Bailout of Freddie Mac and Fannie Mae

What does the move by Treasury secretary Paulson and OFHEO director Lockhart this weekend to put both Freddie Mac and Fannie Mae under conservatorship mean? What conservatorship means is that the federal government has agreed to absorb up to $100 billion in potential future losses of the two institutions. There are all sorts of ways that one could try to put this in some perspective: at one extreme you could characterize the decision as Paulson and Lockhart as tantamount to their promising that every man, woman, and child in America pay as much as $333 apiece for the excesses of Freddie and Fannie management (and that much of this could have been avoided if Congress, President Bush, officials in the Treasury, or at the FED had done something earlier to rein in these two institutions before they got to the point they are now.) At the opposite extreme you could argue that for less than what the typical American family spends in a month on cable services and cell phones we have, at the very least, bought some time for badly stressed financial markets and, at best, taken action that will help us move forward out of the liquidity crunch that world financial markets face. The fact of the matter is that we have been part of a massive run up in housing values that has been fueled by and which in turn has helped perpetuate a massive expansion in the volume of mortgage credit granted to the US population as a whole. With 20-20 hindsight it is easy to say that we should have known better. However I am not confident that we will ever learn. We should be thankful that the much ballyhooed fall in housing prices only really bites those of us unfortunate enough to have purchased homes since the end of 2005. Not to minimize in the slightest the plight of those who entered the housing market at precisely the wrong time, the decline in housing prices only began nationally in the Spring of 2007. For those of us who purchased homes at at any time prior to this the market value of our homes is still higher now than when we purchased them and for those of us who bought in the early to mid 1990s or earlier, just following national trends, the market value of our homes remain ridiculously inflated (on average over two times higher in value now than in the early to mid 1990s) SHOULD WE HAVE KNOWN BETTER? In today’s New York Times (NYT “Countdown to Inevitability”) former secretary of the Treasury under President Clinton, Lawrence Summers, is quoted as saying that he had expressed grave concerns about the explosive growth in Freddie Mac and Fannie Mae’s mortgage loan portfolio and the increased investment in subprime and other risky mortgages. The current administration is far less inclined to worry about decisions being taken when those decisions are being scrutinized by the market and so can perhaps be excused for being so slow to react. The point is that we are at present in a position where vis-à-vis the bailout there is really no other choice open to us. The more fundamental question is indeed how to avoid such crises in the future or more fundamental still, whether, we have the ability to avoid them. In form or another the principles of increasing risk first explicitly outlined in a paper published by Michal Kalecki over seventy year ago (M. Kalecki, “The Principles of Increasing Risk” Economica, November 1937), further developed by Hyman Minsky, and as of late, again the focus of our attention thanks to Nouriel Roubini suggests that part of the price we pay for a sophisticated financial system are these sorts of problems. At the same time, it would be foolhardy in the extreme to celebrate such episodes and to do nothing to prevent them from happening in the first place. At Freddie and Fannie we have seen mortgages or mortgage backed securities owned or guaranteed by the two grow by over a factor of 6 since 1990 and more than doubling since 2000 with an increasing share of these being subprime and Alt-A mortgages. The fine line between making credit as easily available as possible and being over-leveraged is what at root needs to be drawn, despite the fact that it is indeed a fine line. We should look to the specific statements made by both nominees regarding this issue of leverage and try to gauge how well either understands the inability of the market to discipline the financial sector seriously enough ex ante and gently enough ex post. For a bit more background on these two institutions click here.

Housing prices and news coverage of the subprime crisis.

