The Federal Reserve issued a white paper on January 4 that reviews the condition of the housing market, discusses some of the causes of the current situation and assesses possible actions to alleviate some of the distortions in order to return the market and the economy to equilibrium.

The paper cites three key forces within the housing sector that are holding back both housing and the economic recovery: 1) persistent excess supply of vacant homes on the market, 2) a marked and potentially long-term downshift in the supply of mortgage credit, and 3) an unwieldy and inefficient foreclosures process imposing extra costs on homeowners, lenders and communities.

These three forces reinforce each other and have led to a heavy and continuous flow of foreclosed properties, lower home prices, more mortgage distress and a self feeding downward spiral. The slow economic recovery has suppressed demand and deflected the natural cyclic forces that normally boost housing.

Tight Credit

The paper reviews the dramatic fall in housing prices, household equity and resulting share of mortgages underwater. Not only has the collapse caused home buying to plummet, but lenders have tightened credit standards dramatically as well. The paper states that “the extraordinarily tight standards that currently prevail reflect, in part, obstacles that limit or prevent lending to creditworthy borrowers.” Several examples of how tightening has occurred are cited, such as lenders requiring higher credit scores than the GSEs accept out of fears of GSE demanded repurchase or higher regulatory costs of servicing.

Data show particular impacts on first time home buyers, even in parts of the country with lower-than-national unemployment rates. The Fed paper posits that if the same degree of credit tightness had existed in the past, the country would have a much lower homeownership rate. The Fed paper states that “Continued efforts are needed to find an appropriate balance between prudent lending and appropriate consumer protection, on the one hand, and not unduly restricting mortgage credit, on the other hand.”

REO

The paper does not prescribe specific solutions to tight credit but does contain suggestions for reducing the vacant real estate owned and preventing more properties from falling into that grave. The first issue tackled is the real estate already owned by banks and mortgage investors. The paper estimates current supply at 500,000 and an expected flow of 1 million this year and again next year. The steady flow keeps prices from rising and reinforces the trend through additional reductions in homeowner equity. Tied to this observation is the fact that residential rents are rising and so is the number of households renting. Hence, the paper discusses the pros and cons of selling more REO to investors who will rent them to households.

About half of the current REO stock belongs to Fannie Mae, Freddie Mac and FHA. The GSE’s regulator is currently reviewing proposed options for bulk sales of at least some of the inventory. Private mortgage pools own slightly more than another one-quarter of the REO and their servicers control what happens to that share. The last portion, a little below one-quarter, is owned by banks and thrifts. While some REO may be in poor condition or in low density areas too difficult to serve scattered rental units, most homes are in major metropolitan areas in viable rental locations.

The pros of a REO-to-rental program include reduction in the excess inventory of for-sale homes, maintenance and upkeep of the current stock and of the communities where the homes are, more immediate determination of loss to the investor/lender, and housing for households desiring rental single-family homes. The cons include likely lower return to the holder because investors require lower prices to compensate for risk, holding costs until sufficient inventory is accumulated before bulk sale, current regulatory complications that do not allow banks to own real estate, investors’ difficulty in obtaining financing, and determining appropriate owners/managers that assure the property remains well maintained.

Potential solutions to the concerns include auctions to a wide audience of third-party investors to increase competition, auctioning the rights to acquire a future stream of properties that satisfy specific criteria, auctioning future deed-in-lieu transactions to investors so there is not REO but a transfer directly from mortgage holder to investor with the possibility of retaining the current resident, allowing the mortgage holder to rent the property directly, and offering financing to the investor purchaser. When the REO has very low value, an option is transferring the property to a land bank and letting the community determine future use. Land banks have been established in several states but the significant resources they require have impeded broader use of this tool.

Defaults and Foreclosures

The flow of foreclosures could be slowed if there were greater or more effective efforts to address home owners’ under stress either because of reduced income or reduced values, which bar them from selling. The inability to refinance and take advantage of historically low mortgage rates has increased the number of homeowners in mortgage distress and foreclosure. The paper cites two obstacles generated by Fannie Mae and Freddie Mac. The GSEs have increased use of their putback policy, which increases the risk that a mortgage originator may have to take the mortgage back if the slightest flaw is found in a mortgage that defaults, and GSE loan-level pricing adjustments (LLPAs), which raise the rate for loans outside very narrowly defined GSE safe investment parameters. The paper suggested solutions include reducing, or eliminating in the case of refinancing their own loans, the LLPA, reducing putback risks on refinances, and expanding the refinance programs to non-agency mortgages. The Fed paper recognizes the tension between minimizing GSE risk and potential loss with stabilizing the housing market, but suggests the overall benefits of stability may offset the GSE costs.

To avoid the economic and personal disruption of a default for those borrowers already underwater, the paper addresses loan modifications. Suggested modifications to the current relatively ineffective programs include taking into account all long-term debt payments when calculating the maximum 31% payment to income ratio allowed in a modification because some homeowners also have second mortgages or other consumer debt, accounting current unemployed income levels rather than assuming past incomes, and principal reduction. While citing the difficulties that have prevented any substantial use of principal reduction actions, the paper offers alternatives such as aggressively facilitating refinancing for underwater borrowers who are current on their loans and expanding loan modifications for borrowers who are struggling.

When modifications are not sufficient to keep a homeowner in their home, the paper offers alternatives that possess complications but remain viable such as the deed-in-lieu or short sale, which avoids the sometimes lengthy foreclosure process and potential property deterioration.

Mortgage Servicing

The last section of the paper addresses the difficulties and injury that the mortgage servicing processes have and have caused in the process of resolving delinquencies and foreclosures. The system designed to accept and re-distribute mortgage payments was not staffed or trained to address the volume of mortgages in difficulty. The paper focuses on four factors that compounded the impact: no readily available data to assess servicer performance, no effective way of transferring servicing if poor performance is determined, servicer incentives lean toward foreclosure and no central registration of all liens on a property. Curative recommendations include investor access to servicer performance metrics, servicer compensation more in line with probability of default, and an online national registry of liens so all potential claimants can be identified.

Conclusion

The Fed paper takes a larger view of housing market solutions as a portal into the whole economy. The final paragraph states it best. “Restoring the health of the housing market is a necessary part of a broader strategy for economic recovery. As this paper suggests, however, there is unfortunately no single solution for the problems the housing market faces. Instead, progress will come only through persistent and careful efforts to address a range of difficult and interdependent issues.”