By Ramsey Su
Freddie and Fannie (F&F) were placed under conservatorship in September, 2008. The agencies, including FHA, are now responsible for 90% of the mortgage market. In recent quarters, the agencies have been profitable (subject to debate) and returning billions to the Treasury.
Finally, after almost five full years, Senators Corker and Warner are working on a bill to phase out the agencies and pass the secondary market back to private hands. As part of Dodd-Frank, the Consumer Finance Protection Bureau is working on a mountain of regulations, mostly for unknown purposes other than red tape.
Are the agencies ready to stand on their own again? We should first examine why they failed. It is easy to attribute the cause to the broad villain called sub-prime, but how did it affect Freddie and Fannie? During the worst of times, F&F still adhered to conforming loan guidelines, though they might have been relaxed. F&F did not buy the no down payment, no qualifying NINJA loans.
The main reason is simple, but is often overlooked. As an example, let us take a property which had a value of $300,000 before sub-prime, but was inflated to $500,000 at the peak, resulting in a $200,000 bubble. Assume F&F bought a loan secured by this property using prudent underwriting guidelines such as good credit, a 20% down payment and low debt-to-income ratios. This loan should be safe, right? NO. Even with 20% down, the property is over encumbered by a $400,000 loan or 133% LTV based on a true value of $300,000. It was the bubble, not the underwriting, that was the primary cause of failure. Shouldn't the objective of any future policies be to focus on the prevention of bubbles? Isn't price stability one of the missions of the Federal Reserve?
Ten years ago, it was a Fed Chairman and Wall Street greed that were largely responsible for creating the sub-prime bubble. Now once again, it is another Fed Chairman and a new group of Wall Street 1%ers who are trying to inflate a new bubble, all to the detriment of the little people. What improvements are in the works that would prevent Freddie and Fannie from failing again, regardless of how significant a role they may play in real estate finance in the future? Can the new and improved system endure, say, a 20% decline in real estate value? The short answer is: NO.
Qualified Mortgage, or QM, is receiving the bulk of attention in the mortgage industry right now. QM is supposedly going to offer a safe harbor for the originators and a product that is marketable in the secondary market. In reality, QM is just a new term for "agency conforming loans", something that Freddie and Fannie had for as long as they were in existence, and did not prevent them from failing.
Part of QM is a magical formula that somehow determines the ability-to-pay. If property value declines by 20%, does it really matter whether the debt-to-income ratio was 40% or 45% at origination? I expect QM to add a mountain of red tape. The compliance cost is going to be passed on to consumers. Underwriting standards will be tightened as pegs of all sizes are forced into the round QM hole. Small lenders simply cannot compete due to the compliance burden. These issues should all surface before the end of the year as the effective dates for the new regulations approach. I do not see how QM will make financing more affordable to borrowers. Ironically, the destructive force behind this calls itself the Consumer Finance PROTECTION Bureau.
In summary, nothing has changed. Instead of trying to prevent another bubble, Bernanke is busy sowing the seeds for one. Instead of paving the way for the private sector to re-enter the mortgage market, the CFPB is putting a strangle hold on the existing monopoly. It remains to be seen how long the real estate market can be supported by endless Fed buying of mortgages and Wall Street funds buying up houses.
Fannie Mae common stock, monthly since 1987. It is interesting that its all time high occurred well before the now infamous sub-prime credit bubble. Recently speculators bid the essentially worthless stock up to $5. It still trades at $1.50 or so, in spite of actually being worth zilch – a sign (one of many) that we are indeed in an echo bubble (chart via BigCharts, notes by PT) – click to enlarge.