Toryism, Socialism and Housing Reform: Real and Imagined

Institutional Risk Analyst
By Christopher Whalen
March 7, 2011

The entire structure of the American banking system, including the market for home-mortgage loans, hinges on the interventions of the Federal Reserve. Though they take place largely out of sight, they are intrusions of the first order. That the Fed is so detached from evaluation or debate, that it is almost universally praised as a vital institution, is suggestive of what Adolf Hitler branded "the big lie." "[I]n the big lie," he said, "there is always a certain force of credibility; because the broad masses of a nation are always more easily corrupted in the deeper strata of their emotional nature than consciously or voluntarily." So when Ron Paul calls for an end to the Fed, or Austrian School economists demonstrate the congenital flaws of fractional-reserve banking, their claims are regarded as the height of apostasy.Fannie and Freddie Reform: Too Little, Too Late 
Mises Daily 
March 03, 2011 
David S. D'Amato

The commentary below is background for the presentation entitled "GSEs: The Future Role of Government Sponsored Enterprises in the US," at the Global Association of Risk Professionals event on Tuesday, March 8, 2011, in New York.Special thanks to members of the Herbert Gold Society for their comments. But first a couple of housekeeping items.

We are nearing completion of the latest modification to The IRA Bank Monitor, namely a simulation of the before and after for calculating the cost of deposit insurance premiums for all FDIC insured banks. As the template for this pricing model, we are using the final rule on Assessments, Dividends, Assessment Base and Large Bank Pricing that was released by the FDIC on February 7, 2011.

Section 1506 of the Dodd-Frank Wall Street and Reform Consumer Protection Act requires that theFDIC conduct a study to evaluate the bank deposit market and develop a better understanding of current market products and practices. The FDIC is holding a roundtable discussion on core and brokered deposits, as required under the Act, on Friday, March 18, 2011 from 10 a.m. to noon. IRA will be participating.

Finally, Gretchen Morgenson of The New York Times and some of our other favorite writers have been very busy. Some items for your reading enjoyment:In "Hey, S.E.C., That Escape Hatch Is Still Open," Morgenson talks about how the Securities and Exchange Commissions is trying to finesse the implementation of Dodd-Frank with respect to rating agencies and the issuance of new securities:

Even better is the duet with Michael Powell, "MERS? It May Have Swallowed Your Loan," where Morgenson describes the implosion of the mortgage industry's illegal MERS loan registry.

To us the amazing thing is that some lenders actually created residential loans with "MERS" specified in the note and mortgage agreement as the lender. As the fiction of MERS collapses under the weight of litigation, what outcome can these lenders and related investors expect? 

Since the start of 2008, MERS has been named as a party in over 4,200 federal lawsuits, according to PACER. Half of the citations were cases in which MERS appears as a creditor in a bankruptcy proceeding. Hello? MERS was never supposed to act as a legal nominee, as the courts now seem to be concluding. 

To this point about enforcing mortgage notes in foreclosure, we have to recognize the post by Yves Smith of Naked Capitalism, "Paul Jackson Declares "Mission Accomplished" on Securitization Woes Based on Alabama Foreclosure Decision." Says Smith:

 

"It's ironic that Jackson keeps presenting himself as the voice of reason, when in fact his world view is that of a one-sided morality where those with the most money are right. And on top of that he holds himself as a defender of law, yet frequently defends practices that undermine the very foundation of property rights. That stance is, at its core, unreasonable, unfair, and profoundly dangerous."

Jackson's earlier comment, "Ala. court says alleged problems with securitization aren’t a borrower concern,"described a recent court decision that effects how trustees and other agents enforce liens. The upshot of the decision in U.S. Bank v. Congress, Jackson concludes, is that borrowers do not have standing to raise issues related to a securitization of a loan. Writes Jackson:

 

"The upshot of this ruling is very clear, too, at least in Alabama and perhaps in other jurisdictions where similar cases are being tried: alleged problems involving the PSA, securitization, whether the note is owned by the trust—while these issues generate plenty of heat and light amongst bloggers and columnists, none of these issues are ultimately a concern for the borrower who has defaulted on their payments, and who by definition is not a party to the PSA."

