REQUIRED READING: Stabilizing The Housing Market

Written by Elizabeth A. Duke
on February 18, 2009 No Comments
Categories : Required Reading

Housing activity remains extraordinarily weak. Sales of new and existing homes have been running at a pace that is 60% of that seen at the peak in 2005. Single-family housing starts are now less than one-quarter of their peak level. With the cutbacks in construction, inventories of unsold new homes have declined, but the supply – that is, inventories relative to sales – is still very high by historical standards.

The inventory of existing homes for sale is also quite elevated – and it would be even higher if not for would-be sellers that have withheld or withdrawn their homes from the market amid poor selling conditions.

All indications are that the softness in housing activity is likely to persist for some time. In normal times, population growth and the attendant formation of new households tend to support housing demand. Indeed, by some estimates, the current stock of housing is not high relative to the number of housing units that would be predicted by long-run trends in household formation.

However, the actual number of households has fallen well short of trend household formation. Macroeconomic conditions no doubt explain part of the shortfall in household formation, as, for example, younger people facing weak job prospects defer striking out on their own.

More generally, the soft economy has diminished demand for housing among already established households. High rates of job loss and weak income growth are directly reducing what some individuals can spend on housing, and the prospect of losing a job or suffering an income loss is damping the housing demand of others.

Several considerations underscore the need for policy-makers to take further actions to address the problems in the housing and mortgage markets. To begin, the weakness in the housing sector remains a significant drag on the macroeconomy and is reinforcing the strains in the financial system. Moreover, the wave of foreclosures has the potential to exacerbate the problems going forward.

In addition, foreclosures cause significant distress among the families that lose their homes. Whether the foreclosure is the result of inadequate underwriting by the mortgage lender, irresponsibility on the part of the homeowner, or uncontrollable life events such as job loss, the result is the same: Displaced families with depleted resources and impaired credit have difficulty finding a new place to live. They may have to move significant distances, which may affect their ability to retain their jobs and disrupt other aspects of their lives as well as the lives of their family members.

The effects of foreclosure extend beyond these immediate families. One in five foreclosures appears to be affecting renter-occupied units. The families in these units may also be displaced, even if they are paying their rent on time and abiding by the terms of their lease agreement. In areas where foreclosures are concentrated, communities will suffer. Clusters of vacant properties can foster vandalism and crime, and studies have shown that they lead to lower house prices throughout the neighborhood.

Municipal governments may have to spend more on maintaining properties and preventing crime, such as vandalism and arson, just when resources are stretched thin, in part because of the lower tax revenue associated with lower house prices. Such spending may well crowd out the provision of other types of public services.

Fiscal and monetary stimulus directed at improving employment conditions and federal support for housing finance will ultimately strengthen the housing market. However, we also need measures that directly address the foreclosure problem. In designing such measures, we must consider the different types of borrowers.

Avoiding foreclosures

First, there are distressed borrowers who can avoid foreclosure through an appropriate modification of their loan. Second, there are some borrowers who, due to resources or circumstance, will be unable or unwilling to sustain their mortgage payments, even with reasonable loan adjustments from the lender or support from government programs. In such cases, foreclosures will happen, and we need to limit both the direct costs to the borrower and the broader social costs. Of course, there is a third group of borrowers -those who are still successfully meeting their mortgage obligations.

One might be tempted to view these households as a lesser concern, but we must be mindful that they will be more likely to shift into one of the distressed groups if we do not reduce both the number of foreclosures and the cost of the foreclosures that do occur.

To help distressed households for which foreclosure can be prevented, servicers must implement effective and sustainable modifications. Key private and public steps toward preventing unnecessary foreclosures have already been taken. For example, the industry-led HOPE NOW Alliance has produced loss mitigation guidelines for servicers. In addition, HOPE NOW members have agreed to adopt a streamlined modification program for certain loans that they service for the government-sponsored enterprises (GSEs).

Among government efforts, the FHASecure program provided long-term fixed-rate mortgages to borrowers facing a rise in payments due to an interest rate reset. The more recent Federal Housing Administration (FHA) Hope for Homeowners (H4H) program allows lenders to refinance a delinquent borrower into an FHA-insured fixed-rate mortgage if the lender writes down the mortgage balance to create some home equity for the borrower and pays an up-front insurance premium. In exchange for being put ‘above water’ on the mortgage, the borrower is required to share any equity created through the refinancing and any subsequent appreciation of the home with the government.

Although the pace of loan modification has picked up over the past year, more needs to be done. Indeed, many cases still seem to be appearing in which foreclosure is occurring even though both the borrower and lender would benefit from avoiding that outcome. There are several potential ways that the Congress and policy-makers can help expand the number of at-risk borrowers who can obtain assistance and reduce the incidence of preventable foreclosures.

For example, the impact of the H4H program has so far been limited because of the terms and conditions for program loans mandated by the authorizing legislation and because of the general reluctance of servicers and lenders to write down the principal of delinquent mortgages. Congress is currently considering several modifications to the H4H program that have the potential to make the program more attractive to both servicers and homeowners.

These modifications include eliminating the up-front mortgage premium that must be paid by the owner of the current mortgage and the requirement that borrowers share with the government a portion of any future appreciation in the property.

Among other options that Congress or the government might consider is reducing the interest rate that H4H borrowers pay, either through a direct subsidy or through Treasury purchases of the relatively illiquid Ginnie Mae securities to which the borrowers' interest rate is tied. The government might also consider purchasing delinquent or at-risk mortgages in bulk and then refinancing them into the H4H or other FHA programs.

