Who’s got the mortgage credit risk?

Published in Housing Finance International Journal:

The government-centric U.S. system

I have long thought that for any housing finance system which decides to make 30-year fixed rate loans, the Danish mortgage system has created the best division of the main component risks: credit risk and interest rate risk (which includes prepayment risk). The Danish system has a far better division of risk bearing than the government-dominated, taxpayers-at-risk U.S. system.

This was made strikingly clear to me in the year 2000, when thanks to the International Union for Housing Finance (of which I was then the President), I participated in a meeting in Copenhagen in which the Danish mortgage banks presented their covered bond system, and I presented the Fannie Mae and Freddie Mac-based American mortgagebacked securities (MBS) system. I explained how these so-called “GSEs” or “government-sponsored enterprises” worked, how they were the dominant powers in the huge U.S. mortgage market, and how they protected their government-granted financial power with impressive political clout.

At the conclusion of our discussion, the CEO of one of the large Danish mortgage lenders made this unforgettable observation:

“You know, we always say that here in Denmark we are the socialists, and that America is the land of free markets. But now I see that in mortgages, it is exactly the opposite!”

He was so right, especially with respect to American mortgage credit risk, which had become, and still is, heavily concentrated in Fannie and Freddie and thus in Washington DC.

A fundamental characteristic of the American MBS system is that the bank or other lender that makes a mortgage loan quickly sells it to Fannie or Freddie and divests the credit risk generated by its own customer, its own credit judgment, and its own loan. The loan with all its credit risk moves to Fannie or Freddie, totally away from the actual lender which dealt with the borrower. To compensate Fannie and Freddie for taking over the credit risk, the lender must pay them a monthly fee for the life of the loan, which for a prudent and skillful lender, is many times the expected loss rate on the mortgage credit.

Why would the actual lender do this, especially if it believes in its own credit judgment? In America, it does so because it wishes to get the loan financed in the bond market, so it can escape the interest rate risk of a 30-year fixed rate, prepayable, loan.

But the two risks do not necessarily need to be kept together – to divest the interest rate risk you do not in principle need to divest the credit risk, too. The brilliance of the Danish housing finance system is that it gets 100% of the of the interest rate risk of the 30-year fixed rate, prepayable loan financed in the bond market, but the original mortgage lender retains 100% of the credit risk for the life of the loan and gets a fee for doing so. The interest rate risk is divested to bond investors; the credit risk and related income stays with the original private lender. This division of risks, in my judgment, is clearly superior to that of the American system, and results in a far better alignment of incentives to make good loans in the first place

After our most interesting symposium in Denmark, how did the MBS system of the U.S. work out? The risk chickens come home to roost in the US. Treasury. In 2008, both Fannie and Freddie failed from billions in bad loans. They both were bailed out by the Treasury, as being far “too big to fail.” All their creditors, including subordinated debt holders, were fully protected by the bailout, although the stockholders lost 99% from the share price top to the bottom. Fannie and Freddie were both forced into a government conservatorship, which means a government agency is both regulator and exercises all the authority of the board of directors. They became owned principally by the government through the Treasury’s purchase of $190 billion in preferred stock. In addition, the Treasury obtained an option to acquire 79.9% of their common stock for a tiny fraction of one cent per share.

In short, from government-sponsored enterprises, Fannie and Freddie were made into government-owned and government-controlled enterprises (so I call them “GOGCEs”). So they remain in 2024. The government likes having total control of them in political hands, the Treasury likes the profits it currently receives as the majority owner, and no change is anywhere in sight.

While having become part of the government, Fannie and Freddie have maintained their central and dominant role in the U.S. housing finance system. The actual lenders are still divesting the credit risk of their own loans to the GOGCEs. Mortgage credit risk is still concentrated in Washington DC. My mortgage market contacts tell me that Fannie and Freddie’s old arrogance has returned. The two at the end of 2023 represented the remarkable sum of $6.9 trillion of residential mortgage credit risk.

To this huge number, to see the full extent of the U.S. government’s domination of mortgage credit risk, we have to add in Ginnie Mae. Ginnie is a 100% governmentowned corporation, which guarantees MBS formed from the loans of the U.S. government’s official subprime lender, the Federal Housing Administration, and of the Veterans Administration. It guarantees $2.5 trillion in mortgage loans.

Thus, in total, Fannie, Freddie and Ginnie represent about $9.4 trillion or 67% of the $14 trillion total U.S. residential mortgages outstanding. Two-thirds of the mortgage credit risk is ultimately a risk for the taxpayers. In Denmark, in notable contrast, all the credit risk of the mortgage bond market is held by the private mortgage banks.

Can it make any sense to have two-thirds of the entire mortgage credit risk of the country guaranteed by the government and the taxpayers? No, it can’t. The GOGCE-based MBS system can only result in political pressures to weaken credit standards and in excess house price inflation. This is not the system or the risk distribution the U.S. should have, but it is politically hard to get out of it.

The current U.S. MBS system is, I believe, the path-dependent result of the anomalous evolution of American housing finance in the wake of the 1980s collapse of the old savings and loans, combined with the lobbying force of the complex of housingrelated industries. Danish housing finance has superior risk principles, but we in America are unfortunately stuck with our government-centric system.

House prices are falling in Canada, rising in the U.S. — why the difference?

Published in Housing Finance International.

Canada and the United States both span the North American continent, sharing a 3,900- mile border running between the Atlantic and Pacific Oceans. In GDP, the U.S. is more than twelve times as big, but they are both rich, economically advanced countries, with sophisticated financial systems and active housing finance markets, and similar home ownership ratios of about 66%.

The central banks of both countries practiced extreme “quantitative easing” to suppress interest rates and expand credit; both the Federal Reserve and the Bank of Canada multiplied their total assets to nine times in 2021 what they were in 2008; both central banks reduced short term interest rates to nearly zero in response to the Covid crisis. Both countries experienced a massive house price bubble, which took average house prices by 2022 to far above the former housing bubble peaks of 2006 (U.S.) and 2008 (Canada).

With both countries suffering runaway inflation in 2022, both central banks rapidly pushed short-term interest rates up to about 5% and started “quantitative tightening,” letting their balance sheets shrink. The mortgage interest rates in both countries more than doubled, the standard Canadian five-year mortgage rate jumping from 2.4% to 5.5%, and the standard U.S. 30-year mortgage rate from a low of 2.7% to over 7%. (But note the difference between a very low interest rate fixed for five years and one fixed for 30 years, as discussed further below.)

In both countries, the house buyers’ monthly interest payments for a new mortgage loan of the same size has more than doubled. A normal expectation is that this should be making house prices fall. In Canada, they have indeed fallen, but in the U.S., average house prices have been rising.

As of January 2024, average Canadian house prices have dropped more than 18% from their peak of March 2022, although they of course vary by region. In greater Toronto, Canada’s largest city, for example, house prices are 20% down from their peak; in the Hamilton-Burlington area, down 25%. On the other hand, in the oil and gas capital of Calgary, in western Canada, house prices have reached a new all-time high. On average, across the country, house prices are down significantly from their peak, but the peak was steep, and house prices are still historically high. It would not be surprising for them to continue their decline.

In contrast, U.S. average house prices, after dipping about 5% after their June 2022 peak, are back over it. The S&P Case Shiller national house price index was 308.3 at that peak, in December 2023 it was 310.7, in spite of the greatly increased mortgage interest rates. According to the AEI Housing Center (AEI), year-over-year U.S. average house price appreciation,1 measured monthly, has always been positive from 2022 to early 2024, and in January 2024 the year-over-year house price increase was 6.4%. AEI predicts a 5% average U.S. house price increase for the full year 2024.2

Of course, there is regional variation. Along the Pacific coast, San Francisco prices are down 13% from their 2022 peak, Seattle down over 12%, and Portland down about 8%. On the other side of the country, Miami and New York City have made new highs.

An interesting surprise is that the fastest house price appreciation is now in the mid-sized, Midwestern cities of Indianapolis, Indiana; Grand Rapids, Michigan; and Milwaukee, Wisconsin; all far from the Sun Belt and where they have a real winter. House prices are up over the last year by 13% in Indianapolis, 12% in Grand Rapids and about 11% in Milwaukee.

Overall, the U.S. looks not only different from Canada, but an exception to what the Financial Times described as “the widespread drop in global house prices that hit advanced economies” and “the deepest property downturn in a decade.”3

The U.S. house price behavior is even more notable when combined with its dramatic shrinkage of the volumes of house purchases and of mortgage originations. The volume of mortgages for house purchases in early February 2024 was 35% less than it was in 2019, before the Covid crisis. It was 10% below the already weak same period in 2023. Refinance mortgages with cash taken out were down 60% from 2019, and refinance mortgages with no cash out were down 75%.

With these drops in business volumes, U.S. mortgage banks, which rely on an originate-tosell business model, are in their own recession. United Wholesale Mortgage, the top mortgage originator in 2023 with $108 billion in mortgage loans, was second in 2022 with $127 billion. Its volume was thus down 15% and it posted a loss of $70 million for 2023. Rocket Mortgage, the top originator in 2022 with $133 billion in loans originated, was second in 2023 with $79 billion, or down 41% in volume. It made a 2023 annual loss of $390 million. “One of the worst quarters for mortgage origination in recent history,” said its chief financial officer about the end of 2023.4

How can prices still be rising when volumes are so reduced, and interest rates are so much higher? The most common explanation is that the supply of houses for sale also remains low. Among many others, AEI observes the “historically tight supply.”5

Contributing to the tight supply is that people with 3% or less 30-year mortgages are less inclined to sell and give up the striking financial advantage of the cheap mortgage, which is locked in for a very long time, as long as they stay in the house. There is no way to monetize the large value of that existing mortgage to the borrower except by staying put.

A key difference between the Canadian and U.S. mortgage markets, which presumably affects the house price behavior, is the contrast between a typical five-year mortgage and a typical 30-year mortgage, respectively. With low- rate mortgages from three years ago, for example, the Canadian homeowners have only two years left of value from the cheap financing. The new, higher rates work their way into the household finances much more quickly. After the same three years, the American homeowners have 27 years of a large, valuable liability left—a new, higher rate is very far off indeed, if they keep the house. But if they sell it, the mortgage is due on sale, and they will face the new, more than doubled interest rate right away.

The unique American political and financial commitment to the 30-year fixed rate mortgage is now suppressing the supply of houses for sale and helping hold up house prices, postponing the correction of the 21st century’s second house price bubble, and making American houses less affordable for new buyers. This is certainly an unintended consequence of U.S. national housing finance policy.

The provocative financial writer, Wolf Richter, suggests that the causality runs not only from low supply of houses for sale to higher prices, but also the other way around. “Now the hope for lower mortgage rates is holding back potential buyers and potential sellers alike,” he writes. “The housing market remains frozen because prices are still too high.”6 On a historical basis, it appears that both Canadian and U.S. house prices are still too high. The difference between their principal mortgage instruments is one factor explaining why prices have been falling in one and rising in the other, as we continue to live through the distortions of and adjustments to the Covid crisis.

It might be argued that the U.S. housing finance system would be improved by less subsidy for and less political devotion to the 30-year mortgage. There could be more emphasis on 15-year mortgages instead, which have less interest rate risk and create a faster build-up of housing equity for the borrower. A gradual transition by changing the rules applied to the government mortgage promoters, Fannie Mae, Freddie Mac and the Federal Housing Administration, could be imagined. However, the political probability of such a change is zero.

__________________

1 A better name for this measure would be “house price change,” since there of course can be “depreciation” as well as “appreciation.” But we seem to be stuck with the “HPA” term. “Appreciation,” it is true, has prevailed on average over time, especially in nominal, as opposed to inflation-adjusted terms. Inflation-adjusted U.S. year-over-year house prices were falling from November 2022 to June 2023, but remained positive in nominal terms, as reported by AEI.

2 “Home Price Appreciation (HPA) Index—January 2024,” AEI Housing Center.

3 “Global house price downturn shows signs of reversal as rate-cut hopes rise,” Financial Times, February 26, 2024.

4 “Rocket posts $233 million net loss in 4Q,” National Mortgage News, February 22, 2024.

5 “Housing Finance Watch, 2024 Week 6,” AEI Housing Center.

6 “Mortgage Rates Rise Back to 7%, Housing Market Re-Freezes, Buyers’ Strike Continues. Prices Are Just Too High,” Wolf Street, February 21, 2024.

Grant’s Current Yield Podcast: Interest Rates, Home Loan Banks, and more

Published on Grant’s Current Yield Podcast:

Insider Perspectives- Alex J. Pollock Unveils the Intricacies of Housing Markets

Published by the Hartman Media Company:

Jason talks about the resilient real estate market as the cost of money decreases and housing affordability improves. With mortgage rates dropping and the promise of increased affordability by the Fed, he anticipates significant price increases in the low-inventory market. Highlighting the 700,000-home deficit compared to normal inventory, Jason emphasizes the simple supply and demand dynamics driving potential price surges. He also urges viewers to consider the upcoming cruise for a unique learning and networking experience. Overall, the episode provides insights into the current real estate landscape, emphasizing the market's strength and predicting positive trends. Then Jason interviews Alex J. Pollock from the Mises Institute. The discussion revolves around the unpredictability of financial markets, particularly in contrast to more deterministic fields like astronomy. Pollock argues that economic and financial forecasts, even by prominent figures like central bankers, often prove inaccurate due to the interactive and recursive nature of human ideas, intents, and strategies within these systems. The conversation delves into the challenges of predicting economic and financial futures and emphasizes the significance of relying on self-corrective market properties rather than central authorities.

A Look Into the Fed's Role In the Mortgage Market

Published in RealClear Markets:

Although manipulating housing finance is not among the Federal Reserve’s statutory objectives, the U.S. central bank has long been an essential factor in the behavior of mortgage markets, for better or worse, often for worse. 

In 1969, for example, the Fed created a severe credit crunch in housing finance by its interest rate policy.  Its higher interest rates, combined with the then-ceiling on deposit interest rates, cut off the flow of deposits to savings and loans, and thus in those days the availability of residential mortgages.  This caused severe rationing of mortgage loans.  The political result was the Emergency Home Finance Act of 1970 that created Freddie Mac, which with Fannie Mae, became in time the dominating duopoly of the American mortgage market, leading to future problems. 

