Saturday, August 16, 2008

Mortgage Crisis, the Dollar and its Future, Part 2

John Berlau, a scholar at the Competitive Enterprise Institute, says, “The collapse of whole segments of the housing market can be traced to FHA-subsidized mortgage products. Despite its decreasing market share, the FHA appears to have played a significant role in the current mortgage 'meltdown' attributed to subprime loans. For the past three years, [FHA] delinquency rates have consistently been higher than even those of the dreaded subprime mortgages...[and]...nearly twice as high as the rate for all mortgages.”

Berlau also notes: “FHA-insured loans have also been at the center of some of the worst excesses of the housing boom, including mortgage fraud, loans made without income verification, and property 'flipping' with inflated appraisals.” These allegations have been documented by Congressional probes and investigative newspaper reporting. Senator Susan Collins of Maine, who headed a 2001 Senate investigation of mortgage fraud, said, “The federal government has essentially subsidized much of this fraud.” Over the years, FHA's down payment requirement of 20 % was gradually whittled down to 3 %. That was a result of the agency trying to compete for market share by making its own standards even more “subprime” than those of the private sector.

Fannie Mae and Freddie Mac own or guarantee 45 percent of all U.S. home-loan mortgages,. These giant agencies don't make loans. They are forbidden from doing so. Instead they buy mortgages from banks, bundle them into securities, and then resell these to investors. This “securitizing” of mortgages doesn't require Fannie or Freddie to hold a mortgage on its books any longer than it takes to package and resell it. Once a mortgage is off the books, the agency's capital is freed up to do the same thing all over again. Hence the potential for a credit bubble in the housing market. Fannie and Freddie have grown explosively since 1990. In 1990 their combined holdings of mortgages and related securities was $136 billion. In 2004 it was $1.6 trillion. Three years later it was $4.8 trillion.

In May 2006 the Office of Federal Housing Enterprise Oversight (OFHEO) announced a $400 million civil penalty against Fannie Mae for accounting manipulations. The agency discovered “a wide variety of unsafe and unsound practices.” Its report shows “Fannie Mae's faults were not limited to violating accounting and corporate governance standards, but included excessive risk-taking and poor risk management as well.” Fannie was ordered to restate its earnings from prior years by an estimated $11 billion.

In 2003, Freddie Mac was fined $125 million by OFHEO for accounting irregularities and ordered to restate earnings 2000-2002 by $5 billion. In September 2007 Freddie was fined $50 million, this time by the SEC, for accounting fraud that deceived investors, and four former key officials including a CFO, COO and two senior vice presidents, who profited from the scheme, were required to repay ill-gotten gains.

In the housing boom following the tech-stock bubble in 2000, Wall Street investment firms started dominating the lucrative business pioneered by Fannie and Freddie of bundling mortgages into securities. But Wall Street was selling them world-wide, spreading the credit bubble far beyond our shores. By the end of 2006 the total U.S. residential mortgage debt was $10.3 trillion, almost double the level of just six years earlier.

Fannie Mae and Freddie Mac are not government agencies. They are private corporations established by federal charters, implicitly backed by the U.S. government. Government-backed financial institutions have been known to fail. In the savings-and-loan debacle in the 1980s, more than 1,000 S & Ls collapsed. The Federal Savings and Loan Insurance Corporation, which had been in existence since 1934 to guarantee depositors funds, became insolvent. Though recapitalized several times by Congress with multi-billion dollar infusions of taxpayer money, the FSLIC by 1989 was deemed too insolvent to save and was abolished. Overall, the S & L bailout cost taxpayers an estimated $124 billion. For a brief period in the 1980s, Fannie Mae was losing about $1 million a day and was technically insolvent.

The feeling that mortgages are backed by the federal government undoubtedly led investors to be less circumspect than they otherwise would have been. “Unsafe and unsound practices” and “excessive risk taking and poor risk management” escaped scrutiny behind the government guarantee. Inadequate recognition of risk coupled with the explosive growth of Fannie and Freddie produced the potential for a gigantic financial disaster. Even though the mortgages were sold to other investors, Fannie and Freddie for a fee still guaranteed that payments would be made on the loans. So when the banks divided the securitized mortgages and repackaged them in SIVs (structured investment vehicles) and CDOs (collateralized debt obligations), the mortgage payments were still federally guaranteed. And the banks would collect a fee for imaginatively repackaging and selling the SIVs and CDOs.

The situation was made worse by home-equity loans, which exploded during the housing boom. Home owners took advantage of rising home values and tapped their equity to fund spending or leverage other investments. Some took out “piggyback loans,” which allowed them to borrow as much as 100 percent of a home's value by combining a mortgage with a home-equity loan. The value of home-equity loans stood at $1.1 trillion in the third quarter of 2007.

