Making Mortgages With Borrowed Money Is A Lousy Business

Includes: COOP, FMCC, FNMA
by: Martin Lowy

FDIC settlements with Washington Mutual (WAMU.PK) executives are much in the news today (Sunday, Dec 18). The news focuses on ideas like whether or not the amounts paid by the executives hold them sufficiently “accountable.” None of the stories that I read focuses on the fact that the business of borrowing short to lend long and competing against government-created behemoths like Fannie (OTCQB:FNMA) and Freddie (OTCQB:FMCC) is a failed business plan—and has been a failed business plan, like forever. As investors, we should not back such business plans, even if from time to time they may look profitable. (I was lucky. I made money on WAMU stock and sold it all. I should have known better and not have bought it at all.)

Coincidentally, the SEC has brought suit against top officers of Fannie and Freddie this week, as well. The SEC suits allege basically that the two federal mortgage giants guaranteed vastly more subprime mortgage loans than they disclosed they had guaranteed. The complaints make interesting reading, especially since the agencies significantly increased their exposure to subprime or subprime-like loans from 4th quarter 2006 through 4th quarter 2007, a period when anyone paying attention knew that the entire sector was in trouble. (The first significant failures of subprime lenders occurred in the 4th quarter of 2006, and they were followed by several significant failures in the 1st quarter 2007.) What were they thinking?!! See here for links to the complaints and related documents.

A Brief History of Home Lending

Home loans have been a problem at least since the Great Depression. At that time, commercial banks did not make home loans. Home loans were the province of savings and loans (sometimes also called building and loans and similar names), essentially cooperatives set up mostly in rural areas to pool savings and make home loans. When the real estate market, farming and employment all went south at the same time, savings and loans failed by the bushelful.

The New Deal. One of the reforms instituted under the New Deal program was the formation of Fannie Mae, which was a federal agency designed to foster the making of long-term fixed rate mortgage loans that the market seemed unwilling to make. As Fannie grew, its liabilities became a significant part of the liabilities on the Federal Government’s balance sheet, and in 1968 the Government made a public offering of Fannie’s common stock in order to transfer control and get the liabilities off the Federal books. Freddie was created with a similar structure in 1970 (its common stock originally was owned by the S&Ls) and went public in 1989. By a wink and a nod, however, all market participants assumed that the Federal Government would, in practice, as it eventually did in fact, guarantee Fannie’s and Freddie’s obligations by preventing the agencies from failing. Thus, several trillion dollars of Fannie and Freddie exposure that in practice was guaranteed by the Federal Government was not on the Government’s books, and both the markets and the Congress knew this. Only the Government’s accountants, hiding behind corporate formalisms, did not.

In the 1960s, despite the presence of Fannie, mortgage money was tight. Government addressed this situation in a number of ways, adding to the subsidies that it paid to the mortgage market. Mortgage interest already was deductible for borrowers. The Government now gave tax incentives to institutions that would invest a substantial part if their funds in mortgages. This induced mutual savings banks, most of which had already been around for close to a century, to become home lenders, as opposed to more diversified purchasers of bonds. (Due to the maturity mismatch between the home loans and their deposits, many savings banks failed in the early 1980s. We should count that as part of the second wave of mortgage-market failures.)

The S&Ls Fail. But the tax incentives were not enough to spur mortgage lending. One of the problems was that in order to attract deposits, the S&Ls had to pay too high a rate of interest to make mortgage lending both profitable and attractive to borrowers. So the Fed and the other regulatory agencies instituted amendments to Regulation Q that were designed to keep deposit costs down. Basically, Reg Q, that originally had applied only to checking accounts at commercial banks, became a price fixing mechanism for the mortgage market. That worked for a few years until it blew up in the mid-and-late 1970s when market interest rates skyrocketed due to inflation, and money started flowing out of the S&Ls and savings banks. The rates on the mortgages they owned were fixed, so they basically became insolvent without suffering any losses of principal on the mortgages. It may look to many people like the S&Ls failed in the 1980s. But that is because the Government kicked the can down the road for a few years. The failures occurred when interest rate spiked in the 1970s.

