The Federal Reserve plunges into the mortgage market and takes a bath

Published in Housing Finance International Journal.

The most important central bank in the world, the Federal Reserve, owned on September 30, 2024, the staggering sum of $2.3 trillion in mortgage securities, making it by far the biggest investor in the “agency MBS” market which dominates U.S. housing finance. These are the mortgage securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae, which total $9.3 trillion. Thus, the central bank owns 25% of the total relevant market, a massive concentration of interest rate and market risk. How has the Fed done on this investment?

The Fed’s mortgage securities portfolio had, as of September 30, a mark-to-market loss of $315 billion, or more than 7 times its stated total capital of $43 billion. The average yield on its mortgage securities portfolio is only 2.2%, while its deposits are costing it 4.65%, for a negative spread on these investments of 2.45%. This means the Fed has an annualized operating loss on its mortgages of $56 billion, equal to a cash loss per year of 130% of its stated total capital. (The Fed is in addition losing money on its portfolio of long-term Treasury bonds.) The underlying mortgages of the Fed’s mortgage securities are primarily 30-year fixed-rate loans, so they have a long time yet to run. In this respect, the Fed looks just like the biggest 1980s-style savings and loan in history. It is quite amusing to think about what Federal Reserve examiners would say to any regulated bank which ran such risk and produced such outcomes!

Moreover, the Fed must transfer most of any profits it makes to the U.S. Treasury, so when the Fed has losses, its losses are also losses to the Treasury and costs to the taxpayers, imposed on them without legislation or Congressional approval. The Fed’s losses increase the government deficit and the government’s debt. As the provocative financial observer Wolf Richter has written, we are “in the era of the money-losing Fed.” The U.S. has never been in such an era before.

In the process of making these losing investments, the Fed greatly distorted the U.S. housing market. Its purchases of mortgage securities with newly created money, or the monetization of mortgages, resulted in a rapid expansion of abnormally cheap mortgage credit, driving the interest rates on 30-year fixed rate mortgages to below 3%, and fueling a rapid acceleration in house prices which has made them unaffordable to large segments of the American population. This was the Second U.S. Housing Bubble of the still young 21st century.

Many people, including me, thought that when U.S. mortgage interest rates inevitably went back to normal levels of 5%-6% or more, average U.S. house prices would fall. They did fall a little, but then started back up. With the standard U.S. 30-year mortgage now costing 6.8%, U.S. house prices nonetheless went up about 4% over the last 12 months.

The most common theory to explain this surprising outcome is that the lucky borrowers of 3% mortgages with the rate fixed for 30 years don’t want to lose the large financial advantage of their abnormally cheap debt by moving, so they disproportionately stay in their houses, thereby reducing the normal supply of houses available for sale and holding up house prices. If this be true, it is another striking source of distortion in the housing market by the Fed.

Quoting Wolf Richter again: “If [house price] charts look absurd it’s because the housing market has become absurd. Housing market charts should never ever look like this. They’re documenting the crazy distortions triggered by the Fed’s monetary policies.” I believe Wolf is correct about this.

Does a huge position in mortgage securities belong on the balance sheet of the U.S. central bank? An authoritative Federal Reserve study of what assets the Fed might invest in, in addition to Treasury securities, is Alternative Instruments for Open Market and Discount Window Operations (2002), written by an expert Federal Reserve System Study Group. This careful study articulated as two of its essential principles that the Fed should:

“Structure its portfolio and undertake its activities so as to minimize their effect on relative asset values and credit allocation within the private sector.”

“Manage its portfolio to be adequately compensated for risks and to maintain sufficient liquidity in its portfolio to conduct potentially large actions on short notice.”

It is apparent that the Fed’s mortgage investments have violated both these principles.

As for the first, they had a major effect on relative asset values, pushing the price of houses up at double-digit annual rates. And they were a massive allocation of credit by the central bank to a particular sector within the private economy, namely housing.

Regarding the second principle, instead of being adequately compensated for its risks, the Fed is suffering, as discussed above, operating and market value losses on its mortgage investments far greater than its capital. As for liquidity, the Fed can’t get out of its mortgage position in any short term—the position is too big relative to the market. Selling it would entail realizing the portfolio’s market value deficit, thus turning paper losses into cash losses.

It is not a practical possibility for the Fed to liquidate its mortgage portfolio on short notice. If it did manage to sell, at least $315 billion in new cash losses would have to be reported in its profit and loss statement. Adding these to the $210 billion in operating losses it has already reported, that would bring its total cash losses to well over half a trillion dollars. Recall that this is also an increase in the federal deficit and the federal debt. Such losses would not only be an embarrassment to the Fed, but might trigger Congressional attention it doesn’t want.

Worse, the Fed would not be able to unload its mortgage securities for as much as its fair value estimate. Trying to quickly sell its massive position would drive the market prices down against it, causing a loss much greater than $315 billion--indeed it might crash the mortgage-backed securities market. Even the announcement that the Fed planned to sell its securities gradually over time would probably lower MBS prices and thereby increase mortgage interest rates—hardly a welcome political outcome.

So it looks like the Fed will have to just hold its losing mortgage securities until the underlying 30-year mortgages slowly mature over time, as “the era of the money-losing Fed” continues. It does not appear that anyone, including the new Trump Administration, can change this outcome.

Looking further forward, the troublesome results of the Federal Reserve’s mortgage investing experiments will certainly provide good material for future historians and theorists of central banking and housing finance.

A European Fannie/Freddie?

A bad idea

Published in Housing Finance International Journal.

The U.S. national housing finance market is uniquely dominated by two government mortgage companies, Fannie Mae and Freddie Mac. They do exactly the same thing, creating mortgage-backed securities that are de facto government-guaranteed. They are both completely dependent on the credit support of the U.S. Treasury, and thus dependent on American taxpayers. Both went broke in 2008, and both were bailed out by the Treasury, which still owns $193 billion of their senior preferred stock, sixteen years later. Both are in an unending conservatorship of a very political government bureaucracy, the Federal Housing Finance Agency. They are in effect a single huge market intervention and subsidy.

Fannie/Freddie are truly massive, with combined assets of US$ 7.6 trillion.1 They create a systemically risky concentration of national mortgage credit exposure in Washington DC. They are and always have been politicized. They are popular with many politicians because they can be used to create subsidies to favored political constituencies without Congress having to appropriate funds. They are highly popular with Wall Street firms because they create securities easy to sell to domestic and global investors by using the credit of the U.S. Treasury.

Fannie/Freddie were central to causing the U.S. housing bubble of 1999-2006 and its subsequent collapse,2 and supported the explosive house price inflation of 2019-2022, which has made U.S. house prices widely unaffordable.

Should the European Union import this dubious American idea? A distinguished committee chaired by the former Governor of the Bank of France, Christian Noyer, thinks so. Its April 2024 white paper, “Developing European Capital Markets to Finance the Future,” proposes a “European securitization platform,” which would “target a massive asset class,” and “target a homogeneous and low-risk asset class, such as residential loans.”

The paper maintains that “a European platform for securitization could be a powerful tool for deepening capital markets.” So it might, but an essential requirement of the proposal is to move credit risk to the government at a combined European level, analogously to what Fannie/Freddie do. “To achieve the objectives the platform must grant a European guarantee of last resort for securitization of mortgage or SME loans.”3 By providing the guarantee, “a common platform would create a new common safe asset.” The safety for the investors comes from the guarantee: “Any residual heterogeneity would be eliminated, from the investor’s point of view, by a broad government guarantee.” In other words, remove the credit risk from the investors by moving it to the government and the taxpayers.

The U.S. model is clearly in mind: “Platforms for issuing and guaranteeing mortgagebacked securities are long-established in the US,” the proposal observes, and “Guaranteed securitized assets broadly work as safe assets, especially agency MBS,4 which are used as collateral in almost one-third of repo transactions in the United States and trade at close to sovereign rates.”

In short, what is being proposed is a European Fannie/Freddie.

Well aware of the housing finance bailouts previously provided by U.S. taxpayers, the white paper sets an “objective of zero cost for public finances” for a European securitization platform. The zero public cost objective is a nice idea, but the American experience warns of many government guarantee schemes which were similarly supposed to be selffinancing, but failed instead. The Federal Savings and Loan Insurance Corporation, the Farm Credit System, the Pension Benefit Guarantee Corporation, the federal Student Loan program, and of course Fannie/Freddie, all became insolvent and costly to the public finances. Confronted by the combination of political pressures to subsidize current borrowers and the uncertainty of future credit crises, it is very difficult for government guarantee programs to achieve their zero public cost aspirations.

