My goal is to share with you what I see as some “early lessons” from the ongoing period of turmoil in real estate and credit markets. It is important, given the turbulence we have lately experienced, to begin to analyze and act on such lessons as early as possible.
First, some background. For the past two years, the housing market has gone from bad to worse. What began as a mild reduction in residential investment at the start of 2006 has accelerated, with residential investment declining by more than 20 percent during each of the last two quarters of 2007.
Beyond the obvious and intense pain for distressed borrowers, a noteworthy aspect of this downturn in residential investment has been its impact on financial markets. Previous housing downturns caused problems for savings institutions and banks that were generally smaller than the large financial institutions being affected today. This downturn has primarily affected financial markets and large financial institutions. Large financial institutions have lost billions of dollars, and in some cases tens of billions; and some are forecasting significant additional losses.
But this is not just a Wall Street problem. Our real concern is the ways those problems in financial markets translate back to all of us.
After a brief background on the genesis of the current financial turmoil, I am going to discuss three issues that I am sure you are increasingly seeing reported on the business pages of your national and regional newspapers:
Background On Recent Financial Turmoil
First, a bit of background. In early 2007 it became apparent that delinquencies on subprime mortgages issued after 2004 were experiencing problems at a more rapid rate than would be expected, given the rather benign economic environment. We began to see an elevated rate of subprime delinquencies [See Figure 1].
In July of 2007, rating agencies began to highlight the fact that subprime mortgages that had been securitized – a process I’ll describe in a moment – were performing poorly, leading to downgrades for securities that had significant exposure to the subprime market. Just as investors became more uncertain about valuing these securities, it became clear that subprime mortgages were part of various financial instruments that had been viewed as generally low risk.
Securitization relied on the reasonable premise that subprime loans might be more risky than prime, but the majority would not default – and higher interest rates and fees would compensate for those that did. Subprime loans were bundled for investors and “riskiness” was tiered. Investors in the least risky tiers were thought to be well protected from losses. [See Figure 2] Unfortunately, underlying assumptions proved inaccurate.
The market for short-term asset-backed commercial paper (ABCP), short-term securities used to finance a variety of loans from student loans to home equity, has been particularly impacted [See Figure 3]. As problems with mortgage-related loans emerged, some investors became reluctant to continue lending in the ABCP market. This reduction in the availability of short-term funds caused the rates on ABCP to rise; and also forced some financial institutions to buy back ABCP that they could no longer refinance, bringing it onto their balance sheets. The combination of uncertainty over the appropriate rating of mortgage-related securities and the expansion of bank balance sheets caused significant pressure on the availability of short-term credit. In addition banks, as liquidity providers, were expanding their balance sheets in other areas, much of which was not anticipated prior to the financial turmoil. Some banks have had to take write-downs on some assets, and the losses in combination with involuntary growth in assets have made some banks more reticent to expand their balance sheets further.
An indication of the difficulties in short-term financing markets was the marked elevation of the London Interbank Offered Rate (LIBOR) relative to the comparable U.S. Fed Funds target rate. LIBOR is the rate charged in a key international market for short-term lending between banks. The elevated LIBOR rate not only made it difficult for banks to borrow short-term, but also raised the rates on loans tied to LIBOR -- notably including most subprime mortgages, corporate loans, and credit card debt.
Indeed, while the initial trigger for the financial turbulence was related to subprime mortgages, the uncertainty surrounding ratings of complicated financial instruments has caused disruptions in a variety of other assets and markets that depend on securitization – including state and municipal financing, student loans, and commercial real estate. The effects have been felt up and down Main Street, as well as in some markets overseas.
The use of credit ratings for corporate bonds has been longstanding and generally free from substantial concerns about the ratings’ accuracy, with a few notable exceptions. So I think it is useful to consider the similarities and differences between rating corporate securities and mortgage securities, where the accuracy of ratings has been called into question. This is particularly important because much of the current turmoil is driven by investor uncertainty in rating difficult-to-value financial assets.
Relative to mortgage securities, ratings on corporate securities have been time tested. Downgrades have been quite modest. Defaults have often been tied to recessions or problems specific to a given firm, such as excessive leverage or poor management [See Figure 4]. In addition, investors in corporate securities can rely on a wealth of external sources to verify the health of a firm.
Corporate ratings have generally performed well. Despite the recent financial turmoil, corporate default probabilities in aggregate remain quite low [See Figure 5]. With relatively few downgrades, and delinquencies, the corporate balance sheet has held up better than that of the consumer – although the recent widening of spreads for lower-grade bonds gives one pause [See Figure 6].
