Speech

Reputation and the Non-Prime Mortgage Market St.LouisAssociationofRealEstateProfessionals St.Louis,Missouri July20,2007 My topic this morning is the non- subprime.WhatIamcallingthenon-primemarket prime mortgage market, which coverssubprimeandAlt-A.Thereare,ofcourse, has been in the news on almost a avarietyofnon-primemarkets,inautoloansand daily basis. Non-prime mortgages elsewhere.Tostreamlinetheexposition,Iwill are the common denominator in such diverse dropthemodifier“mortgage,”andyoucanassume recent developments as rising household fore- IamdiscussingthemortgagemarketunlessImake closure rates and collapsing hedge funds. You specificmentionofsomeothermarket. also may have read some of the news coverage Someoftheproblemswe’reseeinginthe of Federal Reserve Chairman Ben Bernanke’s non-primemarketmayhavebeeninevitablegiven testimony on this topic before Congress earlier thebreakneckinnovationandgrowthofrecent this week (Bernanke, 2007a). years,followedbyasignificantcoolingofhousing- Developmentsinthenon-primemortgage marketactivity.Yetitisimportantthatwelearn marketmattertotheFederalReserveforthree thecorrectlessonsfromtheseproblems.Inafuture mainreasons.First,thenon-primemortgage housing-marketslowdown,wewanttoavoid market—with2006originationsofaboutone repetitionofrecentproblems.Wealsowantto trilliondollars1—clearlyislargeenoughtoaffect preserveappropriateaccesstocreditbythose aggregatehomebuildingactivityandconsumer withimpairedcreditstanding.Thesubprime spending.Second,theFedalsosupervisessome marketinparticularisanimmaturemarket—a banksandmostfinanciallyorientedholdingcom- babymarketinage,thoughnotinsize—andwe panies;consistentwiththoseresponsibilities,the wanttoremembertheadageaboutnotdiscarding Fedismonitoringtheperformanceofnon-prime thebabywiththebathwater. mortgageloanscarefullyforsignsoffurthercredit Mypremisetodayisthatalastingimprovedeterioration.CongresshasgrantedtheFederal mentinthefunctioningofthenon-primemarket Reservetheauthoritytodefineunfairanddecep- ismostlikelyifwecorrectthefundamentalprobtiveactsandpracticesunderseveralimportant lemsthatseemtobecausingthegreatestdifficulfederalconsumer-protectionstatutes.Wetakethis ties,ratherthanattackingmeresymptomsofthe responsibilityseriously,andwearegathering problem.Topreviewmyconclusionbriefly,I informationnowtodeterminewhatelseweshould believethefundamentalproblemsinthenondotomodifydisclosureandotherregulations. primemortgagemarketamenabletoimprovement Mostofthenews,andmostoftheproblems, stemfrominadequateincentivesamongsomeof relatetothehighestriskpartofthenon-prime thepartiesoperatinginthemarkettocreateand mortgagemarket—thesubprimemarket.There maintainstrongreputationsforqualityandfairhavealsobeensomeproblemsintheso-called dealing.Asolidreputationisavaluableassetfor “Alt-A”market,whichliesbetweenprimeand theindividualfirm,fortheeconomyandsociety 1 Non-primemortgageoriginationsduring2006consistedofapproximately$600billionofsubprimeandabout$400billionofAlt-Amortgages. Thesetermsaredefinedbelow. 1

FINANCIALMARKETS asawhole.Thispointisnotanewone.“Myword ingatheringaccurateinformationaboutthenonismybond”hasbeenthemottooftheLondon primemortgagemarkets.Iwon’tdwellonthose StockExchangesince1801. here,butmytext,whichisavailableontheSt. Everylong-livedbusinessdependsontrust LouisFedwebsite,describesthesedifficulties inthemarketplace.Thefirmbenefitsfroma ingreaterdetail. durablebusinessfranchise,whichiswhybuild- Accordingtothefederalbankingandthrift ingtrustisimportanttothefirm.Theeconomy regulatoryagencies,subprimemortgagesare ismoreefficientbecausemarketdisciplineswill thosemadetoborrowerswhodisplay,among tendtoreduceshortsighted,opportunisticand othercharacteristics,(i)apreviousrecordof ultimatelywastefulbusinesspractices.Abetter- delinquency,foreclosureorbankruptcy,(ii)alow functioningmarketwillrequirelenderswhoare creditscore,and/or(iii)aratioofdebtserviceto betterinformedaboutborrowers’capacitytoserv- incomeof50percentorgreater(Officeofthe icedebtandborrowerswhoarebetterinformed ComptrolleroftheCurrency,etal.,2007).An aboutthecommitmentstheyaremaking.When Alt-Amortgage—shortfor“alternative-A”and lendersandborrowersalikeunderstandtheir alsoknownas“Aminus”—isonemadetoaborcommitmentsandrisks,sub-optimaloutcomes rowerwhomightbeofprimecreditqualitybut suchasmortgagewrite-downsandforeclosures whodoesnotqualifyforaprimeloanbecause arelesslikely.Societybenefitsfromamoreeffi- thereissomethingmissingorirregularintheloan cientuseofitsscarceresources. application.Theborrower’screditrecordmaybe I’llbeginbydescribingthecurrentnon-prime incompleteorslightlyimpaired,ortheborrower