Bush to Back Curbs on Fannie, Freddie. This could have a dramatic effect on housing prices. Here’s why. Much of the reason for the frenzy in home-buying is that banks are making incredibly risky loans. A no-down-payment, interest-only, adjustable loan enables people who don’t make a lot of money to qualify for the monthly payment on a very expensive house. No down payment means that buyers have very little incentive to stay in the house (and keep making those monthly payments) if something goes wrong – they have literally nothing invested. Paying only the interest for the first five years means that their payments will go up dramatically in year six when principal payments are added. Adjustable means that if interest rates rise (and they will) the monthly payments will go up. Meanwhile the whole point of these loans is they make the house purchase possible for people who can’t afford higher payments. The bet is that the price of the house will go up dramatically, so the buyer can sell the house before the end of the five year low-payment period. These are loans that are guaranteed to fail. The only question is when.
So why do the banks and other lenders make such loans? Because they can turn around and sell the loans to “Freddie Mac” and “Fannie Mae.” From There Goes the Neighborhood: Why home prices are about to plummet–and take the recovery with them, in April’s Washington Monthly,
Getting a home loan used to be a particularly nerve-wracking and unpleasant process. A stern loan officer behind a big mahogany desk would pore over your income and credit, suspiciously probing your portfolio for weaknesses. And sensibly enough: The bank that lent you the money would have to collect on the mortgage for the next 30 years and had to make sure you were really good for it. It hired independent appraisers to make sure the price was in line. [. . .] The one exception to this general process was mortgages sold on the secondary market. In the 1930s, Congress created the Federal National Mortgage Corporation (Fannie Mae) to encourage banks to make loans to low-income Americans by agreeing to purchase those mortgages from the banks. In 1970, Congress created a second agency, the Federal Home Loan Mortgage Corporation (Freddie Mac), to do much the same thing. By the late 1980s, these two entities, which belong to the category known as Government Sponsored Entities (GSEs), were buying up and reselling 30 percent of new mortgages and packaging the mortgages to be sold as securities.
Fannie and Freddie’s market share was limited by their ability to attract investment capital. But in 1989, Congress instituted some modest-seeming technical changes that made Freddie and Fannie much more attractive to investors, and able to draw much more capital. Under the new rules, for instance, they were allowed to customize securities at different levels of risk and return to meet more precisely the demands of different sectors of the capital market. Then, too, bank regulators let pension funds and mutual funds class Fannie’s debt as low-risk. As a consequence, during the 1990s, investors practically threw money at Fannie Mae and Freddie Mac, which became enormously, steadily profitable. The GSEs used the new capital to buy up every mortgage they could, and banks were only too happy to sell off the mortgage paper. The price cap on the mortgages Fannie and Freddie could insure was raised. As a result of all these changes, Fannie and Freddie went from buying mostly mortgages for low-end homes to those of the middle- and upper-middle class. And the share of the nation’s conventional mortgage debt which they insure has swelled, to more than 70 percent today, double its share in 1990.
So the risk is off the banks and on these “GSEs.” They used to buy 30% of mortgages, but now they buy 70%.
Once banks knew they could automatically hand off the mortgages they wrote to Fannie and Freddie with basically no risk, the old incentive system dissolved. “Banks and other mortgage lenders are not watching home prices carefully because they rarely hold onto the mortgage paper they create–they just sell it upstream to mortgage investors,” John R. Talbott, a housing researcher at UCLA’s Anderson School of Business, has argued. “It is a dangerous situation indeed when neither home buyers nor the institutions that finance them are concerned with the ultimate price being paid for the housing asset.”
With the risk off the banks, why should they care if these loans fail? See if you can guess who the risk is on now – who will pay if these loans can’t be paid off by the house buyers?
Those who understand that the entire financial system now rests on these loans supporting housing prices are trying to make behind-the-scenes changes to shore up the problem. But this would make loans harder to get, which would pop the housing bubble.
And, of course, Realtors oppose new test in GSE reform bill:
“The ‘bright-line’ test could inhibit innovations associated with Fannie Mae’s and Freddie Mac’s automated underwriting systems and result in higher loan costs and decreased access to mortgage credit that would make it more difficult to buy a home,” said NAR [National Association of Realtors] President Al Mansell.
Requiring reasonable credit checks before making $700,000 loans? No, realtors don’t like that at all!