Thank you, Mr. Chairman. I thought I’d start today talking a bit about housing markets and the condition of banks right now. As many of you have noticed, some of us are optimistic that we may be approaching a bottom in the housing market. I think we’ll see that bottom in housing sales long before we see it on the construction side because there’s a large amount of inventory still to work through. But as we’ve noted, the applications for purchasing mortgages have been level since midyear. The growth in mortgage credit has slowed significantly from where it was in the past two years, dropping to only 10 percent growth this past quarter, a growth rate that is significantly above the growth of personal income and that most of us in the past would have considered to be alarming.
Part of what’s amazing in all of this is that in 2004 and 2006, particularly toward the end of that period, purchase money seconds, by which people borrowed the downpayments for homes, were a big part of mortgage financing. Banks are still getting some of this business and putting it on their balance sheets, and it is part of the growth of what you’re seeing the banks funding. But it is at a pace that I think needs to be adjusted. I’m saying that, although the number of applications may have bottomed out, the amount of leverage in each housing deal may still need some correction going forward, and so we may see some slowdown in the volume of dollars that are funded through mortgage lending.
Delinquency rates are really, really low by historical standards. The one sector that has had a jump in delinquencies is subprime ARMs, and clearly the jump is related to rates that have already reset. We’ve got more to come. Even though these have jumped, they’re still not at alarming levels. But it’s something that I think the banks are watching very, very carefully.
One thing I’m hearing more from some folks who have been investing in mortgage- backed securities and maybe in some CDOs (collateralized debt obligations), where they’ve been tranched into riskier positions through economic leverage, is the realization that a lot of the private mortgages that have been securitized during the past few years really do have much more risk than the investors have been focusing on. I’m hearing this from folks who understand that the quality of what goes into those pools varies tremendously when you don’t have the Fannie Mae and Freddie Mac framework for the underwriting. When a mortgage is originated through a bank, we do a lot through safety and soundness supervision to make sure, if a bank is buying loans from brokers, that the loans are underwritten in a sound manner and are therefore affordable to the borrower when they’re undertaken. We’re seeing that some of the private-label mortgage-backed securities are having very high early default rates or delinquencies in the mortgages, which usually means that the originator has to buy them back out of the pools. There isn’t a whole lot of transparency in the disclosures around some of these bonds, and some of the brokers are underwriting products that have very high early default rates, which is something that investors are starting to focus on. As more products are generated outside the banking sector, they get funneled to pools through broker-dealers as opposed to the banks. I think that we’re missing a level of due diligence regarding brokers, who may not be doing a good job. As you all know, the fraud rate on mortgages has tripled in the past two years. So I think we could see noise in some of the mortgage-backed private deals and some of the riskier CDO economic leverage positions.
Bank earnings are really, really strong overall, especially by historical standards. Banks are making a lot of layoffs connected with the mortgage business. They are taking steps to get costs—whether related to originations, post-loan closings, or payoff administration—under control. Net interest margins, however, continue to be under significant pressure. I’m hearing more from banks that, since we’ve stopped raising rates, they’ve lost the nice little lag effect— the ability to wait for us to move before lagging along. In other words, they have lost that lagniappe in their liability cost that has helped them with their margin pressures. So those pressures are going to be more of a challenge for them, especially with a flat or inverted yield curve, depending on where they’re funding and lending. Loan-loss provision continues to be the best in many, many years. No one really expects it to jump, but clearly it can’t get a whole lot better than it is, and so that will also present challenges going forward.
As for the economy as a whole, I, too, want to compliment President Yellen because I think she did a fantastic job of helping us think about the different signals we’re getting. When I looked again at the graph that I love in the Greenbook that shows where our forecast has been, I was struck that we’ve seen the forecast of GDP growth continuing to moderate in the past several months but our expectations of inflation are actually flat to up a bit. To me that raises questions about the tradeoff that we really have when we are running below capacity and below potential growth rates. The bit of softness that I’m hearing about from some of my contacts in sectors outside housing and mortgages warns me that we need to be a little more vigilant than I had been expecting about growth maybe softening in a broader sense. But the fact that inflation continues to be above 2 percent in the forecast period is something that does concern me, and I think part of my concern relates to the tremendous amount of liquidity that sits out there in the banking sector, in the U.S. financial markets, and clearly globally. The presence of this liquidity is something that we really need to think about. It’s not back to where it was in my money supply days, when I started my career at the St. Louis Fed; but I do worry that liquidity is, as some of you have said, causing a lot of transactions to occur that economically perhaps wouldn’t otherwise occur. That is also something we need to watch very carefully.