'Fannie and Freddie Were Lenders': Part 1 - U.S. Real Estate Bubble Nears Its End.

[Discovery Fuel]

This article appears in the June 21, 2002 issue of Executive Intelligence Review.
'Fannie and Freddie Were Lenders': U.S. Real Estate Bubble Nears Its End

by Richard Freeman

The U.S. financial system is now dependent to an unprecedented degree upon one prop: the greatest housing-real estate bubble in human history. A hyperinflationary spiral has sent home prices shooting up by 10-40% annually in recent years—depending on the region of the country — and artificially pushed the price of millions of homes into the $400,000 to $1million range or above. Already in 2001, one out of every ten homes for sale in the United States was priced at $1,000,000 or more. Since then, prices, assessments, real estate taxes, and mortgage credit volume have continued to spiral upwards, even as the productive economy staggered downhill. Many homes today are simultaneously glorified shacks— with plastic exteriors and gold-plated faucets in the bathroom— and yet unaffordable to most American families.

This housing bubble is without precedent, far larger than the 18th-Century Mississippi Bubble of Venetian-Scottish agent John Law. In 1717, Law established the Mississippi Company and issued shares to the public, initially against the supposed wealth to be drained from France's Louisiana Territories in North America, and eventually against the value of all of France's colonial trade. These were shares, effectively, against ground-rent. In 1719, the value of the Mississippi Company's paper shares rose to 40 times their original value, and many times the wealth that possibly could back them up. In 1720, the shares collapsed, bankrupting the nation of France. The U.S. housing bubble's stated ground-rent value is 1,000 times greater than that of the Mississippi Bubble. Unless corrective measures are taken, the inevitable collapse and the ensuing devastation will destroy millions of families.

The cumulative value of all homes in America is now an astounding $12.04 trillion, which is only $3 trillion less than the hyper inflated value of all the stocks traded in America. People have been deluded into buying homes in the $250,000 to $500,000 range, on the grounds that if they can hold on to them for two to five years, they will be able to re-sell them at an even higher price; or, alternatively, that these are the only homes available, and that if they don't buy them now, however overpriced, prices will go even higher and become further out of reach. Millions of families are spending 35 to 50% of their annual income on mortgage or rent payments. There is a physical constraint on their ability to pay, and thus, ultimately, a constraint on the housing bubble itself: These families are one or two missed paychecks, or the loss of a job, away from defaulting on a mortgage.

Default rates on mortgages insured by the Federal Housing Administration — used primarily by families of middle or modest income —have recently reached 10% in some urban areas of the United States. As a wave of cumulative mortgage defaults spreads, the housing market will implode, wiping out trillions of dollars in housing values.

In testimony on April 17, before Congress' Joint Economic Committee, Federal Reserve Board Chairman Alan Greenspan foolishly denied that there is a housing bubble, and asserted that housing conditions are "scarcely tinder for a speculative conflagration." Greenspan's statements fall under the heading of "he doth protest too much.

On May 28, the 2004 Presidential pre-candidate Lyndon LaRouche told an international webcast audience: "We are sitting on top of real-estate bubble collapse in the United States today; the Fannie Mae/Freddie Macbubble is about to blow. What day it's going to blow, I don't know. But it's going to blow. People are going to find that houses which they have listed as mortgages at a half million [dollars] or so, plus or minus, in the Washington, D.C. area, or the New York area, these shacks will probably be lucky to go for $100,000 redeemable value. People are going to be wiped out. Jobs are going to be wiped out. Firms are going to be closed down."

The Two 'Golems' of the Bubble
The housing bubble has been developing for two decades, and it has been undergoing accelerated growth since 1995. It is under the control of Fed Chairman Greenspan, acting on behalf of the Wall Street-City of London oligarchical financiers. Greenspan depends upon the huge sums of liquidity pumped in by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Mortgage Loan Corporation (Freddie Mac), through the secondary home real estate market, which they control. Fannie Mae and Freddie Mac—which are private corporations, not government agencies & #8212; are the linchpin of the housing bubble; without them, it could not exist. The City of London-Wall Street financiers' objective, and also that of Fannie Mae, is to inflate housing prices through increases of "fictitious value," thereby increasing the size of mortgages needed to buy the houses at
inflated prices, and thus, increasing the principal and interest-rate cash that can be gouged from households. It is an unadulterated looting operation.