In the 1970s, the Fed unleashed the “Great Inflation.”   Finally, to stop the runaway inflation, the now legendary, but then highly controversial Fed Chairman, Paul Volcker, drove interest rates to previously unimaginable highs, with one-year Treasury bills yielding over 16% in 1981 and 30-year mortgage rates rising to 18%. 

This meant the mortgage-specialist savings and loans were crushed in the 1980s.  With their mandatory focus on long-term, fixed rate mortgages, the savings and loan industry as a whole became deeply insolvent on a mark-to-market basis, and experienced huge operating losses as its cost of funding exceeded the yields on its old mortgage portfolios.  So did Fannie Mae.  More than 1,300 thrift institutions failed.  The government’s deposit insurance fund for savings and loans also went broke.  The political result was the Financial Institutions Reform, Recovery and Enforcement Act of 1989, which provided a taxpayer bailout and, it was proclaimed, would solve the crisis so it would “never again” happen.  Similar hopes were entertained for the Federal Deposit Insurance Corporation Improvement Act of 1991.  Of course, future financial crises happened again anyway.

In the early 2000s, faced with the recessionary effects of the bursting of the tech stock bubble, the Fed decided to promote an offsetting housing boom.  This I call the “Greenspan Gamble,” after Alan Greenspan, the Fed Chairman of the time, who was famed as a financial mastermind of the “Great Moderation” and as “The Maestro”—until he wasn’t.  For the boom, fueled by multiple central bank, government and private mistakes, became the first great housing bubble of the 21st century.  It began deflating in 2007 and turned into a mighty crash—setting off what became known as the “Global Financial Crisis” and the “Great Recession.” Fannie Mae and Freddie Mac both ended up in government conservatorship. U.S. house prices fell for six years.  The political result was the Dodd-Frank Act of 2010, which engendered thousands of pages of new regulations, but failed to prevent the renewed buildup, in time, of systemic interest rate risk.

Faced with the 2007-09 crisis, the Federal Reserve pushed short term interest rates to near zero and kept them abnormally low from 2008 to 2022.  It also pushed down long-term interest rates by heavy buying of long-term U.S. Treasury bonds, and in a radical and unprecedented move, buying mortgage-backed securities.  As the Fed kept up this buying for more than a decade, it became by far the largest owner of mortgages in the country, with its mortgage portfolio reaching $2.7 trillion, in addition to its $5 trillion in Treasury notes and bonds.  This remarkable balance sheet expansion forced mortgage loan interest rates to record low levels of under 3% for 30-year fixed rate loans.  The central bank thus set off and was itself the biggest single funder of the second great U.S. housing bubble of the 21st century. 

In this second housing bubble, average house prices soared at annualized rates of up to 20%, and the S&P CoreLogic Case-Shiller National House Price Index (Case-Shiller), which peaked in the first housing bubble in 2006 at 185, rose far higher—to 308 in June 2022, or 67% over the peak of the previous bubble.

The Fed financed its fixed rate mortgage and bond investments with floating rate liabilities, making itself functionally into the all-time biggest savings and loan in the world.  It created for itself enormous interest rate risk, just as the savings and loans had, but while the savings and loans were forced into it by regulation, the extreme riskiness of the Fed’s balance sheet was purely its own decision, never submitted to the legislature for approval.

Confronted with renewed runaway inflation in 2021 and 2022, the Fed pushed up short-term interest rates to over 5%.  That seemed high when compared to almost zero, but is in fact a historically normal level of interest rates.  The Fed also began letting its long-term bond and mortgage portfolio roll off.  U.S. 30-year mortgage interest rates increased to over 7%.  That is in line with the 50-year historical average, but was a lot higher than 3% and meant big increases in monthly payments for new mortgage borrowers.  A lot of people, including me, thought this would cause house prices to fall significantly. 

We were surprised again.  Average U.S. house prices did begin to fall in mid-2022, and went down about 5%, according to the Case-Shiller Index, through January 2023.  Then they started back up, and have so far risen about 6%, up to a new all-time peak.  Over the last year, Case Shiller reports an average 3.9% increase.  Compared to consumer price inflation of 3.2% during this period, this gives a real average house price increase of 0.7%--slightly ahead of inflation.  How is that possible when higher mortgage rates have made houses so much less affordable? 

Of course, not all prices have gone up.  San Francisco’s house prices are down 11% and Seattle’s are down 10% from their 2022 peaks.  The median U.S. house price index of the National Association of Realtors is down 5% from June 2022.  The median price of a new house (as contrasted with the sale of an existing house) fell by over 17% year-over-year in October, according to the U.S. Census Bureau, and home builders are frequently offering reduced mortgage rates and other incentives, effectively additional price reductions, in addition to providing smaller houses.  (Across the border to the north, with a different central bank but a similar rise in interest rates, the Home Price Index of the Canadian Real Estate Association is down over 15% from its March 2022 peak.)

The most salient point, however, is that the volume of U.S. house purchases and accompanying mortgages has dropped dramatically. Purchases of existing houses dropped over 14% year-over-year in October, to the lowest level since 2010.  They are “on track for their worst performance since 1992,” Reuters reported. The lack of mortgage volume has put the mortgage banking industry into its own sharp recession.  So, the much higher interest rates are indeed affecting buyers, but principally by a sharply reduced volume of home sales, not by falling prices on the houses that do sell-- highly interesting bifurcated effects.  The most common explanation offered for this unexpected result is that home owners with the exceptionally advantageous 3% long-term mortgages don’t want to give them up, so they keep their houses off the market, thus restricting supply.  A 3% 30-year mortgage in a 7% market is a highly valuable liability to the borrower, but there is no way to realize the profit except by keeping the house.

As for the Federal Reserve itself, as interest rates have risen, it is experiencing enormous losses.  It has the simple problem of an old-fashioned savings and loan:  its cost of funding far exceeds the yield on its giant portfolio of long-term fixed rate investments.  As of November 2023, the Fed still owns close to $2.5 trillion in very long-term mortgage securities and $4.1 trillion in Treasury notes and bonds, with in total over $3.9 trillion in investments having more than ten years left to maturity.  The average combined yield on the Fed’s investments is about 2%, while the Fed’s cost of deposits and borrowings is over 5%.

Investing at 2% while borrowing at 5% is unlikely to make money—so for 11 months year to date in 2023 the Fed has a colossal net operating loss of $104 billion.  Since September 2022, it has racked up more than $122 billion in losses.  It is certain that the losses will continue.  These are real cash losses to the government and the taxpayers, which under proper accounting would result in the Fed reporting negative capital or technical insolvency.  Such huge losses for the Fed would previously have been thought impossible.

When it comes to the mark-to-market of its investments, as of September 30, 2023, the Fed had a market value loss of $507 billion on its mortgage portfolio.  On top of this, it had a loss of $795 billion on its Treasuries portfolio, for the staggering total mark-to-market loss of $1.3 trillion, or 30 times its stated capital of $43 billion.

While building this losing risk structure, the Fed acted as Pied Piper to the banking industry, which followed it into massive interest rate risk, especially with investments in long-term mortgage securities and mortgage loans, funded with short-term liabilities.  A bottoms-up, detailed analysis of the entire banking industry by my colleague, Paul Kupiec, has revealed that the total unrecognized market value loss in the U.S. banking system is about $1.27 trillion.

If we add the Fed and the banks together as a combined system, the total mark-to-market loss- a substantial portion of it due to losses on that special American instrument, the 30-year fixed rate mortgage- is over $2.5 trillion.  This is a shocking number that nobody forecast.

We can be assured that the profound effects of central banks on housing finance will continue with results as surprising to future financial actors as they have been to us and previous generations.

Central Banks and Housing Finance

Published in Housing Finance International Journal:

Although manipulating housing finance is not among the Federal Reserve’s statutory objectives, the U.S. central bank has long been an essential factor in the behavior of mortgage markets, for better or worse, often for worse.

In 1969, for example, the Fed created a severe credit crunch in housing finance by its interest rate policy. Its higher interest rates, combined with the then-ceiling on deposit interest rates, cut off the flow of deposits to savings and loans, and thus in those days the availability of residential mortgages. This caused severe rationing of mortgage loans. The political result was the Emergency Home Finance Act of 1970 that created Freddie Mac, which with Fannie Mae, became in time the dominating duopoly of the American mortgage market, leading to future problems.

In the 1970s, the Fed unleashed the “Great Inflation.” Finally, to stop the runaway inflation, the now legendary, but then highly controversial Fed Chairman, Paul Volcker, drove interest rates to previously unimaginable highs, with one-year Treasury bills yielding over 16% in 1981 and 30-year mortgage rates rising to 18%.

This meant the mortgage-specialist savings and loans were crushed in the 1980s. With their mandatory focus on long-term, fixed rate mortgages, the savings and loan industry as a whole became deeply insolvent on a mark-tomarket basis, and experienced huge operating losses as its cost of funding exceeded the yields on its old mortgage portfolios. So did Fannie Mae. More than 1,300 thrift institutions failed. The government’s deposit insurance fund for savings and loans also went broke. The political result was the Financial Institutions Reform, Recovery and Enforcement Act of 1989, which provided a taxpayer bailout and, it was proclaimed, would solve the crisis so it would “never again” happen. Similar hopes were entertained for the Federal Deposit Insurance Corporation Improvement Act of 1991. Of course, future financial crises happened again anyway.

In the early 2000s, faced with the recessionary effects of the bursting of the tech stock bubble, the Fed decided to promote an offsetting housing boom. This I call the “Greenspan Gamble,” after Alan Greenspan, the Fed Chairman of the time, who was famed as a financial mastermind of the “Great Moderation” and as “The Maestro” – until he wasn’t. For the boom, fueled by multiple central bank, government and private mistakes, became the first great housing bubble of the 21st century. It began deflating in 2007 and turned into a mighty crash – setting off what became known as the “Global Financial Crisis” and the “Great Recession.” Fannie Mae and Freddie Mac both ended up in government conservatorship. U.S. house prices fell for six years. The political result was the Dodd-Frank Act of 2010, which engendered thousands of pages of new regulations, but failed to prevent the renewed buildup, in time, of systemic interest rate risk.

Faced with the 2007-09 crisis, the Federal Reserve pushed short term interest rates to near zero and kept them abnormally low from 2008 to 2022. It also pushed down long-term interest rates by heavy buying of long-term U.S. Treasury bonds, and in a radical and unprecedented move, buying mortgagebacked securities. As the Fed kept up this buying for more than a decade, it became by far the largest owner of mortgages in the country, with its mortgage portfolio reaching $2.7 trillion, in addition to its $5 trillion in Treasury notes and bonds. This remarkable balance sheet expansion forced mortgage loan interest rates to record low levels of under 3% for 30-year fixed rate loans. The central bank thus set off and was itself the biggest single funder of the second great U.S. housing bubble of the 21st century.

In this second housing bubble, average house prices soared at annualized rates of up to 20%, and the S&P CoreLogic Case-Shiller National House Price Index (Case-Shiller), which peaked in the first housing bubble in 2006 at 185, rose far higher – to 308 in June 2022, or 67% over the peak of the previous bubble.

The Fed financed its fixed rate mortgage and bond investments with floating rate liabilities, making itself functionally into the all-time biggest savings and loan in the world. It created for itself enormous interest rate risk, just as the savings and loans had, but while the savings and loans were forced into it by regulation, the extreme riskiness of the Fed’s balance sheet was purely its own decision, never submitted to the legislature for approval.

Confronted with renewed runaway inflation in 2021 and 2022, the Fed pushed up short-term interest rates to over 5%. That seemed high when compared to almost zero, but is in fact a historically normal level of interest rates. The Fed also began letting its long-term bond and mortgage portfolio roll off. U.S. 30-year mortgage interest rates increased to over 7%. That is in line with the 50-year historical average, but was a lot higher than 3% and meant big increases in monthly payments for new mortgage borrowers. A lot of people, including me, thought this would cause house prices to fall significantly.

We were surprised again. Average U.S. house prices did begin to fall in mid-2022, and went down about 5%, according to the Case-Shiller Index, through January 2023. Then they started back up, and have so far risen about 6%, up to a new all-time peak. Over the last year, Case Shiller reports an average 3.9% increase. Compared to consumer price inflation of 3.2% during this period, this gives a real average house price increase of 0.7% – slightly ahead of inflation. How is that possible when higher mortgage rates have made houses so much less affordable?

Of course, not all prices have gone up. San Francisco’s house prices are down 11% and Seattle’s are down 10% from their 2022 peaks. The median U.S. house price index of the National Association of Realtors is down 5% from June 2022. The median price of a new house (as contrasted with the sale of an existing house) fell by over 17% yearover-year in October, according to the U.S. Census Bureau, and home builders are frequently offering reduced mortgage rates and other incentives, effectively additional price reductions, in addition to providing smaller houses. (Across the border to the north, with a different central bank but a similar rise in interest rates, the Home Price Index of the Canadian Real Estate Association is down over 15% from its March 2022 peak.)

The most salient point, however, is that the volume of U.S. house purchases and accompanying mortgages has dropped dramatically. Purchases of existing houses dropped over 14% year-over-year in October, to the lowest level since 2010. They are “on track for their worst performance since 1992,” Reuters reported.1 The lack of mortgage volume has put the mortgage banking industry into its own sharp recession. So, the much higher interest rates are indeed affecting buyers, but principally by a sharply reduced volume of home sales, not by falling prices on the houses that do sell – highly interesting bifurcated effects. The most common explanation offered for this unexpected result is that home owners with the exceptionally advantageous 3% long-term mortgages don’t want to give them up, so they keep their houses off the market, thus restricting supply. A 3% 30-year mortgage in a 7% market is a highly valuable liability to the borrower, but there is no way to realize the profit except by keeping the house.

As for the Federal Reserve itself, as interest rates have risen, it is experiencing enormous losses. It has the simple problem of an old-fashioned savings and loan: its cost of funding far exceeds the yield on its giant portfolio of long-term fixed rate investments. As of November 2023, the Fed still owns close to $2.5 trillion in very long-term mortgage securities and $4.1 trillion in Treasury notes and bonds, with in total over $3.9 trillion in investments having more than ten years left to maturity. The average combined yield on the Fed’s investments is about 2%, while the Fed’s cost of deposits and borrowings is over 5%.