It was a boom time for the home building industry. With easy credit terms available, many people bought homes who couldn't afford them and would eventually lose them to foreclosure. Others, who were better off, were buying second and third homes as investments, with little or no money down. Home buying was stimulated by people's experience of seeing homes appreciate over the years while the dollar lost purchasing power through inflation. Money is a medium of exchange, but it is also store of value; in fact, it must be a store of value before it can be a medium of exchange. It is often lamented that the U.S. has a low rate of saving, but why should people save dollars that will be worth less in future years? A significant threat of inflation is always an incentive for people to try to get out of the currency, to spend now before the money loses value, or to find an alternative asset which will serve as a store of value. Home ownership was regarded in this manner. Home buying was viewed as a “safe” investment and one likely to appreciate with inflation rather than be eroded by it. Certainly the real estate market, within the memory of most Americans, was much more stable than the stock market. For all these reasons, money poured into the home building industry until the supply of housing outstripped the demand. Then prices started coming down. And the mountain of debt started to crumble.

Banks have been blamed for creating the subprime mortgage crisis by making risky loans to borrowers who did not meet standards of creditworthiness, but the federal government forced them to do so. Boston Globe columnist Jeff Jacoby explains: "The crisis has its roots in the Community Reinvestment Act of 1977, a Carter-era law that purported to prevent 'redlining'—denying mortgages to black borrowers—by pressuring banks to make home loans in 'low- and moderate-income neighborhoods.' ...The CRA [was] made even more stringent during the Clinton administration....Banks nationwide thus ended up making more and more ‘sub-prime’ loans and agreeing to dangerously lax underwriting standards―no down payment, no verification of income, interest-only payment plans, weak credit history....Trapped in a no-win situation entirely of the government’s making, lenders could only hope that home prices would continue to rise, staving off the inevitable collapse. But once the housing bubble burst, there was no escape. Mortgage lenders have been bankrupted, thousands of sub-prime homeowners have been foreclosed on, and countless would-be borrowers can no longer get credit. The financial fallout has hurt investors around the world. And all of it thanks to the government, which was sure it understood the credit industry better than the free market did, and confidently created the conditions that made disaster unavoidable."

Homeowners with little equity found themselves “upside down” with their mortgages: they owed more than the homes were worth. So, many simply walked away, leaving the banks to swallow the losses. Those defaults reduced bank reserves, which further reduced capital to support credit of all types. The same thing was happening with Fannie and Freddie, which were called upon to make good on their mortgage guarantees. When borrowers fall behind on their loan payments, Fannie and Freddie must buy those loans and recognize a loss on any drop in market value below the amount they paid for them. At the end of the third quarter 2007, Freddie had marked down its assets by $3.6 billion to match current market levels. In addition, it took $1.2 billion in credit losses. These losses left the company with core capital of $34.6 billion, a mere $600 million above the minimum requirement of OHFEO. Freddie estimates its losses for 2008 and 2009 will be $1.5 billion and $2.1 billion respectively.

Banks have been trying to keep as much cash as possible as a cushion against further write-downs and credit losses. Banks are also wary of lending to each other because, knowing how bad their own assets are, they don't trust each other's balance sheets. Consequently, they have been charging each other higher interest rates. Those rates, in turn, affect monthly interest payments on millions of credit cards and mortgages in Europe and the U.S.

Research suggests consumer spending drops 9 cents for every dollar decline in home equity. A decline of $2.1 trillion in U.S. residential values has already occurred, implying a decline of $200 billion in consumer spending. Consumer spending accounts for two-thirds of U.S. economic activity.

Alan Greenspan recently stated, “After more than a half-century observing numerous price bubbles evolve and deflate, I have reluctantly concluded that bubbles cannot be safely defused by monetary policy before the speculative fever breaks on its own.”

James Grant, long-time editor of Grant's Interest Rate Observer, neatly summarized Greenspan's current view: “The enlightened central banker will let speculation take its course. Following the inevitable blow-up, he will clean up the mess with low interest rates and lots of freshly printed dollar bills—thereby gassing up a new bubble.”

That was the lesson from the savings and loan crisis. Under Greenspan, the Fed became a kind of first responder to financial distress following the 1987 stock market crash, the Mexican peso crisis in 1994-95, and the Long-Term Capital Management crisis of 1998. Following the tech-stock bubble in 2000, Greenspan steadily brought interest rates down to 1 percent in June 2003 and kept them there until mid-2004. Many economists now blame those low interest rates for contributing to the housing bubble that burst in 2007.

To be continued.

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