Are Fannie Mae and Freddie Mac on the path to a crash à la Thelma and Louise?

The tragic ending of Thelma and Louise could be similar to what awaits Fannie Mae and Freddie Mac.

http://www.thestreet.com/story/10965824/1/fannie-freddie-tough-sell-bailout-now-youre-talking.html

"Despite the fact that America's housing-finance system has cost taxpayers more money than any bank bailout and many consider its flawed structure to be the single biggest contributor to the financial crisis, it seems most people don't know how it works or care how the housing-finance problem is resolved."

"The federal government now stands behind the vast majority of mortgages in the United States, and upwards of 90% of those originated since the financial crisis took hold. The Federal Reserve still holds over $1 trillion worth of residential mortgage-backed securities (RMBS) on its balance sheet, having purchased them to increase liquidity and spur additional lending."

"Yet the very system that has kept the U.S. housing market on life support has also drained federal coffers. Fannie and Freddie have so far cost the U.S Treasury Department $150 billion, a number that may rise to $363 billion, according to the FHFA."


http://www.bloomberg.com/news/2011-01-14/how-to-fix-mortgage-mess-in-three-steps-commentary-by-laurence-kotlikoff.html

How to Fix Mortgage Mess in Three Steps: Laurence Kotlikoff:

"Fannie Mae and Freddie Mac. What cute-sounding names. They suggest adorable siblings, not twin financial disasters that may cost $1 trillion when we get the final bill.

According to Edward Pinto, Fannie Mae’s former chief credit officer, in 2008 the two government-supported mortgage finance companies, along with the Federal Housing Administration and other U.S. agencies, were holding or guaranteeing some 19 million subprime home loans, or about 70 percent of all such debt.

Much of these toxic assets, as well as many of Fannie and Freddie’s prime mortgages, aren’t performing or will likely default. Nationwide, 8 million mortgages -- or one in 10 -- are under water, with the property’s value at least 25 percent below what’s owed.

The Federal Housing Financing Agency puts Fannie and Freddie’s losses at about $300 billion. But industry experts, like Janet Tavakoli, suggest the real number is closer to $700 billion. And if home prices fall another 20 percent to return to their long-term trend, the tab might climb to $1 trillion."

I agree with Laurence's statement in relation to the sick Fannie Mae and Freddie Mac. It is time to end this very expensive joke, once and for all.

The US government has no place in the mortgage business. Look at how the mortgage business has been managed in Denmark for a clue on how a sound mortgage system work.

The first Danish Mortgage Act was passed in 1850. Issued mortgage loans have a maximum loan to value (LTV) of 80% for residential properties.

http://www.globalpropertyguide.com/Europe/Denmark/Price-History

"To fund the loan, banks issue mortgage bonds. The strict legal framework of the “balance principle” requires mortgage bonds to match the value and terms of the corresponding mortgage loan the bank is funding. The framework has provisions limiting the currency, interest, and liquidity risks of bonds. The strict regulations of the mortgage market limit the risks shared between bond-holders and mortgage institutions, create transparency, and offer investors security. This helps the continued growth of the mortgage market despite tough macroeconomic conditions."

"A due on sale clause in a loan contract means that borrowers have to pay their loans in the event the property has to be sold. This clause isn’t attached in Danish mortgage loan contracts, as borrowers can transfer the remaining loan to the new owner, or can buy back the bonds. This is especially beneficial to borrowers who experience situations where house sales are involved.

This payment system discourages borrowers from defaulting their loans, as they remain liable for the payment of their loan if they default."

For more on the subject relating to the Danish system:

http://www.economist.com/node/12855447

http://www.bloomberg.com/news/2010-12-12/danish-top-rated-mortgage-debt-draws-investors-fleeing-crisis.html

Fact:
"Denmark’s mortgage bonds haven’t suffered a default since they were introduced after the great Copenhagen fire of 1795."

Fannie and Freddie were set up in 1968 and 1970. The question that need to be adressed by January 31st is the following: "What is the appropriate role of the government in the housing market?" The Dodd-Frank reform bill required the Treasury Department to issue a comprehensive proposal to Congress.