Investing at 2% while borrowing at 5% is unlikely to make money – so for 11 months year to date in 2023 the Fed has a colossal net operating loss of $104 billion. Since September 2022, it has racked up more than $122 billion in losses. It is certain that the losses will continue. These are real cash losses to the government and the taxpayers, which under proper accounting would result in the Fed reporting negative capital or technical insolvency. Such huge losses for the Fed would previously have been thought impossible.

When it comes to the mark-to-market of its investments, as of September 30, 2023, the Fed had a market value loss of $507 billion on its mortgage portfolio. On top of this, it had a loss of $795 billion on its Treasuries portfolio, for the staggering total mark-to-market loss of $1.3 trillion, or 30 times its stated capital of $43 billion.2

While building this losing risk structure, the Fed acted as Pied Piper to the banking industry, which followed it into massive interest rate risk, especially with investments in long-term mortgage securities and mortgage loans, funded with short-term liabilities. A bottoms-up, detailed analysis of the entire banking industry by my colleague, Paul Kupiec, has revealed that the total unrecognized market value loss in the U.S. banking system is about $1.27 trillion.3

If we add the Fed and the banks together as a combined system, the total mark-to-market loss- a substantial portion of it due to losses on that special American instrument, the 30-year fixed rate mortgage- is over $2.5 trillion. This is a shocking number that nobody forecast.

We can be assured that the profound effects of central banks on housing finance will continue with results as surprising to future financial actors as they have been to us and previous generations.

_______________

1 “Home sales fell to a 13-year low in October as prices rose,” Reuters, November 21 2023.

2 Federal Reserve financial data is taken from the weekly Federal Reserve H.4.1 Release, and from the Federal Reserve Banks Combined Quarterly Financial Report as of September 30 2023.

3 Paul Kupiec, “Forget Climate Change and NBFIs, the Biggest Systemic Risk are the Unrealized Losses in the Banking System,” American Enterprise Institute, November 2023, and personal correspondence with the author.

The Federal Reserve loses billions on mortgages

Published in Housing Finance International.

Can house prices achieve a soft landing?

The largest holder by far of residential mortgages in the United States, a country often supposed to favor private markets, is none other than the central bank, the Federal Reserve. The Fed owns the remarkable sum of $2.5 trillion (that’s “trillion” with a T) in mortgage-backed securities (MBS).[1] That is more than one-quarter of the entire federal agency residential MBS market, the dominant U.S. source of housing finance. The Fed has mainly invested this enormous amount in the typical American 30-year fixed rate, freely prepayable, mortgage, an instrument of notorious interest rate risk. This risk infamously sank the savings and loan industry in the 1980s, and in 2023 was a principal factor in sinking Silicon Valley Bank, the second largest bank failure in U.S. history at the time of its collapse.

In this Fed MBS investment program, the entire risk of the mortgage is absorbed by the government: the credit risk of the Fed’s MBS investments is taken by other government organizations (Fannie Mae, Freddie Mac, Ginnie Mae), but the Fed itself bears 100% of the interest rate risk. How has the Fed managed this risk as interest rates have dramatically risen since 2022? Not well.

Faced with the runaway inflation of 2021- 22, the Fed pushed short-term interest rates rapidly up from close to zero to 5 ½% after it belatedly stopped buying MBS. Interest rates on 30-year mortgage loans have more than doubled from less than 3% to more than 7%. The resulting mark-to market on the Fed’s MBS portfolio is a loss of $394 billion as of June 2023, or more than 9 times the Fed’s total capital of $42 billion. Striking numbers![2]

The Fed’s huge purchases of mortgage securities began as an emergency, “temporary” action in the crisis of 2008, accelerated again in the Covid financial crisis of 2020, and lasted longer than needed—until March 2022. These central bank purchases drove the interest rates on 30-year fixed rate mortgage loans down to under 3% in late 2020 and 2021-- as low as 2.7% in late 2020—not much return for a 30-year risk! —and the yields on MBS can run 1% or so lower than the mortgage loan rates. The Fed bought a lot of MBS at the bottom in MBS yields—that is, it bought a lot at the market top in MBS prices which its own buying created.

In a leveraged balance sheet like the Fed’s, mark to market losses move into operating results through negative interest spreads. The Fed now has a $2.5 trillion MBS portfolio yielding a little over 2%, which to finance, it pays its depositors and repurchase agreement lenders over 5%. So this massive investment is now running at an interest rate spread of about negative 3%.

One hardly needs to say that lending at 2% and borrowing at 5% is a losing proposition. The $2.5 trillion MBS investment at a negative 3% spread is costing the Fed (and the Treasury and the taxpayers) about $75 billion a year. When added together with the rest of the Fed’s operations, principally the profits from issuing currency and losses from investing in long-term Treasury securities, the Fed accumulated from September 2022 through the end of August 2023 net losses of the notable sum of $95 billion.[3]

The losses will clearly continue for the rest of 2023, by which time the Fed will have lost on operations about three times its capital, and on into the future if interest rates stay at their current historically normal levels. Since the Fed’s profits mostly go to the Treasury, its losses mean that the U.S. Treasury and the taxpayers also lose. The many banks which also bought MBS and hold fixed-rate mortgage loans acquired at 3%, also have very large mark-to-market losses and negative spreads on them. These banks, like the failed Silicon Valley Bank, could correctly claim that they were only doing the same thing the Federal Reserve was.

From the point of view of mortgage borrowers, those who borrowed at 3% or less for 30 years obviously got a great and very attractive deal. A current borrower at 7.2% has to pay 2.5 times as much in monthly interest to buy the same house at the same price as a lucky 2.7% borrower did. On a house in the median price range costing $400,000, that is $1,500 more a month. Naturally, this much more expensive mortgage financing puts a downward pressure on house prices, but it also gives former borrowers a strong motivation to stay in their current houses and keep them off the market, in order to preserve the large financial advantage of the great 30-year mortgage rate the Fed created.

The astronomical house price increases of the second great American house price bubble of the 21st century are over. National average house prices, according to the S&P CoreLogic Case-Shiller Index, fell 1.2% yearover-year in June 2023. Over the same period, U.S. consumer price inflation was 3%, so in inflation-adjusted (real) terms, house prices fell 4.2%. That is a far cry from the bubble’s annualized increases in nominal terms which reached 18% and more in 2021 and early 2022. However, U.S. house prices have not fallen as much as many, including me, expected.

Serious reductions in house prices have indeed occurred in overpriced cities in the U.S. West. These year-over-year decreases reported by Case-Shiller as of June 2023 include the following. In real terms, the drops are in double digits.

House Price Changes Year-Over-Year June 2023

| Nominal | Real

San Francisco | -9.7% | -12.7%

Seattle | -8.8% | -11.8%

Las Vegas | -8.2% | -11.2%

Phoenix | -7.5% | -10.5%

These drops are, however, from very high peaks, and prices in these areas remain historically high.

The two metropolitan areas with the largest price increases in the June Case-Shiller report are the Midwestern cities of Chicago, at +4.2%, and Cleveland, at +4.1%, being in real terms, 1.2% and 1.1%, respectively, which are similar to the long-term growth rate in real house prices.

The AEI Housing Center finds that in July 2023, national average house prices increased year-over year by 3.5%, or by +0.3% real, after falling year-over-year in real terms for eight months in a row. Can falling real prices becoming more or less flat make for a “soft landing” of U.S. average house prices? Maybe--considering that 7% is in a historically normal range of mortgage interest rates. It only seems so high to us because of the previous suppression of mortgage rates to abnormally low levels by the Fed.

Still, many observers wonder why U.S. house prices have not fallen more, given the large reduction in buying power for most people from the sharply increased cost of mortgage loans.

Two measures which have dropped like a rock are the volume of home sales and of mortgage originations. Sales of existing houses were down 40% in July 2023 compared to the pre-pandemic July 2019[4] . The volume of interest rate commitments for new mortgage loans is down about 30%- 40% from 2019, and the volume of mortgage refinancings (“refis” in U.S. parlance) simply to lower the interest rate, is correspondingly down 95%.[5] The mortgage banking and brokerage businesses are experiencing heavy stress and their own painful recession with the disappearance of business volumes. Their total staffs have been cut by 43,000 employees or about 11% over the last year.[6]

How can house prices stay high while sales volume shrivels?

One factor is that while sales of existing houses are way down, so is the inventory of houses being put up for sale. The July 2023 inventory of houses for sale was down 36% from July 2019, which helps support house prices.[7]

A popular and plausible theory is that this low inventory at least in part reflects the desire of the lucky mortgage borrowers at 3% or less to hang on to their great mortgages by simply staying in their current houses. As a typical article explains, “Borrowing costs have not had the expected effect of cooling house prices [because] most US homeowners…have in effect been trapped in their properties by [the] low rates.” So the Fed’s manipulation of mortgage interest rates to exceptionally low levels created an unexpected factor to later restrict the supply of houses for sale and help hold house prices up. In addition, when working from home, the borrowers don’t have to change houses to change jobs, which supports the ability to hang on to the old mortgage.

These factors help slow prepayments of 30-year mortgage loans, extend the duration of the Fed’s MBS portfolio, and increase the Fed’s mark-to-market and operating losses.

It doesn’t help right now, but as a long-term strategy the Federal Reserve needs to return the amount of MBS in its balance sheet to what it always was from its founding in 1913 to 2008--namely zero.

_________

1 Federal Reserve H.4.1 Release, August 31, 2023, Section 5.

2 Federal Reserve Banks Combined Quarterly Financial Report, June 30, 2023.

3 Federal Reserve H.4.1 Release, August 31, 2023, Section 6.

4 AEI Housing Center, Home Price Appreciation Index report, July 2023.

5 AEI Housing Center, Housing Market Indicators report, August 1, 2023.

6 “Nonbank mortgage jobs undergo a seasonal dip,” National Mortgage News, September 1, 2023.

7 AEI Housing Center, Home Price Appreciation Index report, July 2023.

8 “Investors keep close eye on US mortgage rates,” Financial Times, September 3, 2023.

U.S. banking problems: Mortgage interest rate risk strikes again

Published in Housing Finance International.

Notable U.S. bank runs and failures in spring 2023 followed speeches from the Treasury Department and the Federal Reserve in 2022 and early 2023 about what a good shape the U.S. banking system was in. Of course, they wanted the non-bank financial companies (so-called “shadow banks”) to be regulated more, but they claimed the commercial banks were in great condition. This was thanks to the Dodd Frank Act and its greatly expanded regulation, it was suggested, and we could congratulate ourselves for this banking stability.

Surprise! Shortly thereafter came the second, third and fourth largest bank failures in U.S. history (First Republic, Silicon Valley, and Signature banks, respectively). These were accompanied by emergency government declarations that the failing banks were “systemically important”—in other words, that the banking system in general was at risk. Such declarations allowed bailouts of wealthy depositors who had accounts with the failing banks of far over the normal statutory maximum of $250,000 for government deposit insurance coverage. Those depositors should have taken a loss on the risky investments they had made and from their folly in maintaining hundreds of millions, in some cases, or even billions of dollars, in single small-enough-to-fail banks. That was quite unwise risk taking on their part, but big money venture capitalists, tech entrepreneurs and cryptocurrency barons, among others, got all their deposits back by being given other people’s money. The insurance fund of the Federal Deposit Insurance Corporation was reduced below its minimum statutory level by the cost of these failures.

Central to the failures were billions of dollars in losses resulting from investing in long-term, fixed rate mortgage securities and financing them with short-term, floating-rate liabilities. The interest rate risk of the American 30-year fixed-rate mortgage strikes again! Although these mortgages were often held in securitized form, making them theoretically liquid, once their market value was far below their cost, selling them would trigger the realization of the huge losses, which could and did set off a run on the bank. So just as in the case of the U.S. savings & loans in the 1980s, the shortfunded 30-year mortgages contributed to first massive interest rate risk and then fatal liquidity risk for the failed banks.

However, not only the failed banks, but hundreds of banks across the country have made this mistake. In doing so, they were following the Pied Piper of the Federal Reserve and its long lasting, but now ended, suppression of both short-term and long-term interest rates, its predictions of “lower interest rates for longer,” and quite remarkably, its own practice of investing trillions of dollars in long term fixed rate assets funded by borrowing short in its own balance sheet. Investing in long-term mortgages and also long-term Treasury securities, the banks and the Federal Reserve together created huge amounts of interest rate risk for the total banking system.

This is a classic banking risk, a classic banking mistake. Along with it comes a classic problem: although it is often said that bank runs reflect irrational fears, in fact runs are highly rational from the viewpoint of the depositor.

Keeping your money in a questionable bank instead of getting it out, when you can’t really know what the bank’s assets are worth or what is really going on inside it or who is lying, has no upside potential and large downside potential of serious losses on money you didn’t intend to be at risk at all. So, it is rational to run.

Every bank should be structured with the thought that runs are rational from the viewpoint of the depositors. This is an old and essential banking truth. As the great Walter Bagehot wrote in Lombard Street in 1873, “A banker, dealing with the money of others, and money payable on demand, must be always, as it were, looking behind him and seeing that he has reserve enough in store if payment should be asked for.” Bagehot adds, “Adventure is the life of commerce, but caution is the life of banking.”

One recent academic analysis has estimated the mark to market loss of all U.S. banks, including both their fixed-rate securities and fixed-rate loans, and concluded that the banking system has a mark to market loss of about $2 trillion on these assets. That’s $2 trillion.

In comparison, the book capital of the U.S. banking system is about $2.2 trillion, and of that $2.2 trillion, $400 billion are intangible assets. So, the tangible capital is approximately $1.8 trillion, while the mark to market loss may be something like $2 trillion. That would suggest that we have an entire banking system with something like zero real capital. While there is large variation among the 4,700 banks and savings associations, the overall situation is certainly sobering on a mark-to-market basis.

The way unrealized losses turn into real losses in financial institutions that have fixed rate, long term assets funded with short term floating rate liabilities, is that the cost of their liabilities goes dramatically up and the yield on their assets doesn’t.

