Monday 17 January 2011

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.

"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."

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.

"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:

"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:
"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:

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.

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