07 September 2008
 
It’s a Wonderful Life

George Bailey Confronts a Run of the Bank
 
A friend wrote me to ask my thoughts about the colossal take-over of the US mortgage market by the Federal Government that is going to be announced today. He is just getting out of college, and he may not fully realize what our generation has done to him.
 
Bless him- I have no expertise in the field, but I am part of the legion of lemmings who got caught in the housing bubble, so I thought I would drop him a line and let him know why the crisis is just like the Hurricanes blowing across the Atlantic towards us.
 
It is a wonderful life here in America, but we have all seen the storm clouds on the horizon. Young people, by and large, assume that Social Security is not going to be there for them. They are right, but being before the catastrophe and assuming that you are going to be around after it are two different things does not take into account how awful it is going to be when it actually happens.
 
Let’s take it like the Hurricane season. Gustav blew by New Orleans this time, but should have provided a reminder about living below sea level on the Gulf Coast.
 
Hanna blew over us yesterday, and dumped about five inches of rain on our houses. It is a bit like the sub-prime phase of the housing bubble- we got soaked. Hurricane Ike, rampaging across the Caribbean, may be the one that blows the houses down. I don’t want to stretch the analogy too far, but what the hell. We have not seen the end of this by a long shot.
 
Fannie Mae
 
Fannie Mae started out in 1938 as an entity called the Federal National Mortgage Association. Now they are known officially by the friendlier nickname, which makes them seem more like Mrs. Butterworth than a green-eyeshade crowd of hard-eyed bankers.
 
Here is their current mission statement: “…we are in the American Dream business…(we) tear down barriers, lower costs, and increase the opportunities for homeownership and affordable rental housing for all Americans. Because having a safe place to call home strengthens families, communities, and our nation as a whole.”
 
The whole thing developed from the curious idea that the Federal Government should encourage home ownership as an intrinsic American good. The Federal Housing Administration was Franklin Roosevelt’s answer in 1934, and we here at Big Pink are part of American History- or, at least the little brick garden apartments and quaint single family brick boxes that surround us are.
 
The Buckingham neighborhood where I live was the original test cases for thirty-year loans to construct single- family homes and apartment buildings. It was developed by a New York industrialist named Allie Freed, who bought the land in Arlington=2 0County and served as an advisor to FDR on housing issues.
 
His contribution to history was the idea that houses could be created in assembly-line fashion, saving time, labor and material costs. Completing the scheme was the FHA, which provided the means for taxpayers to buy or rent the properties when Freed completed them.
 
At the time, two million construction workers were unemployed. Houses were financed as they still are around the world- you normally had to come up with half the property’s market value, and t he repayment of the rest was spread over three to five years with a balloon payment at the end of the period. Just imagine trying to buy a house with those terms.
 
The New Deal Answer
 
The Federally backed thirty-year loan, with a 20% down payment was the answer, and it revolutionized the face of America. Back then, 60% of American were renters. That was going to change.
 
When Allie Freed keeled over and died of a heart attack in 1934, the first garden apartments were just going up in Buckingham. His widow Frances drove the 1,800 unit rental campus forward, and her culminating triumphs were the construction of the two towers the rise on the northwest and southern frontiers of Buckingham.
 
It is sometimes said that the FHA is the only Federal program that worked, since it is the only government agency that operates entirely from its self-generated income and costs the taxpayers nothing.
 
By 2001, American homeownership had soared to an all time high of 68.1%, completely reversing the ratio of renters-to-owners in less than seventy years. That is how we got in this mess.
 
Follow the Money
 
The FHA was basically a policy entity, and was intended to connect to private investors like George Bailey in the film “It’s a Wonderful Life.” You can look at the face of the New Deal in Jimmie Stewart and the fangs of capitalism in Lionel Barrymore who played the tightwad banker Henry Potter who tries to bring down the dream.
 
There were not enough George Baileys around in 1938 to provide the cash to make the dream work- remember, the film was released in 1947.
 
Fannie Mae was the answer. It was created to link investors and the banks that issued loans, since it did not directly provide money to individuals. In 1938, it specialized only in FHA loans, but later took on the gigantic Veteran’s Administration portfolio to accommodate ten million returning GIs after the war- like George Bailey’s brother, who won the Navy Cross, and who would have died if George had not rescued him from drowning.
 
Whew! The metaphors are overwhelming. But, of course, now we are all drowning.
 
Freddie Mac
 
In 1968, those two federally-backed portfolios were spun off to the newly-formed Government National Mortgage Association, or Ginnie Mae. Four years later, the Nixon Administration permitted Fannie Mae to diversify into conventional mortgages not backed by FHA or the VA.
 
