Tuesday, July 15, 2008

Why Fannie and Freddie Have Doomed Housing Prices, Regardless of Bailouts
(July 14, 2008)

If you got a penny for every word written during the past week about Fannie Mae and Freddie Mac, you'd be a millionaire, if not a billionaire. It is highly likely that no stone has been left unturned in this great torrent of words and analysis, but it seems two points have been generally ignored or under-emphasized:

1. Regardless of whatever bailout is proposed for Freddie and Fannie, interest rates and thus mortgage rates will rise significantly. Even if all the distressed garbage loans are fobbed off onto the taxpayers (as wrong as that would be), that won't put the bloom back on the U.S. housing rose. Is there even one person left on the planet who thinks debt based on the U.S. housing market is basically risk-free?

And what happens when risk is priced into debt? The interest rate must include a hefty, if not outrageously gigantic, risk premium. That's how 6% mortgages quickly become 9% or even 12% mortgages. Or how 30-year mortgages might simply vanish and the longest term you can find will be 15 years--at a stupendous premium.

2. Since Freddie, Fannie and Ginnie end up owning up to 75% of all mortgages originated in the U.S. housing market, their inability to sell new garbage loans to now-wary investors means 3/4 of the mortgage market has been impaired. Mortgage availability will contract most savagely.
Let's take a look at a chart that depicts the see-saw effect:

Please go to www.oftwominds.com/blog.html to view charts.

Recall that banks and lenders of all types and sizes are suffering from impairments in their capital. Whatever assets the banks have on the books are depreciating rapidly, essentially gutting their capital base and their ability to originate new loans.

Recall that capital requirements have been as low as 1%, meaning a bank need only retain $1 million in actual cash to write $100 million in loans. If those loans drop in value by 2%, the bank must raise cash or it is essentially insolvent.

As astute correspondent J.F.B. has noted many times before: how can banks make money in an environment of depreciating capital and distressed debt? The short answer is they can't: all the capital they're raising is simply bringing them up to bare solvency (at best; if all the off-balance sheet garbage is forced onto the balance sheets, then the majority would be hopelessly insolvent.)

So what happens to the housing market if rates skyrocket due to risk premium, and mortgage availability dries up? It tanks even further. As noted here many times, housing depends entirely on cheap, readily available mortgages. Once those two conditions go away, housing dies a slow, agonizing death. Prices have to fall--recall that a $600,000 mortgage at 6% is equivalent to a $300,000 mortgage at 12%--and buyers will find they cannot find mortgages without hefty origination points.

And without buyers, then the market freezes up, becomes illiquid. Few sellers will find buyers and prices will decline to the point that cash buyers appear. (Hint: that isn't $500,000, or even $300,000.)

The bond market seems to have been sniffing out this possibility for several years.

Knowledgeable reader J.B. was kind enough to provide the following chart; though he notes a strong cyclical pattern which suggests ultimate yield lows in the 2011-2012 time frame, the triple-bottom I have indicated and the yield's obstinant reluctance to dip below the upper channel suggest to me we are close to breaking out of a 24-year downtrend in yields, and entering a 20+ year cycle of rising rates.

So while much heat and light are being devoted to past debt--who will suck up the enormous losses in Freddie's and Fannie's trillion-dollar portfolios--I am looking at the staggering effects their demise as providers of "low-risk" debt will have on the housing market in the future. If nobody's dumb enough to trust the U.S. housing market or the garbage paper being kited by Freddie and Fannie, then mortgage availability will simply blow away and rates will climb rapidly up to the point that investors are being amply rewarded for taking the grave risks of betting housing won't decline precipitously in the U.S.

Ironically, the "poker hands being called" will trigger the very decline in valuations everyone fears. Think about it. You're responsible for $1 billion of a pension fund's money; are you going to risk your capital on a huge gamble that U.S. housing has bottomed? On what evidence? Hope? Hope is what got us in this mess in the first place.

And recall that despite the implicit government backing of Freddie and Fannie, the market for mortgages is still private: you still have to con a private investor to part with cash to buy the mortgage or mortgage bond. And if nobody's dumb enough to give you cash for depreciating paper, then you still can't sell mortgages, regardless of any guarantee in the world except "You can't lose money because the U.S. taxpayer will buy every single mortgage originated in the U.S." Are we collectively going to approve that $10 trillion bailout?
Craig M. recommended this link to Nouriel Roubini's take on such a bailout, which is the U.S. government losing its AAA rating: Insolvency of the Fannie and Freddie Predicted Here Two Years Ago. What Happens Next? Or How to Avoid the "Mother of All Bailouts".
Is anyone who manages big money really dumb enough to believe housing can't fall another 15-20% or even more? I don't think so. Smart money will be demanding risk premiums large enough to protect against further declines in real estate values: huge down payments, big points (origination fees) up front and high interest rates.

