Mr. Chairman, Ranking Member Issa, and members of the Subcommittee, thank you for the opportunity to be here today. I am Alex Pollock, a Resident Fellow at the American Enterprise Institute, and these are my personal views. Before joining AEI, I spent 35 years in banking, including 12 years as President and CEO of the Federal Home Loan Bank of Chicago, and am a Past President of the International Union for Housing Finance. I have both experienced and studied many credit cycles, of which the subprime mortgage boom and bust is the latest example.

I will address five topics:

• The evolution of American banking structure
• The subprime mortgage bust in context
• The case of Ohio
• Information asymmetries
• The one-page mortgage disclosure proposal

The Evolution of American Banking Structure

In 1970, when I was just beginning in the banking business, there were about 13,500 banks in the U.S. By 2005, there were about 7,500--a reduction almost in half. How should we think about this consolidation?

The historical context is that the normal evolution of banking to a national basis, to match the evolution to a national U.S. economy in other respects, was blocked for decades by artificial legislative and regulatory barriers. This resulted in a fragmented, less efficient, and more risky banking system composed of mostly undiversified small entities. When the barriers to the natural development were removed, the delayed consolidation, which is still in process, began.

This does not result in reduced access to banks--just the opposite. In 1970, there were about 44,600 banking offices, mostly branches; by 2005, this had increased to about 80,300. So while the number of banks halved, the number of banking locations about doubled. They significantly increased per capita--from 1.7 to 2.8 locations per 10,000 of population, or about a 60% increase.

Of course, that does not count off-site ATMs, which weren't there in 1970, but have grown to 260,000, networked across the country and indeed the world. Nor does it include debit cards, then nonexistent, now ubiquitous, with more than 270 million in circulation.

In short, on a national basis, bank consolidation has been accompanied by much greater convenience and access to the banking and payment system.

I am by no means an expert on Cleveland. However, between 1970 and 2005, the population of the city fell from 751,000 to 415,000, or about 45%. If Cleveland matched the national averages, the increase in banking offices per capita combined with the population decline would mean a reduction of about 12% in banking locations. At the same time, there would have been a notable increase in the number of ATMs and debit cards.

The Subprime Mortgage Bust in Context

As we all know, the unsustainable expansion of subprime mortgage credit which accompanied the great house price inflation of the past several years is in reverse. The market is correcting sharply and rapidly. Former enthusiasm has been replaced by large financial losses, layoffs, bankruptcy of subprime lenders, accelerating delinquencies and foreclosures, a recession in homebuilding, tightening liquidity, and of course, recriminations. The subprime boom is over; the bust is here.

All these elements display the classic patterns of recurring credit overexpansions and their aftermath. Such expansions are based on optimism and a euphoric belief in the ever-rising price of some asset class--in this case, houses and condominiums. This appears to offer a surefire way for lenders and borrowers to make money. The booms are inevitably followed by a hangover of defaults, failures, dispossession of unwise or unlucky borrowers, revelations of fraud and scandals, and late-cycle regulatory and political reactions.

With regard to last point, since 1970 we have had the Emergency Home Finance Act of 1970, the Emergency Housing Act of 1975, The Emergency Housing Assistance Act of 1983, and the Emergency Housing Assistance Act of 1988. (I do not count the Hurricane Katrina Emergency Housing Act of 2005, a special case.) The eminent financial historian, Charles Kindleberger, estimated that over the centuries, financial crises of various kinds recur about once a decade on average, and so have emergency housing acts.

In the general pattern of credit overexpansions, nothing changes. You would think that we would learn, but we don't.

This time, we had a period of remarkably rising house prices--the greatest house price inflation ever, according to Professor Robert Shiller of Yale University. This stimulated the lenders--and it stimulated the borrowers. If the price of an asset is always rising, the risk of the loan seems less and less to both.

Subprime mortgages grew from 2.4% to 13.7% of total mortgage loans from 2000 to 2006, according to the Mortgage Bankers Association. Interestingly, however, the MBA numbers show that the proportion of prime loans also increased, from 72.6% to 76.6%. How could both increase? Because the share of the government's FHA and VA loans--also nonprime--fell from 25.2% to 9.7%. So subprime loans basically took share away from the government alternatives. If we add together the subprime, FHA and VA shares as the nonprime total, it falls from 27.6% to 23.4% over the six-year period. Of course all the whole market was growing rapidly.

Booms are usually accompanied by a theory that we are in a "new era": the subprime mortgage boom was no different. A good example of such thinking was a 2005 book by an expert housing economist entitled, Are You Missing the Real Estate Boom? The Boom Will Not Bust and Why Property Values Will Continue to Climb Through the Rest of the Decade. It began, "The recent U.S. real estate boom has made money for an incredible number of households in America."

