Thursday, May 31, 2007
Yara Zakharia, Esq.

Under fire from some members of the U.S. Congress charging that the mortgage market was insufficiently regulated, Federal Reserve Chairman Ben Bernanke stuck to his guns and warned against excessive governmental oversight of the shaken subprime mortgage sector. Speaking before the Federal Reserve Bank of Chicago, Bernanke presented the chronology of events leading up to the current subprime lending crisis and outlined the course of action that federal regulators should take to reduce the magnitude and impact of subprime mortgage difficulties.

His balanced view of the situation was reflected in the following statement:

"We at the Federal Reserve will do all that we can to prevent fraud and abusive lending and to ensure that lenders employ sound underwriting practices and make effective disclosures to consumers...At the same time, we must be careful not to inadvertently suppress responsible lending or eliminate refinancing opportunities for subprime borrowers."

Bernanke emphasized the importance of drafting sharply-drawn rules since "insufficiently clear rules could create legal and regulatory uncertainty and have the unintended effect of substantially reducing legitimate subprime lending."

He stated that regulators could assume a number of different roles, such as assisting creditors in ensuring that borrowers understand disclosures concerning mortgage rates, fees and terms, playing a supervisory role, and providing guidance. Furthermore, they could enforce the predatory lending laws by cracking down on unfair and abusive practices, collaborate with credit counseling groups in an effort to keep consumers well-informed, and engage in informal activity such as promoting sound practices.

Nevertheless, Bernanke highlighted the fact that the types of novelties in credit markets offering innovative subprime lending products have yielded a number of successes, such as paving the way to home ownership for millions of Americans.

The increase in homeownership also coincided with the expansion of secondary markets in which mortgage loans were packaged and sold to investors. The secondary market added welcomed liquidity to mortgage markets; home buyers found it far easier to obtain financing. He explained that during the period in which subprime products became more prevalent, home ownership in the U.S. rose from 65% of households in 1995 to 69 percent in 2007.

Similarly, this expansion in home proprietorship was directly linked to the growth of secondary markets whereby mortgage loans were created and offered for sale. Bernanke noted that the secondary market infused the mortgage market with greater liquidity, thus making it easier for home buyers to acquire financing. However, another result was that the secondary market offered creditors incentives to issue more loans with their revenue depending on volume, and therefore, to lower underwriting standards. A growth in the number of risky loans was one of the factors behind the hike in foreclosure and default filings this year.

"Markets can overshoot, but, ultimately, market forces also work to rein in excesses," Bernanke stated. "For some, the self-correcting pullback may seem too late and too severe. But I believe that, in the long run, markets are better than regulators at allocating credit."

Although Bernanke endorsed regulators' continued vigilance in combating predatory lending and fraud, he urged his audience to “be careful not to inadvertently suppress responsible lending or eliminate refinancing opportunities for subprime borrowers”. He maintained that, “success in balancing these objectives will have significant implications for the financial well-being, access to credit, and opportunities for home ownership of many of our fellow citizens.”