Hearing of the Joint Economic Committee - The Economic Outlook

Interview

Hearing of the Joint Economic Committee - The Economic Outlook

SEN. SCHUMER: Thank you. And I want to welcome you -- the hearing will come to order. I want to welcome Federal Chairman Ben Bernanke to this hearing of the Joint Economic Committee on the economic outlook.

This committee has a broad mandate to study and make recommendations about economic policy, and we're always pleased when the Federal Reserve chairman comes to share his views on the state of our economy.

Chairman Bernanke, when you came before this committee last March, one of the major topics discussed was the potential fallout from the subprime lending crisis. It's something this committee has been very concerned with for quite some time. And I think you'd be the first to admit that the subprime mess has not been contained but instead has proved to be contagion that has spread in dangerous ways throughout not just the housing market but our economy and even into the global financial system.

The seizing up of credit markets this summer was the first and clearest indication of the unanticipated and potentially disastrous risks that out-of-control subprime lending poses to financial markets. There is now a lack of confidence in credit-worthiness throughout the markets. And at the core is a lack of confidence in the subprime mortgage market. Until we correct that, we will not solve our broader problems.

I want to applaud you and the Federal Reserve Board for your aggressive and, I believe, appropriate response to this summer's liquidity crisis. It's vital that we maintain the health of our financial markets and to ensure that they function smoothly. And you deserve credit for your prompt actions.

However, while we did weather that summer storm, I am worried that there may be a bigger storm on the horizon. Quite frankly, I think we are at a moment of economic crisis stemming from four key areas: Falling housing prices, lack of confidence in credit- worthiness, the weak dollar and high oil prices.

Each of these problems alone would be enough of a threat to our economic well-being. But taken together, they are essentially the four horsemen of the economic crisis.

First, as we have warned, and as you acknowledge in your testimony, we face a wave of foreclosures in the next years that threaten millions of American homeowners and their neighbors. The housing boom has busted, and we may see trillions of dollars in lost home values across the nation.

Second, the credit markets remain in crisis. There's just simply a lack of confidence.

Third, the dollar has dropped dramatically against most of the major currencies of the world and seems to hit lows not seen in decades nearly every day.

And finally, oil prices keep reaching near-record highs, driving up energy costs in all sectors of the economy.

Even our bedrock assumptions are being put into doubt. As housing prices decline, there are real fears we won't be able to depend on consumers, the engine of our economy over the past few years, to keep spending. And we now hear that foreign investors may no longer be confident in the dollar as the global currency of choice. I'm not surprised to hear experts, such as your predecessor, Alan Greenspan, warn about the threat of recession. I've begun to worry about it too.

In particular, as I watch bank after bank write down bad investments tied to baroque financial instruments that even sophisticated investors don't understand, I fear about the stability and ultimate confidence in our financial system.

I've talked about the wild west of subprime mortgage brokers. I'm beginning to wonder whether we have a wild west of unregulated financial instruments, of SIVs and misrated CDOs and other complicated investments whose values are not mark to market or even mark to model, but to quote one Wall Street strategist, are mark to make-believe. To quote you, Mr. Chairman, "The markets want to know how much these damn things are worth."

And I want to know what all of us -- the Federal Reserve, the Congress and this administration -- can do, if anything, to assuage those fears. I'm very concerned, Mr. Chairman, that none of the regulators are acting quickly or boldly enough to deal with the risks we're facing. A laissez-faire, hands-off attitude might be appropriate if we had one of these crises, but confronting all of these problems at once should be a call to action, because the danger we face is so much greater.

I know that Secretary Paulson has organized a super-conduit to try to deal with the liquidity crunch faced by SIVs and the threat they pose to the broader financial markets. To be direct, I'm worried this may just be a shell game, an attempt to move bad investments around and keep them from landing back on the books.

I'll be curious to hear your opinion today, Mr. Chairman, about the secretary's plan, as well as your views about the risks these complex and opaque pools of capital now present to our financial system and how you intend to deal with them.

If you don't feel you have the tools at your disposal to address these problems, then I hope you'll share your views what we in Congress ought to do.