This is a key point. The boom gets going because many people experience financial success. This so-far successful speculation is extrapolated. Subprime borrowers could get loans to buy houses they would otherwise be unable to and benefit from subsequent price appreciation. A borrower who took out a very risky 100% LTV, adjustable rate mortgage with a teaser rate to buy a house which subsequently appreciated 30% or 40% now had substantial equity and a successful outcome as a result of taking risk.

Should people be able to take such risks if they want to? Yes, but they should have a reasonable idea of what they're doing.

Mortgage finance has some reliable systematic risk factors, and the subprime boom had all these factors operating together:

• Subprime loans have higher defaults and losses than prime loans 
• Adjustable rate loans of all kinds have higher defaults and losses than fixed rate loans
• High loan-to-value (LTV) loans have higher defaults and losses than low LTV loans
• Low documentation loans have higher defaults and losses than standard documentation loans.

Current statistics reflect all these fundamental factors. The subprime mortgage lenders knew all these statements were true, but the risk acceleration of the boom outstripped the expectations of their models.

The national foreclosure rate on subprime mortgages of 4.5% at the end of 2006 was well below its recent peak of over 9% in 2000, but is rising. The foreclosure rate for the oil patch mortgage loan bust of the 1980s peaked at 14.9% for Arkansas, Louisiana, Mississippi and Oklahoma--an extreme experience used for stress tests by the bond rating agencies.

Booms almost always induce fraud, misrepresentation and scandals. National Mortgage News recently referred to "the explosion of mortgage fraud," that is, the lenders being defrauded.

Consider in this context the spread of so-called "stated income" loans. The disastrous previous experience with this idea, then called "no doc" or "low doc" loans, seems to have been forgotten. They have the now-familiar name of "Liars' Loans," since they are an obvious temptation to exaggerate income in order to get the loan to buy the house you want.

A study cited by a COHHIO paper, "Dimensions of Ohio's Foreclosure Crisis," suggests that "over 90% of stated income loans had inflated incomes." Personally, I doubt that it is that high, but do not doubt that it is widespread. Subprime borrowers with defaulted loans have sometimes been referred to as "victims." In my view, however, people who lied about their income to get a loan do not qualify as victims. In the one-page disclosure I will discuss further below, an essential item is a clear and unambiguous confirmation of the household income upon which the loan is based.

The Case of Ohio

Ohio has the highest percentage of mortgage loans in foreclosure among states, according to MBA statistics, at 3.38%, compared to a national average of 1.19%. It has a relatively high share of subprime loans at 15.4%, compared to a national average of 13.7%. It also has a high rate of homeownership, 73.3%, up from 68.7% in 1990 and well over the national average of 69%. It has relatively high unemployment (5.6%) and low job growth (0.1% year over year), two factors significantly correlated with mortgage loan defaults. Its statistics are quite similar to those of neighboring Michigan and Indiana, but with the highest serious delinquency rate of the three and indeed in the U.S.

The serious delinquency rate, a key credit indicator, is the sum of loans 90 days past due and in foreclosure. Ohio's rate is 5.12%.

But this is not only a subprime problem. Ohio's serious delinquency rate is approximately twice the national average in all loan categories. It is 2.1 times the average in subprime ARMs, 2.2 times in subprime fixed, 1.6 times in FHA loans--and 2.7 times the average in prime ARMs and 2.7 times the average in prime fixed rate loans.

The specific serious delinquency rates of Ohio vs. the U.S. average are as follows:

                                  Ohio         U.S.

Subprime ARMs:       19.03% vs. 9.16%

Subprime fixed rate:   13.05% vs. 6.04%

FHA:                         9.43% vs. 5.78%

Prime ARMs:             3.89% vs. 1.45%

Prime fixed rate:         1.95% vs. 0.69%

It is interesting that for the country as a whole, FHA loans, which are predominately fixed rate, have a serious delinquency rate very similar to fixed rate subprime loans. This is not true for Ohio, however.

Also interesting is that according to the 2007 COHHIO study, "contrary to popular perceptions more subprime mortgages were originated in Ohio's middle and upper income areas, than in moderate and low income areas….Subprime loans are now a predominately middle and upper income product."

All in all, the problems are obviously serious, but they appear to me more complex than a simple "subprime loans" story.

Information Asymmetries

"Information asymmetries" is an academic way of describing a common problem in financial and other transactions when one party knows a lot more about the relevant matters than the other--or stated the other way, when one party is naïve and uninformed and the other is the opposite. This is a classic problem with various remedies. It is quite interestingly discussed in the mortgage context by Professors Engel and McCoy in their paper, "A Tale of Three Markets," although I reach a different conclusion than they do.