The white paper introduces a further difficulty. The platform is to operate with a European-level guarantee, and “supervision at EU-level should be mandatory.” Nonetheless, “The guarantee provided by the platform should be structured to exclude any transfers between Member States.” This is certainly different from the American model with respect to U.S. states. It is impossible to imagine how Fannie/Freddie could operate without pooling income and losses among states, and it is likewise hard to imagine how European-wide guarantees could involve no transfers among Member States. How this is proposed to work is not clear.

The white paper displays a particular danger of all government guarantee schemes. It develops a securitization proposal obviously designed for mortgage loans, based on the need for “low risk” and “homogeneous” loans with a “standardization objective.” Then it slips in, doubtless as a political thought, that maybe the platform could also be used for commercial loans to small and medium-sized enterprises (“SMEs”). Such loans are of an entirely different kind, with fundamentally different risk characteristics. This is a good example of how a government guarantee is always subject to political pressure to move to riskier loans, just as Fannie/Freddie were pressured into buying low quality, nonprime mortgages, helping inflate the housing bubble.

The European Fannie/Freddie proposal has been accurately criticized by Mark Weinrich, Secretary General of the International Union for Housing Finance.5 I will stress four of Mark’s arguments, then state them less diplomatically. His arguments and my changes follow:

Weinrich: “Government backing of mortgage-backed securities can encourage risky lending practices, as lenders may believe that losses will ultimately be absorbed by the government.”

Pollock: “…as lenders will believe that losses will ultimately be absorbed by the government.”

Weinrich: “Government intervention in the mortgage market can distort pricing and allocation of credit.”

Pollock: “Government intervention…will distort pricing and allocation of credit.”

Weinrich: “A centralized entity would concentrate mortgage risk with a single institution, potentially creating a single point of failure.”

Pollock: “…thereby creating a single point of failure.”

Weinrich: “Creating a centralized European securitization platform could increase systemic risk.”

Pollock: “…will increase systemic risk.”

All of these problems have already characterized Fannie/Freddie in the American experience. Creating a massive government guarantee while claiming that it will be selffinancing tempts people to believe it will be free. It won’t be.

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[1] Fannie Mae and Freddie Mac, 10-Q filings, June 30, 2024.

[2] See Peter J. Wallison, Hidden in Plain Sight, 2015; and Alex J. Pollock, Boom and Bust, Chapter 7, “A $5 Trillion Government Failure,” 2011.

[3] We address the troublesome addition of “or SME loans” below.

[4] “Agency” MBS are Fannie/Freddie MBS plus those of Ginnie Mae, which has a separate government guarantee.

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.

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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.

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 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.

Surprised again

Published by the Housing Finance International Journal.

“Why We’re Always Surprised” is the subtitle of my book, Finance and Philosophy. The reason we are so often surprised by financial developments, I argue in the book, is that “The financial future is marked by fundamental uncertainty. This means we not only do not know the financial future, but cannot know it, and that this limitation of knowledge is ineluctable for everybody.” That certainly includes me!

At the end of last year (in December 2018), interest rates had been rising, and it seemed obvious that they would likely rise to a normal level, at last adjusting out of the abnormally low levels to which central banks had pushed them in reaction to the financial crisis. The crisis began in 2007 with the collapse of the subprime lending sector in the United States and of the Northern Rock bank in the United Kingdom, and ran to 2012, which saw the trough of U.S. house prices and settlement of defaulted Greek sovereign debt at 25 cents on the dollar.

Six years had gone by since then, it seemed that it was high time for normalization. This view was shared during 2018 by the chairman of the Federal Reserve Board and its Open Market Committee. It also seemed that the long period of imposing negative real interest rates on savers, thus transferring wealth from savers to leveraged speculators and other borrowers, needed to end.

What would “normal” be? I thought a normal rate for the 10-year U.S. Treasury note would be about 4 percent and correspondingly for a 30-year U.S. fixed-rate mortgage loan about 6 percent, assuming inflation ran at about 2 percent. I still think those would be normal rates. But obviously, it is not where we are going at this point.

For the final 2018 issue of Housing Finance International, I wrote, “The most important thing about U.S. housing finance is that long-term interest rates are rising.” Surprise! Long-term interest rates have fallen dramatically. The United States does not have the negative interest rates, once considered impossible by many economists, which have become so prevalent in Europe, remarkably spreading in some cases to deposits and even mortgage loans. But the United States does have negative rates in inflation-adjusted terms. The 10-year U.S. Treasury note is, as I write, yielding about 1.5 percent. The year-over-year consumer price index is up 1.8 percent, and “core inflation” running at 2.2 percent, so the investor gets a negative real yield once again, savers are again having their assets effectively expropriated, and we can once again wonder how long this can continue.

What do the new, super-low interest rates mean for U.S. housing finance?

The higher U.S. mortgage loan rates, which reached almost 5 percent for the typical U.S. 30-year fixed-rate loan in late 2018, “would have serious downward implications for the elevated level of U.S. house prices, which already stress buyers’ affordability,” I wrote then. Had those levels been maintained, they definitely would have put downward pressure on prices. But as of now, seven years after the 2012 bottom in house prices, the U.S. long-term mortgage borrowing rate has dropped again to about 3.8 percent. This has set off another American mortgage refinancing cycle and is helping house prices to continue upward.

In the U.S. system, getting a new fixed-rate mortgage to refinance the old one is an expensive transaction for the borrower, with fees and costs which must be weighed against the future savings on interest payments. The fees depend on state laws and regulations; they range among the various states from about $1,900 on the low end to almost $6,900 on the high end, according to recent estimates. On the lender side, the post-crisis increases in regulatory burden had raised the lenders’ cost to originate a mortgage loan to as much as $9,000 per loan – the increased volume from “refis” (as we say) may have reduced this average cost to the lender to about $7,500. It is expensive to move all the paper the American housing finance system requires in order for the borrower to obtain a lower interest rate.

Meanwhile, with the new low interest rates and high house prices, “cash out refis” are again becoming more popular. In these transactions, not only do borrowers increase their debt by borrowing more than they owe on the old mortgage loan, but they reset their amortization of the principal further out to a new 30-year schedule. In both ways, they reduce the buildup of equity in their house, making it more likely that they will still have mortgage debt to pay during their retirement.

In general, there are no mortgage prepayment fees in the United States. The old, higher rate loans are simply settled at par. This continues to make prices of mortgage securities in the U.S. system very sensitive to changes in expected prepayment rates. If investors have bought mortgage loans at a premium to par, which they often do, upon prepayment they have lost and must write off any unamortized premiums they paid.

The most notable American investor in mortgage securities is the central bank, the Federal Reserve. As of Aug. 21, 2019, it had on its books $115 billion (with a B) of unamortized premium, net of unamortized discounts. Not all of this may be for its $1.5 trillion mortgage portfolio; still, a refi boom might be expensive for the Fed.

Speaking of the Federal Reserve, then-Chairman Ben Bernanke wrote in 2010 about his bond buying or “quantitative easing” programs: “Lower mortgage rates will make housing more affordable and allow more homeowners to refinance.” The latter effect of promoting refis is always true, but not the former claim of improved affordability. It ceases to be true when low mortgage rates have induced great increases in house prices, as they have. The high prices obviously make houses less affordable, and obviously mean that more debt is required to buy the same house, often with higher leverage – notably higher debt service-to-income ratios.

U.S. house prices are now significantly above where they were at the peak of the housing bubble in 2006. They have risen since 2012 far more rapidly than average incomes. The Fed’s strategy to induce asset price inflation has succeeded in reducing affordability.

According to the Federal Housing Finance Board’s House Price Index, U.S. house prices increased another 5 percent year-over-year for the second quarter of 2019. “House prices rose in all 50 states…and all 100 of the largest metropolitan areas,” it reports. Its house price index has now gone up for 32 consecutive quarters.

The S&P Case-Shiller National House Price Index has just reported a somewhat lower rate of increase, with house prices on average up 3.1 percent for the year ending in June. There is art as well as science in these indexes – the FHFA’s index notably does not include the very high (“jumbo,” in American terms) end of the market. According to Case-Shiller, in some particularly expensive cities, house price appreciation has distinctly moderated, with year-over-year increases of 1.1 percent for New York, 0.7 percent for San Francisco, and negative 1.3 percent for Seattle.

