Repentant Sinners

If Barney Frank doesn't waffle, his recent statement that Fannie Mae and Freddie Mac "should be abolished" may be the best thing a Democrat has said in a long time.

If Canada can have home ownership rates above those of the U.S. without their equivalent of a Fannie Mae or tax subsidies for mortgage interest, so can we.

And then we can avoid a housing-led financial crisis in the future.

The More Things Change, the More They Remain the Same

Fannie Mae and Freddie Mac, the two government-sponsored entities that were designed to promote home ownership, have been the biggest drain on the government's coffers by far in the TARP bailout. The government has poured $148 billion into them so far, on top of guaranteeing trillions of dollars of their debt.

These staggering losses are a manifestation of their seminal role in fueling the housing bubble and ensuing financial crisis. The government used them to subsidize housing, and in Democratic Congressman Barney Frank's words, he wanted to "roll the dice" with Fannie and Freddie to promote home ownership among low income people.

That "role of the dice" led to our catastrophic financial crisis.

So you might think, in a rational world where the Obama Administration claims it wants to prevent future financial crises, that the government would recognize that subsidizing the housing industry and mortgages should end, so bubbles are less likely to develop and so taxpayers are no longer on the hook for bad mortgage loans.

But the power to influence and control the housing industry, and to direct subsidies to favored constituents, is to tempting to the Obama crowd. Treasury Secretary Timothy Geithner has kicked off the administration's discussions of "housing reform" by saying that ther government should retain a role in the the mortgage finance business. Moreover, Geithner says one reason for this need for a government role is that 90% of new mortgage loans made over the past three years have had government support - suggesting that the private market can't provide sufficient mortgage lending.

What it really means is that it is hard for private mortgage lending to compete with government subsidized lending. Canada, which despite its left-oriented government policies has no equivalent to Fannie and Freddie, has no problem providing private mortgages with home ownership rates at or above those of the United States.

The government needs to end its myriad of subsidies for housing: it needs to wind down Fannie Mae and Freddie Mac and other government-sponsored mortgage supporters; it needs to repeal the Community Reinvestment Act which promotes non-economic lending; it needs to end the mortgage interest deduction to reduce the incentives to borrow; and it needs to end the favored tax treatment of capital gains on housing vs. other investments.

Interest Rates and Housing

I started writing this column in November 2008 after witnessing a staggering distortion of the recent historical record regarding the cause of the financial crisis.

The left was blaming Wall Street, bankers, derivatives, and capitalism in general for the crisis when it was a gross exaggeration at best and an outright lie at worst. Instead, one needed to look at key economic factors that led to the crisis, with the housing bubble being the central problem - and the Federal Reserve's low interest rate policy and the government's promotion of housing, particularly subprime borrowers through "rolling the dice" (Barney Frank's words) with Fannie Mae and Freddie Mac.

Recent history is an interesting thing to discuss, since everyone lived through it - unlike debating historical events from decades or centuries ago. But clearly many people don't, or didn't, appreciate the government's role in creating the financial crisis, so it is useful to observe now a new housing bubble potentially being created - in Canada.

The Wall Street Journal reports on the explosive growth in housing prices in Canada recently despite a drop in personal income. Canada's housing prices grew more slowly than America's during the 2000-2006 boom, but it has continued to grow and its cumulative increase is now up 90% since 2000 as compared to less than 50% in America.

And what is fueling the boom? Naturally, the low interest rates that Canada's central bank implemented to address the economic slow down.

Housing prices are, and always have been, extremely sensitive to interest rates. It is true today in Canada as it was in America in the 2000s.

Let's hope Canada's boom doesn't get out of control and create large losses in its banking sector. And if it does happen, it will demonstrate that even well understood bubbles and looming credit losses are difficult for regulators to stop or prevent.

Here We Go Again

The Wall Street Journal reports that academics and housing experts believe the U.S. government should retain the part public entity / part private company aspect of Fannie Mae and Freddie Mac, with Fannie and Freddie promoting loans to low-income borrowers and the government insuring mortgages.

This is exactly the type of government intervention in the housing market that caused the financial crisis.

It is said that "people who forget history are doomed to repeat it."

And then there are those who never learned the "history" of our recent financial crisis to begin with.

Where's the Outrage?

The Congressional Budget Office believes that none of the $50 billion in TARP funds used to modify home mortgages will be repaid to the U.S. Treasury.

$80 billion of TARP funds was invested in the auto companies, and GMAC just announced it needs several billion dollars more. It would be shocking if the government gets its money back, yet alone turns a profit. Staggering losses are more likely.

Meanwhile, many of the banks that received TARP funds have returned the money or have produced a profit for the Treasury.

So in a rationale world, you would expect intense scrutiny of why the government's spending on the mortgage modification and auto company investments has been squandered.