In an interview with Newsweek's Daniel Gross last week, one of the hosts of NPR's All Things Considered, Robert Siegel, described a hypothetical family that had their home appraised at $300,000 last year. He went on to ask Gross to explain the effect of the value of this family's home falling to $250,000 , rather than rising to $350,000 as they might have expected. Mr. Siegel's line of questioning is typical. We accept the notion that across the country housing prices are falling and falling sharply. Given this, we conclude that consumer spending will weaken in the months ahead, perhaps significantly enough to push the economy into recession. The current situation is serious. On the one end of the spectrum you have poorer families - only recently becoming homeowners- who are now losing their homes. In the face of higher interest rates they are unable to make payments. Banks have either abandoned the subprime market entirely or have tightened their lending standards. Either way, other families who might buy these homes cannot raise the money needed. The two forces combined have led to an increase in foreclosures and a glut of inexpensive homes for sale. Not coincidentally, at the other end of the spectrum, there have been increased requirements for those borrowing to fund the purchase of homes with values well in excess of $400,000. What subprime mortgages and jumbos have in common is that Freddie Mac and Fannie Mae refuse to touch them. Borrowers taking out "jumbo mortgages" have typically been asked to pay a minimum of 5% as a downpayment and a premium in interest over what conventional conforming mortgages charged. It is because luxury homes are less liquid (because they are hard to sell quickly without a fairly substantial cut in price) and because of a general desire to limit risk until a clearer picture emerges that lending standards on these sorts of loans have tightened as well. (See "Subprime Mortgage Woes Spreading : Subprime Mortgage Crisis Spreading to High-End Housing Market" AP Wednesday August 29). Therefore the trouble is at the two extremes of the market, where the supply of homes on the market has increased while at the same time, and for the same reasons, the demand for such homes has been depressed. Many banks, formerly in the business of originating these mortgages and then selling them, have seen demand plummet. Where does this leave Mr. Siegel's middle class family with a very nice, fairly new home? They are probably okay. Rather than a home that was worth $300,000 last year selling for only $250,000 today, it would more than likely sell for $308,000-$310,000. (See OFHEO's website) The present crisis as serious as it is, is largely confined to the two extremes of the mortgage market already mentioned. to banks originating such mortgages, and to institutions such as Countrywide that have become more heavily involved in both extremes of the mortgage market. It is an old story, one reminiscent of the junk bond market, where tempted by the higher yields on riskier investments investors convince themselves and others that the market's assessment of risks have been too high. In short, the impact on the consumer spending of middle class America should not be as great as one might imagine. There are if you will several leaks in the roof and serious repairs are needed but the roof is still basically sound and if we patch the roof it should be okay. Pick a different housing price index and you will get a very different number: Estimates of what has happened to housing prices vary enormously. It is indeed confusing. The NAR (National Association of Realtors) suggests that in the second quarter of this year housing prices declined (in fact, NAR sugggests that it is the fourth successive quarter of such declines ). The decline in housing prices according to the NAR number was not as severe as the drop year-over-year in the fourth quarter of 2006 when prices fell by their reckoning 2.7% but still in the second quarter of 2007 they were 1.5% lower than a year earlier. According to the Case-Shiller index however in the second quarter of 2007 there was a "record fall" in housing prices in the second quarter of 2007 with prices falling on average by 3.2% between April-June of this year. Finally, the numbers I used to adjust Mr. Siegel's example are based on the housing price index (HPI) reported by the Office of Federal Housing Enterprise Oversight (OFHEO) which indicated that housing prices rose between 2.6% to 3.2 % over this same period of time. The reason for these discrepancies is, of course, due to the fact that each statistic reported includes or excludes different numbers. (For more detail see "Consider the Source" by Lasalle Bank Associate Economist Adolfo Laurenti) Out of the three just mentioned, the Case-Shiller and OFHEO HPI are far more reliable. Both are to be considered to be so because they are paired-sales statistics. This means that it is the price of particular properties that are tracked over time. Other indices, such as the figure given by the NAR are not paired and as a result are sensitive to not only what is happening to the price of homes themselves but to the types of homes being sold. A drop in the NAR statistic could just as readily mean that proportionately more modestly priced homes are being sold than that the price of houses in general are going down. Say that previously 50% of homes being sold over a three month period were sold for $50,000 and 50% for $200,000. If the proportion of homes being sold in the $50,000 range rises it would not take much to generate a huge decline in the average price of homes being sold (a shift to from a 50% to 60% share would cause the average to fall by 12%!). Nonetheless while OFHEO's HPI indicated an increase in hokme prices, Case-Shiller indicated a decline. The difference between Case-Shiller and the OFHEO's HPI can be explained by the fact that the HPI only considers what is happening to the price of homes being purchased with conventional conforming mortgages while Case-Shiller includes jumbo mortgages. In short, the clearest picture we get nationally for the great middle section of the housing market is not a decline. Rather what is happening to the value of many middle class families' homes is that they are still increasing, albeit at a much slower rate (3.2%) than they had over the last five years overall (an annual rate of about 8.5%) So Why Does This Matter? There is first and foremost the impact of of all of this on poorer families that is going largely unreported. (See however the dicussion of turning properties that would otherwise go into foreclosure into rental properties on Marketplace Morning Report September 6th, 2007. Click here ) There is also the fact that the recent crisis has increased the number of individual financial investors who wish to sit on the sidelines with their cash and wait to see if a clearer picture emerges . This flight into liquidity has inadvertently dampened the demand for commerial paper as well as restricting poorer families' access to credit [(1.) For the significance of commercial paper see "Commercial paper market still shrinking: Asset-backed securities fall 15.6% in past three weeks" by Rex Nutting for MarketWatch Aug 30, 2007. (2) For the reasons behind this shift away from commercial paper see "Subprime `Tsunami' Hits Asset-Backed Commercial Paper Market" by Mark Pittman and Elizabeth Stanton for Bloomberg.com August 8, 2007]. What the Fed has done and promises to do is,simply put, a move to provide the extra cash to satisfy an increased desire for liquidity and therefore quite necessary. And President Bush's promise to assist families caught up in the subprime crisis, if sincere, is also a move in the right direction. However, it is debatable in the extreme that the majority of middle class families have anything immediately to fear in terms of falling home prices and higher mortgage interest. In point of fact, Countrywide and other mortgage brokers are trying to redeem themselves financially. They clearly intend to do this by sharply limiting their investments in mortgages that Fannie Mae and Freddie Mac will not purchase: subprime and jumbo mortgages. Middle income households represent the salvation of mortgage lenders as they turn their backs of higher risk, poorer borrowers. (for more click here.) To focus on falling home prices and the possible impact on middle-class consumers diverts our attention away from the real issues involved. For a previous blog on related issues click here.