The mortgage market is quite different. Most mortgage securities are based on a diversified pool of underlying mortgages. Many investors assumed that there would be significant benefits from diversification, that regional real estate shocks would be dominated by local factors, and that national home prices were very unlikely to decline. These assumptions proved to be wrong, resulting in widespread downgrades of mortgage securities.
The housing price assumption in particular has been critical, and many investors may have significantly underestimated a potential national housing price decline and its effect on defaults. The S&P Case-Shiller national home price index fell 10 percent from its peak in the second quarter of 2006 through the fourth quarter of 2007. Home prices are down in every one of the 20 large metro areas covered by the Case-Shiller national home price index.
In contrast to corporate securities, corroborating information on mortgage securities is not as readily available. There is no equivalent to equity analysts and equity prices to give investors updated market information. The information needed to analyze the individual mortgages in the pool can be expensive to obtain. So investors are more reliant on rating agencies than they are with corporate securities.
The problems in the mortgage market highlight the need for caution where there has been limited ratings history, where the underlying characteristics that drive the asset’s price may not be fully understood or anticipated, and where evaluations cannot be easily corroborated by others such as equity analysts. Certainly one way to highlight these differences is to differentiate ratings on corporate securities from ratings on assets like mortgage-backed securities.
II. Transparency and Disclosure
Now I’d like to turn to a second area, transparency and disclosure. The heightened uncertainty surrounding ratings has been aggravated by the lack of transparency in the pricing of complex financial instruments. Because as many of the more complicated financial instruments have ceased active trading, determining a market price has become quite difficult.
While defaults in housing move rather slowly, the pricing of financial assets has moved much more dramatically, causing many financial institutions to significantly change their expectation of losses from these complex financial instruments. In fact, the highest-graded securities are selling at a very significant discount [See Figure 7], implying a significant risk premium for holding even the highest quality securities of some complex financial instruments.
The opaqueness in pricing has caused a variety of complications:
So, what lesson should we derive from some of these complications?
First, some financial products were not well designed to withstand liquidity problems. To avoid paying banks fees to provide a liquidity backstop, many financial products of recent vintage included provisions to force liquidation when necessary to insure payment to the holders of the higher-graded securities (or slices of securities). This structure was used, for example, by structured investment vehicles (SIVs). However, due to the recent financial stress, assets of SIVs could not be liquidated at prices felt to be reasonable. Broadly speaking, products should be structured to better weather periods of illiquidity, and ratings models should take better account of liquidity risk.
A second way to improve price discovery would be to have greater uniformity in financial products. Standardization of products makes it much easier to price and trade securities. A case in point: many of the positive innovations in mortgage markets resulted from more uniform standards for conforming loans. Standardization helped insure minimum underwriting standards. Non-conforming mortgage markets, as well as other securitized assets, might well benefit from greater uniformity and standardization so that pricing is less idiosyncratic to the particular security an investor holds.
A third possibility is to seek more trading of financial products in exchanges rather than through dealers. Securities that are consistent enough to trade on an exchange are more likely to have market prices that all participants can use.
Finally, investors should give careful consideration to whether such complex financial products are necessary at all. With simpler and more understandable structures, the difficulties in obtaining market prices are likely to be significantly reduced, as are the consequent uncertainties like those we are currently facing.
The housing market was the genesis of current financial turbulence, and a key point is that significant further declines in home prices could greatly complicate efforts to resolve current problems. As housing prices fall, loan-to-value ratios will rise, in some cases exceeding 100 percent, reducing the number of borrowers that qualify for existing government programs like Federal Housing Administration (FHA) loans. Thus when considering ways to mitigate the current housing problem, it is useful to consider borrowers that still have positive equity in their house, as well as those that do not.
Fundamentally, I encourage worried borrowers who hold high-rate loans to approach a responsible lender about refinancing. I also encourage lenders to reach out to borrowers, and to take a fresh look at the state and federal programs that can be of assistance.
In recent months we estimated that a fair number of borrowers with subprime mortgages may be able to refinance into a more affordable loan, because they had good credit scores and some home equity when they got a fully documented loan on an owner-occupied property. As time goes by, however, declining home prices are eroding borrowers’ equity, and some are experiencing financial difficulties or mounting debt as the economy slows. These forces complicate the picture, and narrow the pool of readily “refinanceable” subprime loans.
