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Wednesday, July 23, 2008

A Disaster in the Making

The so-called "housing bill" sailing through the House and Senate on its way to a promised Presidential signature contains every tell-tale sign of an economic and legislative disaster in the making:

* legislation involving hundreds of billions (if not trillions) of dollars
* legislation seemingly drafted in DAYS
* legislation drafted in response to a crisis
* legislation that injects government programs into private transactions
* legislation aimed at spreading risk and transferring costs of bad risks
* legislation whose costs cannot be predicted with more than a power of 10 accuracy

Here are the particulars.

Billions / Trillions

The very existence of Freddie Mac and Fannie Mae, much less their current precarious financial condition, illustrates the danger in devising economic policies that require public agencies to become an actual PARTY to vital business transactions between private parties. The supposed "need" for Freddie and Fannie to provide "liquidity" to secondary markets for home mortgages makes no more sense then claiming a need for a "Frankie" GSE to provide liquidity to sales of individual stocks or bonds. Assets which are fairly valued in a transparent, properly regulated market will find their own level. Isn't that what free-market proponents believe? The creation of GSEs which implicitly backstop errors in private judgment with public dollars produced a monstrosity that morphed into a required presence on over 50% of all mortgage paper in the country. When a government entity becomes a party to over fifty percent of private party transactions in a so-called capitalist economy, no long-term public purpose is being served.

Drafted in Days

Doomsayers have been forecasting problems with mortgage markets for nearly three years. Americans saw two major illustrations of the vulnerability of the financial markets in August 2007 (liquidity lockup) and March 2008 (Bear Stearns) followed by a few "warning shots" in the form of 1Q2008 earnings problems and write-downs for major banks, yet no major legislative push was seen until July 2008. Suddenly, it appears we are nearing enactment of an astronomically expensive "fix" within days. 63 days in fact, from May 20, 2008 when it cleared its first major Senate subcommittee hurdle.

Do you really think key provisions of this housing bill were drafted in the two months since the problem really captured center stage in Congress? Congress isn't noted for doing its best thinking on ways to spend hundreds of billions on short notice. That's why they leave it to lobbyists, who in fact have been preparing language for just this occasion for many months. According to The Washington Post (#1), Credit Suisse and Bank of America spoon fed proposals for mechanisms that would allow "under water" mortgages to be refinanced with lower interest rates made possible by government guarantees. Of course, the program helps the banks by making it possible for more loans to be put back in the "performing" bucket (with taxpayers covering the additional "risk premium" required to yield the lower interest rate) or more easily get those non-performing loans off the banks' books entirely.

Responding to Crisis

Again, doomsayers have been forecasting problems with mortgage markets for over three years, yet the Federal Government failed to intervene earlier in the process for fear of "talking down" the economy and hastening the collapse. Now we've reached a true crisis point where free-floating anxiety on Wall Street and world markets produces chaotic liquidity freeze-ups every two months and failures of banks not even on FDIC watch lists absorb twenty five percent of the Federal Reserve's own reserves. NOW the federal government becomes engaged looking to "help" because "people are hurting" and problems with one bank's bad practices can't be allowed to become a contagion to poison an otherwise "sound" market.

Oh boy, big government's two favorite constituencies are hurting. Borrowers too stupid to understand the implication of adjustable rate mortgages who are also likely to be too stupid to grasp the transfer of losses from private banks to their future tax bills. Banks who are willing to fund the next campaign in exchange for my vote on legislation they spoon-fed to me freeing me to attend even more fundraisers.

Public Middlemen in Private Transactions

As mentioned previously, the proposed housing bill contains language helpfully crafted by Credit Suisse and Bank of America that expands the role of government entities in playing an active role as clearinghouse for troubled loans. Any such scheme is virtually assured to fail because it perpetuates the faulty valuations in home prices and mortgage serviceability. Think about what the skyrocketing foreclosure rates actually say about the income of the borrowers. ARM rates typically jump from an artificially low teaser rate to a 1-year benchmark rate plus a slight premium (maybe 0.75%). ARM rates don't jump from teaser rates to loan shark rates (11 - 15 percent). If a borrower cannot afford the slightly higher (1-year + premium) rate, they could refinance with a traditional 30-year mortgage with a lower 30-year rate if long term rates are lower than short term rates.

The fact that neither of these alternatives makes sense for borrowers facing foreclosure means only one thing. The borrower is occupying a home they cannot afford when paying market rates for interest. If one truly believes the free market knows best, this is a tell-tale sign that risk is not being properly factored into the equation or that someone / something is distorting that market mechanism in the short term for private gain.

At the macro level, this means one of the following is true:

1) thousands of people are sitting in homes which may be fairly priced but THEY cannot afford
2) thousands of people are sitting in homes which themselves are over-valued because of the artificial demand made possible by fraudulent lending practices and artificially low teaser rates

The 2008 housing bill not only increases the role of federal government entities as middlemen in real estate transactions but it also throws billions to state governments to buy up foreclosed properties to somehow help recondition them and sell them. Do we really want state governments trying to flip houses as well? Is this capitalism?

Spreading Risk / Transferring Costs

We already know that the creation of GSE middleman with the implicit backing of US taxpayers encouraged fraudulent retail lending and fraudulent rating at the wholesale level on mortgage backed securities. However, the proposed housing bill contains no provisions whatsoever to apply penalties for gross fiduciary failures on the part of retail lenders or mortgage resellers and arguably rewards fiduciary failures on the part of individual borrowers. This socialization of risk and cost actually continues the incentives which produced the crisis in the first place. A classic sign of bad public policy.

Open Ended Costs

Current estimates put the cost of the 2008 housing bill range from $93 billion to $300 billion. $93 billion according to the CBO assuming if only $68 billion in loans require backstopping and bailing out Freddie and Fannie only costs $25 billion. (#2) In reality, nothing in the legislation establishes upper bounds on expenses generated by the program nor any criteria to use in deciding the problem is fixed and the program is no longer required.

Now think back to the goals established at the creation of Freddie and Fannie. My guess is they were something along the lines of "enable affordable housing by establishing secondary markets in mortgage securities to improve liquidity and balance geographic market variations." Very motherhood and apple pie, warm fuzzy stuff. Nothing in that mission statement would seem to imply the need to become involved in over half of all mortgages in the country. Nothing in that mission statement would seem to imply the need to provide a secondary market for $500,000 loans on McMansions in overpriced real estate markets. No one in the market for a $500,000 home ANYWHERE in the country is in need of government agency assistance for "affordable" housing. You can "afford" a house if you can consider a $500,000 home, You just maybe can't afford a $500,000 home and THAT'S not a public problem.

By failing to establish clear-cut, numerical limits on the size and scope of GSE involvement, Congress created a monster which overtook the center of the market it was intended to merely stabilize. The proposed fixes in the housing bill repeat this failure by failing to cap the volume (in units or dollars) of loans eligible for additional backstopping via public dollars. It doesn't even contain language limiting the mechanisms to loans originated prior to the effective date of the bill, which would not only impose an obvious upper bound to the number of loans that could go through the mechanisms but would also communicate clearly to lenders and borrowers that future idiocy won't be protected by public dollars.



#1) http://www.washingtonpost.com/wp-dyn/content/story/2008/06/24/ST2008062401804.html

#2) http://money.cnn.com/2008/07/23/news/economy/housing_bill/