marketandprovidingsomebasicbackgroundon maybepurchasingthepropertyasaninvestment thesector.Nextcomesadiscussionoftheroleof ratherthantoliveinit(Chomsisengphetand mortgagebrokersandrealtorsandthereputations Pennington-Cross,2006).Anapplicationfileis theyestablish.I’llfinishwithafewcommentson deemedincompletewhenitismissingcertain theFederalReserve’soversightroleinthenon- information,as,forexample,whentheborrower primemarket,includingasummaryofwhatini- isunwillingorunabletodocumentincomeor tiativesandactionswe’reundertaking. assetstothelender’ssatisfaction.Anirregular Beforeproceeding,Iwanttoemphasizethat applicationmightbeonewheretheborrower theviewsIexpressherearemineanddonot doesnothavealargeenoughdownpaymentto necessarilyreflectofficialpositionsoftheFederal satisfythelender’sstandardunderwritingcrite- ReserveSystem.Ithankmycolleaguesatthe riaforprimecredit.Alternatively,theborrower’s FederalReserveBankofSt.Louisfortheircom- credithistorymaybeshort,perhapsbecausethe ments.WilliamR.Emmons,senioreconomistin borrowerisyoung.Thus,thenon-primemortgage theBankingSupervisionandRegulationDivision, sectorconsistsofmortgagesthatentailaborrowandRajdeepSengupta,economistintheResearch inghouseholdwithaB,CorDcreditgrade,a Division,providedspecialassistance.Iretain non-standardorincompleteloanapplicationor fullresponsibilityforerrors. credithistory,orallofthese. Non-primemortgagescarryinterestrates notablyhigherthanthoseonprimemortgages. THE NON-PRIME MORTGAGE Foranon-primefixed-ratemortgage(FRM),the spreadoveraprimeFRMcouldbeseveralper- MARKET: SUBPRIME AND ALT-A centagepoints,dependingontheborrowerand SECTORS theloan.Foranon-primeadjustable-ratemortgage Marketconventionisevolvingtowardadif- (ARM),theinitialratecouldbeone-halftoone ferentiationbetweenprimeandnon-primemort- percentagepointaboveacomparableprimeARM gages,andfurthertosubprimeandAlt-Asectors initialinterestrate,whilethefullyimplemented ofthenon-primemarket.Analystsfaceproblems marginofanon-primeARMcouldbetwoor 2

ReputationandtheNon-PrimeMortgageMarket threepercentagepointshigherthanthemargin primeandAlt-Asectorsincludeawidevariety onaprimeARM,itselflikelytobeasmuchas ofadjustableandhybridinterest-ratestructures, threepercentagepoints.2 togetherwitharangeofprincipal-amortization Higherratesareone,butnottheonly,impor- options.3Ofparticularnoteistherecentpopulartantdistinguishingcharacteristicofnon-prime ityofso-called“negativelyamortizing”mortgages, loans.Highratesarenecessaryforlenderstomake suchasthe“pay-optionARM.”Thefederalbankanadequatereturnoninvestmentwhenfacing ingandthriftsupervisoryagenciesissuedguidrelativelyhighunderwritingcostsandprospec- ancein2006thatdescribedthesecomplex tivelyhighdelinquencyanddefaultrates.Charg- mortgagesandprovideddirectiontosupervisors inghighrates,therefore,reflectscost-and andlendersonhowbesttoofferandmanage risk-basedpricingandcanbeperfectlyconsistent theseloans(OfficeoftheComptrollerofthe withcompetitivemarkets.Itisimportanttounder- Currency,etal.,2006). standthathighratesonnon-primemortgagesdo not,perse,indicateeitheralackofcompetition orpredatorybehaviorbylenders. EVOLUTION OF THE NON-PRIME Thereareseveralothernotabledifferences MORTGAGE MARKET betweenprimeandnon-primeloans.Primemortgagesaremorelikelytoincludeafixedinterest Intheprimemortgagemarket,securitization rateforthelifeoftheloanaswellasautomatic beganaround1970.Packagingmortgagesinto fundingof,anddisbursementfrom,anescrow securitieswasanimportantinnovation,asitperaccountusedtopaythehomeowner’staxesand mitteddevelopmentofasecondarymarketin insuranceobligations.Duringmostperiods,a mortgagesandallowedbanksandothermortgage largerfractionofprimemortgageloansarefor originatorstocontrolportfolioriskbyselling homepurchasethanforrefinancing,incontrast mortgagesintothecapitalmarket.Inthenontothenon-primesector,whererefinancingisa primemarket,securitizationbeganinearnestonly morecommonloanpurpose.Non-primeloans inthemid-1990s.Inpartbecausesecuritization typicallychargehigherup-frontfees,aremore expertiseanddistributionnetworksexisted likelytoincludeprepaymentpenalties,may alreadyforprimemortgages,thegrowthofnonacceptlimitedornodocumentationofthebor- primesecuritizationhasbeenevenmorerapid rower’sincomeorassets,andmaybeusedby thanearlydevelopmentsintheprimesector.It investorsratherthanbyowner-occupiers.Some tookabout35yearsforthreequartersofprime ofthesepracticesinthenon-primemarkethave mortgageoriginationstobesecuritized,buta beenresponsibleforhighdefaultratesanditisno comparablesharemaybereachedinhalfthe doubttruethatlendersaremuchmorecautious timeinthenon-primemarket(Chomsisengphet todaythanafewyearsagoinacceptinglimited andPennington-Cross,2006). documentation. Alongwithanincreasedvolumeofcredit- Anotherdistinguishingfeatureofthenon- relatedinformationabouthouseholdsand primesectorisproductinnovation.Incontrast improvementsincredit-riskanalysisbylenders, tothetraditional30-year,fixed-rate,amortizing securitizationprobablyisthekeyfactorthatsupmortgagethatdominatestheprimesector,thesub- portedtheburgeoninggrowthofthenon-prime 2 AnARMmarginistheamountbywhichtheborrower’sinterestrateexceedstheindexrate,suchasone-yearLIBOR. 