Housing Finance Practices Need Improvement from Start to Finish

Federal Deposit Insurance Corporation (FDIC) Chairman Sheila Bair delivered the keynote address at a joint conference on "Mortgages and the Future of Housing Finance" sponsored by FDIC and the Federal Reserve System on Monday and echoed the words of Fed Chairman Ben Bernanke earlier in the day regarding the current problems with apparently flawed foreclosure procedures.  She said that FDIC is working closely with fellow regulators to get to the bottom of the problem but fears that litigation generated by this issue could ultimately be very damaging to housing markets if necessary and justified foreclosures are unduly prolonged.

Bair said there were warning signs that servicing standards were eroding and those signs should have caused market participants and regulators to question current practices.  For example, Bair said, servicing fees declined significantly over the past several years and, in hindsight, regulators should have been asking servicers how they achieved that without sacrificing quality. 

An initial review indicates that FDIC supervised non-member state banks have limited exposure to the robo-signing problem and investors which have purchased assets from failed banks have been notified that losses associated with improperly executed foreclosures will not be eligible for loss-share arrangements.

Bair said that the robo-signing problems underscore just how time-consuming and expensive foreclosures are for all parties and should be a last resort, undertaken only where bona fide loan restructuring efforts have failed and all legal and procedural requirements have been fulfilled.  At the same time, she fears the regrettable truth is that many of the properties currently in the foreclosure process are either vacant or occupied by borrowers who simply cannot make even a significantly reduced payment and have been in arrears for an extended time. Ultimately, this problem will require some type of global solution such as considering some type of "triage" on foreclosures, perhaps providing safe-harbor relief if the property is vacant or if the servicer offered a meaningful payment reduction - say a minimum of 25 percent - and the borrower could still not perform on the loan.

We know from experience, Bair said, that reducing the monthly payment through modification raises the chance that the borrower will make good on the loan but also know that servicers have not always made meaningful efforts to restructure loans for borrowers who have documented that they are in economic distress. "Our research, based on loans modified by the FDIC at Indy Mac, shows that raising the size of the payment reduction from 10 percent to 40 percent or more can cut redefault rates by half."  The backlogs in foreclosure and the bloated housing inventories make timely and workable loan restructuring more important than ever, but these efforts have been impeded by overly complicated processes and insufficient servicing staff.

Bair pointed to the robo-signing controversy as just another indication of the need to improve institutional practices all along the chain of securitization, from origination, to securities underwriting, to servicing, and said that the misaligned incentives built into the securitization process have left back-office operations far too weak to support a robust system of mortgage finance. READ MORE

In order to restore market discipline to the system, securitization must incorporate features so investors can perform full due diligence through loan level disclosures and the economic incentives of securities issuers are aligned with the long-term performance of the loans.  These steps require greater transparency, clearer documentation, better alignment of incentives, third-party oversight, and high, easily verified underwriting standards for loans or risk-retention requirements for issuers. READ MORE

Bair also called for the end of implicit forms of government support.  Too Big to Fail is just one example of the type of implicit federal backing of selected private companies that has taken root in our financial system over time.  "Whenever investors are led to believe that policymakers will not allow a company to fail, market discipline is weakened. The inevitable result is more risk taking that only raises the value of the implicit government backing," and, while shareholders and insiders capture the upside gains, taxpayers get stuck with potentially catastrophic losses in a time of crisis.  "Any such arrangement can only be regarded as a failure of government policy."

She did, however, leave room for some form of support for securitization in order to maintain stability during economic and financial cycles.  The support, however, must be "publicly acknowledged, appropriately priced, clearly delimited, subject to audit, and backed by the full faith and credit of the U.S. government."

The FDIC, she said, supports covered bond legislation, but has expressed concern about recent proposals that would shift risks from investors to the Deposit Insurance Fund. In developing a viable U.S. covered bond market the rights and responsibilities of issuers, investors and regulators must be clarified.  This variety of general obligation bonds could be a valuable source of liquidity to finance mortgages, and properly structured, provide a way to transfer risk broadly to private-sector investors, rather than the U.S. government. However, improperly structured, they could lead to another system of implicit government guarantees.

The recent crisis in mortgage finance has revealed critical flaws in a system that grew out of the financial reforms of the Great Depression and created government institutions that supported financial stability and the availability of mortgage credit for decades after they were established.  In the end, however, the flaws of the system boiled down to three fundamental and interrelated problems; misaligned incentives, implicit government support, and the emergence of financial companies that were Too Big to Fail.