The big question in the banking system has thus become: how resistant are the banks to the cost of their deposits rising to full market levels of 5% or so, in order to fund the deeply underwater fixed rate loans and securities on which there is a $2 trillion market value loss? How much is their interest cost going to rise? In other words, as the unrealized losses turn into greater interest expense, how much can you continue to cheat the savers in order to prop up the banks? What we will observe going forward is the contest between the inexorable rise in the funding cost, and the hope that banks can continue to cheat the savers and keep the deposit cost below market. This puts the banking regulators, who are in favor of bank safety, on the side of cheating the savers. All this is just like the U.S. savings & loans and their regulators in the 1970s and 1980s.

On top of its interest rate risk, we find out the U.S. banking system has, once again, a large risk exposure to troubled commercial real estate. Consider this observation: “The unfavorable conditions in banking were greatly aggravated by the collapse of unwise speculation in real estate.” That is from the report of the U.S. Comptroller of the Currency in 1891. Little about this connection has changed since then.

The famous Fed Chairman Paul Volcker observed that “There are no new problems in banking, only new people.”

But why do crises keep recurring if we have comprehensive regulation, like the Dodd Frank Act and its thousands of pages of implementing regulations? The banking scholar, Bernard Shull, insightfully wrote, “Comprehensive banking reform, traditionally including augmented and improved supervision, has typically evoked a transcendent, and in retrospect, unwarranted optimism.”Writing in the 1990s, Shull continued, “Confronting the S&L disaster with yet another comprehensive reform, the Secretary of the Treasury proclaimed ‘Two watchwords guided us as we undertook to solve this problem. Never again.’”

That was the savings & loan reform of 1989, and then came the banking reforms of 1991, and the housing finance reforms of 1992. But in the following decade, instead of “never again,” another massive crisis happened again anyway. Then after that 2007-09 crisis, comprehensive reform was once again debated with the political result of the Dodd Frank Act. But another decade or so later, once again we have bank runs and failures.

We are up against the reality of the politics of banking and finance. All finance is political, especially housing finance. No matter how we politically organize any bank regulation, it will over time have to be reorganized, because the perfect answer does not exist. Whenever we try to engineer and control human behavior, the attempts at control themselves induce unexpected adaptations and reactions in the behavior of financial markets, and also in the behavior of the regulators and politicians themselves. Hence, as we observe historically, every reform requires another reform to address the unexpected results and failures of the prior reform, and so on, ad infinitum. The current troubles are part of the ongoing crisis of 2020. Starting in 2020, we experienced the Covid crisis, the financial panic, the sharp economic contraction, the vast expansion of money printing and government expenses in response, the following bubble markets, the everything bubble, the runaway inflation, the correction with rising interest rates, the deflation of the everything bubble in 2022, and now the banking problems of 2023. I think of that as all one big crisis-- we’re still in the aftermath of 2020.

In that aftermath, with assets inflated to $8.4 trillion, the Federal Reserve is by far the biggest bank in the country. It is also the biggest savings & loan, because inside the Fed is a mortgage portfolio of $2.6 trillion of long-term fixed rate mortgages, funded short with floating rate liabilities. This makes it far and away not only the biggest savings & loan in the country, but in all of history. The Fed is now earning more or less 2% on its mortgages, and more or less 2% on its long-term Treasuries. The duration of its mortgages has become longer than expected with their negative convexity and increasing interest rates. Its Treasuries are also very long, over $1.4 trillion with remaining maturities of more than 10 years. While earning 2%, the Fed is now paying over 5% to carry those investments. If your income is 2% and your cost is 5%, it’s hard to make money that way! From September 2022 to early June 2023, the Fed has had a net loss of $68 billion, and is on its way to an annual loss of about $100 billion, more than twice its capital.

The Fed’s own balance sheet was and is jammed with gigantic interest rate risk. One might not unreasonably ask, how could the Fed criticize banks like the failed Silicon Valley Bank for doing exactly the same thing that the Fed itself was and is doing? A fair question!

Of course, if the failed banks or the technically insolvent Fed had been right in the forecast that short-term interest rates would stay abnormally low, that kind of balance sheet would have been a profitable bet. They could have had 2% income and say, 0.25% interest expense. So let us ask: what was the Fed’s own interest rate forecast as it was accumulating its massive portfolio and interest rate risk?

Consider the Fed’s interest rate forecast done in June 2021 for the end of the year 2022. The median forecast for fed funds target was 0.25%. Of Federal Open Market Committee members submitting estimates, the highest rate was 0.75%. Compared to the 4.25%-4.5% reality, a big miss indeed!

What about the projection for 2023 at that same meeting? What did they think the fed funds target interest rate would be by the end of 2023? The median forecast was 0.75%. The highest submitted estimate was 1.75%. Another big miss, to say the least, with the rate now at 5%-5.25% five months into 2023.

The Fed’s poor forecasts bring to mind that famous American baseball poem, Casey at the Bat. In trying to forecast interest rates, and inflation, and banking problems, just like “Mighty Casey,” the mighty Fed has struck out.

In the meantime, the spring of 2023 provided some extreme drama in U.S. banking, tied significantly to the risk of the American 30-year fixed rate mortgage-- and this cycle is not over. Whatever may the coming in the way of further increases in interest rates, or interest rates continuing at current levels, or an often-predicted recession with lower interest rates but increased loan defaults, all will cause risks to the banking system. In any case, financial markets should remember not to put their trust in the forecasts of the Federal Reserve.

Mandating Mortgage Taxes

Published in Law & Liberty.

The Federal Housing Finance Agency (FHFA) is the regulator of Fannie Mae and Freddie Mac. On top of that, it has controlled them as their Conservator since 2008, amazingly for nearly 15 years, since reform of Fannie and Freddie has proved politically impossible. As Conservator, FHFA can exercise the power of their boards of directors. It is therefore not only the regulator, but also the boss of both of these giant providers of mortgage finance. Fannie and Freddie together represent more than $7 trillion in mortgage credit and dominate the mortgage market. FHFA also regulates the $1.6 trillion Federal Home Loan Bank System. Thus, the FHFA has impressive centralized power over the huge US mortgage market, although most people have probably never heard of it.

Housing finance is always political, and a housing finance regulator is always sailing in strong political winds, in addition to the cyclical storms of housing finance crises. The American housing finance system has collapsed twice in the last 40 years, in the decades of the 1980s and the 2000s, with corresponding regulatory reorganizations. The FHFA is a second-generation successor to the unlamented Federal Home Loan Bank Board (FHLBB), the cheerleader-regulator of the savings and loan industry. It presided over the 1980s savings and loan industry collapse, a collapse which also caused the government’s Federal Savings and Loan Insurance Corporation to go broke. The FHLBB was abolished by Congress in 1989 and replaced by the Office of Thrift Supervision (OTS) to regulate savings and loans and the Federal Housing Finance Board (FHLB) to regulate the Federal Home Loan Banks.

Beginning in the 1990s, the federal government made the disastrous mistake of promoting and increasing the amount of risky mortgage loans in the pursuit of increasing home ownership, notably requiring Fannie and Freddie to buy more and more such loans. The riskier loans were promoted as “innovative” mortgages by the Clinton administration. That push was a major contributor first to the housing bubble and then to the housing finance collapse of 2007–09. The homeownership percentage temporarily went up and then fell back to where it had been before. After the crisis, Congress abolished OTS. FHFB was also abolished, with its operations merged into the newly created FHFA. Less than two months after its creation in 2008, FHFA became the Conservator of Fannie and Freddie, which it remarkably remains to this day.

The housing politics and the enjoyment of its power seem to have gone to the FHFA’s head. Now, carrying out instructions from the White House, one imagines, or at a minimum with White House approval, it is trying once again to encourage riskier mortgage loans in Fannie and Freddie. Moreover, it proposes to act as if it were the Congress, trying by its own rule to mandate what are effectively taxes on mortgage borrowers with good credit, in order to provide subsidies to riskier borrowers with poor credit. The FHFA is thus de facto legislating to create in the nationwide mortgage market a welfare and income transfer operation through mortgage pricing. However misguided an idea this is, it could be done by the power of Congress, but the last time we checked, the FHFA wasn’t the Congress. Its project here is remarkable bureaucratic overreach.

In this case, the FHFA wants to politically manipulate Fannie and Freddie’s Loan-Level Price Adjustments (LLPAs). The LLPAs are meant to be credit risk-based adjustments, which reflect fundamental factors in the credit risk of a mortgage loan, to the price of getting Fannie or Freddie to bear the credit risk of the loan. They are an adjustment to the cost of the loan to the borrower, supposed to be based on objective measures of risk. As one mortgage guide says:

A loan-level price adjustment is a risk-based fee assessed to mortgage borrowers … [and] adjustments vary by borrower, based on loan traits such as loan-to-value (LTV), credit score, loan purpose, occupancy, and number of units in a home. Borrowers often pay LLPAs in the form of higher mortgage rates. … Similar to an auto insurance policy, a person loaded with risk will typically pay a higher premium.

Considering the key risks of smaller down payments (higher LTVs) and lower credit scores, there is no doubt that these factors statistically result over time in higher delinquencies, more defaults, and greater credit losses. Simply put, they are riskier loans. The AEI Housing Center has shown that default rates in times of stress differ dramatically based on these factors. For mortgage loans acquired by Fannie and Freddie in 2006–07, for example, the subsequent credit experience was “among borrowers with 20% down payments and credit scores between 720 and 769, the default rate was between 4.2% and 8.8%. Among borrowers with less than 4% down payments and credit scores between 620 and 639, the default rate was between 39.3% and 56.2%.”

Many commentators have pointed out that the FHFA project to manipulate the LLPAs for a political purpose is a distinctly bad idea. It is an “Upside Down Mortgage Policy … against every rational economic model, while encouraging housing market dysfunction and putting taxpayers at risk”; it signals to well-qualified borrowers, “Your credit score is excellent, so prepare to be penalized”; it is income redistribution by bureaucratic fiat; it will encourage the growth of riskier loans in Fannie and Freddie, just as the government disastrously did leading up to the great housing bust of 2007–09; it reduces the incentives to make significant down payments and for establishing a good credit rating—a notably dumb housing credit policy. This is the kind of thing Ed Pinto and I predicted in 2021 that a Biden administration FHFA would do, anticipating “the increased credit risk that Fannie and Freddie, under orders from the FHFA, will be generating.”

The rule is also ethically challenged. As Jeff Jacoby wrote in the Boston Globe, the policy is not only backwards credit logic: “First and foremost, it is egregiously unfair to creditworthy borrowers. … The new mortgage fees amount to a tax on responsible behavior.” In short, “You shouldn’t be punished for having done the right thing.” This seems incontrovertible.

The Congress long ago set up by law a very large, specialized government agency to enable subprime mortgage loans, the Federal Housing Administration (FHA). FHA mortgage loans outstanding total about $1.4 trillion. The FHA provides subsidized mortgage credit, allowing mortgage loans with down payments of as little as 3.5%. The FHA and its sister organization, Ginnie Mae, which guarantees securitized FHA loans, both operate with explicit government support and with direct risk to the taxpayers. The FHFA should not be trying to compete with the FHA for subprime mortgage financing.

The FHFA’s political initiative on loan-level adjustments is a bad idea on the merits, but there is an even more fundamental issue: the creation of a tax and mortgage subsidy program which increases risk to the taxpayers is a question for the Congress to decide—it is not the purview of the FHFA.

Very belatedly, FHFA announced it would issue a “Request for Input” from the public, which would include consideration of LLPAs. This announcement, however, did not alter FHFA’s egregious LLPA changes, which are being imposed long before the “input” will be received.

If the FHFA wanted to pursue its initiative in a constitutional way, it would withdraw its new rule and bring its proposal to Congress, requesting that a bill be introduced to authorize charging those with good credit more on their mortgage loans in order to subsidize those with riskier credit. I imagine that such a bill would not make much progress among the elected representatives of the People.

FHLBs—Mission and Possible Improvements

Based on long experience and extensive study of various systems of housing finance and of financial systems generally, I respectfully offer the following thoughts on the mission of and possible improvements in the Federal Home Loan Banks (FHLBs).

Mission

I think the mission of the FHLBs is to support, in key words of the Federal Home Loan Bank Act, “sound and economical home finance,” by linking sound home finance nationwide to the bond market.  FHLBs’ principal activities should always be clearly tied to this mission, which should benefit tens of millions of mortgage borrowers throughout the country.

FHLB member institutions should be those which provide sound and economical home finance.  As markets evolve over time, which types of institutions are eligible membership should adapt to appropriately reflect this evolution.  For example, as commercial banks, originally excluded from FHLB membership, largely supplanted savings and loans in home finance, they were logically made eligible for FHLB membership by the Financial Institutions Reform, Recovery and Enforcement Act of 1989.

In my view, the FHLBs should take minimum credit risk, and all the credit risk of the mortgages they link to the bond market should be borne in the first place by the FHLB member financial institutions.  This is true of both FHLB advances, in which all the underlying assets stay on the books of the member, and for the fundamental concept of the FHLB Mortgage Partnership Finance program, in which the mortgage loan moves, but a permanent credit risk “skin in the game” stays for the life of the loan with the member institution, where it belongs.  Note that this is the opposite of selling loans to Fannie Mae and Freddie Mac, in which the lending institution divests the credit risk of its own customer that results from its own credit decision.

Since the mission of the FHLBs is sound and economical home finance, their subsidizing affordable housing projects is secondary. In an economic perspective, these programs may be seen as a tax on the FHLBs, and in a political perspective, a tactic which allows members of Congress the convenience of creating subsidies without having to approve or appropriate the expenditures.

FHLBs without doubt have important benefits from their government sponsorship.  These benefits should primarily go to supporting sound and economical home finance provided by member institutions throughout the country.  To assert that all or most of these benefits must go to subsidizing affordable housing is obviously disproportionate.

In the “mission” discussions, we can usefully distinguish between two groups of FHLB beneficiaries.  First are those who have also have skin in the game through having put their own money at risk by capitalizing, funding or financially backing FHLB operations.  They are the stockholder-members, the bondholders, and the U.S. Treasury.  Second are those who only receive subsidies from the FHLBs.

Suggested Improvements

1. The FHLBs should be given the formal power to issue mortgage-backed securities, provided these securities are always designed so that serious credit risk skin in the game remains with the member institutions.  This would give the FHLBs a very important additional method to carry out their mission and would be a long-overdue catching up with financial market evolution.