3 Aso-calledhybridmortgagecommenceswithafixedrateforafewyearsandthenconvertstoanadjustablerateforthedurationofthemortgage term.Forexample,a2/28hybridhasafixedratefortwoyears,afterwhichtheratebeginstoadjusteverysixor12monthswithreferenceto anindexrate,suchassix-monthLIBORortheone-yearTreasuryyield.Asubprime2/28mortgagemightcarrya550basis-pointmargin,which meansthat,aftertheinitialtwo-year“teaser”ratehasexpired,thefullyindexedmortgageratewillbetheindexrateplus550basispoints. Theremaybecontractuallimitsonhowquicklythemortgageratemayadjusttowardthefullyindexedrate,aswellaslimitsonhowmuch themortgageratemaychangeduringthelifeoftheloan. 3

FINANCIALMARKETS mortgagemarketsincethemid-1990s.Byopening saidthat“theCommitteebelievesthatpolicy localnon-primemortgagemarketstonational accommodationcanberemovedatapacethatis andglobalcapitalmarkets,theflowofcapitalto likelytobemeasured.”Asimilarphraseappeared thesectorsurgedasneverbefore.Risinghouse insubsequentFOMCpolicystatementsuntil pricesalsoplayedanimportantrole,asborrowers December2005,whenthelanguagewaschanged andlenderscametoexpecthealthygainsinthe slightlyto“theCommitteejudgesthatsomefurther equitythatborrowershadintheirhouses,sup- measuredpolicyfirmingislikelytobeneeded.” portingmoreaggressiveloan-to-valueratiosin Atitsnextmeeting,inJanuary2006,thelanguage underwritingbothfirst-andsecond-lienmort- changedfrom“islikelytobeneeded”to“may gages.Finally,householdincomeshavegrown beneeded,”andsomewhatsimilarlanguage relativelyrapidlyincomparisontothecostof remainedinthepolicystatementthroughthe borrowing—especiallyduringtheearlypartof FOMCmeetinginJanuary2007. thisdecade,wheneconomicrecoverypreceded Giventhesewidelyheldexpectationsofrising thegradualupwardmovementofmarketinterest interestrates,itisdifficulttoavoidthejudgment rates. thattheseARMloanswerepoorlyunderwritten Oneaspectofrecentdevelopmentswasodd attheoutset.Itwasimprudentformortgagebroandhasturnedouttobethesourceofmuchdif- kersandlenderstoapproveborrowerswholikely ficultyinthenon-primemarket.Thesteepyield couldnotservicetheloanswhenratesrose,and curveduringmuchofthe2002-04periodreflected itissurprisingtomethatsophisticatedcapitalinvestorexpectationsthatshort-terminterestrates marketinvestorswillinglypurchasedsecurities wouldberising,whichtheyinfactdid.Yet,many backedbysuchpoorlyunderwrittenmortgages. mortgage-marketparticipantsapparentlydidnot Asanumberofobservershaveemphasized, anticipatethisincrease.Ofcourse,Iwouldnot rapidgrowthofthenon-primesectorhasbroadexpectaveragehomeownerstobeabletoread enedaccesstomortgagecreditinrecentyears. theyieldcurve,butIfinditoddthatapparently TheFederalReserve’sSurveyofConsumer sophisticatedinvestorsinnon-primemortgage- Financesprovidesdataonthepercentageoffambackedsecuritiesnowclaimsurprisethatmany iliesthathadsomemortgagedebtonaprimary non-primeARMborrowersarefacingpayment residenceatthree-yearintervalsbetween1989 shockbecauseoftheincreaseinshort-terminterest and2004.Between1989and1995,therewaslittle ratesoverthepastfewyears.Apparentlydriven changeinthefractionoffamiliesthathadafirst bytheprospectsofhighfeeincomeandsubstan- mortgageinanyincomegroup,exceptforthe tialspreadsonnon-primeARMs,mortgageorigi- incomegrouprepresentingthe20percentoffamnatorspersuadedmanyrelativelyunsophisticated ilieswiththelowestincomes,wherethefraction borrowerstotakeoutthesemortgages;then, offamilieswithmortgagesrosefrom7.6percent investorswillinglypurchasedthemwhenthey to10.4percent.Gainsforthesefamiliescontinued weresecuritized.Manyofthesemortgagesare after1995,withthefractionofthosewithmortnowindefault,someofthelendersarebankrupt, gagesrisingto15.9percentin2004.Thus,ina andthemortgage-backedsecuritiesaretradingat periodofonly15years,from1989to2004,the deepdiscountstofacevalue. percentageoffamiliesinthelowestincomequin- Itisimportanttoemphasizethatwhatisodd tilethathadmortgagesmorethandoubled. isnotthattherewasariskofrisingshort-term Between1995and2004,thefractionoffamiinterestrates,astherealwaysis,butthatthemar- lieswithamortgageonaprimaryresidence ketclearlyexpectedanincrease,asindicatedby increasednotablyinallincomegroups.The theshapeoftheyieldcurve.Thisexpectation,in largestincreaseswereamongfamiliesbelowthe turn,wasencouragedbytheFed’sOpenMarket highestincomequintile,suggestingthataccess Committee.Thepolicystatementissuedatthe tomortgagecreditmayhaveincreasedmostfor conclusionoftheFOMCmeetingofMay4,2004, familiesthatwereinthemiddleandlowerparts 4

