Eric S. Rosengren ’79 was appointed president and CEO of the Federal Reserve Bank of Boston last July. The regional bank not only helps establish monetary policy, it plays a big role in New England’s regional economy. After taking office in the midst of a credit crisis caused by the collapse of the subprime mortgage market and a slump in the housing market, Rosengren took time to discuss the economic forces at work as well as his outlook for the future with Sasha Brown-Worsham ’99, a Boston-based freelance writer.
The subprime issue has been in the headlines for some time now. How does that issue affect the current national economy?
Foreclosure and delinquency rates on subprime mortgages have continued to rise, house prices by some measures have fallen, and credit markets have been turbulent. This turbulence has been reflected in increases in interest-rate spreads between commercial and government debt, a decline in the liquidity of securities linked to riskier mortgages arising from difficulty in obtaining reliable valuations of these securities, a related decline in asset-backed commercial paper used to finance short-term assets, and an unusual rise in the spread between the cost of short-term funding in Europe and the U.S.
Particularly notable is the decline in housing prices in many regions of the country. Consumer spending is affected by households’ net worth and housing equity is an important component of wealth. While the effect of the problems in housing on consumption has been muted to date, further and more widespread deterioration in housing prices would increase the risk of a more adverse impact on consumption.
What is different about a subprime loan?
Subprime loans refer to mortgage loans that have a higher risk of default than prime loans, often because of the borrowers’ credit history. The loans carry higher interest rates reflecting the higher risk. Certain lenders, typically mortgage banks, may specialize in subprime loans. Banks, especially smaller community banks, generally do not make subprime loans, although a few large banking organizations are active through mortgage banking subsidiaries.
How did the current situation develop?
The subprime market has grown dramatically in the past five years but is still small relative to all domestic financial assets—the value of outstanding subprime mortgages is around one trillion dollars, while U.S. holdings of financial assets total about forty-four trillion dollars. The vehicle used to finance the growth in subprime lending was securitization, which allows for a much larger pool of investors, resulting in a greater supply of loans, benefiting many borrowers.
Most parties involved in the process assumed that house prices would continue rising nationally. This assumption seems to have had the biggest impact on the situation we see today. Foreclosures and house-price growth essentially mirror one another.
How could a single segment of the economy have such a far-reaching impact on the overall economy?
In a strong housing market with rising home prices, a borrower who faced the prospect of an increase in an adjustable rate mortgage could probably refinance the loan, frequently with a withdrawal of some of the appreciated equity. This is borne out by the fact that the duration of subprime loans was relatively short, suggesting that borrowers were able to refinance into another subprime or prime loan prior to their rate re-setting at a higher level—as long as prices were rising. When prices stopped rising, the option of refinancing out of a mortgage with a rising borrowing cost became less available. Lenders’ expectations also seemed to assume that prices would not drop (which, of course, diminishes the collateral that secures the loan for the lender).
The subprime market has grown very rapidly in recent years, so such widespread use of subprime mortgages is a relatively new phenomenon. This limited history made it difficult to assess the likelihood of defaults if underlying economic conditions changed.
Finally, the increased reliance on mortgage brokers who originated the loans but had little stake beyond the front-end origination of the loan was a departure from the traditional buy-and-hold strategy of many financial institutions. These brokers typically are compensated based on volumes of loans made and sometimes on the rates and fees as well; as a result, the brokers have few incentives to worry about the longer-term viability of the mortgage.
Defaults in the subprime market have resulted in even the most secure of subprime securitizations selling at a sizable discount. Investors are now questioning the appropriateness of surrogate securitization, contemplating more independent analysis of the securities and underlying assets and the need to distinguish between securitizations with different underlying assets.
What can be done for the future?
Trying to mitigate the current problems with subprime mortgages requires a balance—between providing credit to borrowers who might not otherwise be able to buy a house and ensuring that the mortgage they get is appropriate for their financial position. In our research, we looked at what happened to homeowners who used subprime loans to buy their homes and found that five years later, ninety percent were either still in their house or had profitably sold it. Most subprime buyers have a positive experience with homeownership.
Perhaps the most critical issue is that financing that supports responsible subprime lending continues, despite recent problems.
I am hopeful that financial institutions will play an important role in providing financing for many of the borrowers facing higher rates as their mortgages reset. In the past, rate-resets may not have been as problematic as they could be now, because borrowers had an easier time refinancing or selling. As we look at the situation now, we want to see borrowers continue to have the option to refinance and want to see lenders continue lending—so that resets do not become an increasing problem.
The Federal Reserve Bank of Boston has created several brochures that are intended to help borrowers consider all their options, and we are creating a Web site to help borrowers in subprime products to get information and help looking for refinance opportunities. Working with financial institutions, city and state governments, community organizations, regulators, and others, we at the Fed hope to play a constructive role in mitigating subprime problems.
Are these problems likely to have a long term effect on the U.S. economy?
August and September have been quite unusual for financial markets. Short-term liquidity has been disrupted for almost two months, as investors have reevaluated the securitization process. I am hopeful that, with appropriate underwriting, the securitization process and the issuance of asset-backed commercial paper will continue to be a source of financing for a wide range of assets.
In the meantime, it will be important for banks to provide their usual role as a provider of liquidity during times of distress. While the subprime market that was the epicenter of the problem is likely to continue to have some difficulties, I am hopeful that financial institutions will play an important role in providing financing for many of the borrowers facing higher rates as their mortgages reset.
What are some other issues you plan to address while you are at the helm of the Boston Fed?
I’m intrigued by student migration out of Boston and New England when they graduate. One of the keys to being a competitive region is quality human capital. We need to learn how to retain more of the skilled workers coming out of our colleges and universities.
Please talk a bit about the timing of your new position in the midst of this turmoil. What do you foresee as the challenges? What will be the rewards?
In terms of the FOMC [Federal Open Market Committee—the monetary policymaking body of the Federal Reserve System], it’s a challenging time because a lot of issues are being thought through concerning the best way to conduct monetary policy. Chairman [Ben] Bernanke seems to have a very collegial style, and he seeks input.
In supervision, there are a number of challenges we’re going to have to wrestle with over the next few years. Our holding company responsibilities are one such area. Our roles vis-à-vis other bank supervisory agencies are another. I wouldn’t be surprised if there’s active discussion about whether there should be one regulator in the U.S. and [about] the role of the central bank in bank supervision. I strongly believe the Fed should have a role. In payments, there are far fewer checks being written. There’s still going to be a role for thinking about how we regulate the payments system and help it evolve. While we’ll be doing different payment-system work, it will be very interesting work.
New England tends to value independence, and that sometimes means that consensus can be elusive. I feel there is an opportunity to try to work with other leaders to try to forge some solutions to regional problems.