I'm glad to see that much of your statement is given over to the importance of helping distressed subprime borrowers. You mentioned some of the efforts my colleagues and I have made, and I won't spend more time on that right now.

But I will say it would really be nice if the administration would join us in our attempts to protect families from fallout of the subprime lending disaster. The policy responses from the administration have not come close to matching the magnitude of the crisis. There's a lack of confidence that anyone is in charge.

Mr. Chairman, if you feel that in your position you cannot speak publicly about the changes that are needed, I urge you to speak privately to members of the administration. Use your position to jawbone them into action. Your predecessor was not shy about putting his prestige and credibility to work behind the scenes, and I encourage you to do the same.

One of the great legacies of the American economy has been its ability to make everyone better off. Throughout most of our history, when our economic pie has gotten bigger, everyone has shared. The nation has prospered. Everyone got along.

But over the seven years of this administration, that has not been the case. Even in the recovery of the last few years, the benefits have gone mainly to those at the top. Now, as we face an economic slowdown or worse, I'm very worried it's those Americans who haven't shared in our recent growth who will bear the brunt of economic decline and that the policies of this administration will only further exacerbate their difficulties.

I don't pretend that there are easy solutions to troubling challenges facing our economy; the oil crisis, the falling dollar. They took years in the making and will not be solved with the snap of a finger. But we cannot shy away from those challenges. We cannot, for another day or month, avoid these problems any longer, because the chickens seem to be coming home to roost. And we need your voice, either publicly or privately, to help move us in that direction.

I look forward to your testimony on the economic outlook and to an interesting discussion of how we best meet these and other economic challenges we face.

Now, normally I encourage all of our members to make opening statements. But because we only have a limited time with Chairman Bernanke, I'm going to ask our vice chairman and the Senate and House ranking members to make opening statements. Other members may submit their full opening statements for the record.

And now I turn to the committee's ranking Republican, my colleague on the House side, Congressman Saxton.

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SEN. SCHUMER: Mr. Chairman, please proceed.

MR. BERNANKE: Thank you.

Chairman Schumer, Vice Chairman Maloney, Representative Saxton and other members of the committee, thank you for inviting me here this morning to present an update on the economic situation and outlook.

Since I last appeared before this committee in March, the U.S. economy has performed reasonably well. On preliminary estimates, real gross domestic product grew at an average pace of nearly 4 percent over the second and third quarters despite the ongoing correction in the housing market. Core inflation has improved modestly, although recent increases in energy prices will likely lead overall inflation to rise for a time.

However, the economic outlook has been importantly affected by recent developments in financial markets which have come under significant pressure over the past few months.

The financial turmoil was triggered by investor concerns about the credit quality of mortgages, especially subprime mortgages with adjustable interest rates. The continuing increase in the rate of serious delinquencies in such mortgages reflects, in part, a decline in underwriting standards in recent years as well as a softening of house prices. Delinquencies on these mortgages are likely to rise further in coming quarters as a sizeable number of recent vintage subprime loans experienced their first interest rate resets. I will have more to say about this problem and its implications for homeowners later in my testimony.

At one time, most mortgages were originated and held by depository institutions. Today, however, mortgages are commonly bundled together into mortgage-backed securities or structured credit products, rated by credit rating agencies, and then sold to investors. As mortgage losses have mounted, investors have questioned the reliability of credit ratings, especially those of structured products. Because many investors had not developed the capacity to perform independent evaluations of these often-complex instruments, the loss of confidence in the credit ratings, together with uncertainty about developments in the housing market, led to a sharp decline in demand for these products. Since July, few securities backed by subprime mortgages have been issued.

Although the problems with subprime mortgages initiated the financial turmoil, credit concerns quickly spilled over into a number of other areas. Importantly, the secondary market for securities backed by prime jumbo mortgages also contracted, and the issuance of such securities has declined significantly. Prime jumbo loans are still being made to prospective home purchasers, but they are at higher spreads and have more-restrictive terms.

