Real Estate Market Collapse: Whose Fault was it?

The trend is to leave all fingers pointed to Fannie Mae and Freddie Mac, the two government sponsored companies who repurchase and are in control of nearly 90% of the mortgages in our country. In essence, they are the driving forces behind mortgage lending in this county. However, to blame mortgage repurchasers is a very superficial approach, and shows a very superficial understanding of the economic factors influencing lending and banking. Here’s the true story of the market collapse. The tale starts in September, 2001, focusing on the actions of the less-than-capitalist aspect of our supposedly capitalist economy.

We fear pure capitalism because, upon poor financial happenstance, there will be no available means of control to potentially navigate through any economic storm. Laissez-Faire, the concept including no government intervention, carries with it negative stigma rooted back to Herbert Hoover’s perceived apathy in the Great Depression’s insipient stages, so we avoid it. To counter this thought, we have powers allotted to the federal reserve, allowing: the manipulation of our money supply through federal funds trading on the open market, the ability to instill reserve requirements on banks, and changing the discount rate by which the reserve will lend to banks on the short term. Most important here is federal funds trading, and its influence on the Federal Funds Rate – the rate by which banks can borrow from one another. Banks borrowing from one another is pivotal to mortgage lending as a bank may borrow money from another at the federal funds rate and loan that same money out to individual borrowers (home purchasers) at a higher rate. However, these interbank loans are typically short term, and the principal must be re-paid quickly. To do so, banks re-sell these loans in a secondary loan market at a profit, and the original interbank loan can be repaid. When interest charged on interbank loans is low, money is cheaper and more available for investment. In order to profit from the re-sale of loans, banks must relend at a higher rate than that at which they borrowed. In that way, the loan may be re-sold at a higher value.

Okay, now we know, in general, how borrowing and lending can be parlayed into profitability. However when we speak of mortgages, banks must have a conduit of re-sale, especially if the money used to fuel a mortgage issued from interbank lending, as outstanding loans must be paid to originating banks. For many reasons, the main re-purchasers of mortgages are Fannie Mae and Freddie Mac, so without them, mortgage lending will not work as described. The two companies are sponsored and supported by the government, so they are subject to the desires of our governing body. Remember this note, as it will be useful later.

So much of our banking system is based off of mortgage lending, as 70% of American’s own homes, and the largest assets of most Americans are their homes. Knowing how pivotal the ability to issue and resell mortgages is to our banking system, real estate market and our overall economy, it is understandable why the government would pledge its support to the two institutions that maintain so much liquidity and velocity in the real estate market, and moreover, our economy.

After 9/11, the Federal Reserve and, more generally, our government feared that the economic losses suffered along with the potential of further loss would penetrate too deeply into our economy. To counter this possibility, trading on most stock exchanges was suspended for nearly a week; the Federal Reserve pumped $300 million in liquidity, and eventually dropped the effective federal funds rate to an astoundingly low 1%, remaining this low until 2003.  Now, I have my views on why these tactics were misguided, but for the sake of brevity, let’s move forward. Now that the Federal Reserve mitigated such a low rate at which banks may borrow from one another, there was a surplus of inexpensive money available to banking institutions. Because of this, banks could offer loans to individuals at significantly lower interest rates than before. Now, borrowable money was inexpensive enough and available enough for many individuals to mortgage homes who had previously not had the ability. Furthermore, the spike in demand came from sub-prime borrowers, as they were the ones whose door of opportunity had freshly been open. The banks could afford to lend money at a low sub-prime rate, and could now charge a surplus because of the poor quality of borrower, while still maintaining affordability to these borrowers. Banks were now creating huge spreads on money borrowed to money lent, borrowing at 1% and lending at 5%, as an example.  The 5% was still historically low, especially considering the poor quality of borrowers – made possible by government manipulation of interest rates.

Sounds great right? Everyone was buying, circulating money – banking and real estate both booming. Here’s the problem: mortgages are long-term loans, and these particular mortgages were organized around an unusually low rate of interest that spurned from a short-term cause. Fannie and Freddie cannot repurchase loans that do not have long-term marketability because they sell interest-bearing securities backed by those mortgages. If the interest and risk on the mortgages cannot compete with other interest bearing securities that will exist in the future, few people will be willing buy the mortgage-backed security being the riskier, less profitable investment, and alas, significantly driving down security price.  So, why would Fannie and Freddie repurchase loans that could eventually lead to loss?

The government sponsors these companies to maintain liquidity and accommodate for demand in the mortgage market. Essentially, it is the job of these companies to find a way to make mortgages available to the public, an extremely important responsibility, as home purchase is by far the largest financial transaction of the American family; if these transactions suddenly had limited means of actually occurring, the effects would corrode our economy from construction to banking to investment spending and everything in between. Our governing body does recognize these facts, and that is why it has offered full support of the services provided by Fannie and Freddie, but along with the support, the companies must adhere to the requests of their sponsor. The time of low interest rates in question provided a huge opportunity of profitability for banks and private investors, while offering home ownership to those once excluded from the housing party, but we still have a problem: the two companies were pushed to repurchase loans that had no long term profitability, as future securities will out perform these particular mortgage backed assets once interest rates climb. Without government influence, the two companies likely would have avoided purchasing these loans to incorporate into their mortgage repackaging, but politically levied orders forced the companies to find a way to meet the new demand for mortgages, as it was an apparent opportunity for economic profitability, and for some time it was. So how did Fannie and Freddie manage to justify the repurchase of these mortgages?

In order to lend to risky borrowers with the low associated interest rate, while remaining competitive in future markets, Fannie and Freddie would only buy loans associated with sub-prime debtors if the interest rate would adjust with market interest rate in the future. I seem to remember the House Financial Services Committee encourage the continued repurchase of these new floating rate mortgages to instigate large returns for banks, generate great liquidity in the real estate market, and provide opportunity for first-time home buyers. Particularly, I recall Congressman Barney Frank (now the chairman of the committee) pushing Fannie Mae and Freddie Mac in the same direction. It’s a bit queer that Mr. Frank was the first to chastise the two companies for those actions, calling for their heads (no Congressman, that was no low blow). Before tangents take over, let’s finish.

After time, the money supply could no longer support the enormous demand for borrowed money, and the Federal Reserve had no choice but to progressively aim to increase the federal funds rate by trading on the open market.  Notice, the increase in the Federal Funds Target Rate from mid-2004 to 2008.

During this time, monthly costs of floating rate mortgages nearly tripled, poisoning the once affordable loan payments. Folks delayed the inevitable with home equity loans and second mortgages, but default not only plagued individuals, it found its way into our banking system and those companies whose portfolios carried mortgage back securities. So, whose to blame?

Surely it cannot be Fannie or Freddie, who only responded under government coercion to find any way possible to meet mortgage demand. Is it the Financial Services committee who applied the pressure, or was it the Federal Reserve who traded the Federal Funds Rate to an un-naturally low level that spurned sub-prime demand. How about a combination of the two, plus the fact that mortgage brokerage is typically done by economically uneducated sales people who aim to collect a one-time commission without the long-term financial concern for those acquiring new mortgages. Make a dime any way possible, right? America, take your fingers off the two companies who have helped drive our economy for years. Without them, I assure that your quality of life would be slightly lessened. Congressman Frank, take time to learn economic fundamentals before barking your financial opinion. Be real, be knowledgeable and understand the contributing factors to Real Estate’s booms and busts. Peek at the chart once more, paying attention to where the Federal Funds Rate sits now… interesting, eh?