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Governor Randall S. Kroszner

Loan modifications and foreclosure prevention

Before the Committee on Financial Services, U.S. House of Representatives

December 6, 2007
Chairman Frank, Ranking Member Bachus, and members of the Committee, I appreciate the
opportunity to appear before you today to discuss recent problems in the subprime mortgage market
and possible legislative responses. The challenges facing the housing market at the moment are
significant. Increasing numbers of homeowners and communities are experiencing problems. We
continue to work to find and implement the best and most sustainable solutions to the current
In recent years, the subprime market has grown dramatically, enabling more and more borrowers to
obtain credit who traditionally would have been unable to access it. Increasing numbers of lenders
entered this market, with underwriting standards, industry practices, and risk-based pricing evolving
along with the subprime market.
The growth of this market is well recognized. Also well recognized are the problems that have
arisen with these changes. The Board believes that responsible subprime lending has an important
role to play in expanding credit to traditionally underserved borrowers. It also recognizes, however,
that some of the lending undertaken in recent years was neither responsible nor prudent.
Mortgage delinquency and foreclosure rates have increased substantially over the past few months.
Over 17 percent of subprime adjustable-rate mortgages were in serious delinquency at the end of
September, a rate over three times higher than that in mid-2005. Serious delinquencies also
increased among near-prime and prime mortgages, although these delinquencies remain much lower
than among subprime mortgages. Lenders initiated foreclosure proceedings for an average of
320,000 loans per quarter in the first half of this year, up from 240,000 loans per quarter in the
preceding two years.
One significant factor in the increase in delinquency rates has been the slowing of house prices.
Prices decreased slightly for the nation as a whole in the third quarter of 2007, and declined more
dramatically in some regions. Over a quarter of homeowners report that their houses decreased in
value over the past year, just a bit above the level last seen in the early 1990s.1 These price changes
will affect homeowners' abilities to resolve financial troubles by refinancing their mortgages or
pulling equity out of their homes, and may lead to increased defaults. In addition, some borrowers
whose mortgage balances exceed their house values may be tempted to walk away from their loans.
Borrowers who purchased properties solely for investment purposes may be more likely to default
in this situation; indeed, the Mortgage Bankers' Association has found a disproportionate share of
serious delinquencies are associated with non-owner-occupied properties in some of the states with
the highest increases in delinquencies. A recently released study by the Federal Reserve Bank of
Boston attributes most of the recent rise in foreclosures in Massachusetts to declining house prices.2
Borrowers who have lost their jobs, not surprisingly, may have difficulty meeting their mortgage
payments. Thus, increases in unemployment in certain areas, such as states in the Midwest
struggling with job cuts in the auto industry, are another major factor contributing to higher
delinquency rates.