2. The Federal Home Loan Bank Act should be amended specifically to authorize the FHLBs to form a joint subsidiary to carry out functions best provided on a combined, national basis.  The participating FHLBs should own 100% of this joint subsidiary.  This addition to the FHLB Act is needed because of the requirements of the Government Corporations Control Act of 1945, when the U.S. Treasury still owned some FHLB stock.  It has not owned any for 70 years, but the 1945 statutory requirement is still there.

3. The prohibition of captive insurance companies from being FHLB members should be promptly withdrawn.  In my view, this was not only a mistake, but inconsistent with the FHLB Act, which has provided from July 1932 to today that “insurance companies” in general, with no distinctions among them, are eligible for FHLB membership.  I believe to change that required Congressional action, which was not taken.  Any insurance company, including a captive insurance company, which provides sound and economical home finance should be eligible for FHLB membership.

I hope these ideas will be helpful for the ongoing success of the FHLBs.

Alex J. Pollock is a Senior Fellow of the Mises Institute and co-author of the new book, Surprised Again!—The Covid Crisis and the New Market Bubble.  He was previously president and CEO of the Chicago FHLB, president of the International Union for Housing Finance, and Principal Deputy Director of the U.S. Office of Financial Research.

How FedGov Destroyed the Housing Market

This podcast is published by the Mises Institute.

There is no real housing market in the US. Instead, an unholy trinity of Fannie/Freddie, the US Treasury, and the Federal Reserve Bank operate to distort the market at every turn and drive home prices up dramatically. Mises Institute Senior Fellow Alex Pollock, an economist and former mortgage banker, joins Jeff to describe the reality few Americans know.

Alex Pollock's new book Surprised Again: The Covid Crisis and the New Market Bubble : Mises.org/HAP377a

Alex Pollock on how the Fed became the world's biggest S&L: Mises.org/HAP377b

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The second housing bubble of the 21st Century ends

Published in the Housing Finance International Journal and re-published in RealClear Markets.

The 21st century, only 23 years old, has already had two giant, international housing bubbles. It makes one doubt that we are getting any smarter with experience.

Among the countries involved in the second bubble, both the U.S. and Canada fully participated in the newest rampant inflation of house prices. Prices this time reached levels far above those of the last boom peak. In the U.S., the S&P/Case-Shiller National House Price Index by mid-2022 had risen to 67% over its 2006 bubble peak (130% over its 2012 trough). In Canada, the Teranet-National Bank House Price Index had soared to 143% over its 2008 peak (168% over its 2009 trough). What the Federal Reserve and the Bank of Canada both wrought with their hyper-low interest rate policies, were house prices which would be unaffordable as soon as mortgage interest rates returned to more normal levels. For a number of years, one could ask: When would that ever happen? Now we know: in 2022.

Now, in late 2022, with mortgage interest rates higher, housing bubbles are deflating, and house prices are dropping on a nationwide basis in both the U.S. and Canada. Here we go again into another house price fizzle following another house price boom.

How is it that we could find ourselves caught up in the problems of another housing bubble so soon? It is only ten years since 2012, the year house prices stopped falling in the U.S., and formed the trough of the painful bust which had followed the preceding bubble of 1999- 2006. Up to the point when house prices started falling across the U.S. last time, expert voices pronounced that U.S. house prices could fall on a regional basis, as they had numerous times, but that it was not possible for house prices to fall on a national basis in an economy so large and diversified. That theory could not have been more mistaken, and national average house prices fell 27%. In 2022, the theory is again being shown to be wrong, but how big the fall will be this time is not known or knowable.

We can take as a key ironic lesson that when large numbers of people believe house prices cannot fall, especially when they are emboldened by central bank behavior, it makes it more probable, and finally makes it certain, that the prices will ultimately fall. When they do, what had been built into everybody’s financial models as “HPA,” or “House Price Appreciation,” becomes instead “HPD”— “House Price Depreciation.” It would be better all along to refer to it as “HPC,” or “House Price Change,” thus reminding ourselves that prices of any asset can go both up and down, perhaps by a lot.

Ten years, it seems, is long enough to dim the memories that prices can move dramatically in both directions, even on a nationwide basis. A bubble market when extended for years makes a great many people happy, since they are making money and seem to be growing richer, and the higher their leverage, the faster they seem to be growing richer. As the great financial observer Walter Bagehot wrote 150 years ago, “the times of too high price” mean “almost everything will be believed for a little while.”

Then the reversal comes and different beliefs come to prevail. In just four months, from June to October 2022, U.S. median house prices dropped a remarkable 8.4%, with prices declining from their peak in all 60 of the largest metropolitan areas in the country. In October, sales of existing houses declined for the ninth month in a row, and were down 28% from a year earlier. Applications for a mortgage to buy a house were down 42% from the year before. Mortgage banks reported they were on average losing money on mortgage originations and many were laying off staff. The share price of 2021’s largest mortgage bank, Rocket Companies, was down 70% from its 2021 high. The CEO of the National Association of Home Builders stated, “We’re heading into a housing recession.”

In Canada, average house prices fell 7.7% from May to October, the largest five-month drop in the history of the Teranet index, which goes back to 1997. In Toronto, the country’s financial capital and a former star of rapid house price inflation, the May to October house price drop was a vertiginous 11.9%. Successive headlines in monthly Teranet-National Bank House Price Index announcements read: “Record price drop in August”; “Another record monthly decline in September”; “Another monthly decline in October.”

In spite of these rapid percentage rates of decline, house prices in both countries are still at very high levels. How much further can they fall from here? For the U.S., the Federal Reserve carefully stated in its latest Financial Stability Report, “With valuations at high levels, house prices could be particularly sensitive to shocks.” Coming to specifics, the AEI Housing Center predicts a 10%-15% nationalaverage fall in house prices during 2023. That would wipe out a lot of housing wealth that the bubble made people think they had, a reduction of perhaps $4 or $5 trillion of perceived wealth on top of the $3 trillion lost so far this year. It would put many houses bought near the top of the market, especially under government low- down payment programs, into no or negative owner’s equity.

For Canada, the Wall Street Journal suggested that its housing market is “particularly sensitive to monetary tightening,” and reported that Oxford Analytics “estimates that home prices in Canada could fall 30%.”

Recall that a price has no substantive reality: it is an intersection of human expectations, actions, hopes and fears. I like to ask audiences, “How much can the price of an asset change?” My proposed answer: “More than you think.”

Of course, nobody, including the Federal Reserve and the Bank of Canada, knows just where house prices will go, but we can all guess. Noted economist Gary Shilling wrote in November, “Price declines are just starting,” and “recent weakness probably has far to go.” This seems to me likely.

In any case, the second great housing bubble of this still young century is over and a new phase has begun.

The historical waning of the U.S. Savings & Loans

Published in Housing Finance International Journal.

At its founding in 1914, the original name of the association which publishes Housing Finance International was the “International Union of Building Societies and Savings & Loan Associations.” This narrow focus fit the times; the name got the unattractive acronym of “IUBSSA.” When it was 75 years old, and after the disastrous number of failures in the U.S. savings & loan industry during the 1980s, a broader perspective was reflected in a new name for the association in 1989: the “International Union of Housing Finance Institutions” (“IUHFI”). Fundamental change in housing finance markets continued, notably the great expansion of mortgage securitization, and showed this was still too narrow an idea. So 1997 brought a yet broader and still current name: the “International Union for Housing Finance.”

I had the honor of co-chairing the committee which proposed the by-law revisions of 1997 that included changing the name, symbolizing that the IUHF is interested in and welcomes participation from all forms of the essential, worldwide activity of housing finance, one of the largest credit markets in the world, as well as one of the most politically and socially most important. Financial evolution, as it has continued in the 25 years since then, shows that wider perspective to be the correct approach.

A fundamental idea governing the shape of housing finance in its historical form of building societies and savings and loans was what was called the “special circuit” of funding for housing finance. As Michael Lea, a former Director of Research for the IUHF, and Douglas Diamond, Jr. wrote in 1992:

“Housing finance traditionally has been an area of intervention by governments, especially through the creation of special circuits for [mortgage] funding flows. … In many countries, governments intervened in the market to set up special circuits, characterized by a significant degree of regulation, segmentation from the rest of the financial markets, and often substantial government subsidy.”1

American savings & loan associations were a large and perfect example of such a special circuit, with savings accounts, which received regulatory advantages, directly linked to mortgage loans, both of which got a lot of favorable political attention. In the U.S. case, the savings & loans were required by law and regulation to make principally very long mortgage loans, with the interest rate fixed for 20 or 30 years. A special circuit was also represented by building societies in the United Kingdom and other countries, thus making up the two parts of the original name and membership of the International Union of Building Societies and Savings & Loans. As Lea also wrote:

“Specialist-deposit funded institutions… traditionally dominated the provision of housing finance in Anglo-Saxon countries (for example, Australia, Canada, South Africa and the United States) as well as Commonwealth countries… Through most of the 20th century, the building societies/savings & loan model dominated housing finance in the English-speaking world.”2 In the U.S., the specialist institutions included, in addition to the savings & loans, their close cousins, the mutual savings banks, known together as “thrift institutions.” In 1980, there were 5,073 thrift institutions in the United States.

As Lea observes, “Starting in the 1980s, this model began to lose influence and market share to commercial banks.” In the U.S., they also lost massive market share to the government-sponsored enterprises, Fannie Mae and Freddie Mac, as that duopoly’s government-guaranteed securitization replaced the balance sheets of thrifts for mortgage funding. By the late 1980s, one housing finance expert could write, “Mortgage-backed securities have forever blown apart thrift balance-sheet compartmentalization.”3

The decline of the special circuit was especially marked in the United States by the collapse of much of the thrift industry. There were failures by the hundreds. Between 1982 and 1992, 1,332 U.S. thrift institutions failed. That is on average 121 housing finance institution failures per year continuing over eleven years, or a rate of more than two failures per week for a decade.

The savings & loan industry as a whole became insolvent on a mark-to-market basis. The government’s deposit insurance fund for the savings & loans, the Federal Savings & Loan Insurance Corporation (FSLIC), itself became completely broke. In 1989, the same year IUBSSA was renamed IUHFI, all these failures resulted in a $150 billion U.S. taxpayer bailout under the emergency Financial Institutions Reform, Recovery and Enforcement Act. Expressed in inflation-adjusted 2022 dollars, that is a bailout of $350 billion.

This was a crisis indeed: the collapse of an entire housing finance structure of a special circuit promoted and guaranteed by the U.S. government. The thrifts had total assets of $796 billion in 1980, or $2.8 trillion in 2022 dollars.

Since the savings & loans had unwisely been required by the government to make primarily long-term fixed rate mortgage loans with their short term, variable rate deposits, when the Great Inflation of the 1970s resulted in double-digit interest rates—with 3-month Treasury bill rates reaching 15% in 1981—such a balance sheet was an obvious formula for disaster.

The savings & loans and other thrifts were, for example, financing assets yielding 6% with liabilities costing 10% or more, spilling an ocean of red ink. The savings & loan regulator of the time, the Federal Home Loan Bank Board (FHLBB), tried earnestly, frantically, and unsuccessfully to avoid the fate of the industry, but it was too late.

Thomas Vartanian, a General Counsel of the FHLBB during the 1980s crisis, looking back from 2021, reflected on the culpability of the government, which had promoted and tried to protect the thrifts, but ended up first trapping them and then charging the taxpayers for their losses.

“In this government-made economic biosphere,” Vartanian wrote, “Savings & loans generally had portfolios of thirty-year fixed-rate that they normally held to maturity. Variable rate mortgages were disfavored and actually prohibited under federal law until 1981”—that applied to federally-chartered savings & loans. “A few states did permit state-chartered savings & loans to make variable rate mortgages…but most savings & loans were compelled by law to do what no sane businessperson would ever advocate: borrow short…and lend long”—very long.

Vartanian concluded, perhaps not too diplomatically, “This financial gross negligence had been imposed on savings & loans by federal law.”4 Of course it was all imposed with good intentions and with cheering from housing interest groups.

By 2000, the more than five thousand thrift institutions had shrunk to 1,589, a nearly 70% attrition. By 2022, the total had been reduced to 602, 88% fewer than as the 1980s began.

This was a dramatic shift in industrial structure from the days of the great post-World War II American housing boom, when savings & loans were the most important mortgage lenders. In this golden age of the savings & loans, the American home ownership rate increased dramatically, from about 50% in 1944 to over 64% in 1980. Waving the banner of housing and home ownership, the savings and loans were politically potent. Their national trade association, the U.S. League for Savings, was a political lobbying force to be reckoned with.

They had their own government deposit insurance fund and their own governmentsponsored liquidity facility, the Federal Home Loan Banks.

The list of the 25 biggest savings & loans in America in 1983 contained many names famous in housing finance circles in those days. How many do you think still exist, thoughtful Reader? Make your guess before you read the answer.

The answer is that of these 25 formerly industryleading institutions, the number still existing as independent companies is zero. Of the 25, 17 failed or were acquired by institutions that later failed. The other eight were acquired and became just a part of much bigger commercial banks. These 25 formerly well-known names are unheard of now, a good lesson for the young in the fragility of institutions and a source of nostalgia, perhaps, for old housing finance veterans.5

The U.S. League for Savings no longer exists, having first changed its name to the Savings and Community Bankers of America, then to America’s Community Banks, then joining with the commercial banks by becoming part of the American Bankers Association.

The Federal Home Loan Bank Board was abolished by Congress and replaced by the Office of Thrift Supervision (OTS). The OTS was subsequently abolished, and its responsibilities moved to regulator of national commercial banks, the Comptroller of the Currency.

FSLIC was abolished by Congress and its deposit insurance fund first taken over by, and then merged into, the Federal Deposit Insurance Corporation, the guarantor of commercial bank deposits.

The Federal Home Loan Banks (FHLBs) remain large and active, but the thrifts, which used to represent all of the FHLB stockholding members, now are only 9% of the members, while commercial banks are 58%.

Lea and Diamond concluded that “Political and market forces seem to have eroded the reasons for having special circuits and the ability to maintain them.” In the U.S. savings & loan case, they certainly did.

