What's Driving Fannie and Freddie

Fannie and Freddie are down again; the shares are so cheap at this point that even a relatively modest fluctuation of less than 80 cents in the Freddie (FRE) share price will hit the headlines as a 20% move. The fact is that they're not plummeting this morning, as the headlines would have it: they've plummeted already, and now they're fluctuating at levels modestly around zero since no one really has much of an idea what the option value of the shares might be.

Why are the shares at zero (plus a little something for option value)? Because Hank Paulson is a ball-buster, as he proved with Bear Stearns, and if he's going to have to inject capital, the markets are convinced that he's going to require the existing shareholders to be wiped out. He doesn't have to do that, of course, but he will: after all, if government capital is the only thing keeping the GSEs functioning, then it's hardly fair that the primary beneficiaries of that capital infusion should be the shareholders rather than the taxpayer.

The more interesting question is why the GSEs are still paying such a high premium to fund themselves. Freddie paid 113bp over Treasuries to issue five-year notes yesterday, even though Paulson has made it crystal clear that he stands behind that debt.

Here's my theory: Any company's bond spreads naturally gap out whenever its stock approaches zero. In this case, there's a countervailing force -- the moral hazard play, whereby you don't trust Freddie the standalone entity to pay you back, but you're pretty sure that someone (the US taxpayer) will cough up if push comes to shove.

The problem is that although certain hedge funds might be perfectly happy making that moral hazard play, most of the people who historically buy GSE debt like to think that they're buying something which is more or less risk-free in its own right. Yes, they've historically been reassured that there's a government backstop, but there's a difference between being reassured by the backstop and relying on it.

So let's say that a large number of historical buyers of GSE debt (like, say, the Chinese government) decided that if they wanted to take US government risk, they'd much rather just buy US government debt, rather than relying on not-entirely-explicit pronouncements from the Treasury secretary. Right now, there's not a huge amount of liquidity in global debt markets, and the absence of those buyers can drive rates up quite a lot. It might look irrational -- it might be irrational -- but it's not hard to see how a company in trouble will have difficulty raising billions of dollars these days, no matter how much government support it has.

Comments

[jackeast:]

Solving the Housing “crisis”.

A. In order to solve the crisis a quick look at the underlying issues of the crisis are important.

1. The rate of increase in housing prices was artificially accelerated by the availability of high risk loans. The loans were high risk in that people could not afford to pay the principle and interest while maintaining a quality of lifestyle commensurate with the property they were purchasing. Risk increased as the available cash flow of home owners was not enough to create capital reserves to offset future risk. The loan types were generally variable rate mortgages that even financially savvy borrowers could not adequately assess risk.

2. Supply over the last few years was increased in response to the artificially accelerated rate of home price increases. While the rate of home prices increases was high and capital was easy to come by a large portion of the pool of potential buyers entered the pool of buyers. Those “potential buyers” who transitioned into the “buyers” pool were forced to purchase homes that would normally have stayed out off the market or been eliminated from the market due to development, nature, or disaster for inflated prices. So while these homes in “normal” markets would not have been marketable or tradable in a period of “abnormal” markets they became commodities that were prized by two classes of buyers. The first were marginal buyers who generally would have stayed in the “potential pool” of buyers and “investors” who desired to purchase and “flip” with marginal and minimal “upgrades” to the properties. Further, the accelerating pool of “new” homes added to available supply making the calculus for home buyers more complicated. i.e. Pay slightly more for a new home or slightly less for an existing home. More and more buyers were choosing the former over the latter. This increased risk and resulted in builders having competitive advantages over existing homes. The competitive advantage resulted in more new home construction. At the same time the dynamic of the marginal buyer and investor and now exacerbated by those seeking to “trade up” increased the supply of existing homes. A general but not unreasonable increase in basic commodities created situations in which marginal buyers (i.e. those that recently transitioned into the buyer pool because of the previous dynamics) became unable to service their mortgage debt. As these properties entered the market as sell before foreclosure the supply increased even more. This portion of the supply was marked at very close to cost causing a DECELERATION in the median price of homes in at risk markets.

3. The availability of rental properties became reduced as they became converted to finance and buy properties. This began to drive up the cost of renting. As the cost of renting increased, the calculus of buy versus rent increased the number of those transitioning from “potential buyers” to “buyers”.