The final major factor explaining the current increase in delinquency rates is the apparent
deterioration in underwriting standards beginning in late 2005. An increasing number of subprime
loans were made with layers of additional risk factors, such as a lack of full documentation or very
high loan-to-value ratios. Much of this weakening in underwriting standards happened outside of
institutions regulated by the federal banking agencies. For instance, in 2006, over 45 percent of
high-cost first mortgages were originated by independent mortgage companies.3 In addition, prior
to late 2005, high demand for housing and rising house prices allowed borrowers to recover from
these risks through profitable home sales and refinancings, hiding the weakened underwriting
standards from view. The slowdown in house prices, coupled with shifts in underwriting standards,
are the most likely explanation for the pronounced rise we have seen in defaults occurring within a
few months of origination, before most borrowers would have experienced significant changes in
their payment obligations or in their financial situations.
Looking forward, we expect the substantial payment increases often experienced at the first interestrate reset to result in higher delinquencies. From now until the end of next year, each quarter
roughly one out of ten borrowers with an adjustable-rate subprime mortgage is scheduled to
experience the first rate reset.4 In addition, tightening credit conditions as reported in the Federal
Reserve's Senior Loan Officer Surveys suggest that refinancing may become more difficult. In the
past, many borrowers experiencing these resets were able to avoid the payment increases by
refinancing their mortgages. The recent declines in house prices and the current tighter credit
conditions, however, reduced the viability of this option for significant numbers of borrowers.
The Federal Reserve's Response to Problems in the Subprime Market
As I testified before this Committee in October, the Federal Reserve is actively working to respond
to these challenges. If the benefits of homeownership are to be realized, we believe that
homeownership must be sustainable and that access to responsible lending be available for
consumers. To achieve this, the Board believes that there must be appropriate consumer protection
and responsible lending to traditionally underserved borrowers. Accordingly, we continue to
coordinate with other federal and state agencies, and consult with consumer advocates, lenders,
investors, and others. We take these issues very seriously, and, along with the other federal banking
regulators, began issuing guidance on subprime lending in 1999 for the institutions we regulate. We
significantly expanded that guidance in 2001, issued guidance on non-traditional mortgage products
(such as payment-option and interest-only loans) in 2006, and issued guidance on adjustable-rate
subprime mortgages earlier this year. I would like to take this opportunity to share a brief update on
some of the work that the Federal Reserve is undertaking on these issues.
Coordinated enforcement of consumer protection laws
First, the enforcement of consumer protection laws and regulations is critical and the Federal
Reserve enforces these measures through oversight of the institutions it examines. As the mortgage
industry has diversified, increasing coordination among regulators has been helpful. In particular,
our need to cooperate with state bank regulators has increased in importance, and we have
responded to that need. In that vein, we launched a cooperative pilot project with other federal and
state agencies to conduct reviews of certain non-depository lenders involved in the subprime market.
The reviews will evaluate underwriting standards, risk-management strategies, and compliance with
certain consumer protection laws and regulations. This initiative brings together the Federal
Reserve, the Office of Thrift Supervision, the Federal Trade Commission, and state agencies
represented by the Conference of State Banking Supervisors (CSBS) and the American Association
of Residential Mortgage Regulators (AARMR). The companies being reviewed include those that
are supervised by the federal agencies, as well as independent entities that are licensed by the states.
Loss mitigation efforts
Second, the Board, along with the other federal financial agencies, has worked to guide federally
supervised institutions as they deal with mortgage defaults and delinquencies. The federal financial
institution agencies issued a Statement on Working with Mortgage Borrowers in April 2007, and, in

