old financial axioms — levelheaded notions such as “know your customer” (or your counterparty) and “there is a difference between price and value” — remain valid.  I expect market discipline to reassert itself, swiftly punishing those who pressed the limits of imprudence or suffered selective amnesia, hopefully doing so in a way that staves off the impulse for lawmakers and regulators to interfere disproportionately. 

Whether, and if so, how to try to differentiate "good" from "bad" lending in the CRA context is an issue that is likely to challenge us for some time.    

Although the turmoil in the subprime mortgage market has created severe financial problems for many individuals and families, the implications of these developments for the housing market as a whole are less clear. The ongoing tightening of lending standards, although an appropriate market response, will reduce somewhat the effective demand for housing, and foreclosed properties will add to the inventories of unsold homes. At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.

These concerns have been heightened in some quarters by the problems currently being experienced in the subprime mortgage sector.  It will take some time before the full implications are understood and the full impact can be assessed.  As of now, though, there are few signs that the disruptions in this one sector of the credit markets will have a lasting impact on credit markets as a whole.

Federal Reserve Bank of Minneapolis President Gary Stern said Friday that recent problems in subprime mortgage markets haven't had any spillover effects yet, but cautioned those types of forces haven't been fully 'stress tested.'

Stern was speaking at a monetary policy conference in Washington with other officials.

As reported by DJ Newswires

Our assessment, though -- while this is a very important problem and an issue, obviously, for many people who are facing foreclosure, our assessment is that there's not much indication at this point that subprime mortgage issues have spread into the broader mortgage market, which still seems to be healthy and the lending side of that still seems to be healthy.

From the Q&A session

A forward-looking view of the credit risks associated with subprime mortgages can be obtained from a new financial instrument related to these mortgages. These instruments {CDS} suggest a big increase in the risk associated with loans made to the lowest-rated borrowers, but little change in risk for other higher-rated borrowers. Based on these results, it appears that investors in these instruments expect the losses to be fairly well contained. Of course, a shift in market sentiment about the risk of some of these securities is always possible. Such a shift would have ramifications for mortgage financing and housing, likely through tighter credit standards and higher mortgage rates for certain borrowers. In fact, we already have seen some tightening among commercial banks in recent months.

There has been a surge in delinquencies and foreclosures, particularly, as I mentioned in my testimony, in sub-prime lending with variable rates, rates that adjust with short-term interest rates.

 And that is a concern to us. We certainly have been following it carefully. It's obviously very bad for those who borrowed on those circumstances, and it's not good for the lenders either, who are taking losses. We have tried, together with the other banking agencies, to address some of these concerns. We recently issued a guidance on nontraditional mortgages, which had three major themes.

The first was that lenders should underwrite properly, that is they should make sure that borrowers had the financial capacity to pay even when rates go up, and not simply underwrite based on the initial rate - deal with the possible payment shock.

Secondly, that lenders should give a full disclosure and make sure that people understand the terms of the mortgages they're getting into. And I would add that the Federal Reserve provides a number of documents, booklets and descriptions that are required to be included along with mortgage applications for adjustable rate mortgages.

 And thirdly - and this is more on the issue of the lenders rather than the borrowers - that lenders should make sure that they appropriately risk manage these exotic mortgages, which we don't have much experience with and so some caution is needed, as we're now seeing, in managing them.

To be clear, nontraditional mortgages certainly serve a useful purpose when used appropriately. These products have increased the range of financing options available to consumers and have grown in popularity over the past few years. Some consumers may benefit from these products’ more flexible payment options. For example, consumers with seasonal or irregular income or who expect their incomes to increase are more likely to be able to absorb the increase in payments in the near term of the loan.

But nontraditional mortgage loan products can be complex and may not be appropriate for everyone. Concerns have been raised that consumers are not getting clear and balanced information about the risks and features of interest-only and payment option ARMs. These products have been advertised and promoted based on their initially low monthly payments when compared with traditional mortgage products. By focusing on initial monthly payments without appropriate understanding of how the payments can vary over time or that minimum payments may actually increase the amount owed, many consumers have become financially overextended.

Supervisors have also observed that lenders are increasingly combining nontraditional mortgage loans with "risk layering" practices--such as by not evaluating the borrower's ability to meet increasing monthly payments when amortization begins or when interest rates on adjustable rate mortgages rise due to indexing or at the end of a "teaser" rate period.  We are also seeing more frequent use of limited or no documentation in evaluating an applicant's income and assets.  Although some lenders may have used elements of nontraditional mortgage products successfully in the past, the recent easing of traditional underwriting controls and the sale of some types of nontraditional products to subprime borrowers may generate losses on these products greater than has been observed in the past.

Subprime 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, these instruments represent a net gain to society. Here there is a role for public policy. On the part of the Fed, we are supervising lenders with regard to the disclosure of terms and costs to borrowers and with regard to the risks of carrying such nonstandard loans on their books. We are also promoting financial literacy efforts for borrowers.

[I]t is the abusive end of the spectrum that has drawn so much attention and generated the discussion about discrimination in pricing and terms.

Although the line between legitimate and predatory subprime loans is often fuzzy, it is clear that some lenders make subprime loans with the intent of separating borrowers from the equity in their homes. Borrowers with good credit ratings have a dizzying array of mortgage loan products to choose from. For those with poor credit ratings or those who may be unfamiliar with financial-service providers and products, the choices are even more baffling. And because of the many different ways in which lenders might disclose information about this array of products, even knowledgeable borrowers who are familiar with the process and who have shopped diligently may not feel certain that they have gotten the loan that is best for them.