personal savings, consumer debt and subprime mortgages

I have been trying over the last several days to come to grips with the current subprime mortgage "crisis". We Americans are exceedingly fond of beating ourselves up for not saving enough, for carrying excessive amounts of debt, and for taking too many risks. The numbers, as they are reported, seem to confirm these things. Consumer debt is at record levels, our personal savings rate is negative, and there are a number of families who, having bought homes over the last few years, cannot make payments on their mortgages (a , b,c,d). Some very fundamental questions present themselves. Is it really the case that Americans spend too much and save too little? Do we really carry too much debt? Are we too willing to take risks? (Of course there are too many of us and we consumer far too much of the planet's resources than we have any right to but that is another matter. Environmental concerns be damned in what follows and let's focus on the question of savings, debt, and what can be refered to as "financial fragility". ) The personal savings rate. Imagine a young couple who last year earned good salaries and, after paying their taxes, paid all of the interest due on their student loans, credit card debt, and car loans. With the balance they paid rent, bought food, paid for entertainment, bought electronics, and paid for a variety of services. They will have not saved a dime by the reckoning of the BEA (the Bureau of Economic Analysis, the agency that reports the personal savings rate each month.) This despite the fact that they have given up spending on goods and services now to pay the interest they owe on the their financial obligations. Imagine a family that has a home that has gone up in value by quite a lot. Their 18 year old daughter is off to her first year of college. They refinance their mortgage at a lower rate of interest and take cash out of their home. The cash taken out of their home and the money freed up by lower mortgage payments are used to help fund their daughter's first year in college and to make improvements in their home. Despite the fact that they are spending money on their daughter's education and are protecting the investment already made in their home the personal savings rate will decline as a result of what they have done. Imagine someone who bought shares of stock last year for $10,000 and then sells them this year for $40,000. The net capital gain let's say is $20,000 and they spend it. The $10,000 they pay in taxes and the $20,000 they spend will be counted as $30,000 pulled out of past savings and reduce personal savings by $30,000. Despite the fact that what has happened is qualitatively quite different from having put $30,000 in the bank last year and then drawing on those savings this year it will be treated in exactly the same way. All statistics are flawed but the personal savings rate has several. (See also a). When stocks are being sold to realize capital gains and the money from this is spent personal savings decline. When mortgages are being refinanced and cash is taken out to do the sorts of things described in the above example personal savings fall. When families take a sizeable portion of their earnings and use it to pay interest on debt, if it is not interest paid on mortgages, personal savings drop. In short, any economy in which financial values are rising and in which the value of new and existing homes are rising, interest rates are falling and refinancing is common you should expect to see this number fall. While we responsibly pay for the privilege of enjoying goods and services sooner rather than later by making car loan payments and payments on out credit cards, as we put money into our children's education and our homes and as we enjoy the good fortune of having made financial investments that have gone up in value we are told that we are spendthrifts. Taking the personal savings rate at face value, we fell as guilty as someone who takes the family's meagre paycheck and spends it all at the corner bar on drink and betting. The investment ratio: A considerably more meaningful figure can be calculated from statistics reported quarterly by the BEA, the investment ratio. The investment ratio is the ratio of gross private domestic investment to total production. It measures how much of total production in a quarter has been devoted to maintaining or expanding our stock of physical capital. Indirectly, it measures how much of the resources we choose to employ that are used to produce machines, tools, build buildings, spend on computer software and hardware and so on. It is the nature of the beast that this number fluctuates quite a bit. Not surprisingly the lowest it has been was during the Great Depression of the 1930s (1932 the investment ratio was under 2%). Even with the extremely low figures for the 1930s included we have devoted an average of over 11% of our productive efforts each year to investment. Last year in 2006 it was 17%. If we broaden our focus to include not only private investment but include as well investment carried out by state and local governments and the federal government the share of production devoted to maintaining or expanding our stock of physical capital was a little under 19% last year (with an average since January-March of 1988 to the second quarter of this year of 17.52%) . Therefore as a nation, last year we devoted a little under one-fifth of our efforts to providing for our future. This is not at all bad. And this number does not include the share of our produtive energies devoted to educating ourselves, keeping ourselves healthy, and keeping ourselves safe.