Given the worsening housing scene, Boston Fed researchers recently updated prior work in this area in an attempt to calculate the share of people with subprime loans who might qualify for FHA programs. They looked at subprime loans in Rhode Island, Connecticut, and Massachusetts that had full documentation, were owner occupied, had a loan-to-value (LTV) of no greater than 97 percent, met current FHA loan-size limits by county, were never 60 days delinquent, and had a maximum debt-to-income ratio (including other forms of debt) of 45 percent. This approximates current FHA standards.
They estimate that about 16 percent of borrowers with subprime loans would meet those criteria. However, over time this pool is likely to shrink, as the number of delinquent borrowers has been rising and housing prices have been falling, likely reducing the number of qualified borrowers. For borrowers that could convert their subprime loan to an FHA-insured loan, saving significant money from converting from a subprime to a prime rate is an alternative that should be considered.
One refinance option is the Mortgage Relief Fund (www.MortgageReliefFund.com). Five large banks joined forces to set up this program, with the encouragement of the Federal Reserve Bank of Boston, to join forces in reaching out to borrowers with high-rate loans. The banks can help borrowers explore refinancing into a more-affordable loan – maybe an FHA loan, a state-guaranteed loan, or a conventional loan. We believe a number of community banks will join the effort in the coming months.
With two months completed, and realizing the lags from first contact on a mortgage to closing, the banks have logged over 1,000 inquiries, taken in more than 50 applications, made 115 referrals to nonprofit housing counseling services, and are now starting to close some of those loans from the first applicants – with the first dozen loans having recently closed. It is a modest start, but this month we are pursuing a second wave of outreach, and the banks are pursuing an additional advertising push, especially in areas with higher concentrations of subprime loans. We see the effort as a marathon, not a sprint, and we are refining and adding to it as we go.
As I noted a moment ago, as delinquencies and home prices shrink the pool of potential borrowers in existing Federal and state programs, an important consideration for lenders and policymakers involves the situations of borrowers whose loan now exceeds the value of their house. Of course, any remedies need to take into account the future risk to taxpayers, and the incentives created for borrowers and lenders. But we need to weigh that against the problems for communities that can occur with widespread foreclosures – including the negative effects on neighboring homeowners, the burden on tenants, and the costs borne by municipalities and communities in addressing blight and crime in areas of clustered foreclosures.
As Federal Reserve Board Chairman Ben Bernanke said on Tuesday, this situation calls for a vigorous response – but care must be taken in designing solutions, so they represent safety and soundness for lenders and are characterized by fairness and minimal “moral hazard.” I would note that foreclosure costs are often substantial to lenders (and by extension, I would add investors) – of course it goes without saying that they are painfully costly on many levels for borrowers. So there is considerable scope for negotiating a mutually beneficial outcome.
Somewhat along those lines, some parties are proposing variants of a “shared appreciation” loan approach. Lenders could write down the loan amount to the current home value, cap losses, avoid the costs associated with foreclosure, and receive a share of any future home appreciation when the buyer sells. The borrower could avoid foreclosure and reduce monthly payments. The FHA could provide insurance, but defray the increased risk with a share of the gains when the homeowner sells. Approaches like this, and other worthy ideas that are being proposed, should be debated by policymakers and interested parties – but without delay.
The uncertainty surrounding ratings has caused a variety of financial markets to become illiquid and caused very significant write-offs at major financial institutions. Considering ways to differentiate ratings on assets like corporate securities from ratings on assets whose ratings histories and price-drivers may be quite different, and less well understood, is probably a first important step.
The difficulty in pricing assets should make investors consider whether such complexity is necessary, and whether some of these instruments should be more standardized or possibly moved from dealer markets to exchange-traded instruments.
In the housing area, thought will likely be needed regarding programs for those with negative as well as positive equity in their houses. As long as housing prices continue to fall, the decline increases the risks to borrowers, lenders, markets and the economy.
I thank you for exploring with me today these problems that have roiled Wall Street, and are beginning to significantly affect Main Street. We are facing some unique and complex challenges in all of these areas. Let me leave you with the thought, however, that there may be a significant cost to delaying needed actions that could restore confidence in the ratings process, the pricing of financial assets, and the impact of declining house prices.
The views I express today are my own, not necessarily those of my colleagues on the Board of Governors or the Federal Open Market Committee (the FOMC).
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 GDP is essentially the value of goods and services put in place during a time
period, and residential investment is the housing component of GDP. “The main
indicator of the quantity of new housing supplied to the economy is the
residential fixed investment series from the national income and product
accounts. Residential investment is made up of new construction put in place,
expenditures on maintenance and home improvement, equipment purchased for use
in residential structures (e.g., washers and dryers purchased by landlords and
rented out to tenants), and brokerage commissions.” (Source: “Residential
Investment over the Real Estate Cycle” by John Krainer, in the Federal Reserve
Bank of San Francisco’s Economic Letter #2006-15; June 30, 2006).
