[Mb-civic] Made for walking

Wed Mar 9 11:22:18 PST 2005

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Made for walking

Mar 8th 2005
>From The Economist Global Agenda

House prices and America¹s mortgage-finance giants have both grown too big
for their boots. Will one trip up the other?

BUTTONWOOD had to chuckle at the photos of Martha Stewart, the world¹s most
tasteful jailbird, just released from Cupcake Correctional Facility last
weekend. Adorably dressed, she looked suspiciously botoxed and
understandably cheerful‹if only because shares in Martha Stewart Living
Omnimedia had more than doubled in price during the previous seven months
(though they are down this week). She would be a role model, were it not for
the record.

It is hard to know whether the shares have risen at the prospect of her
manicured hand profitably on the tiller once more or because home-furnishing
companies usually rise when the housing sector flourishes. And flourishing
it is. The price of residential housing in America rose faster last year
than at any time since 1979, says Freddie Mac, one of the two big
government-sponsored entities (GSEs) that provide mortgage liquidity. The
ratio of house prices to rents is now a third above its average level from
1975 to 2000, on calculations by The Economist.

Though the pace is likely to slow a bit this year, people keep on buying,
and borrowing to do so. There are all sorts of tempting mortgages on offer,
including 110 LTVs (110% loan-to-value mortgages), which lend the full price
of the house plus a bit extra for transaction costs. Turnover is frenetic:
as one commentator puts it, ³Day traders in shares have become day traders
in real estate.²

Does all this amount to a bubble? Without a doubt. Alan Greenspan¹s attempt
to save capitalism from the burst dotcom bubble in 2000 (and the effects of
terrorist attack in 2001), by cutting short-term interest rates from 6.5% in
2000 to 1% in 2003, produced a new bubble in the credit markets. One sign of
that is the compression in bond yields, with riskier assets paying investors
only slightly more than governments and blue chips. Another is the
debt-fuelled explosion in property prices.

What is less clear is the link between America¹s huge and hugely troubled
mortgage-finance behemoths‹Fannie Mae and Freddie Mac‹and the house-price
bubble. If these custodians of $3 trillion in securitised mortgages back out
of the market‹either because there is further bad news to emerge from within
them or because their masters make them‹could this prick the bubble by
making mortgages scarcer and dearer? And would Fannie and Freddie go bust if
the bubble popped?

The GSEs, created by statute but both private-sector companies these days,
are supposed to pump liquidity into the lower end of the housing market.
They do this by buying mortgages from banks and other lenders, most of which
they then pool as collateral for marketable securities, collecting a ³G-fee²
for guaranteeing repayment. Some mortgages and mortgage-backed bonds,
however, they hold in their own portfolios. The difference between what they
pay to borrow (just a little more than Treasuries, as they are assumed to be
guaranteed by the federal government) and what they make on their holdings
(less the cost of hedging against interest-rate risks, plus the G-fees they
earn) has made both companies among the most consistently profitable of the
S&P 500.

But those profits have been called into question. The agencies¹ regulators
have stumbled more than once on accounting fiddles at both and are now
making Fannie Mae restate four years of earnings, slow the breakneck pace of
growth in its portfolio, and strengthen capital. Mr Greenspan seems keen to
get mortgage lending back into the hands of banks whose behaviour he can
influence. Congress, meanwhile, may enact stronger controls over Fannie and
Freddie. Economists at the Federal Reserve reckon that the GSEs pass on to
consumers only seven basis points of the 15-18 point spread between the
mortgages they buy and ordinary mortgages. Richard Baker, a Republican
congressman who sits on one of the committees considering the GSEs¹ future,
says he worries that Fannie and Freddie have forgotten their mission to help
low-income people and instead have become ³a very sophisticated hedge fund
which uses its leverage in the marketplace given by the taxpayers to yield
significant profits for shareholders².

If the agencies are cut back dramatically, how much will it affect the
markets? Looking at it another way, how much is the house-price bubble due
to the availability of this huge pool of cheap credit? Not much, some would
say. After all, many other countries, including Britain, have managed to
produce perfectly good house-price bubbles without Fannie and Freddie, so
the condition may have more to do with general global liquidity and tax
breaks.

More specifically, house prices in America galloped merrily on in 2004 while
Fannie and Freddie were less active than they had been in years. Rising
house prices pushed the size of many mortgages up through the limit
($359,650 at present) that the GSEs are allowed to buy. Many borrowers chose
more complicated mortgages, such as hybrids (partly fixed-rate, partly
floating), which the GSEs find harder to buy up and securitise. The result
of all this is that the GSEs¹ furious pace of securitising mortgages slowed
in 2004, and their portfolios were virtually flat. Since then, Fannie has
slimmed its portfolio by another 17%.

It is too soon to know whether the GSEs can really absent themselves from
the market without its noticing. Despite everything, says Jim Vogel, senior
vice-president of FTN Financial Capital Markets, ³everyone out there still
assumes that there¹s a put [option to sell] at some price back to Fannie and
Freddie.² And there is plenty of money around to lend at the moment. Though
Fannie¹s shares, unlike Martha Stewart¹s, have fared unhappily over the past
few months, yields on its long-term debt have been reasonably resilient.

If house prices dropped and defaults rose sharply, could that seriously trip
up Fannie and Freddie? That would depend on how sharp the changes were. The
agencies are prohibited from buying mortgages that represent more than 80%
of the value of the house. Prices would have to fall by more than 20%‹by
much more, in areas where prices have risen most‹before Fannie and Freddie
took a serious hit.

All this is not to say that a sharp change in either the agencies¹ status or
house prices would not roil the markets. But it seems that Congress could
dare to be bold, paring back the GSEs¹ portfolios and giving a new, stronger
regulator broader powers. The boldest move of all, of course, would be to
give up altogether on subsidising the American dream of home ownership for
all. Surely Congress would not go that far? Buttonwood thought not‹until a
colleague pointed out that Britain had had a similar dream, financed through
tax breaks on mortgage interest. Where are those tax breaks today? History,
pure history. Just like Martha Stewart¹s time inside.

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