Concerns about mortgage-backed securities and structured credit products, even those unrelated to mortgages, also greatly reduced investor appetite for asset-backed commercial paper, although that market has improved somewhat recently. In the area of business credit, investors shied away from financing leveraged buyouts and from purchasing speculative-grade corporate bonds. And some larger banks, concerned about potentially large and difficult-to-predict draws on their liquidity and balance sheet capacity, became less willing to provide funding to their customers and to each other.

To be sure, the recent developments may well lead to a healthier financial system in the medium to long term: Increased investor scrutiny of structured credit products is likely to lead ultimately to greater transparency in these products and to better differentiation among assets of varying quality. Investors have also become more cautious and are demanding greater compensation for bearing risk. In the short term, however, these events do imply a greater measure of financial restraint on economic growth as credit becomes more expensive and difficult to obtain.

At the height of the recent financial turmoil, the Federal Reserve took a number of steps to help markets return to more orderly functioning. The Fed increased liquidity in short-term money markets in early August through larger-than-normal open market operations. And on August 17th, the Federal Reserve Board cut the discount rate -- the rate at which it lends directly to banks -- 50 basis points, or 1/2 percentage point, and subsequently took several additional measures.

These efforts to provide liquidity appear to have been helpful on the whole, but the functioning of a number of important markets remained impaired. The turmoil in financial markets significantly affected the Federal Reserve's outlook for the broader economy. Indeed, in a statement issued simultaneously with the Board's August 17th announcement of the cut in the discount rate, the Federal Open Market Committee noted that the downside risks to economic growth had increased appreciably.

The Committee took further action at its next scheduled meeting on September 18th, when it cut its target for the federal funds rate 50 basis points. This action was intended as a counterbalance to the tightening of credit conditions and to address, in a preemptive fashion, some of the risks that financial developments posed to the broader economy.

The Committee met most recently on October 30-31. The data reviewed at that meeting suggested that growth in the third quarter had been solid -- at a 3.9 percent rate, according to the initial estimate by the Bureau of Economic Analysis. Residential construction declined sharply during the quarter, as expected, subtracting about 1 percentage point from overall growth.

However, the GDP report provided scant evidence of spillovers from housing to other components of final demand: Strong growth in consumer spending was supported by gains in employment and income, and businesses increased their capital spending at a solid pace. A strong global economy stimulated foreign demand for U.S.-produced goods and services, as foreign trade contributed nearly 1 percentage point to the growth of real output last quarter.

Looking forward, however, the Committee did not see the recent growth performance as likely to be sustained in the near term. Financial conditions had improved somewhat after the September FOMC action, but the market for nonconforming mortgages remained significantly impaired, and survey information suggested that banks had tightened terms and standards for a range of credit products over recent months. In part because of the reduced availability of mortgage credit, the contraction in housing-related activity seemed likely to intensify.

Indicators of overall consumer sentiment suggested that household spending would grow more slowly, a reading consistent with the expected effects of higher energy prices, tighter credit, and continuing weakness in housing. Most businesses appeared to enjoy relatively good access to credit, but heightened uncertainty about economic prospects could lead business spending to decelerate as well. Overall, the Committee expected that the growth of economic activity would slow noticeably in the fourth quarter from its third-quarter rate. Growth was seen as remaining sluggish during the first part of next year, then strengthening as the effects of tighter credit and the housing correction began to wane.

The Committee also saw down-side risks to this projection: One such risk was that financial market conditions would fail to improve, or even worsen, causing credit conditions to become even more restrictive than expected. Another risk was that, in light of the problems in mortgage markets and the large inventories of unsold homes, house prices might weaken more than expected, which could further reduce consumers' willingness to spend and increase investors' concerns about mortgage credit.

The Committee projected overall and core inflation to be in a range consistent with price stability next year. Supporting this view were modest improvements in core inflation over the course of the year, inflation expectations that appeared reasonably well anchored, and futures quotes suggesting that investors saw food and energy prices coming off their recent peaks next year.

But the inflation outlook was also seen as subject to important up-side risks. In particular, prices of crude oil and other commodities had increased sharply in recent weeks, and the foreign exchange value of the dollar had weakened. These factors were likely to increase overall inflation in the short-run and, should inflation expectations become unmoored, had the potential to boost inflation in the longer run as well.

