Tuesday, January 31, 2006

A Pin That Could Pop The Housing Bubble

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An interesting essay on the housing bubble was published on the Resource Investor website out of Toronto, Ontario, Canada. The essay is from a data provider called Precious Metal Warrants out of Arizona. The point it tries to make — the housing bubble's Achilles' heel could be short-term rate increases like the one announced Tuesday.

Here's an excerpt:
The key to holding up the entire speculative U.S. financial system with its current excessive levels of debt - federal (current account and trade), state, municipal, corporate and household - is maintaining the U.S. housing bubble. Anything less would result in America’s worst nightmare and, in short order, the entire world.

The housing market is dominated by Fannie Mae and Freddie Mac who hold 75% of all outstanding home mortgages (and the Federal Home Loan Bank Board to a much lesser extent). One too many additional increases in the Fed rate may well turn out to be the U.S. economy's Achilles' heel and lead to a major crisis at these two institutions generating an out-of-control systemic breakdown situation and disastrous financial implosion.

Here's why. Fannie’s and Freddie's (FF) original functions were to provide liquidity to the housing market. After a mortgage lending institution (MLI) originated a mortgage – say, $100,000 – FF would purchase that mortgage from the MLI for a fee and hold the mortgage to maturity. The MLI now had $100,000 to make yet another mortgage loan and earn yet another fee. By the repeating of this process FF injected liquidity into the housing market making it possible for MLIs to increase the number of mortgage loans they could make each year and earn considerably more fees in the process.

Where did the money come from for FF to raise money to purchase these mortgages from MLIs? It was easy. FF simply issued bonds (which, as you know, are a form of debt) at a somewhat higher interest rate, which was their spread or profit. The more mortgages they bought from the MLIs covered by the issuance of their bonds the more money they made. And it was all totally secured by the assets of the houses themselves. A risk free arrangement. Not bad. The MLIs made money, FF made money and the consumers owned houses on which they could afford to make their monthly mortgage payments.

Beginning in the 1980's FF got greedy! They began to encourage the MLIs to sell mortgages to purchasers who would have to spend more than the U.S. Department of Housing’s recommended 28% of gross income to service the housing (mortgage payments, home insurance payments and home property tax due) costs involved. As FF expected the demand for houses went up, the price of houses went up, the number of mortgages went up, the size of mortgages went up, the profits of the MLIs went up and the profits of FF went up. But the degree of financial risk for FF increased dramatically. Many mortgagees had to pay out 50%-60% of their household income in housing costs and were extremely vulnerable to any economic setback they might encounter - loss of job; increased cost of living; health problems; death, incarceration or illness of breadwinner. As a result, the rate of delinquencies and foreclosures went up. In many cases the down payments made by these new mortgagees were so small that the only way FF could recoup its outstanding mortgages was if the resale prices of the homes appreciated considerably from the date of the initial purchase. The greater the appreciation of such homes the less the risk to FF.

Next, in the unending search for increased profits, FF undertook some financial innovation. They began bundling groups of mortgages together as mortgage-backed securities (MBS) on which they guaranteed, in case of default, to pay interest and principal “fully and in a timely fashion.” They sold these MBSs for a fee, to mutual and pension funds and to insurance companies around the world. This gave the funds a claim to the underlying principal and interest stream of the mortgage. In doing so the risks entailed in the owning of mortgage debt were broadened beyond FF. If FF were unable to fulfil their guarantee (and the monies provided by the government are totally inadequate) these funds, too, would be adversely affected and depending on the extend of the default, gravely so. FF's profits went up but its reward/risk ratio dropped like a stone!

And finally, to squeeze out even more profits, FF began taking 50% of their MBS holdings and pooling them once again into derivative instruments called Real Estate Mortgage Investment Conduits, i.e."restructured MBS" or into what are called Collateralized Mortgage Obligations for which they are paid a fee. These instruments are highly specialized derivatives, i.e. bets on the direction of future rates of interest. FF's profits went up even more but the risks associated with these actions became excessive!!

Thus, what started out as a simple home mortgage, has been transmogrified in to something one would expect to find at a Las Vegas gambling casino. Yet the housing bubble now depends on precisely these instruments as sources of funds.
This has been an excerpt. For the entire essay visit Resource Investor at this link.

— The Boy in the Big Housing Bubble