The government triangle at the heart of U.S. housing finance

Published by Housing Finance International.

The U.S. central bank’s great 21st century monetization of residential mortgages, with $2.7 trillion of mortgage securities on the books of the Federal Reserve, is a fundamental expansion of the role of the government in the American housing finance system.

In Economics in One Lesson (1946), Henry Hazlitt gave a classic description of those whose private interests are served by government policies carried out at the expense of everybody else. “The group that would benefit by such policies,” Hazlitt wrote, “having such a direct interest in them, will argue for them plausibly and persistently. It will hire the best buyable minds to devote their whole time to presenting its case,” with “endless pleadings of self-interest.”

Such pleadings have characterized the U.S. housing and mortgage lending industries over many decades, in Hazlitt’s day and in ours, with notable success, and resulted in the massive involvement and interventions of the U.S. government in housing finance. Through Fannie Mae, Freddie Mac and Ginnie Mae, the U.S. government guarantees about $8 trillion of mortgage debt. That’s $8 trillion. This sum is about 70% of the $11 trillion of mortgages in the country. Does it make sense for the U.S. government to guarantee 70% of the whole market? It does not. But so it has evolved in the politics of U.S. housing.

As part of this evolution, U.S. mortgage finance has become dominated by a tightly linked government triangle. The first leg of the triangle is composed of Fannie, Freddie and Ginnie (with its associated Federal Housing Administration). This leg we may call the Government Housing Complex.

The second leg in the government mortgage triangle is the United States Treasury. The Treasury is fully liable for all the obligations of the 100% government-owned Ginnie. The Treasury is also the majority owner of both Fannie and Freddie and effectively guarantees all their obligations, too. Through clever financial lawyering, it is not a legal guarantee, however, because that would require the honest inclusion of all Fannie and Freddie’s debt in the calculation of the total U.S. government debt. Unsurprisingly, this is not politically desired.

The same politically undesired, but honest, accounting result would follow if, on top of owning 100% of Fannie and Freddie’s $270 billion of senior preferred stock, the Treasury controlled 80% of their common stock. Government accounting rules require that at 80% the entity's debt must be consolidated into the government debt. That is why Treasury controls 79.9%, not 80%, of their common stock, which is done through warrants with an exercise price that rounds to zero. This is historically consistent, since to get Fannie’s debt off the government’s books was the main reason for its 1968 restructuring it into a so-called “government-sponsored enterprise,” so that President Lyndon Johnson’s federal deficit did not look as big.

The Federal Reserve didn’t used to be, but it has become the third leg of the government mortgage triangle, as the single biggest funder of mortgages by far. Its $2.7 trillion of mortgage securities holdings are limited to those guaranteed by Fannie, Freddie and Ginnie. But those guarantees are only credible because they are in turn backed by the credit of the Treasury.

However, there is another curious circle here. How can the Treasury, which runs huge continuing deficits and runs up its debt year after year, be thought such a good credit? It turns out that an essential support of the credit of the Treasury is the readiness of the Federal Reserve always to buy government debt by printing up the money to do so. This is why having a fiat currency central bank of its own is so very useful to any government. The intertwined credit of the Treasury and of the Federal Reserve are intriguingly dependent on each other, and they both support the credit of the government mortgage complex of Fannie, Freddie and Ginnie.

In this sense, it is helpful to think of the Federal Reserve and the Treasury as one thing – one combined government financing operation, whose financial statements should be consolidated. In such consolidated statements, the $5.8 trillion of Treasury debt owned by the Federal Reserve would be a consolidating elimination. With this approach, we could see the reality more clearly. The Federal Reserve buys and monetizes Treasury debt. Consolidate the statements. The Treasury bonds disappear. What is really happening? The consolidated government prints up money and spends it. In order to spend, it is taxing by monetary inflation, without the need to vote on taxes and without the need for the legislature to act at all.

We should then bring Fannie, Freddie and Ginnie into the consolidation. The government mortgage complex issues mortgage securities, then the Federal Reserve buys and monetizes them. Consolidate the statements, and the mortgage securities held by the Federal Reserve also disappear as a consolidating elimination. What reality is left? The consolidated government prints up “free” money and uses it to make mortgage loans, inflating the price of houses. This arrangement suits housing lobbyists, to be sure, and the proponents of “modern monetary theory” who wish to have no limits on the government’s ability to spend. Of course, this theory is an illusion. The reality, and the most fundamental of all economic principles is: Nothing is free. Free printed money becomes very expensive indeed when it turns into destructive inflation.

In principle, a fiat currency central bank can buy and monetize not just bonds and mortgages, but any asset. For example, the Swiss National Bank (the central bank) includes a large portfolio of U.S. stocks in its investments. It recently reported a net loss of $33 billion for the first quarter of 2022, caused by its $37 billion in investment losses. In the U.S. case, the Federal Reserve in the Covid financial crisis, in cooperation with the Treasury, devised ways to buy corporate debt and even the debt of the nearly insolvent state of Illinois as investments for the central bank.

Further back in history, in the 1960s, some members of the U.S. Congress thought, with the encouragement of the savings & loan industry, that the Federal Reserve ought to buy bonds to provide money to housing. Federal Reserve Chairman William McChesney Martin resisted, arguing that this would “violate a fundamental principle of sound monetary policy, in that it would attempt to use the credit-creating powers of the central bank to subsidize programs benefitting special sectors of the economy.”

That was the right answer, consistent with Economics in One Lesson. But it did not please the politicians. Senator William Proxmire pointedly threatened the Fed:

“You recognize, I take it” he said to the Fed Vice Chairman in 1968, “that the Federal Reserve Board is a creature of the Congress? [That] the Congress can create it, abolish it, and so forth?... What would Congress have to do to indicate that it wishes…greater support to the housing market?”

A new Federal Reserve Chairman, Arthur Burns, arrived in 1971, and decided it would be a good idea to “demonstrate a cooperative attitude.” So, the Federal Reserve began to buy the bonds (not mortgages) of federal housing and other government agencies. It ended up buying the bonds of Fannie Mae, the Federal Home Loan Banks, the Federal Farm Credit Banks, the Federal Land Banks, the Federal Intermediate Credit Banks, the Banks of Cooperatives, and – believe it or not – the debt of the Washington DC subway system. There were suggestions it ought to buy the debt of New York City, when it nearly went bankrupt in 1975.

The Federal Reserve fortunately managed to get out of this program starting in 1978, but the liquidation of the portfolio lasted until the 1990s. Will it be able to get out of its vastly bigger mortgage program now?

In 1978, Hazlitt wrote in The Inflation Crisis, And How to Resolve It: “Inflation, not only in the United States but throughout the world, has… not only continued, but spread and accelerated. The problems it presents, in a score of aspects, have become increasingly grave and urgent.”

In 2022, with U.S. inflation is running at over 8%, here we are again.

As the Federal Reserve now moves to address the inflation, interest rates on the standard American 30-year fixed rate mortgage have gone from their suppressed level of 3% in 2021 to about 5½% in May 2022. Although historically speaking, that is still rather low, it will make many houses unaffordable for those who need a mortgage loan to buy. The interest expense for the same-sized mortgage for the same-priced house has increased by about 80%. How much higher might mortgage interest rates go? With higher mortgage rates, how quickly will the runaway house price inflation end? Will that be followed by a fall in U.S. house prices from their current bubble heights? We are waiting to see.

Can the Federal Reserve Stop Being the World’s Biggest Savings & Loan?

Published in Housing Finance International Journal. Also published in HCWE.

The Federal Reserve’s huge monetization of residential real estate mortgages is one of the radical developments in the history of American housing finance, central banking, money creation, and credit inflation.

Through this investment, the Federal Reserve has become a new element in the massive interventions of the U.S. government in housing finance. Through Fannie Mae, Freddie Mac and Ginnie Mae, the U.S. government guarantees about $8 trillion of mortgage debt, which represents about 70% of the country’s total mortgage loans. In addition, we now find that mortgage funding, cheap mortgage interest rates, and inflated house prices have become dependent on the Federal Reserve. Getting mortgages on the central bank’s balance sheet was a fateful step.

To summarize the story: Into the American financial system strode the Federal Reserve, its pockets filled with newly printed dollars and its printer handy to create more. It bought up the biggest pile of mortgage assets than anybody ever owned. It bought even more Treasury securities, too, accumulating $5.8 trillion of them, so that its balance sheet has reached the memorable total of $8.9 trillion. This is a development not imagined by anyone beforehand, including the Fed itself.

As of March 2022, the Fed owns $2.7 trillion of mortgage securities – in other words, about 23% of all the mortgages in the country are on the central bank’s balance sheet. Moreover, mortgages have become 30% of the Fed’s own inflated total assets. These are truly remarkable numbers, which would certainly have astonished the founders of the Federal Reserve System. I enjoy imagining the architects of the Fed in financial Valhalla, in a lively but puzzled discussion of how their creation of 1913 turned into a giant mortgage funder. Nothing could have been further from their intentions.

Since March 2021, one year ago, the Fed has added $557 billion to its mortgage portfolio, increasing the balance by $46 billion a month on average. It had to buy a lot more than that in order first to replace the repayments and prepayments of the underlying mortgages and then increase the outstanding holdings. The Fed has been the reliable Big Bid in the market, buying mortgages with one hand and printing money to make the purchases with the other.

During this time, the giant U.S. housing sector, representing about $38 trillion in current market value of houses, has experienced an amazing price inflation. U.S. house prices shot up 17% in 2021, as measured by the median sales price, and by 18.8%, as measured by the Case-Shiller national house price index. In January 2022, average house prices rose at the rate of 17%. House prices are far over the 2006 peak which was reached during the infamous Housing Bubble (which was followed by six years of falling prices).

Faced with the rapid escalation in house prices, the Fed unbelievably kept on stimulating the housing market by buying ever more mortgage securities. It thus further inflated the asset price bubble, subsidizing mortgages and distorting house and land prices.

By acquiring $2.7 trillion in mortgages on its balance sheet, the Federal Reserve has made itself far and away the biggest savings & loan institution in the world. Like the savings & loans of old, the Fed owns very long-term fixed-rate assets, and it neither marks its investments to market in its financial statements nor hedges it’s extremely large interest rate risk.

Like the saving & loans of the 1970s, it has loaded up on 15 and 30-year fixed rate mortgages, just in time to experience a period of threateningly high inflation.

Will the Federal Reserve withdraw from being a giant savings & loan? On March 16, 2022, the Fed announced that it “expects to begin reducing its holdings of Treasury securities and agency debt securities and mortgage-backed securities.” This move is very late. The specific decision may be made, the Fed said, “at a coming meeting.” For now, it will keep buying to replace the runoff of the current portfolio. However, shrinkage of the investments in the future seems intended and may be “faster than last time.” How far will such shrinkage, especially of the massive mortgage portfolio, go?

The Fed’s $2.7 trillion in mortgage securities is double the level of March 2020, but more to the point, infinitely greater than the zero of 2006.

From 1913 to 2006, the amount of mortgages the Federal Reserve owned was always zero. That defined “normal.” What is normal now? Should the Fed’s mortgage portfolio be permanent or temporary? Can the mortgage market now even imagine a Fed which owns zero mortgages? Can the Fed itself imagine that?

Should the Federal Reserve’s mortgage portfolio not just shrink some, but go back to zero?

In my opinion, it should indeed go back to zero.

In the beginning of its mortgage buying, this was clearly the Federal Reserve’s intent. As Chairman Bernanke testified to Congress about this bond and mortgage buying program (or “QE”) in 2011:

“What we are doing here is a temporary measure which will be reversed so that at the end of the process the money supply will be normalized, the amount of the Fed’s balance sheet will be normalized, and there will be no permanent increase, either in the money outstanding, or in the Fed’s balance sheet.”

Obviously, that was bad forecast, but that does not mean the intentions were not sincere at the time. “I genuinely believed that it was a temporary program and that our balance sheet would go back [to normal]” said Elizabeth Duke, a Fed Governor from 2008 to 2013.

The recent book, Lords of Easy Money, relates that:

“As far back as 2010, the Fed was debating how to normalize. Credible arguments were made that the process would be completed by 2015, meaning that the Fed would have sold off the assets it purchased through quantitative easing.”

A formal presentation to the Federal Open Market Committee in 2012 projected that the Fed’s investments “would expand quickly during 2013 and then level off at around $3.5 trillion after the Fed was done buying bonds. After that, the balance sheet would start to shrink, gradually, as the Fed sold off all the assets it bought, falling to under $2 trillion by 2019.” Obviously, that didn’t happen.

Early on, the Fed realized that if it did sell assets, and interest rates had normalized to higher levels, and the prices of bonds and mortgages had therefore fallen, it could be realizing significant losses on its sales. Of course, the Fed has made no sales as yet.

The yield of the 10-year U.S. Treasury note touched 2.38% on March 22 as I write, and the 30-year fixed rate mortgage rate reached 4.62%. These rates are high compared to recent experience, but they are still very low, historically speaking, especially compared to the current inflation. Historically, more typical rates would be 4% or more for the 10-year Treasury, and 5% to 6% for mortgages, or more. The interest rate on 30-year mortgage loans was never less than 5% from the mid1960s to 2008.

If the Fed stops suppressing mortgage interest rates and stops being the Big Bid for mortgages, how much higher could those interest rates go from their present, still historically very low level? When the mortgage interest rates rise, how quickly will the runaway house price inflation end?

This leads to an interesting question about the Fed itself: As interest rates rise, how big will the losses on the Fed’s vast mortgage portfolio, and on its even vaster portfolio of long-term Treasury bonds, be? Could the losses be big enough to make the Fed insolvent on a mark-to-market basis?

The duration of the Fed’s $2.7 trillion mortgage portfolio is estimated at about 5 years. That means that for each 1% that mortgage interest rates rise, the portfolio loses 5% of its market value. So a 1% rise would be a loss in market value of about $135 billion, and a 2% rise in mortgage rates, a loss of value of $270 billion.

With the $5.8 trillion of Treasury securities on the Fed’s balance sheet, it owns about 24% of all Treasury debt in the hands of the public and a lot of very long bonds. I tried to estimate the duration of the portfolio and came up with about 5 years. Then on a 1% increase in rates, the market value loss to the Fed will be $285 billion and on a 2% rise, $570 billion.

