A Fannie/Freddie By Any Other Name

Politicians are now paying lip service to reforming Fannie/Freddie. I wouldn't expect anything to actually get done but be prepared for all sorts of hair brained ideas. The first is by Congressman Barney Frank.

The more things change, the more they stay the same. Take the case of Barney Frank, Chairman of House Financial Services Committee. In an interview with FOX Business’ Neil Cavuto, he called for Fannie Mae and Freddie Mac to be abolished. “The only question is what do you put in their place,” he said.

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What would he propose? He said, “I’ve worked closely with the Financial Services Roundtable… They are talking about the following: first of all, you separate it out, so there’s no more hybrid public-private. So, Fannie and Freddie and anything like them go out. You have a purely public FHA [Federal Housing Administration]… [that is] fully self-financing.”

Frank added, “If we want to subsidize housing then we could do it upfront and let the budget be clear about that.”

Clearly, Barney Frank hasn't been paying attention to me. Beyond that, Frank clearly doesn't understand why Fannie/Freddie are such a problem. It's as though the problem is the names. They've become too toxic and so if we change them and have another mechanism that does the exact same thing everything will be fine.

Let's start at the beginning. Mortgage securitization is a very complicated process but, in my opinion, it's a necessary one. It provides liquidity in the market and it transfers risk from banks to speculators. All of that is good. That means more people get loans and rates will be lower.

The problem is that in loan securitization there's only two games in town, Fannie Mae and Freddie Mac. That's duopoly and those never work. The second problem is that both are extensions of the government. So, what we had was a government run monopoly on securitization. Fix both problems and you fix Fannie/Freddie.

Instead, Barney Frank wants to go the other way. He wants to stop simply having an implicit government guarantee and just have an explicit government guarantee. Of course, that perpetuates the problem.

Fannie/Freddie Price Tag on the Rise

Moneynews has the analysis on the latest price tag.

For all the focus on the historic federal rescue of the banking industry, it is the government’s decision to seize Fannie Mae and Freddie Mac in September 2008 that reportedly is likely to cost taxpayers the most money.

So far the tab stands at $145.9 billion and rising, the New York Times reports.

The Congressional Budget Office has predicted that the final bill could reach $389 billion.

Some analysts even estimate the total may reach $1 trillion, which Sean Egan, president of Egan-Jones Ratings, recently told Bloomberg is “a reasonable worst-case scenario."

Fannie/Freddie currently holds about $5 trillion worth of loans. The biggest struggle is figuring out the worth of those loans and just how many will default. That's why it's difficult to estimate just how much the tax payers will be on the hook.

Beyond that, Fannie/Freddie are now effectively most of the residential housing market along with FHA loans. So, their long term viability is tied to how quickly the housing market turns around. That's yet another major variable.

One thing that isn't a variable is that both are in desperate need of reform. It's clear that reform of Fannie/Freddie is something that isn't on the table any time soon. Without reforming these two, we are in constant danger since both pervert the market at all times.

More Money from Fannie Mae

Fannie Mae lost a whopping more than $13 billion last quarter. Wow!! Now, they need more money.

Mortgage giant Fannie Mae (FNM: 1.06, 0.04, 3.92%) bled another $13.1 billion during the first quarter, prompting the U.S.-owned company to request another $8.4 billion cash infusion from the Treasury Department.

Fannie Mae, which was placed into conservatorship in 2008 amid enormous mortgage losses, said it lost $13.1 billion, or $2.29 a share, last quarter, compared with a loss of $16.3 billion, or $2.87 a share, during the fourth quarter of 2009.

The company blamed the heavy losses on credit-related expenses that remain “at elevated levels” due to weakness in the U.S. economy and the housing market.

“In the first quarter we continued to serve as a leading source of liquidity to the mortgage market, and we made solid progress in our ongoing efforts to keep people in their homes,” CEO Mike Williams said in a statement.

This is a black hole and no one on either side understands the issue let alone has a solution.

The problem is without Fannie/Freddie there is no mortgage market. Banks now almost exclusively rely on Fannie/Freddie to sell their loans. The other source is FHA. So, we can't just let them fail because that would set the mortgage market into a tailspin.

The Republicans are pushing reform of Fannie/Freddie but their idea of reform is nonsensical. John McCain wants to give Fannie/Freddie five years to be self sufficient or fail. First, failure is not an option for the reasons I mentioned. Second, they could very well be self sufficient in five years.

That doesn't mean that the problems will be solved. The problems will merely be masked. The problems and solutions are simple. First, there's two of them. That's a duopoly and not economically viable. So, break them up. Second, they are extensions of the government. So, fully privatize them. It's that simple.

Soros on Fannie/Freddie

This particular article is so wonky even I had trouble following but here is Soros' plan for removing Fannie/Freddie from mortgage financing.

The first is to introduce mortgage securities based on the Principle of Balance. GSEs could, and should, do this, with the government regulator setting clear and conservative standards. No legislation is required.

The second step is to open the process so all qualified MCIs can issue POB bonds. To make this market work, this means new law requiring that MCIs maintain skin in the game for any federally guaranteed mortgage.

After that, the GSEs could be phased out from their role as MCIs, and the guarantee function hived off to a government agency. Eventually, the GSEs would be liquidated, as their portfolios run off.

Legislation would also be required to extend the POB system to areas that government insurance does not cover.

In fact, legislation authorizing “covered bonds” is making its way through Congress.

This is based on a system in Denmark in which individual loans become bonds that can be bought back.

The Scourge of Fannie/Freddie

This past week, both Fannie Mae and Freddie Mac reared their ugly heads with two stories. First, here's the most important one.

The Obama administration's decision to cover an unlimited amount of losses at the mortgage-finance giants Fannie Mae and Freddie Mac over the next three years stirred controversy over the holiday.

The Treasury announced Thursday it was removing the caps that limited the amount of available capital to the companies to $200 billion each.Unlimited access to bailout funds through 2012 was "necessary for preserving the continued strength and stability of the mortgage market," the Treasury said. Fannie and Freddie purchase or guarantee most U.S. home mortgages and have run up huge losses stemming from the worst wave of defaults since the 1930s.

Beyond that, we found out that the two mortgage giants will be paying their top execs handsomely over the next few years.

The chief executives of Fannie Mae and Freddie Mac each could earn as much as $6 million this year and next, despite huge continued losses at the seized mortgage giants and a government bailout tab of more than $100 billion that the Obama administration said could rise even higher.

Fannie Mae Chief Executive Michael Williams will earn a base salary of $900,000 in 2009 and 2010, with a deferred base salary of $3.1 million each year to be paid "only if the enterprise meets performance metrics" set by its board and subject to government review, according to filings Thursday with the Securities and Exchange Commission. An additional $2 million is possible annually, identified as "target incentive opportunity." Freddie Mac Chief Executive Charles E. Haldeman Jr. will get the same compensation package.

Four additional Fannie Mae executives will earn base salaries above $500,000 and have compensation packages for 2009 and 2010 that could pay each of them at least $2.7 million annually. One other Freddie Mac executive will receive a base salary over $500,000 and could earn as much as $1.15 million a year.

Stories about executive pays and bonuses aren't necessarily all that important in the larger scheme of things. After all, whether or not the CEO of Fannie Mae makes $6 million next year or $6 isn't going to make or break our economy. Those stories are fueled mostly by class warfare, envy, AND the sense that incompetence at the top is being rewarded and HANDSOMELY.

In the first story, the government announced that they would raise the debt they will cover for Fannie/Freddie to an unlimited amount. It was $200 billion each. Here's how a Treasury spokesperson characterized the decision.

(the move was) necessary for preserving the continued strength and stability of the mortgage market,

That's all nonsense. The government wouldn't be making the debt ceiling unlimited unless their number crunchers thought that was necessary to cover the necessary losses. A year and a half ago, when this crisis first hit with Fannie/Freddie, I pointed out their two problems. First, there's only two of them and so they are essentially monopolies, or technically duopolies. Second, they are extensions of the government making them quasi socialistic. I said the solution would be to break them up and privatize them.

Since then, the government has gone backwards. They're no longer merely extensions of the government but wholly owned subsidiaries of the government. This leads to all sorts of moral hazards. That's why we're here in the first place.

The problem is that mortgage securitization is necessary to the entire mortgage world. Since they're the only securitization game in town, we have to prop them up. So, if they're about to collapse without a significant lifeline, we have to bail them out.

Long ago, I said that we must use this as an opportunity to reform both. Instead, the government has made the situation worse. Now, these two giants hold the real estate market, the economy, and with it everything else at the barrel of their financial gun. They can't fail, and so we must continue to bail them out. Instead of fixing the problem, we've made it worse.

The U.S. as an Oligarchy

The President, in his 60 minutes interview, came out with this quote in particular that seems to have the most staying power.

I did not run for office to be helping out a bunch of fat cat bankers on Wall Street

Whether President Obama did or not, in fact, that's exactly what's happened. The only thing that is clear that's come out of the financial crisis is that our banks were on the brink of collapse, they were given a near $1 trillion lifeline, and now most are doing just fine. That was followed immediately by a $50 billion lifeline to the auto companies.