Fannie and Freddie Ascendant. But after the S&Ls failed, there was a sort of vacuum in the mortgage market. Fannie and Freddie stepped in. Indeed, they stepped in before the S&Ls actually had been declared failed, and by doing so, they sealed the fate of many S&Ls that might have had a chance of survival. By the mid-1990s, Fannie and Freddie were accounting for more than half of the mortgage market. A number of mortgage specialists did, however, compete with them. Many of those were small institutions that had survived the S&L carnage of the 1970s-80s. Others were fast-growing S&L-type lenders or mortgage companies that sought to make large volumes of mortgage loans. Countrywide, WAMU, Golden West and Indy Mac were among these lenders. Countrywide, WAMU and Indy Mac were among the 2007-2008 failures. Golden West’s management was smarter (and older) and sold out to Wachovia in 2006, which contributed to Wachovia almost failing in 2008. The remains of Countrywide were bought by Bank of America (NYSE:BAC) in 2007, and BofA almost failed as a result of that (would have failed but for government bailout). Why these commercial banks thought mortgages were a good business, I have no idea. I have to guess that the commercial banking business is not so good, either. See my articles “Bank Lending is Dangerous: The Federal Government Should Stop Subsidizing It.”

Private Label Securitization Stumbles. For a time, it looked like securitization might be the best form for supporting the mortgage market. It is flexible and it does not require the ultimate funders to mismatch their assets and liabilities. Standing back from the details of the subprime failures that triggered the Great Recession, I think one can see that the “private label securities” market could compete with Fannie and Freddie’s government-guaranteed low costs only in the jumbo sphere and in the higher-risk subprime and “alt-A” spheres. (Securitization expert Janet Tavakoli said that the term “alt-A” was coined to put “lipstick on the pig.”) Thus the private label market forced itself further and further up the risk scale, with the inevitable results. The basic problem is not the securitization architecture; it is the inability of any private party to compete with Fannie and Freddie.

Some Conclusions

At the current time, Fannie and Freddie are practically the only ultimate lenders to the mortgage market. In the most classic sense, they have “crowded out” all private competition for loans that meet their criteria because they are charging below-market rates (as Government policy). No private mortgage market can begin to flourish until Fannie and Freddie either stop lending or charge market rates.

That brings us back to the officers of WAMU and Fannie and Freddie. They did do things that appear to have been imprudent. But for the officers of WAMU, at least, they were in competition with Fannie and Freddie and Countrywide. As they saw the world, their stockholders, in the form, largely, of institutional investors and Wall Street analysts, were demanding that they achieve higher rates of return. In order to achieve such rates of return in the mortgage market, they had to do more business, and in order to do that, they had to take greater risks.

In the Fannie and Freddie cases, they had a double whammy. They had stockholders demanding that they grow market share and profits; but they also had Congress and HUD demanding that they serve the riskier parts of the market—lower-income borrowers who had almost no money for down payments. Both avenues turned out to lead to disaster for institutions that had been permitted to maintain extremely high ratios of liabilities to equity capital and therefore had little cushion for credit losses.

We come out at the end of this excursion into economic history with two basic conclusions: (1) In the United States, no institution of size has made money holding mortgages over the last 80 years, which suggests that something is basically wrong with the business model. (2) Throughout that period, the Federal Government has subsidized mortgages in various ways in support of home ownership as a significant aspect of the American Dream. To what extent those subsidies have caused the mortgage business to be non-viable I do not know. It is clear that at certain times and in certain ways, the subsidies have done so. But whether the business model of using high leverage to make home mortgage loans is viable at all, I have my doubts.

Based on these two conclusions, I have hopes that eventually some form of securitization, some form of peer-to-peer lending, some form of crowd funding can take over from the highly leveraged lenders that have failed to be able to build a stable mortgage lending business. If the only surviving lenders are on constant government support and guaranteed, I have to believe the business must change.

(Some of the officers of WAMU and Freddie Mac have been my friends in years past when I was active as a banker and as a lawyer representing banks. I believe that those relationships have not influenced my views about these cases, but one never can be certain.)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.