Bernanke's Speech at the Kansas City Fed Symposium
August 31, 2007— -- Over the years, Tom Hoenig and his colleagues at the Federal Reserve Bank of Kansas City have done an excellent job of selecting interesting and relevant topics for this annual symposium. I think I can safely say that this year they have outdone themselves. Recently, the subject of housing finance has preoccupied financial-market participants and observers in the United States and around the world. The financial turbulence we have seen had its immediate origins in the problems in the subprime mortgage market, but the effects have been felt in the broader mortgage market and in financial markets more generally, with potential consequences for the performance of the overall economy.
In my remarks this morning, I will begin with some observations about recent market developments and their economic implications. I will then try to place recent events in a broader historical context by discussing the evolution of housing markets and housing finance in the United States. In particular, I will argue that, over the years, institutional changes in U.S. housing and mortgage markets have significantly influenced both the transmission of monetary policy and the economy's cyclical dynamics. As our system of housing finance continues to evolve, understanding these linkages not only provides useful insights into the past but also holds the promise of helping us better cope with the implications of future developments.
Recent Developments in Financial Markets and the Economy
I will begin my review of recent developments by discussing the housing situation. As you know, the downturn in the housing market, which began in the summer of 2005, has been sharp. Sales of new and existing homes have declined significantly from their mid-2005 peaks and have remained slow in recent months. As demand has weakened, house prices have decelerated or even declined by some measures, and homebuilders have scaled back their construction of new homes. The cutback in residential construction has directly reduced the annual rate of U.S. economic growth about 3/4 percentage point on average over the past year and a half. Despite the slowdown in construction, the stock of unsold new homes remains quite elevated relative to sales, suggesting that further declines in homebuilding are likely.
The outlook for home sales and construction will also depend on unfolding developments in mortgage markets. A substantial increase in lending to nonprime borrowers contributed to the bulge in residential investment in 2004 and 2005, and the tightening of credit conditions for these borrowers likely accounts for some of the continued softening in demand we have seen this year. As I will discuss, recent market developments have resulted in additional tightening of rates and terms for nonprime borrowers as well as for potential borrowers through "jumbo" mortgages. Obviously, if current conditions persist in mortgage markets, the demand for homes could weaken further, with possible implications for the broader economy. We are following these developments closely.
As house prices have softened, and as interest rates have risen from the low levels of a couple of years ago, we have seen a marked deterioration in the performance of nonprime mortgages. The problems have been most severe for subprime mortgages with adjustable rates: the proportion of those loans with serious delinquencies rose to about 13-1/2 percent in June, more than double the recent low seen in mid-2005.1 The adjustable-rate subprime mortgages originated in late 2005 and in 2006 have performed the worst, in part because of slippage in underwriting standards, reflected for example in high loan-to-value ratios and incomplete documentation. With many of these borrowers facing their first interest rate resets in coming quarters, and with softness in house prices expected to continue to impede refinancing, delinquencies among this class of mortgages are likely to rise further. Apart from adjustable-rate subprime mortgages, however, the deterioration in performance has been less pronounced, at least to this point. For subprime mortgages with fixed rather than variable rates, for example, serious delinquencies have been fairly stable at about 5-1/2 percent. The rate of serious delinquencies on alt-A securitized pools rose to nearly 3 percent in June, from a low of less than 1 percent in mid-2005. Delinquency rates on prime jumbo mortgages have also risen, though they are lower than those for prime conforming loans, and both rates are below 1 percent.
Investors' concerns about mortgage credit performance have intensified sharply in recent weeks, reflecting, among other factors, worries about the housing market and the effects of impending interest-rate resets on borrowers' ability to remain current. Credit spreads on new securities backed by subprime mortgages, which had jumped earlier this year, rose significantly more in July. Issuance of such securities has been negligible since then, as dealers have faced difficulties placing even the AAA-rated tranches. Issuance of securities backed by alt-A and prime jumbo mortgages also has fallen sharply, as investors have evidently become concerned that the losses associated with these types of mortgages may be higher than had been expected.
With securitization impaired, some major lenders have announced the cancellation of their adjustable-rate subprime lending programs. A number of others that specialize in nontraditional mortgages have been forced by funding pressures to scale back or close down. Some lenders that sponsor asset-backed commercial paper conduits as bridge financing for their mortgage originations have been unable to "roll" the maturing paper, forcing them to draw on back-up liquidity facilities or to exercise options to extend the maturity of their paper. As a result of these developments, borrowers face noticeably tighter terms and standards for all but conforming mortgages.
As you know, the financial stress has not been confined to mortgage markets. The markets for asset-backed commercial paper and for lower-rated unsecured commercial paper market also have suffered from pronounced declines in investor demand, and the associated flight to quality has contributed to surges in the demand for short-dated Treasury bills, pushing T-bill rates down sharply on some days. Swings in stock prices have been sharp, with implied price volatilities rising to about twice the levels seen in the spring. Credit spreads for a range of financial instruments have widened, notably for lower-rated corporate credits. Diminished demand for loans and bonds to finance highly leveraged transactions has increased some banks' concerns that they may have to bring significant quantities of these instruments onto their balance sheets. These banks, as well as those that have committed to serve as back-up facilities to commercial paper programs, have become more protective of their liquidity and balance-sheet capacity.
Although this episode appears to have been triggered largely by heightened concerns about subprime mortgages, global financial losses have far exceeded even the most pessimistic projections of credit losses on those loans. In part, these wider losses likely reflect concerns that weakness in U.S. housing will restrain overall economic growth. But other factors are also at work. Investor uncertainty has increased significantly, as the difficulty of evaluating the risks of structured products that can be opaque or have complex payoffs has become more evident. Also, as in many episodes of financial stress, uncertainty about possible forced sales by leveraged participants and a higher cost of risk capital seem to have made investors hesitant to take advantage of possible buying opportunities. More generally, investors may have become less willing to assume risk. Some increase in the premiums that investors require to take risk is probably a healthy development on the whole, as these premiums have been exceptionally low for some time. However, in this episode, the shift in risk attitudes has interacted with heightened concerns about credit risks and uncertainty about how to evaluate those risks to create significant market stress. On the positive side of the ledger, we should recognize that past efforts to strengthen capital positions and the financial infrastructure place the global financial system in a relatively strong position to work through this process.
In the statement following its August 7 meeting, the Federal Open Market Committee (FOMC) recognized that the rise in financial volatility and the tightening of credit conditions for some households and businesses had increased the downside risks to growth somewhat but reiterated that inflation risks remained its predominant policy concern. In subsequent days, however, following several events that led investors to believe that credit risks might be larger and more pervasive than previously thought, the functioning of financial markets became increasingly impaired. Liquidity dried up and spreads widened as many market participants sought to retreat from certain types of asset exposures altogether.
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