ReputationandtheNon-PrimeMortgageMarket Table 1 Incidence of Mortgage Debt on Primary Residence Familyincomequintile Percentoffamiliesthathadsome I V All mortgagedebtonaprimaryresidence Lowest II III IV Highest families 1989 7.6 23.4 37.8 56.4 72.1 39.5 1995 10.4 25.9 38.2 59.1 71.4 41.0 2004 15.9 29.5 51.7 65.8 76.5 47.9 Change,1989-1995 +2.8 +2.5 +0.4 +2.7 –0.8 +1.5 Change,1995-2004 +5.5 +3.6 +13.5 +6.7 +5.1 +6.9 SOURCE:SurveyofConsumerFinances,BoardofGovernorsoftheFederalReserveSystem. oftheincomedistribution.Themiddle-income purchasedbyFannieMaeandFreddieMac,the quintile—thosefamilieswithincomesbetween federallycharteredmortgageinstitutions.Instead, the40thandthe60thpercentilesoftheincome amyriadofsmallerandspecializednondistribution—isparticularlystriking.Afteressen- depositorylenderspioneeredthesubprimeand tiallynoincreaseintheincidenceoffirstmort- Alt-Asectors,andregulatoryagenciesdidnot gagesbetween1989and1995,thefraction requirethesefirmstocollectandreportdatato increased13.5percentagepointsbetween1995 thesameextentastheirfederallyregulated and2004.Thisperiodcoincideswiththemost depository-institutioncounterparts. rapidgrowthofthenon-primemortgagemarket, Giventhesedisclaimersaboutthelimitsof anditislikelythatfamiliesinlowerandmiddleourknowledge,wedoknowthatthetotalamount incomegroupswereamongthosereceivingnonofhomemortgagesoutstandingattheendof primemortgages.Table1providesmorecomplete March2007wasabout$10.4trillion.Itappears data. thatasmuchas$1.3trillionofsubprimemortgages Thedatajustdiscussedcoverallmortgages. wasoutstandingatthattime,alongwithabout Comprehensive,long-termdataarenotreadily thesameamountofAlt-Amortgages(although availableontheshareofthenon-primemortgage differentdatasourcesprovidesomewhatdiffersectorinthetotalmarketoritscomposition.One entestimatesofthissector).Thus,thesubprime reasonforthelackofgooddataonthenon-prime andAlt-Asegmentseachrepresent13or14permarketisthatthetermsincommonusetoday— centoftheoverallmortgagemarket.Thesesectors subprimeandAlt-A,orborrowergradesB,Cand togetheraccountedforonlyabout10percentof D—arenotdefinedpreciselyorconsistently mortgageoriginationsin1995(Chomsisengphet acrosslendersoracrosstime.Anotherreasonfor andPennington-Cross,2006). thelackofagoodhistoricaldatabaseisthatwhat Thejumbosector—comprisingmortgages wenowcallthenon-primesectorwasquitesmall untilrecently,andthuswaseasilyoverlooked. largerthanthemaximumloansizeeligiblefor Yetanotherimportantreasonforthepaucityof purchasebyFannieMaeandFreddieMac—congooddataisthatthesetypesofmortgageswere, sistedofperhaps$2.5trillioninMarch2007, untilrecently,notevenofferedbydepository whileprime,conventional,conformingmortgages institutions(banks,thriftsorcreditunions)or comprisedtheremaining$5trillion.4Intermsof 4 ThemarketsharesIcitewereestimatedbyaprominentWallStreetinvestmentfirm,whileothersourcesprovidesomewhatdifferentmarket shares.Theprecisenumbersarenotimportantformypurposestoday. 5

FINANCIALMARKETS thenumberofsubprimeborrowers,thereare preneurialfirmthatcontributesmightilytoall about7.5millionfirst-liensubprimemortgages segmentsoftheU.S.economy.Itisquiteplausible outstanding(Bernanke,2007c),outofatotalof thatthesefirmsgenerallyaremoreknowledgemorethan50millionfirstmortgages. ablethanlargerlendersaboutlocalmarketsand Despitetheheterogeneityinthenon-prime borrowersandperhapscanbemoreresponsive market,thebottomlineisthatmorepeoplehave andinnovative.Theemployeesofalocalmortaccesstomortgagecreditnowthaneverbefore. gagebrokerarelikelytobelong-timeresidents Thenon-primemarkethasbecomeverylarge;it withastakeinthecommunity. isevolvingconstantly,andyetremainsrelatively Itisclearthatafirmoperatingwithlittle opaque.Despiteitslimitationsandflaws,the capitalinvestmentenjoyssomebenefits.One non-primemarkethasservedalargenumberof couldmentiontheeaseofopeningupanew borrowersverywell. business,ofincreasingordecreasingthescaleof operations,andofmovingorclosingdownthe business.Operatingunderaregimeof“light- BROKERS AND REALTORS IN touch”supervisionalsokeepscostslowand THE NON-PRIME MORTGAGE enhancesflexibility. MARKET Butthefinancialriskofoperatingwithlittle capitalisthatshockstotheoperatingenviron- OneofthekeyfeaturesoftheU.S.mortgage