Weighing its projections for growth and inflation, as well as the risks to those projections, the FOMC on October 31st reduced its target for the federal funds rate an additional 25 basis points, to 4- 1/2 percent. In the Committee's judgment, the cumulative easing of policy over the past two months should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time. Nonetheless, the Committee recognized that risks remained to both of its statutory objectives of maximum employment and price stability. All told, it was the judgment of the FOMC that, after its action on October 31st, the stance of monetary policy roughly balanced the up-side risks to inflation and the down-side risks to growth.

In the days since the October FOMC meeting, the few data releases that have become available have continued to suggest that the overall economy activity -- the overall economy remained resilient in recent months. However, financial market volatility and strains have persisted. Incoming information on the performance of mortgage- related assets has intensified investors' concerns about credit market developments and the implications of the downturn in the housing market for economic growth. In addition, further sharp increases in crude oil prices have put renewed upward pressure on inflation and it may impose further restraint on economic activity. The FOMC will continue to carefully assess the implications for the outlook of the incoming economic data and financial market developments and will act, as needed, to foster price stability and sustainable economic growth.

I would like to say a few words about actions being taken to help homeowners who have fallen behind on their mortgage payments, or seem likely to do so.

As I mentioned, delinquencies will probably rise further for borrowers who have a subprime mortgage with an adjustable interest rate. As many of these mortgages will soon see their rates reset at significantly higher levels.

Indeed, on average from now until the end of next year, nearly 450,000 supreme mortgages per quarter are scheduled to undergo their first interest rate reset. Relative to past years, avoiding the payment shock of an interest rate rest by refinancing the mortgage will be much more difficult, as home prices have flattened out or declined, thereby reducing homeowners' equity and lending terms have tightened.

Should the rate of foreclosure rise proportionately, communities as well as individual borrowers will be hurt because concentrations of foreclosures tend to reduce property values in surrounding areas. A sharp increase in foreclosed properties for sale could also weaken the already struggling housing market and thus potentially the broader economy. Home losses through foreclosure can be reduced in financial institutions work with borrowers who are having difficulty meeting their mortgage payment obligations.

In recent months, the Federal Reserve and other banking agencies have issued statements calling on mortgage lenders and mortgage servicers to pursue prudent loan workouts. Our contacts with the mortgage industry suggest that servicers recently have stepped up their efforts to work with borrowers facing financial difficulties or an imminent rate reset.

Some servicers have been proactive about contacting borrowers who have missed payments or faced resets, and experience shows that addressing the problem early increases the odds of a successful outcome. Foreclosure cannot always be avoided, but in many cases loss mitigation techniques that preserve home ownership are less costly than foreclosure. To help keep borrowers in their homes, servicers have been offering assistance for the repayment plans, temporary forbearance and loan modifications.

Comprehensive data on the success of these efforts to avert foreclosures are not available. My sense is that there is scope for services to further increase their loss mitigation efforts. The development of standardized approaches to workouts and the sharing of best practices can help increase the scale of the effort even if, ultimately, workouts must be undertaken loan by loan.

Although workouts are to be encouraged, regulators must be alert to ensure that they are done in ways that protect consumers' interests and do not disguise lenders' losses or impair safety and soundness. The Federal Reserve has been participating in efforts by community groups to help homeowners avoid foreclosure. For example, Governor Kroszner of the Federal Reserve Board serves as the director of NeighborWorks America, a nonprofit organization that has been helping thousands of borrowers facing current or potential distress to obtain assistance from their lenders, their servicers or trusted counselors through a hotline.

The Federal Reserve Board 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. Other contributions include foreclosure prevention programs, such as the Home Ownership Preservation Initiative, which the Federal Reserve Bank of Chicago helped to initiate, and efforts by Reserve banks to convene workshops for stakeholders to develop community-based solutions to mortgage delinquencies in their areas. The Federal Reserve System is also engaged in research and analysis that should help inform policy responses to these issues.

