The voice of mortgage originators and housing professionals was broadcast loud and clear by Federal Reserve Governor Elizabeth Duke today.

Speaking at the Mortgage Foreclosure Policy Conference in Chicago today, Duke's prepared speech, Envisioning a Future for Housing Finance, called attention to overtightened mortgage underwriting standards and pointed out the effects it was having on the housing recovery.

"Even taking into account the excesses of the bubble period, it appears that lenders have tightened underwriting terms so much that the lack of credit availability is at least partially an impediment to homeownership," said Duke.

Duke highlighted the lack of available lending products:

"The scarcity of available mortgage lending at present--especially the lack of relatively low-down-payment products beyond the Veterans Administration (VA) and Federal Housing Administration (FHA) market--most hurts modest-income households who lack other assets. This makes it especially difficult for first-time and minority homebuyers to enter the market."

She pointed out the fact that banks are missing an opportunity to lend to eligible borrowers because of over-tightened guidelines:

"Some would argue that most of the really risky behavior is now out of the market. But, unfortunately, the backlash has restricted a lot of perfectly responsible lending as well. Banks are reluctant to put any but the lowest possible risk loans in their portfolios. And the market for new private mortgage loan securitizations is essentially closed. Thus, borrowers face tight underwriting requirements, even if their own risk profile looks relatively "safe" by historical standards. Moreover, even homebuyers with the requisite down payment realize that their home equity is much less liquid than in the past. Once, borrowers could count on cash-out refinancing or home equity lines of credit as a means of cheaply accessing their home equity; these avenues are now much more restricted."

Duke then outlined four principles we should focus on when evaluating mortgage reform proposals, here is an outline:

1. Adequate consumer protection.

First and foremost, any new system must contain adequate protections for consumers. In the aftermath of widespread abuses, consumers need to feel confident that they can satisfactorily negotiate a reasonable mortgage.

2. Transparency.

Second, there must be transparency at all levels. Retail products should be as transparent as possible, so that consumers find it easy to understand the terms and risks of their mortgages. Lenders and servicers should also make as much information as is reasonably feasible available to investors. Indeed, adequate information for due diligence is likely a prerequisite to attract capital back to the mortgage market.

3. Simplicity.

Third, the new system should encourage simplicity. Retail mortgage contracts ought to be as simple as possible. Too often, the complexity of mortgages has served to confuse borrowers and make it more difficult to make informed decisions. Similarly, the complexity of the securitizations into which mortgages were packaged made analysis difficult for investors. These structures turned out to be especially fragile when stressed with high defaults and subsequent losses. After the crash, with delinquencies rising, investors found modeling the cash flows under alternative scenarios confusing and uncertain. While complexity may prove to be an inevitable byproduct of financial innovation, investors will likely demand much simpler instruments going forward.

4. Properly aligned incentives.

Finally, the new system should feature clear roles and properly aligned incentives for all players. Too often in the recent turmoil, we saw examples of misaligned interests and competing objectives. For instance, there is evidence that some loan officers and mortgage brokers may have been as concerned about whether loans were profitable to them personally as they were about whether the borrower could actually repay.

She then went on to discuss what the new mortgage market structure might look like. Here is a summary:

1. Lending Practices.

Under Truth in Lending we also have recently proposed revised mortgage disclosure forms for all loans. Despite efforts to improve disclosures and ban egregious practices, obtaining a mortgage and purchasing a home is still a significant and complex transaction. Evidence indicates that consumer counseling, whether for pre-purchase or foreclosure prevention, leads to better outcomes for consumers.

2. Secondary Market

Whether the ultimate vehicle is covered bonds, loan securitizations, or some other model, a mechanism for channeling investment funds into housing finance will be critical to meeting the demands of a normally functioning housing market. Restoration of the residential housing finance market will require more than liquidity. At a minimum, it is likely to require access to information, standardized contracts, and simplified structures.

3. Servicers

Servicers have not always been the most visible part of the mortgage business. Responses to this current crisis, however, including attempts to make large-scale loan modifications, have pointed to the critical role that servicers play through their direct interaction with borrowers. Yet, there have been problems. Many servicers did not have--and some may still not have--adequate systems and personnel in place to deal with the sheer scale of the foreclosure crisis. Servicers are concerned about the competing interest of investors and the threat of litigation for pursuing alternatives to foreclosure. In turn, some investors have questioned servicers' incentives.

In the future, servicer contracts will need to provide clear guidance and incentive structures that lead to transparency and certainty in loan modifications and other loss mitigation tools.

4. Fannie and Freddie

It would be unrealistic to expect the private mortgage market to rebound without defining the ongoing role of Fannie Mae and Freddie Mac. These government sponsored enterprises (GSEs) have continued to issue large quantities of securities even as private securitization faltered, apparently because investors have continued to believe that the government stands behind them. That experience suggests that, at least under the most stressed conditions, some form of government backstop may be necessary to ensure continued securitization of mortgages.

However, restarting the GSEs in their old forms would do nothing but ask for a repeat of recent history. Without getting into specific proposals today, I'll simply say that whatever is the ultimate future for Fannie and Freddie, market participants will need to see a clear roadmap for both the individual institutions and the role of government in housing finance before private markets can begin to map a course for themselves.


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