OK, sources:

This is slightly dated (2001), but this report from the Federal Reserve Bank of Atlanta shows how incredibly dependent the mortgage business has long been on Freddie, Fannie and Ginnie:
Fannie Mae and Freddie Mac at Work in the Secondary Mortgage Market

Of this amount, 29.3 percent were sold to Fannie Mae, 24.5 percent to Freddie Mac and 22.7 percent to Ginnie Mae. (CHS: That adds up to 76.5%.)
Contracts with Fannie Mae and Freddie Mac make up 62.5 percent of the outstanding principal of serviced mortgages by commercial banks. Ginnie Mae contracts constitute 19.2 percent. (That's 81.7%)

Back in the good old days of, say, a year ago, Freddie and Fannie were actually seen as beneficiaries of the subprime meltdown (heh): Fannie Mae and Freddie Mac enrich shareholders in subprime's shakeout (Bloomberg, June 2007)

Fannie Mae and Freddie Mac, which are U.S. government-chartered companies and the biggest source of money for Americans buying houses, accounted for 46.9 percent of all mortgage bonds sold through April, according to Inside Mortgage Finance, a newsletter.

Fannie Mae and Freddie Mac, which together own or guarantee about $4.5 trillion of residential mortgage assets, are offering the capital after foreclosures increased 62 percent in April from a year earlier, according to a recent report by RealtyTrac, which sells information on defaults.
Fannie Mae and Freddie Mac finance about 40 percent of the $10.9 trillion of U.S. residential mortgages. More than $6 trillion of mortgage bonds are outstanding, making it the largest debt market in the world and about 50 percent more than the amount of U.S. Treasury securities.
The prices that investors pay for the bonds help determine the rates lenders charge consumers.

Back in 2006, after billion-dollar questions arose in their accounting, Fannie and Freddie were slapped with modest restrictions which shrank their ability to buy more garbage oops, I mean mortgages and mortgage-backed securities: Fannie, Freddie Retreat as Mortgage Bonds Mutate (9/6/06)
The companies accounted for 38 percent of mortgage-bond sales this year through June, down from a record 70 percent in 2003, according to data service Inside MBS & ABS. The bonds, which help determine rates homeowners pay on loans, have risen 51 percent since 2001 to $6.2 trillion, Bond Market Association data show.

They were losing market share just as a growing economy and low borrowing rates fueled a boom in housing. The amount of residential mortgage debt rose to a record $9.17 trillion last year from $5.57 trillion in 2001, according to the Federal Reserve.

So regardless of what bailout is proposed, we're still sitting on a $10 trillion powderkeg with about an inch of fuse left. I cannot repeat this often enough: with all the risks of further valuation declines now visible, who is going to step up and buy another couple trillion in housing debt? The taxpayers? No way. We're already on the hook for the $1 trillion+ losses in the existing garbage mortgage pool.

Again: who would be dumb enough to be buying mortgages or mortgage-backed securities with the sizzling fuse just an inch away from the powderkeg?

Of course not every mortgage owned by Freddie or Fannie is garbage (yet); but the question remains: how many mortgaged properties in the U.S. are truly immune from future valuation declines? How safe are even conventional 80/20 mortgages? What about all those markets which have declined 25-30% Even a conventional mortgage with 20% down in these markets is completely underwater.

But here's Fannie's own website to reassure you: Discussion of Credit Book of Business (rest assured it's all under control)

Several readers have recommended my esteemed blogger colleague Karl Denninger's clear-sighted analysis of the situation, and as a longtime reader and fan of Mr. Denninger I heartily concur: Fannie, Freddie, Banks and Government Debt.

Thank you, Carlos C. ($100), for your stunningly generous contribution to this site. I am greatly honored by your support and readership.


Is the U.S. Alcoholic, or Merely Schizophrenic?
July 15, 2008

Please go to www.oftwominds.com/blog.html to view humorous images.

Since it runs in our family, I do not use the word "alcoholic" lightly. Those of you who have to deal with alcoholics know the drill: the liquor stashed behind the fridge, as if everyone doesn't know it's there; the stumbling into the pool, the humiliating rescue, the tearful promise of change which goes nowhere, and all the rest.