So, President Obama's populist rhetoric means little with a policy that clearly favors the connected in the business world. In fact though, President Obama is not unique. Most of those in power produce policies that favor those in power. This isn't a Republican or Democrat thing but a power thing. President Obama merely produced rhetoric that made some people believe that he would be different. When push came to shove, he showered the elites with billions like every other politicians.

What we effectively have in this country is an oligarchy.

An oligarchy (Greek Ὀλιγαρχία, Oligarkhía) (oligocracy) is a form of government in which power effectively rests with a small elite segment of society distinguished by royal, wealth, intellectual, family, military, or religious hegemony

It's a government run by the special interests, big business, and everyone else with access to power. Long ago, it stopped being a government of the people, by the people, and for the people, if it ever really was.

This time last year, Goldman Sachs was on the verge of collapse. Now, it's making billions trading oil futures. The same could have been said of Chase. Now, it's making billions in mergers and acquisitions. Fannie Mae/Freddie Mac have stripped the illusion entirely of being separate of the government and are now just owned. Before then, powerful politicians would move seamlessly from D.C. to powerful positions within either or both (a la Rahm Emanuel) and, as a result, both have been given special treatment and perks for decades. While President Obama demands reforms of just about everything, he's doing nothing to reform either Fannie/Freddie.

After the banks got their bailout, the auto companies were next and the bailout was followed by cash for clunkers which made served as a major stimulant to sell cars. All of it has a dubious effect on the economy as a whole, but certainly it benefits the bankers and the automakers.

President Obama is not unique in this at all. For decades Republicans have protected the oil industry as though their cousins worked there. Six companies control more than 60% of the entire market. All of them make tens of billions yearly all at once and no politician finds anything the slightest bit wrong with any of it.

The insurance companies receive their own special favors. McCarron/Ferguson gave the health insurance provider a special denomination that exempts them from Sherman Anti Trust and as a result they have conducted a so called market that's actually just created a set of regional monopolies that allow the insurance companies to dominate their own regional markets and leave other regional markets for their so called competitors. In reality, it allows a series of health insurance companies to all make money at the same time all while enjoying an environment with little competition.

If it isn't big business that gets special treatment, then it's big labor. The labor unions enjoy just as many special privileges from our government as many of our biggest companies. Health care reform can't pass unless it gets its stamp of approval from the top labor unions. When I say stamp of approval, I mean that health care reform can't hurt the health care packages of the unions.

The list goes on and on. We have a government based on influence and power. In Chicago, we call this clout. Our government benefits those with clout. If you have clout, you have influence. If you have influence, the government legislates in your favor. You could just call it an oligarchy.

Is FHA Next?

Investor's Business Daily has an article that will raise some eyebrows for the mortgage market.

Skyrocketing growth in loans from the Federal Housing Administration and Ginnie Mae have helped support the mortgage market — but could leave taxpayers on the hook for massive new losses.

FHA-insured loans have more than tripled from 530,000 in fiscal year 2007 to 1.7 million thus far in 2009. The Government National Mortgage Association, which securitizes FHA loans, has boosted its mortgage-related issuance to $287 billion from $85 billion.

Yet during that same period, the FHA's loan delinquency rate has climbed to 14.4% in Q2 from 12.6% two years earlier.

Now, everything in the article is perfectly natural and not necessarily alarming. The meteoric rise in FHA loans is to be expected. During the height of the mortgage boom, there were so many alternatives to FHA that it lost a lot of favor. FHA has significantly higher up front costs and it has a built in mortgage insurance on all loans. Furthermore, FHA has no stated loans. As such, when there was a plethora of loan options, there was usually plenty of more favorable alternatives to FHA.

Remember, 2003-2007 were the years of overbuying. Yet, FHA had no stated loans. In fact, FHA has fairly strict debt to income requirements. Often, the requirement wouldn't allow any more than a total DTI of 37%, though there were exceptions. So, during the boom, FHA naturally lost favor.

Now, there's no more sub prime. There's no more Alt A. There's no more stated. In fact, all there is is Fannie/Freddie and FHA. So, is any surprised that in the last two years FHA's loan volumes have exploded? Of course, they have.

It's true that FHA allows for very high loan to value. In fact, you can buy a property with less than 3% down. At this point, FHA is the only outlet for high ltv loans. FHA still has strict debt to income requirements. It's credit requirements are less than that of Fannie/Freddie but it does require fairly good credit. Here's the thing that's of most concern.

Adding to the concern, the FHA's fund to cover losses has dropped to a projected 3% of insured loans. That's a leverage ratio of 33-to-1, the level banking giant Bear Stearns was at before it failed.

All FHA loans have something called Mortgage Insurance Premium. Up front, FHA receives 1.5% of the loan from the borrower. Then, it receives .5% yearly split month over month as part of the mortgage. This is used as an insurance policy to protect banks on loans that go bad. So, right now, FHA has $3 in the MIP accounts for every $100 worth of loans.

Now, the article compares that to Bear Strearns, but that's awfully misleading. Bear Stearns was leveraging something totally different. They would make investments in MBS and other things. They would put down a $1 and borrow $30 more. This isn't quite the same thing.

This is probably less than FHA would want, but that's also to be expected when there's suddenly an explosion in new loans. Between, the 1.5% up front and another .5% over the first year, FHA only collects 2% in MIP premiums in the first year. So, if there's an explosion of new loans, as has happened, then this leverage ratio will go down. Yet, as FHA starts to hold on to these loans long term that ratio will go up.

There is also some inside mortgage baseball that's important. Last month, Taylor Bean and Whitaker went out of business. They were the third largest FHA lender in the country. They were also known for taking a lot of the "junk FHA" loans. So, the more aggressive FHA loans no longer have an outlet. I was concerned about FHA last summer when Hope for Homeowners passed. This was essentially a pseudo loan modification program in FHA. Yet, this program has been a total failure and only a handful of loans have been under it.

FHA has all the potential problems that all mortgages have. The dropping real estate prices causes an alarming number of FHA loans to go underwater. Rising unemployment means more and more FHA borrowers have no jobs. The high ltv is its own problem, but FHA counters that with strict dti limits. We should be concerned about FHA like we should be concerned about any part of the mortgage market. Yet, I don't see anything yet to sound extra alarms.

Fixing Fannie/Freddie: The Latest Obama Gimmick

Fannie Mae reported another terrible quarter today.

Fannie Mae, the largest provider of U.S. home mortgage funding, on Thursday reported a $14.8 billion quarterly net loss that it said would force it to go to the U.S. Treasury trough a third time for money to stay in business.

The company noted a "significant uncertainty" of its long-term financial health in reporting its eighth consecutive quarterly loss, which illustrates its struggle to make money in the face of rising defaults and pressure to do more to stabilize the housing market.

The mortgage giant is about to ask the federal government for another $10.7 billion lifeline. The government of course now owns both Fannie Mae and its sister company Freddie Mac. Now, the administration is floating an idea to help the deal with their long term viability.

The Obama administration is considering an overhaul of Fannie Mae and Freddie Mac that would strip the mortgage finance giants of hundreds of billions of dollars in troubled loans and create a new structure to support the home-loan market, government officials said.

The bad debts the firms own would be placed in new government-backed financial institutions -- so-called bad banks -- that would take responsibility for collecting as much of the outstanding balance as possible. What would be left would be two healthy financial companies with a clean slate.

This is very similar to what the Swedish government did to their banks. In that case, the whole banking system was nationalized, the bad debt was removed, the board and upper management dissolved, and then new private banks were created out of the rubble.

In this case, it remains unclear if the management will be dissolved. In fact, its unclear if anything will happen besides the federal government completing a full bailout for these two giants in under this plan. In fact, this appears to be little less than bailing these two out from years of bad and irresponsible behavior.

The president has proposed for a total overhaul of the regulatory framework of the entire financial system and all he will do to Fannie/Freddie appears to be to take their bad debts off their hands. He will have fixed none of their structural problems. They will still continue to have a monopoly and they'll now be even more tied to the Federal government. In fact, by doing this, all he'll do is create even more moral hazard and encourage a repeat in a few years. Let's hope this is NOT the final plan for the two mortgage giants.

Here's my ideas for fixing the two giants.

Revisiting Fannie/Freddie and the CRA in the Mortgage Crisis

The Republicans have again chosen their favorite boogey men for blame in the mortgage crisis, Fannie Mae, Freddie Mac and the Community Reinvestment Act. The Republicans House Committee on Oversight and Government Reform lead by Congressman Darrell Issa has released this white paper today on all three entity's roles in the mortgage crisis. In my opinion, the Republicans have once again inflated the role of all three in the crisis.



The committee traces the roots of the crisis back to 1993 when Congress intially toughened their mandate on Fannie/Freddie to increase lending in low income neighborhoods. This caused Fannie to create quotas and it lead to loosening of standards on their loans.



This was perpetuated by the Clinton administration when HUD Secretary Henry Cisneros created the National Homeownership Strategy. The NHS directed Fannie/Freddie and other banks to create strategies to create underwriting guidelines that would lower down payment requirements, loosen standards, and in any other way make it easier for the poor to qualify for loans.



