The following is an excerpt from the transcript of recent comments made by Fed Chairman Ben S. Bernanke before the Committee on Financial Services, U.S. House of Representatives. The entire transcript can be found here.
Beyond the actions underway at the regulatory agencies, I am aware that the Congress is considering statutory changes to help alleviate the problem of foreclosures. Modernizing the programs administered by the Federal Housing Administration (FHA) is one promising direction. The FHA has considerable experience in providing home financing for low- and moderate-income borrowers. It insures mortgages made to borrowers who meet certain underwriting criteria and who pay premiums into a reserve fund that is designated to cover the costs in the event of default. This insurance makes the loans less risky for lenders and investors, and it makes the loans eligible for securitization through the Government National Mortgage Association (Ginnie Mae).
Historically, the FHA has played an important role in the mortgage market, particularly for first-time home buyers. However, 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. In addition, maximum loan values that the FHA will insure have failed to keep pace with rising home values in many areas of the country.
In modernizing FHA programs, Congress might wish to be guided by design principles that allow flexibility and risk-based pricing. To alleviate foreclosures, the FHA could be encouraged to collaborate with the private sector to expedite the refinancing of creditworthy subprime borrowers facing large resets. Other changes could allow the agency more flexibility to design new products that improve affordability through features such as variable maturities or shared appreciation. In addition, creating risk-based FHA insurance premiums that match insurance premiums with borrowers’ credit profiles would give more households access to refinancing options.
The risk of moral hazard must be considered in designing government-backed programs; such programs should not bail out failed investors, as doing so would only encourage excessive risk-taking. One must also consider adverse selection; programs that provide credit to only the weakest eligible borrowers are likely to be more costly than those that serve a broader risk spectrum. Risk-based insurance premiums or tighter screening and monitoring by lenders can mitigate adverse selection. But ultimately such mechanisms have their limits, and no government program will be able to provide meaningful help to the highest-risk borrowers without a public subsidy. Whether such subsidies should be employed is a decision for the Congress.
The government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac are, to a limited extent, assisting in subprime refinancings and should be encouraged to provide products for subprime borrowers to the extent permitted by their charters. However, the GSE charters are likely to limit the ability of the GSEs to serve any but the most creditworthy subprime borrowers. Indeed, if GSE programs remove the strongest borrowers from the pool, the risks faced by other programs—such as a modernized FHA program—could be increased.
Some have suggested that the GSEs could help restore functioning in the secondary markets for non-conforming mortgages (specifically jumbo mortgages, those with principal value greater than $417,000) if the conforming-loan limits were raised. However, in my view, the reason that GSE securitizations are well-accepted in the secondary market is because they come with GSE-provided guarantees of financial performance, which market participants appear to treat as backed by the full faith and credit of the U.S. government, even though this federal guarantee does not exist. Evidently, market participants believe that, in the event of the failure of a GSE, the government would have no alternative but to come to the rescue. The perception, however inaccurate, that the GSEs are fully government-backed implies that investors have few incentives in their role as counterparties or creditors to act to constrain GSE risk-taking. Raising the conforming-loan limit would expand this implied guarantee to another portion of the mortgage market, reducing market discipline further. If, despite these considerations, the Congress were inclined to move in this direction, it should assess whether such action could be taken in a way that is both explicitly temporary and able to be implemented sufficiently promptly to serve its intended purpose. Any benefits that might conceivably accrue to this action would likely be lost if implementation were significantly delayed, as private securitization activity would likely be inhibited in the interim.