The AEI Housing Center of the American Enterprise Institute has house price indexes that very usefully divide the market into four price tiers. It finds that at the high end of the market, the rate of increase in prices is now falling, while the most rapid increases are in the lowest-priced houses – just where affordability and high leverage are the biggest issues, and where the U.S. government’s subprime lender, the Federal Housing Administration, is most active.

On a longer-term view, Case-Shiller reports that national U.S. house prices are 57 percent over their 2012 trough, and 14 percent over their bubble peak. When U.S. interest rates rise again, whether to normal levels or something else, these prices are vulnerable. How much might they fall? That may be another surprise.

The U.S. can reform housing finance without any action from Congress

Published in Housing Finance International.

The U.S. came out of the 2007-12 housing bust with a housing finance system even more government-centric than it was before, because the Government completely took over Fannie Mae and Freddie Mac by way of a regulatory conservatorship. Most people assumed that Fannie and Freddie’s financial collapse would inspire the U.S. Congress to reform them, which would mean fixing the excessive leverage of their own balance sheets and the excessive leverage the Government promoted through them in the whole housing finance sector. This, as it has turned out, was a bad assumption. Congress tried to create reform legislation, and the accompanying debates were long and energetic, but in the end nothing happened.

Meanwhile Fannie and Freddie remain dominant and huge operations. Their combined assets are a staggering $5.5 trillion. These assets are supported by virtually no capital. Their latest quarterly financial statements show a capital ratio of a risible 0.2 percent, or a leverage of 500 to 1. Under current rules, the Government does not let Fannie and Freddie retain any earnings to speak of, so they are utterly dependent upon the continuing credit support from the U.S. Treasury. Without this support, they could not exist even for one minute. Their government conservatorships are in their 11th year – an outcome nobody anticipated and nobody wants.

It now appears there is virtually zero probability of reform legislation in the current divided Congress.

However, significant reform can occur with-out needing Congress to act. A determined administration – the president, the Treasury Department, and the Federal Housing Finance Agency (which is the regulator and conservator) – can do a lot on its own, without any legislation. It looks like they intend to do so .

President Trump recently told a conference of the National Association of Realtors:

“My administration is committed to reforming our housing finance system…Fannie and Freddie still dominate the market with no real competition from the private sector. And tax-payers are still on the hook…That’s why I recently directed the Department of Treasury and HUD [the Department of Housing and Urban Development] to develop a framework for a modern housing finance system…one that welcomes private sector competition, protects taxpayers and preserves home ownership.” (The transcript adds: “Applause.”)

The president was referring to his formal “Memorandum on Federal Housing Finance Reform” of March 27, 2019. This memorandum includes the following:

“The Secretary of the Treasury is hereby directed to develop a plan for administrative and legislative reforms.”

As stated above, the legislative part of the reforms is very unlikely to happen, but the administrative ones can. The goals of the plan are to include:

• “Ending the conservatorships” of Fannie and Freddie”

• “Facilitating competition in the housing finance market”

• “Providing that the federal government is properly compensated for any explicit or implicit support is provides” to Fannie and Freddie”

• “Establishing appropriate capital and liquidity requirements” for Fannie and Freddie. The capital requirements will need to be a lot higher than the current virtually zero. Personally, I am recommending a 4 percent tangible equity to assets requirement, reflecting that 4 percent is the global capital standard for prime mortgage credit risk. The Treasury will pro-duce its own recommendation.

• “Increasing competition and participation of the private sector in the mortgage market”

• “Heightened prudential requirements and safety and soundness standards, including increased capital requirements” for Fannie and Freddie

And of special interest to my former colleagues in the Home Loan Bank of Chicago, the former home of the Secretariat of the IUHF: “Defining the mission of the Federal Home Loan Bank system and its role in supporting Federal housing finance.”

About all of these goals, the Memorandum directs that “the Secretary of the Treasury must specify whether the proposed reform…could be implemented without Congressional action. For each administrative reform, the Treasury Housing Reform Plan shall include a timeline for implementation.” That sounds serious.

And: “The Treasury Housing Reform Plan shall be submitted to the president for approval…as soon as practicable.”

If the administration does implement administrative reforms, here are some suggestions for additional things it has the power to do:

• The FHFA should set for Fannie and Freddie, like for all other financial institutions, both a leverage capital requirement (for Fannie and Freddie, 4 percent of total assets) and a risk-based capital standard, requiring whichever is higher.

• Fannie and Freddie should pay a fee to the Treasury for its credit support based on what the Federal Deposit Insurance Corporation would charge an equally huge bank of equivalent riskiness for deposit insurance.

• The Financial Stability Oversight Council should designate Fannie and Freddie as the Systemically Important Financial Institutions [SIFIs] they are, since they have proven they can put the whole financial system at risk.

• The FHFA should ensure emphasis on sound credit risk management throughout the inevitable cycles.

• The Federal Home Loan Banks should especially expand the role of secondary mortgage finance in which the original lender retains credit expo-sure (“skin in the game”) for the life of the loan, which ensures an alignment of incentives superior to the Fannie and Freddie model.

• The Treasury should exercise the options it owns to acquire 79.9 percent of Fannie and Freddie’s common stock at an exercise price of one-thousandth of a cent per share. This will represent a nice and well-deserved profit for the taxpayers who bailed Fannie and Freddie out.

Will the administration really act to implement reform through its purely administrative powers? I think there is a good probability that it will. Congress will, it appears, be left to continue debating without acting.

Ten years later, the U.S. is still debating Fannie and Freddie

Published in Housing Finance International.

The giant U.S. government-guaranteed mortgage companies, Fannie Mae and Freddie Mac, were and are unique features of American housing finance compared to other countries. In the days before their 2008 fall into insolvency and government conservatorship, which also saw their previously feared political power fizzle, Fannie and Freddie used to claim they were “the envy of the world.” In those days, they could always get many members of the U.S. Congress to repeat that claim, even though it wasn’t true.

But Fannie and Freddie were huge and still are – their combined 2018 total assets are $5.5 trillion. (This amount is about the same as the combined GDPs of the United Kingdom and France.) Fannie and Freddie were, and continue to be, dominant factors in U.S. housing finance markets. But they remain in government conservatorship more than 10 years after the collapse of the housing bubble they helped inflate and after the government bailed them out. Even after more than 10 years of debating, the government can’t figure out what to do with them next. All kinds of plans have been proposed by various politicians, trade associations, financial commentators, think tanks and investors. None has been adopted. The amount of talk has been vast, but no agreed-upon path has emerged out of the fog of endless debate.

The central problem is this: Fannie and Freddie have always been dependent on the guarantee of their obligations by the U.S. government. The guarantee was said to be “implicit,” but it was absolutely real, as events proved. Based on this guarantee, they sold trillions of dollars of bonds and mortgage-backed securities around the world. They never could have done this without their credit support from the government, and when they failed, the government protected the buyers. Although there is still not a formal guarantee, their backing by the government is even more indubitable now, since the U.S. Treasury has agreed to put in enough new senior preferred stock to keep the net worth of each from falling below zero.

Before the housing bubble shriveled, Fannie and Freddie did have some capital of their own, though a small amount relative to their obligations. In 2006, before their fall, they had combined total equity of $66 billion. That may sound significant, but it was to support assets plus outstanding guarantees already totaling $5.5 trillion, giving them a capital ratio of a risible 1.2 percent. In other words, they were leveraged 83 to 1. Such was the advantage of being darlings of the government. To get up to international risk-based capital standards, I calculate they would then have needed $90 billion more in capital than they had.

Now, 10 years after their government bailout, their combined equity is $10.7 billion, giving them a capital ratio of a mere 0.2 percent. In other words, their capital rounds to zero, and their leverage is 514 to one. To meet international standards, they would now require an additional $124 billion in capital. Without capital, Fannie and Freddie at this point rely not just in large measure, but utterly and completely, on their government guarantee. Indeed, they could not stay in business for even one more minute without it, and this has continued for 10 years.

In good times, running on the government’s credit can be very profitable, and so Fannie and Freddie have been, following the recovery of U.S. house prices which began in 2012. Why have they not built up any capital at all since then? Well, in that same year, the U.S. Treasury Department and the conservator for Fannie and Freddie (the Federal Housing Finance Agency), agreed that each quarter, essentially all of the profits of Fannie and Freddie would be paid to the Treasury, thence going to offset the federal deficit.