I seriously suspect the entire American culture is alcoholic--not about liquor, but about debt. In all the thousands of words printed about the subprime meltdown, the meltdown of Bear Stearns and now, the crispy-crittering of Fannie Mae and Freddie Mac (can Ginnie Mae be far behind?), not once have I seen anyone in the MSM or mainstream financial press confess that "borrow our way of out of trouble" is not just financially bankrupt but morally bankrupt as well.

Like a full-blown alcoholic, the U.S. populace and government stagger from debt source to debt source, weaving drunkenly between "stashes" of new debt in the Fed, Treasury and private sector markets. Meanwhile, behind the scenes, you can bet you last depreciating dollar that the Fed and Treasury are leaning on all their pals in other central banks to buy T-bills and U.S. mortgage bonds, to maintain the alcoholic's ever-important image of low-rate, low-risk normalcy.

As our overseas friends suffer stupendous losses propping up their free-spending alcoholic "buddy," the loan-soused, totally debt-addicted U.S., the apologists for the alcoholic debt-binge continue to claim the risk of systemic failure and collapse of asset values is low.

Like the closet alcoholic who quickly comes to the defense of the full-blown addict, the mainstream media is careful to treat the debt-hurricane as if it were an act of Nature. We just need to help those poor people who have found themselves at the head of investment banks, throwing up all the bad debt they swilled in such quantity, and those poor homeowners who were struck by the terrible uncontrollable urge to leverage a few thousand bucks into a mountain of mortgage debt. Poor, poor people, we really need to bail them all out.

This is the classic "enabler," the folks who yearn to help the poor alcoholic mend his ways--if only the rest of us were more sympathetic and generous. In other words--don't demand a dose of reality for your neighbor's little drinking problem--then your own debt addiction might attract some unwelcome attention, too.

The media's role as enabler/apologist for the privatization of profit and the socialization of risk is well-stated by knowledgeable reader John H., who recently wrote:

The media doesn't control what you think about the issues, it controls what issues you think about.

That's why we talk about abortion, gun control, and missing white girls in black countries. It's irrelevant to the Powers That Be if you are for or against abortion, they just don't want you discussing economic policy or how 'free markets' aren't free at all."

And a free market is precisely what our government (the Fed and Treasury) are fighting so hard to avoid. If our nation is as debt-drunk as it appears to be, perhaps we need a national 12-step program, which would begin with this:

1. We need to appeal to a higher power: an open, free market.

And you already know what much of the off-balance sheet portfolios of investment banks and other institutions will be once they're marked-to-market: zilch, nada, zero. Like the full-blown alcohoic who fears "cold turkey," the Fed and Treasury just keep hoping that another bottle or two of Wild Turkey (as opposed to cold turkey) will ease the delirium and we can all go back to hiding our addiction behind the fridge.

Like an alcoholic's pathetic attempts to con listeners into believing he's got his "problem" under control, the Treasury announces a $2 billion loan to Fannie, as if a little nip of the good stuff will "cure" the dementia of the U.S. real estate market's debt addiction. My esteemed blogger colleague Karl Denninger pegged Fannie and Freddie's mortgage losses at a minimum of $900 billion, and I agree with him that this number is being extremely charitable.

Let's be a little more hard-nosed and say that $2 trillion (out of $10 trillion in total loans and mortgage bonds) has already vanished; and when the bubble has well and truly deflated, Freddie and Fannie's $5 trillion portfolios will have lost $2 trillion themselves, with another $2 trillion being lost by the other bagholders.

Does anyone see the absurdity of the Treasury plinking down $2 billion to "cover" a $2 trillion loss? This raises an even more horrendous possibility: the U.S. is not alcoholic: it's schizophrenic, literally unable to discern reality.

Frequent contributor Harun I. recently provided this troubling summary of our plight:

"All the banter about Fannie and Freddie is interesting but no one seems to be asking: how did the people in a democratic republic, the world's largest economy, host to the world's reserve currency, the only remaining super power, let their economy become solely dependent on the ability to process and reprocess debt on homes? How did we let our government legislate into being, through the GSE's, the largest Ponzi scheme ever?
Isn't this the crux of the matter?
The legacies of Wilson, Roosevelt, Nixon and Reagan are coming to a tragic and chaotic apex."