Consumer credit:

Isn't it still true that the average American family carries massive amounts of debt? Without question we do. Looking at figures from 1953 to the present the ratio of household liabilities to personal income has grown significantly. But this simply means that we spend now and save later. Our savings take the form of interest payments and payment of principal on the funds we have already borrowed. We save ex post (after the fact) not ex ante (before the fact). This debt is part of the price we pay for enjoying goods and services sooner rather than later and it does carry with it certain risks. Our ability to retire this debt is senstive to the rate of interest charged, the total amount we have borrowed, and what happens to our earnings. If I use my credit card to make major purchases, the more I charge to this card, the higher the interest rate attached to this credit and the lower my income is as I pay back this debt, the larger the share of my earnings I must commit to paying interest and the original amount charged if I am to retire this debt any time soon. The temptation to delay this final day of reckoning and the almost inevitable need to so as unexpected expenses come up means that for many individual families the burden can grow to be considerable. We may in fact long for the mythical days when to buy something one had to build up cash reserves over time. In this case, in the event of a broken windshield and $100 deductible to cover or hundreds of dollars in plumbing bills, one could draw on these balances and simply delay further the major purchase originally planned.

The moral virtues of delayed graitifaction aside, the real advantage of "saving-up" for something then is the flexibility is provides. The temptation of simply putting off payment, the risk of rising rate being charged on balances you still owe and the financially precarious position one faces having amassed such debt if their earnings decline are the real reaons to be concerned about consumer credit. The personal advanatges of controlling spending and using this money to make extra payments on the mortgage, on car loans, and on credit cards are very real. And a shift from the buy now/pay later mentality that easy access to consumer credit makes possible would provide the sort of freedom of manouevre already discussed. However, these actions will weaken the financial position of businesses accustomed to the trade of such familes. As their revenues fall, given costs, profits and cash flow will decline. It is this a very fundamental fallacy to reason from the individual advantages of higher savings that it will be socially advantageous. Reduced spending will free resources that could be used for more investment. However, since saving in the aggregate will not increase -increased personal saving leads to reduced business saving- the rate of interest will not fall. And the degree to which these businesses rely on cash flow to honr their debts, any belt tightening by households will simply push the burden on to the business sector. At any rate, although we obviously save today so that we will have the power to spend sometime in the future we have only the vaguest ideas of what form exactly this spending will takeor when it will take place. As a result, assuming they could somehow raise the funds to employ investible resources, businesses contemplating investment are left to themselves to decide what fraction of the resources available they should employ and in what direction they should employ them. Subprime mortgages: It is interesting to go back to comments made by Greenspan in 2004 regarding what we now refer to as the subprime market. He pointed to advances in computer technology that made it easier to identify good credit risks out of the pool of low income borrowers. In particular he was referring to the automated underwriting systems such as Freddie Mac's Loan Prospector (see a, b, c, d). These systems promised to make it possible to extend credit to many who otherwise might be denied mortgage credit under traditional underwriting. With automatic underwriting systems to screen applicants (and separate the wheat from the chaff high credit risk borrowers from lower risk ones) Freddie Mac claimed in 1996 to have reduced such costs by on average $350 to $600 per loan (a) (For claims made more recently that it is has been reduced by over $900 see b). As a result of such technologies, lenders- anxious to mine a previously untapped vein of borrowers and to tap a market where the rates charged typically were 2% points higher than a prime mortgage for the same amount would be- aggressively begain issuing mortgages to economically poorer families with less of an estiablished credit history in more depressed areas. Banks increasingly originated variable rate mortgages to low income families to purchase modest homes. According to one source, last year in 2006 20% of all mortgages granted were to subprime borrowers. The social benefits of subprime lending are that home ownership rates have risen from 65% of the population to 69% with 12 million new homeowners and approximaltely half from racial minorities (see a and b) Greater competition among banks for the business of higher income families with proven credit histories and buying expensive homes meant that potentially greater returns could be obtained by