ment—suchasrecentdisruptionsinsecondary marketisthelargeroleplayedbyindependent marketsfornon-primemortgages—quicklycan mortgagebrokers.Mortgagebrokersarelicensed damage,ifnotdestroy,thebusiness.Oneofthe andsupervisedbystate,ratherthanfederal, benefitsoffinancialcapitalisthatitcanserveas authoritiesandthereforetheindustryisnotsuba“bufferstock”ofpatientfundingthatwillhelp jecttoasingle,consistentsupervisoryregime afirmsurviveadversedevelopmentsinitsmarket. acrossthenation.TheBureauofLaborStatistics Clearly,manymortgagebrokersarethinlycapireportsthatabout136,000peoplewereemployed talizedfirmsthatarefacingdifficulttimesnowin as“mortgageandnon-mortgageloanbrokers”in somemarketsandsegments.Manyhavealready May2007,upfromabout50,000justtenyears enteredbankruptcyandothersarelikelytofollow ago.Whilethelatestemploymentfigureisdown giventhescaleofthecurrentmortgage-market somewhatfromitsrecentpeakinearly2006,the downturn.Significantexitfromamarketsector sector’scumulativeemploymentgrowthduring isnotaproblemaslongassubsequententry recentyearsremainsimpressive(seeFigure1). remainsrelativelyeasy,asappearstobethecase Mortgagebrokersareespeciallyimportantin inmortgagebroking. thenon-primesector.Accordingtoaprivate Thereisreasonforconcernaboutthisbusiresearchfirm’sestimates,about58percentofall recentresidentialmortgageloansinvolvedamort- nessmodel,however,whencapitalissothinthat gagebroker,upfromabout40percentadecade ownershavelittletoloseifthebusinessceases ago.5About50percentofprimemortgagetrans- operations.Iftheownershaveasignificantfinanactionsinvolveabroker,butbrokersoriginated cialinvestmentinthebusiness,andifthiscapital around75percentofsubprimemortgagesand cannotbewithdrawneasily,thenthekeytoprofabout70percentofAlt-Aloans.Clearly,anon- itabilityislong-termsurvivalinordertoearn primeborrowerisespeciallylikelytodealwith returnsyearafteryearontheinvestedcapital. astate-licensedand-supervisedmortgagebroker. Theownersalwayswillkeeponeeyeonthe U.S.mortgagebrokersarepredominantly immediateprospectsforshort-termprofitand small,localfirms—preciselythetypeofentre- theothereyeonfutureprofitability. 5 SimonandHagerty(2007).TheresearchfirmwhoseestimatesIciteisWholesaleAccess,ofColumbia,Maryland. 6

ReputationandtheNon-PrimeMortgageMarket Figure 1 Employees of Mortgage and Nonmortgage Loan Brokers NotSeasonallyAdjusted,ThousandsofEmployees 150 150 125 125 100 100 75 75 50 50 25 25 90 95 00 05 SOURCE:BureauofLaborStatistics/HaverAnalytics. Inthemortgage-bankingbusiness,adurable Advertisingmayhelpgetoutafirm’sname, streamofprofitsrequiresacontinuingflowof butitisthefirm’sgoodnameandreputation customers,bothnewandrepeatbusiness.The spreadthroughwordofmouththatpaysthe businessalsorequiresacontinuingflowofcapital highestdividends.6AsformerFederalReserve frominvestorswillingtobuythemortgagesa ChairmanGreenspanaptlyputit,reputationcan mortgageoriginatorwantstosellandsecuritize. bethoughtofasavaluableassetinitsownright: Giventhedifficultyanymortgagebrokerlikely Trustasthenecessaryconditionforcommerce facesindifferentiatingitsownproducts,how wasparticularlyevidentinfreewheeling canabrokerstandoutfromthecrowdtobecome nineteenth-centuryAmerica,wherereputation along-termsurvivor?Onewayistogiveoutstandbecameavaluedasset…Insuchanenvironingservicetocustomersinthemortgage-shopping ment,areputationforhonestdealing,which process.Anotherwayistostandbehindthework manyfearedwasinshortsupply,wasparticthefirmdoesandtobetherewhenaprevious ularlyvalued.Eventhoseinclinedtobeless customer(orinvestor)hasaquestionorcomplaint. thanscrupulousintheirpersonaldealingshad Turningthesepracticesintofuturebusiness toadheretoamoreethicalstandardintheir prospects,attractingbothmortgageborrowers markettransactions,ortheyriskedbeingdriven andinvestors,ispreciselytheroleforreputation. outofbusiness(Greenspan,2005). 6 Idonotmeantosuggestthatonlymortgagebrokerswouldbenefitfromgreaterinvestmentsinreputationandfocusonthelongterm.Even somelargeWallStreetfirmsactiveinunderwriting,trading,andinvestinginnon-primemortgage-backedsecuritiesappeartohavehesitated inrecentmonthswhenaskedbysomeoftheircounterpartiestoprovethattheirreputationsareofgreatvalue—todemonstratetheoldadage infinancialmarkets,“Mywordismybond.”Giventhatthesefirmshavelargecapitalinvestmentsandthattheydealrepeatedlywitheach other,onewouldhavethoughtthatreputationwouldbesacrosanct. 7