Ginnie Mae still backs direct government guaranteed loans, and is not in the same trouble as the two giants.
 
Fannie and Freddie conduct business by buying mortgages from lenders, packaging the mortgages into securities and selling the securities to investors. Mortgage lenders use the proceeds from selling loans to fund new mortgages, constantly replenishing the pool of funds available for lending to homebuyers and apartment owners.
 
The whole thing is transparent to most of us. Think of it this way: America's mortgage lenders are the retail outlets where people go to get mortgages, and the secondary mortgage market is their supplier. Fannie Mae and Freddie Mac are the secondary market conduit between mortgage lenders and investors.
 
Over the last thirty-five years, Fannie and her younger brother Freddie became the largest non-bank financial service companies in the world, and as a shareholder-owned companies, among the largest corporations in America.
 
Creative Financing
 
As interest rates began to rise in 1979, Fannie Mae faced the most critical period in its history. Because the company borrows the money it uses to purchase mortgages through debentures and short-term notes, it is especially vulnerable to rising interest rates.
 
Several programs were initiated to transfer some of the interest-rate risk to someone else. One of these programs was to begin buying adjustable-rate mortgages (ARMs), since many primary lending institutions were shifting to them to encourage consumers to commit to loans they thought they could afford. The kicker, of course, is that if the prime rate goes up, the homeowner pays more per month; if it goes down so does the payment.
 
Fannie Mae also began selling mortgage-backed securities (MBS) in 1981 to help finance mortgage purchases and to generate income based on transaction fees. These securities were attractive investments because they were more liquid than the usual packaged mortgage pools. The MBS "Swap Program" allowed lending institutions to trade loans directly, with Fannie Mae holding the bag to ensure the timely payment of interest and principal.
 
By 1985, Fannie Mae had survived the interest-rate nightmares of the early 1980s.
 
I recall the mortgage rate on the first house I bought in 1986 was something like 12%- just think about that, even in the context of the market today. That was the year the 30% withholding tax on foreign investment was abolished and foreign money began to flow into the market. To accommodate the overseas bounty, Fannie Mae began marketing real estate mortgage investment conduits (REMICs) in 1987. These securities could be specifically tailored to an investor's needs in terms of maturity dates, allowing Fannie Mae to attract investors not traditionally interested in mortgage-related investment products.
 
Falling interest rates meant that investors had to scramble, just as savvy home owners did. Refinancing became a way of life. It was a no-brainer under the reign of Alan Greenspan, who took the helm of the Federal Reserve in 1987, and kept his hand on the tiller until 2006. In order to bring the economy out of the mini-recession that cost George Herman Walker Bush the Presidency in 1992, the Prime was suppressed to the point that money was just about free.
 
No Such Thing
 
Why wouldn’t you take advantage of an ARM?  Inflation had been killed, and wasn’t going to come back. Even if it did, it would be easy to refinance, based on the growing equity of the home, which had nothing to do with how much you put into it. I think I refinanced houses four or five times over the years, riding the bubble.
 
We all seemed to have forgotten that there is no such thing as a free lunch.
 
F annie and Freddie expanded their charters under the Clinton Administration. The organization's traditional role in the industry had been to provide a source of liquidity for the fixed rate conforming mortgage market, but increasingly played a larger role in the sub-prime lending to people with lousy credit, multifamily dwellings, and adjustable rate markets. By 2001, the peak of home ownership, Fannie Mae and Freddie Mac controlled about 43 percent of the U.S. mortgage market, and was looking to increase it.
 
The two institutions had many allies in Washington and former executives were among Democratic and Republican insiders. Fannie and Freddie spent the better part of a hundred million dollars on advertising in this decade to promote the American Dream.
 
What we are waking up to this morning is that it was more along the lines of a nightmare.
 
What is Happening Today
 
Congress is coming back to town this week, and the summer is over. Fannie Mae and Freddie Mac are in deep shit. Earlier this year, Federal  Regulators20loosened restrictions on the two in the hope they would be able to prop up real estate by holding financing costs down. Unfortunately, there is no one left to buy, and everyone is stuck.
 
The artificially low interest rates got a lot of people into the housing market who had no business being there. I got to be a player myself, through painful circumstance. With my Ex, I owned a nice house out in the County, a four or five bedroom place, depending on how you counted. It is about the counting that the story turned.
 
We bought the place at the time we did because we had to. We needed a house and the Navy had summoned us back to Washington. One of the painful things about being a military vagabond is that you need to make big decisions without regard to the larger economy. Housing costs had stabilized after the bubble ended in the early nineties and had stayed flat in the Washington area.
 