This agreement between two parts of the government that the government would take all the profits until further notice has been viewed as unfair and illegal by investors in the common and junior preferred stocks of Fannie and Freddie, which continue to exist. Hedge fund investors, employing top legal talent, have generated various lawsuits against the government, none of which has succeeded.

It is essential to understand the most important macro effect of Fannie and Freddie. This was and is to run up the leverage and therefore the risk of the entire mortgage and housing sectors. Thanks to them, the aggregate leverage of the system is much higher than would otherwise have been possible, and house prices get inflated relative to incomes and down payments. As this leveraging proceeds, it shifts more and more of the risk of mortgage credit from the lenders and from private capital to the government and to the taxpayers. Fannie and Freddie did and do create major systemic risk.

This sounds like a bad idea, and it is. But once the government has gotten itself deeply committed to such a scheme, and the mortgage and housing sectors have gotten used to enjoying the credit subsidy and economic rents involved, it is very hard to change.

Numerous important interest groups benefit from Fannie and Freddie’s running up the systemic leverage and risk. These include:

• Homebuilders, who benefit from more easily selling bigger and more profitable houses.

• Realtors, who likewise profit when selling houses is made easier and get bigger commissions when house prices rise.

• Wall Street firms, whose business of selling mortgage-related securities around the world is easier and bigger when they have government guaranteed bonds to sell.

• Banks, who have become organized to make mortgage loans and pass the credit risk to the government.

• Mortgage banks, who do not have the capital to hold loans themselves and likewise can pass the risk to somebody else.

• Municipal governments, who like the higher real estate taxes generated by high property prices.

• Investors in mortgages who don’t want to have to worry about credit risk because the taxpayers have it instead.

• Affordable housing groups, who get subsidies from Fannie and Freddie.

• Politicians, whose constituents and contributors include the aforementioned groups.

This daunting Gordian knot of private and political interests, all of whom get advantages from the economic distortions of Fannie and Freddie, all of which are always busy lobbying or being lobbied, makes it highly unlikely that the currently divided Congress will do any better at reform than its predecessors of the last decade. My own view is that the probability of meaningful legislation for Fannie and Freddie over the next year is zero.

But a different source of change is now a frequent subject of discussion and speculation. This is direct administrative action by the Federal Housing Finance Agency (FHFA) and the U.S. Treasury. The FHFA has a new director coming, Mark Calabria, nominated by President Donald Trump and apparently headed for confirmation by the Senate. Mr. Calabria has deep experience in the issues of Fannie and Freddie and might use his wide powers as their conservator and regulator for reform, including renegotiating their bailout deal with the Treasury.

Two essential reform items are putting Fannie and Freddie’s capital requirements on the same basis as every other too-big-to-fail financial institution; and making them pay a fair price to the government for its ongoing credit support. This should be in line with what all the big banks have to pay for deposit insurance, which is their form of government guarantee.

Might such things happen by administrative action? They might. But not without a lot of lobbying, arguing and complaining by all of the interest groups listed above.

Higher interest rates and the looming end of the second real estate double bubble

Published in Housing Finance International Journal.

At this point, the most important thing about U.S. housing finance is that long-term interest rates are rising. The rate on 30-year fixed rate mortgages, the benchmark U.S. mortgage instrument, has since September 2017 gone from less than 4 percent to close to 5 percent. This is in line with the rise in 10-year U.S. Treasury note yields from something over 2 percent to more than 3 percent. The massive manipulation of long-term interest rates by the Federal Reserve is belatedly winding down, step by step. The house price inflation the Fed thereby promoted also must inevitably end.

The real (inflation-adjusted) interest rate on the 10-year Treasury note has gone from about 0.4 percent to just over 1 percent. These rate movements from extraordinarily low levels to somewhat higher levels are shown in Graph 1.

Read the rest here.

The Cincinnatian Doctrine revisited

Published by the R Street Institute.

The attached policy study originally appeared in the Winter 2016 edition of Housing Finance International.

Ten years ago, in September 2006, just before the great housing bubble’s disastrous collapse, the World Congress of the International Union for Housing Finance, meeting in Vancouver, Canada, devoted its opening plenary session to the topic of “Housing Bubbles and Bubble Markets.” That was certainly timely!

Naturally, knowing what would come next is easier for us in retrospect than it was for those of us then present in prospect. One keynote speaker, Robert Shiller, famous for studies of irrational financial expectations and later a winner of a Nobel Prize in economics, hedged his position about any predictions of what would come next in housing finance. Six months later, the U.S. housing collapse was underway. The second keynote speaker argued, with many graphs and charts, that the Irish housing boom was solid. Of course, it soon turned into a colossal bust. As the saying goes, “Predicting is hard, especially the future.”

Some IUHF members, in the ensuing discussion, expressed the correct view that something very bad was going to result from the excess leverage and risky financial behavior of the time. None of us, however, foresaw how very severe the crisis in both the United States and Europe would turn out to be, and the huge extent of the interventions by numerous governments it would involve.

Later in the program, also very timely as it turned out, was a session on the “Role of Government” in housing finance. On that panel, I proposed what I called “The Cincinnatian Doctrine.” Looking back a decade later, it seems to me that that this idea proved sound and is highly relevant to our situation now. I am therefore reviewing the argument with observations on the accompanying “Cincinnatian Dilemma” as 2016 draws to a close.

The two dominant theories of the proper role for government in the financial system, including housing finance, are respectively derived from two of the greatest political economists, Adam Smith and John Maynard Keynes.

Smith’s classic work, “The Wealth of Nations,” published in the famous year 1776, set the enduring intellectual framework for understanding the amazing productive power of competitive private markets, which have since then utterly transformed human life. In this view, government intervention into markets is particularly prone to creating monopolies and special privileges for politically favored groups, which constrains competition, generates monopoly profits or economic rents, reduces productivity and growth, and transfers money from consumers to the recipients of government favors. It thus results in less wealth being created for the society and ordinary people are made worse off.

Keynes, writing amid the world economic collapse of the 1930s, came to the opposite view: that government intervention was both necessary and beneficial to address problems that private markets could not solve on their own. When the behavior underlying financial markets becomes dominated by fear and panic, when uncertainty is extreme, then only the compact power of the state, with its sovereign authority to compel and tax, and its sovereign credit to borrow against, is available to stabilize the situation and move things back to going forward.

Which of these two is right? Considering this ongoing debate between fundamental ideas and prescriptions for political economy, the eminent financial historian, Charles Kindleberger, asked, “So should we follow Smith or Keynes?” He concluded that the only possible rational answer is: “Both, depending on the circumstances.” In other words, the answer is different at different times.

Kindleberger was the author (among many other works) of “Manias, Panics and Crashes,” a wide-ranging history of the financial busts which follow enthusiastic booms. First published in 1978, the book was prescient about the financial crises that would follow in subsequent decades, and has become a modern financial classic. A sixth edition of this book, updated by Robert Z. Aliber in 2011, brought the history up through the 21st century’s international housing bubbles, the shrivels of these bubbles that inevitably followed and the crisis bailouts performed by the involved governments. Throughout all the history Kindleberger and Aliber recount, the same fundamental patterns continue to recur.

Surveying several centuries of financial history, Kindleberger concluded that financial crises and their accompanying scandals occur, on average, about once every 10 years. In the same vein, former Federal Reserve Chairman Paul Volcker wittily remarked, “About every 10 years, we have the biggest crisis in 50 years.” This matches my own experience in banking, which began with the “credit crunch” of 1969 and has featured many memorable busts since, not less than one a decade. Unfortunately, financial group memory is short, and it seems to take financial actors less than a decade to lose track of the lessons previously so painfully (it was thought) learned.

Note that with the peak of the last crisis being in 2008, on the historical average, another crisis might be due in 2018 or so. About how severe it might be we have no more insight than those of us present at the 2006 World Congress did.

The historical pattern gives rise to my proposal for balancing Smith and Keynes, building on Kindleberger’s great insight of “Both, depending on the circumstances.” I quantify how much we should have of each. Since crises occur about 10 percent of the time, the right mix is:

• Adam Smith, 90 percent, for normal times

• J.M. Keynes, 10 percent, for times of crisis.

In normal times, we want the economic effi­ciency, innovation, risk-taking, productivity and the resulting economic well-being of ordinary people that only competitive private markets can create. But when the financial system hits its periodic crisis and panic, we want the interven­tion and coordination of the government. The intervention should, however, be temporary. This is an essential point. If prolonged, it will tend to monopoly, more bureaucracy, less innovation, less risk-taking and less growth and less eco­nomic well-being. In the extreme, it will become socialist stagnation.

