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The Continuous Housing Free Fall

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Financial markets have finally internalized the brutal fact that house prices still have a long way to fall. The full-year price drop in 2007 was 8.5 percent. From January through April of this year, the most recent data available, prices fell by another 8.2 percent — a remarkable rate of acceleration.

Can they fall further? Unfortunately, yes. By conventional ratios of prices to rental values and prices to incomes, they may still be 20 percent too high.

Falling asset values have a way of turning free-market avatars into raving Socialists. For example, the housing rescue bill currently working its way through the Congress has Bank of America’s fingerprints all over it. But while the rescue bill gets all the attention, much bigger bucks are already in play.


Illustration by: Matt Mahurin

Start with the “Government-Sponsored Entities,” or GSEs – Fannie Mae, Freddie Mac and the Federal Home Loan Bank Board. These are private-sector stock companies created by the federal government, and they enjoy certain tax and other privileges. While they have no legal claim to government support, everyone believes that the government is the de facto insurer of their debt.

Fannie Mae and Freddie Mac, which are by far the biggest of the GSEs, are a mess — both financially and operationally. Freddie is leveraged 50:1, which means that it has two pennies of capital supporting every dollar of risk exposure. It is desperately in need of new capital. Now it claims to have lined up an additional $5.5 billion; but it has been forced to delay the closing, because it hasn’t been able to register the shares with the Securities and Exchange Commission.

Fannie and Freddie had once been exempt from SEC registration. But after a series of early 2000s accounting scandals, Congress insisted that they register. Fannie has done so. The fact that Freddie is still stuck in the process suggests continued accounting issues.

Collectively, Fannie and Freddie lost more than $5 billion in 2007, and Fannie had another blowout $2.5-billion loss in the first quarter. Freddie had a far smaller first-quarter loss, but the improvement is almost all accounting gimmickry. Fannie has completed its capital raise and, though still shaky, it has substantially lowered its leverage ratio. Until Freddie completes its capital raise, it is a pure financial basket case.

Almost as soon as the credit crisis hit last summer, however, Fannie and Freddie were quietly anointed as the twin engines of a bank bailout. The numbers involved are big. In the fourth quarter of last year, the annualized rate of home mortgage borrowing was about $600 billion, a sharp drop from previous years. But the GSEs’ rate of mortgage lending jumped to $1.2 trillion, or twice as much.

The same thing happened in the first quarter of this year. Home mortgage borrowing dropped to only $321 billion annualized, but the GSE lending was again twice as much, $655 billion annualized. Where did all the extra money go? To absorb existing mortgages from banks, of course – a fine example of the charitable works supported by taxpayer dollars.

The Federal Reserve Bank has been doing its part here. Over the past six months, it has created a plethora of lending programs that essentially provide banks with Treasury securities in return for illiquid paper — like subprime mortgage-backed bonds. A good guess is that of the total of $500 billion in bank assets absorbed by the Fed, about $200 billion, are backed by subprime mortgages.

These are instruments that sell for, at most, 60 cents on the dollar on the open market — if any buyers can be found. But the Fed takes them off bankers’ hands at 98 cents on the dollar. The silk tie and vintage wine industries need help too.

Or consider the Federal Home Loan Bank of Atlanta, which might be dubbed “Countrywide East.” Home loan banks provide liquidity to mortgage lenders by advancing cash in exchange for mortgages. Nearly one-third of the Atlanta bank’s lending, or $46 billion, has been to Countrywide Financial — perhaps the most notorious of predatory lenders. Since its mortgage portfolio is in a state of collapse, it was recently picked up for peanuts by Bank of America. But the Atlanta bank was sufficiently confident of the integrity of Countrywide that it maintains no loss reserves against its Countrywide loans.

But that’s ok now, since BofA just bought Countrywide, right? Er, no. The merger proxy makes clear that BofA doesn’t accept any liability for Countrywide’s debts.

Which brings us to the Congressional bailout bill (pdf) – which is set to provide $300 billion in new money so the Federal Housing Admin. can exchange expensive, inflated mortgages for traditional fixed-rate mortgages at more realistic values.

Good idea. But the catch is that the banks will choose the mortgages they want to exchange. Despite some toothless language to prevent “adverse selection,” what mortgages do you think the banks will be volunteering? Any bets on the loss rates? 50 percent? 60 percent? Did we mention that the FHA lost $4.6 billion last year, so it is already in Fannie and Freddie red-ink territory?

The final rub-your-nose-in-it charade is the claim, supported by the Congressional Budget Office, that the new bailout program will make money for the taxpayer. How will it manage that feat? By imposing charges on Fannie and Freddie!

In other words, as Fannie and Freddie careen toward insolvency, they are charged with financing a new bailout program, which will just be added to the taxpayer’s final Fannie and Freddie insolvency. If Enron had been as ingenious, they would still be in business.

The sad fact is that all these programs, well-meaning as many are, are hopeless. House prices doubled from 2000 through 2005 – an unheard of 12+ percent per year rate of increase. There were no demographic or economic drivers for the housing boom. It was cooked up entirely by the banks from financial fakery and outright fraud. And they extracted enormous rewards from their misdeeds.

There are many ways to help homeowners without saving the banks -– like forcing the conversion of toxic mortgages into market-value rental contracts in bankruptcy courts. Instead, we could well waste trillions, with no result except to create a zombie industry based on false prices that will delay a true recovery for years.

We did much the same thing in the early 1980s, when the problems in the savings and loan industry first surfaced. A decade later, it all went onto the taxpayer books at 10 times the cost. History repeats itself, as Marx said, the first time as tragedy, the second as farce.

  • Charles R. Morris, a lawyer and former banker, is the author of “The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash.” His other books include “The Tycoons: How Andrew Carnegie, John D. Rockefeller, Jay Gould and J.P. Morgan Invented the American Supereconomy” and “Money, Greed, and Risk: Why Financial Crises and Crashes Happen.”*

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