And now, fresh off passing the 2300-page Dodd-Frank Wall Street Reform and Consumer Protection Act, Congress promises to address the “problem” of Fannie Mae and Freddie Mac.
Be afraid. Be very afraid.
Oh, not because Fannie Mae and Freddie Mac don’t need to be reformed. They sure do. They were at the heart of the U.S. housing bubble and the mortgage debacle that mutated into the global financial crisis.
And not because Congress can be counted on to compromise its way into a hash that combines the worst of private market gestures with the worst of bureaucratic rule-splitting.
No, the real danger is that a mistake in fixing Fannie and Freddie could take down the U.S. Federal Reserve. Or at least take down the Fed to the degree that any central bank, with a central bank’s ability to create money, can be taken down.
All hyperbole aside, a mistake in fixing Fannie Mae and Freddie Mac could throw the U.S. financial system into crisis again by destroying the balance sheet of the Federal Reserve.
The two entities—I don’t know quite what else to call them at the moment now that the once government agencies turned publicly traded companies turned ward of the taxpayer—played a central role in the housing bubble that led to the global financial crisis. By using an assumed government guarantee to raise cheap money from investors who persisted until the very end in thinking that so-called agency paper was “like” a U.S. Treasury, Fannie Mae and Freddie enabled mortgage lenders to pass on a riskier and riskier mix of mortgage paper to the financial markets.
And if you can pass on risk to someone else, the temptation to make more money by taking on greater and greater risk—for someone else—is almost irresistible. Certainly very few mortgage lenders were able to fight the urge. The result was shoddy underwriting that at its worst wrote mortgages to any borrower with a pulse—even if they didn’t have an income, a credit rating as high as the mortgage banker’s IQ, or any real need for the money.
Now, as a result of the mortgage debacle and the global financial crisis, private mortgage lenders from banks to savings and loans have pretty much stopped lending. In the first quarter of 2010 the two entities—plus Ginnie Mae, which had an actual explicit government guarantee before the crisis—guaranteed 95% of all mortgage originations in United States. In other words in the first quarter of 2010 Fannie Mae and Freddie Mac were the mortgage industry.
Or maybe more accurately U.S. taxpayers are the mortgage industry. The Federal government took over Fannie Mae and Freddie Mac in 2008 and taxpayers now own about 80% of the two entities.
What do we own? It’s not pretty. Fannie Mae own or guarantee almost half of the $10 trillion in outstanding U.S. mortgages. But at the end of the first quarter, Fannie and Freddie reported $330 billion in non-performing loans. And that portfolio is likely to get worse before it gets better.
In 2008, once the damage was done, both Fannie and Freddie began tightening their standards for mortgages and raised the fees they charge to guarantee bundles of mortgages wrapped up into mortgage-backed securities. For example, in 2007 10% of mortgages at Fannie and Freddie were for 95% or more of the value of the house. By 2009 that figure had dropped to just 1%
But the damage to the loan portfolios from pre-2008 lending practices is staggering. At the end of March 2010 about 4% of the mortgages originated by Freddie Mac in 2008 were delinquent by at least 90 days. For mortgages originated in 2009 the figure was a little less than 0.1%.
That’s swell—except that Fannie and Freddie guaranteed a huge number of mortgages in the boom years of 2006 and 2007. Mortgages originated in those two years make up 24% of Fannie Mae’s business, for example, but account for 67% of its credit losses,
So far, propping up Fannie Mae and Freddie Mac by providing them with the money to cover losses and stay in business has cost taxpayers $145 billion.
So far. Estimates of the total cost to taxpayers come in all over the block because they’re all based on guesses about when the U.S. economy—and the U.S. housing market—improves and how fast that improvement is. The White House estimates $160 billion. (Let’s see we’re at $145 billion and defaults are still accelerating for prime mortgages. I’ll be kind and say, Unlikely. For more on the rising number of the “best” mortgages that are now going bad see my post https://jubakpicks.com/2010/07/28/more-cheery-numbers-from-the-mortgage-front/ ) The Congressional Budget Office says $389 billion through 2019. Barclays Capital said the cost could rise to as much as $500 billion if housing prices fall by 20% from the levels of the end of 2009 and default rates triple.
If. The truth is nobody knows exactly but it’s a big figure.
