Washington – Senate Banking Committee members questioned Roger Cole, the Federal Reserve's Director, Division of Banking Supervision and Regulation, over the Fed's role in regulating mortgage lenders in lieu of the number of bankruptcies being filed thanks to subprime mortgage loans originated during the housing boom.
While credit deteriation has been focused on the subprime mortgage sector, lawmakers wanted to know if the rate of foreclosures would affect the US economy, what impact it may have and how the Fed is managing it.
In his opening comments before the Senate Committee this morning, Cole said that "the deterioration in housing credit has been focused on the relatively narrow market for subprime, adjustable-rate mortgages, which represent fewer than one out of ten outstanding mortgages."
"We know from past cycles that credit problems in one segment of the economy can disturb the flow of credit to other segments, including to sound borrowers, creating the potential for spillover effects in the broader economy," Cole said.
In assuring lawmakers over risks to the economy, Cole told the Senators that "credit problems in one segment of the economy can disturb the flow of credit to other segments."
"Nevertheless, at this time, we are not observing spillover effects from the problems in the subprime market to traditional mortgage portfolios or, more generally, to the safety and soundness of the banking system," said Cole.
The chairman of the Senate Banking Committee, Senator Christopher Dodd (D-CT) told Fed Chairman Ben Bernanke earlier this month that regulators needed to extend the exotic mortgage guidance to subprime hybrid adjustable rate mortgages (ARMs), in a move aimed at protecting borrowers as well as banking institutions.
"In my view, there is broad agreement that we should create a new regulator to oversee Fannie Mae, Freddie Mac, and the Federal Home Loan Banks," said Sen. Dodd. "This new regulator must have a number of core powers in order to do its job effectively, and to be considered credible in the eyes of the public."
While still only a relatively small part of outstanding mortgages, the subprime sector grew rapidly over the past three years and accounted for an outsized share of originations in 2006.
New entrants in the mortgage industry, including independent mortgage brokers and finance companies, also ramped up their origination capacity. With the rise in short-term market interest rates beginning in 2004, the cost burden of such infrastructures came under increasing pressure as both mortgage refinance and new origination volumes declined.
An additional layer of risk was embedded in the subprime market since subprime borrowers are more likely to use adjustable-rate mortgages, or ARMs, because these loans generally carry lower interest rates at origination, particularly if a promotional or "teaser" rate is offered for the loan's introductory period. While these loans contribute to more manageable payments early in the life of the mortgage loan, borrowers can be exposed to payment shock when rates adjust. ARMs account for only about one in eight prime mortgages, but they account for between one-half and two-thirds of subprime mortgages.