The Congress is also focused on reducing homeowners' risk of foreclosure. One statutory change that could help is the modernization of programs administered by the Federal Housing Administration. The FHA has considerable experience helping low and moderate-income households obtain home financing, but it has lost market share in recent years partly because borrowers have moved toward non-traditional products with more flexible and quicker underwriting and processing, and partly because of a cap on the maximum loan value that can be ensured. In modernizing the FHA, the Congress might encourage joint efforts with the private sector that expedite the refinancing of subprime loans held by credit-worthy borrowers facing resets. It might also consider granting the agency the flexibility to design products that improve affordability through such features as variable maturities or shared appreciation. Also, the FHA could provide more refinancing options for riskier households if it could tailor the premiums that charges for mortgage insurance to the risk profile of the borrower.

As I have discussed in earlier testimony, the Federal Reserve is taking steps to avoid subprime lending problems from recurring while preserving responsible subprime lending. In coordination with other federal supervisory agencies and the Conference of State Banking Supervisors, we have issued principles-based underwriting guidance on subprime mortgages to help ensure that borrowers obtain loans that they can afford to repay and have the opportunity to refinance without prepayment penalty for a reasonable period before the first interest rate reset. In addition, together with the Office of Thrift Supervision, the Federal Trade Commission, the CSBS and the American Association of Residential Mortgage Regulators, we have launched a pilot program aimed at strengthening reviews of consumer protection compliance at selected non-depository lenders with significant subprime mortgage operations.

Finally, using the authority granted us by the Congress under the Home Ownership and Equity Protection Act, we are on schedule to propose rules by the end of this year to address unfair or deceptive mortgage lending practices. These rules would apply to subprime loans offered by any mortgage lender. We are looking closely at practices such prepayment penalties, failure to escrow for taxes and insurance, stated income and low-documentation lending and failure to give adequate consideration to a borrower's ability to repay.

Using our authority under the Truth in Lending Act, or TILA, we expect that we will soon propose rules to curtail abuses in mortgage advertising and to ensure that consumers receive mortgage disclosures at a time when the information is likely to be the most useful to them. We are also engaged in a rigorous broader review of the TILA rules for mortgage loans, which will make use of extensive consumer testing of disclosures.

Thank you. I'd be pleased to answer your questions.

SEN. SCHUMER: Thank you, Mr. Chairman. Very much appreciate your comprehensive testimony. And you noted in the -- you noted in your statement that you thought there would be slow growth in the next few quarters, but not a recession. You also noted there are downsides that one would have to take into account and they would be, again, what I call the four horsemen of our economic problems: low housing price -- lower housing prices, higher oil prices, dropping dollar and lack of confidence in the credit markets.

So let me ask you a question. What -- is a recession out of the question? What is the likelihood we might go into a recession? If I could make it simple, on a scale of one to 10 -- 10 being most likely -- how likely is a recession?

MR. BERNANKE: Mr. Chairman, as I -- as you noted, our forecast is for moderate but positive growth going forward for the next few quarters. Economists are extremely bad at predicting turning points and we don't pretend to be any better. We have not calculated the probability of recession and I wouldn't want to offer that today. Again, our assessment is for slower growth, but positive growth going into next year. We think that by the spring -- early next year that is -- as these credit problems resolve and as we hope the housing market begins to find a bottom, that the broader resiliency of the economy, which we are seeing in other areas outside of housing, will take control and will help the economy recover to a more reasonable growth pace.

SEN. SCHUMER: Thank you.

Next, yesterday, there was mention by a Chinese official -- some gave it more credence than others -- that the Chinese might start investing more of their assets, even switching over some of their assets, to those in stronger currencies than the dollar. How worried are you about that? How likely is it to occur? How much credibility do you give the statement that was made yesterday?

MR. BERNANKE: There is no official government statement on -- in this regard and I am not particularly concerned about any major change in the holdings of China or any other country. There is on the margin sovereign wealth funds and portions of reserve accumulations that are being devoted to higher return, which means spreading across instruments as well as across currencies. But again, I don't see any significant change in the broad holdings of dollars around the world. Dollars remain the dominant reserve asset and I expect that to continue to be the case.