those moving into the subprime market. The securitization of such mortgages meant that there was money to be made through fees paid to the banks that originated these mortgages and the pooling of such loans into firms specializing in subprime mortgages meant that the risks could be spread out among a large number of investors. Lending to lower income families at variable rates of interest is one thing when jobs are relatively plentiful and market interest rates are low. It is quite another matter when higher interest rates are targetted and weakness in the overall economy (or specific sectors such as construction and the automobile industry) and the housing market caused in part by higher interest rates are coupled with competition from abroad, immigrant labor and computerization reduce employment opportunities and growth in earnings. Also, unlike prime mortgages, subprime mortgages more often than not carry substantial prepayment penaltie. Typically they were set up in such a way that they were more than viable in an economy with low interest rates, easy refinancing, and rising house prices but carried, as we can now see, a considerable amount of downside risk. Were lenders who originated these mortgages, the companies that bought them, and the borrowers blind to these risks? Probably in the case of many borrowers yes. Less financially savvy, eager to buy their own home, and trusting the authority of bankers and mortgage brokers they have workers with, they focused on the initial terms of the mortgage and were reassured that later on they had little to worry about. What is chilling is how little attention is being paid to 1 million plus families who are expected to go into default this year and therefore who will face foreclosure. Equally chilling is that the many families who were misled, given the complexities and layering of these securitized mortgages, have a far more daunting task if they wish to complain of consumer fraud than if this were a more traditional mortgage both issued and held by the bank that set up the mortgage(See Kiff and Mills). In the case of the bankers, mortgage brokers, and investors who provided the demand for subprime mortgages, rather than being blind to these downside risks they have rightly assumed that downside risks would be shared and, if lucky, the lion's share of the burden would be borne by others. Many involved in the formerly lucrative business of originating subprime mortgages are leaving both the families they lent money to and the investors who bought these mortgages from them to twist in the wind. That the focus has been on the latter group and the much more economically and financially significant repercussion of their difficulties is shameful. The real victims are those who have lost their homes and suffered the embarassment of default. Should the Fed and other central banks intervened as they have? Consider what the root causes of this crisis are. Many subprime mortgages start with the first two, three, or five years at low fixed rates and then change over to variable rate loans. The rates charged on variable rate loans may be a high as a full five percent over LIBOR. In addition to income and a borrower's debt service ratio, the feasibility of refinancing will depend on the ratio of the amount of money that must be borrowed to retire the old debt and convert it into a new mortgage relative to the value of the home. With prepayment penalities and stagnant or falling home prices the amount to be borrowed climbs as well as the loan to value ratio rises. First lax regulation by the Fed and other regulatory bodies allowed banks to become increasingly cavalier about credit risk. Second, Fed policy since 2004 has been to tighten credit and push interest rates higher. The fed funds rate stands over 4% points higher than it was in June 2004. Fed monetary restraint, whatever the intention, in turn has contributed to the fall in the U.S. housing market. All of this has made payment of existing mortgages or refinancing difficult if not impossible for subprime borrowers. This crisis, like the foreign/Latin American debt crisis of the 1980s or the Dot.com bust of the late 1990s, is therefore due to no small degree to shifts in Fed policy. Since the current crisis is in part the Fed's doing, it is only right therefore that the Fed do something. I am little concerned that specualtors will come to expect the Fed to bail out markets when they falter significantly and therefore become more reckless still. It seems few involved with Fed policy understand how often in recent years they are simply being forced to offset the harmful effects of the sort of stop/go cycle that constitutes modern monetary policy. If Fed officials fail to discern this pattern why should one expect private investors, with a much narrower and a shorter time horizon, to see one? Since Hyman Minksy, inspired by Irving Fisher and Michal Kalecki, wrote about these issues in the 1960s and 1970s we have understood that the price we pay for a robust growing economy is the sort of excesses that we are seeing now. The Fed has again shown its incredible knack for tapping on the brakes just as we are starting to climb up a very steep hill. What is regrettable is how little attention is given to the low income homeowners being crushed under the wheels of our economic machine as it rolls backwards.