Federal Reserve Governor Elizabeth A. Duke told attendees at a break-out session of the National Association of Realtors® (NAR) Midyear Legislative Meetings that she wished she had, as the session title suggested a "Prescription for Housing Recovery." "I do see policies that I believe will help reduce the shadow inventory of houses in the foreclosure pipeline," she said. "I also see policy actions that could be taken to improve credit availability for potential homebuyers and, in turn, demand for houses."
Duke briefly recounted the toll that the housing market had taken on homeowners and the nation's housing stock and some of the signs of recovery such as improving delinquency rates, and declining inventories of unsold and foreclosed homes.
She said there have also been signs that home prices are stabilizing and even improving. These modest improvements, she said, can only continue if the demand for homes strengthens or the supply fails to meet the weak demand. "My Realtor friends," she said, "have taught me that when inventories of houses for sale reach a level equal to six months of sales, then markets are usually in rough balance. And, indeed, just as the inventory of existing homes for sale nationally has approached six months of sales, we have seen a leveling of prices suggesting that some equilibrium is being achieved, albeit at low levels."
The national data, of course, masks differences in regional markets. She pointed to Miami and Phoenix where there is actually an undersupply of homes while delinquencies and foreclosures are still high. "For me, this calls into question the notion that housing prices cannot stabilize until the foreclosure pipeline is worked off. I believe that this reduction in inventory, even in the face of a steady supply of foreclosed homes, is a result of a sharp contraction in normal homeowner activity and an equally sharp expansion of investor activity". This could mean that discouraged homeowners have pulled homes off the market or that a significant portion of inventory has been absorbed by investors.
Despite some signs of improvement, demand for owner-occupied housing remains what Duke called "stubbornly tepid." One driver of demand is household formation which typically falls during economic downturns but has been especially weak in this cycle, running at three-quarters of the normal rate since 2007. At the same time some homebuyers are delaying home purchases because of uncertainty, others because they expect prices might fall even further.
Some who would like to buy cannot because they are unable to obtain a mortgage. She pointed to the Feds most recent Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) showing that underwriting standards for residential mortgages tightened steadily from 2007 to 2009, "and they do not appear to have eased much since then."
Obviously lenders are trying to correct for the lax and problematic lending standards in the years leading up to the crash, but Duke listed other factors causing the problem.
Lenders apparently lack adequate capacity. Some lenders have gone out of business and others have cut staff at the same time that requirements for documentation have increased and lenders have become more cautious over fear they might have to repurchase loans. This has increased the processing time for mortgages from about 4 weeks in 20008 to around 6 weeks in 2010. Of course if lenders were eager to originate mortgages they could increase staff and invest in systems but Duke believes uncertainty is inhibiting these investments.
Uncertainty is impacting lenders in other ways. Turning first to macroeconomic uncertainty, Duke said so long as unemployment remains elevated and further house price declines remain possible, lenders will be cautious in setting their requirements for credit. The continuing effects on house prices of the large number of underwater mortgages and of the mortgages still in the foreclosure pipeline remain unclear. In one recent survey, house price forecasts for 2012 ranged from a decline of 8 percent to an increase of 5 percent.
House price uncertainty and the high volume of distressed sales make the job of residential appraisers and lenders more difficult. Appraisers may lean toward the conservative in setting a home's value and, as long a house prices continue to decline lenders may lean toward more conservative underwriting which, taken together could discourage or even disrupt sales and Duke said she hears of that happening.
Lenders have tended to be conservative in making some mortgages that are guaranteed by government-sponsored enterprises (GSEs)--loans in which lenders do not bear the credit risk in the event of borrower default--which suggests that issues other than macroeconomic risk are affecting lending decisions.
In the April SLOOS lenders said they are less likely today to originate loans to borrowers in several different categories than several years ago and when asked why about 80 percent cited the difficulty of obtaining affordable private mortgage insurance. More than half the respondents cited risks associated with loans becoming delinquent as being at least somewhat important--in particular, higher servicing costs of past due loans or the risk that GSEs would require banks to repurchase or putback delinquent loans, their right when lenders are thought to have misrepresented their riskiness. If lenders perceive that minor errors can result in significant losses from putback loans, they may respond by being more conservative in originating those loans. If technology and data standardization can be used to enhance quality control reviews at the time of purchase rather than after the loans became delinquent, it would allow errors to be corrected much earlier, resulting in better outcomes for taxpayers, borrowers, investors, and lenders.
There is also uncertainty about future standards for delinquency servicing and the associated costs. This was partially resolved by the $25 billion servicing settlement and the consent orders entered into by 14 large servicers. However these agreements cover only about two-thirds of all mortgages and the new Consumer Financial Protection Bureau (CFPB) has declared it will develop servicing rules for all mortgage loans, The conservator of the GSEs are developing a set of servicing protocols for GSE loans and federal regulators are doing the same for banks they regulate. Also affecting decisions about investing in servicing are new approaches to servicer compensation under consideration by the FHFA and new international capital standards that change the capital treatment of mortgage servicing rights
Two major areas of uncertainty arise out of regulations being written under the Dodd-Frank Act; rules that will set requirements for establishing a borrower's ability to repay a mortgage including a definition of a "qualified mortgage" or QM. Mortgages that meet the definition would be presumed to meet the standards regarding the ability of the borrower to repay. Regulators are also developing a definition for "qualified residential mortgages," or QRMs, a subset of QM that would be exempt from risk retention requirements in mortgage loan securitizations. Each one of these rules will affect the costs and liabilities associated with mortgage lending and thus the attractiveness of the mortgage lending business.
Other big uncertainty is the potential role of the government in the mortgage market, especially the future of Fannie Mae and Freddie Mac still unreserved more than three years after they were put into conservatorship. Private capital might be reluctant to enter the market until their future is settled.
Duke concluded by returning to the theme of the session, writing a prescription for housing recovery which she said would include resolving uncertainty about the strength of the economic recovery, especially the labor market which is affecting both homeowners' willingness to buy and lenders willingness to lend. The Federal Reserve remains committed to fostering maximum employment consistent with price stability, which should help reduce some of the macroeconomic uncertainty.
The efforts underway to reduce foreclosures and distressed sales will stabilize home prices and mortgage loan modifications and short sales will cut the homes in the foreclosure pipeline as will reallocating some properties to rental use. Policy changes that increase opportunities to refinance and neighborhood stabilization efforts are other solutions.
But, she said, perhaps the most important solution is that policymakers move forward with the difficult decisions that will affect the future of the mortgage market. She listed the future of the GSEs, how to promote a robust secondary market, the form of crucial regulations, "and it is unlikely that anyone will fully agree with the final decisions that are made. Nevertheless, until these tough decisions are made, uncertainties will continue to hinder access to credit, the evolution of the mortgage finance system, and the ultimate recovery in the housing market. I don't want to diminish the importance of any individual policy decision, but I do believe that the most important prescription for the housing market is for these decisions to be made and the path for the future of housing finance to be set. It's time to start choosing that path.