To get the 90 percent Smith, 10 percent Keynes mix, the state interventions and bailouts must be with­drawn after the crisis is over.

This is the Cincinnatian Doctrine, named after the Roman hero Cincinnatus, who flourished in the fifth century B.C. Cincinnatus became the dictator of Rome, being “called from the plough to save the state.” In the old Roman Republic, the dictatorship was a temporary office, from which the holder had to resign after the crisis was over. Cincinnatus did—and went back to his farm.

Cincinnatus was a model for the American founding fathers, and for George Washington in particular. Washington became the “modern Cincinnatus” for saving his country twice, once as general and once as president, and returning to his farm each time.

But those who attain political, economic and bureaucratic power do not often have the virtue of Cincinnatus or Washington. When the crisis is over, they want to hang around and keep wielding the power which has come to them in the crisis. The Cincinnatian Dilemma is how to get the government interventions withdrawn once the crisis is past. In other words, how to bring the Keynesian 10 percent crisis period to end, and the normal Smith 90 percent to resume its natural creation of growth and wealth.

The financial panic ended in the United States in 2009 and in Europe in 2012. But the interventions have not been withdrawn. The central banks of the United States and Europe are still running hugely distorting negative real interest rate experiments years after the respective crises ended. Fannie Mae and Freddie Mac, effectively nationalized in the midst of the crisis in 2008, have not been reformed and are still operating as arms of the U.S. Treasury. The Dodd-Frank extreme regula­tory overreaction, obviously a child of the heat of its political moment, has not yet been reformed.

The Cincinnatian Doctrine cannot work to its optimum unless we can figure out how to solve the Cincinnatian Dilemma.

What have the massive guarantees of mortgages by the U.S. government achieved?

Published in the Winter 2017 edition of Housing Finance International.

R Street link.

The U.S. government, through multiple agencies, indulges in massive guarantees of U.S residential mortgages. Much, but not all, of this happens through the formerly celebrated, then failed, humiliated and notorious, Fannie Mae and Freddie Mac. These companies, now owned principally by the U.S. Treasury and completely controlled by the government as conservator, are still mammoth, with $5 trillion in combined assets. And there are trillions of dollars of additional government involvement in the U.S. housing finance sector, which with $10.4 trillion in outstanding rst lien loans, is the largest loan market in the world.

In the early 2000s, in the days B.B.B. [Before the Bursting Bubble], I had the pleasure to meet in Copenhagen with representatives of the Danish Mortgage Banking Association. They presented their highly interesting, efficient and private mortgage bond-based housing finance system, and I presented the government-centric, Fannie and Freddie-based mortgage system of the United States. (I was describing, by no means promoting, this system.) When I had finished my talk, the chief executive of one of the Danish mortgage banks made this unforgettable observation, “You know, in Denmark we always say that we are the socialists and America is the land of free enterprise and free markets. But I see that in housing finance, it is just the opposite!”

He was so right.

What has all the U.S. government intervention in mortgage credit achieved, if anything?

In 1967, the U.S. home ownership rate was 63.6 percent. Today, in 2017, it is 63.7 percent. After fifty years of intense government mortgage credit promotion and guarantees, the home ownership rate is just the same as it was before. The government mountain labored mightily and brought forth less than a mouse, at least as far as the home ownership rate goes.

The scale of the U.S. government’s absorption of mortgage credit risk boggles the mind of anyone who prefers market solutions. Fannie Mae guarantees or owns more than $2.7 trillion in mortgages. Freddie Mac guarantees or owns more than $1.7 trillion. Fannie and Freddie are said to be “implicitly guaranteed” by the U.S. Treasury, but whatever it is called, the guarantee is real. This was proved beyond doubt by the $187 billion government bailout they got when they went broke in 2008.

Then we have Ginnie Mae, a wholly-owned government corporation which is explicitly guaranteed by the U.S. Treasury. It guarantees another $1.7 trillion in mortgage-backed securities, with its total slightly greater than Freddie’s.

The three together absorb $6.2 trillion of mort- gage credit risk, all of it ultimately putting the risk on the taxpayers. This is more than 59 percent of the total mortgage loans outstanding. The U.S. government is in the mortgage business in a big way!

But this is not all. There is, interlocked with Ginnie Mae, the Federal Housing Administration [FHA], a part of the federal Department of Housing and Urban Development. The FHA is the U.S. government’s official subprime lender. (Of course, they don’t say it that way, but it is.) It insures very low down-payment and otherwise risky mortgage loans to the total amount of $1.4 trillion.

The federal Veterans Administration insures mortgages for veterans of the armed services to the amount of $596 billion.

The Federal Home Loan Banks, another government-sponsored housing finance enterprise, have total assets of $1.1 trillion.

Even the federal Department of Agriculture gets into the mortgage credit act. It guarantees housing loans of $108 billion.

A more recent, but now huge government player in mortgage credit is America’s central bank, the Federal Reserve. The Fed is the largest investor in mortgage-backed securities in the world, owning $1.8 trillion of very long term, fixed rate MBS guaranteed by Fannie, Freddie and Ginnie. So, one part of the government guarantees them, taking the credit risk, and another part of the government buys and holds them, taking the interest rate risk.

How does the Fed finance this long-term investment? By monetization – creating floating-rate deposits on its own books. This results in the Fed having the balance sheet structure of a 1980s American savings and loan: holding very long-term fixed-rate assets financed with variable rate liabilities. There is no doubt that this would have astonished and outraged the founders of the Federal Reserve System, and that for most of the Fed’s history, its new role as mortgage investor would have been thought impossible.

We can see that the U.S. now has a giant Government Housing Combine. It has a lot of elements, but most importantly there is a tight interlinking of three principal parts: the U.S. Treasury; the Federal Reserve; and Fannie-Freddie-Ginnie. It is depicted in Figure 1 as an iron triangle.

Let us consider each leg of the triangle:

(1) The U.S. Treasury guarantees all the obligations of Fannie, Freddie and Ginnie, which allows them to dominate the mortgage- backed securities market. The Treasury owns 100 percent of Ginnie, and $189 billion of the senior preferred stock of Fannie and Freddie, plus warrants to acquire 79.9 percent of Fannie and Freddie’s common stock for a minimal price, virtually zero. Essentially 100 percent of the net profits of Fannie and Freddie are paid to the Treasury as a dividend on the senior preferred stock. Fannie, Freddie and Ginnie are financial arms of the U.S Treasury.

(2) The Federal Reserve owns $1.8 trillion in mortgage-backed securities, mostly those of Fannie and Freddie. Without monetization of their securities by the Fed, Fannie and Freddie would either have much less debt, or have to pay a significantly higher interest rate to sell it, or both. Without the guarantee of the Treasury, Fannie and Freddie could sell no debt whatsoever. The Fed earned $46 billion on its MBS investments in 2016, almost all of which was sent to the Treasury. The U.S. government is reducing its budget deficit by running its big mortgage business.

(3) The Federal Reserve finances the Treasury, as well as Fannie and Freddie. The Fed owns $2.5 trillion of long-term Treasury notes and bonds, in addition to its $1.8 trillion of MBS. Almost all, about 99 percent, of the Fed’s profits are sent to the U.S. Treasury to reduce the budget deficit.

You can rightly view all this as one big government mortgage business. As my Danish colleague wondered, who is the socialist?

We asked before what this massive government intervention in housing finance has achieved. There are two very large, but not positive, results: inflating house prices and inducing higher debt and leverage in the system. Government guarantees and subsidies will get capitalized into house prices, and with the impetus of the Government Housing Combine, U.S. average house prices are now back up over their bubble peak. This makes it harder for new households to buy a house, and it means on average they have to take on more debt to do so.

Confronted with these inevitable effects, one school of politics always demands still more government guarantees, more debt, and more leverage. This will result in yet higher house prices and less affordability until the boom cycle ingloriously ends. A better answer is instead to reduce the government interventions and distortions, and move toward a housing finance sector with a much bigger private market presence.

I propose the goal should be to develop a U.S. housing finance sector in which the mortgage credit risk is at least 80 percent private, and not more than 20 percent run by the government. That’s a long way from where we are, but defines the needed strategic direction.

What’s next for U.S. housing finance?

Published by the R Street Institute.

The attached policy study originally was published in the Spring 2017 edition of Housing Finance International.