Tim Rood, a former Fannie Mae official, compares the idea of relinquishing federal support to going cold turkey off of a powerful drug:

http://www.thestreet.com/story/10965824/5/fannie-freddie-tough-sell-bailout-now-youre-talking.html
"You see some folks trying to draw the analogy between markets like Canada which have never had any government support or backing for the mortgage market and which seems to have achieved - on a much smaller scale - the nirvana of housing in homeownership rates, perfect matching of interest rate risks and all that," says Rood, who's now a managing director at D.C. consulting firm The Collingwood Group. "But it's like trying to compare an Amish baker to Keith Richards. There's no policy equivalent to methadone. We've been on it forever - you can't just say 'Look how easy it is to live without government involvement or backing of the mortgage market.' It's just not an easy thing to undo."

The answer is to privatize the system, following a Danish approach to mortgage financing:

"Affordable housing doesn't have to mean that everyone has to own a home. It's still a great dream and everyone should still aspire, if they choose to, to own a home. But when it comes to the government fostering 'affordable housing,' that might be rental housing."
says Edward Kramer, a former banker and regulator who is now a consultant at Wolters Kluwer.

Below is what George Soros has to say about the Danish system and reforming the US mortgage market in 2008. The problems of the US mortgage market are yet to be addressed.

Soros: Denmark Offers a Model Mortgage Market
There is a safe way to securitize home loans.

By George Soros

"The American system of mortgage financing is broken and needs a total overhaul. Until there is a raealistic prospect of stabilizing housing prices, the value of mortgage-related securities will erode and Treasury Secretary Henry Paulson's efforts will come to naught. There are four fundamental problems with our current system of mortgage financing.

First, the business model of Government Sponsored Entities (GSEs) in which profits accrue to the private sector but risks are underwritten by the public has proven unworkable. It would be a grave mistake to preserve the GSEs in anything resembling their current form.

Second, the American style of mortgage securitization is rife with conflicts where entities that originate, securitize and service mortgages are generally not the same as those that invest in mortgage securities. As a result, the incentives to originate sound mortgages and to service them well are inadequate. No wonder that the quality of mortgages degenerated so rapidly.

Third, mortgage-backed securitizations, which were meant to reduce risk by creating geographically diversified pools of mortgages, actually increased risk by creating complex capital structures that impede the modification of mortgages in the case of default.

Finally, and most fundamentally, the American mortgages market is asymmetric. When interest rates fall and house prices rise, mortgages can be refinanced at par value, generating the mortgage equity withdrawals that fueled the housing bubble. However, when interest rates rise and house prices fall, mortgages can only be refinanced at par value even though the market price of the securitized mortgage has fallen.

To reconstruct our mortgage system on a sounder basis, we ought to look to the Danish model, which has withstood many tests since it was brought into existence after the great fire of Copenhagen in 1795. It remains the best performing in Europe during the current crisis. First, it is an open system in which all mortgage originators can participate on equal terms as long as they meet the rigorous regulatory requirements.
There are no GSEs enjoying a quasimonopolistic position.

Second, mortgage originators are required to retain credit risk and to perform the servicing functions, thereby properly aligning the incentives. Third, the mortgage is funded by the issuance of standardized bonds, creating a large and liquid market. Indeed, the spread on Danish mortgage bonds is similar to the option-adjusted spread on bonds issued by the GSEs, although they carry no implicit government guarantees.

Finally, the asymmetric nature of American mortgages is replaced by what the Danes call the Principle of Balance. Every mortgage is instantly converted into a security of the same amount and the two remain interchangeable at all times. Homeowners can retire mortgages not only by paying them off, but also by buying an equivalent face amount of bonds at market price. Because the value of homes and the associated mortgage bonds tend to move in the same direction, homeowners should not end up with negative equity in their homes.

To state it more clearly, as home prices decline, the amount that a homeowner must spend to retire his mortgage decreases because he can buy the bonds at lower prices. The U.S. can emulate the Danish system with surprisingly few modifications from our current practices. What is required is transparent, standardized securities which create large and fungible pools. Today in the U.S., over half of all mortgages are securitized by Ginnie Mae, which issues standardized securities. All that is missing is allowing the borrowers to redeem their mortgages at the lower of par or market.