4. Eventually the pool of available buyers became maximized to the market conditions and there were no new entries into the demand market. At this point demand began to decelerate. All those who could trade up had done so. All those who could buy a house to live in had done so. The available leverage and capital of “flippers” was maximized.

5. As demand decelerated, the time it took to sell properties increased. Loan brokers and financial institutions as well as construction firms and sellers attempted to reduce this time to sell through special “fast track” loan programs and incentives. Eventually the only way to reduce the time to sell was to reduce prices. This reversed home price increases and began the process of accelerating decreases in home values in the system. As comparable homes were sold for less and less month over month investors began to question the actual value of the collateral behind financial instruments.

6. As interest rates reset on homes and the true cost of ownership began to affect marginal buyers a new class of supply entered the market; the foreclosure. While this class of supply had generally been available to the market they had generally been in demand by the investor and developer. The market could not absorb this extra supply and as housing prices had entered the phase of declining values already, these new entries resulted in drastic rates of declines in “key” markets.

7. Declining values of collateral and leveraging strategies by financial institutions resulted in decelerating returns on loan portfolios and even losses. These losses were identified rightly as due to the decrease in value of properties, which erased the value of collateral, the increasing costs of foreclosure, the decreasing revenue for loan generation, the decreasing interest payments from the pool of home owners, and the increasing cost of refinancing debt as the capital markets began to doubt the value of financial instruments in a new wave of analysis.

8. Risk insurance and cost of capital increased as the traditional backstop of losses, the insurers exited the market place. The scope and depth of losses in the insurance sector locked up the entire market place and made the cost of refinancing and capitalization such that losses mounted. The result was two-fold: 1) increased capitalization that reduced the amount of liquidity in the market and 2) increased cost of gaining capital at the retail level. The result was pushing a large portion of those in the “buyer pool” back to the “pool of potential buyers” and drying up demand.

9. With even less demand and an over abundance of supply prices fell at an even accelerated rate.

10. Psychology of the market place now dictated that the entire pool of buyers analyze the risk of entering a falling market. At this point the cost of moving first may be the further erosion of the value of one’s home and missed opportunity to purchase higher quality at equal or less cost. The buyer market then became limited to those who “HAD” to purchase as a result of market conditions.

11. Interest rates for those financing and the information requirements (i.e. total cost) increased dramatically further eroding demand for properties.

12. The end result is a stagnant market of buyers and sellers and financial institutions with an increasing portfolio of under or non performing loans making all the financial instruments that are supported by the market of an uncertain value. This has further eroded both availability of capital to fund purchases and the ability of financial institutions to finance its debt increasing threats of insolvency. As certainty and confidence is eroded the problems become worse and a feed-back-loop results.


Now that the underlying process leading to the current “crisis” is understood some solutions can be formulated.

B. Reduce supply.

Stabilizing the values of homes is essential to create certainty as to the value of securities and collateral. It will also change the calculus of buyers who are staying out the market because of hopes that they will be able to buy more for less. Reducing supply would also decrease the time that homes are on the market creating conditions that will decelerate the rate of foreclosure. This too will create conditions of certainty and solve the under-and non-performing loan problem.

There are several possibilities for reducing supply and they include:

