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Prof. Lawrence Summers testified before the U.S. Senate Committee on Banking, Housing, and Urban Affairs on April 10, 2008, as part of a discussion about solutions to mitigate the rising number of foreclosures occurring across the nation, which have led to turmoil in the mortgage and credit markets.
The economy is very likely to be in a recession. If it is not in recession this is just a technicality. The dislocations typically associated with recessions are almost certain to be felt. The likelihood is very high that the downturn will continue for at least the next two quarters despite the many constructive steps including fiscal and monetary stimulus that have been taken in recent months.
More distress lies ahead. Confident forecasts are impossible but available futures markets' estimates suggest that house prices could easily fall an additional 15% to 25% from current levels. Declines are likely to be concentrated in lower priced homes that have been financed through sub-prime mortgages and in areas of the country where sub-prime lending has been especially prevalent. It is conceivable that if the recession proves protracted or there are further serious problems in the financial system the decline in house prices could be considerably more severe.
These declines in house prices are placing unprecedented burdens on the mortgage finance system. It appears that the dominant determinant of foreclosure experience is the behavior of home prices and not the financial fortunes of individual borrowers. It is likely that within the next 2 years up to 15 million homes will have negative equity and that more than 2 million foreclosures will take place. Because we are in unprecedented territory with respect to the pervasiveness of negative equity it is impossible to predict accurately how many people will walk away from their homes. I believe there is more room for foreclosures to surprise on the high than on the low side.
While there has been some restoration of normality in the financial markets since the Bear Stearns events of mid-March, markets remain quite fragile. In particular there is considerable reason to believe that some debt securities, including those backed by mortgages, are selling at prices that reflect scenarios considerably more dire than those set out above. In the judgment of most sophisticated market observers, this reflects financial conditions rather than a market judgment that house prices will fall even more catastrophically than the consensus envisions.
There is no legitimate basis given the magnitude of disruptions in the financial markets for complete confidence that the housing market will be self-correcting. There is the risk of vicious cycles as declining prices lead to foreclosures which lead to increased supply which lead to declining prices. There are also risks of vicious cycles of a similar kind in the mortgage market. Prudent public policy can make an important insurance for the housing sector and by supporting the housing sector, to overall economic health.
At the same time, it is essential to recognize that policies that serve only to delay inevitable adjustments can easily prove counterproductive. There will be no ultimate stability until market prices reach levels at which potential investors and homeowners feel good about their prospects. The policy challenge is to mitigate market overreactions while not interfering with necessary or inevitable adjustments. Policy makers should give serious consideration to these four areas:
Lawrence Summers, Charles W. Eliot University Professor of Harvard University
"It is likely that within the next 2 years up to 15 million homes will have negative equity and that more than 2 million foreclosures will take place...It is impossible to predict accurately how many people will walk away from their homes. I believe there is more room for foreclosures to surprise on the high than on the low side." Summers told lawmakers.