In 1997, the house cost $297,500, if I recall correctly. We put down about 30% to keep the monthly payments low. It was all the money we had, but there was no reason to think that the house was not the best piggie bank there was.
 
It was a wonderful life.
 
It certainly seemed that it was going to stay that way, too, even getting better. By the millennium, it was clear that something queer was going on. Houses in the neighborhood were going on the market for a third more than we had paid, and kept going up.
 
A bubble is an intoxicating thing, and that is the best analogy to it. We were all drunk on real estate, and=2 0the drinks appeared to be free. Fueled by low interest rates and the search for better paying investments, the flexible and liquid bundling of mortgages was a very attractive destination for the world’s money.
 
Fannie and Freddie were happy to oblige, and the conversion of stolid thirty-year mortgages backed by a 20% down-payment gave way to all manner of creative monetary vehicles.
 
I had occasion to purchase an efficiency condo as a good price in 2004. I had an astonishing number of options on how to do it,=2 0the first of which was that while I did not have the 20% to put down, if I had 10%, they would be happy to cut me a second loan to get to the necessary down-payment. I thought it was odd, but the people who were borrowing money from Fannie Mae didn’t seem to mind.
 
They were very helpful.
 
No one can live in an efficiency apartment for long, as my sons and their friends are realizing now. With the bubble still expanding and prices continuing to rise, I began to frantically search for something l arger that I could afford. It appeared that I might not ever be able to afford anything, ever. There was a fever abroad in the land.
 
Apparently a lot of people felt the same way. I managed to find a larger place for sale in Big Pink, and jumped on it. The competition was fierce, by the way, and I prided myself on my skill in negotiating the price upward to seal the deal.
 
It was just as easy as buying the efficiency uni t- actually, easier, since there were even more options. In addition to issuing the second note, the mortgage companies were happy to use Fannie Mae’s money to offer me a jumbo ARM, which included a low-cost variant on which I would pay the interest only on the loan.
 
That was indeed a wonderful thing, since it enabled me to take a bigger loan and keep the monthly payment to a minimum, at least until the interest rate re-set. But, hell, the place would be worth a lot more by the time that happened, and I could always re-finance, you know?
 
That was late in 2005.
 
Melt Down
 
We were awakened abruptly from the American Dream a couple months later. As it turned out, Fannie Mae and Freddie Mac had succeeded beyond their wildest imagination. Not only did most Americans own their homes, most of them couldn’t pay for them.
 
The Sub-prime crisis was first to bubble over. Some of those debtors were unable to make even the first payment. Others were squeezed by the creative financing into default.
 
We are now into a period where most of the junk mortgages have been digested- the ones who could not, or would not, pay on time has largely been disposed of. The problem is that now the adjustable rate mortgages are coming due on nearly 1.5 million loans given to people like me with pretty good credit. It is simple math, really, and what worked in the upward bubble does not work in a declining one.
 
I have run the numbers myself, thinking I might re-finance my way out of the problem, but there is no way. Prices have declined to the point that there is negative equity in the place I own- or rather, my Credit Union and Fannie Mae do. With the loss of a third in value, I would eat to eat that and come up with 20% on my own to qualify for a new loan.
 
That essentially takes us back to where we started seventy years ago with the FHA- half down to qualify for a mortgage.
It isn’t any different for Fannie and Freddie, though they have several battalions of accountants to consider ways to deny reality.
 
They were inflating the market value on the mortgages, and deferring losses into distant future quarterly reports. They were increasingly in denial of reality, and their delusions threatened to drive the entire system into default.
 
It was the same thing at Bear-Sterns, when the Feds=2 0had to march in and mandate a transfer of assets to JP Morgan-Chase to avoid default. The Feds were not going to allow management to profit, so the stockholders were basically wiped out, though it did not ripple failure through the rest of the market system.
 
That is what is going to happen today to Fannie and Freddie. It is not going to be pretty or cheap. They back $5.3 trillion in mortgages, after all, and the foreigners are going to insist on being paid.
 
The storm that reached Washington yesterd ay was pretty much the same. There were torrential rains, and in Arlington and northern Virginia there are about 55,000 people left without power as power lines went down with the trees. There were a few flash floods and accidents on the more than a hundred roads that had to be closed temporarily.
 
But we will get through this, just as Fannie and Freddie will, even if it takes some painful action. It is still a pretty good life.
The question, though, is what happens in the next storm that is following.
 
Those pesky interest rates are going to re-set later this year, and 1.5 million home-owners are going to have check the weather.

Copyright 2008 Vic Socotra
www.vicsocotra.com