Well, it's been several years, but the Federal Reserve, America's central bank, seems finally to have noticed that there is something really screwed up about the housing market — and that it won't simply be fixed by lowering interest rates or buying mortgage-backed securities in the open market. Last week, Federal Reserve Chairman Ben Bernanke delivered a white paper to Congress on the condition of the housing market.
Last Friday, William Dudley, president of the New York Fed, which is responsible for the nation's financial plumbing, gave a speech about the housing market, pointing out a series of measures lenders and policymakers could take to help make housing less of an economic drag. (The speech can be seen and heard here.) Dudley discussed some of his proposals with me in an interview.
Why speak out now, at a time when housing is showing signs of life and there are suggestions that the worst of the crisis is behind us? Beyond the data, Dudley and his staff were motivated by "some of the personal anecdotes we've heard when we have gone out in the district, in terms of the difficulty of getting anything done with mortgage modifications and servicers," he said. "That reinforced a prior [idea] going in that this system is pretty dysfunctional."
First, Dudley suggests that lenders need to be a little less strict when doling out credit. In a classic case of overreaction to risk after a classic case of under-reaction to risk, lenders are now rationing credit to those with the best credit scores — even though the government is guaranteeing virtually all of them. In his speech, Dudley noted that "over 50 percent of all new loans and 70 percent of new prime conforming loans — go to borrowers with FICO scores of 760 or above." In addition, borrowers whose FICO scores are above 720, who make up 52 percent of the population, account for less than 30 percent of mortgages. Banks, in part because of fears they'll have to buy back mortgages they securitize if they fail to perform, have become extremely conservative underwriters. "People are not willing to refinance loans that qualify for refinancing under Fannie and Freddie, and that tells you that the needle has gone too far," Dudley told me. "We certainly don't want to go back to the 2005 and 2006 experience," he continued. "But we don't want to have a system that discourages people from doing prudent underwriting."
Banks and policymakers should also get much smarter about foreclosures. Aside from creating legal problems and social hardship, the banks' rush to foreclose on delinquent borrowers, kick people out of homes and dump repossessed houses onto the market has caused systemic financial problems. Foreclosure creates legal and maintenance costs for banks, and the process discourages the retention of value for lenders. And yet mortgage modification efforts have been halting and feeble.
Dudley has a couple of ideas in this area. Job loss is closely associated with home loss, and it's difficult for people to insure against job loss. Research indicates that there are 4-5 million people who can swing their mortgage, but wouldn't be able to if the main earner loses her job. And for the typical person in that situation, the difference between staying current until job returns and foreclosing would be about $21,000. His proposal: Banks (or government entities) should make bridge loans to unemployed homeowners. "If people lose their jobs, we don't want that to lead to delinquency and foreclosure," Dudley said. The experience of a bridge financing program in Pennsylvania enacted in the late 1980s suggests that bridge loans would be less costly and disruptive to banks —and to the market at large.
In his speech, Dudley also made a pitch for "earned principal reduction." The data, and reason, suggest that once people fall behind on mortgages that are underwater, regardless of their income and credit score, they're more likely to walk away. The solution would be for Fannie Mae and Freddie Mac to kick off principal reduction efforts before borrowers fall behind. But rather than simply lop off a big chunk of the debt immediately — something lenders of all types are reluctant to do for fear of moral hazard — they could pursue a more sophisticated approach. "If you provide incentives to pay on the mortgage, you could end up in a better place," Dudley told me.
Imagine, for example, that the lender would reduce a small chunk of principal each time a payment is made on time. Dudley's staff developed a concept whereby Fannie and Freddie would offer borrowers the right to pay off (or refinance) underwater loans for less than the full amount under certain conditions. For example, underwater borrowers who make timely payments for three years would be allowed to pay off the loan at 95 percent of the value of the home. While some of the people benefiting would likely have paid anyway, "we found that, under a pretty broad set of circumstances, the benefits outweighed the cost," Dudley said. Also, if housing prices were to recover and rise, homeowners would have to share the appreciation with the lender.
Finally, Dudley suggested policies that could give greater push to home rental. For example, those who buy repossessed homes and rent them out to tenants could receive favorable tax treatment.
There are plenty of good ideas here, and it's a positive sign that high-ranking officials are urging action. But none of the items Dudley discussed is a silver bullet. And there's only so much the New York Fed — or the Federal Reserve at large — can do. The solutions to the housing problem really lie in the hands of banks, mortgage lenders, Fannie and Freddie, and state and federal legislators. There's a final reason for skepticism. Many of Dudley's proposals are rational, common-sense approaches that would prevent banks from inflicting more damage on themselves. Alas, recent history has shown that, when it comes to lending — and dealing with the consequences of poor lending — banks can't be relied upon to act in their own self-interest.
Daniel Gross is economics editor at Yahoo! Finance.
Follow him on Twitter @grossdm; email him at grossdaniel11@yahoo.com.
196 comments