Upside-Down Mortgages and Sinking Home Prices

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An upside-down mortgage is a mortgage for which the home owner owes more on the mortgage than the home is worth.

According to a report on the CBS TV “Early Morning Show” on March 10, if house prices fall another 10% nationally, 20 million households will be in an upside-down condition.

As of the year 2000, at the last census, there were 83 million residential properties. Almost 68 million were owner-occupied. Of these 68 million properties, 67% had a first mortgage. So, about 45 million homes had mortgages.

If the 20 million figure is correct, then about 43% of all mortgage-owing households would be stuck with underwater mortgages. But this assumes conditions of 2000, before the really maniacal phase of the bubble took place.

The source of this estimate was not identified on the broadcast. It may be wildly pessimistic, but I doubt it. Millions of home owners have borrowed on their home equity since 2000. When people have sold their homes at a profit, they have moved up — more expensive homes, more debt.

Lenders will not lend money to families whose collateral is a home on which the mortgage owed exceeds the market value of the home. This will put a crimp in consumer spending. It will make the transition to a new capital structure — the recession — that much worse.

There are three other factors to consider. First, the actual sale prices of these homes will be lower than the listed prices — maybe substantially lower. It already takes almost a year to sell a home nationally. This delay period is going to get longer. Those who need to sell will take lower prices.

Second, the appraisal agencies are in panic mode, fearful of lawsuits for overinflated prices. They are cutting appraised values. This is possible for them because, with liquidity gone, homes are staying on the market far longer. Appraisers are assuming the worst regarding market value. The appraised value is the “sold today” value. That is a discounted value.

Third, it costs $50,000 to foreclose on a house. Incredible, isn’t it? The lenders made loans on the assumption that they would not have to foreclose to get the properties back. Now that assumption is seen as nave. Owners can live rent-free simply by paying property taxes.

The recession has only just begun. The number of abandoned homes is rising. The holders of these now-dead mortgages cannot get renters in fast enough. Weather and vandalism and crackheads are now threatening the collateral of the loans even before foreclosure.

Will home prices nationally fall by 10%? There are no signs today that they will not fall this year through 2009 because of ARM mortgage interest rate re-sets. At the margin, home prices will fall, which will force appraisers to lower appraised value, which will lower what lenders are willing to lend.

I think 10% is a low-ball estimate.

BUT IS HOUSING REALLY A BUBBLE?

Why do I think it’s a bubble? Because it has these characteristics:
1. Funded by extensive leverage (debt)
2. Carry-trade: borrowed short and lent long
3. Widespread belief that it is not a bubble
4. A huge percentage of borrowers
5. Faith that the government can protect debtors
6. Economists deny it is a bubble

The Federal government and its licensed agency, the Federal Reserve System, have combined to create the ultimate economic bubble: the residential housing market. Other national governments have done the same thing. The housing bubble is now international, but especially in English-speaking nations.

The U.S. government has created an economic illusion, namely, that the two government-sponsored enterprises (GSE’s), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), are agencies of the U.S. government. They are not.

One piece of evidence for a bubble that I take seriously is provided in the 2007 annual report of Freddie Mac. The Chairman began his lengthy message with this admission, signed on February 28, 2008.
In 2007, our sector suffered the most severe housing correction since the Great Depression. In my 35 years as an economist, central banker, regulator and businessman, I have never witnessed a situation quite like this one — in which a housing bubble has played such a central role in bringing the world’s largest economy to the brink of recession.

But this is a concealed bubble. This makes it unique. How is it concealed?
1. No market index for housing in general
2. Extensive reservation demand: owners won’t sell
3. Illusion that GSE’s are legally protected by the Federal government

The Federal government created both organizations, then let them become private, profit-seeking corporations. They both can borrow at below-market rates because of their special relationship with the Federal government. The question is this: To what extent will Congress be pressured by constituents to bail out these forms in a true freeze-up in the mortgage credit markets?

This is a crucial question. These firms together own 40% of all mortgages in the U.S. The total value of these mortgages is equal to the total annual production, including government, of the United States — over $11 trillion.

The Investopedia site provides these insights into the two organizations.
Both companies have a board of directors made up of 18 members, five of which are appointed by the president of the United States.

To support their liquidity, the secretary of the Treasury is authorized, but not required, to purchase up to $2.25 billion of securities from each company.

Both companies are exempt from state and local taxes.

Because of these ties, the market tends to believe that the securities issued by Fannie Mae and Freddie Mac carry the implied guarantee of the U.S. government. In other words, the market believes that if anything were to go wrong at Fannie Mae or Freddie Mac, the U.S. government would step in to bail them out. This implicit guarantee is reflected by how cheaply they are able to access funding. Fannie Mae and Freddie Mac are able to issue corporate debt, known as “agency debentures,” at yields lower than other institutions.

The idea that $2.25 billion could do anything to bail out a pair of companies holding mortgages with over $4 trillion gives some idea of the bubble mentality of investors in the two organizations. That Congress would add to this credit line in a national crisis is politically obvious. That Congress could and would pony up an extra trillion dollars is something else again.

