In testimony to the House Financial Services Committee, Ben Bernanke outlined the history of the subprime mortgage mess, the recent rise in defaults and foreclosure proceedings, and a plan of attack to quell further problems.
Bernanke noted that the advent of the credit score along with the “originate-to-distribute model” (lenders originating loans and selling them on the secondary market) had led to a wider availability of home financing, but a rise in subprime ARM loan origination, loans which ultimately performed much more poorly than their prime counterparts.
“During the past two years, serious delinquencies among subprime adjustable-rate mortgages (ARMs) have increased dramatically,” Bernanke said.
“The fraction of subprime ARMs past due ninety days or more or in foreclosure reached nearly 15 percent in July, roughly triple the low seen in mid-2005.”
“These patterns contrast sharply with those in the prime-mortgage sector, in which less than 1 percent of loans are seriously delinquent.”
The Fed chief also noted that Alt-A loans were showing signs of weakness as well, saying, “the serious delinquency rate has also risen, to 3 percent from 1 percent only a year ago.”
The rise in defaults has also translated to more foreclosures, especially in regions of the nation where economic growth is sluggish and home prices are decelerating rapidly.
Borrowers simply don’t have any equity in their homes, or otherwise any options to refinance or sell.
Bernanke added that underwriting standards were likely undermined by the quick sale of mortgages on the secondary market, as lenders had less at stake to ensure the loans were of high quality.
“When an originator sells a mortgage and its servicing rights, depending on the terms of the sale, much or all of the risks are passed on to the loan purchaser. Thus, originators who sell loans may have less incentive to undertake careful underwriting than if they kept the loans.”
He went on to explain that many of the higher-priced loans were originated by independent mortgage companies and mortgage brokers, whose regulation was more difficult to monitor.
“Investors are demanding that originators employ tighter underwriting standards, and some large lenders are pulling back from the use of brokers.”
Bernanke said the Federal Reserve was actively working to improve the fragmented lending environment, with plans to develop enhanced disclosures, crack down on bad lending, and improve underwriting standards.
The Federal Reserve has been working with numerous agencies and industry groups to improve loan disclosure and outline “loan workouts” to ensure borrowers stay in their homes.
“We have also encouraged lenders and servicers to identify and contact borrowers who, with counseling and possible loan modifications, may be able to avoid entering delinquency or foreclosure.”
In regard to improved disclosure, Bernanke added, “In my view, better disclosure of the schedule of mortgage payments over the life of the loan can help borrowers understand the terms of their mortgages and judge their ability to make future payments.”
The Fed is also cracking down on loose lending practices that have been scrutinized for their somewhat predatory nature.
“We are looking closely at some mortgage lending practices, including prepayment penalties, escrow accounts for taxes and insurance, stated-income and low-documentation lending, and the evaluation of a borrower’s ability to repay,” he said.
Bernanke said that “inter-agency cooperation” from a variety of federal and state agencies would be essential to making things work, and that many programs are being tested and subsequently launched.
With regard to the FHA, Bernanke felt the agency needed to take a stronger role in the current crisis, noting that subprime outlets had serviced borrowers more quickly and creatively than the agency, leading to the problems we’re seeing now.
“The FHA’s share of first-lien home purchase loans declined substantially, from about 16 percent in 2000 to about 5 percent in 2006, as borrowers who might have sought FHA backing instead were attracted to nontraditional products with more-flexible and quicker underwriting and processing.”
He did however express concern in designing government-backed programs, adding that such programs should not serve to bail out failed investors and prospectors.
He also revealed his disapproval concerning a rise in the conforming loan limit, saying any such change should be a temporary one, as it would undermine the guaranteed financial performance the GSEs offer.
“Raising the conforming-loan limit would expand this implied guarantee to another portion of the mortgage market, reducing market discipline further.”
In reference to the somewhat unexpected half-point rate cut, Bernanke said, “We took that action to try to get out ahead of the situation.”
He also left the door open for future cuts, saying, “The [Federal Open Market] Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable growth.”