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Exotics Create More Borrowers

Exotics Create More BorrowersChicago Federal Reserve president speaks

January 23, 2007


The president of the Chicago Federal Reserve Bank recently said exotic and nonprime mortgages make it possible for borrowers to obtain financing when they otherwise couldn’t.

Subprime, interest-only and hybrid adjustable-rate mortgages “represent a net gain to society,” according to President and CEO Michael Moskow, by opening up financing to “borrowers who previously could not obtain it at all or could not borrow as much as they would like.”

But that gain from the “broadened selection of loan types available” exists only to “the extent that both borrowers and lenders understand the risks involved and markets have priced this risk properly,” he explained in a speech at an economic forecast luncheon in Coralville, Iowa.

This creates a role for public policy, he pointed out, noting that the Fed is supervising lenders with regard to the disclosure of terms and costs to borrowers and with regard to the risks of carrying such nonstandard loans on their books. And the Chicago Fed, which covers Iowa, Indiana, Michigan, Wisconsin and most of Illinois, is promoting financial literacy efforts for borrowers through an expanding number of programs, including its Money Smart Weeks.

Other changes in the mortgage origination process have contributed to a drop in initial fees and charges on mortgages from about 2.50% in the mid-1980s to less than 0.5% in recent years, he said. These include such innovations as credit scoring and automation, which have made the mortgage origination process less costly, and Internet shopping for the lowest rates and terms, which has increased competition.

Further, Moskow pointed out, the financial environment underlying today’s mortgage market is “quite different” than it was in the 1960s ands 1970s when regulatory ceilings on interest rates and other factors prevented some people from obtaining mortgages “regardless of the interest rates they were willing to pay.”

As for core inflation, he said it will ease “somewhat further” although “risks to the inflation outlook remain,” because of the low unemployment rate, accelerating unit labor costs and the potential of tight labor markets “down the road.”

But Moscow’s outlook for new home construction also was cautious.

“While I expect to see some further decline in residential construction, I do not think that the developments in housing markets will lead to more general economic weakness,” he said. “One reason is that a number of positive longer-run fundamentals underpin housing demand and thus put a floor on how far residential construction will decline.”

These include improved long-run income prospects for Americans and rising homeownership rates as well as mortgage industry innovations, he explained.

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