“Brokers’ commissions…are part of the cost of acquiring a house and,
therefore, a capital expenditure.” (Source: “National and Regional
Housing Patterns” by Lynn Elaine Browne in the New England Economic
Review, July/August 2000, published by the Federal Reserve Bank of Boston).
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 For example see Greenlaw, Hatzius, Kashyap, and Shin (2008), “Leveraged Losses: Lessons from the Mortgage Meltdown.” presented at the 2008 U.S. Monetary Policy Forum on February 29, 2008. Using three different methods, they conclude that mortgage related losses will be $400 billion.
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 In essence subprime loans refer to mortgage loans that have a higher risk of default than prime loans, often because of the borrowers’ credit history. The loans carry higher interest rates reflecting the higher risk. Certain lenders, typically mortgage banks, may specialize in subprime loans. Banks, especially smaller community banks, generally do not make subprime loans, although a few large banking organizations are active through mortgage banking subsidiaries.
According to interagency
guidance issued, in 2001, “The term ‘subprime’ refers to the credit
characteristics of individual borrowers. Subprime borrowers typically have
weakened credit histories that include payment delinquencies and possibly more
severe problems such as charge-offs, judgments, and bankruptcies. They may also
display reduced repayment capacity as measured by credit scores, debt-to-income
ratios, or other criteria that may encompass borrowers with incomplete credit
histories. Subprime loans are loans to borrowers displaying one or more of
these characteristics at the time of origination or purchase. Such loans have a
higher risk of default than loans to prime borrowers. Generally, subprime
borrowers will display a range of credit risk characteristics that may include
one or more of the following: Two or more 30-day delinquencies in the last 12
months, or one or more 60-day delinquencies in the last 24 months; Judgment,
foreclosure, repossession, or charge-off in the prior 24 months; Bankruptcy in
the last 5 years; Relatively high default probability as evidenced by, for
example, a credit bureau risk score (FICO) of 660 or below (depending on the
product/collateral), or other bureau or proprietary scores with an equivalent
default probability likelihood; and/or Debt service-to-income ratio of 50
percent or greater, or otherwise limited ability to cover family living
expenses after deducting total monthly debt-service requirements from monthly
income. This list is illustrative rather than exhaustive and is not meant to
define specific parameters for all subprime borrowers. Additionally, this
definition may not match all market or institution specific subprime
definitions, but should be viewed as a starting point from which the Agencies
will expand examination efforts.”
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 Based on historical experience, 70 percent or more of the securities were
viewed as relatively safe and could carry high investment-grade ratings. Often
these higher quality securities were also repackaged into new securities, such
as collateralized debt obligations, making the risk tiering even less clear to
the investor. If the ratings were accurate, highly rated securities containing
subprime debt would have only a remote chance of default – similar to
investment-grade securities containing prime mortgages, home equity loans, or
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 Financing arrangements involving so-called auction-rate securities have
experienced difficulties – investor interest in such securities waned as investors
became concerned that insurers of debt might not have sufficient financial
capacity to meet all their obligations. In a similar vein the private
student-loan market has found securitizations used to finance pools of student
loans are more difficult, as investors avoid securitized financial instruments
in general. And the commercial real estate market has been disrupted as
investors have become reluctant to buy commercial-mortgage-backed securities.
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 It should be noted that there was criticism of corporate ratings for a number
of specific companies, such as Enron, earlier this decade.
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 Most firms that issue debt also have publicly traded equity. Equity analysts provide a variety of perspectives on a firm's prospects. In addition, investors often have access to default probabilities, known as KMV, or can observe credit default spreads to get another perspective on the accuracy of ratings. Also, firm's equity and options can provide important evidence of how other investors perceive the company.
Finally, there is a long history of the SEC enforcing
disclosure rules to insure that investors have sufficient information about
important corporate developments. With this plethora of corroborating data,
investors have a wide variety of indicators to help evaluate a firm's debt
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 In particular, those investors who are not well positioned to make independent
credit evaluations should seek rated assets where the information costs for
validating ratings are low.
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 The recent declines in the highest-graded of some mortgage securities implies
very significant losses, as investors would only take losses on these high-grade
securities after all lower-graded securities had been wiped out.