Inherently, the Committee realizes that blaming CRA for the crisis is absurd. In the report, the Committee states

Although, CRA lending increased by 250% between 1996-2008, CRA never accounted for more than 3% of total lending

Think about that. Even at its most prevalent, CRA was never more than 3% of the overall market. We are lead to believe that a program that accounted for no more than 1% of the overall market throughout the 1990's somehow had so much scope that it influenced lending on a systemic basis. Even the committee itself knows this is absurd. That's why the Committee includes the NHS in its list of deviants of the mortgage crisis. The problem is that NHS was no more in scope than CRA. The committee would have us believe that two obscure programs, two programs no one had heard of prior to 2008, created such a ripple that the entire industry was affected? Does this seem logical?



The Committee makes several leaps that would only seem reasonable to a layman. It doesn't account for significant gaps between events that they blame for the crisis and the crisis itself. Worse than that, the Committee simply mischaracterizes the nature of the mortgage market then and now.



For instance, here is one conclusion that the committee makes.

Fannie Mae and Freddie Mac were leaders in risky mortgage lending. According to an analysis presented to the Committee, between 2002 and 2007, Fannie and Freddie purchased $1.9 trillion of mortgages made to borrowers with credit scores below 660, one of the definitions of “subprime” used by federal banking regulators. This represents over 54% of all such mortgages purchased during those years. (p.24)

To say that loans below 660 are necessarily "sub prime" is just nonsense. There is absolutely no context there. I once did a loan for two borrowers both below 600. Their loan to value, however, was about 50% and their debt to income was below 30%. This loan qualified for Fannie Mae and no one would consider it sub prime. In fact, mortgage professionals would have classified "sub prime" as any loan not bought by Fannie/Freddie or FHA. The report never does say just how much of the market loans under the "NHS" program became but I doubt it was any more than CRA.



Then, the report says this.

Once government-sponsored efforts to decrease down payments spread to the wider market, home prices became increasingly untethered from any kind of demand limited by borrowers’ ability to pay. Instead, borrowers could just make smaller down payments and take on higher debt, allowing home prices to continue their unrestrained rise. Some statistics help illustrate how this occurred. Between 2001 and 2006, median home prices increased by an inflation-adjusted 50 percent, yet at the same time Americans’ income failed to keep up.

This is also a dubious claim. One of the characteristics of sub prime was always to offer borrowers the opportunity to purchase a property with little or no money down. Besides that, Fannie/Freddie didn't begin to relax their standards on no money down loans in earnest until 2004-2005-2006. Before the crisis occurred, it was very rare to find a Fannie/Freddie loan that could be done with no money down. That became a lot more prevalent once the real estate boom began.



To hear the Committee say it, Fannie/Freddie expanded their portfolio of no money down loans and this caused sub prime to do it. This flies in the face of logic. Sub prime was by nature the basket of loans that were more aggressive. They didn't need to wait for Fannie/Freddie to create more aggressive loans. Their loans were already more aggressive.



The Committee also doesn't answer the most obvious question. If the roots of all of this happened in the 1990's, why did the crisis start in earnest in 2003. Sub prime had grown since the early 1990's. Yet, it was the loans that were created starting in 2004 that turned growth into crisis. So, how exactly were events in the 1990's responsible for loan decisions in 2004?



I have long pointed out that the problem wasn't merely no money down loans. Rather, it was the layering of risks. It was no money down loans for borrowers with poor credit scores who were also not verifying their incomes. In 2002, there was no such thing as a no money down stated loan. In fact, in 2002, sub prime was careful about offering stated in only selected situations. (for self employed borrowers, commissioned borrwers, and other borrowers with uneven income) By 2006, the industry standard was a loan for a 620 credit score borrower, stating income and stating assets to a full 100% of the value of the property.

So, what causes such an explosive decrease in underwriting standards? How about an explosion in competition? In 2003, sub prime was still dominated by a select few players.

The top 25 lenders made nearly 90% of loans in 2002, nearly double their 1990 market share, according to the Harvard Joint Center for Housing Studies. Ameriquest, New Century Mortgage and National City are among industry leaders. Mainstream lenders are entering the market, but the vast majority of business is done by mortgage firms, thrifts and other entities.

Between 2003, 2007, there was an exponential growth in the number of banks and mortgage companies that provided sub prime loans. There was a financial event much closer to all of this that could much more easily explain this explosion. That was the Fed's loose money policy between 2001-2003 in which the Fed Funds Rate fell eventually below 1%. That gave banks far more access to money. The rub, if you will, of sub prime is that was always more easily vulnerable to the characteristics of a speculative market. Prime loans were for borrowers of good credit quality. There is a natural end to the underwriting levels of such borrowers. Sub prime was for borrowers of dubious credit quality. That's a universe with no end. You can always extend credit to more and more dubious borrowers. Once banks gained access to more money, they naturally gravitated to sub prime because that universe always had frontiers still unexplored.

None of this has anything to do with CRA and NHS. In reality, these two programs were rather inconsequential. (don't believe me, just look at the figures provided by the committee. neither program accounted for very much of the basket of loans) They are now being demonized for political purposes. Don't get me wrong, it's an awful idea to set quotas so that borrowers of dubious credit profiles get loans they shouldn't. That's the nature of both CRA and NHS. I just believe that reckless monetary policy has a much greater effect on our economy than some obscure misguided social engineering program.

Both Fannie and Freddie are and were terribly corrupt, and both have a lot to answer for in this crisis. I believe both added fuel to the fire. They jumped into sub prime lending after seeing how hot it was in earnest in 2005. They were both created in order to facilitate lending to borrowers of good credit. Their charter was never meant for them to speculate in markets for borrowers of dubious credit. They did this not to help expand the market. It didn't need any help. It was booming without them. They did it because everyone in the market was making tons of money and they wanted their piece. That is outrageously scandalous. People should be held responsible.

What people shouldn't do is use them, or the CRA, as boogey men to try and score political points. Both Fannie/Freddie are much more tied to Democrats than Republicans. The CRA is an example of the kind of social engineering program that Democrats love. That's why Republicans are desperate to blame all of these entities for the crisis. We can't make the narrative for this crisis what we want. We must tell the story as it happened, not as we want it to happen. This latest white paper is an example of the former.

Epilogue:

Because I expect conservative readers to attack my thesis, I am including my own white paper on this crisis.

To try and understand the current crisis, we first need to understand how we got here. First, we must go all the way back to the end of 1999. That’s when Alan Greenspan, then head of the Federal Reserve, first began raising the Prime Interest Rate. This move surprised most everyone, and Wall Street included. This lead directly to the popping of the so called Internet bubble. This bubble popping cost roughly $3 trillion in paper losses in stocks between March and December of 2000. This lead directly to the recession that awaited George Bush when he entered office in Januray of 2001.

The economic malaise that was materializing in late 2000 was only exacerbated by two other events, 9/11 and the revelations of Enron et al. As such, by the end of 2001, we were in a full blown recession. While President Bush was enacting tax cuts, Alan Greenspan was furiously reducing interest rates just as quickly as he raised them in 1999-2000.

By the end of 2002, Greenspan had lowered interest rates so aggressively that the Fed Funds Rate, the rate that banks borrow from each other at, stood at .75%. The Fed Funds Rate is an overnight rate. This is important to understand because there are only two reasons why a bank would borrow overnight 1) they’d done something reckless and needed the money or 2) they were about to do something reckless and need the money. Greenspan lowered the Fed Funds Rate below 1% for well over a year and kept it there.

What this did was create so called loose money. Banks had access to far too much easily available cash. The recession had depressed almost all industries at the time except one, real estate. That’s because the recession had also lead directly to record low mortgage rates. We were at the time in the middle of what was dubbed the refi boom. Because interest rates work in relation to relative inflation, the recession was great for rates because at the time the only fear was deflation. The record low rates didn’t only create a lot of refinancing but also lead to more buying. At the time, we were just seeing the beginning of the real estate boom.

Because real estate was the only good sector, all this extra available bank capital went into one place, mortgages. The ‘problem” if you will at the time was that banks had more money than available loans. The solution was the birth of the sub prime explosion. Because folks with good credit (prime borrowers) were limited, banks began looking to more non traditional places for their money.

Mortgage Backed Securities, which bundled these sub prime loans and turned them into bonds, were the brainchild originally of Lew Ranieri at Lehman Brothers in the 1980’s. The financial vehicle had its glory days in the late 1980’s and early 1990’s, but since then the vehicle had lost some favor. It was, however, ready for a resurgence. Banks came to hedge funds, insurance companies, private equity firms and other financial conglomerates with ideas for new and aggressive loans. Because real estate was starting to move, these securitizers (those that package these loans together and turn them into bond) were all to willing to create newMortgage Backed Securities out of these more aggressive ideas.

For the first couple years, the industry moved aggressively to loosen guidelines, but these moves were still relatively tempered. That all changed in 2005 when a new sub prime player entered the market. That player was Argent Mortgage, the sister company of Ameriquest. Argent would be able to walk into just about any mortgage company and offer more aggressive loans than anyone else. This caused panic and frustration in all their competitors as they saw their market share rapidly deteriorate. In response, the entire competitive landscape was trying to one up each other. So, what was a meticulous loosening of guidelines, turned into a free for all. Banks were in a constant war with each other to offer new and more aggressive programs.

