Thesernnegative benchmarks, Dudley said, have inhibited economic activity through arnnumber of channels.   First,rnthe usual driving power of residential investment has been absent from thisrnrecovery.  In the nine quarters followingrnthe ends of the mid-1970s and early 1980s recessions, residential investmentrnhad climbed by 65 percent and 55 percent above their respective troughs.  There has been no rebound in this cycle. </p

Since the peak homeowners have lostrnabout $7.3 trillion in home equity – about one-half the total.  This decline has eroded household wealth andrncontributed to greater weakness in consumption. rnIt has also reduced credit availability as financial institutions arernless willing to lend on collateral when prices could fall further.  Problems in the foreclosure process andrnobstacles to efficient modification of loans in securitizations exacerbate thisrnreluctance.  This has reduced the amountrnof credit available for households, including for small business formation. </p

Finally, the resulting decline in refinancingrn deprives borrowers of a channel throughrnwhich lower interest rates support spending and employment. This has undercutrnto a degree the ability of monetary policy to support demand. </p

Other systemic problems in housing arerncontributing to the lack of recovery despite the fact that housing no longerrnappears overvalued.  Items on Dudley’s listrninclude:</p<ul

These factors, Dudley said, implyrnthat there are many potential equilibrium outcomes in terms of housing demandrnand home prices and some are considerably more desirable than others. Housingrnpolicy should seek to break adverse feedback loops, promote more economicallyrnefficient outcomes in housing and support growth. </p

He restated the features of arncomprehensive approach to stabilize housing as was outlined in the Fed whiternpapers:  measures to improve access tornmortgage credit, reduce obstacles to refinancing, lessen the flow of homes intornforeclosure through bridge financing and accelerated principal reduction, andrnto facilitate the absorption of REO back into use as owner- or renter- housing.</p

Many of these policies, he said, “simplyrnseek to solve or bypass the legal and incentive problems in the market todayrnand mimic efficient private actions that might be taken if mortgage loans werernall held in portfolio and accounting rules did not discourage net present valuernmaximization.”  </p

Several steps should be taken to offerrnopportunities for new mortgages to creditworthy borrowers on reasonable terms. Onlyrn30 percent of originations now go to borrowers with credit scores under 720rneven though they represent 52 percent of the population.  Lenders are applying tougher restrictions thanrnthe GSEs formally require, limiting their take-back risks. While lenders shouldrnbe accountable for the representations they make, blanket repurchasernrequirements lead to bad outcomes in a period of high job loss risk.  It would be better to establish alternativernways to penalize lenders for misrepresentation that are not so closely tied tornthe risk of job loss.  For example, arnbetter balance between encouraging for sound underwriting and credit availabilityrncould be a materiality test in the rep and warranty agreement.   Another possibility is to explore whetherrnreps and warranties should have a finite duration supplemented by a rigorousrncheck of a random sample of the mortgages being securitized.</p

Dudley said he did not advocate forrna return to the lax standards and under-pricing of credit risk of the boomrnperiod, but a review leading to guarantee fees for new mortgages should bernbased on the expected losses on those mortgages, not what actually happened tornearlier vintages</p

There is also a strong case forrntackling the downward bias on appraisals, which are voiding many transactionsrnbetween willing buyers and willing sellers. Incentives for individualrnappraisers favor conservatism today-just as they favored over-optimism duringrnthe boom.  The industry also needsrnstandards to establish benchmark prices in slow markets with disproportionaterndistressed sales.  </p

Increasing refinancing would creaternadditional cash flow for borrowers to absorb any adverse income shocks,rnreducing the likelihood of default, distress sales and foreclosures.  However, declines in equity, tighterrnstandards, high fees, burdensome processes and legal risks to lenders arernhindering this goal.</p

“Because the taxpayer, via Fanniernand Freddie, is already exposed to the risk of conforming loans defaulting, itrnmakes no sense to make it expensive or difficult for borrowers with these loansrnto refinance,” Dudley said, as after all, refinancing reduces the existing creditrnrisk to which taxpayers are already exposed. It is also inefficient to fullyrnre-underwrite applications for such refinancing. </p

Many of these issues have beenrnaddressed by recent revisions to Home Affordable Refinance Program (HARP),rnDudley said, but more could and should be done. ‘I would like to seernrefinancing made broadly available on streamlined terms and with moderate feesrnto all prime conforming borrowers who are current on their payments.” </p

In a departure from the Fed’s listrnof improvements, Dudley added the need to weaken the link between unemploymentrnand new foreclosures because the primary reason for distress sales and mortgagerndefaults today is the loss of a job. Some support for unemployed homeowners hasrnbeen provided in some states under the Hardest Hit program and Dudley favors arnbroad program to “provide bridge financing for all qualified borrowers withrndemonstrated ability to service their debts but who have become unemployedrninvoluntarily. In economic terms, this is a form of collective insurance.^{“</sup </p}