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 “Auction rate securities were first offered for sale in U.S. financial markets
in the early 1980s. As of the end of 2005, there were approximately $263
billion of auction rate securities outstanding. Many different types of issuers
have issued auction rate securities – for example, closed-end funds,
corporations, municipal authorities and student loan organizations. Auction
rate securities have generally been issued as either bonds or preferred stock
and are designed to serve as money market-type instruments. They are purchased
and sold, at established intervals, through an auction-type mechanism, but have
long-term maturities, or no maturity at all. In the auctions, auction rate securities
are purchased and sold at par. Auction rate securities have also been called
‘Auction Market Preferred Stock,’ ‘Variable Rate Preferred Securities,’ ‘Money
Market Preferred Securities’ and ‘Periodic Auction Rate Securities.’ The
interest or dividend rate of an auction rate security is reset at these
established intervals based on an auction in which investors who already hold
the security (called ‘holders’) and investors who seek to acquire the security
(called ‘prospective holders’) indicate their interest in continuing to hold,
or in purchasing or selling, the security at rates that they specify to
broker-dealers, such as Merrill Lynch, who have been appointed to participate
in the auction. The dates on which the auctions take place (the ‘auction
dates’), and the interval between the auction dates (the ‘auction period’),
vary depending on the security. The auctions commonly are every seven days,
twenty-eight days, thirty-five days or forty-nine days, but there are also some
securities for which the auctions occur daily and others for which the auctions
occur at longer intervals – for example, every six months or once over a
multi-year period.” Source: Merrill Lynch, “Description of Merrill Lynch’s
Auction Rate Securities Practices and Procedures”
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 “A structured investment vehicle or SIV is a limited-purpose operating company
that undertakes arbitrage activities by purchasing mostly highly rated medium-
and long-term, fixed-income assets and funding itself with cheaper, mostly
short-term, highly rated CP and MTNs. While there are a number of costs
associated with running a structured investment vehicle, these are balanced by
economic incentives: the creation of net spread to pay subordinated noteholder
returns and the creation of management fee income. Vehicles sponsored by
financial institutions also have the incentive to create off-balance-sheet
funds management structures with products that can be fed to existing and new
clients by way of investment in the capital notes of the vehicle.” Source:
Standard & Poor’s
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 And enabled investors to evaluate whether pricing of their mortgage security
was appropriate given the pricing of similar products.
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 While making financial products more standard involves some trade-offs – less
opportunity to provide investors a more customized product – such customized
products involve some down-sides when accurate pricing requires the particular
security to trade hands in order to have confidence in its market price.
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 In addition, an exchange can very significantly reduce counterparty risk by
enforcing margin requirements and other mechanism, to insure counterparties
meets their contractual obligations. The credit-default swap market has grown
to the point where pricing and counterparty risk could be mitigated if more
transactions were exchange-traded.
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 “The Federal Housing Administration (FHA), an agency of the federal government,
insures private loans that are issued for new and existing housing... Created
by congress in 1934, the FHA became part of the Department of Housing and Urban
Development's Office of Housing (HUD) in 1965. Today the mission of the FHA
includes helping borrowers get amounts they qualify for, and assisting lenders
by reducing their risk in issuing loans.” (Source: www.FHA.com)
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 This is an approximation of FHA practice. The FHA would qualify the borrower
at the FHA rate, not the original subprime rate, so we have used 45 percent
rather than 41 percent of the back-end debt-to-income. Actual credit standards
may differ from the assumption used of never more than 60 days past due. Also,
the FHA lending limits are in the process of changing. However, given the
changes in both the economy and housing prices, these factors may be more
important in determining who qualifies in the future.
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 “Reducing Preventable Mortgage Foreclosures” – March 4 speech at the
Independent Community Bankers of America Annual Convention, available at: http://www.federalreserve.gov/newsevents/speech/bernanke20080304a.htm
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 The Office of Thrift Supervision is one such party.
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 The borrower would have a reduced loan balance and receive a prime rate, but
would be obligated, upon selling, to share some of the future appreciation with
the current lender and the FHA. Consider for example a borrower with a loan of
$110,000 and a value of the house of $100,000. The lender would write off
$10,000 but would receive $100,000 when the loan was refinanced with FHA
financing. The lender would receive an option that gave the lender a share of
any appreciated value in the house, for example 20%. If the home was sold for
$150,000, the lender would receive the $10,000 at time of sale. The FHA would
receive a share of the appreciated value in the house, for example 10%. If the
home sold for $150,000 the FHA would receive $5000 at the time of sale. The
borrower would avoid foreclosure, and still receive 70% of the appreciation, or
$35,000. The shared appreciation values could be designed as transferable
options that are recorded with the registry of deeds.
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