1. Offering grants to localities to purchase properties to turn into green-space or to place in land/property trusts for later development.
2. Offer terms that would allow the refinance of properties to reduce the foreclosure of homes. Terms such as 40 year or 50 year mortgages at increased interest rates with provisions that state that the property cannot be sold or transferred for 2, 3, or 5 years. The lender can force refinance instead of foreclosure.
3. Market clearing houses can be established where people in foreclosure can have the option of “trading down”. Financial institutions can offer homeowners the ability to refinance into a lower cost home removing it from supply, keeping a marginal home-owner in the home owner pool and maintaining the very highest valued properties in the supply system. These properties would be the most likely ones to benefit from the “trust” green-space programs mentioned above. They are also the most likely to be successfully managed in foreclosure.
4. Financial institutions should enter into property management agreements utilizing programs such as the Defense National Relocation Program that offers property management services for relocating home owners. Properties are rented. By transiting homes from the sale/finance pool to the rental pool two things are accomplished. 1) Those entering the rental pool may be able to remain in their homes as renters paying less cost such as insurance and local property taxes. These costs are transferred to the lender. However, with rental rates as they are, it is possible that even with decreased rates due to increased supply that the lender will be able to cover the costs with rents. 2) Financial institutions are able to maintain the book value of their collateral (real property does not suffer from mark-to-market issues) and still maintain a revenue stream. A provision for refinance and repurchase may be included in the lease/rental agreement offering the potential for future revenue and a ready market of borrowers when future conditions improve.
5. Increase the costs associated with selling a home. For those home owners who cannot show cause for sale( i.e. not in threat of foreclosure as certified by their financial institutions) will pay a tax penalty on the sale of their home regardless of whether they make a profit or not. Something like a .005 tax on the total proceeds of the sale payable into a “Green Space and Trust” account for giving block grants to localities for purchase and clearing homes. This could be in effect for 2 or three years while the market cleans itself up.
6. Decrease the costs of home purchase if one is not also selling a home. Offer a tax rebate equal to the total costs of closing (minus down payments and points) payable in 5 years if the home is owned as a primary or secondary residence for 3, 4, or 5 years. The payment can be prorated based on the length of ownership. The payment can also be divided into two segments, one payable to the lender as a principle payment and one payable to the owner. The rebate could be recouped by the federal government at a rate equal to 10% or 20% a year from the mortgage tax deduction in the years following the payout.
7. Increase the regulatory requirements to offer adjustable rate mortgages. For instance, increased equity in the home through higher down-payments, or increased monthly payments into an “Interest rate adjustment account” to offset the affects of interest rate increases.
8. Allow new home construction companies to purchase their own inventory at reduced prices to claim the loss on their taxes and to not pay sales tax on the properties if held for 2 or 3 years.
9. Allow construction companies and owners of residentially zoned lots to “charge off” or deduct an “opportunity cost” equal to some percentage of the assessed value of the land if the land is undeveloped for 2 years after the deduction. If developed then the individual or company has to pay back the savings resulted from the deduction + 20%.

C. Close the gap between cost of capital for the financial institution and the return on loans given.

1. Embrace the fractured pricing of the housing market by creating new loan segments. Break the housing price market into segments of 100K each in which each higher segment has higher real interest requirements. For instance on a 30 year fixed, the “base” bracket may be between 0 and 100K and equate to the 5 and 6 % range. From 100 – 200K the interest may be between 6 and 6.5% range. Between 200K and 300K the rate may be between 6.5 and 7%. Over 300K the rate may come back to between 6 and 6.5%.
2. Restructure equity requirements based on tiers or categories of loans. For under 100K the equity requirement may be 0%. From 100K to 200K the equity requirement may be between 5% and 10%. Between 200K and 300K the requirement may be between 10% and 15%. From 300K to 400K the requirement may be 20%. Over 400K the requirement may be 10-15% again.
3. Extend the period of repayment to reduce monthly payments on existing loans without refinancing, sort of an automatic renegotiating of terms. By extending the period of the loans and reducing principle payments it decreases the likelihood of default but increases the total expected interest payments to the loan. A 200K loan at 7% moved from 30 to 40 years would reduce the interest and principle payment from $1330 to $1242 a month.
4. Use savings from Dividend Cuts and equity offerings to reduce debt through retirement and repurchase. Repurchase of low quality debt at prices lower than issued with higher quality debt issues and cash would reduce borrowing costs for institutions.
5. Reduce leverage from the current 3:1 (for FRE) to 2.5:1 or less through the process of retiring debt and building cash reserves.
6. Increase cash flow to reduce borrowing requirements. Renegotiate mortgage terms to allow interest reductions, special incentives, and benefits for increasing principal payments.
7. Increase and capital cash flow to reduce borrowing requirements. Encourage voluntary increases to ESCROW and manage ESCROW accounts like Debit Card accounts. Pay interest on excess escrow balances and charge fees for the use of the account. Fence ESCROW DEBIT Accounts as capital reserves not to count in leverage decisions so that a “cushion” or “emergency reserve” of capital exists.