With the new administration of President Donald Trump, and simultaneous Republican majorities in both houses of the Congress, can the United States look forward to meaningful reform of Fannie Mae, Freddie Mac and American housing finance?

My view is that it is highly unlikely. The interested parties and the policy ideas are simply too fragmented for a politically energetic solution to emerge and be enacted. Many powerful interest groups are fond of the subsidies that Fannie and Freddie pass on to them from the taxpayers. At the same time, a dissonant chorus of well-intentioned theoreticians promote mutually inconsistent proposals.

The topic of the debates—the American housing finance sector—is genuinely huge, with $10.2 trillion in outstanding mortgage loans. That is a number about equal to the combined gross domestic products of Germany, France, the United Kingdom and Canada.

U.S. housing finance also has a troubled history. It collapsed in the 1980s, when based on the savings and loan model, and required a $150 billion taxpayer bailout. The bonds sold to finance that bailout won’t be paid in full for another 13 years from now – until 2030. The 1980s U.S. housing finance scandal led to abolition of the government’s housing finance promoter and regulator of the time, the Federal Home Loan Bank Board, in 1989. One of the lessons drawn by American financial regulators at that point was that housing finance needed to focus on the securitization of mortgages, a less-than-perfect conclusion.

So, the United States tried again, this time with a model that featured at its core securitization and the “government-sponsored enterprises” Fannie Mae and Freddie Mac. Fannie and Freddie rapidly expanded mortgage credit by issuing trillions of dollars in mortgage-backed securities and debt in highly leveraged balance sheets, which always depended on the so-called “implicit” guarantee of the U.S. government. That was a mistake, but they and the politicians who promoted them foolishly claimed that this model was “the envy of the world.” Both government-sponsored and private mortgage securitization inflated. The increase in outstanding mortgage loans was remarkable, as shown in Graph 1, and was accompanied by political cheering.

Total American mortgage loans reached $2 trillion in 1988. By 2006, during the golden years of Fannie and Freddie, they had quintupled to $10 trillion. Nominal GDP increased by 2.6 times during this period, so mortgage debt was growing far faster the economy for years, a clear danger sign in retrospect. There was an acceleration after 1998, when mortgages crossed $4 trillion. Today, after the fall, total mortgage loans are at about the same level as in 2006, having gone basically sideways for a decade. Graph 2 shifts to the long-term growth of total U.S. mortgage loans relative to the size of the economy, measured as a percent of GDP – and displays an instructive history.

In this graph, we see first the post-World War II U.S. mortgage credit boom, which ran until 1964. Then mortgages as a percent of GDP were flat at about 30 percent for 20 years. They rose to 45 percent in the 1980s-1990s, then took off with the great mortgage bubble, reaching 77 percent in 2007 as disaster loomed.

At that point, as we know, the American housing finance sector, with its post-1980s “improvements,” had an even bigger collapse than before, including the failure of Fannie and Freddie. Among the bailouts of the time was a $189 billion crisis equity infusion in the deeply insolvent Fannie and Freddie by the taxpayers. Fannie and Freddie thus became subsidiaries of the U.S. government. They remain so to this day, almost nine years after their humiliating failure.

Since the top of the bubble, total U.S. mortgages as a percent of GDP have fallen to 55 percent. This is sharply corrected from the peak, but is still a high level, historically speaking – equal to the proportion in 2002 and close to twice the level of 1964 or 1980.

Because of their government support, Fannie and Freddie remain powers in the American mortgage system. They guarantee or own $4.9 trillion of mortgage loans – or 48 percent of all the mortgage loans in the United States. They have combined $5.3 trillion in total assets and $5.3 trillion in liabilities. You will readily see by arithmetic that they have no net worth to speak of.

The Treasury Department controls 79.9 percent of the common stock of Fannie and Freddie. Why not 80 percent or 100 percent? Because that would have forced the government to put Fannie and Freddie’s $5 trillion of debt on the government’s books – an outcome the government was and is desperate to avoid. Honest accounting is not going to happen, and the Treasury will continue whatever gyrations it takes to keep its Fannie and Freddie exposure as an off-balance-sheet liability.

The Treasury Department also owns $189 billion of senior preferred stock in Fannie and Freddie, the bailout investment. This was the amount required to bring their net worth up to zero, where it remains. Although Fannie and Freddie are now reporting profits – a combined $20.1 billion for 2016 – virtually all of this is paid to the Treasury as dividends on the senior preferred stock, so there is no increase in their capital. The profits made by the government, at least for now, from owning these biggest companies in the mortgage business, and from absorbing half the country’s mortgage credit risk, thus go to help reduce the annual government deficit.

At Dec. 31, 2016, Fannie and Freddie’s combined net worth was about $11 billion, compared to their assets of $5.3 trillion. This gives them a risible capital ratio of 0.2 percent – so close to zero that the difference doesn’t matter.

Fannie and Freddie’s principal business is guaranteeing mortgages. So here is an essential question: What is the value of $5 trillion in guarantees from guarantors with zero capital? Clearly the answer is that such guarantees by themselves have no value. Every bit of the value and all ability of Fannie and Freddie to report a profit comes not from themselves, but from the fact that the government truly (though not formally) guarantees their $5.3 trillion in liabilities. In this sense, it certainly seems fair that the Treasury continue to take all the profits which its guarantee creates.

The government is also involved in directly financing Fannie and Freddie’s debt, for the U.S. central bank has in its investment portfolio the remarkable amount of $1.7 trillion of Fannie and Freddie’s mortgage-backed securities. Thus, the Federal Reserve owns and has monetized one-third of Fannie and Freddie’s liabilities and one-sixth of all the mortgages in the country. This is unorthodox central banking, to say the least. The Fed is still buying Fannie and Freddie’s MBS, eight years after the 2009 end of the crisis, as they make new investments to replace any maturity or prepayment of principal. The Fed’s interest-rate risk position is exactly like that of a 1980s savings and loan institution: long-term, fixed rate mortgages funded short. How will that turn out? One must wonder.

In the meantime, the Fed is reporting billions of dollars of short-term profits from investing in long-term fixed-rate mortgages and funding them with floating rate deposits. The bulk of this profit it then pays to the U.S. Treasury. The scheme reduces the government deficit in the short run by speculating in the interest rate risk of mortgages guaranteed by Fannie and Freddie and in turn guaranteed by the Treasury. The financial relationships of the Federal Reserve, the Treasury Department and Fannie and Freddie make an intriguing tangle. One plausible argument is that we should view them all together as one financial entity, the intertwined Treasury-Fed-Fannie-Freddie financial combine.

Viewed from the rest of the world, the American housing finance system is not only impressively big, but odd and indeed unique. The thing that makes it most odd continues to be the role and financial structure of Fannie and Freddie. In addition to their function of guaranteeing and massively concentrating mortgage credit risk, it is clear that they are entirely wards of the state and intertwined in a very complex fashion in the government’s finances.

What’s next for U.S. housing finance? Will Fannie and Freddie just continue forever as subsidiaries of the government? Nobody admits to liking the status quo very much. But the status quo has tremendous inertia and has proved highly resistant to change over the last eight years.

Do Fannie and Freddie as government subsidiaries represent a good model for American housing finance? For those (like me) who believe in competitive, private markets as the superior form of allocating resources and risk, the answer is obviously “no.” In particular, people like me think that reinstating anything like the former disastrous Fannie and Freddie “GSE” structure would be a monumental mistake. Many people do not want to see another government bailout of a Fannie and Freddie that have eternally zero capital. Many others correctly think that private capital should bear the principal credit risk in the mortgage market. Speculators who have bought the 20.1 percent of Fannie and Freddie’s common stock that the government does not control, or who own the old, junior preferred stock whose noncumulative dividends have not been paid for years, hope for some political event that will generate windfall gains for them.

All these people would like change, but there is no consensus proposal. Moreover, many other interests wouldn’t mind seeing the old Fannie and Freddie come back, or even the current Fannie and Freddie continue.

For example, homebuilders like having the government guarantee mortgages so it’s easier to sell houses, including bigger and more expensive houses. Realtors like anything that helps sell houses faster and increases their commissions. Investment banks find it easier and more profitable to sell mortgage-backed securities around the world when they are guaranteed by the U.S. government. Then they can be marketed as so-called “rate products,” where the investors don’t have to worry about credit risk. In addition, these firms can then more make money selling swaps and options to hedge the interest rate risk of Fannie and Freddie MBS. Affordable housing groups like the subsidies that Fannie and Freddie used to pass out so freely, as do left-leaning politicians looking for ways to get money for their constituents without facing a vote in Congress.