Instead, we are treated to attacks on the banks who have returned the money or where the government made a profit.

Why? Because the Obama administration and the Democrats are doing all they can to deflect attention from the government's role in causing the financial crisis, through encouraging subprime lending and the low interest rate policy of the Federal Reserve, by focusing on the employee compensation at the banks. And in the process, Obama can hand subsidies to his union supporters and people looking to restructure their mortgage obligations.

Chris Dodd to Wall Street: Drop Dead

Chris Dodd, as a U.S. Senator from Connecticut and a former presidential aspirant in the Democratic primaries in 2008, is an important figure in our national politics. Tragically for our country, he is a real menace to our well-being.

He has long sought to improve U.S. relations with Hugo Chavez, the socialist thug in charge of Venezuela who is doing his best to make himself dictator.

He received low interest rate mortgages from Countrywide in a "Friends of Angelo" program to provide politically important figures attractive mortgages, in a program named for Countrywide's CEO Angelo Mozilo. Countrywide had an extensive relationship with the failed mortgage giants, Fannie Mae and Freddie Mac, providing Friends of Angelo loans to key executives there while Fannie and Freddie were buying Countrywide mortgages.

And why would Dodd get such favorable treatment? Because he sat on the Senate Finance committee that regulates the financial services industry in general, and Fannie and Freddie in particular. Suffice to say, he presided over the massive expansion of mortgage lending by Countrywide/Fannie/Freddie that has helped cause our current financial crisis.

And now Dodd has pulled another caper, worthy of this distinguished record. At the last minute, he inserted to the recent "stimulus" bill a provision that limits bonuses to a broad number of top executives at future and previous recipients of TARP money. It is so destructive, even the Obama administration is opposed to the measure. The measure:

• Encourages TARP recipients to increase salaries, since only bonuses are limited, to offset the reduction in compensation. More compensation will be fixed, rather than performance-based as bonuses provide.

• Motivates employees of TARP firms to leave for financial firms that are not TARP recipients, where these restrictions don't apply. This "brain drain" will increase the likelihood that TARP firms continue to struggle and be unable to repay the government for the money invested in them.

• Provides incentives for TARP recipients to repay the government investment sooner, and discourage potential future TARP recipients from accepting such funds. While this has some positive aspects to it, it is important to recognize that the Treasury Department under both President Bush and Obama want to encourage firms to accept TARP money to strengthen the financial system.

• Violates the principle that ex post facto laws are wrong, since existing TARP recipients didn't realize when they accepted TARP funds that this restriction would be applicable. Recall that the government twisted the arms of some firms to accept TARP money so as to minimize the stigma for the weaker firms for receiving TARP money. The financial sector gets tarped again.
  

This is quite a record for the dear Senator.

Fannie and Freddie Dwarf the Rest

When the government put Fannie Mae and Freddie Mac into conservatorship in September, it committed to provide up to $100 billion in equity capital for each company. The companies have drawn down or said they need to draw down $55-60 billion in government equity.

The first thing to note is this amount of government equity investment is greater than the amount is has invested in any other financial institution (so far, $45 billion is the maximum in the case of Citigroup, although the new bailout plan being discussed may raise this amounts). Yet it hasn't received the publicity or scandal-mongering that is associated with TARP recipients.

Why? Because it is a creature of government and its poor financial policies were spurred on and even mandated in some cases by the government in general, and the Democrats in particular - including many of the Democrats who now wield power in Washington (Barney Frank and Chris Dodd are leaders of the pack in this regard). So the left-leaning media doesn't turn up the attack machine on Fannie Mae and Freddie Mac as it does for private companies such as Bank of America or Citigroup.

But Federal Reserve policies, and government promotion of the housing market led by Fannie Mae and Freddie Mac, are the fundamental cause of our economic crisis today (as discussed here). We can't lose sight of that, and the staggering losses at Fannie and Freddie only reconfirm that fact.

A New Mortgage Tax

Congressional Democrats should be pleased they are finally getting something from their support of TARP, with Citigroup's agreement to support allowing judges to reduce mortgage balances for people who have filed for bankruptcy.

Going forward, mortgage lenders and investors will now factor into their risk assessments the possibility of future bankruptcy modifications to mortgage balances - which will drive up the interest rate on mortgages and/or tighten underwriting standards to make it harder to get a mortgage.

When Congress in 1979 passed legislation preventing bankruptcy from being used to reduce mortgage debt, it did so specifically to reduce such risks and keep mortgage rates lower.

In effect, this is a new tax on mortgage - a hidden tax so Congress can avoid the blame for imposing this additional cost on homeowners.