Add the mortgage results and the Treasury portfolio results together and you get these market value losses in round numbers: for a 1% rise in rates, over $400 billion; for a 2% rise, over $800 billion.

Now compare that to the net worth of the consolidated Federal Reserve System, which is $41 billion. A capital of $41 billion is subject to a potential market value loss of $400 billion or $800 billion. It is easy to imagine that the Fed may become insolvent on a mark-to-market basis, just as the savings & loans were in the 1980s.

But does mark to market insolvency matter if you are a fiat currency central bank? Most economists say No. If the Fed were mark-to-market insolvent, probably nothing would actually happen. You would still keep accepting its notes in payments. The Fed would keep accounting for its securities at par value plus unamortized premium, and the unrealized loss, however massive, would not touch the balance sheet or the capital account.

But suppose the Fed actually does sell mortgages and bonds into a rising rate market, and takes realized, cash losses. Suppose they bought a mortgage security for the price of 103, and sell it for 98, for a realized loss of 5, and that 5 is gone forever. Wouldn’t that loss have to hit the capital account, and if such losses were big enough, force the Fed’s balance sheet to report a negative capital – that is, technical insolvency?

It may surprise you to learn, as it surprised me to learn, that the answer is that this realized, cash loss would not affect the Fed’s reported capital at all. No matter how big the realized losses were, the Fed’s reported capital would be exactly the same as before. That ought to be impossible, so how is it possible?

It is because in 2011, while considering how it might one day sell the mortgages and bonds it was accumulating, the Fed logically realized that if interest rates returned to more normal levels, it would be selling at a loss. What to do? It decided to change its accounting. The Federal Reserve has the advantage of setting its own accounting standards. It decided to account for any realized losses on the sale of securities not as a reduction in retained earnings and capital but as an intangible asset! This was clever, perhaps, but hardly upright accounting. I would certainly hate to be the CFO of an SEC-regulated corporation who tried that one.

But here is a great irony: This is precisely what the old savings & loans, facing insolvency, did in the early 1980s. So the new, biggest savings and loan in the world, potentially faced with the same problem as the old ones, came up with the same idea.

Will the Federal Reserve really get out of its “temporary” mortgage program now? Will it ever get back to the formerly normal zero? And if it ever sells mortgage securities, what losses will it realize?

It's Another Housing Bubble And The Fed Is Holding The Pin

Published in Zero Hedge:

As economist Alex Pollock put it in an article published by the Mises Wire earlier this year, the Fed “continues to be the price-setting marginal buyer or Big Bid in the mortgage market, expanding its mortgage portfolio with one hand, and printing money with the other.”

In 2006, the Fed owned zero mortgages. Today, The central bank holds about $2.6 trillion in mortgage-backed securities on its balance sheet. According to Pollock, about 24% of all outstanding residential mortgages in the US reside in the central bank. That makes the Fed, by far, the largest savings and loan institution in the world.

The Federal Reserve KeepsBuying Mortgages

Published by the Housing Finance International Journal.

Runaway house price inflation continues to characterize the U.S. market. House prices across the country rose 15.8% on average in October 2021 from the year before. U.S. house prices are far over their 2006 Bubble peak, and remain over the Bubble peak even after adjustment for consumer price inflation. They will keep on rising at the annual rate of 14-16% for the rest of 2021, according to the AEI Housing Center.

Unbelievably, in this situation the Federal Reserve keeps on buying mortgages. It buys a lot of them and continues to be the price-setting marginal buyer or Big Bid in the mortgage market, expanding its mortgage portfolio with one hand, and printing money with the other. It should have stopped before now, but the purchases, financed by newly created fiat money, or monetization, go on. They proceed at the rate of tens of billions of dollars a month, stoking the house price inflation, making it harder and harder for new families to afford a house. A recent Wall Street Journal opinion piece was entitled, “How the Fed Rigs the Bond Market” – it rigs the mortgage market, too.

The balance sheet of the Federal Reserve has grown to a size that would have amazed previous generations of Federal Reserve governors and economists. Although we have become somewhat accustomed to it, so fast do perceptions adjust, it would also have surprised readers of Housing Finance International of five years ago, and readers of 15 years ago would probably have judged the current reality simply impossible. Over time, we keep discovering how feeble are our judgments of what is possible or impossible.

The total assets of the Federal Reserve reached $8.7 trillion in November 2021. This is just about double the $4.5 trillion of November 2016, five years before – and we thought it was really big then. Today’s Federal Reserve assets are ten times what they were in November 2006, 15 years ago, when they were $861 billion, and none were mortgages.

The Federal Reserve now owns on its balance sheet $2.6 trillion in mortgages. That means about 24 % of all outstanding residential mortgages in this whole big country reside in the central bank, which has thereby earned the remarkable status of becoming by far the largest savings and loan institution in the world. Like the historical U.S. savings and loans associations, the Federal Reserve owns very long- term mortgages, with their interest rates fixed for 15 to 30 years, and neither marks its investments to market in its financial statements nor hedges its substantial interest rate risk. It accounts for its mortgages at par value, not what it paid for them, and separately reports $338 billion of unamortized premiums (net of discounts) on securities – presumably a significant proportion of this is premiums paid on mortgages and thus additional investment in them.

This $2.6 trillion in mortgages is 48% more than the Federal Reserve’s $1.76 trillion of five years ago, and of course, infinitely greater than the zero of 2006. Remember that from the founding of the Federal Reserve until then, the number of mortgages it owned had always been zero. That was what was normal. Whether moving into directly subsidizing mortgages and inflating the price of houses be considered progress or deterioration, or perhaps first the former and then the latter, it was certainly a big change. It was an emergency action in both the financial crisis of 2007-09 and the financial panic of 2020. Should a giant Federal Reserve mortgage portfolio be permanent or temporary? If temporary, how long should it go on?

The Cincinnatian Problem

An abiding problem is how you can reverse central bank and government crisis interventions, initially thought and meant to be temporary, after the crisis passes. The idea that government intervention, required in times of crisis, should be withdrawn in the renewed normal times which follow, I call the Cincinnatian Doctrine. It is named for the ancient Roman hero Cincinnatus, who was called from his plow to save the State, became temporary Dictator, did save the State, and then, mission accomplished, went back to his farm. (I introduced this term at the IUHF World Congress in 2006, just before the housing bubble of the time imploded.)

However sincere the intent that they should be temporary, the emergency interventions inevitably build up economic and political constituencies who profit from them and want them continued indefinitely. The difficulty of winding them back down, once they have become established, I call the Cincinnatian Problem. There is no easy answer to the problem. How, so to speak, do you get the Federal Reserve to go back to its farm, once it has enjoyed becoming the dominant mortgage investor in the world?

In the 1960s, the Congress pushed the Federal Reserve to support the housing market by buying the debt issues (not mortgages) of Fannie Mae and other federal agencies involved with housing. The Federal Reserve of the time resisted. Fed Chairman William McChesney Martin testified that such an idea would “violate a fundamental principle of sound monetary policy in that it would attempt to use the credit-creating powers of the central bank to subsidize programs benefitting special sectors of the economy.”

That seems to me exactly the right principle for normal times. In the last two crises, the Federal Reserve has decided to do precisely the opposite, that is “to use the credit-creating powers of the central bank to subsidize” a particularly political sector of the economy, namely housing finance. When the crises are over, and the interventions have become huge distortions, what next? Can we now even imagine a Federal Reserve which owns zero mortgages? At this point, can the Federal Reserve itself imagine that?

“Tapering”

In November 2021, the Federal Reserve belatedly announced it would begin to “taper” its purchases of mortgages (as well as of Treasury debt) and in December announced further that it would “taper” more quickly. This still means with ongoing, unabated inflation in house prices, the Federal Reserve is going to continue buying mortgages – only it will buy less than before. It will reduce the rate at which it increases its mortgage portfolio.

Specifically, the Federal Reserve had been buying enough mortgages to make its portfolio go up by $40 billion a month, after replacing all principal repayments and prepayments. Now the net increase will be reduced by $10 billion a month. If it proceeds at this rate, the Federal Reserve will add $60 billion to its mortgage portfolio over three months before getting to a zero net addition. What happens then? Will it keep buying to maintain the size of its massive portfolio? Will it let the portfolio run off? – which would take a long time, perhaps lasting to the next financial crisis. Will it ever sell a single mortgage security? I believe nobody knows, including the Federal Reserve.

Our closing questions on the outlook are: If the Federal Reserve stops being the Big Bid for mortgages, how much higher will mortgage interest rates go from their present abnormally low level? When the mortgage rates rise, how quickly will the house price inflation end? Will it reverse? How will the Federal Reserve, and the country, address their Cincinnatian Problem?

William Isaac Announcements: December 23, 2021

From William Isaac’s email campaign and website:

December 23, 2021

Alex Pollock and Ed Pinto, two long-time friends of mine, who are THE leading experts on government housing programs, have written an important article on the past, present and future of government housing programs. I encourage you to read their new article on my website.

• Federal Housing Regulators Have Learned and Forgotten Everything by Alex J. Pollock and Edward J. Pinto

The full article can be found at williamisaac.com. Be safe and be well.

Federal Housing Regulators Have Learned and Forgotten Everything

Published in Law & Liberty and in Real Clear Markets.

Should the government subsidize buying houses that cost $1.2 million? The answer is obviously no. But the government is going to do it anyway through Fannie Mae and Freddie Mac. The Federal Housing Finance Authority (FHFA) has just increased the size of mortgage loans Fannie and Freddie can buy (the “conforming loan limit”) to $970,080 in “high cost areas.” With a 20% down payment, that means loans for the purchase of houses with a price up to $1,212,600.

Similarly, the Federal Housing Administration (FHA) will be subsidizing houses costing up to $1,011,250. That’s the house price with a FHA mortgage at its increased “high cost” limit of $970,800 and a 4% down payment.

The regular Fannie and Freddie loan limit will become $647,200, which with a 20% down payment means a house costing $809,000. The median U.S. price sold in June 2021 was $310,000. A house selling for $809,000 is in the top 7% in the country. One selling for $1,212,600 is in the top 3%. To take North Carolina for example, where house prices are less exaggerated, an $809,000 house is in the top 2%. For FHA loans, the regular limit will become $420,680, or a house costing over $438,000 with a 4% down payment—41% above the national median sales price.

Average citizens who own ordinary houses may think it makes no sense for the government to support people who buy, lenders that lend on, and builders that build such high-priced houses, not to mention the Wall Street firms that deal in the resulting government-backed mortgage securities. They’re right.

Fannie and Freddie, which continue to enjoy an effective guarantee from the U.S. Treasury, will now be putting the taxpayers on the hook for the risks of financing these houses. Through clever financial lawyering, it’s not legally a guarantee, but everyone involved knows it really is a guarantee, and the taxpayers really are on the hook for Fannie and Freddie, whose massive $7 trillion in assets have only 1% capital to back them. FHA, which is fully guaranteed by the Treasury, has in addition well over a trillion dollars in loans it has insured.

By pushing more government-sponsored loans, Fannie, Freddie, its government conservator, the FHFA, and sister agency, the FHA, are feeding the already runaway house price inflation. House prices are now 48% over their 2006 Housing Bubble peak. In October, they were up 15.8% from the year before. As the government helps push house prices up, houses grow less and less affordable for new families, and low-income families in particular, who are trying to climb onto the rungs of the homeownership ladder.

As distinguished housing economist Ernest Fisher pointed out in 1975:

[T]he tendency for costs and prices to absorb the amounts made available to prospective purchasers or renters has plagued government programs since…1934. Close examination of these tendencies indicates that promises of extending the loan-to-value ratio of the mortgage and extending its term so as to make home purchase ‘possible for lower income prospective purchasers’ may bring greater profits and wages to builders, building suppliers, and building labor rather than assisting lower-income households.

The reason the FHFA is raising the Fannie and Freddie loan-size limits by 18%, is that its House Price Index is up 18% over the last year. FHA’s limit automatically goes up in lock step with these changes. These increases are procyclical acts. They feed the house price increases, rather than acting to moderate them, as a countercyclical policy would do. Procyclical government policies by definition make financial cycles worse and hurt low-income families, the originally intended beneficiaries.

The contrasting countercyclical objective was memorably expressed by William McChesney Martin, the longest-serving Chairman of the Federal Reserve Board. In office from 1951 to 1970, under five U.S. presidents, Martin gave us the most famous of all central banking metaphors. The Federal Reserve, he said in 1955, “is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”

Long after the current housing price party has gotten not only warmed up, but positively tipsy, the Federal Reserve of 2021 has, instead of removing the punch bowl, been spiking the punch. It has done this by, in addition to keeping short term rates at historically low levels, buying hundreds of billions of dollars of mortgage securities, thus keeping mortgage rates abnormally low, and continuing to heat up the party further.

In general, what a robust housing finance system needs is less government subsidy and distortion, not more.

In fact, the government has been spiking the housing party punch in three ways. First is the Federal Reserve’s purchases of mortgage securities, which have bloated its mortgage portfolio to a massive $2.6 trillion, or about 24% of all U.S. residential mortgages outstanding.

Second, the government through Fannie and Freddie runs up the leverage in the housing finance system, making it riskier. This is true of both leverage of income and leverage of the asset price. It is also true of FHA lending. Graph 1 shows how Fannie and Freddie’s large loans have a much higher proportion of high debt-to-income (DTI) ratios than large private sector loans do. In other words, Fannie and Freddie tend to lend more against income, a key risk factor.

Graph 1: Percent of loans over 43% DTI ratio

Source: Fisher, Lynn M., et al. “Jumbo rates below conforming rates: When did this happen and why?.” Real Estate Economics 49.S2 (2021): 461-489.

Fannie and Freddie also make a greater proportion of large loans with low down payments, or high loan-to-value (LTV) ratios, than do corresponding private markets. Graph 2 shows the percent of their large loans with LTVs of 90% or more—that is, with down payments of 10% or less—another key risk factor.

Graph 2:  Share of loans with LTV ratios over 90%

Source: Fisher, Lynn M., et al. “Jumbo rates below conforming rates: When did this happen and why?.” Real Estate Economics 49.S2 (2021): 461-489.

