For weeks now I've been telling you the markets are broken.
Now I'm going to prove it.
Today I'm talking about the housing market. It's broken. The truth is Congress broke it. Of course, it had help from mortgage originators, banks, and a deliriously greedy public.
But now, amidst all the rhetoric about class warfare, wouldn't you know it, some congressmen want to further grease the wheels of an already slippery housing market for a class of homebuyers I call the "middle-rich."
It's just plain stupid. And not only will it add to our housing woes, it's ammunition for middle-class Americans, who rightly recognize they are the biggest losers in a class warfare battle they never imagined would undermine the American dream.
A Good Idea Gone Terribly Wrong
What's being debated in Congress is the maximum size of mortgages that Fannie Mae and Freddie Mac can guarantee.
The previous maximum mortgage eligible to be backed by the Government Sponsored Entities (GSEs) was $625,000. In the aftermath of the credit crisis and housing bust lobbyists easily got that maximum raised to $729,750.
The increased limit expired on September 30, 2011. But the usual lobbying forces – in this case that would be banks, mortgage originators, realtors, home builders and financial intermediaries that trade mortgage pools guaranteed by taxpayers – are pushing to extend the higher limit until at least the end of 2013.
It doesn't make sense for the government, or taxpayers, to guarantee mortgages at all. The whole scheme, which originated in the Great Depression and made good sense at that time, should have been phased out decades ago. Instead, it mushroomed.
The idea is simple enough. In order to drive money towards housing finance, the government establishes "conforming" criteria for mortgages. When mortgages conform they are believed to be of a certain standard and quality and can be packaged into mortgage-backed pools. The government guarantees the payment of principal and interest on those pools. Investors buy the pools because they are guaranteed, and the money they pay banks and originators for the mortgages in the pools goes back to originators and banks, which now have more money to make more loans to more homebuyers.
Taken at face value this isn't a bad idea. But as is so often the case with even the best ideas, there are unintended consequences. In the case of the government guaranteeing mortgages, there are plenty of very negative unintended consequences, like "moral hazard," for example.
That's why, after the horror of the Great Depression had passed, government guarantee programs should have been phased out, so that private markets could freely price the risk of originating and holding mortgages.
Unfortunately, that didn't happen. That's why we find ourselves in the situation we do today.
Still, not everything is broken. As it stands now, the government does not guarantee the jumbo loans wealthy Americans need to purchase expensive homes. Private lenders and private pool packagers do their own due diligence and investors buy pools of jumbo mortgages based on market-based risk realities. That's how it should be.
So, why are the middle-rich, who presumably can afford to buy a home costing $729,750, being backstopped by government guarantees?
Forget the higher limit. The previous limit was $625,000. I call that middle-rich too.
Why do I call that middle-rich?
Because according to the U.S. Census Bureau in March 2007 (at the peak of the housing boom) the median price for a home in the United States was $262,600 and the average price was $329,400.
As of September 2011 the median price is down to $204,400 and the average price is down to $243,900.
It makes no sense to have taxpayers guarantee mortgages for homebuyers that can afford a house that's three-times the price of a home sold at the national average – or actually, at any price.
Let me make something clear. The government isn't backstopping homeowners, who can and do lose their homes. The guarantee programs are for investors that buy pools of these GSE- stipulated "conforming" mortgages.
The point is that if there weren't guarantees at all, investors would take a much harder look at what's in the pools they're buying. And mortgage originators, who should be the first to take losses on the bad mortgages they create and that get put into pools, would do a much better job in the origination process.
Phasing Out Fannie and Freddie
It's not that Fannie Mae and Freddie Mac are doing so well that they can afford to continue to backstop homebuyers — they can't. In fact, they're both insolvent wards of the government. They have to be phased out, eventually.
Fannie Mae just reported a third-quarter loss of $5.1 billion, considerably higher than last year's third-quarter loss of $1.3 billion. So they ended up taking another $7.8 billion from the U.S. Treasury to cover their loss – which included $2.5 billion the company already owes the government in dividends on what it's already borrowed.
That gives new meaning to the phrase "robbing Peter to pay Paul" doesn't it?
Fannie so far has borrowed $111.6 billion and paid the Treasury $17 billion in dividends. And Freddie Mac is no better. To date it's had to borrow $71 billion and only paid the Treasury dividends of $15 billion.
And people wonder what broke the housing market. Government guarantees broke it.
Backstopping the middle-rich's mortgages broke the housing market, just as much as backstopping subprime borrowers (which wasn't always allowed by Fannie and Freddie) broke the housing market.
Now, the poor are poorer, the rich are richer, and the middle-rich are making a comeback. That's good for the wealthy and the recovering middle-rich, but pretty bad for everybody else.
Still, it is possible to fix the broken housing market. It may take some time, but if it's fixed properly, the middle-class will truly benefit – even more so than the rich and middle-rich. That's because members of the middle-class traditionally have more of their net worth tied up in their homes.
How can this be accomplished? Write your congressman and tell him or her to vote against raising the conforming limit for mortgages.
We need to phase out all government guarantee programs that have been distorting the housing market. If the government wants to help the middle-class, let it come up with tax breaks for investors who invest in private mortgage pools holding medium- to average-sales priced homes.
In other words: Absolutely no taxpayer guarantees for investors. If they get it wrong, let them lose, or if there's fraud involved, sue the mortgage pool packagers and sellers.
Giving tax breaks to spur investors to take risks isn't exactly free market stuff, but it's pretty far from a guarantee and at least lends a hand to the middle- class when it needs it most.
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About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
He helped develop what has become known as the Volatility Index (VIX) - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
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