Crisis Redux

The Wall Street Journal is reporting that the U.S. Treasury is considering a plan to lower mortgage rates to 4.5% to new home buyers who qualify for a traditional mortgage (documenting income, etc.) to spur a rise in home prices.

While it is true that falling home prices are driving the financial crisis as it increases defaults on mortgages held by financial institutions, what this proposal entails is artificially propping up asset prices by lowering interest rates.

We need asset prices to fall to those levels that induce buyers to return to the market on their own accord. That is a necessary predicate for recovery to begin.

Actions which defer that reality simply increase the length of this recession and sow the seeds for future financial losses.

Fear and Loathing in Washington, aka The Cover Up

Senator Tom Harkin (D-Iowa) has introduced a bill to treat all over-the-counter derivatives as futures contracts, requiring them to be to be traded on regulated futures exchanges. He seems to prefer to do more when he recently said, "Shouldn't we just outlaw all of these fancy little things?"

This legislation reflects the concern often expressed recently about the complexity of sophisticated new financial instruments, such as credit default swaps. Much has been implied that these are a significant cause of the financial crisis.

Nothing could be further from the truth, and focusing on an incorrect cause deflects attention from the real problem and risks repeating the same mistakes in the future.

Banks and other financial institutions are suffering from enormous losses in the most traditional investment for banks: mortgage loans. As the bubble in housing prices has burst, housing prices have collapsed - and due to the high percentage of a home's purchase price that a mortgage typically represents, the mortgage holder faces severe losses. The traditional arrangement where the mortgage provides 80% of the purchase price illustrates that home buying is really a leveraged buyout (LBO), involving a home instead of a business.

Securitization facilitates the spreading of mortgage loans widely, but doesn't change the basic calculus that the lenders, or investors in loans, suffer if housing prices drop significantly.

So the real question is: why did so many lenders and investors pour money into the housing market, both driving up home prices and lending against the value of those inflated home prices?

For any given investment, people make mistakes all the time and suffer losses - but don't produce an economic crisis. But something more profound and fundamental needs to occur to produce a financial crisis of the depth and breadth across the globe that we are currently witnessing.

The main culprit was the extraordinarily accommodating monetary policy that the Federal Reserve pursued beginning in 2002, reducing its base interest rate to 1.00% - an unprecedented low level. The purpose of such low interest rates was to encourage borrowing, and boy did it ever. Banks could borrow at low rates, and pass on the low interest rates to borrowers.

That's why the Fed lowers interest rates. Alan Greenspan and other Fed officials can't escape that fact.

Such low interest rates, for such a long period of time, encouraged lenders to offer, and borrowers to accept, mortgages with ever more aggressive terms. Mortgages with low interest rates for the first year before later resetting to higher rates became more common.

As example, imagine a family can afford to pay $2,000 a month in mortgage payments. At a 6% interest rate, the size of the mortgage loan would be $333,000. But at a 3% rate, the mortgage loan that monthly payments of $2,000 support is $474,000. And that higher borrowing capacity allowed buyers to offer sellers higher prices as they bid for homes - in this example, the buyer could increase the price by $141,000 and still "afford" the house.

This higher borrowing capacity as a result of low interest rates directly fueled the bubble in home prices.

Of course, once the interest rate reset, the mortgage became unaffordable. And as this happened across the economy, housing prices began to drop. Then, lenders and investors realized their mistake and stopped making such loans, further contracting home prices.

Illustrating this was an economy-wide problem, a similar phenomenon developed in leveraged buyouts of corporations and commercial real estate. Large losses have arisen in those markets too, but are dwarfed in size by the housing market.

Alan Greenspan, the architect of this low interest rate policy, elected to blame banks and investors for not exercising greater discretion in their lending and investment decisions. And some banks, and some investors, elected not to participate in this frenzy and are doing well today. But Greenspan should understand market participants react to signals, and there was no bigger green light flashing "Go" then the extraordinary low interest rates that the Fed pursued.

Back to Washington, you will be hard pressed to find politicians who bemoaned low interest rates at the time. The Wall Street Journal editorial pages did, so it isn't as if this problem wasn't recognized at the time.

Moreover, low interest rates facilitated an important public policy goal - promoting home ownership. Fannie Mae, Freddie Mac, and other government sponsored entities (GSE) were pushed by activists and Congress to expand lending for subprime mortgages to increase home ownership among less creditworthy borrowers who in the past couldn't qualify for a mortgage.

This added fuel to fire, with the blame squarely on the shoulders of the primarily Democratic politicians who pushed these policies and defended the GSEs against primarily Republican efforts to regulate them to limit the scope of their activities.

So the assault on sophisticated financial instruments represents both the fear of the new, as well as an attempt to deflect scrutiny from the real causes of this crisis.

If this history isn't understood, we are doomed to repeat it.