Freddie and Fannie: Living in the Past

Shares plummet and pundits rage. Everyone has an opinion about the health and best future for the semi-governmental agencies designed to smooth attainment of the American Dream. It is sad that few have found the time or interest to explore the history, function, predicament of these pillars of middle class home ownership and international finance.

Fannie Mae (FNM) was created in the depths of the great depression to decrease foreclosure and increase homeownership. In 1968 it was re-chartered as a public company. Since its inception in 1970 [PDF file], Freddie Mac (FRE) has financed 50 million homes. As both enterprises' mission statements make clear, they exist to facilitate, ease and cheapen home ownership by acting as liaisons between international capital markets and those seeking to purchase private residences in the US. They borrow at preferential rates, based on the implicit/explicit assurance of the US government. Borrowed funds are used to buy mortgages and bundles of mortgages aimed at reducing the bank risk and buyer cost of home mortgages. These firms exist to facilitate, ease and accelerate bank lending for home purchase. Firms, central banks, investors and funds lend to get returns above the Treasuries that carry an explicit form of Uncle Sam's guarantee and lower yields.

Fannie and Freddie form a central hub in the relations between lenders and investors. This relationship is neither healthy nor sustainable in its present form. Uncertainty of direction and speed of deterioration are riling markets, regulators and anyone with the faintest understanding of what is at stake. As the Street and investors seek explicit assistance, one thing is sure. These firms will not be operating over the next few years as they have across the last decade.

Freddie and Fannie went into overdrive during the crazy phase of the recent housing bubble (2002-2007). Interest rates and credit standards tumbled. Homes were bid up to lunatic excess and these firms continued to do what they were chartered to do. They slurped up hundreds upon hundreds of billions of dollars from international capital markets and help direct world 'excess' savings into American home mortgage loans, bundles of home mortgage loans and bundles of bundles of mortgage loans. Home mortgage lending doubled between 2001 and 2008- an increase of $5.5 trillion.

Freddie and Fannie kept pace with the bubble by buying and backing mortgages, selling and packaging mortgages as they rolled in, wave after wave. Private firms entered the lucrative markets in growing scale across the boom years. Some of these firms specialized in mortgages that were too large, too poor in credit quality, too exotically structured or too low on documentation for Freddie and Fannie. Many of these loans went to the lower income folks Fannie and Freddie were supposed to be focused on. A solution was found, Fannie and Freddie bought some of the securities made up of these loans. I think you already know the rest of that story.

The size of the retained mortgage portfolios is truly gigantic. The extent of the firms' guarantee commitments is global in scope. 66 global central banks buy loans bundled and or backed with Freddie Mac and Fannie Mae involvement. As of June 30, 2007 Foreign entities and individuals held over $1.4trillion in US agency securities [PDF file]. Fannie Mae's June 2008 statement declares a gross mortgage portfolio of $750 billion and guarantees of mortgage backed securities and loans of $2.6 trillion. Freddie Mac's June 2008 [PDF file] statement details a retained portfolio balance of $792billions and a total mortgage portfolio balance of $2.2 trillion.

These two giants have retained interest in over $1.5 trillion and guaranteed over $4.5 trillion in mortgages, mortgage backed securities and loans. There are $11 trillion in outstanding mortgage liabilities in the US. The quality of retained loans, securities and guarantees is open to serious question. Present capital not with standing, there are serious valuation and long term credit quality issues.

What we are witnessing is the breakdown of the link between middle class America and the global financial markets it has over-tapped across the last several decades. The serious and persistent issues at Fannie and Freddie are only the most obvious example of a shift in the relationship between American families and international capital markets. The speed and size of the turning away from further lending to US real estate is astounding. Fannie and Freddie have been caught with weak financials, swollen balance sheets and escalating carnage. The housing market is and continues to melt down with dire consequence. In the 7 years from 2001 through 3Q2007, household real estate value increased by $8.873trillion to $22.495 trillion. It has since fallen by $426billion.

Those claiming a bottom, or even knowledge as to the timing of a bottom, should be viewed with extreme weariness. The search for parallels yields little. The closest one finds is the interesting decline in home ownership across the period 1905-1920 followed by a surging rise across the twenties and then collapse across the 1930s. Fannie was born of this collapse, the ideology of The New Deal and sense that government driven market interventions could broaden home ownership in America. This was a success. Home ownership did grow spectacularly across the period from 1938-2007. It is falling now.

In 1940 US home ownership stood just below 44%. At the start of 2008, following the largest decline in the history of home ownership record keeping, 68% of Americans owned their home. Over the decades, Fannie and Freddie changed, middle class America changed and the global financial realm underwent several revolutions.

