Richard X. Bove, Vice President Equity Research at Rafferty Capital Markets, highlights the importance of the privatization of Fannie Mae and Freddie Mac and what caused private sector funds to flee the mortgage sector in a letter to investors.
What Happened?
There were two driving factors that caused private sector funds to flee the mortgage sector:
- Most important, the return on investment turned negative; and
- Second, a new series of laws, rules and punitive actions were put in place that chilled money flows from traditional sources.
This caused a shift in the source of mortgage originations and greater reliance on the government in the secondary markets. Some factors to consider:
- Banks are increasingly unwilling to originate loans that are to be insured by the government because they do not believe the government will meet its obligations under the insurance agreements. This now means that the bulk of government insured loans are created in the shadow banking sector – i.e., by mortgage bankers and brokers. Virtually 100% of these loans are sold to, or insured by, Fannie Mae and Freddie Mac.
- Conversations with a number of bankers also indicate that while they are willing to originate conforming mortgages with fixed rates, they are not willing to put these loans on their balance sheets. There is a general belief that this is no longer a money making business. Thus, the bulk of the conforming mortgages are being originated for sale through the GSE system.
- While there is some appetite for mortgage loans rebuilding in the privately insured secondary markets, it has yet to reach a level that offsets the outflow of funds.
- Surprisingly, even the Federal Reserve has gotten involved. During QE3 it was buying $10 billion in mortgages each week. It was thought that the Fed would eliminate these loans as they matured or that the Fed would sell them when the mortgage market resumed more normal activity. Not so, the Fed is maintaining its ownership of these loans and in recent months has been a net buyer (this latter statement is not shown in the chart on the next page because all of the numbers in this section of this report are derived from the Financial Accounts of the United States which only has data up to Q2 2015).
Fannie Mae: State of The Mortgage Markets
All Roads Lead To Rome (or in this case Fannie Mae and Freddie Mac)
Thus, it is beginning to appear that the only home mortgage loans that are sought after in the private sector are the so-called “jumbos” or non-conforming loans that meet the qualified mortgage rules, in the main. Virtually everything else is going through Fannie Mae and Freddie Mac.
This is not good for taxpayers nor is it good for home builders and buyers.
Taxpayers
The chart below shows how the GSEs have been reacting to the various thrusts from the Administration since it issued its white paper on housing finance in 2010.
Initially, it put pressure on Fannie Mae and Freddie Mac to stop buying any mortgages. By 2012, when it issued its demand that 100% of the GSE capital be eliminated the net pay down of the GSE portfolios accelerated. Then the forces described above took hold and the GSEs have been buying and insuring, driving the taxpayers’ exposure to housing up meaningfully. This exposure can be seen in two fashions:
- Fannie Mae’s common equity to asset ratio is presently negative 4.0%; its shareholder’s equity to assets is 0.2%. Freddie Mac’s common shareholders equity to assets is negative 4.1%; its total shareholder’s equity is 0.3%. By 2017, shareholder equity is mandated to decline to zero at both companies. This means that neither company is able to support its claim that it can insure or back any mortgage holding. All of its guarantees are directly backed by the U.S. taxpayer.
- By 2017, the façade will end. If these companies have no equity, they will have shown to be what they are –i.e., insolvent. They are currently owned in a conservatorship by the U.S. government. Their combined debt obligation according to the Federal Reserve is $6.5 trillion. Since this is a direct obligation of the United States government, or the U.S. taxpayer, it will have to be added to the national debt.
Home Builders and Buyers
If only 38% of the money to support the mortgage markets (GSE position subtracted from 100%) then one may logically ask where the money is going to come from to support the current state of housing or to help housing grow. It is unrealistic to assume that when Fannie and Freddie are without capital and the U.S. government has added what, in essence, will be mortgage debt to the U.S. deficit, funds will continue to flow from government sources.
This puts the value of all houses at risk. If there is another general collapse in housing prices it puts the whole economy at risk.
Conclusions
There are solutions that would avoid this threat. The privatization of Fannie Mae and Freddie Mac is at the top of the list. However:
- The President recently made it clear that he has “washed his hands” of the subject. His spokespeople have stated that this is a 2017 issue when this President will no longer be in office.
- Congress agrees. All of the bills related to the GSEs are in the “dead letter box.”
- The court system is not moving forward either. There are lawsuits stalled in the Appeals Court, the Claims Court, and courts in states from Delaware to Iowa to Kentucky.
Meanwhile the debt obligation of the taxpayer keeps growing mortgage by mortgage. It is ultimately going to impact housing activity and the economy. Insolvent companies cannot continue to be the sole hope for the mortgage market.