For several years after the most recent housing crisis, it seemed that Fannie and Freddie’s egregious failure, and their embarrassing bailout, would surely trigger some kind of fundamental reform. But it didn’t. Bills were introduced in Congress, but didn’t pass. Many plans for how to reform American housing finance in general and Fannie and Freddie in particular were published, and some of them widely circulated and debated, but years went by and nothing happened.

The Trump administration would clearly have different ideas for housing finance reform than its predecessor, but in its early months, it has not so far articulated any specific recommendations. The new secretary of the Treasury, Steven Mnuchin, has previously said that continuing government ownership of Fannie and Freddie is unacceptable, but has not yet provided any proposed path to change it.

In my opinion, no legislative reform proposals, whether from the new administration or elsewhere, have a high probability of success in any near term. But there is one possibility we should consider as the one that makes the most sense.

This requires admitting that we cannot get rid of Fannie and Freddie, and that we cannot stop the government from making them “too big to fail” whenever they next get themselves in trouble. However, we should in the meantime take away all the special government favors and sponsorship that allowed Fannie and Freddie to so distort the gigantic American housing finance market.

I propose that Fannie and Freddie should be treated in exactly the same way as every other trillion-dollar bank—that is, exactly the same as Citigroup, JPMorgan Chase, Bank of America, Well Fargo and the like. They should have the same capital requirements—with a minimum of 5 percent equity capital to total assets. They should make equivalent payments to the government for their taxpayer credit support, just as the banks do for deposit insurance. They should lose their indefensible exemption from state and local corporate income taxes. They should be clearly designated as the “systemically important” institutions they so obviously are and be regulated just like the other big banks under the forceful hand of the Federal Reserve.

Life under these terms would be harder for Fannie and Freddie than just living on the free guarantee from the taxpayers as a subsidiary of the government. But the American housing finance sector would be healthier, more based on private capital and less prone to entering yet another collapse.

Is this scenario possible? Yes. Is it likely? No.

Homeownership Rates: It depends on whether you are married

Published by the R Street Institute.

The attached piece originally appeared in the Autumn 2016 edition of Housing Finance International.

American political rhetoric endlessly repeats that homeownership is part of the “American Dream.” So it is for most people, especially if you are married, as we will see.

As part of promoting this “dream,” the U.S. government has for many years created large subsidies for mortgage borrowing and huge government-sponsored financial institutions to expand mortgage lending. Most notable among these are Fannie Mae and Freddie Mac, which notoriously went broke in 2008 while following the government’s orders to make more so-called “affordable” loans, and survived only thanks to a $189 billion taxpayer bailout.

Fannie and Freddie are still massive operations, featuring a combined $5 trillion in assets (that’s trillion with a “T”), equity capital that is basically zero and utter dependence on the credit of the U.S. Treasury.

Given these massive and extremely expensive efforts, how has the American homeownership rate fared? Let us look back 30 years to 1985, and compare it to 2015. Thus we can go past the housing bubble and collapse of the 2000s, as well as past the financial collapse of the savings and loans in the late 1980s, and observe what has happened over a generation.

Read the rest.

Why can’t the US reform its housing-finance sector?

Published by the R Street Institute.

The attached policy brief appeared in the Summer 2016 edition of Housing Finance International, the quarterly journal of the International Union for Housing Finance (IUHF).

It is sobering to Americans that the U.S. housing finance collapsed twice in three decades: in the 1980s and again in the 2000s. This is certainly an embarrassing record.

The giant American housing finance sector, with $10 trillion in mortgage loans, is as important politically as it is financially. Many interest groups want to receive government subsidies through the housing finance system. This makes it very hard to reform.

From the 1980s to today, U.S. housing finance has been unique in the world for its overreliance on the so-called “government-sponsored enterprises,” Fannie Mae and Freddie Mac. Fannie and Freddie get government guarantees for free, which are said to be only “implicit,” but are utterly real. According to Fannie and Freddie in their former days of power and glory, this made American housing finance “the envy of the world.” In fact, the rest of the world did not feel such envy. But Fannie and Freddie did attract investment from the rest of the world, which correctly saw their issues as U.S. government credit with a higher yield. In the 2000s, this channeled the savings of thrifty Chinese and others into helping inflate American house prices into their amazing bubble. Fannie and Freddie became a key point of concentrated systemic vulnerability.

In 2008, Fannie and Freddie went broke. What schadenfreude my German housing finance colleagues enjoyed after years of being lectured on the superiority of the American system!  Official bodies in the rest of the world pressured the U.S. Treasury to protect their investments in the obligations of the insolvent Fannie and Freddie, which the Treasury did and continues to do. The Federal Reserve, in the meantime, has become the world’s biggest investor in Fannie and Freddie securities.

Almost eight years after the financial collapse, America is still unique in the world for centering its housing finance sector on Fannie and Freddie, even though they have equity capital that rounds to zero. They are primarily government-owned and entirely government-controlled housing finance operations, completely dependent on the taxpayers. Nobody likes this situation, but it has outlasted numerous reform efforts.

Is there a way out of this statist scheme—can we move American housing finance toward something more like a market?  Is there a way to reduce the distortions caused by Fannie and Freddie, to control the hyper-leverage that inflates house prices and the excessive credit that sets up both borrowers and lenders for failure?  Can we reduce the chance of repeating the mistakes of 1980 to 2007?  Here are some ideas.

Restructure Fannie and Freddie

The original government bailout of Fannie and Freddie created senior preferred stock with a 10 percent dividend, which the U.S. Treasury bought on behalf of the taxpayers. This was later amended to make the dividend be all their net profit. That meant there would never be any reduction of the principal, and the GSEs will be permanent wards of the state.

It is easy, however, to calculate the cash-on-cash internal rate of return (IRR) to the Treasury on its $189.5 billion investment in senior preferred stock, given the dividend payments so far of $245 billion. This represents a return of about 7 percent – positive, but short of the required 10 percent. As Fannie and Freddie keep sending cash to the Treasury, the IRR will rise, and will reach a point when total cash paid is equivalent to a 10 percent compound return, plus repayment of the entire principal. That is what I call the “10 Percent Moment.” It provides a uniquely logical point for reform, and it is not far off, perhaps in early 2018.

At the 10 Percent Moment, whenever it arrives, Congress should declare the senior preferred stock fully repaid and retired, as in financial substance, it will have been. Simultaneously, Congress should formally designate Fannie and Freddie as systemically important financial institutions (SIFIs). They are unquestionably SIFIs – indeed, they are Global SIFIs – able to put not only the entire financial system, but also the finances of the U.S. government at risk. This is beyond the slightest doubt.

As soon as Fannie and Freddie are designated officially – as well as in economic fact – as SIFIs, they will get the same minimum equity capital requirement as bank SIFIs: 5 percent of total assets. At their current size, this would require about $250 billion in equity. They must, of course, be regulated as undercapitalized until they aren’t. Among other things, this means no dividends on any class of stock until the capital requirement is met.

As SIFIs, Fannie and Freddie will and should get the Federal Reserve as their systemic risk regulator, in addition to their housing finance regulator.

It is impossible to take away Fannie and Freddie’s too-big-to-fail status, no matter what any government official says or does. Therefore they should pay the government for its ongoing credit guaranty, on the same basis as banks have to pay for deposit insurance. I recommend a fee of 0.15 percent of total liabilities per year.

Then Fannie and Freddie will be able to compete in mortgage finance on a level basis with other SIFIs, and swim or sink according to their competence.

Promote skin in the game for mortgage originators

A universally recognized lesson from the American housing bubble was the need for more “skin in the game” of credit risk by those involved in mortgage securitization. Lost in the discussion is the optimal point at which to apply credit risk skin in the game. This optimal point is originator of mortgage loans, which should have a junior credit risk position for the life of the loan. The entity making the original mortgage is in the best position to know the most about the borrower and the credit risk of the borrower. It is the most important point at which to align incentives for creating sound credits.

The Mortgage Partnership Finance (MPF) program of the Federal Home Loan Banks was and is based on this principle (I had the pleasure of leading the creation of this program). It finances interest-rate risk in the bond market but keeps the junior credit risk with the original lender. The result was excellent credit performance of the MPF mortgage loans, including through the 2000s crisis.

I believe this credit-risk principle is obvious to most of the world. Why not to the United States?