D. Increase Demand

1. Allowing the cashing out of 401K and IRAs for the purchase of homes if the family is “trading down”, the refinance of a home if lived in for more than 1 year and will live in for the next 5 without penalty, or the making of mortgage payments if in foreclosure and have lived in the property for more than a year and will live in it for more than 3 without penalty. If a family uses these funds then the financial institution has to forgive all interest and fees related to the foreclosure proceedings.
2. Stabilize the value of homes through the previously mentioned actions in order to eliminate the tendency of current buyers to wait for a better or lower price.
3. Provide grants and tax incentives for investors to purchase “distressed” properties and to transform them into green spaces.
4. Provide tax incentives for investors to purchase properties in foreclosure, to hold them for 2 or 3 years and then to redevelop or sell them. The incentive could be NO tax on the profit, a tax loss on the purchase that is then offset by a gain when and if sold, or any other program.
5. Allow the purchase of lots zoned for residential single home construction to be held for 3 years. At the end of three years the lots may be developed and no federal taxes paid on the assessed value of the land when sold, only on the property built on it.
6. Allow companies and individuals to purchase residential lots from themselves and to not pay federal taxes on the profits from the assessed value of the land if held for 3 years, only on the value of the property built on it.


E. Accept Losses to reduce Losses

1. Allow the “forgiving” of a % of an outstanding mortgage coupled with rate and term adjustments in order to reduce monthly payments and bring mortgage rates in line with actual values. The owner will pay taxes on the forgiven amount as income, the financial institution accepts a “loss” less than foreclosure, and the terms of the financing are transformed to create a new lower risk asset. For instance: 200K at 8% on a property worth 170K (for whatever the reason for drop in value) with 27 years left, turns into a Mortgage for 180K at 8.5% for 40 years saves over $200 a month when reduced payments and re-assessment of the property and the corresponding tax savings are taken into account. The government collects income taxes on the $20,000.00, the financial institution takes a tax loss on the $20,000.00, and instead of losing 1/3 or more by Foreclosing the financial institution only losses 10% on the revaluation and increases by .5%.
2. “Donate” distressed properties to localities for them to turn into green spaces or rental properties for low income persons. These properties can be “written off” at a value equal to the foreclosure costs and balance of the mortgage.
3. Offer programs by which local communities can purchase/finance distressed properties for destruction/rental/gre... space initiative/business development. For instance, a distressed property in a community could be refinanced under a special community works program at a low interest rate to be paid for by a locality such as a city or even a neighborhood corporation. A group of 25 home owners take partial (4%) ownership of a property that is foreclosed in their neighborhood that is then rented to own to a child care provider at a cost per month equal to the mortgage. While the child care provider may not have the capital to purchase the property the community does. The child care provider then provides care for the community and locality at market rates. This could be the same for any type of community home based business, a medical clinic, or even a library or dentist.
4. The property could be financed by a community and be torn down at cost to the lender in exchange for the community taking a refinanced stake to turn the lot into a neighborhood playground, green space, or held in common for later sale. On a 200K home each resident of the community (if 25 were included) would finance $8,000.00 over 30 years at 5%, or less than $50.00 a month. This may be added to a community association dues and the federal government may grant tax deduction status to the interest and any profit from the use or sale of the lot/property. The amount may be managed on an individual basis by the loan provider. 25 low risk loans at the price of 1 HIGH RISK loan. $50.00 is a small price to pay to maintain the value of homes in a community. And the cost is borne by the community that benefit from a maintenance of value. This also reduces supply and increases demand.

2008 Aug 20 01:29 PM

[westwest888:]

Maybe the bond market is projecting the new cost of Treasury debt, in the agency spreads. In other words, when the Treasury bails out FNM, FRE, here are your new costs for the 5y and 10y.

2008 Aug 20 01:48 PM

[poncawolf:]

It's just simple - AS they say - Just like countrywide - It's time to get the H*ll out of Dodge.

Or you better grap what you can and head for the hills.

But either way - this is a grap stock now.

All the brainiacs did was - say Paul was going to pay John - then John would pay Paul - The last resort - The American Taxpayers would pay for it all.

Only Problem - Is the braniacs - Have put America so much in the whole - it would bankrupt the Country.

So as another saying goes - You made your bed time to sleep in it.

Whats that - Cheering at the Gallows - Should of treated the American People with a little more respect.

2008 Aug 20 02:10 PM

[whidbey:]

jackeast may have been abusive! Who does it think it is, anyway? I mean the library is the place of essays, this is a quick toss off market. I swear we have no apparent rules. Z

2008 Aug 20 04:18 PM

[User 229496:]

to instill confidence the Board must act decivesly and fire syron and risk management

2008 Aug 20 04:47 PM

[Philip Davis:]

I love it Jack, lots of good actionable ideas.

2008 Aug 20 05:42 PM

[b3rkut:]

my question is: will Freddie and Mannie be around for the long-term? If yes, then they're at rock-bottom prices to buy.

2008 Aug 23 05:31 PM