And that’s really only part of the balance sheet. Taxpayers acting directly through sending truckloads of money to Fannie and Freddie were only part of the effort to prop up these entities in order to prevent the meltdown of the mortgage market and the complete collapse of housing industry.
The Federal Reserve also rode to the rescue. While taxpayers were providing billions so Fannie and Freddie could keep guaranteeing mortgages, the Federal Reserve was stepping in as a buyer to preserve at least the illusion of a market for the resulting paper. By its press release after its March 18 meeting, when the Fed began winding down its mortgage buying program, the Federal Reserve said it had The Fed, it notes in its statement, has purchased $1.25 trillion of Fannie Mae and Freddie Mac mortgage-backed securities and bought an addition $175 billion of debt from those two-entities.
Which puts the Fed’s balance sheet on the hook if anything goes wrong in the mortgage market. Or with a fix of Fannie Mae and Freddie Mac.
What could go wrong?
Normal stuff like an increase in interest rates. Remember that an increase in interest rates pushes down the price of existing bonds and other yield instruments—such as mortgage-backed securities. An interest rate increase of one percentage point would deliver a $50 billion haircut to the Fed’s Fannie Mae and Freddie Mac portfolio.
I’m not too worried about this. Not because it can’t or won’t happen but because it falls that the category of predictable bad news. The Fed has a ton of people who spend all their time worrying about the effect of interest rates on things that include the U.S. economy and, by the way, the Fed’s portfolio. The Fed may not be able to control the direction of long-term rates (the central bank only sets short-term rates) but it’s unlikely to get blindsided by the effect of interest rates on its own portfolio.
Reform—a word that covers a multitude of sins, good intentions, and botched legislation—is a far different matter. Once you start making changes in a market—and that’s what we’re talking about when we’re talking about “reforming” half of the $10 trillion in U.S mortgages—then you leave yourself side open to all kinds of unintended and unpredictable effects.
Including, and this is what worries me most, the possibility that some change will make investors lose all confidence in a market that is finally showing tiny signs of returning confidence. Remember that in the first quarter Fannie, Freddie, and Ginnie made up 95% of the mortgage guarantee market? Well, in the second quarter that figure dropped to somewhere around 85%. (I say “somewhere” because the data is not terribly reliable.) That’s not a huge change but it is progress.
What would happen if “reform” did hit the Fed’s portfolio and hit it hard? In the short term nothing much. The Fed is able to “create” money. It doesn’t face capital requirements like private banks do. Reporting and transparency standards are laughable by corporate standards.
But the long-term effects would be tremendous. At a time when the world is increasingly worried about the fiscal soundness of the United States, a major ding to the Fed’s balance sheet would further undermine U.S. financial credibility. Overseas investors would rightly worry about the Fed managing the money supply for the benefit of its own balance sheet. I’d worry about the possibility that the Fed would manage the economy with one eye on its own balance sheet.
You can make—well, I would make—a pretty strong case, that bailing out Fannie Mae and Freddie Mac in the middle of a financial crisis and with housing prices plunging was the right thing to do. I wince when I think of sending $145 billion and counting of our money down this rat hole, but I think not doing it would have hurt too much of the economy at a time when the economy was teetering. The time to install fire alarms is before the fire. Once the building is burning, the job is to put the fire out.
And then you fix the problem that resulted in the fire.
Fannie Mae and Freddie Mac need to be fixed. More precisely they need to be dismantled. The capital markets during normal times are up to the job of setting mortgage prices (otherwise known as interest rates) and private companies can price mortgage guarantees with less distortion than entities can that feel in their heart of hearts that they can always tap the U.S. Treasury. Certainly linking that implicit guarantee with a private for profit company as Fannie Mae and Freddie Mac once were, has proven to be a really, really bad idea.
But making that fix or dismantling the two companies will require a very delicate hand on the controls. It will require setting up a mechanism for selling off the current portfolios at Fannie and Freddie without sinking the market for mortgage-backed securities and the Fed’s balance sheet. And it will require a transition period that lets private companies gradually move to provide the services to the market that Fannie Mae and Freddie Mac once did. Many countries in the world get along just fine without anything like the government participation in the housing market represented by Fannie and Freddie and they have home ownership rates comparable to the United States.