Create countercyclical LTVs

As the famous investor Benjamin Graham pointed out long ago, price and value are not the same:  “Price is what you pay, and value is what you get.” Likewise, in mortgage finance, the price of the house being financed is not the same as its value: in bubbles, prices greatly exceed the sustainable value of houses. Whenever house prices are in a boom, the ratio of the loan to the sound lendable value becomes something much bigger than the ratio of the loan to the inflated current price.

As the price of any asset (including houses) goes rapidly higher and further over its trend line, the riskiness of the future price behavior becomes greater—the probability that the price will fall continues to increase. Just when lenders and borrowers feel most confident because of high collateral “values” (which really are prices), their danger is in fact growing. Just when they are most tempted to lend and borrow more against the price of the asset, they should be lending and borrowing less.

A countercyclical LTV (loan-to-value ratio) regime reduces the maximum loan size relative to current prices, in order to keep the maximum ratio of loan size to underlying lendable value more stable. The boom would thus induce smaller LTVs, and greater down payments, in bubbly markets—thus providing a financial stabilizer and an automatic dampening of price inflation.

Countercyclical capital requirements for financial institutions reduce the leverage of those lending against riskier prices. The same logic applies to reducing the leverage of those who are borrowing against risky prices. We should do both.

Canada provides an interesting example of where countercyclical LTVs have actually been used; Germany uses sustainable lendable value as the same basic idea. The United States needs to import this approach.

Liquidate the Fed’s mortgage portfolio

What is the Federal Reserve doing holding $1.7 trillion of mortgage-backed securities (MBS)? The authors of the Federal Reserve Act and generations of Fed chairmen since would have found that impossible even to imagine. This massive MBS portfolio means the Fed allocates credit to housing through its own balance sheet. Its goal was to push up house prices, as part of its general scheme to create “wealth effects.” It succeeded— house prices have not only risen rapidly, but are back over their trend line on a national average basis. This means, by definition, that the Fed also has made houses less affordable for new buyers.

Why in 2016 is the Fed still holding all these mortgages?  For one thing, it doesn’t want to recognize losses when selling its vastly outsized position would drive the market against it. Some economists argue that losses of many times your capital do not matter if you are a fiat currency central bank. Perhaps or perhaps not, but they would be embarrassing and cut off the profits the Fed sends the Treasury to reduce the deficit.

Whatever justification there might have been in the wake of the collapsed housing bubble, the Fed should now get out of the business of manipulating the mortgage-securities market. If it is unwilling to sell, it can simply let its mortgage portfolio run off to zero over time through maturities and prepayments. It should do so, and cease acting as the world’s biggest savings and loan.

The collapses of the 1980s and 2000s should have taught the American government a lesson about the effects of subsidized, overleveraged mortgage markets. It didn’t. The reform of the Fannie and Freddie-centric U.S. housing finance sector has not arrived, nor is there any sign of its approach. But we need to keep working on it.

The temptations of housing finance bubbles

A version of this policy short originally appeared in the Winter 2015 issue of the journal Housing Finance International.

Running up the leverage is the snake in the housing finance Garden of Eden. It is a constant set of alluring temptations to enjoy the fruit of increased risk in the medium term, while setting ourselves up for the inevitable fall.

Let us view this famous painting by Lucas Cranach:

The woman is Fannie Mae. The man is Freddie Mac. The snake is whispering, “If you just run up the leverage of the whole housing finance system, you will become powerful and rich.” Fannie and Freddie are about to eat the apple of risk, which will indeed make them very powerful and very rich for a while, after which they will be shamed, humiliated and punished.

Bubbles in housing finance have occurred in many countries and times. They always end painfully, yet they keep happening. As the prophet said (slightly amended), “There is nothing new under the financial sun. The cycle that hath been, it is that which shall be.” Why is this?

Consider this quotation: “The [banking] failures for the current year have been numerous…In many cases, however, the unfavorable conditions were greatly aggravated by the collapse of unwise speculation in real estate.” What year was that? It could have been 2008, to be sure, but it is actually from 1891, as the then-U.S. comptroller of the currency looked sadly at the wreck of many of the banks of his day.

Some people say the problem is that housing lenders who go broke need to be personally punished, to get their incentives right. Economists are big, not without reason, on worrying about economic incentives. But a bigger problem is that it is so hard to know the future. Housing lenders don’t create housing-finance collapses on purpose, but by mistake.

The city of Barcelona in the 14th century decided to manage the incentives of bankers by decreeing that those who defaulted on their deposits would be subject to capital punishment. And as one financial history tells us, “at least one banker, Francesch Castello, was beheaded directly in front of his counter in 1360.” But this did not stop banks from failing.

One of the most important reasons that housing-finance bubbles are so hard to control is that they make nearly everyone happy while they last. Who is making money from a housing-finance bubble? Almost everybody. This is why the experience of a bubble is so insidious.

For example, take the most recent American experience. For a long time, the seven years of 2000-2006, the housing-finance bubble generated profits and wealth. A lot of the profits and wealth turned out to be illusory in the end, but at the time, some of it was real and all of it seemed real. As house prices rose, borrowers made more money if they bought more expensive houses with the maximum amount of leverage. Property flippers bought and sold condominiums for quick and repetitive profits, even if no one was living in them. Housing lenders had big volumes and profits. Their officers and employees got big bonuses. Numerous officers of Fannie Mae and Freddie Mac made more than $1 million a year each. Real estate brokers had high volumes and big commissions. Equity investors saw the value of their housing-related stocks go up. Fixed-income investors all over the world enjoyed the returns from subprime mortgage-backed securities, which seemed low risk, and from Fannie Mae and Freddie Mac securities, which seemed to be, and actually were, guaranteed by the U.S. government.

Most importantly, the 75 million households that were homeowners saw the market price of their houses keep rising. This felt like, and was discussed by economists as, increased wealth. Of course, this was politically popular. The new equity in their houses at then-market prices allowed many consumers to borrow on second mortgages and home-equity loans, so they could spend money they had not had to earn by working. Then-Federal Reserve Chairman Alan Greenspan smiled approvingly on this housing “wealth effect,” which was offsetting the recessionary effects of the collapse of the previous bubble in technology stocks in 2000.

Homebuilders profited by a boom in new building. Local governments got higher real-estate-transaction taxes and greater property taxes, which reflected the increased tax valuations of their citizens’ houses. They could increase their spending with the new tax receipts. The investment banks, which pooled mortgages, packaged them into ever more complex mortgage-backed securities, and sold and traded them, made a lot of money and paid big bonuses to the members of their mortgage operations, including the former physicists and mathematicians who built the models of how the securities were supposed to work. Bond-rating agencies were paid to rate the expanding volumes of mortgage-backed securities and were highly profitable. Bank regulators happily noted that bank capital ratios were good, and that zero banks failed in the United States in the years 2005 and 2006 – the very top of the bubble. In the next six years, 468 U.S. banks would fail.

The politicians are not to be forgotten. The politicians trumpeted and took credit for the increasing home ownership rate, which the housing finance bubble temporarily carried to 69 percent, before it fell back to its historical level of 64 percent. The politicians pushed for easier credit and more leverage for riskier borrowers, which they praised as “increasing access” to borrowing. (The snake had most certainly been whispering to the politicians, too.)

The bubble was highly profitable for everybody involved – as long as the house prices kept going up. As long as house prices rise, the more everybody borrows, the more money everybody makes. This general happiness creates a vast temptation to keep the leverage increasing at all levels.

This brings us to two essential questions.

The first is: What is the collateral for a mortgage loan?

Most people answer, “That’s easy – the house.” But that is not the correct answer.

The correct answer is: Not the house, but the price of the house. The only way a housing lender can recover from the property is by selling it at some price.

The second key question is: How much can a price change? To this question, the answer is: A lot more than you think. It can go up a lot more than you expected, and it can then go down a lot more than you thought possible. It can go down a lot more than your worst-case planning scenario dared to contemplate.

So the temptations of housing-finance bubbles generate mistaken beliefs about how much prices can go down. American housing experts knew that house prices could fall on a regional basis, but most were convinced that house prices would not fall on a national average basis. Of course, now we know they were wrong, and that national average house prices fell by 30 percent. And they fell for six years.

By then, Fannie Mae and Freddie Mac had been banished from their pleasant housing finance Garden of Eden. Here they are, being sent into government conservatorship, as depicted by Michelangelo:

In conservatorship they remain to this day, more than seven years after their failure. Having played a key role in running up the leverage of the whole system, they had suffered a fall they never thought possible.