What was lost was any semblance of reason. Whereas at the beginning, even sub prime frowned on such things as prior bankruptcies, foreclosures, and mortgage lates, by the end, nearly everything was dismissed. Furthermore, the revolution of so called “stated loans” became the fruit of future disaster. Stated started out only for borrowers with uneven or sophisticated incomes: commissioned borrowers, self employed borrowers, or borrowers with multiple investment properties. By 2005, nearly everyone could get a stated loan. As such, folks on salary like teachers, secretaries, and even janitors could get a loan by stating their income without actually providing any income documentation.

By the end of 2006, the industry’s recklessness had reached its limit. The industry had standardized the so called 620 stated/stated no money down loan. This was a loan for a borrower with a credit score of 620 (which is in the bottom third of all credit scores) and this borrower could state but not verify their income, their liquid assets (meaning how much they had in the bank) and do all of this with no money down.

Meanwhile, several things were happening on the securitization side of the business. In 1999, Congress and then President Bill Clinton passed landmark deregulation legislation of banks and financial services companies. What this bill allowed was for investment banks and commercial banks to perform each other’s functions. This had many different effects. For instance, brokerage firms like Merrill Lynch could offer checking accounts, and banks could offer investments. More pertinent to this discussion, it allowed more financial services firms to both package loans together and turn them into bonds, and to buy the buyers of said bonds. So, as the real estate market got hotter and hotter, more and more financial services firms began taking bigger positions in these bonds. Even more troubling was the availability of leverage to buy these bonds. Financial services firms were using margin, and very leveraged margin, to take massive positions in these bonds.

At the beginning of 2007, with no more new loans to create, the real estate market finally took a breather. With the real estate market taking a breather, all of the excesses that were masked by the hot market began to come to light. The entire industry was now discovering that billions of Dollars worth financial vehicles were being held with underlying borrowers with no ability to pay for their mortgage. These excesses were masked by the hot real estate market in several ways. Often these borrowers were able to refinance out of their loans before they got into trouble. Other times, these borrowers were even able to sell and buy new properties. Now that neither option was possible, the industry discovered that billions of Dollars worth of assets were attached to “toxic borrowers”. This of course lead to toxic assets. The beginning of 2007 was the end of sub prime.

The first part of 2007, it looked as though the toxicity would be limited to sub prime. By August, the industry realized that toxicity was wide spread. The next domino to fall was so called Alt A. This is the sub set of loans between prime and sub prime. At about this time, both Fannie and Freddie both asked for massive bailouts as well. These two giants both got themselves far too involved in aggressive loans. When these loans were money makers, they piled on to take massive positions. Now that they went bad, both held billions of worthless assets.

The next major event was in September of 2007 when FASB rule 157, mark to market, took effect. This forced banks to put a current market value on all assets, including billions worth of MBS’. While this rule may seem reasonable, what it did was force a so called write down of billions worth illiquid MBS. Because the market for Mortgage Backed Securities was no longer liquid, these banks couldn’t sell their assets, and each month their balance sheets got progressively worse as they had to apply ever lessening values on their MBS holdings. With shrinking assets, banks needed to raise capital in other places just to meet minimum capital requirements.

The next major event was the near downfall of Bear Stearns. In one weekend, the Federal Reserve orchestrated a multi billion Dollar buyout and essentially brokered a merger between JP Morgan/Chase and Bear Stearns. Of course, this consolidation of power was met with controversy and skepticism, but we were all told that it was necessary to avoid a financial meltdown. As it turns out, it only masked this meltdown for another six months. The meltdown came when the Fed couldn’t do the same for Lehman Brothers that it did for Bear Stearns in September of 2008. Since, we have seen a quick deterioration of wealth, jobs, and Gross Domestic Product. We have been told that there is a credit freeze while financial institutions clean their balance sheets of these so called “toxic assets”.

Barney Frank and the Condos

Bill O'Reilly had an eerily cordial interview with Barney Frank last night.



They went over a series of topics but I want to focus on Congressman Frank's directive to Fannie/Freddie to loosen their restrictions on condominiums. Many in the media, like the Wall Street Journal, are characterizing this as a repeat of mistakes that caused the crisis.

Back when the housing mania was taking off, Massachusetts Congressman Barney Frank famously said he wanted Fannie Mae and Freddie Mac to "roll the dice" in the name of affordable housing. That didn't turn out so well, but Mr. Frank has since only accumulated more power. And now he is returning to the scene of the calamity -- with your money. He and New York Representative Anthony Weiner have sent a letter to the heads of Fannie and Freddie exhorting them to lower lending standards for condo buyers.

You read that right. After two years of telling us how lax lending standards drove up the market and led to loans that should never have been made, Mr. Frank wants Fannie and Freddie to take more risk in condo developments with high percentages of unsold units, high delinquency rates or high concentrations of ownership within the development.

I am very torn about this. On the one hand, I really don't want to defend Barney Frank. On the other hand, Fannie/Freddie have really restricted condominium guidelines to the point where loans over 75% are extremely difficult to get done. Still, the last thing we need is for legislators to dictate to Fannie/Freddie what their underwriting standards should be.

Within the last month, both have made condominium financing even more restrictive. Now, they won't finance any condo in which the building is less than 70% sold. (it used to be 50.1%) Furthermore, they won't finance any condo in which more than 15% of the units are behind on their assessments. Finally, any condominium project in which any one owner owns more than ten percent of the entire lot is one they won't do.

In my opinion, Frank makes some legitimate points. This new rule makes it nearly impossible to finance any new condominium project. If Fannie/Freddie won't finance any project less than 70% sold, how is any new condominium supposed to get to 70%? The second part of the rule makes perfect sense. Any condominium with too much delinquency on assessments can't function because they don't have money. The third rule makes sense in theory, but in practice, it has all sorts of unintended consequences.

For instance, technically, this rule would disqualify any building that's less than ten units. After all, every owner would own more than ten percent. Fannie/Freddie make exceptions to this rule in such a situation, but the rule itself makes it very difficult to finance small condominium projects. It's nearly impossible for any one owner to own ten percent or more of a four hundred unit project, but fifteen units is a different story. If one person happens to own two units of a 15 unit project, is that necessarily a sign that this project is on the brink of financial collapse? Yet, it would no longer qualify for a Fannie/Freddie loan.

There are three problems with this story. The first is that the media, almost in unison, attacked Frank merely because he's an easy target. Since he is linked to to prior loose guidelines, almost everyone reflexively attacked his idea as more of the same. Most of these folks don't have nearly the type of sophistication necessary to make a judgement, but they attacked him regardless.

The second problem is much more serious. We now live in a mortgage world where it's Fannie/Freddie and FHA. That's it. If we had more loan choices, it wouldn't make that much of a difference that Fannie/Freddie tightened their guidelines on condos. We'd still be able to go elsewhere. Since they are basically the only game in town, this becomes a market moving phenomenon. It's further exaserbated by the fact that FHA has also moved to make condo financing more difficult. When there was also Sub Prime and Alt A available, this sort of a thing wouldn't be so devastating. That's because the entire market wasn't dependent on these two. Now, it is. What all of this should reveal is that we need serious reform to Fannie/Freddie. Their duopoly on the mortgage market has perverted real estate itself. What this reveals is that both wield far too much power in the market.

Third, Fannie/Freddie are far too close to Congress. Whether the idea has merit or not, we can't have Congress suggesting financing guidelines to mortgage securitizers. Yet, we've moved to making Fannie/Freddie closer to Congress not further away. They used to be an extension of the government which was bad enough. Now, they are a wholly owned subsidiary of the government. That makes it much easier for folks like Barney Frank to dictate terms.

Some Thoughts on the Republicans' Regulatory Reform Proposals

So far, all we know is what has been leaked. CNBC has the round up on what the Republicans will focus on.

Among other things, it would ban additional government bailouts and create a new bankruptcy court category for big institutions that pose a systemic risk — a clear alternative to the resolution authority concept.

Other key components would limit the Federal Reserve’s regulatory and lending authority; initiate the privatization of mortgage giants Fannie Mae and Freddie Mac, which have been under direct government control since their near collapse a year ago; and restructure the existing regulatory framework for depositary institutions, including the FDIC, such that supervision of bank holding company subsidiaries would be spread among various agencies rather than consolidated in one banking regulatory.

In particular, the proposal appears to strike at the Fed’s expanded role in the current financial crisis, which has raised alarms on both sides of the political aisle.

The plan would force the Fed’s special lending facilities to be transferred to the Treasury’s balance sheet after a certain period and curtail its ability to lend under the emergency powers in section 13.3 of its charter. The central bank would also be subject to new oversight, in the form of audits by the General Accountability Office.

If I had written the reforms myself, there would have been only marginal, though at times important, differences. (my reforms can be found here and here) I like the Republicans' focus on bankruptcy over bailouts. That's an idea I hadn't thought of that I could support depending on the details.

