Anatomy of a Housing Market Crisis
Housing-Market / US Housing Apr 16, 2010 - 06:57 AM GMTBy: Sol_Palha
"A fool despises good counsel, but a wise man takes it to heart." ~ Confucius, BC 551-479, Chinese Ethical Teacher, Philosopher
Freddie and Fannie certainly had a large role to play in the housing crisis and many may claim that they were the main contributors of the housing crisis which eventually resulted in a market meltdown. Before we proceed let's get some background info on these two chaps.
Some background info on these two companies
They were created by the Federal National Mortgage Association in the 1930's to help speed up the home ownership process by buying mortgagees from banks. Banks would normally sell a mortgage and then put it on their books, this means that each time they did so, a certain amount of capital was tied up and this limited the number of mortgages they could issue. Now they could simply issue a mortgage and sell it to Freddie or Fannie and as a result banks could issue almost as many mortgages as they could sell.
Although they are private companies, they are government sponsored enterprises established by federal law. As GSE's they received special privileges, the main one being that if they were threatened with failure, the federal government would come to their rescue. This gave them the best of both worlds; profits are privatised but losses are socialized. This guarantee basically encourages immoral and unconscionable behaviour because there is no downside; the downside becomes the government's problem, which in turn becomes the tax payer's problem.
Factors that support the claim that Fannie and Freddie had a role to play in the housing crisis
Freddie and Fannie were prevented from buying mortgages that did not meet down payment and credit requirements by law. As the structure of the mortgage market changes, so did their business model. From 2005 until the onset of the crisis most of the mortgages they purchased did not fall within the convention fixed interest rate with a 20% down payment category instead most of the loans fell within the following categories.
Fannie mae's loans
- 62% negative amortization
- 84% interest only
- 58% subprime
- 62% required less than 10% down payment.
Freddie Mac's loans
- 72% negative amortization
- 97% interest only
- 67% subprime
- 68% required less than 10% down payment. (source about.com)
This incestuous desire to issue exotic loans and to open the market to subprime borrowers made most of their loan acquisitions extremely toxic and in doing so helped fuel the speculative real estate bubble. This is a very huge topic, and we have only just touched the tip of the iceberg. The information laid out should provide enough food for thought such that if peeks your interest further research on this topic can be conducted at your own leisure.
Now let's examine if these GSE's really helped the Public
Freddie Mac lost 50 billion last year but has now come begging to the government for another 31.8 billion and this comes on top of the 13.8 billion Freddie asked for last year. The government has pledged a massive 200 billion line of credit to support this disaster and based on all the talk so far, they would probably offer even more if Freddie ever needed it.
If we weigh the cost to the taxpayer and the so called savings these two mortgage giants provided, one finds that they failed miserably and have really provided no benefit at all. How can this be? The so called benefits from offering lower mortgage rates has been offsetted by the cost of all the money taxpayers have poured into these two companies. . They had access to money at a lower rate than private companies and could in turn pass these savings to the consumer; lenders provided them with lower rates because their survival was guaranteed by the Federal government. Based on the amount of money they have already asked for and the future amounts they will need to continue functioning, it is estimated that by the end of the year they will become net losers. In other words, they would have moved from providing some value to providing none at all.
Lawrence J. White an economist at the New York University (Stern School of business) states that the GSE's could borrow money 35-40 basis points lower than the private sector. Thus if the standard rate was 6%, they paid only 5.60-5.65%.
At the end of 2008 these two companies had 31 million mortgages on their books, which were worth in excess of 5 trillion (actual figures were roughly in the 5.4-5.6 trillion ranges). Thus borrowers would have saved roughly 10 billion in 2008. According to Daniel Gross over the years, they supposedly produced savings of $100 billion.
Contrast the potential saving of $100 million against the $300 billion plus in financial support the government has pledged and one can immediately see that they have provided no real benefit at all. If they were regular business, they would have gone bankrupt long time ago, but because they are GSE's the government sees fit to pump billions of dollars into losing cause. It is true they have not used up all the money the government has pledged to them, but at the rate, they are burning this money, it's only a matter of time before they go through those funds before they start begging for more.
While these two GSE's did play a role the financial crisis that hit this nation; after all they did provide banks with an incentive by virtually buying any junk that the banks were willing to throw at them.