All that will require a delicate hand capable of dealing in nuances and adept at making mid-course adjustments.
Instead we have Congress.
Full disclosure: I don’t own shares of any company mentioned in this post.
Can you give us an example how other countries handle a similiar “mortgage pass through” securities to keep pooled-mortgage loans marketable?
jrb,
BP is radioactive. Even if you think it’s undervalued, where’s the dividend? When they bring back the dividend, then I’ll look at it.
Too bad we can’t get Ludwig von Mises over on the conservative side, and John Maynard Keynes for the liberals [a couple of guys who actually knew their stuff]- strip ’em to the waist, chalk off a big circle, and let them go at it bareknuckles, single combat.
Best 3 falls out of 5 takes it – and the world runs that way for the next 100 years. NQA.
That, folks, is my Energy Conservation Policy for the Planet. I’m sure there is someone, somewhere, that will take issue.
[Full disclosure: I have no personal position in NQA at this time.]
jrb- I think the pollies [as in politcal debaters] have this one, and no one but us wants to talk investments. That’s OK- maybe they will change the world, or change one mind…I was never so lucky.
You must be smiling about STD and TOT tho- if you got in where Jim did, or a bit before- or even a bit after. I was hoping to pick up some STD if it would drop a bit further [it didn’t, so I didn’t] but I have owned TOT for some time- and I am smiling.
When I think of all the money I could have made on STD, I remind myself it is just a banco.
“Sound familiar?”
Absolutely. The government pushed the cheap money button, not only encouraged risky mortgages but threatened banks if they started asking pertinent questions, gobbled up all the good mortgage business which forced bankers to look down new avenues for revenue, and encouraged risk offloading by offering an “implicit guarantee”.
After looking at the facts and not being wed to a market hating ideology, blaming the housing bubble on the free market and asking “how can the free market get out of its current problems in housing?” seems a bit delusional to far too many.
False assumptions in = false conclusions out.
Again, referencing the Wheelock analysis, he notes writings dated back to 1974 that the housing bubble of the 1920’s was on “real estate speculation [that] was widespread, fueled by lax lending standards, and the ease with which securities could be sold to finance construction.” Sound familiar?
@lakesider–The immediate issue I see is the idea that we could legislate the problems of a bubble away. We still have 6 million extra homes built (above the normal 7 or so million vacant). Glut is glut. I’m not sure it matters much what we do or don’t do.
@charltonlegal
“They do occasionally fail very badly. The Great Depression was one such period and I think we’re in a similar period now.”
May I suggest you are possibly starting from a faulty foundation? What makes you so sure the GD was a market failure? Last I checked there was a monopoly on money supply back then, and significant market distorting power held by the sole central bank of the US. Remember Bernanke’s speech on Milton Friedman’s 90th birthday? “You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.” You was Friedman, We was government. So what makes you believe it was a market failure? If you start from a faulty conclusion then you’re almost certain to come to a faulty result.
Thanks Cjxland. And yes Ed, if you read this and have any thoughts on BP, I would love to hear them. I did buy into TOT (and STD) on weakness even before Jim had recommended them for his dividend income portfolio, along with shares of XOM as well.
jrb-
MAYBE successful blowout containment…safely.
But the liablilities are still rolling in- and there is no way of knowing how many will land directly on BP. [Intersting the way those costs of 2.3 Billion turned into 21.7 Billion almost over a weekend…]
BP might be a fine trading vehicle for awhile- both for and agin- but I know nothing of that. Ask Ed. There are better oil majors to invest in, if that interests you, including Jim’s Picks TOT and XOM.
To those who considered the idea satire, let me emphasize that I am very serious. Uhless you are wedded as a matter of principle to the concept that markets can correct all these problems in its own and its corollary that government needs to stay out, then this is a potential solution to a very serious problem and one that the government has successfully used before.
Free Markets are fine and they work very very well under most conditions, including adverse ones. They do occasionally fail very badly. The Great Depression was one such period and I think we’re in a similar period now.
So if you are a free market loyalist, you have to ask yourself how can the free market get out of its current problems in housing? What sort of free market solutions are available that won’t wreck the one asset that, for a huge majority of Americans, is their largest asset? One has to keep in mind that financial institutions have no obligation, legal or otherwise, to anyone other than their shareholders, which is at it should be, and they certainly have neither the duty, the inclination or ability to make this transition a smooth one or a socially beneficial one.