The most important part of their regulatory reform focuses on the Federal Reserve. I have long been talking about the expanded power that the Fed has been gaining. Controlling the money supply is an enormous amount of power and there is absolutely NO OVERSIGHT OF THE FED IN THIS ROLE. The Republicans want to change that. They are following the lead of Ron Paul in finally trying to hold the Fed to rules of audits.

When I first found out that no one but insiders has ever seen the books of the Fed I was shocked. Can you imagine that? The Fed is by far the most powerful institution in the world. Yet, we have no idea what their assets and liabilities are. No one outside the organization has ever seen their books. The first step to true reform of that institution is transparency. The power of the Fed can be implied from the fact that the organization has resisted every effort to ever open up its books. Meanwhile, it's power to oversee and regulate has expanded.

The President and the Democrats would like to go the other way on the Fed. They have no intention on asking for transparency and they not only want to make the Fed the systemic risk manager but also give it regulatory power over all financial institutions. (currently it is just banks)

The other part I really like is reforming Fannie/Freddie. That's something I have also long called for. That said, the Republicans only take one of two important steps. They are correct that they need to be fully privatized. There's one piece missing. These two form a duopoly in mortgage securitization. To end this, they also need to be broken up. It's absolutely necessary if we want any sort of stability in mortgages.

The other reforms are still vague. There is no reason to comment until I have seen the details.

The Republicans do absolutely have an opportunity to begin a very important and necessary debate over the role of the Federal reserve in our economy. This is a rather misunderstood organization, for instance it is actually private, and once it is fully opened up to the public, I firmly believe the public at large will be with the Republicans in favor of less power and more transparency of the Federal Reserve.

Some Thoughts on the Beginning of the New Regulatory Framework

Treasury Secretary Geithner laid out some broad principles today for a significant increase in new regulations of the financial sector.

The Obama administration is proposing an extensive overhaul of financial regulations in an effort to prevent a repeat of the banking crisis last fall that toppled once-mighty institutions and wiped out trillions of dollars in investor wealth.


Congress would have to pass new rules to regulate the market for credit default swaps and other types of derivatives and require hedge funds to register with the Securities and Exchange Commission.



...



Let me be clear," Geithner added. "The days when a major insurance company could bet the house on credit default swaps with no one watching and no credible backing to protect the company or taxpayers must end."


The program the administration was presenting to Congress includes a recommendation for creation of a systemic risk regulator, possibly at the Federal Reserve, to monitor risks to the entire system.

There is a lot here I agree with. It's long past time that Hedge Funds and Private Equity Firms become more transparent and this will go a long way toward doing that. That said, such regulations often have unintended consequences. McCain/Feingold lead directly to the proliferation of 501 (C)3's. In much the same way, such regulations of Private Equity and Hedge Funds can, and in my opinion will, lead to the proliferation of other financial services firms that aren't regulated. Furthermore, it also means that hedge funds and private equity firms will likely move off shore to places where the regulations aren't as stiff.

I also agree that credit default swaps are desperate need of regulation (I have called for this as well), however, in my opinion, the market is a much better regulator of such markets. Once markets like credit default swaps collapse, the market is usually much more ruthless than any regulation. I suspect that most of the regulations that the government will propose have already been created by the market. In fact, I suspect that credit default swaps are rarely used at this point entirely.

I can support a systemic risk regulator. I am also in favor of figuring out a way to stop too big to fail. I am, however, troubled that the Obama administration wants to allow the government to step in and take controlling interest in any company deemed too big to fail. In fact, I was concerned myself about making such regulations a power grab.

To update Sherman to include companies that are too big to fail would consolidate an obscene amount of new power in the hands of the government. As such, a new law would have to be narrowly defined to determine just how it would be determined that a company is truly to big too fail.

So far, this regulation is rather vague and vague regulations lead directly to the government consolidating far too much power. There needs to be something done to prevent further companies from becoming too big to fail, but it must be much more specific than it is now.

Finally, most disappointing is that while there is a plethora of new regulations in the financial industry there is no new regulations for Fannie/Freddie. Given that the company owns and runs both now, they might see them is not needing regulations, but in fact they are both in desperate need of it. I have proposed breaking them up and privatizing them however that is the antithesis of what is going on now. Their reform is not necessary for a vibrant financial system but it is vital for a vibrant real estate market. Hopefully, their reform is coming soon.

Countering the Mortgage Bailout: Ethically, Philosophically, and Economically

If you listen to most defenders of the President's $275 billion bailout of troubled mortgage borrowers it is a "yeah but" argument. Yes, we may be bailing out those that overbought, but we need to do it to stabilize housing. Yes, this maybe rewarding bad behavior, but everyone suffers from mass foreclosures. Yes, many of these borrowers likely lied to get a loan in the first place, but our banking system requires that these toxic loans be replaced. It's a sort of desperate times call for desperate action argument. For an example, here is how two leading Democrats put it.

Rep. Bruce Braley (D-Iowa), who founded the House Populist Caucus, says the president has actually gone “to great lengths” not to reward people who have been irresponsible, and that the plan is really an effort to stem another wave of foreclosures in order to stabilize the housing market, which would be to everyone’s benefit.

Michigan Gov. Jennifer M. Granholm, also a Democrat, agrees: “This is not directed at those who didn’t play by the rules,” she says. “It’s directed at trying to fix a system so everyone can stay in their homes and so that everyone’s community is not negatively affected by the foreclosures that are popping up all over that neighborhood.”

All of this rhetoric may sound reasonable but in fact, this mortgage bailout fails not only ethically, but philosophically and mostly importantly economically.

Ethically, the President has assured everyone that this plan will only help those that "played by the rules". Not only is this something that all politicians say, but the numbers simply don't add up. President Obama promises to save up to 9 million homeowners. We aren't in this mess because people played by the rules and fell on hard times. We are in this mess because people lied on their applications and simply overbought. To help 9 million borrowers is to help many that overbought. To only help those that fell on hard times is to only help a few hundred thousand. Furthermore, that help would do little to stabilize housing. Now, we can have a philosophical debate on whether or not someone that lost their job or got sick should get a better mortgage, but in fact that debate is moot. This plan will mostly help those that simply overbought. The numbers tell the story.

Philosophically, this bailout creates a moral hazard. It rewards bad behavior. That's just the long and short of it. In order to qualify for a loan modification, the process is nearly the reverse of a regular qualification. You want to show an inability to pay your current mortgage in order to get a better one. If someone gets a mortgage they can't afford and then is rewarded with a better one, that only encourages more people to get mortgages they can't afford.

The most important argument is the economic one. That's because supporters want all of us to forget the ethical and philosophical one because they tell us that we need to swallow them for the greater good. The problem is that there is no greater good. First, there are those that say this is the only way to stabilize housing and thus that is good for everyone. This is very misleading. First, if you are a renter, you want to see housing dropping as it is. Second, stable housing is only good for those looking to sell immediately. If you plan on being in your property for five ten or even twenty years, a housing crash is of little consequence. Rather, what you really want is to reach a bottom as quickly as possible. The only way to do that is to see all of these troubled borrowers dealt with as soon as possible.

Foreclosures do bring down property values but they only bring them down for six to twelve months. So, it is really only those looking to sell right now that are hurt. Plus, for every foreclosure there is a buyer. If the government steps in to save a borrower, there is a real estate investor that is unable to get a property at a cheap value. So, this idea that stemming foreclosures helps everyone is dubious at best and disingenuous at worst.

Finally, there is the argument that banks need this in order to remove all of these toxic assets. All you need to do is look at recent loan modification history to understand how frivolous that argument is.

Many borrowers who received help with mortgage modifications earlier this year tended to re-default on their payments, a top U.S. banking regulator said on Monday, citing recent data.

"The results, I confess, were somewhat surprising, and not in a good way," John Dugan, head of the U.S. Office of the Comptroller of the Currency, said in prepared remarks for a U.S. housing forum.

"Put simply, it shows that over half of mortgage modifications seemed not to be working after six months."

The latest figures on loans that have been modified in the last twelve months show that more than half go into default within six months. To understand how much of a problem this is for the system, one needs to have a perspective on how good a deals these loan modifications are. Borrowers average rates at about 5%. Often, they have their balances reduced. Rates can be as low as one percent. To offer deals that good on a mass scale, banks would need to have re default rates of less than one percent. Fannie/Freddie loans aren't that good and if their default rates pass one percent that becomes a problem. Yet, default rates approach 50 percent on loan modifications. That is an untennable figure. If the default rates came anywhere near that in the President's program, we truly would turn a crisis into a catastrophe. Banks simply can't sustain a mass of loans at 2%, 3%, 4%, and 5% and have half of them default. They aren't making nearly enough on each loan to sustain those default rates.

Furthermore, with default rates anywhere near there, the housing market wouldn't stabilize anyway. We would still have 30%, 40%, or 50% of these nine million homeowners get defaulted. We would just do it with banks carrying the other half at below market rates. That's truly a recipe for economic disaster.

