Could this era of U.S. economic woe be ended through a housing sector rescue? Would it be wise to pursue a sector-specific intervention?

By Echelon.

Published on April 11, 2013 with No Comments


It seemed like a good idea at the time. During the 1990s, America went crazy for ‘subprime’ mortgages to homebuyers who failed to meet traditional standards of creditworthiness. For a while, this fueled a bonanza in rising home values as purchasers flooded the market. Investors meanwhile piled paper profits to the sky dealing in securities based on subprime loans.
Then it all came crashing down. The 2007 financial crisis, the ensuing recession and ongoing real estate doldrums all stem from the subprime mania.
The craze took off as lenders found they could sell off risky loans en masse in newfangled packages called mortgage-backed securities (MBSs). These got bought by investors willing to risk non-payment of some loans in return for large-volume returns on those that paid off. Financial houses were soon holding and trading huge positions on risks they knew nothing about.
The chief MBS pioneers were two vastly-profitable mortgage institutions known as Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation). Though Fannie and Freddie were private sector firms, they were uniquely chartered by the federal government to serve policy objectives.
Created to promote home ownership by making lending more attractive, Fannie and Freddie made money for decades selling default insurance to banks issuing mortgages. Over time, however, they expanded an originally supplemental line of enterprise: purchasing mortgages in volume, holding some on their books and packaging others for sale as MBSs. This helps mortgage lenders unload speculative assets (loans that might default) for immediate cash. As with default insurance, this lowers the risk of mortgage lending so that more loans get made at lower interest rates.
In order to foster low-income home ownership, Fannie and Freddie relaxed standards during the 1990s on loans they would insure and purchase. Meanwhile, banks and other financial houses dove into the game of buying subprime mortgages and bundling them into MBSs for sale. The risks of subprime lending seemed to disappear like magic. Banks became eager to make subprime loans because the risks could be sold onward into the MBS market for instant cash that could be used to finance even more loans. A previously minor lender called Countrywide jumped in with both feet, pushing out subprime loans as fast as it could and selling them, first to Fannie and Freddie and later to others. With loans jumping from $92 million in 1992 to $200 billion in 2004, Countrywide had become America’s largest mortgage issuer by 2004, largely thanks to its subprime portfolio. Fannie, Freddie, Wall Street and players from all corners soon entangled themselves in webs of risky loans and MBSs. Prices went through the roof. Between 1992 and 2006, average home values rose an astonishing 125%. The psychological ‘wealth effect’ of increased home values kept Americans on a prolonged shopping spree that pumped up the wider economy. But danger lurked in millions of homes, mortgaged to the edge of their owners’ means. Many borrowers did not understand the obligations they were undertaking. Many loans were ‘back-loaded,’ with easy payments early in the life of the loan but sharp step-ups later. Many banks failed to clarify terms in their haste to push loans over the counter and quickly resell the rights to collect on them.
obama quoteTrickling delinquency reports became a rivulet and then a river. Some financial houses with MBS positions faced massive losses, while others feared they might. Credit froze as lenders sought to gather and hold their capital. Business activity slowed. Meanwhile, the music in the housing market stopped. As prices began to tumble, homeowners saw their nest eggs melt away. Millions of families realized they could no longer borrow and spend but must instead save and save. And we know what happens when everyone stops spending at once.
Much of the buying was done with borrowed funds to boot. Wall Street, Fannie and Freddie all borrowed billions to support their burgeoning and for a time highly profitable MBS activities. Lenders supported the sector even as ominous default reports began mounting. Financers believed that their loans were safe because the federal government would furnish taxpapayer funds to keep Fannie, Freddie and Wall Street from defaulting, though no law required this.
That is precisely what happened. When they came up short of cash, Uncle Sam poured funds into Fannie and Freddie, while taking ownership of their assets and control of their managements. Whether taxpayers will take a loss on this unprecedented ‘investment’ remains to be seen, but the hit is potentially huge. It was much the same with Wall Street firms deemed ‘too big to fail.’ Faced with the risk of financial meltdown as Wall Street teetered, Uncle Sam duly opened his wallet.
Though the crisis-driven recession officially ended in 2009, recovery has been weak by historical standards. Four years into recovery, unemployment has barely dipped below 8%. Fears of a ‘double dip’ cannot be gainsaid and housing remains central to the story.
Past recoveries have usually been led by the housing sector: increased mortgage lending, new home starts, quick hiring for construction jobs, money in pockets, increased consumer spending. Precious little of that has been happening this time around and the recovery has been correspondingly weak. Taken by itself, the housing sector has remained in a recession that some even call a depression.
New home construction is down, construction and real estate employment down, mortgage lending down despite record low interest rates, sales prices down. It’s been unrelieved gloom for nearly seven years now, with an uptick only in the past few months. Roughly one quarter of all U.S. mortgages are now ‘underwater,’ meaning that the home’s value in today’s depressed market is less than the principal owed on the loan, taken out when prices were higher.
Banks, along with Fannie and Freddie, have meanwhile tightened up big-time on mortgage standards. Critics say they have overcorrected on previously lax standards at the worst possible time, especially since a lot of default risk was squeezed out of the market as prices and loan sizes fell back to realistic levels. Though some think the market has now at last hit bottom, few expect prices to rebound quickly.Could this era of U.S. economic woe be ended through a housing sector rescue? Would it be wise to pursue a sector-specific intervention? Does the fact that housing has failed in its usual recovery-sparking role argue in favor of a sector-specific intervention or against it? Are there interventions that would work or would it be better just to wait till people slowly find the money to start buying again? Do interventions have any chance of being enacted into law?
President Obama recently urged passage of a law promoting refinancing on mortgages owned or insured by Fannie or Freddie. New mortgages would be issued at current low interest rates, with householders using newly-borrowed funds to pay off their older, high-interest loans. With debt burdens lightened, homeowners would be freer to spend, thereby boosting recovery. Proposed by Democratic Senators Bob Menendez and Barbara Boxer, the law could save homeowners an average of $3,000 a year in interest payments.
Even with current low interest rates, many homeowners shun re-mortgaging because the associated fees outweigh the interest rate savings. Menendez-Boxer would cut the fees and hike the savings. Appraisal fees for new mortgages would be borne by Freddie and Fannie, which purportedly would recoup the costs by switching their insurance coverage from high-interest to low-interest loans less prone to default. Lenders would be banned from imposing closing costs on borrowers who put their interest rate savings into paying down the loan principal. And outsiders would be invited to compete against the original lender for each re-mortgage opportunity, which means that interest rates would be bid further downward.
In further encouragement of re-mortgaging, Menendez-Boxer would release re-mortgage lenders from legal responsibility to assess loan risks and would ban consideration of a home’s current value or the borrower’s income and employment status when deciding whether to issue a new loan, if payments have properly been made on the old one. All this would raise risks of loan defaults, risks to be borne by Fannie, Freddie and the taxpayer who now in effect owns them. Republicans who control the House of Representatives are not going to like that one bit.
> A graduate of Harvard Law School, Mark Hager consults on complex legal and writing challenges.


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