Housing Finance Practices Need Improvement from Start to Finish

Federal Deposit InsurancernCorporation (FDIC) Chairman Sheila Bair delivered the keynote address at arnjoint conference on “Mortgages and the Future of Housing Finance”rnsponsored by FDIC and the Federal Reserve System on Monday and echoed the wordsrnof Fed Chairman Ben Bernanke earlier in the day regarding the current problemsrnwith apparently flawed foreclosure procedures. rnShe said that FDIC is working closely with fellow regulators to get tornthe bottom of the problem but fears that litigation generated by this issue could ultimatelyrnbe very damaging to housing markets if necessary and justified foreclosures arernunduly prolonged.</p

Bair said there were warningrnsigns that servicing standards were eroding and those signs should have causedrnmarket participants and regulators to question current practices.  For example, Bair said, servicing fees declinedrnsignificantly over the past several years and, in hindsight, regulators should havernbeen asking servicers how they achieved that without sacrificing quality.  </p

An initial review indicates thatrnFDIC supervised non-member state banks have limited exposure to thernrobo-signing problem and investors which have purchased assets from failedrnbanks have been notified that losses associated with improperly executedrnforeclosures will not be eligible for loss-share arrangements.</p

Bair said that the robo-signingrnproblems underscore just how time-consuming and expensive foreclosures are forrnall parties and should be a last resort, undertaken only where bona fide loanrnrestructuring efforts have failed and all legal and procedural requirementsrnhave been fulfilled.  At the samerntime, she fears the regrettable truth is that many of the properties currentlyrnin the foreclosure process are either vacant or occupied by borrowers whornsimply cannot make even a significantly reduced payment and have been inrnarrears for an extended time. Ultimately, this problem will require some typernof global solution such as considering some type of “triage” onrnforeclosures, perhaps providing safe-harbor relief if the property is vacant orrnif the servicer offered a meaningful payment reduction – say a minimum of 25rnpercent – and the borrower could still not perform on the loan. </p

We know fromrnexperience, Bair said, that reducing the monthly payment through modificationrnraises the chance that the borrower will make good on the loan but also knowrnthat servicers have not always made meaningful efforts to restructure loans forrnborrowers who have documented that they are in economic distress. “Ourrnresearch, based on loans modified by the FDIC at Indy Mac, shows that raisingrnthe size of the payment reduction from 10 percent to 40 percent or more can cutrnredefault rates by half.”  Thernbacklogs in foreclosure and the bloated housing inventories make timely andrnworkable loan restructuring more important than ever, but these efforts havernbeen impeded by overly complicated processes and insufficient servicing staff. </p

Bair pointed tornthe robo-signing controversy as just another indication of the need to improverninstitutional practices all along the chain of securitization, fromrnorigination, to securities underwriting, to servicing, and said that thernmisaligned incentives built into the securitization process have leftrnback-office operations far too weak to support a robust system of mortgagernfinance. READ MORE</p

In order tornrestore market discipline to the system, securitization must incorporate featuresrnso investors can perform full due diligence through loan level disclosures andrnthe economic incentives of securities issuers are aligned with the long-termrnperformance of the loans.  These stepsrnrequire greater transparency, clearer documentation, better alignment ofrnincentives, third-party oversight, and high, easily verified underwriting standardsrnfor loans or risk-retention requirements for issuers. READ MORE
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Bair alsorncalled for the end of implicit forms of government support.  Too Big to Fail is just one example of therntype of implicit federal backing of selected private companies that has takenrnroot in our financial system over time. rn”Whenever investors are led to believe that policymakers will notrnallow a company to fail, market discipline is weakened. The inevitable resultrnis more risk taking that only raises the value of the implicit governmentrnbacking,” and, while shareholders and insiders capture the upside gains,rntaxpayers get stuck with potentially catastrophic losses in a time ofrncrisis.  “Any such arrangement canrnonly be regarded as a failure of government policy.”</p

She did,rnhowever, leave room for some form of support for securitization in order tornmaintain stability during economic and financial cycles.  The support, however, must be “publiclyrnacknowledged, appropriately priced, clearly delimited, subject to audit, andrnbacked by the full faith and credit of the U.S. government.”</p

The FDIC, shernsaid, supports covered bond legislation, but has expressed concern about recentrnproposals that would shift risks from investors to the Deposit Insurance Fund.rnIn developing a viable U.S. covered bond market the rights and responsibilitiesrnof issuers, investors and regulators must be clarified.  This variety of general obligation bonds couldrnbe a valuable source of liquidity to finance mortgages, and properlyrnstructured, provide a way to transfer risk broadly to private-sector investors,rnrather than the U.S. government. However, improperly structured, they couldrnlead to another system of implicit government guarantees. </p

The recentrncrisis in mortgage finance has revealed critical flaws in a system that grewrnout of the financial reforms of the Great Depression and created governmentrninstitutions that supported financial stability and the availability ofrnmortgage credit for decades after they were established.  In the end, however, the flaws of the systemrnboiled down to three fundamental and interrelated problems; misalignedrnincentives, implicit government support, and the emergence of financialrncompanies that were Too Big to Fail.

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