President Obama's Bubble Mentality

In the mortgage subset of FHA, there is a loan called FHA streamline. With this loan, if a borrower is currently in an FHA loan, and never late, they can qualify with little documentation and no new appraisal. All the borrower needs to do is maintain a loan amount no more than the original and receive a lower rate and monthly payment than the original. (they could theoretically get the exact same rate and monthly payment though there would be no reason to do the loan then) Then, all they would need to prove is they are gainfully employed and they qualify. As such, someone in an FHA loan that has had its value drop, can still refinance into a lower rate. In yesterday's mortgage bailout plan, President Obama made a similar pronouncement for Fannie Mae loans. If someone has a mortgage with a loan to value of above 80%, the President will now direct Fannie/Freddie to dismiss their rules for any loans above 80% LTV and give them rates as though they are below.

There are two major differences between FHA streamline and President Obama's plan. With FHA, a borrower pays an upfront fee of 1.5% that goes to FHA to pool to cover and default and foreclosed loans. Second, the monthly mortgage insurance on FHA loans is the same no matter your LTV.

What is troubling about this new rule is two things. First, of all of President Obama's ideas this is the one that has been most universally applauded. Second, it is part and parcel of President Obama's myopic determination of giving anyone he can better mortgage terms. Let's put something into perspective. Most everyone agrees that Fannie/Freddie contributed to the crisis by loosening their own term and buying far too many aggressive mortgages. Yet, throughout this period 2003-2007, never once did either suspend their rules for mortgages above 80%. Any such mortgage required mortgage insurance. In other words, even these two companies, which knew no limits to their irresponsibile behavior, knew to draw the line at waiving mortgage insurance for loans above 80%. President Obama has no such qualms. He says, glowingly, that even though the rules specifically bar such mortgages from being refinanced, all those rules must be suspended because current mortgage rates are very low. In President Obama's world, making sure that everyone possible gets a better deal is much more important than such "trivial" things as being qualified for a new loan. It's as though he missed that a lack of qualification for loans is what got us here.

Besides this scheme to dismiss long standing Fannie/Freddie rules for loans above 80%, President Obama's mortgage bailout reads like a laundry list of programs to get most any borrower a better deal. Those that currently owe more than the home is worth will be eligible to reduce their mortgage payment to as low as 31% of their income. Never mind for one second whether any of these folks are actually qualified to receive these new loans. In fact, they aren't. Their only qualification appears to be that they currently have mortgages who's payments make their debt to income higher than 31%. Borrowers on the brink of foreclosure will also be eligible to receive loans that drop their debt to income to 31%. The rates, according to the Obama administration, can be no lower than 2%. That's right, if you took out a mortgage that is unaffordable, you will now be eligible for a new more affordable mortgage and that right can be as low as 2%. The only eligibility we know of so far is that your mortgage is currently not affordable. Whether or not you had anything to do with creating this situation appears to be of little consequence. Sure he pays lip service to only providing these deals to borrowers that "played by the rules". Yet, he hasn't defined how he will determine if did play by the rules. He has however defined that anyone with a mortgage that is more than 31% of their income is now eligible. For the first time in the history of credit, eligibility will be determined by having too much debt rather than too little.

Frankly, I say that if President Obama simply wants to give as many people as possible an affordable mortgage we should skip all of these formalities. Just announce that the Treasury will refinance everyone's loan at 4%. Tell people to form a line immediately and the President himself can help the borrower's sign the closing documents. That way he can insure that everyone knows what they are signing.

During the real estate boom, the industry suffered through a bubble mentality. We all believed that real estate could and would go up forever. We all became myopic in this view and thus everyone was determined to simply constantly bring in new people into the real estate market. As such, guidelines continued to loosen until it all became ridiculous. Now, President Obama is suffering from his own bubble mentality. He believes that he needs to do everything possible to get as many people as possible more affordable mortgages. He pays no attention to such trivial things as credit worthiness and other qualifications (like that nasty thing called loan to value). It's exactly this sort of myopic determination that got us here, and it appears that President Obama is determined to repeat it.

Understanding the Role of Securitization in Mortgages

As most everyone Fannie Mae and Freddie Mac have come under a great deal of criticism (to put it mildly). In fact, they have come under so much criticism that some may not realize the very vital role they play in the mortgage process, mortgage securitization

A mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans. Payments
are typically made monthly over the lifetime of the underlying loans.[1][2]

To understand why securitization is so important we need only to look at the current market. Right now, it's possible for an individual borrower to get rates as low as 5% and have those rates be fixed for 30 years.



Now, a layman might ask how a bank could afford to guarantee such a low rate for such a long period of time. After all, while money is cheap now it won't necessarily be cheap forever. As such, what happens when money is more expensive to get for the bank. If it starts to cost the bank, 3, 4, and 5% to get the money, how could they possibly afford to continue to only receive a rate of 5%?



What the process of mortgage securitization does is removes all of this risk from the bank. What these banks do is bundle millions of loans together and sell them to Fannie/Freddie. Then, Fannie/Freddie bundle these same loans together and turn those loans into bonds at the current market rate. Then, those loans are sold to investors.

Those that invest in bonds are essentially making a bet that current interest rates will be more than future rates. Let's look at an example to illustrate. Let's say I receive a Fannie Mae bond at 5%. Then, six months later Fannie Mae bonds only pay 4%. Of course, my bond is then more valuable because my bond receives a higher rate than the current market rate. What's important to understand is that those that invest in bonds can afford to take a risk on interest rate. Banks, on the other hand, are not in the business of taking interest rate risks. At their core, all banks ever want to do is loan money at a higher rate than they get it at. The process of mortgage securitization takes this risk away from the bank and moves it to bond investors, where it is more appropriate.

The other thing that mortgage securitization does is it creates liquidity in mortgages. While over the long term, a bank would make more money by collecting the monthly mortgage payment for the full 30 year term, it would also leave banks with less money in the short term to lend to new borrowers. By relieving banks of the loans immediately, banks have money to lend to a new person immediately. As such, the process of mortgage securitization allows banks to lend to far more people than without it.

The travails of Fannie/Freddie should not minimize their vital role in the process. In fact, quite the opposite should be seen. Because mortgage securitization is so vital, it is that much more vital that this process not be corrupted. These two companies are a virtual monopoly and they are fully funded by the government making their profits private while their losses are covered by the tax payers. This has perverted this very important process. The failure of both make it that much more vital that the process of mortgage securitization be done in a free market and private system.

A Thought Experiment on a Newspaper Bailout: Some Context on Government Intervention

In the last couple weeks, some conservative blogs here and there have suggested that the bailout would get so ridiculous that even newspapers would eventually receive a bailout.

Back in October, I joked that it wouldn’t be long before the junk-bond New York Times was lining up for a government bailout. Last month, I followed up with the launch of the Newspaper Bailout Countdown Clock in a post about Tribune Media’s financial woes.

Well, it has come to pass: Democrats have proposed a newspaper bailout in Connecticut:

Of course, there is just one problem with a newspaper bailout. That problem is the first amendment.

Congress shall make no law respecting an establishment of religion, or prohibiting the free exercise thereof; or abridging the freedom of speech, or of the press; or the right of the people peaceably to assemble, and to petition the Government for a redress of grievances.

So far, each and every bailout has eventually lead to a government take over of said industry or company. That appears to be where the auto bailout is going. The government already owns Fannie Mae and Freddie Mac, and they have substantial stakes in many of the banks getting a part of the bailout. Obviously, the government couldn't take any stake in any newspaper because that would be a clear violation of the first amendment. In fact, any sort of a bailout of any media can and should be viewed as a violation of the first amendment. You never get something for nothing and so any money comes with strings. Any government money to any newspaper should be viewed immediately as the government attempting to control the flow of news.

That's why the public would never stand for any bailout of any media. That would be a clear violation of our Constitution. Yet, we stand by while the government takes over cars, banks, and mortgage giants. We would never stand by while the government took over our media because we don't want the government telling us what to think. Yet, why do we want the government telling us what cars to drive, how to bank, and how to get a mortgage? That's what has happened while the government has taken over industry after industry.

The landscape is filled with pitfalls when the government interferes in any industry. If the government takes over the media, the media becomes nothing more than a mouthpiece for the government. That's why our Constitution strictly forbids the takeover of the media by the government. Yet, when our government begins to meddle in other industries, the danger is that incompetent, naive, and arrogant politicians begin to direct businesses they have no understanding of.

So, now we are on the brink of having an auto bailout. With this bailout, we will have a car czar. What is a car czar? It's the government's automaker's CEO. Since the automakers will now be running on government money, the government will tell the automakers how to spend it. Does anyone really believe that Nancy Pelosi, Harry Reid, and whoever is the car czar have the first clue how to run a car company? If the government appointed a newspaper czar, that would violate the first amendment. Yet, a car czar is seen by most as "prudent".

Last week, I pointed out that Fannie and Freddie were manipulating mortgage rates. While I can't know for sure why this is happening, I would be willing to make a healthy wager that this came as a directive from a government bureaucrat that thought mortgage manipulation was a good idea. This is the sort of thing that happens when government runs mortgages. Imagine if a government bureaucrat put a quota on the number of stories newspapers should cover on any given topic. That would be viewed, correctly, as a violation of the first amendment. Yet, when the government manipulates another business in a similar fashion we all shake our heads and move on.