If we are worried that A is insufficiently knowledgeable to be able to achieve a fair transaction, there are two fundamental approaches. One is to appoint B to take care of A.

This is the class of regulatory or fiduciary approaches, paternalistic in various degrees. The other is to require B to tell A the truth and equip A to take care of himself. This is the class of disclosure approaches, which maintain that people will protect their own interests if they have the relevant information.

To help address the shortcomings of the subprime market which have become evident, I believe a new, superior disclosure approach is needed, whether or not we do anything else. The key is to realize that complex, lengthy statements in regulatoryese and legalese do not achieve the goal. Moreover, the simple, clear disclosure should be focused on the financial impact on the borrower, not on the financial instruments. Of this, more in a moment.

Another information asymmetry which has characterized the subprime mortgage boom is the difference between the credit knowledge possessed by the party actually making the loan and the investor buying the security. This is a general problem with securitized markets.

I believe that in an ideal mortgage finance system, the loan originator should always maintain a significant credit risk position in the loan, which creates a superior alignment of incentives. This is always my advice to developing countries as they consider housing finance ideas. As it did in the subprime mortgage boom, securitization typically breaks the link between the originator of the loan and who actually bears the credit risk. This can lead to less careful lending.

But securitization, as it developed in the 1980s, also saved the fixed rate mortgage loan. Remember that fixed rate mortgages kept in portfolio by the savings and loans were the basic cause of the savings and loan collapse of the 1980s, due to their interest rate risk.

Financial markets are always experimenting with how best to move risks around, but risk cannot be made to disappear.

The Ohio Attorney General has recently announced that he plans to sue subprime mortgage lenders and investment banks on behalf of both borrowers and the Ohio Public Employees Retirement System, which invested in subprime mortgage-backed securities. The argument would be that there were unfair information asymmetries on both ends.

However, the Attorney General should be glad that investors in subprime assets are not legally responsible for the actions of the lenders--as some people have suggested they should be--or he would have to sue his own Retirement System.

The One-Page Mortgage Disclosure Proposal

When considering borrowers in financial trouble, whether from unwise borrowing, not having understood the loan, or even induced into loans by misrepresentation, there is a natural political reaction to try to protect them through credit regulation.

I believe a superior strategy is to equip borrowers to protect themselves by requiring short, simple and clear disclosures of the key mortgage loan terms and their relation to household income. The borrowers can then "underwrite themselves." They have the natural incentive to do so--we need to add intelligible, practical information.

Thus I propose there should be a required one-page form which gives the essentials of the loan and its monthly cost, which must be given to every mortgage borrower three days before closing.

A good mortgage lender wants a borrower who understands how the loan will work, including any possible future interest rate increases and prepayment penalties. The total monthly obligation needs to be put clearly in the context of the borrower's income.

Current American mortgage loan documents certainly do not achieve this. Most of us have had the experience of being overwhelmed and befuddled by the huge stack of documents full of confusing language in small print presented to us for signature at a mortgage closing. The complexity results from legal and compliance requirements. Ironically, past regulatory attempts to insure full disclosure have made the problem worse. That is because they attempt full, rather than relevant, disclosure.

To achieve an informed borrower, the key information must be simply stated and clear, in regular-sized type: 90% of the relevant information which is clear and understandable is far better than 100% of the details which are complex and hard to read. Trying to describe the details in specific legal and bureaucratic terms results in essentially zero information transfer to the borrower.

The one-page form should include key underwriting concepts, including the borrower's income and housing expense ratio, as well as principal loan terms. The "housing expense ratio" means the sum of the monthly interest payment, principal payment, property tax, and house insurance premium, expressed as a percent of the borrower's monthly income. This should be shown for both the initial interest rate and the fully-indexed interest rate. In typical types of subprime loans, the fully-indexed expense ratio can be a remarkably larger burden than the initial or "teaser" rate suggests.

The proposed one-page "Basic Facts About Your Mortgage Loan" form, with accompanying common sense explanations and avuncular advice, is Attachment 1.

The Shadow Financial Regulatory Committee, while rejecting on economic grounds a number of other proposals for government actions, supports the simplified disclosure approach as "the only reform that merits attention at this time." Their statement is Attachment 2.

One of the deans of mortgage journalists has written of how the one-page proposal is distinct from previous regulations and simplification attempts. His article is Attachment 3.

Whatever else is done or not done, I believe the one-page disclosure would be an important step forward for America's and Ohio's mortgage borrowers and housing finance system.

Thank you again for the opportunity to share these views.

Attachment 1: "The Basic Facts About Your Mortage Loan"

Attachment 2: "Subprime Mortgage Lending Remedies and Concerns"

Attachment 3: "Form Simplifies Rules for Lending Process"