WHAT IF THE GSE’S LOCK UP?

The GSE’s primary role is to provide liquidity in the secondary mortgage markets. Loan originators sell the mortgages to the GSE’s. What happens if investors in these agencies decide that these two behemoths are too illiquid to continue to make purchases of mortgages? That will end the mortgage market’s liquidity overnight.

In the first week of March, the interest rate spread between agency-backed mortgage bonds and T-bonds reached the highest level in 20 years. Twenty years ago, the United States was in the middle of the S&L crisis.

Meanwhile, non-GSE lenders have ceased to lend. In 2000, the GSE’s accounted for 40% of mortgages. According to the Housing Wire site,
Both Fannie Mae and Freddie Mac accounted for a record 76.1 percent of new mortgage-backed securities issued in the fourth quarter, a number than industry sources say is likely to reach well above 80 percent to start 2008. Some have even suggested that the GSEs may end up owning as much as 90 percent of the lending market before this year is out.

The American housing market is now almost completely dependent on two non-government agencies that are widely regarded as government agencies. These two agencies are facing the most risky market in their history.

William Poole, president of the Federal Reserve Bank of St. Louis, offered this assessment on February 29: “I am more skeptical of the financial strength of the GSEs, and believe that we could see substantial problems in that sector.” He is concerned about the fall in home prices in cities such as Phoenix, San Diego, Las Vegas, Miami, and Detroit. These declines have not been offset by increases in other cities.
I do not have any information on the GSEs that the market does not also have. Nevertheless, in assessing the risk of further credit disruptions this year, I would put the GSEs at the top of my list of sources of potentially serious problems. If those problems were realized, they would be a direct result of moral hazard inherent in the current structure of the GSEs.
But can’t the
Federal Reserve intervene and bail out these agencies? He doesn’t
think so. “As I have emphasized before, the Federal Reserve can deal
with liquidity pressures but cannot deal with solvency issues.”

Solvency issues are at the heart of this recession: the solvency of home borrowers and, by implication, the solvency of Fannie Mae and Freddie Mac.

The FED can always monetize both organizations’ inventory of mortgages. This would solve the solvency problem of both organizations, if such insolvency ever threatens their survival. Poole has not yet discussed in public this fall-back position of the Federal Reserve.

Consider this anonymous assessment of what we are now facing.
“Imagine a sinking ship with only two lifeboats, and that the sinking ship would need closer to 50 lifeboats for everyone on board,” said one source, a manager at a large independent lender who asked not to be named. “Those two lifeboats may be the best on the planet, but it won’t matter much if everyone tries to pile onto them, which is exactly what’s happening right now.”

http://www.garynorth.com/snip/515.htm

In his 13-page message to Freddie Mac shareholders, the chairman tried to make the best of a $3 billion loss, compared with $3 billion profit in 2006. He ended with a note of optimism: rising long-term demand for homes.
As Freddie Mac shareholders, you have shown extraordinary patience in an extraordinary time. But let’s remember that for all that has changed, very important long-term aspects of demography and demand have not changed — and are positive.
This is true.
There is demand. People want to buy homes. The question is: Who is
going to lend money to them at rates that have prevailed under the
Greenspan era? Where are the GSE’s going to get lenders to forfeit
access to their money for 30 years at 6%?
America remains a growing developed nation: one with relatively high rates of birth, immigration and household formation. Long-term demand for housing finance will remain strong. And now, having built a firm foundation, Freddie Mac is positioned like very few other companies to benefit from the inevitable recovery of housing in this country.
But when will
this recovery take place? After what percentage of decline in housing
prices? Are they headed back to where they were in 1995? If not, why
not? He ended with these words:
So thank you for your fortitude and confidence in Freddie Mac. During this difficult time for housing and the economy, rarely have they been as needed or as beneficial for our nation. Yet also, from my perspective, rarely as well justified.
Fortitude and
confidence are indeed great things, as General Custer no doubt remarked
to his troops.

From my perspective, I see a lot of Indians.

CONCLUSION

We are now facing the previously unthinkable: a real lock-up of the mortgage market, followed by a sharp decline in housing prices. This would produce dramatic capital losses. It would reverse the wealth effect. The wealth effect is the emotional effect of a person’s equity any party of his portfolio. He feels richer. He spends more. He saves less.

The poverty effect reverses this mentality. He spends less. He saves more.

The transition period is what we call a recession. Capital values in formerly booming markets fall rapidly. There is a rush for liquidity and safety.

We are seeing this in T-bill rates, which have been under 1.5% this month. This does not compensate investors for losses to inflation and income taxes. When people move to T-bills below the FedFunds rate, they are scared. This includes bankers who are borrowing from the FED at 3% and lending to the Treasury at 1.5%. They are taking a beating on their profit and loss statements, but not so great a beating as their balance sheets will take if they hang onto the mortgages that they are unloading on the FED at the TAF (term auction facility) window.

The housing bubble has burst where it was most prominent. There is no sign that housing prices have begun to rise there. When they do, and when this lasts a year, the rest of the country will be able to breathe more easily. That is not now.

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

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