The last and most transformative revolution involved the rise of securitization and integration of global financial markets. A world of wealth poured into US real estate. This flow was channeled and molded by the actions of Fannie Mae and Freddie Mac.

The decline of these firms will have dramatic and long lasting implications for home mortgage finance. Securitization will lag its recent levels for years, if it ever attains its 2006-2007 heights. Housing prices have further to fall and global savings will likely never be lent to American consumers at recent levels. The diminished role of these institutions risks combining with a virtual cessation of private activity. Policy makers and management at Fannie and Freddie are at a crossroads between modern realities, their missions and international financial realities. Many things have to give.

Disclosure: Long SKF and SRS.

Comments

[Lex Luz:]

Interestingly, the American middle class did pretty well before the securitization miracle took hold. Back when banking was a relatively simple endeavor (hey, I said "relatively," right?) and the watchword was "know thy customer," people had to do more than fog up a mirror to borrow a half-million dollars... and yet somehow, we managed to hold up. Fannie and Freddie fulfilled an important mission. The problem, to my way of thinking, wasn't the mission or even the implied government intervention in capital markets. The problem was runaway greed and the foolish belief that the party would never, ever, EVER end. It's a problem shared by virtually everyone, from the treasonous monsters currently occupying every federal government office, to the foul cretins in the executive suites (and formerly in the executive suites - yes, you, Uncle Angelo, and you too, Dave, you foul, soulless slime), right down to the cash-out-equity-tappin... hummer-driving, sybaritic suburbanites who couldn't bear the thought of setting aside a few bucks a month and waiting a year to "upgrade" your media rooms.

The only thing that's missing from America today is the courage to face ourselves and get to work solving the ONLY national security issue in front of us: debt and the necessity to take the pain of the great unwind. Unfortunately, because that courage is missing, we are all but unquestionably finished as a "superpower." This, by the way, is exactly how every other empire came crashing to the ground, and so in the final analysis it is really true what they say:

The only thing we learn from history is that we never learn anything from history.

2008 Aug 22 09:54 AM

[ozzy43:]

Nicely put, Lex.

I would add the following: the entire argument above is premised upon the notion that increasing the rate of home ownership is an unalloyed good in all ways and for all concerned - for the economy, for individuals, for families and communities, etc. I do not think things are anywhere near this simple, and I positively assert that that premise is debatable, and in my view wrongheaded. Not least because malinvestment and market/risk distortion - which is what Fannie and Freddie represent - always leads to pain in the end. And the longer we postpone this pain - Lex's apt the 'great unwind' - the more severe it will be. And we certainly seem determined to postpone it just as far and as hard as we possibly can, praying for a miracle to deliver us from the towering wall of pain that is headed straight for us. If the past is any guide, we will somehow figure out a way to make sure that most of the pain falls on our children and grandchildren, just like most of our debt will. That's what you get for trusting politicians.

2008 Aug 22 10:39 AM

[zevach:]

right on - looking outside ourselves as the cause or solution to any problem is the human way and of course we are doomed to failure over and over again. Welcome to the real world - fantasy land is nice but the dream will always end. Reality wins in the end. Everything and everyone has the day in the sunshine (15 minutes of fame) and then the brightness flares up somewhere else. China anyone.

The senate debated useless issues while Rome burned and the barbarians took over - something like that. Here we are again - we are no longer hungry so we debate and argue who is at fault. The hungry work harder than you and me.

2008 Aug 22 10:46 AM

[Midas Mulligan:]

"History may not repeat itself, but it does rhyme a lot."

Samuel Langhorne Clemens

2008 Aug 22 11:05 AM

[Umm, yeah:]

A question - you say: In the 7 years from 2001 through 3Q2007, household real estate value increased by $8.873trillion to $22.495 trillion. It has since fallen by $426billion.

So according to that math, there's only <2% of a loss so far (i.e. 500 billion divided by 22.5 trillion)? That sounds off.

Otherwise, good article. Dire consequences for us all. And it appears that we're heading towards just lengthening the problem out over a decade ala Japan rather than taking all the pain at once.

2008 Aug 22 11:17 AM

[phdinsuntan...:]

get more SKF today !!

2008 Aug 22 11:43 AM

[bearfund:]

You correctly point out that rates of home ownership (or, let us say, home equity stakes, since often very little is actually owned) have risen since the 1940s. No doubt artificially low mortgage costs played a role in this. But you neglect to mention that, especially in the past two decades, "homeowners'" debt-to-equity ratio has risen dramatically. In other words, more own less.