The interesting thing to us is that Jakson and Smith both see the sloppiness and negligence in the mortgage sale and servicing sectors. One seemingly sees big dumb business as the main motive, while the other sees deliberate fraud and racketeering by banks, lawyers and other agents involved with the assignment of the mortgage note. We think they are both right. 

More, to the point made by Morgenson, MERS seems to be a delibertae effort to avoid state law regulation of property title transfers. Equity, we believe, will eventually govern these disputes, but along the way we shall see lots of amazing claims and court decisions. And we forgot to ask: Is your allonge properly attached?

The endgame for the GSEs and the largest banks is suggested by last week's item in American Bankerreporting a possible settlement proposal by the various state AGs and the Obama Administration. The report suggests a target of $20 billion in loan modifications to settle claims of abuses of process related to home foreclosures. But as discussed below, such a sum does not even begin to describe the totality of the financial and operational risk sliding towards the large banks and GSEs as the mortgage crisis heads into the next stage.

GSE Reform: Background and Process Going Forward

The Obama Administration recently advanced some proposals to reform several government agencies that control the market for housing. Treasury/HUD plan is really a menu of possible options, eliminating what would not work and making it clear that change will happen slowly, it at all. Below is a summary discussion of the history of housing finance in America and the points for the presentation by IRA co-founder Chris Whalen at the GARP annual meeting tomorrow. 

Let's first recall some history and then raise several structural issues that must be addressed in the context of GSE reform. We hope this aids in what will be a long discussion and process. Depression era agencies such as Fannie Mae, the Federal Housing Administration, and later parastatal spawn such a Freddie Mac, essentially dominate the market for residential mortgage loans. But government support for housing in the US goes back even further. If you think of the creation of state-chartered and national banks as the first phase of the expansion of leverage capacity in the US, and the rise of the GSE in the 1930s as the second stage, the expansion of the home mortgage sector via the issuance of RMBS from the 1970s forward to the subprime crisis in 2007 arguably marks the third. 

In terms of modern American history, the first government spnsoredsponsored agencies in the US that supported housing finance were the state-sponsored banks of the early 1800s. Some of these state sponsored banks fueled the land boom of the 1830s that eventually led to the default of many states in the 1840s. This issue is discussed at length in "Inflated: How Money and Debt Built th American Dream," which was most recently reviewed in Barron's.

Later, in the 1860s, Congress sponsored national banks ostensibly to strengthen the national currency, but in fact to float the government debt used to finance the war. The state chartered banks of that era refused to buy the government's debt and shunned the fiat paper dollars or "greenbacks" that are Lincoln's inflationary legacy to all Americans. Mark Calabria of Cato Institute writes in his review in Barron's:

 

"Of particular interest is the role that Civil War financing played in the creation of the national banking system, which today seems more focused on funding government than business. In fact, the history surrounding the creation of the national banking system offers a useful reminder that much of it was expressly designed with the intention of providing a ready source of demand for government debt."

Gradually national and state banks were allowed to broaden their asset base and even make mortgage loans, an activity that was frowned upon because of the high risk and lack of liquidity of these assets. But as banks grew along with the US economy, so too did the public's acceptance of debt. The victory bonds sold to finance WWI made debt issuance a common part of the American experience. Broad public demand for securities started to grow rapidly in the early part of the 20th Century and the use of leverage to support real estate and other emerging asset classes also increased apace.

The creation of the Federal Reserve System in 1913, another GSE, added further credit creation capacity to the US economy, some of which also supported land and homes. But the creation of the Fed did not help economic growth nor did it alleviate the deflationary tendencies seen in commodities and agriculture following WWI. By the 1920s, America's financial markets were roaring under the laisez faire government of President Calvin Coolidge. Coolidge is Larry Kudlow's favorite conservative and a man who gave new meaning to the term "limited government." In the 1920s, real estate speculation was again rife in states such as Florida, as John Kenneth Galbraith describes beautifully in The Great Crash.