Because of the current havoc in the mortgage market, there is no confidence in the origination and securitization process. As a result, a government guarantee is indispensable at this time, and may be needed for the next few years. As the private sector regains its strength, the government guarantees could, and should, be gradually phased out.

How to get there from here? It will involve modifying the existing stock of mortgages, so that the principal does not exceed the current market value of the houses, and refinancing them with Danish-style loans. The modification will have to be done by servicing companies that need to be properly incentivized. Modifying mortgages that have been sliced and diced into securitizations may require legislative authorization. The virtual monopoly of the GSEs would be terminated and they would be liquidated over time.

A plan to reorganize the mortgage industry along these lines would inspire the confidence that would allow a successful recapitalization of the banking system with the help of the $700 billion package approved last week."

Mr. Soros is chairman of Soros Fund Management and the author of The New Paradigm for Financial Markets (Public Affairs, 2008).

For an additional essay from George Soros on the subject please see below:

http://www.georgesoros.com/articles-essays/entry/reforming_a_broken_mortgage_system1/

Both GSEs Fannie and Freddie have been held in federal conservatorship since September 2008 and have received roughly 134 billion USD in taxpayer money to stay afloat so far...

US Home Ownership from 1980 until 2010:

The End of the American Dream:

The current S&P Case Schiller index 20-City Home Price Index:

Ben Bernanke is well aware of the issue with both GSEs. There cannot be a sutained recovery in the housing market before the Obama administration releases its recommendations for the future of Fannie Mae and Freddie Mac.
The dominance of the GSEs in mortgage finance needs to be reduced.

It is up to the US Congress to work on a solution. Let's hope the the Treasury Department issue a comprehensive and intelligent proposal to Congress before the 31st of January.

Canada, a great example of successful structural reforms and efficient banking regulation

When United States economy tanked, everyone was expecting the Canadian economy to follow the same fate given how connected both economies are.

It was not the case.

Jim Flaherty, Canadian's finance minister attributed the resilience of the Canadian economy to its "boring" financial system, rock solid and heavily regulated.
Leverage for banks was capped to around 20 times.

Maybe Canadians are strict followers of Austrian economics and have learnt more about the importance of a sound financial system?

Truth is Canadians are much more conservative than their American neighbors when it comes to lending. But the main difference as well compared to the US is that the government did not interfere in the way the housing market was financed: No Fannie Mae or Freddie Mac (we know the story on how well these two ex "private" companies are doing at the moment, losing billions after billions of dollars but that's another story to come in my blog).

Also Canadian banks have truly been much better than their US counterpats in managing risk and cutting risk when needed.

This is a link to a very good article from the Wall Street Journal regarding the Canadian Banks.

http://online.wsj.com/article/SB124165325829393691.html

"Start with the housing sector. Canadian banks are not compelled by laws such as our Community Reinvestment Act to lend to less creditworthy borrowers. Nor does Canada have agencies like Fannie Mae and Freddie Mac promoting "affordable housing" through guarantees or purchases of high-risk and securitized loans. With fewer incentives to sell off their mortgage loans, Canadian banks held a larger share of them on their balance sheets. Bank-held mortgages tend to perform more soundly than securitized ones.

In the U.S., Federal Housing Administration programs allowed mortgages with only a 3% down payment, while the Federal Home Loan Bank provided multiple subsidies to finance borrowing. In Canada, if a down payment is less than 20% of the value of a home, the mortgage holder must purchase mortgage insurance. Mortgage interest is not tax deductible.

The differences do not end there. A homeowner in the U.S. can simply walk away from his loan if the balance on his mortgage exceeds the value of his house. The lender has no recourse except to take the house in satisfaction of the debt. Canadian mortgage holders are held strictly responsible for their home loans and banks can launch claims against their other assets.

And yet Canada's homeownership rate equals that in the U.S. (Both fluctuate, in the mid to high 60% range.)"

Yes that's the way it should be done! Banks like individuals have skin in the game, simple as that, and they are accountable for it.

As a fact reminder, in the US, one quarter of US household are in negative equity territory.

Update from Reuters on the trend in the US Housing:

http://www.reuters.com/article/idUSN0720997220100510

"The percentage of American single-family homes with mortgages in negative equity rose to 23.3 percent in the first quarter from 21.4 percent in the fourth quarter, according to the Zillow Real Estate Market Reports."

