How Federal Regulators, Lenders, and
Wall Street Created America’s Housing Crisis
Nine Proposals for a Long-Term Recovery

Executive Summary:

For many Americans, the dream of home ownership is turning into a nightmare.

Despite the absence of an economic recession, delinquencies are surging, home sales are falling, prices are declining, and foreclosure rates are rising to multi-year highs. All told, up to 2.4 million could lose their homes, while investors may lose as much as $110 billion.

The impacts of the housing slump on home financing are serious: Delinquency rates on all forms of mortgages have climbed sharply. Some 96 higher-risk lenders have succumbed to rising loan losses, early payment defaults, funding cutoffs and related financial difficulties. At the same time, delinquencies and charge-offs may be spilling over into the commercial real estate lending sector.

As a result, some large banks and thrifts may be at risk. And overall, it appears the mortgage crisis may not be limited to niche players that specialized in low-quality loans.

How did the housing and mortgage crisis reach this extreme?

Rather than acting as a moderating force, the Federal Reserve often played an important role in further inflating the housing bubble.

In the early 2000s, the Fed drove real interest rates into negative territory, erasing the real returns on a wide variety of savings instruments relied upon for income by millions of Americans and encouraging them to shift resources to real estate speculation. At the same time, it drove down the real cost of borrowing and encouraged imprudent risk-taking.

The Fed replaced one bubble, mostly confined to the technology sector, with another, far larger bubble, encompassing most of the housing market. And consequently, homes became unaffordable to most Americans, as the housing affordability index compiled by the National Association of Realtors dropped to its lowest level on record.

By 2004, it was nearly impossible to ignore that the housing market was overheating, as home prices rose at the fastest rates in decades and by more than four-and-a-half times as quickly as inflation. Yet the Federal Reserve did not believe it should play a forceful role in stemming this mania via monetary policy.

Although setting monetary policy is a complex process, we believe that, in the face of a potentially dangerous speculative mania in housing, policymakers at the Federal Reserve failed to recognize the evidence, failed to send clear signals to market participants, and failed to lean against the inflating asset bubble.

Most of the private marketplace players also failed to take protective steps. Rather than maintain prudent lending standards and accept a decline in loan volume, they debased lending standards and accepted the risk of serious long-term damage to their finances, to the industry, and, ultimately, to the economy.

The securitization boom, aided by excess liquidity, significantly boosted risk-taking and greatly inflated the housing bubble.

As of year-end 2006, there were $6.5 trillion worth of securitized loans outstanding, compared to $4.3 trillion in U.S. Treasuries. The issuance of mortgage-backed securities surged to $2.4 trillion in 2006 from $738 billion in 2000, more than a three-fold increase.

This aggravated the boom and bust in several ways: Securitization removed, minimized, or postponed the consequences of poor lending decisions from those making those decisions. It stressed quantity over quality. It made it more profitable and easier for lenders and brokers to lead borrowers to inappropriate loan products. And it resulted in distorted market price signals regarding the risks inherent in the subprime mortgage market. Several investment funds have suffered severe financial difficulties in 2007.

Nine Proposals for a Long-Term Recovery

With the goal of avoiding quick fixes and fostering a healthy, long-term recovery, we offer the following proposals to federal regulators and legislators:

1. Better monitoring and prompter action by the Federal Reserve to help avert run-away asset price inflation.

2. Better enforcement of existing predatory lending statutes.

3. Better protection of borrowers through a model akin to one recently established between the Office of Thrift Supervision (OTS) and three subsidiaries of American International Group.

4. Greater focus by regulators on banks and thrifts whose mortgage performance measures are showing the most stress.

5. Suitability requirements for the mortgage lending industry.

6. Restrict, but do not ban, specific lending practices.

7. Federal training, education, licensing, and testing standards for mortgage lenders.

8. Assignee liability for secondary market buyers of home loans should be seriously considered.

9. More focus on developing programs that promote saving for a down payment.

These solutions cannot be painless. But in order to pave the way for a sounder future, many of the sacrifices that were avoided in the past may have to be made in the present.

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