The collapse of the US real estate market in the mid-1920s presaged the eventual crash on Wall Street, a fact we ought to ponder today. Deflation in real estate, banks and finally Wall Street also opened the door to an enormous increase in government intervention in the financial markets and particularly in housing. As a result of the socialist great leap forward we refer to as the New Deal, a number of GSEs were created in the image of older corporate structures used in the fascist states of Europe. The willing embrace by American leaders for what are alien European mechanisms of market manipulation was as much due to WWI as to the Great Depression. 

The fact of significant state intervention in the American economy was the chief legacy of both WWI and FDR's New Deal. WWII and the subsequent Cold War only confirmed these tendencies, often under the benign rubric of providing afforable housing for veterans and other deserving constituencies. Whereas Civil War veterans were only awarded pensions if wounded in battle, by the end of WWII all soldiers and their dependents qualified for federal pensions and a host of other entitlements, including VA subsidized home loans.

With the creation of the Federal Home Loan Banks (1932), the FHA (1934) and the Federal National Mortgage Association (1938), among other GSEs, the government's intervention in the US housing sector became massive. Private banks were effectively turned into loan origination agents for the US government. No private corporation can compete with a GSE, especially when the government sponsored agency consistently underprices the cost of its products.

More important, the 1930s created a government-sponsored structure for deposit insurance, farm lending, small business lending and all manner of special credit entitlements funded by Washington. And yet even with this grotesque expansion of the federal government's role in the private sector, Americans continued to pretend that we were primarily a free market economy. An economy of free riders is a better description. And recall to that many of these statist initiatives such as federal deposit insurance were sponsored by Republicans. This confirms the view that, on either side of the proverbial pond, "Toryism is Socialism," to paraphrase Ford Madox Ford.

In 1954, Congress amended the FNMA charter to allow private investors to purchase common shares while the government retained preferred stock, as shown in the timeline of an excellent article by Jon Prior, " The Elephant in the Room," in the February 2011 issue of Housing Wire. By 1968, FNMA was reconstituted as a private corporation and Ginnie Mae split off into a new federal agency. Of note, Ginnie Mae recently hired a former Fannie exec named Mary Kinney to be the EVP, the highest non-political position in the agency. Apparently Kinney has been systematically firing or reassigning Ginnie employees and hiring Fannie Mae personnel. Could the Obama Administration be planning to ask Congress to increase loan purchases by Ginnie Mae? 

By 1970, FNMA was permitted to purchase private mortgages. Around the same time, Congress created Freddie Mac to, according to Housing Wire, "rejuvinate the secondary market" for home loans, but this was a market by then dominated by GSEs. In the early 1970s, the US economy was facing slowing growth for the first time in the post-WWII era. FNMA issued the first mortgage pass throughs in 1971 and the next stage in the expansion of government sponsorship of the US housing market begins.

The growing focus of the US banking industry on real estate is illustrated by the rapid expansion of the thirft industry and the Federal Home Loan Banks in the 1970s, followed by the commercial banks, leading to the real estate bust of the 1980s. By the early 1990s, however, large lenders such as Citigroup were again experimenting in creating private label RMBS. Insurgent, non-bank firms such as Countrywide, Bear Stearns and Lehman Brothers were growing their involvement in mortgage finance during this time. But all of these early players in private, subprime RMBS operated on the perfiphery of a prime loan market that was dominated by the GSEs. This is why you cannot blame Wall Street entirely for the 2007 financial crisis.