FINANCIALMARKETS Thenon-primemortgagebusinessmaynot Whilenoneofthesedevelopmentsispleasant beasfreewheelingasnineteenth-centuryAmerica, forthelendersandfinancialfirmsmostdirectly butithascomeinforitsfairshareofcriticism affected,onecannothelpbeingimpressedwith recently,tobesure.Areputationforhonestdeal- theeven-handednessofitall.Untilwereceive ingsurelywouldbeaninvestmentwellworth clearevidencethatbasicallysoundfinancial makingbymanyoftoday’smarketparticipants decisionsandarrangementsweredisruptedby thatwouldpaydividendswellintothefuture— erraticandirrationalmarketforces,Ibelievewe notjustforthefirmsbuildingtheirreputations, shouldconcludethatthisyear’smarketspunished butforallothermarketparticipants,aswell. mostlybadactorsand/orpoorlendingpractices. Realtorsalsohaveanimportantresponsibil- Lenderswhomadeloanstoborrowerswithout ityinthemortgagemarket.Fromhappyexperidocumentation,orwhodidnotcheckborrower enceovertheyears,Imyselfknowhowvaluable documentsthatprovedfraudulent,orwhomade arealtorcanbeinprovidingadviceandinformaadjustable-rateloanstoborrowerswhocouldnot tiononneighborhoods,theirschools,quirksof hopetoservicethedebtwhenratesadjustedup, localgovernmentandeverythingelseahomedeservedfinancialfailure.Asisoftenthecase, ownershoulddiscoverbeforemakingacommitmenttobuyaparticularhouse.Realtorscanhelp themarket’spunishmentofunsoundfinancial potentialmortgageborrowersshopformortgages arrangementshasbeenswift,harshandwithout andselectmortgagetermsappropriateforthe prejudice. WhileIcannotfeelsorryforthe individualcircumstancesofeachborrower. lenderswhohavegoneoutofbusiness,myattitudeisentirelydifferenttowardtherelatively unsophisticated,buthonest,borrowerswho THE FEDERAL RESERVE AND havelosttheirhomesthroughforeclosure.Many THE NON-PRIME MORTGAGE aretruevictims. Likeotherobservers,wehavenotedwith MARKET greatconcerntheincreasingdelinquencyand TheFederalReservehadfolloweddevelopforeclosureratesoncertainnon-primeloancatementsinhousingandthenon-primemortgage goriesduring2006and2007.BecauseCongress marketsverycloselythisyear(Bernanke,2007a, hasassignedtotheFederalReserveandtothe 2007b,2007c).Ahighlyvisibledevelopmentis FederalTradeCommissiontheprimaryresponthegrowingamountoffinancialstressamong sibilityofinterpretingandimplementingseveral someofthemillionsofhouseholdswithnonimportantconsumer-protectionstatutes,we primemortgages.Weknowthatmanynon-prime havebeenundertakinganumberofconsumermortgagelendersandbrokershavegoneoutof protectioninitiativesandactions.7Wehavebeen businessortightenedtheirlendingstandardsthis workingonrevisingrequiredcredit-carddiscloyear,reducingtheflowofmortgagecredittoborsuresforseveralyearsand,beginningin2006,we rowersunabletoaccesstheprimemarket.Financialmarketshavedealtharshly,butonthewhole haveturnedourattentionincreasinglytononappropriately,withbanks,hedgefundsandcer- prime-mortgageissues.Iwilllistbrieflysomeof tainotherinvestorswhowereheavilyexposed themoreimportantrecentFederalReservecontotheriskiestsegmentsofthenon-primesecuri- sumer-protectioninitiativesrelatedtonon-prime tizedmortgagemarket. mortgages:8 7 Mostnotably,theFederalReserveisresponsibleforimplementingtheTruthinLendingAct(TILA,implementedasRegulationZ)andfor definingunfairanddeceptiveactsandpracticesunderandtheHomeMortgageDisclosureAct(HMDA,implementedasRegulationC)and itskeyamendments,theHomeOwnershipandEquityProtectionAct(HOEPA),andundertheFederalTradeCommissionAct(FTCAct). TheFed’senforcementauthority,however,islimitedtothefinancialinstitutionstheFederalReservesupervisesdirectly. 8 Formoredetails,seeChairmanBernanke’sCongressionaltestimony(Bernanke,2007a). 8

ReputationandtheNon-PrimeMortgageMarket • Incoordinationwiththeotherfederal • Weplantoexerciseourauthorityunderthe supervisoryagencies,weareencouraging HomeOwnershipandEquityProtection thefinancialindustrytoworkwithborrow- Act(HOEPA)toaddressspecificpractices erstoarrangeprudentloanmodifications thatareunfairordeceptive,includingbut toavoidunnecessaryforeclosures. notlimitedtopre-paymentpenalties,the useofescrowaccountsfortaxesandinsur- • FederalReservebanksaroundthecountry ance,stated-incomeandlow-documentation arecooperatingwithcommunityand lending,andtheevaluationofaborrower’s industrygroupsthatworkdirectlywith abilitytorepay. borrowershavingtroublemeetingtheir mortgageobligations. • Incoordinationwiththeotherfederal supervisoryagencies,in2006,theFed • Weareworkingwithorganizationsthat issuedprinciples-basedguidanceonnonprovidecounselingaboutmortgageprodtraditionalmortgages,and,inJuneof2007, uctstocurrentandpotentialhomeowners. theFedissuedsupervisoryguidanceon • Wearemeetingwithmarketparticipants— subprimelending. includinglenders,investors,servicersand • Wereviewedourpoliciesrelatedtothe communitygroups—todiscusstheirconexaminationofnon-banksubsidiariesof cernsandtogaininformationaboutmarket