Wednesday, March 12, 2014

Fannie Mae, The Financial Crisis, and Who's Next

Was Fannie Mae to Blame for the Financial Crisis? By Market Authority

Bloomberg reports - Common shares of Fannie Mae and Freddie Mac experienced their biggest intraday drop in 10 months after leaders of the Senate Banking Committee announced plans to eliminate the companies in a new bill.

Fannie Mae shares tumbled as much as 44 percent, paring the losses to 31 percent to close in New York at $4.03, after Edwin Groshans, a managing director at Washington-based equity research firm Height Analytics LLC, described the proposal as holder-negative. Freddie Mac fell 27 percent to close at $4.04. Preferred shares also dropped, some by as much as 12 percent.

The bipartisan measure, drafted with input from President Barack Obama’s administration, would replace the U.S.-owned mortgage financiers with government bond insurance that would kick in only after private capital suffered losses of at least 10 percent, Senate Banking Committee Chairman Tim Johnson and Senator Mike Crapo said in a statement today. The bill would require most borrowers to make down payments of at least 5 percent. Read article here

In a nutshell, legislators are looking to reduce the role of government in mortgage lending, but still allow for a government backstop in the event of catastrophic losses. A new agency called the Federal Mortgage Insurance Corp would charge fees and provide guarantees when private investors lose more than 10%.

There are some serious misconceptions about the government’s role in creating the 2008 financial crisis. The government is an easy scapegoat for problems that aren’t readily understood. The crux of these arguments stems from widely held belief that the government forced lenders to make subprime loans and that people took out more credit due to a government backstop. Let me explain why these views are incorrect.

In regards to subprime, people who point the finger at the government blame the Community Reinvestment Act (CRA), legislation which mandated a certain percent of loans extended to subprime borrowers. But the banks subject to the the CRA weren’t the ones making the loans in the first place- it was private lenders. You can see this in the table below.

Subprime was only a small part of CRA bank lending throughout the growth years in the mortgage market. CRA banks only gained significant market share in 2007, and this was because the private lenders (non-CRA) were already imploding and cutting back on loans.

The non-CRA lenders, companies like Household Finance, New Century, and Countrywide, comprised the majority of subprime lendings. And the government wasn’t forcing these private lenders to make subprimes loans. They were lending because they were making truckloads of money on historically wide spreads between the cost of funding and the interest rate at which they were able to lend.

The next argument is that government backstop provides cover for banks to extend more loans than they normally would without a guarantee. Thus, the over-extension of credit leads to a bubble / bubble implosion scenario. They point to Canada as a country that doesn’t have government-sponsored entities like Freddie Mac and Fannie Mae making loans. Canada avoided the housing crisis, they say, so it’s government’s fault.

If you think that banks over-extended credit in the US due to the GSE’s, take a look at what’s going on in Canada now.

While the US has been reducing household debt, Canadian banks have been lending away. Debt to income levels in Canada are quickly approaching the same ratios (160%) that led to our financial collapse. When debt service costs rise to a level higher than the borrower’s ability to repay, you have a deleveraging. This is not a question of “if,” it’s a question of “when.” The fact that the Canadian government isn’t involved in the mortgage market isn’t preventing banks from lending at dangerously high levels.

As you can see, even without a government backstop in Canada, the Canadian banks keep on lending.

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