You dance around the real issue: there is at any time a natural level of home ownership in any economy. If we assume that the fundamental (i.e., utility) value of a residence is approximately constant, that level of ownership will depend on the amount and distribution of wealth in the economy and the attractiveness of other assets. No doubt that level fluctuates over time. But as with any other natural limit, attempts to exceed it by manipulating variables, most notably the cost of borrowing, will work only for a limited period of time. When that period is over, there will be a reaction commensurate with the duration and degree to which the limit was exceeded.

We cannot know with accuracy what the natural level of home ownership was over the past 60 years. It does, however, seem safe to conclude that 68% exceeds it by a wide margin; we know this for two reasons. First, from our theory; we can observe that wealth inequality has been increasing and median personal income adjusted for inflation has been largely stagnant. Ceteris paribus, home ownership ought to have been flat or declining. Second, from empirical evidence; equity has fallen. There can be no clearer sign that many of the buyers of the past two decades, and especially the past 8 years, were not able to afford their purchases. Certainly not without a flood of cheap money, and many of them even with it (witness the cascade of teaser defaults and the rise in option ARM underwriting).

None of this is news. But judging the degree of excess "ownership" is key to gauging the scale of the reaction. Many of the buyers of the past 60 years have already taken cheap money from Fannie and Freddie (really, thus, from the taxpayers) and repaid it in full. They now live in houses unencumbered by any mortgage, and will remain there for the rest of their lives. They are of little concern to us. But some part of the 24% of Americans who are "owner"-occupiers and were not in 1940 are underwater and/or in default. Many others are marginal owners with weak balance sheets who will be unable to withstand a prolonged recession. What part of that 24% do these make up?

My basic thesis in this sector is that substantially all option ARMs ($500b in nominal value) will result in loss and that recovery will usually be less than half the outstanding balance at the time of foreclosure. It's not a stretch to forecast $150b in losses, nearly all of them yet to come. Fannie and Freddie do not hold this paper, but it has been widely argued that by pricing private institutions out of better mortgages, they created it just the same. Subprime and Alt-A have been discussed to death already; I've nothing to add.

So what of prime? How many of the prime borrowers bought property at or perhaps beyond their true ability to pay, either because cheap credit was available or because they feared being forever priced out of a rapidly rising market? How many are slowly accumulating credit card debt, paying their mortgages on time but ready to topple in the slightest breeze? You correctly point out that "middle-class America" has overtapped the credit markets. It would be far more helpful to attempt to quantify the degree to which they have done so; in other words, to assess how much of the borrowed money could just as well have been savings withdrawals (i.e., sustainable spending) and how much reflects cheap credit and excessive leverage. I look to the equity figures for this; there is little reason to believe that a household has the ability to support debt at higher multiples of equity or income now than in the past. Lower interest rates are of little importance as they rarely feed through to small-scale borrowers. This approach suggests that the blowoff is only beginning, as a high proportion of "owners" have minimal or negative equity. And it may have a long time to run - 2000 US Census data showed that home ownership rose between 1989 and 1999 but average equity fell. It is reasonable to conclude that most of those with negative equity will be renting again in a few years; Americans live in a home 7 years on average, so it is likely that most buyers from 2003-2007 will take capital losses when they sell, especially if they are forced to sell by a job loss, relocation, or foreclosure. Many of these have no equity, so whatever savings they have will be depleted, and those with little savings and substantial other debt are surely headed for bankruptcy. This too is not news, but the point is that the pain will run for several more years at least.

Only a substantial increase in equity levels back to long-term averages will indicate the end. We've a long way to go to get there: data shows that equity currently sits near 46%, the lowest since - you guessed it - 1940, and nearly 1/3 of all mortgaged property owners have negative or zero equity. In order for equity to return to 60%, the weakest 20% or so of today's homeowners need to be washed out of the market. Not too surprisingly, that would take us right back to 54% ownership - slightly below the long-term (1940-2008) average and a reasonable downside overshoot target. Since 40% of homeowners have no mortgage at all, this suggests that about 1/3 of all mortgaged homeowners will be washed out - which corresponds rather well to the 1/3 of mortgaged homeowners with no equity. In other words, if we immediately foreclosed on every insolvent homeowner, the remaining homeowners would be fairly typical of the long-term mix and the market could reasonably be considered healthy. In fact, this is substantially what I expect to happen. House prices are not rising, real income is not rising, and many of these people are making interest-only or neg-am payments, so their equity is not rising. Simply waiting for equity to rise on its own is not going to work. So anyone want to guess at how long it will take for the weak hands to fold? You're correct to be wary of anyone predicting the timeframe for a bottom, but I'll at least venture a partial guess: it's at least 2 years out.