Wall Street firms (Goldman, JP Morgan, Merrill lynch, etc) and rating agencies also had a big role and may have contributed even more to this housing crisis then Freddie and Fannie. These firms combined subprime mortgages with other mortgages that carried slightly higher ratings and sold them of as Collateralized Default Obligations (CDO).
CDO's were nothing but a bunch of BB rated mortgages that were bundled up to create a security that carried an AAA rating. The rating agencies (Moody's, S&P, and Fitch) all played a role in this process by putting their stamp of approval on these toxic products. By putting their stamp of approval on these products these agencies made these toxic products appear to be of investment grade.
Investors in General rely heavily on these agencies to determine risk. Thus when investors realized they could achieve superior returns with AAA, AA or A rated mortgages, like idiots they jumped in. We use the word idiots because they could have and should have spent time understanding what was behind this new product. If something is too good to be true, take time to dig for you will find out that it is usually fraught with risk. Large institutions started to jump in and buy these CDO's left right and centre creating a huge demand for these products; demand soon overwhelmed supply. As the demand rose, it drove the borrowing costs lower and made qualifying for a loan easier and this in turn drove housing prices higher. Mortgage lenders were making huge sums of money and each player wanted to increase its share of the market. Lack of oversight, poor underwritings and outright fraud were all perpetuated as a result of this greed. It will take years for the housing and mortgage sectors to recover as a result of this greed. Investors continued to pour into CDO's and as the supply grew so did the demand; the only way to bring this vicious cycle to an end was for the real estate and mortgages markets to crash.
Investors were given several warnings that all was not well; towards the end of 2006 home prices peaked. In 2007 home prices stopped rising and finally started to decline. Worse yet default rates start to increase and yet like drug addicts investors kept buying these securities and Wall Street like a drug dealer continued to issue these securitized instruments.
If the blame should be laid on anyone it, the biggest culprits are the banks and rating agencies.
However, we have one final culprit and that culprit is the average Joe, who jumped on the band wagon because he wanted to make a quick buck without taking a risk. Well at least that's what he thought, for real estate seemed like a sure bet.
Every con has a conman and sucker; for the game to proceed both have to be willing participants. Thus the conmen provided the suckers with what they were looking for. The suckers did not complain as long as they were getting paid. Only when the whole house cards crumbled did they wake up and start to squeal like fat pigs being roasted alive.
The morale of this story is that one should never jump into anything that has attracted mass attention. The masses are always late to the party and usually end up leaving with a massive hangover.
Conclusion
Before one lays blame on another one must look in the mirror and be sure that one did not have a hand to play in the crisis. It takes one to cry, two to tango and 3 to have a party. Individuals wanted to party without having to do any work, and they thought they could do this without taking on any risk. If something appears too good to be true, it generally is.
The government is hell bent on pouring good money into these two completely useless companies, Freddie Mac and Fannie Mae. Ironically the Government finds it very easy to turn down individuals that really need a helping hand; for example, not approving a $250 check for senior citizens. To make matters worse they create money out of thin air to pay for these projects, thereby further devaluing our currency and indirectly imposing a silent tax on the population. This silent tax is otherwise known as inflation.
Meanwhile, taxpayers have pumped more than $125 billion into the failed firms -- and on the hook for many more after the administration promised an unlimited source of funds just before Christmas to backstop their growing losses. "We will do everything necessary to ensure these institutions have the capital they need to meet their commitments," Geithner said in response to tough questions from Rep. Scott Garrett, a New Jersey Republican. Underscoring the need for change, Geithner acknowledged that taxpayers are likely to face "very substantial" losses on the government's takeover of Fannie and Freddie. Full Story
The best way to protect oneself against inflation is to get into hard assets; hard assets are anything that cannot be mass produced and are in finite supply. Examples are oil, timber, copper, iron, precious metals, etc. The easiest way to protect oneself against the harmful effects of inflation is by purchasing precious metals (Gold and Silver bullion). If one wants to play the ETF game one can open up positions in SLV and GLD.
"Once the game is over, the king and the pawn go back in the same box." ~ Italian Proverb
Disclosure: we have positions in Gold, Silver and Palladium bullion
by Sol Palha
Sol Palha is a market analyst and educator who uses Mass Psychology, Technical Analysis and Esoteric Cycles to keep you on the right side of the market. He and his partners are on the web at www.tacticalinvestor.com.
© 2010 Copyright Sol Palha - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.
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