cooperation with the CSBS, a Statement on Loss Mitigation Strategies for Servicers of Residential
Mortgages in September 2007. Together, these statements encourage institutions to work
proactively with borrowers who may be facing delinquency or foreclosure, and encourage servicers
of securitized residential mortgages to determine the full extent of their authority to restructure
failing loans and to pursue appropriate loss mitigation strategies.
The Board continues to encourage servicers and investors to make every effort to keep troubled
borrowers in their homes. I, and other members of the Board, have had numerous meetings in recent
months with a wide array of market participants and consumer advocates to understand the
complexity of the issues and to encourage appropriate responses. Each of the twelve Federal
Reserve Banks has been working with financial institutions and community groups around the
country to address challenges posed by loan performance problems. And the Federal Reserve
Board's staff has been working with consumer and community affairs groups throughout the Federal
Reserve System to help identify localities that are most at risk of high foreclosures, with the intent
to help local groups better focus their outreach efforts to borrowers.
We have also been talking with lenders, servicers and investors, independently as well as through
the Hope Now alliance, to support prudent efforts to reach out to as many borrowers as possible.
Many servicers have established procedures to identify segments of borrowers who are current but
could face trouble at reset, to contact these borrowers ahead of the reset, and to systematically
evaluate the ability of borrowers to make higher payments. On the basis of this analysis, they can
sometimes present prudent refinancing or loan modification alternatives to the borrower. Other
efforts, such as the FHASecure product and various state and local efforts, can play a role in
avoiding foreclosure. As I will discuss further in a moment, we support these efforts because
foreclosure is generally the worst possible option for consumers, investors, and communities, and
should be avoided whenever other viable options exist. Changes to existing terms, however, should
not be made lightly, should be consistent with safe and sound lending practices, and should not be
made when they are only delaying losses to investors and consumers. In short, we should pursue
sustainable solutions.
Consumer protection regulations
Finally, the Board continues to work toward more effective consumer protection rules. We will
soon begin extensive consumer testing to ensure that new disclosures are effective and
comprehensible. Later this month, we will propose changes to the Truth in Lending Act (TILA)
rules to require earlier disclosures by lenders and to address concerns about misleading mortgage
loan advertisements.
The Board recognizes, however, that improved disclosures are necessary but not sufficient to
address the problems. In addition to these actions, therefore, the Federal Reserve will exercise its
rulemaking authority under the Home Ownership and Equity Protection Act (HOEPA) to address
unfair or deceptive mortgage lending practices. At the same time we propose the TILA rule changes
on advertising and timing of disclosures, we will issue, for public comment, significant new rules
that would apply to subprime loans offered by all mortgage lenders. In formulating our proposal,
we are looking closely at practices in the subprime mortgage market, such as prepayment penalties,
failure to offer escrow accounts for taxes and insurance, stated-income and low-documentation
lending, and the failure to give adequate consideration to a borrower's ability to repay.
I can assure you that our proposed rules will be based on detailed analyses of the issues and our
statutory authority to address them, extraordinary outreach efforts to gather a wide range of
information and opinions, and attempts to balance the needs of adequately protecting consumers and
maintaining responsible lending markets. The rules will reflect input obtained through public
meetings in 2006 and a hearing that dealt specifically with these issues that I chaired this past June.
We also considered nearly 100 comment letters, following the June meeting, and consulted with
other federal and state agencies and our own Consumer Advisory Council. Finally, we have
continued to meet with, and listen to informed opinions from, consumer groups, the financial
services industry, lawmakers, and others to ensure that our proposed rules are likely to achieve the

goal of adequate consumer protection without shutting off access to responsible credit.
Legislative Responses
Congress has expressed understandable and appropriate concern about subprime lending and the
challenges in the mortgage market more generally. We commend leaders in Congress who are
looking into these problems and wrestling with the challenges of addressing abusive lending while
encouraging responsible lending.
The Mortgage Reform and Anti-Predatory Lending Act of 2007, which was passed by the House of
Representatives last month, would extend additional oversight and consumer protections to the
market. We were asked in today's testimony to comment on two issues, not addressed in the current
version of the Act, that could be addressed through amendments or other actions.
Loan modifications
One issue is the possible legal exposure of servicers of mortgages who enter into loan modifications
or workout plans. Because loan servicers play a critical role in implementing possible loss
mitigation strategies, this is a timely and important question.
We believe that investors and servicers generally want to work with borrowers to avoid foreclosure.
Prudent loss mitigation techniques that avoid foreclosure not only help homeowners, they are
usually cost-effective for investors. Borrowers who have been current in their payments but could
default after reset, for instance, may be able to work with their lender or servicer to adjust their
payments or otherwise change their loans to make them more manageable. Working with borrowers
before they experience payment problems has other benefits; for instance, late payments will not
have affected such borrowers' credit scores, preserving a wider range of options including
refinancing. Such proactive outreach by servicers may mean the difference between loan payment
and default, particularly for lower-income families who may have little financial cushion.
Given the substantial number of resets expected from now through the end of 2008, it is in the
interest of the industry to go further than it has historically to join together and explore
collaborative, creative efforts to develop prudent loan modification programs and other assistance to
help large groups of borrowers systematically. Such programs can streamline and speed the process
of anticipating and addressing delinquent loans, reduce transaction costs, and provide guidance to
borrowers and to mortgage counselors. Many servicers are, in fact, working with counselors who
can play a crucial role in helping homeowners, many of whom do not even communicate with their
servicers out of fear, embarrassment, or misinformation about their options. Loan modification
programs should be a bottom-up approach designed to balance the needs of all parties, and we are
encouraged by the progress being made by the industry in advancing such programs.
Because systematic approaches to dealing with troubled loans are often likely to lead to better
aggregate investor returns than foreclosures, we are encouraged by industry efforts to pursue these
approaches. When servicers modify loans, however, they may face potential litigation risk from
investors because of their contractual obligations under the servicing agreements. One particular
source of litigation risk, we understand, may be that different asset classes have conflicting
interests. Therefore, we encourage ongoing industry efforts to agree to standards for addressing
these issues. We are hopeful that the industry can resolve these conflicts on a consensual basis so
that they do not preclude servicers from taking actions that are in the overall best interests of
consumers and the industry.
More generally, the Board supports efforts by the industry and others to develop reasonable and
standardized approaches to dealing with these challenges. Such approaches, when applied
consistently and predictably, can reduce uncertainty and ultimately help the markets function.
Prudent workout arrangements that are consistent with safe and sound lending practices are
generally in the long-term best interest of both the financial institution and the borrower, but there
may be instances when such arrangements are not prudent or appropriate. In trying to help
homeowners, we must also be careful to recognize the existing legal rights of investors, avoid

