After a speech on revitalizing neighborhoods in Maryland Wednesday, Elizabeth Duke, a governor of the board of the Federal Reserve System presented framework for a “better-functioning” mortgage market while speaking at the Federal Reserve Bank of Chicago. Data collected under the Home Mortgage Disclosure Act for 2008 showed a fractured market for housing finance, Duke said, with frozen private lending and new loans dependent on government support. Only 75% of the mortgage companies active in 2006 remained in 2008 as warehouse lines of credit – which the companies depended upon to fund their loans – shrank “significantly,” Duke said. “Some would argue that most of the really risky behavior is now out of the market,” Duke said. “But, unfortunately, the backlash has restricted a lot of perfectly responsible lending as well. Banks are reluctant to put any but the lowest possible risk loans in their portfolios.” Duke said that a new system must provide adequate consumer protection after widespread abuses so consumers can feel confident in negotiating a mortgage. “Second, there must be transparency at all levels. Retail products should be as transparent as possible, so that consumers find it easy to understand the terms and risks of their mortgages,” Duke said. She added that lenders and servicers should provide as much information as possible to investors to attract capital back to the market. “Third, the new system should encourage simplicity. Retail mortgage contracts ought to be as simple as possible. Too often, the complexity of mortgages has served to confuse borrowers and make it more difficult to make informed decisions,” Duke said. While the complexities of financial innovations are an inevitable byproduct, simpler instruments would likely grow in demand in the future, she said. “Finally, the new system should feature clear roles and properly aligned incentives for all players. Too often in the recent turmoil, we saw examples of misaligned interests and competing objectives,” Duke said. On the origination side, Duke said that incentives for counseling, whether before a purchase or during foreclosure would, would continue to provide better outcomes for consumers. For the secondary market, a mechanism for moving investment funds into housing finance, either through covered bonds, loan securitizations “or some other mode,” would be critical in meeting the demands of a normal market. Going forward, servicer contracts must provide guidance and incentive structures for “transparency and certainty” in the use of loss mitigation tools such as modification. “It would be hard to overestimate the damage that has been done to the housing market in recent years, and especially to the millions of families that are suffering the devastating consequences of foreclosure,” Duke said. “It would be equally difficult to overestimate the damage that would be done in the future if we must live with a chronically impaired mortgage market.” Write to Jon Prior.

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