I would agree. We all know what happened in the past decade:

1. Thanks to intervention by the Fed and Treasury, money became insanely cheap and easy to borrow.
2. This fueled a frenzied, utterly unsustainble, insane real estate bubble.
3. Homeowners and businesses alike borrowed vast sums based on these inflated valuations, a.k.a. the home equity ATM.
4. As valuations begin returning to reality, howmeowners and businesses now have negative equity and can no longer borrow more.
5. Without trillions in borrowed money flowing into the economy, the economy sinks into recession.
6. As the recession/credit contraction takes hold, people lose their jobs and businesses lose their lines of credit, further restricting their ability to service their massive loans.
7. As defaults and impaired debt rises, lenders fall like dominoes into insolvency.
8. A feedback loop takes hold: credit contracts, more businesses close and workers lose their jobs, which further reduces the value of assets backing outstanding loans, which then further reduces credit and consumer spending, sending more borrowers and lenders into bankruptcy/insolvency.

So what caused our collective blindness to risk and the consequences of relying on an addiction to ever-rising debt? I asked Harun for further comments, and he responded thusly:

"My main point was that the mess we are in is the fault of the people. It was not just one generation but several generations of greed, ineptitude and apathy on the part of the citizenry that has allowed this to happen. (emphasis added, CHS) We have gotten exactly what we deserve because it could be no other way. At every juncture the American people had the ability to raise its voice and demand a new direction. But generation after generation, administration after administration, the lies were told and we bought into it when we knew or should have known the consequences.

What is happening is no freak happenstance of history. This con has been perpetrated so many times throughout history we should hang our heads in shame that we let it happen again. It would take a book to go back through history and bring us up to date on where we are today.
From Wilson's establishment of the Fed and the IRS under cover of darkness (Christmas holiday) to appease the bankers that got him elected, to Roosevelt's theft of gold and establishment of GSE's, to Nixon's unilateral destruction of the gold standard, to Reagan's Voodoo Economics (Greenspan era), to Clinton's NAFTA, to Bush's preemptive perpetual warfare doctrine, the collective never batted a critical eye because they were mesmerized by, if not intoxicated by, the bread and circuses.

The one thing people in a democratic republic must do well is think critically. Unfortunately the bar for inductive and deductive skill is abysmally low. Our collective grasp of history as a practical matter is virtually nonexistent.

All governments, at some point, will do what is necessary for its survival and hold on power rather than real and only purpose of serving the people. Our government is uniquely structured to prevent this but because of the vices of man we are watching it go the way of lesser governments before it.

At the close of the Constitutional Convention in Philadelphia on September 18, 1787, a Mrs. Powel anxiously awaited the results, and as Benjamin Franklin emerged from the long task now finished, asked him directly: "Well Doctor, what have we got, a republic or a monarchy?" "A republic if you can keep it," responded Franklin."

It is a terrible thing to hope that the U.S. is only alcoholic and not completely out of touch with reality. The alcoholic knows he has a problem, and fears the solution more than the destruction he is wreaking on himself and everyone around him.

Will we ever get tired of listening to the media enablers, who manage to cast everyone as a victim of forces beyond their control and responsibility? Will we ever get tired of a Congress, Fed and Treasury filled with prevaricators and liars of the most alcoholic sort, too drunk on their own lies and power to countenance anyone else speaking truth to a higher power?

If you know any alcoholics, you know how painful it is for them to face reality --that they have to stop drinking, totally, completely, and now, not tomorrow. You also know that it all too often takes a crisis to instigate this admission of their sorry state.

I don't expect any change until the crisis forces it upon us. The years of denial and enabling are about to end. The long 24-year era of ever-cheaper, ever easier money is ending, and a 20+ year cycle of ever higher interest rates is poised to begin.

How can I know this? Easy. The U.S. debt addiction is now so large that the global financial markets will soon be unable to finance its continuation. As global recession cuts profits, incomes and assets across the board, there simply won't be enough money to fund trillions more in new debt to keep the U.S. debt machine staggering on. Other nations are running huge deficits, too; everyone joined us on the debt-binge, and the only answer--cold turkey--is about to be forced on us all.

New Reader commentaries and essays:

Readers Journal commentaries week of July 14, 2008 China oil and inflation, blaming oil speculators, mortgage madness and more.

What's For Dinner at Your House has been updated! Two new recipes: Papillotes de Poisson and Craisin Bread/Cream Cheese/Walnut Sandwich

Thank you, John H. ($20), for your generous contribution via mail to this site. I am greatly honored by your support and readership

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