In remarks prepared for delivery to the New Jersey Bankers Association Economic Forum on Friday, Federal Reserve Bank of New York President and Chief Executive Officer William C. Dudley focused on what he referred to as "only one factor behind the frustratingly slow economic recovery," the nation's housing market.  He elaborated on the framework presented in a Fed "white paper" earlier this week and advocated for further Fed intervention in the housing market.

Among the new suggestions put forward by Dudley in his remarks are an earned principal reduction program for underwater but performing homeowners, freeing lenders from employment-related credit risks, expanded bridge financing for the unemployed, and a "home for heroes" program.

Dudley outlined the current status of the housing market;

  • Housing prices down from the peak by 30 to 40 percent (depending on location) and still declining;
  • Home construction now at a negligible 425,000 annual units from the 1.75 million unit peak.
  • Mortgage delinquencies, while declining, remain very elevated. Currently there are 1.5 million seriously delinquent mortgages and 2 million in some stage of foreclosure;
  • Without improvements in housing and labor markets, more loans will become delinquent and the flow of loans into lender-owned real estate (REO) could rise from the current 1.1 million per year to as many as 1.8 million this year and next.
  • Increasing REO will continue to exert downward pressure on prices and housing activity.

These negative benchmarks, Dudley said, have inhibited economic activity through a number of channels.   First, the usual driving power of residential investment has been absent from this recovery.  In the nine quarters following the ends of the mid-1970s and early 1980s recessions, residential investment had climbed by 65 percent and 55 percent above their respective troughs.  There has been no rebound in this cycle.

Since the peak homeowners have lost about $7.3 trillion in home equity - about one-half the total.  This decline has eroded household wealth and contributed to greater weakness in consumption.  It has also reduced credit availability as financial institutions are less willing to lend on collateral when prices could fall further.  Problems in the foreclosure process and obstacles to efficient modification of loans in securitizations exacerbate this reluctance.  This has reduced the amount of credit available for households, including for small business formation.

Finally, the resulting decline in refinancing  deprives borrowers of a channel through which lower interest rates support spending and employment. This has undercut to a degree the ability of monetary policy to support demand.

Other systemic problems in housing are contributing to the lack of recovery despite the fact that housing no longer appears overvalued.  Items on Dudley's list include:

  • Supply and demand are not correcting efficiently because of lagging household formation and that housing is a long-lived asset.  The feedback loop from prices to demand also indicates this is not the time to own a home.
  • Factors that affect demand and home prices are not immutable and can be affected by the legal and operational structure of the mortgage market which has been inadequate for dealing with the recent systemic shock and is amplifying bad outcomes.
  • Conflicts of interest between first and second lien-holders are undermining remediation efforts.
  • There are too few mortgage modifications and short sales and too much emphasis on foreclosures to resolve difficulties.
  • Much damage is caused by inefficient foreclosures to families, neighborhoods, communities and the tax base.
  • The potential of "defaults by choice" could significantly swell REO if home prices continue to fall.

These factors, Dudley said, imply that there are many potential equilibrium outcomes in terms of housing demand and home prices and some are considerably more desirable than others. Housing policy should seek to break adverse feedback loops, promote more economically efficient outcomes in housing and support growth.

He restated the features of a comprehensive approach to stabilize housing as was outlined in the Fed white papers:  measures to improve access to mortgage credit, reduce obstacles to refinancing, lessen the flow of homes into foreclosure through bridge financing and accelerated principal reduction, and to facilitate the absorption of REO back into use as owner- or renter- housing.

Many of these policies, he said, "simply seek to solve or bypass the legal and incentive problems in the market today and mimic efficient private actions that might be taken if mortgage loans were all held in portfolio and accounting rules did not discourage net present value maximization." 

Several steps should be taken to offer opportunities for new mortgages to creditworthy borrowers on reasonable terms. Only 30 percent of originations now go to borrowers with credit scores under 720 even though they represent 52 percent of the population.  Lenders are applying tougher restrictions than the GSEs formally require, limiting their take-back risks. While lenders should be accountable for the representations they make, blanket repurchase requirements lead to bad outcomes in a period of high job loss risk.  It would be better to establish alternative ways to penalize lenders for misrepresentation that are not so closely tied to the risk of job loss.  For example, a better balance between encouraging for sound underwriting and credit availability could be a materiality test in the rep and warranty agreement.   Another possibility is to explore whether reps and warranties should have a finite duration supplemented by a rigorous check of a random sample of the mortgages being securitized.

Dudley said he did not advocate for a return to the lax standards and under-pricing of credit risk of the boom period, but a review leading to guarantee fees for new mortgages should be based on the expected losses on those mortgages, not what actually happened to earlier vintages

There is also a strong case for tackling the downward bias on appraisals, which are voiding many transactions between willing buyers and willing sellers. Incentives for individual appraisers favor conservatism today-just as they favored over-optimism during the boom.  The industry also needs standards to establish benchmark prices in slow markets with disproportionate distressed sales. 

Increasing refinancing would create additional cash flow for borrowers to absorb any adverse income shocks, reducing the likelihood of default, distress sales and foreclosures.  However, declines in equity, tighter standards, high fees, burdensome processes and legal risks to lenders are hindering this goal.