 

During the latest mortgage boom, when private label securitizations reached a peak principal amount of over $1.5 trillion, the private sector actually out-bid the GSEs for loans. So ravenous was the Sell Side deal machine for paper to fuel private label RMBS deals that the market share of the GSEs was pushed down to something like half of all secondary mortgage issuance in 2005 and 2006. Banks added to the feeding fenzy by paying more for whole loans issued by others, this so as to not interfere with the “gain on sale” generated by their own internal mortgage orgination and securitization operations.

As late as 2004, let's recall, the White House under George W. Bush was pushing for FHA to extend guarantees to subprime loans. The affordable housing coalition in Washington was working flat out to increase home ownership. The creation of CDOs and other derivatives base upon private label RMBS allowed the footings of residential mortgage credit risk to expand many times greater than what existed in the cash market, fueling huge profits for hedge funds and later losses for Sell and Buy Side counterparties, a loss realization process that is still underway.

Over 95% of new loans today depend upon some government guarantee, either from FHA, VA, USDA’s Rural Housing service or from the GSEs. The market for non-government guaranteed loans is non-existant, except for a small amount of high quality jumbo loans, deals which really are just an arbitrage on the US tax code. Roughly half of the current principal amount of private label RMBS has either defaulted, in delinquency or foreclosure. A similar proportion of all CDOs have defaulted and/or accelerated, with total losses to most of the investors in these deals. As the remainder of private label loans runs off, this financing capacity is being withdrawn from the US housing market permanently.

The GSEs now form an effective cartel with the top four banks in the secondary market for home loans. Despite what you read in the paper, this cartel has prevented most existing, performing borrowers from exercising their contractual right to refinance, despite the lowest “market” interest rates in our lifetimes. The combination of GSE loan level pricing adjustments, fees to be paid in cash up front, a lack of competition in the third party origination channels of the big banks, and unintended consequences of Basle III capital rules, has raised effective mortgage rates by hundreds of basis points.

The GSEs and large banks, not the real economy, are the true beneficiaries of QE and low interest rate policies by the Fed. The loan origination and purchase policies imposed by the GSEs since 2008 did a good job of keeping high SATO loans in GSE and bank portfolios (which are the highest guarantee fee loans, BTW) from prepaying, further maximizing yields. Meanwhile, the GSEs benefited when debt rolled off and they were able to replace it with much lower coupons. The same thing happened to the banks, who were even more short funded than the GSEs.

Any bank that can run a callable asset vs callable debt book, and prevent the assets from prepaying, can make a fortune. The losers here are tens of millions of American homeowners and consumers who are denied the right to refrinancerefinance by the GSE/large bank cartel. And all the while savers and investors pay a tax to the banks in the form of artifically low rates care of the Fed. Now you can understand why Ron Paul wants to abolish the central bank.

In addition, the GSEs continue to charge lower guarantee fees to the large banks, which have correctly argued that they will always be around to perform on reps and warranties. The problem here is that the taxpayer is the one passing a subsidy to the largest banks. The taxpayer should be the one that reaps the benefit of the lower guarantee fees. Instead American households pay a higher mortgage rate, and higher "taxes" in terms of low rates on savings and the direct cost of the subsidies for the GSEs. The benefits are going entirely to the shareholders and creditors of the large banks that caused the financial crisis in the first instance.

Thankfully, the FHA has finally raised their upfront and annual guarantee fees to more accurately reflect the risk on 97% LTV loans to first time homebuyers. Dave Stevens and Bob Ryan at FHA should be congratulated for finally introducing proper risk-based pricing, but more needs to be done. Sadly, private mortgage insurance companies ("PMI") are still charging roughly the same premium today as the FHA, but only because they never pay on claims. This means that greater than 80% LTV conventional loans can get a GSE guarantee, this even as federal bank regulators consider setting 20% down as the requirement for a "qualified residential mortage" under the Dodd-Fank law.