Government has enough trouble doing its own job. The last thing we need is for government to try and do everyone else's job. That's what is happening as a result of all these bailouts. The government is now also a banker, a mortgage company, and the CEO of all the automakers. There is a reason we would never stand for this in the newspaper business, and that reason has plenty of application in their current roles as well.

Some More Context on the Treasury's Plan to Drive Down Mortgage Rates

Yesterday, I analyzed the Treasury's plan to drive down mortgage rates to about 4.5%. I called it no different than any other plan for a price ceiling. Yesterday though, details were sketchy as to how the Treasury would attempt to accomplish this. Today, more details have been leaked and we should all be scared that the Treasury will actually follow through.

The head of the government's financial system rescue effort said Thursday
the Treasury Department is considering a program to encourage banks to make
mortgage loans at low rates to help revive the battered housing
market.

Under the proposal being pushed by the financial industry, Treasury would
seek to lower the rate on a 30-year mortgage to 4.5 percent by purchasing
mortgage-backed securities from Fannie Mae and Freddie Mac. It's unclear exactly
how much the plan would cost.

Asked about the proposal during his testimony before a Senate
Appropriations subcommittee, Neel Kashkari said that it was one of the options
the administration had under review.

Treasury is striving to use the
"right tools for the right job" in an effort to help as many homeowners as
possible, said Kashkari, the department official in charge of the $700 billion
rescue effort.

The goal of the industry's proposal would be to take advantage of the unusually large difference, or spread, between mortgage rates and yields on government debt. On Thursday, the yield on the 10-year Treasury note yield sank to a record low of 2.56 percent, while the national average rate on a 30-year fixed rate mortgages was 5.54 percent, according to financial publisher HSH Associates.

There are several reasons to be afraid. First, this plan is being pushed by the financial industry. Of course it is, the financial industry would be the beneficiary of such a plan. Politicians spend all campaign decrying the influence of special interests and yet this plan is the ultimate special interest give away. Second, no one at the Treasury knows just how much this is going to cost. The total value of the housing market is in excess of $10 trillion and Fannie/Freddie now account for about 80% of that. So in order to manipulate the market to reach 4.5%, the Treasury would have to spend hundreds of billions of Dollars.

Yet, it is the third part that is most troubling. The Treasury thinks they see an albatross situation because Treasury bond rates are so low, about 2.65%. The Treasury will borrow the money, they think, at 2.65% and buy bonds that will pay them in excess of 4%. If only it were that tidy. When the Treasury reaches into the Treasury money for hundreds of billions of Dollars more than they are already borrowing, on top of all of the extra borrowing they are already doing, what do you think will happen to Treasury rates? They will likely go up, way up.I've already warned about how explosive it maybe when Barack Obama asks form money for the hundreds of billions in new spending he wants. This plan will costs hundreds of billions more. Furthermore, since they will artificially drive down mortgage rates, the bonds they will hold will be worthless once their stimulus is through. As such, the Treasury will have to hold onto those bonds for the duration. This scheme won't work unless Treasury rates continue to be close to 2.65% for the duration of the period that Treasury holds onto these mortgage bonds. I have already shown that this very scheme will likely force Treasury bond rates way up. While the Treasury continues to get about 4% on their money, what will happen once the rate that Treasury bonds give goes up? Eventually, the Treasury will start to lose all sorts of money to do this.

In other words, the Treasury is willing to borrow hundreds of billions of more Dollars to take advantage of some hokey scheme that is normally reserved for quick buck artists. The Treasury was never meant to be used for this kind of market manipulation, and certainly not when it is predicated on some hokey idea like the CURRENT spread between mortgage bond rates. In fact, this particular article clearly lays out that Fannie/Freddie used a very similar scheme that wound up blowing up on them and put them into the mess they are in. In other words, the Treasury is about to attempt the same type of hokey scheme that blew up on Fannie/Freddie WITH TAXPAYER MONEY.

The problem again is that Hank Paulsen seems to forget that he is no longer an investment banker. He continues to treat everything at Treasury as though it was an investment banking deal. Playing spreads is the sort of thing an investment bank might try. That would be fine if the Treasury were an investment bank, but it isn't. Tax payer money was never supposed to be used in such a risky way. This is the worst sort of market manipulation. It's being done with tax payer money, and it's not only dangerous to our economy, but it's predicated on a very dangerous scheme.

The Tyranny of Duopoly: Fannie/Freddie's New Pricing Policies

When Fannie/Freddie asked for a bailout in July, these two giants, who before mostly stayed in the background, burst onto the national scene. With it, there came a national debate over their roles in just about everything. Many so called "experts" even try and pin the blame them for the crisis itself. While there is a lot of debate about their role, there is little debate about how to structurally change these two giants so that they never poison the market again. When they burst on the scene in need of roughly $50 billion in order to function, the whole country took notice. Unfortunately, the tyranny thest two perform everyday inside the mortgage industry gets little notice. It is a tyranny they are afforded because Fannie Mae and Freddie Mac maintain a Duopoly in Mortgage Securitization. By maintaining this Duopoly, they, together, make each and every rule. Because the securitizer is the ultimate holder of any given loan, it also means that setting rules applies to every part of the process: pricing, underwriting, and the terms.

Throughout the boom, Fannie/Freddie loans were essentially pass fail. What this means was that either a particular loan did or didn't qualify. Both Fannie/Freddie also had a sort of minor league of loans, known as Expanded Level, for borrowers that didn't qualify for their best product. That said, neither Fannie/Freddie made a distinction in terms of pricing for a borrower with a 650 credit score or a borrower with an 800 credit score. If both borrowers qualified, they got the exact same rate. Both made distinctions for property types. In other words, a two unit property received a slightly worse rate than a single family home. Of course, they also made distinctions for property dispositions. In other words, there was a rate difference for an investment property over a property the borrower would occupy. Finally, each made a small distinction for loans with very high loan to value. A loan which put only 5% down (or had only 5% in equity in the case of refinance) received a slightly higher rate than those with 10% down and more. In this case, the rate was only about an eighth of a percent worse.

As such, up until this year, most folks got the exact same rate as long as they qualified. This all changed at the beginning of the year. Now, each have all sorts of new break points. A borrower with a 650 credit score receives a significantly worse credit score than one with a 750 score. In fact, anyone with less than 740 credit score now receives a pricing adjustment. A 740 credit score is found in top one half of one percent of all borrowers. What's more, while there is a pricing adjustment for the credit score, there is no adjustment for other factors that one could consider important. For instance, someone with a 650 score gets a worse rate than someone with a 750 score. Someone that shows that they have $100,000 in the bank though, gets the same EXACT rate as someone with nothing in the bank, assuming both qualify. Someone with a debt to equity ratio of 15% gets the same rate as someone with a 45% debt to income ratio.

Beyond this, the two have also made adjustments at much lower loan to values. For instance, there is almost no adjustments for loans below 70% loan to value regardless of the credit score. Over 70% though, things begin to adjust and the adjustments become more acute when higher loan to values are combined with lower credit scores. For instance there is a massive adjustment for someone with an 80% loan to value and a 650 credit score.

This change, less than a year old, is a near 180 degree turnaround in the way that each do business. It is certainly open to debate whether or not this is a good idea. Some might even say their adjustments don't go far enough and weren't done soon enough. What can't be argued is that each made the EXACT SAME rule changes at the exact same time. Furthermore, Fannie/Freddie loans are about 85% of all residential loans currently. In other words, by dictatorial fiat, the two have revolutionized the way in which mortgages are priced, and by extension the rates that borrowers get, overnight, without warning, and without anything anyone else can do about it.

They can do this because there are two of them controlling this mysterious market known as mortgage securitization. Mortgage securitization is the process in which loans are packaged togehter and turned into bonds. It is vital in maintaining liquidity because it allows banks to immediately unload a loan and have more money for the next loan. Now, it is like a drug. Because banks are now trained only to do loans that are eventually sold to Fannie/Freddie they couldn't do it any other way even if they wanted to. Even during the boom, those loans that banks did on their own and held in their own portfolio made up no more than 10% of the market. Now, it is no more one percent.

Whether you agree with the changes made by Fannie/Freddie in pricing, one thing is clear. They couldn't have made such revolutionary changes if the market for loan securitization was an actual market. If there was more than two of them, they wouldn't be able to suddenly become so restrictive in price and get away with it. One of their competitors would take advantage of the draconian rule changes and offer an alternative and banks would have their loans securitized through them.

Fannie/Freddie have two problems, they are quasi Socialisitic and they are monopolies. The problems of their quasi Socialism reared its ugly head when they were bailed out. The problems of their monopolization rears its ugly head in their tyrannical rules like the one I just illustrated. Fix both problems and you fix the giants.

The Coming Mortgage Class War

My dad gets angry every time he hears about a potential mortgage bailout. Frankly, he should. He's maintained perfect credit his entire life. He's always lived within his means. The idea that someone more irresponsible than him would be provided with some sort of a lifetime specifically because they were irresponsible bothers him to the core. What my dad doesn't even realize is just how good a deal some of these folks will get.