So if we are going to see a liquidation of surpuls cheap housing conducted in a responsible manner, how do we do that? probably through government intervention.
My suggestion isn’t the first time the government has intervened. In 2008, David Wheelock published a paper for the St Louis Fed – here’s the link – research.stlouisfed.org/publications/review/08/05/Wheelock.pdf
He describes the various federal agencies that dealt with the housing problems of the Depression which were similar to those we face today. The Home Owner Loan Corporation was created in 1933 to purchase and refinance delinquent mortgages, even those that had been foreclosed on. HOLC sold tax exempt bonds to finance its activiities and could purchase properties worth, in today’s dollar terms, $320,000. Recipients had to have the necessary income levels to justify the mortgage. The restructured loans were amortized as 15 year fixed rate mortgages with an interest rate of 5%.
Even though private lenders faced a loss, they usually preferred to sell the mortgages to HOLC rather than hold on to them and recoup losses through foreclosure. HOLC did have a higher foreclosure rate but the agency was fairly lenient in working with borrowers. It was phased out in 1951. It got only one congressional appropriation, an initial one of $200 million. Though Wheelock notes that such a program might encourage risky lending and borrowing, he also notes that there is almost no evidence that the HOLC program actually did that.
There always different conditions that might justify different actions and a precise recreation of HOLC might not work in our current economy. Wheelock notes some of these differences and I agree with him.
But my main point is several fold: (1) I don’t believe that the free market forces will resolve the current housing market collapse on its own without causing a huge amount of disruption. (2) we have a government that is determined, and in my view, properly so, to refashion a more modern economy with a view to creating environmentally more sustainable housing, transportation, power generation and energy. (3) we have a huge unemployment problem, though not as severe as the Depression, that does not appear to be abating rapidly and probably won’t abate rapidly without more government intervention. Against that, we have an opportunity for a more modern version of HOLC, financed, as was HOLC, by bonds under the guidelines I orignally proposed.
Off Topic.. New ETF following Brazil Financials:
“Global X Funds launches first Brazil Financials ETF (BRAF)
NEW YORK (July 29, 2010) – Global X Funds, the New York-based provider of exchange traded funds, launched today the Global X Brazil Financials ETF (ticker: BRAF). This is the first ETF to offer targeted access to the rapidly growing Brazilian financial sector.
The Global X Brazil Financials ETF tracks the Solactive Brazil Financials Index, which is designed to track the performance of the Brazilian financial sector. As of July 20, 2010, the largest index components were banks Itau Unibanco, Banco Bradesco and Banco do Brasil.”
OFF TOPIC:
Given that BP appears to now have safely contained the well, does anyone really doubt that BP will now successfully bounce back from this? Is this an amazing buying opportunity for the stock? Anyone have any thoughts on this? Or is there still not enough info on whether the solution to the spill is permanent?
I believe the bailout money of the last couple of years was misdirected. Instead of lending it directly to banks to build up their reserves, the Feseral Reserve should have loaned the money to homeowners who are temporarily unemployed.
The Fed could have continued the monthly payments on behalf of the unemployed homeowner, at interest (perhaps at the Fed funds rate), and when the homeowner gets back to work, that loan gets paid off over time. Collections shouldn’t be a problem; the government has the borrowers social security number and access to any tax refunds, plus garnishment powers.
The mortgage holders would not have had to foreclose, and the real estate market would not have collapsed, so the homeowners would have had plenty of incentive to continue making their payments; their homes would still have had value in excess of the mortgage debt. No walk-aways. These homeowners would also have plenty of incentive to seek employment quickly, because every month that goes by builds their debt.
Does anybody see a flaw in this idea?
Jim,
I appreciate your forward-looking, where do we go from this point forward mentality. However, here you seem to be avoiding the notion that we’re trying to cure our ills with exactly what got us sick in the first place. To me the better argument from your school of thought would be that govt. got us into this and, unfortunately, only govt. is large enough to get us out. But once out, then let us choke this chicken slowly but surely.
Solution to the mortgage mess: Gov get out of it. Stop guarantee mortgage with money that you don’t have.
CharltonLegal – I hope what you wrote was satire.
