Housing Sector Hangs by a Thread Despite Rock-Bottom Rates

Mortgage Market Propped Up by Fannie and Freddie on Government Life Support; Now What?


July 6, 2010 —

Interest rates for homebuyers are lower than at any time since the Eisenhower era and home prices in many regions have fallen drastically.

Buyers who qualified for the federal tax credit program that ended in April, meanwhile, were given extra time, through the end of September, to close on their homes.

And yet, home sales are in decline. Existing home sales fell 2.2 percent in May compared to the prior month, the National Association of Realtors said in June. Pending home sales -- contracts signed but not closed -- dropped 30 percent in May, the NAR said July 1.

As perplexing and disturbing as this economic brainteaser may seem, the housing sector would be in even worse shape if not for those twin government sponsored enterprises, Fannie Mae and Freddie Mac, both in government conservatorship and bleeding assets.

Such a scenario, a housing market propped up by Fannie and Freddie, several economic experts admit glumly, is akin to running a power plant on an auxiliary generator that is jumper-cabled to a car running on fumes.

"As bad as the housing price situation is, it'd be even worse if not for the cheap mortgage financing enabled by Fannie and Freddie, as scary as that sounds," said Dan Alpert, managing partner of Westwood Capital LLC, a New York-based investment bank.

Beleaguered as they may be, Fannie and Freddie still are pumping liquidity into a near-bone-dry mortgage loan market, primarily by converting pools of loans into mortgage-backed securities, and by guarantying such securities.

Both Freddie and Fannie, having failed two summers ago, are 79.9 percent owned by the U.S. government, which means that the remaining 20.1 percent is still owned by the investing public.

However, shares of both are trading well under $1. In fact, $1 would be enough to buy a share of each and still have some spare change.

Both Fannie and Freddie are about to become de-listed by the New York Stock Exchange, which has rules about companies trading below $1 for an extended period of time. So starting July 8 these once mighty enterprises will trade alongside penny stocks on the Over-the-Counter Bulletin Board, a place where many companies go to die.

While it's doubtful Fannie and Freddie ever will return to anything resembling solvent, it's difficult to contemplate how the U.S. mortgage market could function without the nearly $6 trillion in funding they provide to this market and the institutions that comprise it.

Talk about being between a rock and a hard place. After the Dodd-Frank financial reform bill made it through the House-Senate reconciliation phase in late June, Republican critics immediately blasted the legislation's failure to address the problems and risks to taxpayers surrounding Freddie and Fannie, although no one on either side of the aisle has much to offer by way of a solution. Too big to fail, and too broke to fix.

"It's a problem that can't be ignored much longer, but at the same time, with the economy still not fully recovered and the housing market still wobbly, now is definitely not the time to pull the plug," said Paul Leonard, a spokesman for the Housing Policy Council in Washington, D.C.

The HPC, part of the Financial Services Roundtable, a financial industry lobbying group, has advocated replacing Freddie and Fannie at some point in the not-too-distant future by new private-sector enterprises that would be known as Mortgage Securities Insurance Companies. MSICs would provide the same liquidity to the mortgage market as the GSEs do, except without the implicit government guarantee.

While MSICs would not be backed by the government, the HPC's proposal calls for the government to provide an "explicit" backup-guarantee directly on mortgage backed securities that are insured by the MSICs, John Dalton, HPC president said recently during a roundtable sponsored by the Smith School's Center for Financial Policy.

"To be clear, this catastrophic guarantee would not apply to the MSICs themselves; it would apply only to the [mortgage backed securities] that they guarantee," Dalton said. "Without such a guarantee, investors in MBS will seek other investments, and as they do so, the level of funds available for housing finance will be reduced and the cost of mortgage loans will increase."

The proposal, which, according to the HPC's Leonard, has gotten positive response from Wall Street banks, would open the door for a new kind of mortgage lending behemoth but limit the government's guarantee to a form of "catastrophic reinsurance," covering interest and principal payments on MBS only after all private capital backing an MBS is exhausted.

Gilbert Leistner, a Swiss-based financial industry consultant and a member of the Chicago Board of Trade, has a more blunt approach for dealing with Fannie and Freddie: "Euthanize them," he said.

Kevin Duffy, co-founder of Bearing Asset Management in Dallas, said his firm, which has $75 million in assets, began shorting Fannie eight years ago when shares traded around $70, and Freddie when it was around $50.

"They are hemorrhaging right now and the taxpayer is keeping them on life support," he said. "You have a sliver of equity on a mountain of debt. They need to be put down. Sever all ties to the government and let the private sector run the mortgage market, painful as that will be."

Mortgage rates may spike, Duffy said. But they are now as low as any time in a half century. Rates have nowhere to go but up, anyway.