Yesterday, the Federal Government announced that the Fannie Mae/Freddie Mac would soon begin to modify loans en mass of borrowers struggling to make their payments, but some folks think this plan doesn't go far enough.

“It’s definitely a step forward,” says Howard Glaser, a mortgage industry consultant and a U.S. Department of Housing and Urban Development official during the Clinton administration. “They do have several hundred thousand eligible loans, and Fannie and Freddie are likely to be better than the private industry has been in applying modifications across the board because they don’t have the shareholder issue to deal with.”

But there are limiting factors, Glaser says. “Fannie and Freddie’s share of high risk mortgages is very small compared to the market as a whole. And as you get into 2005 and 2006, sixty five percent the mortgages were done in securitizations outside Fannie and Freddie--and that’s where most of the trouble is.”

Indeed, James Lockhart--Fannie and Freddie’s regulator--said in a speech announcing the program that “private label securities represent less than 20% of the mortgages but 60% of the serious delinquencies.”

And that’s where the plan falls short, says Susan Wachter, a professor of real estate at the University of Pennsylvania's Wharton School of Business. The program does no apply to loans in most private label mortgage-backed securities. Instead, Lockhart is asking investors and servicers of such securities to do so voluntarily. “I ask the private label MBS [mortgage-backed securities] servicers and investors to rapidly adopt this program as the industry standard,” Lockhart said.

But simply asking them to do so is not enough, Wachter says. The private sector has
demonstrated that it is “unwilling or unable” to voluntary modify loans in significant numbers since the onset of the crisis, she says. “There’s hope here, but its moral suasion,” Wachter says. “And we don’t have a lot of time to see if moral suasion works.”

I believe this idea of mass loan modifications will soon produce one of the most corrosive class wars in the history of this country. Loan modification is the process by which a distressed borrower gets new loan terms not based on their merit but based on their ability to pay. Either or both, the loan amount and the interest rate are adjusted so that the new payment is now something the borrower can handle. Because loan modifications are available to those based on ability to pay not credit worthiness, this is a process that someone with perfect credit like my dad would not qualify for. That's because those with perfect credit are perfectly capable of paying the loan terms they AGREED TO WHEN THEY GOT THEIR LOAN.

Yesterday, I mentioned a loan modification I recently saw. This particular borrower got a interest rate of 4% for the next five years. That rate would go to 6% for the next two years after that, and then it would go to 6.75% for the rest of the loan. That's not a bad deal considering this borrower only got said deal by not being able to pay their current loan.

What do you think will happen when word gets out just how good a deal some of these modifications are? What will happen when borrowers with good credit find out those with bad credit are having not only their interest rates reduced but their loan amounts as well? What do you think will happen when the borrowers with perfect credit realize that it is their own credit worthiness that holds them back from getting the exact same deal?

We will have a class war the likes of which we've never seen. Those that acted responsibly won't merely be jealous and envious, but rather they will be outraged. This will pit neighbor against neighbor, friend against friend, and colleague against colleague. Those with good credit will demand action. They will demand justice and they will demand accountability. I have always believed that there is a silent majority in this mortgage mess. That majority are the folks that have paid their bills on time. For the most part, they want no one bailed out. They were responsible. Others weren't and they won't stand for those that were irresponsibly being rewarded.

The process of loan modifications is just entering the public consciousnesses. Once the public at large understands just what all of this means, there will be a revolt from those that don't "qualify" for loan modifications. Those that have been responsible have been overlooked by this entire process. Those that have acted irresponsibly have been catered to and turned into victims. In my opinion, turning them into victims has always been a source outrage as exhibited by my dad. This sentiment is out there however the MSM has buried it. Just look for a sob story about some family that lost their home. See if there are comments and read the comments. Almost always the bulk of the comments come from people that feel the situation was their own fault.

The dirty little secret of loan modifications is about to come out. Once it does, that secret will start a class war the likes of which we have not seen in a long time.

A MSM Ally Against the Demonization of Deregulation?

I was shocked to read this piece by Sebestian Mallanby of the Washington Post. I was shocked because I have generally found nothing upon which I agree with Mallanby on. That said, he agrees with me on two points 1) demonizing deregulation for the mortgage crisis is in correct and 2)it is dangerous. Mallanby sees a slightly different culprit for the problem than I do.

The real roots of the crisis lie in a flawed response to China. Starting in the 1990s, the flood of cheap products from China kept global inflation low, allowing central banks to operate relatively loose monetary policies. But the flip side of China's export surplus was that China had a capital surplus, too. Chinese savings sloshed into asset markets 'round the world, driving up the price of everything from Florida condos to Latin American stocks.

That gave central bankers a choice: Should they carry on targeting regular consumer inflation, which Chinese exports had pushed down, or should they restrain asset inflation, which Chinese savings had pushed upward? Alan Greenspan's Fed chose to stand aside as asset prices rose; it preferred to deal with bubbles after they popped by cutting interest rates rather than by preventing those bubbles from inflating. After the dot-com bubble, this clean-up-later policy worked fine. With the real estate bubble, it has proved disastrous.

So the first cause of the crisis lies with the Fed, not with deregulation. If too much money was lent and borrowed, it was because Chinese savings made capital cheap and the Fed was not aggressive enough in hiking interest rates to counteract that. Moreover, the Fed's track record of cutting interest rates to clear up previous bubbles had created a seductive one-way bet. Financial engineers built huge mountains of debt partly because they expected to profit in good times -- and then be rescued by the Fed when they got into trouble.

He blames the Fed like I do only he blames them for not raising interest rates aggressively enough to counteract all the cheap money that China was dumping into the U.S. markets. Frankly, I remember things much differently. When the Fed dropped the Prime Rate to 3.75% the Federal Funds Rate dropped with it to .75%. That, to me, was what created far too much money in the system, not anything that China did or the Fed's non response to their actions. Still, while the debate over the real roots of this crisis is vital, that is one that I will leave for another day. For now, let's examine why Mallanby believes that deregulation is the wrong scapegoat.

The key financiers in this game were not the mortgage lenders, the ratings agencies or the investment banks that created those now infamous mortgage securities. In different ways, these players were all peddling financial snake oil, but as Columbia University's Charles Calomiris observes, there will always be snake-oil salesmen. Rather, the key financiers were the ones who bought the toxic mortgage products. If they hadn't been willing to buy snake oil, nobody would have been peddling it.

Who were the purchasers? They were by no means unregulated. U.S. investment banks, regulated by the Securities and Exchange Commission, bought piles of toxic waste. U.S. commercial banks, regulated by several agencies, including the Fed, also devoured large quantities. European banks, which faced a different and supposedly more up-to-date supervisory scheme, turn out to have been just as rash. By contrast, lightly regulated hedge funds resisted buying toxic waste for the most part -- though they are now vulnerable to the broader credit crunch because they operate with borrowed money.


If that doesn't convince you that deregulation is the wrong scapegoat, consider this: The appetite for toxic mortgages was fueled by Fannie Mae and Freddie Mac, the super-regulated housing finance companies. Calomiris calculates that Fannie and Freddie bought more than a third of the $3 trillion in junk mortgages created during the bubble and that they did so because heavy government oversight obliged them to push money toward marginal home purchasers. There's a vigorous argument about whether Calomiris's number is too high. But everyone concedes that Fannie and Freddie poured fuel on the fire to the tune of hundreds of billions of dollars.

Mallanby is absolutely correct that the purchasers of these bonds were all themselves hyper regulated. Though, if a regulated industry is buying a product that is totally unregulated there is something to be said for regulating that product. These mortgage bonds were extremely sophisticated and as we learned the players buying them didn't really understand the product themselves. While they may themselves have been regulated that doesn't mean the product they were buying was safe. What's missing from Mallanby's argument is what is missing from all discussions about deregulation and this crisis. That's that most of the mortgages were done fraudulently. If the most basic regulation was not enforced, what in the world is more regulation going to do?

Mallanby ends with a word of warning.

So blaming deregulation for the financial mess is misguided. But it is dangerous, too, because one of the big challenges for the next president will be to defend markets against the inevitable backlash that follows this crisis. Even before finance went haywire, the Doha trade negotiations had collapsed; wage stagnation for middle-class Americans had raised legitimate questions about whom the market system served; and the food-price spike had driven many emerging economies to give up on global agricultural markets as a source of food security. Coming on top of all these challenges, the financial turmoil is bound to intensify skepticism about markets. Framing the mess as the product of deregulation will make the backlash nastier.

The next president will have to make some subtle choices. In certain areas, markets need to be reformed -- by pushing murky "over-the-counter" trades between banks onto transparent exchanges, for example. In other areas, government needs to fix itself -- by not subsidizing reckless mortgage lending. But a president who has a mandate only to reregulate will be a boxer with a missing glove. By going along with the market skepticism of his party, Obama may end up winning an election while compromising his presidency.

He's correct. The markets will be weak enough as it is on their own coming out of this crisis. If a whole host of new regulations follow this crisis, that will be an extra incentive for players to stay away. Hyper regulation is the anti thesis of any economic recovery. Adding a whole host of new rules for the players in charge of bringing our economy out of this rut is counter productive.