actions that may have the unintended consequence of disrupting the orderly functioning of the
market, or unnecessarily reducing future access to credit. Provisions intended to immunize servicers
from liability should be crafted to avoid creating moral hazard of parties disregarding their
contractual obligations, which would ultimately have negative impacts for markets and consumers.
Sustainable solutions, and not those that simply hide for the short term real repayment challenges,
should be our goal.
Patterns or practices of violations
A second issue is the possible imposition of civil money penalties when the enforcement agencies
find that there is a pattern or practice of violations. Penalties collected would be used to establish a
trust fund for those consumers whose interests had been harmed but who lack a remedy in the event,
for instance, that the responsible party has gone out of business.
The proper magnitude for any such penalties, or under what circumstances they should be imposed,
is Congress' decision to make. As a general rule, the Board believes that penalties for any violation
of law should be sufficient to deter the prohibited conduct, and also reasonably related to the injury
caused by the violation. Penalties that are clearly articulated, and that reasonably match the
magnitude of the violation, are the most appropriate and effective forms of deterrence.
We would recommend that the amount of such civil money penalties, if imposed, be given a ceiling
as well as a floor because of the market uncertainty that can be introduced by open-ended liability.
We would also suggest that some discretion in the actual amount of the penalty, within such a range,
be given to the enforcing agencies. This sort of flexibility in enforcement would help the agencies
adjust the punishment to fit the infraction.
The proposed increase in civil money penalties draws attention to the critical role that enforcement
plays in ensuring compliance with the new responsibilities enacted by Congress. But the
effectiveness of increased penalties can be diminished by a lack of enforcement resources. As
Congress weighs the merits of the bill and possible amendments, we would encourage you to also
look at the resource needs of the agencies that are authorized to take enforcement actions to ensure
that sufficient resources for this important role are available.
The Board recognizes the magnitude of the challenges facing mortgage borrowers today. We
understand the uncertainty and harm being experienced by consumers across the country as the
housing market challenges continue. We are engaged in an array of activities to respond to these
concerns. In coming weeks, we will propose new rules regarding advertising, the timing of
disclosures, and practices that we find to be unfair or deceptive under our HOEPA authority, all of
which we believe will offer increasing protection to consumers. We look forward to continuing to
work with Congress to achieve sustainable solutions to challenges in the mortgage market.

1. Reuters/University of Michigan Survey of Consumers, November 2007. Return to text
2. Kristopher Gerardi, Adam Hale Shapiro, and Paul Willen, "Subprime Outcomes: Risky
Mortgages, Homeownership Experiences, and Foreclosures,” Federal Reserve Bank of Boston
Working Paper 07-15, 2007. Return to text
3. 2006 Home Mortgage Disclosure Act data. Return to text
4. Federal Reserve Board staff calculations based on data from First American
LoanPerformance. Return to text

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Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102