Evil Stepchildren

By David Galland

The administration is making a lot of noise today about reforming its evil stepchildren, Fannie and Freddie, the “government sponsored enterprises” (GSE) that back virtually all of the conforming mortgages in America these days.

The intention, according to the spinmeisters, is for these entities to scale back their involvement in the nation’s mortgage market and by doing so encourage a return of private lenders.

As part of the process the Treasury is recommending an increase in the size of mortgages considered to be “conforming,” and therefore qualified for coverage by Fannie and Freddie.

Wait a second!

That’s not going to lessen their involvement in mortgage lending – just the opposite!

Is it April 1 already?

Nope, checked the calendar – still February.

Could it be that the government is insulting the intelligence of the American public with all this talk of reforming Fannie and Freddie?

Business activities related to the U.S. real-estate industry make up about 17% of GDP. As you don’t need me to tell you, the busted housing bubble has caused havoc in this large corner of the economy. I won’t restate all the gory stats here, but will mention that the annual value of private construction begun in 2010 rang in 44% below the pre-bust level, in 2006.

And, according to the Bureau of Labor Statistics, employment in the construction industry was 7.6 million in January of 2006. As of January 2011, the BLS reported only 5.5 million people employed in construction – a decline of nearly 30%. And it’s worse than that, because a sizable percentage of those workers still in construction are now on government jobs.

In addition, the amount of knock-on business from homeowners using their bubbly-priced houses as collateral for loans was a huge factor in the go-go days of the recent past. Today, at least 35% of U.S. mortgages are technically underwater, with the house worth less than what remains on the mortgage. And, if you add in the considerable costs associated with a real estate transaction – costs such as the typical 6% brokerage fee that reduces the net received by the seller, then the actual number of mortgages underwater soars. One credible estimate puts the actual number, when factoring in those costs, at well over 60% of all the homes in the nation.

Put simply, the housing sector is a huge and important component of the U.S. economy; and it is already in deep trouble. If mortgage rates were to increase by any appreciable amount, it would be devastating to both housing and the feeble economy. And make no mistake, absent government stooge companies guaranteeing loans for anyone with a pulse, interest rates will soar.

Always interested in his opinion on this topic, I asked Andy Miller, real estate entrepreneur and confirmed faculty member for our Casey Research Boca Raton Summit (April 29 – May 1) to comment on the noise on Fannie and Freddie coming out of Washington. His response follows.

David,

I have to laugh at it. The only other reaction a person could have is to cry.

In 2010, something over 90% of all home mortgages were sponsored by a GSA or FHA. Is it realistic to think that there will be some non-government sponsored program that could do what is now being done by government entities? I don’t think so.

I won’t encumber you with a long, dull email, but consider this: Fannie and Freddie routinely write mortgages over 90% LTVs (loan to value). They do so at extremely low rates. As a result, they are having huge problems with defaults and with the massive foreclosure and securitization structures. There is no outfit in the private sector that would write paper like that. It would be suicide. Therefore, how will you fill the void left by dismantling Fannie or Freddie?

I can illustrate this easily for you by directing you to the jumbo residential mortgage market. There is no Fannie or Freddie in that market since their lending stops at $417,000, depending on what part of the country you are in. At any rate, when you see what paper is being written in the jumbo market, it becomes easy to contrast. For example, there are very few private, jumbo loans written over 80% loan to value, and most are less than 80% LTV.

Can you imagine what would happen in the conforming market if, all of a sudden, Fannie and Freddie stopped writing loans, and a borrower had to turn to the private sector to get a loan? How many borrowers in America would be able and willing to write checks for 20%-25% down? We have become heroin addicts for high LTV/ low interest loans.

I don’t doubt that the federal government will engage in some optical illusions, assuring us that they have stanched the losses on homes by terminating Fannie or Freddie. However, to think that the government can just turn this over to the private sector, and expect the private sector to write stupid loans with no federal guarantee is simply ludicrous.

As an aside, the Treasury, the administration, and Congress have spent the better part of the last two years railing about how bad and dishonest the private sector was while writing home mortgages. What happened? Why are they now advocating having mortgages written by the same people that wrote the paper in 2004, 2005, and 2006? I hope you are laughing too, because this should be on the Jay Leno show. Andy

On sharing Andy’s remarks with our own Terry Coxon, also on the faculty in Boca Raton, he emailed back the following quip.

Every word Andy wrote is true. But why does any politician talk about the government getting out of the mortgage business? The only reason I can think of for saying “government out of the mortgage business” is to dodge blame for an expected train wreck.