If not, I recommend that you read some books like “Free to choose” and “The road to serfdom”. If you would like to learn about a political philosophy that espouses freedom and choice in all matters, I would recommend “Libertarianism: A Primer”.
Kathy: You are absolutely right. These agencies have dumped their moral hazard onto the taxpayers who are now faced with a moral dilemma. Why should those who excercised fiscal constraint have to pay for the greed of those who used their houses as ATM’s? And, does anyone here, regardless of party, think that Congress is capable of acting wisely???
Dmartin…I completely agree with you. Government stay out. I have been waiting for this insane real estate bubble to be over with for over 4 years and will probably wait for a couple more. I live in CA and pay insane taxes and get sick when I read crap like this. I don’t want my hard earn money and taxes to be spent on bailing anyone else out!
Charltonlegal,
Isn’t this the sort of mentality that led to the Fannie/Freddie problem in the first place? The classic mentality that doesn’t understand capatilism at all and the natural forces of supply and demand. Why, as you say, must the government “make sure everyone that wants one has a home”? Seriously???? WE DON’T NEED THE GOVERNMENT FOR THAT!!!! If they can afford it, and if they have a history of intelligent money managment (credit score), they can get a house they can afford. There is absolutely no need for government intervention in the process. It will only add extra cost and hassle, or in the most recent history lesson, carelessness and stupidity that disrupts the entire economy. Keep the government out of it.
At the risk of an accusation of heresy, I’d like to pose a different solution. First, I agree with you that the two “agencies” need to be dismantled. Second, Kotikoff has a very good point that the pre-2008 system was a form of casino banking.
Where I disagree is whether there should be even a “market” for mortgage securities at all. If the US taxpayer is on the “hook” for the defaults to the extent both commentators note, then we should recognize that this is no longer a “market” but a government agency and take steps to take over the mortgage market under administrative guidelines and run it accordingly.
In this sense, it would not be that necessary to insure a profit. The Government’s responsibility would be to make sure everyone that wants one has a home, a home whose financing is in accord with the “homeowner’s” capacity to pay. If I make $50,000 per year, I get a house commensurate with that income level. If I make $200,000, I get a “better”house or a bigger house, or whatever. But I get a house, based on a loan issued either by a gov’t agency or a bank operating under a contract and guildelines from the government.
As to existing mortgages, give them up or have the gov’t assume the losses. We are doing it anyway and we can prorate those losses over a long period of time to minimize the already extensive disruption that’s occurred.
There are plenty of social goals that can be accomplished and for which we’ll spend money anyway if we recognize the reality and accept this responsibility. We have tens of thousands of homes that need modernizing with energy efficient re-do’s. You want to re-fi that old ARM? fine, you agree to install insulation, efficient AC/ Heating, energy grid conservation: you get the loan and the money and a payment you can live with. We save energy, reduce CO2 emissions and put currently out of work electricians, plumbers etc. back to work.
New Mortgages – same thing. If you are ABC builder, you’ll know you can’t sell your house unless it complies with all these new standards; the government won’t issue you a mortgage unless you comply.
What about those who become disabled or who lose their jobs? We are subsidizing them anyway and only the flintiest of hearts advocates doing away with that. A government mortgage agency could issue a “debt moratorium” while you look for a new job or reduce payments because of your disability.
The bottom line is that we keep people in their homes and avoid the worst of the current disruption in the market place, where home values fluctuate and even collapse depending on how fast Fannie Mae and Freddie Mac decide to sell those properties they now own.
Is this socialism? I am not qualified to answer that but if it i s, so what? We are paying for the “casino banking” experiment, every day because our home values are either way below what we paid or are still declining. We can’t sell even if we are current in our payments and can’t refinance because the banks have no idea what’s going in in their so called market place. We are spending billions of dollars trying to encourage energy conservation and getting folks back to work and underwriting huge losses in housing?
Isn’t it simply time to recognize the inevitable and find a more productive way to accomplish all these goals?
Hey lets be positive. It’s less worse than EURO! This will hang over our heads for 10 years….. AHH
Here’s economist Laurence Kotlikoff’s view on fixing Fannie and Freddie…
http://www.esplanner.com/view/blog/whither-fannie-and-freddie
I’m not worried, all we need is another 2000 page reform bill. And we’ll find out what’s in it after it becomes law.