Without the huge margin of Fannie- and Freddie-generated liquidity, the housing mortgage market would not be the size that it is, and without an enormous mortgage market, there absolutely could be no housing bubble. Since 1995, the housing bubble has required between $400 to$600 billion per year in new mortgages to finance homeowners' purchase of new and existing homes at inflated prices. Between 1995 and 2001, banking institutions (including savings and loan institutions) lent $2.25 trillion in new housing loans to prospective home-buyers. But during the same interval, banking institutions lent only $1.29 trillion in loans of all types, including to commerce and industry, to consumers (for car purchases, etc.), and for housing. This seems impossible. How could banks lend more for housing, at $2.25 trillion, than they lend to the entire economy, at $1.29 trillion, when the latter includes housing as a sub-sector? The answer: the great Fannie Mae and Freddie Mac lending machine. Between 1995 and 2001, Fannie and Freddie (and a few similar, smaller agencies) acquired almost three-quarters of the $2.25 trillion in new mortgage loans that all banks had made. Upon getting cash from Fannie and Freddie, the banks made new housing loans. Since 1995, Fannie and Freddie, et al., accounted for almost three-quarters of all housing-mortgages. The housing bubble can only function if it pushes home prices up; the home price can only go up, if there is a mortgage to purchase the home at the increased price. Without Fannie Mae and Freddie Mac, the home mortgage
market would have been only one-quarter as large as it actually was. A housing bubble could not exist in that framework.

Fannie Mae and Freddie Mac have raked in huge profits from the housing bubble. But they have also concentrated in themselves, an enormous exposure to mortgage debt — a concentration even greater than the 35%o fall financial derivatives contracts sitting in one bank, J.P. Morgan Chase — and have issued some obligations which are very risky. Thus, it is ironic that the housing market depends on Fannie Mae and Freddie Mac, which are in such rotten condition that they could puncture the very housing bubble which they are called upon to support.

How It Grows
To understand the importance of Fannie Mae and Freddie Mac, one must understand the rudiments of the housing financing market. To buy a home, a prospective purchaser must have the financial means: Either the purchaser is wealthy enough to buy the home in cash, or— in most cases — the purchaser takes out a mortgage loan. Commercial banks, and savings and loan associations are the financial institutions most likely to originate a mortgage loan. The primary mortgage-lending institution can hold that loan until maturity— 30 years, for example—collecting, during this time, interest and principal payments. However, the primary mortgage-lending institution can exercise a second option: After originating the mortgage loan, it can sell it off. Two of the leading corporations that could buy the mortgage from the primary institution — known as secondary market corporations—are Fannie Mae and Freddie Mac. As a result of Fannie Mae and/or Freddie Mac buying the mortgage from the primary lending institution, that primary institution now has cash, which it can use to originate a new mortgage

This process can be, and is, repeated several times during the course of the year, for each primary-mortgage lending institution in America. Thus, Fannie Mae and Freddie Mac act as a spigot pouring liquidity into the U.S. mortgage market.

There is another step to this process. When a primary mortgage lending institution offers to sell a mortgage loan it has originated, Fannie Mae or Freddie Mac can do one of two things. They can, as described, buy the mortgage loan outright and hold onto it (Fannie and Freddie issue bonds in their own names, and use the proceeds from the bond sale to buy mortgage loans). Or, they can pool several mortgage loans together, into a derivatives-like instrument, called a Mortgage-Backed Security (MBS); put a guarantee on it; and sell it to a third party—such as a mutual fund, a pension fund, or an insurance company. In the latter case, the pension fund or mutual fund end up owning the MBS, which gives them a claim to the underlying principal and interest stream of the mortgage. Thus, it is the cash from the pension fund, or mutual fund, etc., which is going into the housing market, having been drawn into that market by Fannie Mae and Freddie Mac as issuers of securities.


Volcker Destroys Traditional Home Financing
In the post-World War II period to 1963, when a previous generation of Americans bought their homes, the purchase cost reflected the cost of construction, such as materials and labor, plus a moderate, but fair profit for the homebuilder. It also reflected the cost of the land, which was not high. For financing, a traditional relationship existed with savings and loan institutions, so that the home purchaser could readily obtain a 30-year mortgage, usually at a 5-6% interest rate which would make the mortgage affordable. As late as the 1950s, the median price of an American home was less than $15,000.

In the mid-1960s, the financier oligarchy moved America away from a producer to a consumer society, by introducing the "post-industrial society" policy, which also shattered the workable housing relationships. There were a few key benchmarks in this process.

In 1979, then Federal Reserve Board Chairman Paul Volcker instituted the New York Council on Foreign Relations' policy of "controlled disintegration of the economy," so that the commercial banks' prime
interest rate reached 20.5% by December 1980. This policy intentionally shattered manufacturing, agriculture, and infrastructure, and built a gigantic speculative bubble. It also crushed the savings and loan associations, which were the mainstay of the housing industry. They then had to pay interest rates of 15-18% to attract and hold depositors, but they were earning only about 5% on the mortgage loans they had previously made. The negative spread of 10-13% caused the S &Ls huge losses.