2008 Aug 22 12:22 PM

[BSCLossMan:]

In my humble opinion, entities like fannie and freddie should not exist and should never have existed. Banks that write loans should never be allowed to package them in any way, shape or form, to sell elsewhere. It's clear that Wild Capitalism, during which anyone will do anything to make money and juice returns, the only restraint (obviously government supervision doesn't do much) is to force, by law, banks to hold all loans on their books. Period.

2008 Aug 22 12:53 PM

[ETF Wanderer_:]

what most people have missed out in all the FRE and FNM debates is that the govt of China is one of the largest losers.

2008 Aug 22 02:31 PM

[corporatebully:]

Att: RBC Bank President Gordon Nixon - Salary - 11.73 Million!!

$100,000 - MISTAKE (FISHERMEN'S LOAN)
I'm a commercial fisherman fighting the Royal Bank of Canada (RBC Bank) over a $100,000 loan mistake. I lost my home, fishing vessel and equipment. Help me fight this corporate bully by closing your RBC account.
Website www.corporatebully.ca
YouTube www.youtube.com/CORPOR...

There is no monthly interest payment date on the contract.
Date of first installment payment, (Principal + interest) is approximately 1 year from the signing of my contract.
Demand loan contracts signed by other fishermen around the same time showed a monthly interest payment date on their contract,(agreement).
The lending policy did change at RBC from one payment (principal + interest) per year for fishing loans to principal paid yearly with interest paid monthly. This lending practice was in place when I approached RBC.
Only problem is the loans officer was a replacement who wasn't familiar with these type of loans. She never informed me verbally or in writing about this new criteria.

Phone or e-mail:
RBC President, Gordon Nixon, Toronto [phone]
RBC Vice President, Sales, Anne Lockie, Toronto [phone]
RBC President, Atlantic Provinces, Greg Grice [phone] mailto:greg.grice@rbc....
RBC Manager, Cape Breton/Eastern Nova Scotia, Jerry Rankin [phone]
RBC Vice President, Atlantic Provinces, Brian Conway [phone] mailto:brian.conway@rb...
RBC Vice President, Halifax Region, Tammy Holland [phone] mailto:tammy.holland@r...
RBC Senior Manager, Media & Public Relations, Beja Rodeck [phone] mailto:beja.rodeck@rbc...
RBC Ombudsman, Wendy Knight, Toronto, Ontario 1-800-769-2542 mailto:ombudsman@rbc.c...

2008 Aug 22 09:21 PM

[Tancred:]

"Wild Capitalism" is an oxymoron. People putting their own capital (which is to say savings) at risk are typically very conservative in lending.

People who put other people's capital at risk are bankers, not "capitalists".

People who grant bankers an exclusive license to issue unlimited quantities of fictitious money out of thin air are politicians, not "capitalists".

People who do not understand these vital differences are patsies.

2008 Aug 22 09:56 PM

[WEBISKING:]

Buffett said it best yesterday by saying these companies common stock hadno value and only the government could bailthem outNuff said

2008 Aug 23 10:58 PM

[Terry Thprsen:]

Thank god there aren't margin calls on houses or the "unwind" would degenerate into an out and out spiral. I'd like to add a couple of points.

The decrease in percentage of equity can be compared with the one-time bumps to P/E ratios in the stock market over the years. The debate is still out as to whether those bumps will realign but it has been many years with not much of a fall. These lower ratios might likewise be the new reality.

The rise in equity assets has to be adjusted for the rise in money supply. Unfortunately we don't have M3 numbers anymore which are critical given that all of this agency debt is foreign and institutional. MZ indicates a 26% increase in money supply just over the past 18 months alone. So that 5.5 trillion number might actually act like much less money. The fact that surplus nations have nowhere else to invest their export dollars is the thumb in the dike.

One way out of this is to keep inflating. Eventually currencies will align but it will be a bumpy ride. This is clearly the approach that was taken in 2002 to create a soft landing with the unintended consequence of just shifting the bubble over to real estate. With the rates low again where is the bubble heading next?

The other situation that is pretty scary is the looming demand gap. Retiring baby boomers will be downsizing and eventually bequeathing their homes to their children creating an oversupply that dwarfs what we see today (vacation home anyone?). Meanwhile our immigration policies are bottlenecked preventing demand from entering the system. Unfortunately you can't export homes. (Interestingly I think immigration reform is the only policy that McCain, Obama *and* Bush all agree on but can't get through congress. So much for executive power...).

My personal prediction is that Bernanke & Co. will continue to let the air out of the tires with as many smalt jolts as they can conjure. $29b for Bear bailout. $30b for Fannie bailout. and so on and so on. Where did all the money go? You'll find out when DVD players cost $700 again...

Demand - baby boomer, immigration

2008 Sep 06 04:03 PM