Banks inflate home prices

SUBHEAD: Real estate price conundrum of the Great American Affordability Scheme.

By Raul Ilargi Meijer on 05 September 2009 in The Automatic Earth

Image above: A 1953 futuristic illustration of selling a housing bubble. From
Labor Day, Monday September 7, marks the first anniversary of the US takeover of Fannie Mae and Freddie Mac. Prior to the takeover, the two had for over 70 years bought over half of US mortgage loans from lenders and sold them on, packaged as securities, to investors. If you put it in in the right terminology, Fannie and Freddie are just one step shy of the Red Cross and Salvation Army. The Financial Times gives it a try:
[..] many have enjoyed lower interest rates on their home loans because the two companies kept money flowing through the market. Backed by an implicit government guarantee, their mission was to support the US housing market by providing liquidity, stability and affordability for those in need of a mortgage.
This is the sort of description of Fannie and Freddie's activities that has become standard in the US media. But there is something missing, and something crucial at that. By allowing lenders to rake in commissions and other fees for a loan they originate, while selling off the risk of default on that loan to global investors, in a set-up that provides implicit government (re: taxpayer) guarantees for that risk, Fannie and Freddie serve to drive up real estate prices, and dramatically so.

 There was a time when mortgage loans were provided for maximum 50% or 60% of the purchasing price, and when they were standard paid off in 5 or 10 years. At today's prices, compared to people's incomes, that is unthinkable. Loans are now paid off in 25, 30 or even 40 years. Moreover, when all accumulated fees are taken into consideration, home-"owners" will more often than not have paid 3 or 4 times the purchasing price of the home once the loan has been paid in full.

This is not a typical US phenomenon, government "support" for homebuyers exists in many countries. For example, when I was in Portugal ten years or so ago, I noticed that multi-generational loans were all the fad. It's a generally accepted sort of scheme, but that doesn't make it any more morally acceptable. The often lauded additional "affordability" offered through a government guaranteed home loan system is of course nothing but a hoax.

In essence, what it delivers is the opportunity for someone who couldn't afford a $50,000 house under "normal" conditions to now get financing for the exact same abode for $350,000. And if everybody can "afford" to spend that much more, prices will, as if by magic, rise accordingly. After all, why would anyone try to sell a house for only $50,000 when there's that much credit in the market?

Buyers wouldn't even want it, they'd think there was something wrong with it. So if the home still costs about as much to build, where does all the extra money go? Well, builders become "project developers" and drive fancy cars. Suppliers get a share; until the crash the cement and plastics industries were doing just fine, thank you. Most of it, though, goes to the banks. That is the one and only real effect of Fannie, Freddie, their brethren around the globe, and the government guarantees they offer.

Instead of a hard working family paying George Bailey's Building & Loan Association in "It's a Wonderful Life" 50% of their income plus 5% interest for 5 years, that same family, if it wants a home of its own, is forced to pay 30% or 40% of its income for 30 or 40 years to a bank that runs no risk whatsoever and that will charge it fees left, right and center on top of everything else. Is it any wonder that the real wealth of American families has been falling since the early 1970's?

The largest and most important purchase for everyone who wants a family has turned into the largest and most important transfer of money from Main Street to Wall Street. And now that Wall Street’s gambles with all the money raked in through the scheme, as well as the highly leveraged securities written on the loans, turn sour, the government guarantees kick in, and it's up to deeply impoverished Main Street to cough up the cash to pay the piper.

Meanwhile, the banks still operate, their traders still make millions, Fannie and Freddie are about to be replaced by a side-scheme operated through Ginnie Mae and the Federal Housing Administration (which will need a taxpayer bail-out before the year is over). There is one thing more crucial than any other to the present US economy: a program must remain in place which guarantees that people pay far too much for their homes.

If that would be let go, there would be no financial or banking system left in the country. Sharply lower property taxes would bankrupt all states, counties and municipalities save for a precious few. And perhaps most of all, the previously incurred losses would be forced to the surface. You can't keep a $350,000 loan in your books for a home right next to a similar one that sold for $35,000.

 If we want to ever shine a light on any of this. before the next step in this tragic drama is locked in by the White House, it would be good for an investigative journalist or two (hello, Huffington!) to dig up the answers to a few questions such as these:
  • What is Fannie and Freddie's securities portfolio valued at presently?
  • How did Ginnie Mae end up with over $1 trillion in loans?
  • How did the FHA become insolvent?
  • What is the situation at the various Federal Home Loan Banks? What is the precise role they play in the scheme?
  • What happened to Fannie and Freddie share prices recently that makes them compliant with NYSE rules once more?
  • Who puts money into companies with a combined negative asset value of $260 billion?
  • What would have been the estimated effect if both had been de-listed?
Do Fannie Mae and Freddie Mac provide "affordability for those in need of a mortgage"? No, clearly not, they provide the opposite. They raise home prices by guaranteeing loans at steeply elevated prices. They pervert the market. Is it true that "many have enjoyed lower interest rates on their home loans" because of Fannie and Freddie?

Well yes, but who of sane mind would rather pay 5% + fees on a $350,000 mortgage than 6% + no fees on a $50,000 loan? What sort of discussion is that to begin with? If the government and media keep repeating the positive sides often enough, and god knows they’ve been at it for 75 years now, who will dare be critical? A system with government guarantees for real estate could work, but never if it is provided through a banking system that seeks to maximize its profits at the expense of the taxpayers whose money is being spent by that government. It won't stand.

The system is broken beyond repair. The boondoggle has extracted so much capital out of the economy that there cannot be a market any longer at the higher price levels. Sure, according to the S&P-Case/Shiller index, prices are down 30% from their peak already. But if you think that’ll be all, imagine what would happen if Fannie and Freddie, or their taxpayer-guarantee providing successors, would be taken out of the market. Real estate prices can no longer be kept at such artificially high levels, since people can't afford them anymore no matter what guarantee they come with.

At the same time, if real estate prices are allowed to fall, by taking the guarantees away, the housing market will implode overnight, taking individual homeowners as well as the banking system and indeed the entire American economy with it. A real life conundrum. If you don’t want the banks and the economy to implode, you need to keep prices high. But if you keep prices high, there are no buyers, which means the banks and the economy will implode (just a bit slower). Now, you would think a government would choose the lesser of two evils. Instead, the present administration elects to embrace both evils.

What should a government do? In the end, it all comes down to Garrett Hardin again, who said the main task of the shepherd is to minimize the suffering of the herd. What the Fed and White House do instead is try to minimize the suffering of the rich. The only consolation for the rest of us is that it won't work. Unfortunately, we’ll pay a high price to figure that out.

See also:
 Island Breath: Wall Street Bets Agianst Homeowners 4/19/06
Island Breath: NYSE on Tumble. It this it? 6/6/07

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