Now—on top of all that– the FHFA, by upping the loan sizes for Fannie and Freddie, is bringing to the party a bigger punch bowl. That the size limit for Fannie and Freddie is very important in mortgage loan behavior, we can see from how their large loans bunch right at the limit, as shown by Graph 3.

The third spiking of the house price punch bowl consists of the government’s huge payments and subsidies in reaction to the pandemic. A portion of this poorly targeted deficit spending money made its way into housing markets to bid up prices.

A key housing finance issue is the differential impact of house price inflation on lower-income households. AEI Housing Center research has demonstrated how the spiked punch bowl has inflated the cost of lower-priced houses more than others. This research shows that rapid price increases crowd out low-income potential home buyers in housing markets. Thus, as Ernest Fisher observed nearly 50 years ago, government policies that make for rapid house price inflation constrain the ability to become homeowners of the very group the government professes to help.

In general, what a robust housing finance system needs is less government subsidy and distortion, not more. The question of upping the size of Fannie and Freddie loans, and correspondingly those of the FHA, is part of a larger picture of what the overall policy for them should be. Should we favor making their subsidized, market distorting, taxpayer guaranteed activities even bigger than the combined $8 trillion they are already?  Should they become even more dominant than they are now?  Or should the government’s dominance of the sector and its risk be systematically reduced?  That would be a movement toward a mortgage sector that is more like a market and less like a political machine.

In short, what about the future of the government mortgage complex, especially Fannie and Freddie: Should they be even bigger or smaller?  We vote for smaller.

How might this be done? As a good example, Senator Patrick Toomey, the Ranking Member of the Senate Banking Committee, has introduced a bill that would eliminate Fannie and Freddie’s ability to subsidize loans on investment properties, a very apt proposal. It will not advance with the current configuration of the Congress, but it’s the right idea. Similarly, it would make sense to stop Fannie and Freddie from subsidizing cash-out refis, mortgages that increase the debt on the house. Another basic idea, often proposed historically, but of course never implemented, would be to reduce, not increase, the maximum size of the loans Fannie and Freddie can buy, and by extension, FHA can insure.

In the meantime, the house price party rolls on. How will it end after all the spiked punch?  Doubtless with a hangover.

Alex J. Pollock is a senior fellow at the Mises Institute and the author of Finance and Philosophy: Why We're Always Surprised. His five decades of financial experience include being the Principal Deputy Director of the U.S. Treasury’s Office of Financial Research and the president and CEO of the Federal Home Loan Bank of Chicago.

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Edward J. Pinto is an American Enterprise Institute (AEI) senior fellow and director of AEI’s Housing Center. The Center monitors the US markets using a unique set of Housing Market Indicators. Active in housing finance for over 40 years, he was an executive vice president and chief credit officer for Fannie Mae until the late 1980s.

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The Next Housing Bust

Published in Law & Liberty.

The Supreme Court has determined that the Federal Housing Finance Agency (FHFA)—the regulator and conservator of the government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac—was unconstitutionally structured because its director could only be removed from office for cause. The Court held in its June 23, 2021 decision that the constitutional issue could be resolved by striking the “for cause” language—leaving the FHFA in place, but headed by a director who could be removed from office at any time by the President.

Immediately upon the Court’s decision, the White House fired the FHFA director, Mark Calabria, and replaced him with a temporary appointment. Calabria had been following a policy of increasing the capital of the GSEs in preparation for privatizing them and reducing their risk to the taxpayers; his temporary replacement forthwith reversed course. Said Sandra Thompson, Calabria’s acting replacement, “It is FHFA’s duty through our regulated entities to ensure that all Americans have equal access to safe, decent, and affordable housing.”

This means a sharp change in marching orders for Fannie and Freddie—from a future as privatized companies to a future of being used to accumulate the risk of the government’s housing policies and increase the risk to taxpayers. 

This sets up the conditions for the next housing bust. We have seen this movie twice before and know the ending.

The first time began in 1968 when HUD developed a “10-year housing program to eliminate all substandard housing.” Since there were then, like now, very large budget deficits, this program was implemented off-budget. The answer was the 1968 Housing and Urban Development Act, which had FHA insuring the 10-year plans’ subsidized single- and multifamily loans and Fannie funding them. Fannie was up to then a government agency with its debt on-budget. The 1968 Act converted it to an off-budget GSE. Now it was in a position to fund the largest expansion of newly built and rehabilitated subsidized housing in the nation’s history with up to 40-year fixed-rate loans. There have been only two years where privately owned single- and multifamily housing completions exceeded 2 million: 1972 (2.00 million) and 1973 (2.10 million)—when the population was 210 million and the number of households was 67 million, 36% and 48% respectively and smaller than today. As a reference, in 2006, at the peak of the Housing Bubble, there were 1.98 million completions.

In just a few years, HUD’s program turned into a disaster for cities and their residents, as described in the book Cities Destroyed for Cash: The FHA Scandal at HUD written in 1973.  Detroit, Chicago, Cleveland, and many other cities never fully recovered from the effects of HUD’s scheme. By the early 1980s, Fannie’s investment in these loans had suffered huge interest rate risk losses that left it effectively insolvent. It was only able to continue in business given its GSE status and backing by the Treasury.   

The second time began in 1992. Over the following years, the government forced Fannie and Freddie to reduce their credit standards so as to acquire trillions in risky loans under the rubric of affordable housing. The first of many trillion-dollar commitments was announced by Jim Johnson, Fannie’s very politically connected CEO, in March 1994. He vowed to “transform the housing finance system.” He did, but not in the way he intended. In 1994, HUD followed with its National Homeownership Strategy, about which President Clinton claimed: “Our home ownership strategy will not cost the taxpayers one extra cent.” A poor prediction indeed!

This government policy was pursued until 2008 through HUD’s authority to impose what were called “Affordable Housing Goals” on the GSEs. To meet ever more aggressive HUD goals, Fannie and Freddie had to continually reduce their mortgage credit standards, especially with respect to loan-to value and debt-to-income ratios. Instead of HUD’s strategy promoting homeownership, it resulted in some 10 million foreclosures and once again devastated our cities.

The full extent of the catastrophic credit risk expansion that took place has now been documented in a detailed analysis that researchers at FHFA and AEI released in May 2021. This is the first “comprehensive account of the changes in mortgage risk that produced the worst foreclosure wave since the Great Depression.” By analyzing over 200 million mortgage originations from 1990 onward, they showed “that mortgage risk had already risen in the 1990s, planting seeds of the financial crisis well before the actual event.” Average leverage and average DTI (the debt-payment to income ratio) on both home purchase and refinance loans increased significantly over the decade. Since Fannie and Freddie accounted for about 50% of the total mortgage market over the period 1994-2007, their complicity in the ensuing disaster is clear. The bubble’s inevitable collapse brought down many banks and other financial institutions, creating the 2008 financial crisis. In 2008 Fannie and Freddie were bailed out by the taxpayers and put into conservatorship, where they remain today, 13 years later.

The Democratic Congress elected in the wake of the crisis adopted the Dodd-Frank Act of 2010. It reflected the Democrats’ view that insufficient regulation caused the crisis. But the most important culprits—Fannie and Freddie—were left untouched, insolvent, and still functioning. Because it has become entirely clear that the US government is effectively the 100 percent guarantor of the GSEs, with the taxpayers fully on the hook, the financial markets provide unlimited funds for their operations. Thus the GSEs are allowed to operate profitably in their government conservatorship by using the U.S. Treasury’s global credit card. Today their off-budget, taxpayer-backed debt totals nearly $6 trillion, with the Federal Reserve funding more than $2 trillion of their mortgage-backed securities. 

As the saying goes, those who cannot remember the past are condemned to repeat it, and the U.S. has a history of catastrophic housing blunders to remember, also including the spectacular failure and bailout at taxpayer expense of the savings and loan industry in 1989. Three dramatic failures in four decades—not an enviable track record. 

Any president, thanks to the Supreme Court decision, now has direct control over most of the mortgage finance system. This includes Fannie and Freddie through FHFA; and the FHA and Ginnie Mae through HUD.

Government involvement not only creates moral hazard but also always generates political pressures for increasingly risky lending such as “affordable loans” to constituent groups, which in the end harms both these groups and the taxpayers. 

While the Supreme Court’s decision about the governance of FHFA is correct on its merits, the main problem is that we have a nationalized and socialized housing finance system. The American Jobs Plan proposes spending $318 billion to construct, restore, and modernize more than two million affordable homes. It is almost certain that the government will use its new control over the GSEs to once again make them the central elements of its plan with another weakening of credit standards. Thus we face the prospect of combining some of the worst features of HUD’s 1968 subsidized housing debacle with the GSEs’ disastrous foray into high-risk lending. Given this, can another mortgage debt crisis be far behind? 

However, the government does not have to follow the fatally flawed policies of the Johnson, Clinton, and Bush administrations. If instead the following four principles were implemented, the United States would have a robust, successful housing finance system it needs and its citizens deserve.

I. The housing finance market—like other US industries and housing finance systems in most other developed countries—can and should function principally as a private market, not a government-dominated one.

The foreclosures and financial losses associated with the 1968 Housing Act, the savings and loan (S&L) debacle of the 1980s, and the actions of Fannie, Freddie, and HUD did not come about in spite of government support for housing finance but because of that government backing. Government involvement not only creates moral hazard but also always generates political pressures for increasingly risky lending such as “affordable loans” to constituent groups, which in the end harms both these groups and the taxpayers. 

Although many schemes for government guarantees of housing finance in various forms have been circulating in Washington ever since the GSEs entered receivership, they are fundamentally the same as the policies that caused failures in the past. The flaw in all these ideas is the notion that the government can successfully guarantee increasing risk and will establish an accurate risk-based price for its guarantees. Many examples show that this is politically beyond the capacity of government.

First, the government’s guarantee eliminates an essential element of financial discipline—it removes credit risk from the investors. Second, the seemingly free-lunch nature of the off-budget guarantees creates the lure of the “affordable housing cookie jar”—cross-subsidies, “free money,” FHA and the GSEs competing for high-risk borrowers, and the perennial weakening of underwriting standards—all of which are backed by a government guarantee. So the outcome will be the same: underwriting standards will deteriorate, regulation of issuers will fail, and taxpayers will take losses once again.

II. Ensuring mortgage credit quality, and fostering the accumulation of adequate capital behind housing risk, can create a robust housing investment market without a government guarantee.

This principle is based on the fact that high-quality mortgages are good investments and have a long history of low losses. Instead of expanding government guarantees to reassure investors in MBS, we should simply ensure that the mortgages originated and distributed are predominantly of good quality. The characteristics of a good mortgage do not have to be invented; they are well known from many decades of experience. These are loan characteristics that, taken together, are highly predictive of loan performance. They include the borrower’s credit score, the debt-payment to income ratio (DTI), the combined loan-to-value ratio (CLTV), loan type (fixed or adjustable mortgage rate), loan term, loan purpose, whether the borrower’s income is fully documented, and whether the mortgage has a feature that modifies the amortization of loan principal. We know that mortgage lending must limit risk layering. We know how to apply a summary measure of default risk. The Stressed Mortgage Default Rate (MDR) is a simple, straightforward way to do this.

Regulation of credit quality could help prevent the deterioration in underwriting standards, although in previous cycles regulation promoted lower credit standards. The natural human tendency to believe that good times will continue—and that “this time is different”—will continue to create price booms in housing. Housing bubbles spawn risky lending; investors see high yields and few defaults, while other market participants come to believe that housing prices will continue to rise. Future bubbles and the losses suffered when they deflate can be minimized by focusing regulation on the maintenance of credit quality.

Stressed MDRs have demonstrated their efficacy. Calculated solely on the basis of loan characteristics present at origination, Stressed MDRs are highly predictive of default rates both in a non-stress delinquency environment (R-squared is 96%) and in a stress delinquency environment (R-squared is 99.9%) for all types of mortgage loans. By using MDR to risk rate loans at origination and regulate loan risk, we can control the accumulation of future losses which result from deteriorating underwriting standards.

III. All programs for assisting low-income families to become homeowners should be on-budget and should limit risks to both homeowners and taxpayers.

The third principle recognizes that there is an important place for social policies that assist low-income families to become homeowners, but these policies must explicitly balance the interest in low-income lending against the risks to the borrowers and to the taxpayers. In the past, implicit “affordable housing” subsidies through weak credit standards turned out to escalate the risks for both borrowers and taxpayers. The quality and budgetary trade-offs of riskier lending should be clear and on-budget.

The boom-bust cycle that low-income homebuyers have been subjected to for decades under the guise of making homes more affordable by escalating risk with weak lending standards should be broken. This result could be accomplished with the 20-Year Wealth Building Home Loan combined with an interest rate buy down provided by the federal government to an income-targeted group of first-time buyers. This would materially reduce defaults in low-income neighborhoods and sustainably foster generational wealth building. 

If the federal government wants to subsidize low and moderate income homebuyers effectively, it should use this and other on-budget, transparent and sustainable ways to do it. Fannie and Freddie have no role here, as the only way they can participate is through reducing their credit standards with the real cost hidden in the form of expanding risk.

IV. Fannie Mae and Freddie Mac should be truly privatized, with their hidden subsidies and government-sponsored privileges eliminated over time.

Finally, Fannie and Freddie should be eliminated as GSEs and privatized—but gradually, so the private sector takes on more of the secondary market as the GSEs withdraw. The progressive withdrawal of GSE distortions from the housing finance market should lead to the sunset of the GSE charters at the end of the transition. This should include successive reductions in the GSEs’ conforming loan limits by 20 percent of the previous year’s limits each year, according to a published schedule, so the private sector can plan for the investment of the necessary capital and create the necessary operational capacity. The private mortgage market would include banks, S&Ls, insurance companies, pension funds, other portfolio lenders and investors, mortgage bankers, mortgage insurance (MI) companies, and private securitization. Congress should make sure that it facilitates opportunities for additional financing alternatives.

We know that none of this will happen in the near term, and the opposite of these principles will probably be followed by the current administration. Nonetheless, the principles define the housing finance direction that a future, market-oriented Congress and administration should take. In the meantime, all mortgage actors should try to protect themselves against the increased credit risk that Fannie and Freddie, under orders from the FHFA, will be generating.