"Because the taxpayer, via Fannie and Freddie, is already exposed to the risk of conforming loans defaulting, it makes no sense to make it expensive or difficult for borrowers with these loans to refinance," Dudley said, as after all, refinancing reduces the existing credit risk to which taxpayers are already exposed. It is also inefficient to fully re-underwrite applications for such refinancing.

Many of these issues have been addressed by recent revisions to Home Affordable Refinance Program (HARP), Dudley said, but more could and should be done. 'I would like to see refinancing made broadly available on streamlined terms and with moderate fees to all prime conforming borrowers who are current on their payments."

In a departure from the Fed's list of improvements, Dudley added the need to weaken the link between unemployment and new foreclosures because the primary reason for distress sales and mortgage defaults today is the loss of a job. Some support for unemployed homeowners has been provided in some states under the Hardest Hit program and Dudley favors a broad program to "provide bridge financing for all qualified borrowers with demonstrated ability to service their debts but who have become unemployed involuntarily. In economic terms, this is a form of collective insurance."  

 His staff, he said, estimates that there are 4 to 5 million "at risk" homeowners who can afford their mortgage, but who would struggle in the event that the primary earner in the household became unemployed and that around 600,000 of these households will experience an involuntary job loss that lasts longer than a month over the next year. The average annual amount that would be required to keep the mortgage current for these households while unemployed and receiving unemployment insurance is around $21,000 which implies an annual bridge lending program of $15 billion per year during the current stress period.  In the future, loan repayments would help to offset the cost and, absent the negative externalities achieved by limiting distress sales, the expected program cost would be even lower.  This financing would have to have features such as requiring lenders to write down excess debt so as to assure against another lender "bailout."

Investment firms that purchase delinquent mortgages routinely reduce principal in order to maximize value on these loans. It would make sense for Fannie and Freddie to do this as well in order to minimize loss of value on the delinquent loans they guarantee. However, borrowers should not have to become delinquent to benefit from such reduction.  There could be a program for earned principal reduction for performing but underwater borrowers which would provide an incentive to remain current, reduce defaults and ultimately REO.

"One option developed by my staff is for Fannie Mae and Freddie Mac to give underwater borrowers on loans that they have guaranteed the right to pay off the loan at below par in the future under certain circumstances, including that the borrowers have continued to make timely payments. For instance, the borrower could be given an open-ended option to pay off the loan at an LTV of 125 percent, and the right to pay off the loan at an LTV of 95 percent after three years of timely payments."  This would protect the borrower from further price declines but he would give up a portion of the upside from appreciation.

Even with aggressive policies to minimize loans flowing into foreclosure Dudley estimates that large such volumes will continue and the growing overhang could continue to depress houses for several years.  Thus both incentives for short sales and steps to facilitate the orderly disposal of properties must be taken.  An interagency group is working on issues relating to REO-to-rental conversations and, among other steps, investors could be encouraged to purchase REO to be made available as rental housing. Fannie Mae and Freddie Mac could increase the number of loans offered to individual investors, and REO properties in a given locality could be bundled for sale.

The government might consider a package of tax incentives for purchases of REO that are used as rental properties such as a reduction of the current 27½ year depreciation period and/or a reduction of capital gains tax liability if the property is held for a minimum period, such as five years, Dudley said.

"One idea developed by my staff-let's call it "homes for heroes"-would be to create a new tax credit or other home purchase subsidy specifically for veterans of our foreign wars that would enable these veterans to purchase such properties at a discount. There are over 2½ million Gulf War II veterans alone, many of whom served multiple tours of duty overseas, and a significant proportion of them might otherwise not be able to purchase homes today."

Dudley disputed the contention that interventions in the real estate market would lead to moral hazard, i.e. rewarding bad behavior.  First, he said, programs can be designed with proper incentives to limit hazard and encourage desirable behavior, but  today, in contrast to the early part of the crisis, persons running into problems with their mortgages took them under standard conditions of downpayment then ran into an adverse life shock.  There is not a moral hazard issue, he said; punishing misfortune accomplishes little.

He also believes his proposals are strongly in the public interest and good for taxpayers.  The programs are not without cost, but the payoff could be modest price increases, few defaults, and shared appreciation as well as the avoidance of negative externalities such as reducing losses on loans that do not default as well as the fiscal benefits generated by strong economic growth.

In closing Dudley said the housing policy agenda he describes would "address one factor that  has impeded the economic recovery. Implementing such policies would improve the economic outlook and make monetary accommodation more effective.  However, because the outlook for unemployment is unacceptably high relative to our dual mandate and the outlook for inflation is moderate, I believe it is also appropriate to continue to evaluate whether we could provide additional accommodation in a manner that produces more benefits than costs, regardless of whether action in housing is undertaken or not. Monetary policy and housing policy are much more complements than substitutes."  And, he said, we have to recognize that there is more to economic policy than just monetary policy. "Low interest rates help housing, but cannot resolve the problems in that sector that are pressing on wider economic activity. With additional housing policy interventions, we could achieve a better set of economic outcomes than with just monetary policy alone."