The latest noises out of both Fannie and Freddie are for increasing intrusion into housing, which is a sharp departure from where this was all heading (and where it should). The previous GSE administration (Ed DeMarco left in January, replaced by Mel Watts) had left the impression of winding down the troubled firms that have been in conservatorship since the week before Lehman failed.
Now Watts has made the statement that Fannie and Freddie are actively seeking a new entrance (really a return) to GSE favored status – as Rick Santelli first pointed out on his show. As part of winding down these government hybrids (in name), the plan was to reduce the ceiling on individual mortgage loans, thereby requiring more and more private participation in mortgages. Under Watts, that has apparently been scrapped.
Instead, it looks like Fannie and Freddie are seeking to reduce the credit standards for loan put-backs – legal instruments put in place after the collapse where it was “noticed” that banks “sold” all manner of junk loans to the GSE’s. The put-back clauses basically require any loan that begins toward NPL is mandatorily repurchased by the originator, indemnifying the GSE’s (and thus taxpayers) from more imprudent losses (really the breakdown of actual intermediation). That has led, rightfully, to a dramatic tightening of lending standards since banks do not want put-back risk after sale.
The theory that Watts seems to be courting, and which Santelli is rightfully upset about, is that reducing put-back standards amounts to the same type of behavior as we saw during the big housing bubble. In reality, it is an attempt to inject more leverage into housing.
I don’t think the timing is coincidental here, particularly as even FOMC members and Janet Yellen herself have gone soft on housing interpretations lately. It has become pretty clear that the mini-bubble of Bernanke’s QE3 is being burst with his taper gift to the new regime. What better way to try to mitigate the damage (decimation) in mortgages than stirring up GSE favoritism.
The leverage of the GSE intrusion hides a very simple fact, namely that mortgage lending in this paradigm is unprofitable on its face. In the traditional, intermediation of actual lending, banks are not going to make any money on a 3.5% to 4.5% mortgage (or for that matter any of the “historic” lows of the current age of central bank activism) – the vast majority of profits are derived elsewhere (the words “gain on sale” were the biggest free leverage boost in human history). But since the orthodoxy at the Fed has determined that low interest rates are “necessary” to conduct its experimentation with “aggregate demand”, the financial system has created all these ad hoc, but approved, means of extracting indirect profits.
Low nominal mortgage rates, first of all, put more emphasis on volume and flow than creditworthiness. Second, and this is where the GSE’s are vital, that needs to be augmented by both funding leverage and regulatory leverage. By shipping individual mortgages to the GSE’s to be pooled and securitized, what comes back into the “market” is a security with the lowest possible capital charge to a bank’s balance sheet (regulatory leverage). Further, that security is highly repo-able, and thus very much eligible for rehypothecation (funding leverage). Without the GSE’s, this leverage disappears and mortgages as a whole become much more of an actual market proposition (and no one apparently wants that).
So the Watts’ proposition is one in which the GSE guarantee ,and thus leverage coverage, is expanded to a larger potential mortgage pool. Ideally, from this perspective alone, that will be self-fulfilling as more leverage opportunities raise the profitability proposition (artificial as it is). The net effect is intended as yet another boost to mortgages and housing.
Again, as I said this morning on Rick’s show, this is all extremely inefficient, not the least of which is the convolution necessary just to make this plausible. It’s a horrible policy in its basic construction.
One major problem, and the issue that I raised last week, is that this is nothing but socialism’s unacknowledged counterpart on the financial side. A true market is one in which resources are allocated based on true profitability, signaling wide and broad through the free setting of prices. If a particular market is unprofitable on its own, resources will flow elsewhere. That would mean of mortgages far less resources dedicated to that financial end and in the real economy.
The Fed and the fiscal meddlers will not allow that, and have not for decades. Where banks should have been reducing mortgage exposure across all system levels, the market’s clear determination was intentionally undone by both interest rate targeting and GSE-provided dual leverage. Instead of markets allowing an imbalance to clear, government intrusions toward a social goal of economic growth (inefficient as we see it now through bubbles) did not allow or even countenance such. And now they are stuck, and us with it. Any hint of an actual market reckoning will mean renewed price pressures as well as a rerun of financial indignities.
As it inevitably failed in 2007 and 2008, and appears on its way again in 2014, the blame falls on free markets and capitalism. None of this is anything close to free markets and capitalism. The free market says unequivocally that mortgage lending in the strict, capitalist sense of intermediation is unprofitable and has been for a long, long time. Take away these artificial forms of leverage and resources will mercifully stop flowing to where they aren’t really needed (here in South Florida they are building massive new apartment complexes in the shadows of still mostly-empty condo buildings).
If you can find a free market in any of that, be my guest. What I find there, on the other hand, is one big clue as to why the economy suffers as it has for so long. Namely, this forced financial inefficiency is, by its very nature, a drag on both current growth and potential. Resources are supposed to allocate via true profitability, thus assuring long run, sustainable growth. This leverage is the opposite.
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