As hard as the government has tried to keep the train from leaving the rails, the chart here points to the coming wreck. Rates are already beginning to move up: take away government guarantees and the 30-year rate will pop way above where it was just ahead of the crash. Remember, back when instead of taking your wallet, muggers would pin you against the alley wall until you agreed to take a loan?

The government can jawbone all it wants about unwinding Fannie and Freddie as part of its new initiative to appear more “Republican,” but that doesn’t begin to address the trillions in loans those entities are now standing behind, many of which, per above, are underwater. And it completely ignores the consequences of what would actually happen if the government stopped competing with the private sector and stopped guaranteeing new loans.

To wit, private sector lenders would:

• Require realistic house appraisals. A friend of mine recently took out a mortgage, and the lender didn’t even ask for an appraisal – Why bother? The loan was conforming and would be shipped off to Fannie Mae before the ink was dry on the paperwork.
  
  
• Demand large down payments. Per Andy, 20% or even more – depending on a person’s credit history.
  
  
• Proof of things like an ability to repay. You know, steady job and all that sort of thing.
  
  
• A much higher interest rate. Knowing what you know about the government’s printing operations, would you lend money for 30 years for a yield fixed at 4.5%?

In other words, if the government steps away from the mortgage lending business, as it is now threatening to do, it would trigger an absolute rout in the housing market.

Is there a solution? Well, the country could begin offering citizenships to any foreigner who plops cash money down for a house in the U.S. worth more than, say, $300,000. The Chinese, among others, would be lined up at the door. Who knows, maybe that house down the street might catch the eye of Hosni Mubarak. I suspect he’ll be looking for new digs outside of Egypt pretty soon – throw in a passport, and it would be a pretty sweet deal.

(Whoops, just heard that the Swiss have frozen Mubarak’s accounts… no passport for you!)

In all seriousness, absent something that dramatic, the problems with housing will be with us for a long time to come.

Since we’re on the topic of coming train wrecks, steady correspondent Nitin from Nepal shot me a snippet from Matt McAbby from Oakshire Financial on the current enthusiasm about the U.S. stock market. Some quotes worth reflecting on:

• 1. Perhaps the rally is running out of buyers.

  2. Perhaps the greater part of the trade is taking place off-exchange, in the institutionally murkiest of dark pools.

  3. Perhaps sellers are holding out for a liquidity-induced jump to Dow 16,000.

  4. Perhaps brokerages (which make big margins off commissions) are bored of profits and are discouraging “overtrading” among sales staff.

First on everyone’s radar should be the dwindling volumes that are driving the current rally in equities. NYSE volumes have shrunk significantly of late, running as low as 30% below average – which could mean a few things:

Whatever the reason, higher highs on low volume is generally not a positive sign.

And another thing

Two more indicators we keep an eye on are flashing danger at the moment. You should be aware of them, too.

The first is the insider sell/buy ratio, which last week saw wild numbers on the sell side at 434:1. For the week, $1.7 million worth of stock was bought in sixteen separate purchases, while 126 sales totaled just under $750 million.

Why were insiders cashing out in such manic fashion? Everyone going to the Super Bowl? Needed some spending cash for the trip?

Hmm.

The second indicator is overall margin debt, which last month hit levels higher than anything seen since Lehman Bros. got a toe tag.

Total NYSE margin debt printed at $276.6 billion, its highest reading since September 2008, though not yet the ultimate highs reached in June 2007 (“Alas, Sabrina, are we headed there again?!”).

At that point, overall margin debt read $381 billion, a truly staggering number.

The simple truth is that we are in truly unchartered waters here. If there was ever a time to be cautious, and to keep your ear close to the ground, it is now. This view, of course, runs contrary to the herd which, as another dear correspondent wrote recently, is getting “crisis fatigue.”

I think she’s right. It’s hard to stay on high alert for a protracted period of time. That Americans just want to have fun can be seen in the increased margin debt just referenced, as well as in the 2.5% leap in credit card debt in December 2010 alone.

Unfortunately, if we’re right about where things are headed, then the shock of the next blow to the economy is going to have an especially devastating impact on those who – believing the steady talk about recovery – have again inched out on the credit limb.

Combine a dark turn in the mass psychology with an overheated stock market, and next thing you know my wonderful partner Doug Casey’s Greater Depression will be upon us. Actually, based on the fundamentals, it already is. People just don’t know it yet.

The good news is that you don’t have to be glum, if you are prepared, and if you are careful. That brings me to what you might view as a public service announcement, aimed at all of you who have done so well with our resource picks.

And that, dear reader, is that for this week. Until next week, thank you for reading and for subscribing to a Casey Research service!

Vedran Vuk
Casey's Daily Dispatch Editor