bankandfinancialholdingcompaniesfor developments. compliancewithconsumerprotectionlaws • Weareconductingatop-to-bottomreview andguidance. ofpossibleactionswemighttaketohelp • Asaresultofthatreviewandfollowing preventrecurrenceofrecentproblems, discussionswiththeOfficeofThrift includingmore-effectivedisclosuresto Supervision,theFederalTradeCommission helpconsumersdefendagainstimproper andstateregulators,asrepresentedbythe lending. ConferenceofStateBankSupervisorsand • Weheldfivepublichearingsacrossthe theAmericanAssociationofResidential countryduring2006and2007,during MortgageRegulators,wearelaunchinga whichwegatheredinformationonthe cooperativepilotprojectaimedatexpanding adequacyofdisclosuresformortgages,parconsumerprotectioncompliancereviews ticularlyfornontraditionalandadjustableatselectednon-depositorylenderswith rateproducts(seeKroszner,2007,formore significantsubprimemortgageoperations. information). Basedontheseactivities,Ithinkyouwill • Bytheendoftheyear,wewillpropose agreethattheFederalReservetakesitsconsumerchangestoTILArulestoaddressconcerns protectionresponsibilitiesintheareaofnonaboutmortgageloanadvertisementsand primemortgagelendingveryseriously. solicitationsthatmaybeincompleteor misleadingandtorequirelenderstoprovidemortgagedisclosuresmorequicklyso thatconsumerscangettheinformation CONCLUDING REMARKS theyneedwhenitismostusefultothem. Everymortgageforeclosureisatragedyfor • Wehaveimprovedadisclosurethatcredi- theborrower,exceptperhapsthosewherethe torsmustprovidetoeveryapplicantforan borrowerparticipatedinafraud.Yetthisobseradjustable-ratemortgageproducttoexplain vationdoesnotbyitselfsuggestwhatcanor betterthefeaturesandrisksoftheseprod- shouldbedonetoimprovethefunctioningof ucts,suchas“paymentshock”andrising themortgagemarket.Basedonmyobservation loanbalances. offinancialmarkets,institutionsandregulation 9

FINANCIALMARKETS overmanyyears,Iamconvincedthatweneedto http://www.federalreserve.gov/boarddocs/speeches/ searchforwaystostrengthenborrowerprotections 2007/20070605/default.htm. withoutsoincreasingregulatorycostsandrisks tolendersthattheywithdrawfromthenon-prime Bernanke,BenS.“TheSubprimeMortgageMarket.” market.Whenweconsiderregulationsdesigned PresentedattheFederalReserveBankofChicago’s toaddressabusivelendingpractices,weneedto 43rdAnnualConferenceonBankStructureand understandtheirpossibleimpactonresponsible Competition,Chicago,Illinois,May17,2007c, http://www.federalreserve.gov/boarddocs/speeches/ lenders.Wewillnotbehelpingpotentialborrow- 2007/20070517/default.htm. ersifweeliminateabusesbyimposingregulations thathavetheunintendedeffectofeliminating Chomsisengphet,SouphalaandPennington-Cross, theentiresubprimemarket.Mycommentisnot Anthony.“TheEvolutionoftheSubprimeMortgage acounselofdespair,butacounselofcaution. Market.”FederalReserveBankofSt.LouisReview, Regulatorsneedtobecreativeandnotnecessarily January/February2006,88(1),pp.31-56, inactive. http://research.stlouisfed.org/publications/review/ Weneedtoemphasizeindividualresponsi- 06/01/ChomPennCross.pdf. bilityandaccountabilityineverycornerofthe market.Lendersandbrokerswhoputnaivebor- Greenspan,Alan.“CommencementAddress.” rowersintounsuitablemortgages,whichlatergo PresentedattheWhartonSchool,Universityof intodefault,deservethelossestheysuffer.But Pennsylvania,Philadelphia,Pennsylvania,May15, theselendersandbrokersalsolosealong-term 2005,http://www.federalreserve.gov/boarddocs/ businessopportunity.Asuccessfulborrower, speeches/2005/20050515/. whoisabletostaycurrentonasubprimemortgage,canexpecttobecomeaprimeborrowerin Kroszner,RandallS.“EncouragingResponsible time.Everymortgagelenderorbrokershould MortgageLending:ProspectiveRulemaking wantthatborrowertobecomearepeatcustomer. Initiatives.”Presentedatthepublichearingunder Regulatorsshoulddowhattheycantohelp theHomeOwnershipandEquityProtectionAct educateborrowersandencourageimprovements (HOEPA),FederalReserveBoard,Washington,DC, ofincentivesandbusinesspractices.Ifanyof June14,2007. youbelievetherearewaystheFederalReserve canhelpinprovidinginformation,Ihopeyou OfficeoftheComptrolleroftheCurrency,etal,Joint willcallonussowecanbepartnersinthis PressRelease,“FederalFinancialRegulatory endeavor. AgenciesIssueFinalGuidanceonNontraditional Thankyou,andI’dbedelightedtotakeyour MortgageProductRisks,”Sept.29,2006, questions. http://www.federalreserve.gov/boarddocs/press/ bcreg/2006/20060929/default.htm. OfficeoftheComptrolleroftheCurrency,etal,Joint REFERENCES PressRelease,“FederalFinancialRegulatory Bernanke,BenS.“SemiannualMonetaryPolicy AgenciesIssueFinalStatementonSubprime ReporttoCongress.”PresentedtotheCommitteeon MortgageLending,”June29,2007. FinancialServices,U.S.HouseofRepresentatives, July18,2007a,http://www.federalreserve.gov/ Quigley,JohnM.“FederalCreditandInsurance boarddocs/hh/2007/july/testimony.htm. Programs:Housing.”FederalReserveBankofSt. LouisReview,July/August2006,88(4),pp.281-309. Bernanke,BenS.“TheHousingMarketandSubprime Lending.”Presentedtothe2007International Simon,Ruth,andHagerty,JamesR.“MortgageMess MonetaryConference,CapeTown,SouthAfrica ShinesLightonBrokers’Role.”WallStreet (viasatellite),June5,2007b, Journal,July5,2007,p.A1. 10