In addition, government funds might be used to offer some general inducement for servicers to modify loans at risk of default. For example, the Federal Deposit Insurance Corp. (FDIC) has proposed that, for loans modified in accordance with a streamlined process adapted from the protocol that the FDIC has used for IndyMac loans, the government would agree to absorb some of the losses on the modified loans that redefault. Another approach would have the government share with the servicer the cost of a reduction in the borrower's monthly payment.

Alternatively, the government might make payments directly to homeowners who – because of temporary job loss or a similar event – need help meeting their mortgage obligations. Because institutional and legal obstacles may be holding back modifications by servicers, these plans could be effective ways to deliver assistance to some distressed homeowners.

Reducing costs on foreclosures

Without in any way minimizing the need for continued emphasis on foreclosure prevention, I don't believe we can fully formulate appropriate policy responses to the crisis unless we acknowledge and address the large numbers of foreclosures that are not avoidable. We are likely only beginning to see the serious costs of the foreclosures that have already been initiated, both because of the often substantial amount of time required to complete a foreclosure and because the costs likely compound as the number of foreclosures grows larger.

Moreover, even under optimistic assumptions for the number of loan modifications and other forms of private and public assistance that may be realized, the pace at which foreclosures are initiated is likely to remain extremely elevated for some time. Just as public focus, experimentation and policy debate have informed best practices with regard to loan modifications, we must also begin the work of developing responsible foreclosure and real estate inventory management protocols.

Minimizing the amount of time that properties remain vacant and maximizing the price at which they are sold will serve the interests of both lenders and the communities. At this moment, lenders and communities alike are woefully under-resourced and unprepared for the volume of real estate that will need to be processed.

Given the likely number of properties that will enter foreclosure and the time and resources involved in the foreclosure process, financial institutions can help minimize the cost by developing clear policies and procedures for approval of short sales and deeds in lieu of foreclosure. For homeowners who cannot, or no longer wish to, stay in their homes, such strategies would release them from their obligation and avoid foreclosure.

Some institutions offer a so-called fresh start or cash-for-keys program, in which they provide a payment to consumers in exchange for voluntarily surrendering the deed to the home. Such arrangements reduce the cost of foreclosure and effectively provide the borrower with funds that can help offset some of the expenses associated with relocation. Other lenders are offering borrowers the option to remain in the house as renters rather than owners. Options such as these could be offered in conjunction with loan modification programs as further inducement for borrowers to engage in loan resolution discussions.

If renters occupy the property, servicers of real estate owned (REO) properties should extend existing lease arrangements, when possible, and while tenants are abiding by the terms of their lease. Some REO owners, including Fannie Mae and Freddie Mac, are already taking steps to minimize the disruption and displacement to renters living in foreclosed-upon properties.

Vacant properties are especially problematic for communities. Ideally, lenders would identify early in the process whether or not property securing delinquent loans is occupied and, if occupied, by whom. Lenders might be provided the incentive to do so if foreclosure laws permitted lenders who agree to secure and maintain the property to accelerate foreclosure in cases where the property has been vacated.

If a property is likely to sit vacant for long periods of time and create problems for the surrounding area, servicers might consider sale of REO properties to, or partnerships with, responsible third parties, including local governments and nonprofit groups. And financial institutions should look for ways to partner with community groups and governments to support strategies to stabilize communities affected by foreclosure. Last summer, the Congress set aside $3.92 billion through the Housing and Economic Recovery Act of 2008 to assist state and local governments with REO purchases and related efforts.

It is likely that such efforts will require significantly more funding. In addition, regulators should consider whether to review regulations regarding real estate held for extended periods of time on bank balance sheets to be sure that they do not preclude creative solutions to the foreclosure problem.

The last credit cycle primarily involved loans secured with commercial property. The properties liquidated by banks and the Resolution Trust Corp. weighed on commercial property values for years. This time, we are talking about homes, and we are talking about neighborhoods. Whether mortgage assets are taken off banks' balance sheets, ring fenced, or left alone, the REO problem remains the same. Regardless of which entities actually own the loan assets – be they financial institutions, investors or government entities – the servicers who represent them are going to have to deal with large real estate inventories.

Wholesale dumping of those inventories that leads to sharply lower prices and recovery rates will not serve the interests of the public or the investors. But strategies to avoid dumping and to maximize the ultimate value of the properties could be beyond the normal liquidity and expertise resources of servicers. To avoid such an outcome, owners of the assets will need to adequately fund servicers or separately engage property managers.

For example, they may need funding to repair and improve properties, which will lead to higher returns than sale of those same properties in ‘as is’ condition. They may need to offer seller financing. Bulk sale or land banking strategies may offer the best likely outcome. Using today's technology, Internet auctions could increase the pool of potential buyers as well as price transparency.

In summary, broadly targeted policy is a central ingredient to restoring the health of the U.S. economy and global financial system. However, as I have discussed today, there is also a pressing need for more policy measures that specifically address the problems in the housing sector. We need considerable public support for housing finance until private credit and securitization markets are restarted. We need to strengthen and augment our efforts to reduce preventable foreclosures.

In addition, we need to turn far greater attention to limiting the costs of foreclosures that do occur. Such efforts are not only in the interest of the affected families and their communities, but also in the interest of the financial institutions involved and the broader economy. Because much of the costs do not occur immediately after a foreclosure has been initiated and can grow with time, we must be forward-looking and affirmatively engage in efforts to mitigate the consequences now.

Elizabeth A. Duke is a governor with the Federal Reserve System. This article is adapted from a speech delivered on Feb. 11 at the Global Association of Risk Professionals Risk Management Convention in New York.

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