He explained that as lenders and borrowers focused on minimizing the initial payment, the choice of mortgage became far more important than the level of short-term interest rates. The key culprits responsible for creating the housing bubble include:
- Alternative types of variable-rate mortgages, including interest-only ARMs, long-amortization ARMs, negative-amortization ARMs (where the initial payment does not cover even the interest costs) and pay-option ARMs (where borrowers determine the payment amount in the early years of the mortgage). These exotic features began to come on the market in 2000 but increased in usage rapidly in 2005 and 2006.
- These exotic loans were coupled with a protracted deterioration of mortgage underwriting standards, including practices such as no-documentation loans, also known as liar loans because borrowers needed to provide no evidence of income.
- Both lenders and borrowers become convinced that house prices would only go up. Borrowers chose, and were extended, mortgages they could not make payments on over the long term.
- Instead, they expected homes to keep appreciating so they could refinance into a more sustainable mortgage in the future.
- These expectations that prices will only go up provided the classic fuel that sustains any bubble.
A key change he noted is that the Fed is now supplementing reviews of individual firms with "comparative evaluations across firms and with the analysis of the interactions among firms and markets."
An Abdication of Responsibility
He also promises to be more attentive to consumer protection. The primary criticisms from those in Congress seeking to reduce the Fed's powers stem primarily from the central bank's inaction when consumers needed that protection. Clearly, had the Fed moved more quickly to fix the key factors that caused the housing bubble, the financial crisis may have been avoided or at least minimized.
After all, Beranke's list of culprits all relate to borrowers' ability to get mortgages too easily and without proper financial advice and protections. The banker or mortgage broker is supposed to be a professional adviser when one seeks a loan, and they should have greater responsibility for the loan options they recommend.
Still, as the lead banking regulator, the Federal Reserve had the responsibility to recognize the dangers of these consumer abuses and act on them quickly. That's why a federal financial agency that focuses on protecting consumers is sorely needed. The Consumer Financial Protection Agency has passed the House, and, as Bernanke's latest speech makes clear, it's time for the Senate to act.