ReputationandtheNon-PrimeMortgageMarket APPENDIX Classifying the Non-Prime Mortgage Market Thereareseveralconceptuallydistinctapproachestoclassifyingthevarioussegmentsoftheresidentialmortgagemarket.Thesectorclassificationssometimesoverlapeachother,andsometimesthey createanomaliesofvarioussorts.Thisappendixprovidesabriefintroductiontosomeoftheclassificationschemesusedinthemortgagemarket. Conventional vs. Non-Conventional. One way to split the market is to distinguish between government-insured or -guaranteed mortgages and the private, or “conventional” sector. The government(non-conventional)sectorcomprisesmortgagesmadebyprivatelendersbutbackedbytheFederal Housing Administration (FHA) or the Veterans Administration (VA). Government-guaranteed mortgages constitute only about 10 percent of the total market today.9 Conforming vs. Non-Conforming. Another way to split the mortgage market is to distinguish between mortgages eligible for purchase by Fannie Mae and Freddie Mac—so-called “conforming” mortgages—and all others (“non-conforming”). The conforming share of the market is perhaps 70 percent in the sense that this fraction of borrowing households could qualify for a mortgage eligible for purchase by Fannie or Freddie if they chose to submit such an application. The actual purchases madebyFannieMaeandFreddieMacwerejustover50percentofthetotalmarketearlierthisdecade and now are below half. In addition, some conforming mortgages are held by the loan originators or sold to others without the intermediation of Fannie or Freddie. Theconformingmarketisentirelyconventionalandprime,butthereareconventionalandprime mortgagesthatarenotconforming.Thenon-conformingsectorincludes“jumbo”mortgages—those largerthantheupperlimitplacedbylawonFannieandFreddiepurchases—andothersthatfailtomeet FannieandFreddieunderwritingguidelinesforonereasonoranother.Thesubprime,Alt-Aandjumbo sectorsemergedfromtheconventional,non-conformingpartofthemortgagemarket. Subprime Mortgage Lenders vs. Prime Lenders. A third mortgage classification scheme is especiallyimportantforunderstandingthesubprimesectorandfederalconsumer-protectioneffortsinthis area. The U.S. Department of Housing and Urban Development (HUD) deems all mortgage loans subprime that are made by a lending institution engaged primarily in that business line.10 While not idealfromananalyticalperspectivebecauseitlumpstogethersomedissimilarmortgagesandborrowerssimplybecausetheyhaveacommonoriginator,theHUDclassificationschemeisextremelyimportantinpracticalterms.11ThisclassificationconventionisfollowedbothforHomeMortgageDisclosure Act (HMDA) reporting purposes and by the Mortgage Bankers Association when compiling its widely used mortgage-originations and -delinquency surveys. SubprimeMortgageProductsandPracticesvs.PrimeProductsandPractices.Afourthapproach todeterminingwhatthenon-primemarketiscouldbetermedaproduct-andpractices-basedapproach. Someconsumeradvocateshavearguedthatcertainmortgagefeatures,producttypesorunderwriting practicesaretargetedtovulnerablepopulations,suchasminorities,women,householdswithirregular incomesandothers.Theseadvocatesarguethatsomefeatures,productsandpractices—suchaspre- 9 Formoreinformationongovernmentmortgageprograms,seeQuigley(2006). 10FordetailsofHUD’smethodologyandalistofsubprimelenders,seetheHUDwebsite,http://www.huduser.org/datasets/manu.html. 11FormoreinformationonHMDAandtheHomeOwnershipandEquityProtectionActamendmentstoHMDA,see http://stlouisfed.org/hmdaregcamendments/default.html. 11

FINANCIALMARKETS paymentpenalties,hybridARMswithintroductoryteaserrates,underwritingwithoutregardtolongrunmortgageaffordabilityandyield-spreadpremiumspaidtobrokersbylenders—aredeceptiveand abusiveintheirownrights.Inotherwords,theadvocatesarguethatthesefeatures,productsandpracticesshouldbeconsideredpersesubprime—ifnotpredatory—anddeservingofgreateroversight.In thisview,someborrowerswhocouldhavequalifiedforaprimemortgageendupwithmore-expensive subprimeorAlt-Aloansbecausetheyarepartofagroupthatistargetedtoreceiveanon-primemortgage. 12