The difference between an FHA guarantee and PMI, of course, is that the FHA pays out on valid insurance claims, wherease PMI does not. Repeat after us: PMI is not insurance! The major PMI underwriters have no capital reserves. They do not buy reinsurance to cover tail event loss. Most PMI underwriters are insolvent, so they spend their staff time exercising “right of recission”. Claims are litigated. The remaining bit of the private mortgage market which does attempt to operate in a prudential fashion lies in tatters. The world of PMI, which itself is a by-product of the government manipulation of the housing sector, provides no true indication of the free market pricing of default risk for a prime mortgage. 

A Realistic Framework for Reform

In trying to fashion a way forward in terms of mortgage market reform, two larger questions must be asked:

First, can the private market participants in the US organize themselves to take the place of Washington in the secondary market for home loans? Can the major Buy and Sell Side firms show some leadership? Can the private sector even propose a national standard for mortgage servicing? Or will the large servicers -- JPM, C, WFC and BAC -- continue with the same ill funded and staffed servicing operations as exist today?

Second, what is the true, economic cost of mortgage insurance, and who is best positioned to bear that risk? In a marketplace where collateral prices are not going up 5-10% annually, the true economic cost of default in RMBS will show through in current loss experience. Indeed, we at IRA worry more than a little that current high rates of charge-offs in banks, compared with the past decade, may be closer to normal than markets appreciate.

Somehow the discussion of GSE reform must begin with the loan originator, who ought to have some permanent interest alignment with both the borrower and the investor. Sadly, regardless of how the reform debate progresses, the reinsurance issue must end up at the feet of the US taxpayer. The taxpayer today bears all of the risk because the government is the only balance sheet big enough to write reinsurance on risk measured in the trillions. The true economic risk on all US home mortgages, at the end of the day, may be "too big to insure" under commercial terms.

There are a several issues that must be addressed as we seek to answer these two questions and, more broadly, address the issue of reforming the GSEs. The first general point is to recognize that in seeking to reduce the market share of the FHA, for example, we must make changes to the entire money market and therfore the ability of home buyers to get a new loans. Read that last sentence again. Changing how credit risk is allocated in home mortgages will have profound implications for credit availability to households, asset allocation for banks and Buy Side investors, and issue such as prudential regulation and capital adequacy.

The second major point to consider is that, we still do not have nearly a consensus on how to reform and modernize the secondary market for mortgages in the US. The proposals to add some new guidelines regarding loan servicing are a start, but in order to credibly propose the privatization of the US mortgage market we must have a basic framework to govern private label RMBS. The SEC and the federal financial regulators will be making additional rules on the servicing issue in coming months. This process needs to be made a top priority.

Finally, the judgement of Treasury Secretary Tim Geithner needs to be emphasized in one respect, namely that talking about reform of the GSEs is a medium term project. The current environment in the housing market is deflationary and the net supply of financing available to the market also is shrinking. If housing prices continue decline, by the end of this year more than half of all mortgagees in the US will be under water and thus not bankable.

The Obama Administration has apparently proposed a settlement to the largest banks that includes write-downs of $20 billion in underwater loans. To be meaningful, such a program would need to be measured in the hundreds of billions -- an amount that would leave the GSEs and the large servicer banks insolvent. Insolvency is, at the end of the day, the economic reality inside all of these institutions, esepcially if we see residential home prices slip another 10% or more during 2011. The zombie dance party is not nearly at an end.

It may not be possible or advisable to be reducing the role of the GSEs at a time when millions of American homeowners cannot sell or even refinance their homes. This situation has dramatically reduced labor mobility in the USA, making the visible unemployment rate ever higher. Ultimately, these credit-bound Americans may simply walk away from their homes. This is why we believe that the restructuring of the GSEs may need to be combined with a much larger approach to the financial woes of the largest servicer banks. Indeed, it may be that we will see calls for expanding the role of the GSEs and raising the cap on conforming loans to $1 million or more as the implication of the continued decline in home prices becomes clear to the markets and policy makers. Without any action by Congress, the maximum loan size eligible for GSE cover will drop later this year and the market valuation for residential homes in the US may fall with it.

Questions? Comments? info@institutionalriskanalytics.com