Rafferty Capital Markets’ Richard X. Bove chimes in on the ongoing Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) / Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) saga, asserting that the US government is making some crucial missteps, and backing up his assertions with some well-reasoned arguments.
This Will Hit Housing and the Economy
Let me make some assertions and then see if I can back them up:
- The United States government has eliminated the possibility of low income households ever buying a house.
- The United States government is eliminating the profit from originating conforming mortgages in this country.
- The United States government may be driving some of the nation’s largest banks to leave the mortgage industry, altogether.
- The United States government is pushing mortgage originations into the grey or shadow banking markets dramatically increasing the risk to the financial system.
- The United States government is in the process of pushing housing prices lower negatively impacting economic growth.
In sum, the bureaucrats have gone too far and every American will suffer because of this. The bureaucrats are able to do this because the press has abdicated its objectivity when it comes to banking and the media simply refuses to take a serious look at what the government is doing to the American people.
Approximately 80 years ago, the United States government made the decision that having households own their own homes was critical for two reasons:
- Stimulating economic growth, and
- Maintaining domestic peace.
Therefore, in the Depression and again in the 1960s the government created programs that heavily subsidized the housing markets and it committed itself to the concept that neighborhoods are best served when the houses in these areas are owned by the people living in them. The subsidies took many forms:
- FDIC insurance allowed banks to obtain funds at rates lower than what the government, itself, paid for money.
- Tax benefits for homeowners – arguably the biggest welfare payment in the nation.
- Subsidized borrowing costs for the Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) that were passed along to borrowers through secondary mortgage operations.
- Direct subsidy payments under various programs like Section 8.
- Mortgage mitigation programs when borrowers could not afford their housing units.
This is all being changed. In a white paper released jointly by the Department of the Treasury and the Housing and Urban Development Department, the government clearly indicated that it wanted to extract itself from the housing finance business. The view, endorsed by the President, is that every American deserves affordable housing but this does not mean that every American deserves his/her own single family home.
To assure that this latter condition is met, the government has built a myriad set of regulations that raise the cost to the banks of originating mortgage loans to low income housing. These regulations extend from the risk weightings associated with Basel III to the new Qualified Mortgage (QM) regulations published by the Consumer Financial Protection Bureau.
Basel III requires banks back low income housing loans with above average amounts of capital. The QM requirements actually allow the homeowners to sue the banks for inducing the homeowners to obtain mortgages that the banks knew the homeowners would not be able to afford. While mortgage bankers and brokers may be willing to make non-qualified mortgage loans, regulated banking companies are virtually united in the belief that making these loans to low income households requires the taking on of an unacceptable level of risk.
Therefore, while many might support the idea that the government should remove itself from subsidizing the housing industry; it should be recognized that the replacement of owned housing with rental housing in low income areas has generally resulted in the creation of instant slums, high levels of crime, and deteriorating broader neighborhoods. These costs may well outweigh the cost of subsidizing the ownership of low income housing.
There are four sources of profit to a bank that makes mortgage loans. Let’s explore them:
Mortgage origination is a money losing business. Originating a new mortgage loan has become labor intensive activity because, through litigation and direct penalties, most of the automation in residential underwriting has been eliminated. Consequently, mortgage originators hope to recover the loss in underwriting a housing loan with profits elsewhere in the system.
After a mortgage loan is approved by a lender and before it is sold, the loan is held in what is euphemistically called a “warehouse.” It is in the warehouse that the mortgage lender hopes to recover the losses generated when the loan is originated. At the moment, one might argue that the spread on warehoused loans is a hefty 400 basis points. This is more than adequate to generate a sizable profit in normal times. However, the losses on originating mortgages may be as high as 250 to 275 basis points. This cuts the warehouse profit to about 150 basis points which is not profitable.
Fannie Mae and Freddie Mac progressively shut down by the government
Thus, we reach the third profit source –i.e., the sale of the mortgage out of the warehouse to a permanent holder. The problem encountered here is that supply is overwhelming demand. Lenders are only willing to originate qualified conforming loans. The buyers of these loans are limited. The two biggest buyers, the GSEs, Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) are being progressively shut down by the government and under current regulation will be out of the market entirely by 2017. Thus, sales spreads have plummeted from a very rich 250 basis points a year ago to 1/5th of that level today.
It becomes evident that banks are not going to make a profit originating qualified conforming mortgage loans. Therefore, they must make their profit by servicing the originated loan. However, the banks are not pricing for risk in this business. In the past five years due to the high level of foreclosures, fines and litigation costs, it is unlikely that any bank made any money servicing a large mortgage loan portfolio. At present, the new rules established by the CFPB suggests that the cost of servicing will rise meaningfully but it is not yet evident that the banks have adjusted the price for servicing to cover the higher costs.
Leaving the Business
Two of the nation’s 15 largest banks have indicated to me that they have studied the business to determine whether they should remain in it at all or simply shut down their mortgage operations. One concluded it should leave the business and it is slowly eliminating its mortgage operations. The other concluded it could still make a profit in the business if it could price servicing properly. However, that bank is not willing to make 20 or 30 year fixed rate mortgages. I will be pursuing the question of leaving the industry with other major regulated lenders.
Banks are apparently willing to make non-qualified mortgages at the high end of the spectrum – so-called jumbos. However, since there are a limited number of these loans available price competition is eroding the attractiveness of this higher risk business.
Look to the Grey Markets
Since the demand for housing is growing at the same time that the funds for the industry are being cut back, third parties are returning to the business – mortgage brokers and bankers. History shows that these companies flourish for a period of time and then disappear. They do not stay around to be sued and fined for whatever action they may have taken during their limited lives.
Their wisdom in following this policy has in a sense been certified by the United States government. To date the Justice Department has sued and penalized stockholders of companies who were not involved in questionable underwriting practices at the time of the market excesses. It has assiduously avoided suing anyone who committed the excesses. The lesson is clear. You will not be fined or sued if you commit crimes in housing as long as you eliminate the company you used to commit the excesses.
The cost of originating and servicing mortgages has reached a point whereby the nature of the business must change. The price of mortgages must rise. This will happen by shifting from 20 and 30 year fixed rate mortgages to 10 and 15 year variable rate loans. This will drive the monthly cost of owning a home higher. It will lower the prices of homes reducing the available equity for other purchases.
The regulated companies will gravitate to jumbo loans. The unregulated companies will charge very high prices for their services. Risk has been re-introduced into the housing finance market through excessive government regulation. Every American is a loser as a result.
Every American, that is, except the entrepreneurs who are smart enough to set up “bucket shops” that originate loans and then after collecting a profit the loan originator disappears into the night.