It doesn't bode well for the American banks balance sheet...

Although during the recession the Bank of Canada reduced its benchmark interest rate to 0.25% and injected liquidity, given the latest price action in the housing market, the authorities are already moving to prevent the bubble to grow and a rate hike is expected in June.

Furthermore, Canada has been hugely successful in reducing its debt burden since 1995.
Canada's debt-to-GDP ratio is now around 53%.
Canada's debt burden has dropped by more than 50 percentage points from its peak in 1995. At that time it was the second-highest in the G8: from 68% in 1995 to about 29% in 2008.





Canada's debt chart 1979 to 2008:



How was this achieved?

By a radical 20% cut in spending imposed by the federal government in the 1990s which led to a cut of 47,000 civil servants jobs.

Canada was at the time close to the brink.

Here are the details of the cuts they proceeded with and what the government of Prime Minister Jean Chretien targeted, as per the following link from an article of The Times from Alexander Frean, Ottawa :

http://business.timesonline.co.uk/tol/business/economics/article7127360.ece

"There were big cuts in fisheries (22 per cent), defence (more than 15 per cent), transport (50 per cent) and international aid (20 per cent) departments but benefits for the elderly increased by 15 per cent over six years and spending on aboriginal peoples and children rose by around 10 per cent."

"They believe that other countries have something to learn from their country’s experience. One said: “Some nations think you cannot just eliminate the public debt. But we have shown that it is possible.” "

It was brutal but it did put the country back in the right direction.

This is what Europe needs to adress in relation to its public finances issues. They need to follow Canada and cut agressively. Spain and Portugal as well as Greece should apply the Canadian recipe. The UK as well would be wise to follow a similar path and the task is truly daunting for the new coalition government.
Ireland, Spain and Portugal are on the right track, Greece is in a difficult position due to a very lax fiscal system and general widespread corruption.
France has hardly started reducing public spending and it is a concern given the last balanced budget was in 1980 and budget surplus was 1976.

The projections for the Canadian Economy going forward are very good as per below's link:

http://www.shindico.com/news/articles/2010/030510_2.htm

"In 1994, when Canada's deficit peaked before federal spending cuts, including to provincial transfers, started the road to surplus, the only industrialized nation in the world with a worse fiscal picture than Canada was Italy. Canada's debt-to-GDP ratio was over 70 per cent.

In 2009-10, when the deficit hit a record $53.8 billion, Canada had the best record of any nation in the G7 on most economic indicators, including debt-to-GDP ratio.

In 2008-09, the debt-to-GDP ratio was 29 per cent, the lowest in 29 years. It will peak at 35.4 per cent in 2010-11 and then begin dropping again slowly hitting 31.9 per cent in 2014-15."

The sad reality behind last Friday Non Farm Payroll Number

I was reading through today an excellent article from John Mauldin, from Thoughts From the Frontline. You can subscribe for free on the following link:

http://www.frontlinethoughts.com/

The article relates to John's prediction for 2010 and it is a good read:

http://www.investorsinsight.com/blogs/thoughts_from_the_frontline/archive/2010/01/08/2010-forecast-the-year-of-uncertainty.

In his article John writes the following:
"we will find we have not fixed the causes of the last one. We still have banks too big to fail, we have not put the credit default swaps on an exchange, we have not reinstated Glass-Steagall, Barney Frank's bill (which was not the one that came out of committee) now makes it exceedingly more difficult to short stocks, we keep in power the same people who missed the problems the last time, and the list of bad policies bought (typo intended) to you by bank lobbyists grows ever longer. If the current bill looks like it was written by the bank lobby, that's because it was. But it means we will have to face the same problems all over again. But that is another story for another day."

I agree with his analysis. We have not resolved any issues, we are in fact compounding them. Glass-Steagall act should be re-instated and CDS like other vanilla derivatives should be cleared and traded on an exchange.

Adding insult to injury, the debt cap ceiling on the two Government agencies, Fannie and Freddie have been removed and it has been decided without consulting the US Congress. The US taxpayers will have to pick up an even larger tab by the end of the day.

Basically you can expect the equity rally to last a little bit longer given current level of inventories and activity picking up.