I would like to add, though, that the strength of the dollar in the medium term will ultimately depend not on those portfolio choices so much as on the strength of the U.S. economy, our trade situation and on the openness of our financial markets to foreign capital. And I'm optimistic on those fronts, and I do believe that that will lead to a sound dollar in the medium term.

SEN. SCHUMER: Wouldn't it be in the interest of some of these foreign countries in the longer term, not in the immediate term, if the dollar continues to show the weakness it has shown so far to diversify?

MR. BERNANKE: Well, if they are pegging their exchange rate to the dollar, then there's a certain need -- to whole dollars, of course. But I think, more broadly, that the financial markets in the U.S. are still the deepest, the most liquid and offer the most range of investment opportunities. And in that respect, you often see, for example, trade between third countries still being invoiced in dollars, because it remains a standard of value around the world, and I expect that to continue.

SEN. SCHUMER: One of the engines of our economic growth, the main engine, has been consumer spending. It's been estimated that a significantly high percentage of that consumer spending was fueled by refinancings of homes, which gave the consumer more money to spend for other things. The decline in housing prices, both because refinancings would decline and because people felt they had less in terms of assets, present a problem for consumer spending. How much do you expect the decline in housing prices to affect consumer spending? And again, if home prices decline further than you expect, would that create a real danger for our economy?

MR. BERNANKE: Well, certainly as homeowners see their wealth declining in terms of their house value, that will affect their thinking about their long-term spending opportunities and affect their spending. We do not take an alarmist view on this, however. There are some who feel that consumers react extremely strongly to changes, for example, in home equity line availability. Our sense is that the relationship between home wealth and consumer spending is governed primarily by what's called the wealth effect which suggests that for each dollar that a house value falls there's a net effect on consumer spending of somewhere between four and nine cents, something like that. And that effect may be spread over a period of time. So there would be an effect, but we see it as relatively moderate.

But as you point out correctly, there are a number of factors at play right now, including high oil prices, for example, that would be negatives for consumer spending. On the other hand, to the extent the labor market has remained reasonably strong and employment income has continued to grow, that is a positive to help sustain the consumer.

SEN. SCHUMER: One final question. Federal Reserve Governor Kroszner recently suggested that mortgage investors and servicers modify subprime mortgages en masse rather than on a case-by-case basis, because it's just so hard, there are so few people on the ground. These are complicated instruments these days. What is your view of doing that? I know that the Federal Reserve, you said you were going to issue some guidance to lenders on rules-based standardized loan modifications. Could you comment on how seriously the Fed would take Governor Kroszner's idea and what you're doing about it?

MR. BERNANKE: We take it seriously. I mentioned in my testimony the need to begin to scale-up these efforts as resets become imminent. So we are looking, for example, we are already talking with servicers who are developing either computer programs or templates or procedures that allow them, at least as a first cut, to categorize mortgages in terms of how they are to be treated. That, on the one hand, will help them scale-up their efforts, and we believe that's beginning to happen, and we encourage that to happen. And in addition, by providing a systematic approach to addressing these mortgages, they actually protect themselves against claims by investors or others who feel that they are arbitrarily changing or modifying the loans. So we do support scaling-up these efforts, and the best way to do that is by creating some more systematic approaches to doing so.

SEN. SCHUMER: Thank you.

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SEN. SCHUMER: Thank you, Mr. Chairman and thank you, Senator Casey.

We want to thank you. I know you have to leave at 12:20, so I just have a quick, quick question here. In your testimony, you suggested that GSEs might be allowed to securitize jumbo loans with the federal government acting as guarantors. I think that's a very good idea. In fact, legislatively it's something that I would try to introduce and get passed. Do you have any idea of how high that ought to go for all loans, even 2 (million dollars) or $3 million mortgages?

MR. BERNANKE: That's up to Congress, but certainly --

SEN. SCHUMER: What would be your thought?

MR. BERNANKE: A million -- $1 million.

SEN. SCHUMER: Thank you.

Okay. Thank you, Mr. Chairman, for your patience. We had a series of votes. We very much appreciate your being here. (Gavel sound.)

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