 His staff, he said, estimates that there are 4rnto 5 million “at risk” homeowners who can afford their mortgage, butrnwho would struggle in the event that the primary earner in the household becamernunemployed and that around 600,000 of these households will experience anrninvoluntary job loss that lasts longer than a month over the next year. Thernaverage annual amount that would be required to keep the mortgage current forrnthese households while unemployed and receiving unemployment insurance isrnaround $21,000 which implies an annual bridge lending program of $15 billionrnper year during the current stress period.  In the future, loan repayments would help tornoffset the cost and, absent the negative externalities achieved by limitingrndistress sales, the expected program cost would be even lower.  This financing would have to have featuresrnsuch as requiring lenders to write down excess debt so as to assure againstrnanother lender “bailout.” </p

Investment firms that purchaserndelinquent mortgages routinely reduce principal in order to maximize value onrnthese loans. It would make sense for Fannie and Freddie to do this as well inrnorder to minimize loss of value on the delinquent loans they guarantee. However,rnborrowers should not have to become delinquent to benefit from suchrnreduction.  There could be a program forrnearned principal reduction for performing but underwater borrowers which wouldrnprovide an incentive to remain current, reduce defaults and ultimately REO. </p

“One option developed by my staff isrnfor Fannie Mae and Freddie Mac to give underwater borrowers on loans that theyrnhave guaranteed the right to pay off the loan at below par in the future underrncertain circumstances, including that the borrowers have continued to makerntimely payments. For instance, the borrower could be given an open-ended optionrnto pay off the loan at an LTV of 125 percent, and the right to pay off the loanrnat an LTV of 95 percent after three years of timely payments.”  This would protect the borrower from furtherrnprice declines but he would give up a portion of the upside from appreciation. </p

Even with aggressive policies tornminimize loans flowing into foreclosure Dudley estimates that large suchrnvolumes will continue and the growing overhang could continue to depress housesrnfor several years.  Thus both incentivesrnfor short sales and steps to facilitate the orderly disposal of properties mustrnbe taken.  An interagency group isrnworking on issues relating to REO-to-rental conversations and, among other steps,rninvestors could be encouraged to purchase REO to be made available as rentalrnhousing. Fannie Mae and Freddie Mac could increase the number of loans offeredrnto individual investors, and REO properties in a given locality could bernbundled for sale.</p

The government might consider arnpackage of tax incentives for purchases of REO that are used as rentalrnproperties such as a reduction of the current 27½ year depreciation periodrnand/or a reduction of capital gains tax liability if the property is held for arnminimum period, such as five years, Dudley said.</p

“One idea developed by myrnstaff-let’s call it “homes for heroes“-would be to create a new taxrncredit or other home purchase subsidy specifically for veterans of our foreignrnwars that would enable these veterans to purchase such properties at arndiscount. There are over 2½ million Gulf War II veterans alone, many of whomrnserved multiple tours of duty overseas, and a significant proportion of themrnmight otherwise not be able to purchase homes today.”</p

Dudley disputed the contention thatrninterventions in the real estate market would lead to moral hazard, i.e.rnrewarding bad behavior.  First, he said,rnprograms can be designed with proper incentives to limit hazard and encouragerndesirable behavior, but  today, inrncontrast to the early part of the crisis, persons running into problems withrntheir mortgages took them under standard conditions of downpayment then ranrninto an adverse life shock.  There is notrna moral hazard issue, he said; punishing misfortune accomplishes little.</p

He also believes his proposals arernstrongly in the public interest and good for taxpayers.  The programs are not without cost, but thernpayoff could be modest price increases, few defaults, and shared appreciationrnas well as the avoidance of negative externalities such as reducing losses onrnloans that do not default as well as the fiscal benefits generated by strongrneconomic growth. </p

In closing Dudley said the housingrnpolicy agenda he describes would “address one factor that  has impeded the economic recovery.rnImplementing such policies would improve the economic outlook and make monetaryrnaccommodation more effective.  However,rnbecause the outlook for unemployment is unacceptably high relative to our dualrnmandate and the outlook for inflation is moderate, I believe it is alsornappropriate to continue to evaluate whether we could provide additionalrnaccommodation in a manner that produces more benefits than costs, regardless ofrnwhether action in housing is undertaken or not. Monetary policy and housingrnpolicy are much more complements than substitutes.”  And, he said, we have to recognize that therernis more to economic policy than just monetary policy. “Low interest rates helprnhousing, but cannot resolve the problems in that sector that are pressing onrnwider economic activity. With additional housing policy interventions, we couldrnachieve a better set of economic outcomes than with just monetary policy alone.”rn

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