In 1982, the disastrous Garn-St Germain law, which deregulated the banking system, was approved, removing the wise and longstanding restrictions which had severely limited the amount of money the S &Ls could invest in commercial real estate. Advised to invest in commercial real estate to make up the losses that Volcker's policy had created in housing, the panicked S &Ls lost more than a quarter of a trillion additional dollars. The bailout of these losses in the mid-1980s, became known as the S&L
debacle.

In 1986, the Tax Reform Act was passed, which created tax breaks for speculative shelters in real estate. By this point, the bankers thought it timely to introduce the full speculative virus into the home real estate market. Home prices rose, although there was a downturn in the 1989-91 period.

By 1995, Fed Chairman Greenspan, who had been nurturing the housing bubble since he was ensconced in that post in 1987, let out all the stops to pump up the bubble. Fannie Mae and Freddie Mac began priming the bubble with hundreds of billions of dollars in funds per year

Today, the basic characteristic of the housing market has been altered so that it is entirely different from what it had been in the mid-1960s. The home's principal function is no longer shelter and development of a family, obtained through the instrument of the mortgage market; rather, the home has become the mere instrument of the housing market bubble. The home price is a function of whatever the hyperinflationary housing spiral can drive it up to.

For the banks, the objective is to create fictitious value in a home, through a fake appreciation in price. To comprehend what fictitious value is, consider the example of a home built in 1992, and sold then for
$100,000, which is now priced on the market for $225,000. The $125,000 increase in the home's price represents fictitious value. In real physical construction terms, the home has depreciated for ten years, and is worth less; even if there were home improvements made to keep the home at the
same functional level, it is worth, at most, $100,000.

Take any other useful entity, such as a car or a machine tool. One could not put ten years of wear and tear on it, and then sell it for twice what it was worth ten years ago. However, this is what is done with housing.

The process is the same in the case of a McMansion, which sells for $400,000, but is made of the shoddiest material, and is only worth $125,000. The difference of $275,000, between what it sells for and what it is worth, is fictitious. For the banks, the aim is: If the price of a home can be fictitiously
doubled, say to $400,000, then the market value of the mortgage attached to the home can be fictitiously doubled to $400,000, and the income cash flow stream of principal and interest payments that can be looted, can be doubled. The banks pre-figure what principal and interest cash stream they
want to realize from a mortgage, and then set the price of the house at a level that will allow them to extract, through an attached mortgage, that principal and interest cash stream.

This is the system that the banks put into place during the course of the 1980s, and which Greenspan and Fannie Mae have geared up full force since 1995. It is completely unsustainable and unstable.

Explosion in Home Prices
There is an explosion of home prices since 1995, but especially since1999, in the hot markets in New York, Florida, California, and Greater Washington, D.C.— the last of which may be the hottest market in the nation. Greater Washington includes Washington, D.C. proper; Arlington and
Fairfax Counties in northern Virginia; and Montgomery County in Maryland.

Table 1 and Table 2 show, respectively, the average and median prices of homes in this region.

In Washington, D.C. proper, in 1999, the average price of a home was $264,668. Now, less than two and one-half years later, it has jumped to $367,676, a compounded annual rate of increase of 16%. (During this time, the median home price increased at a compounded annual rate of 15%.) Elsewhere in the area, the pattern is the same. In Fairfax County, in northern Virginia, between 1999 and the present, the average single family home price skyrocketed from $132,667 to $341,680, a staggering compounded annual rate of increase of 38.4%. In Arlington County, in northern Virginia, the average price of a home has jumped to $416,579. In the Greater Washington, D.C. region as a whole, the average single family home price is above $340,000, and rising at an incredible rate.

During 2001, home prices for the entire states of California, Florida, and Massachusetts, rose by more than 10%, and in portions of New York, by more than 15%.

This explosion in home prices increased the collective valuation of all household-owned home real estate in America. Figure 1 shows that since 1950, the value of all U.S. households' home real estate holdings rose steadily. Then it rose more rapidly during the 1980s, reaching $6.608 trillion by 1990.

But between 1990 and 1995, the collective value of all homes rose only by $1 trillion. However, since then, under the deliberate manipulation of Alan Greenspan, nurtured by the Fannie Mae-Freddie Mac money-pumping machine, it shot upward: Just between 1999 and 2001, the collective valuation of all households' home real estate holdings increased by $2.084 trillion to $12.04 trillion, a rise of 20.9% during those two years. The increase in the collective valuation of all household-owned homes achieved the bankers' prime objective: Against that valuation, a tremendous amount of mortgages and secondary forms of mortgage-based debt could be floated, thus increasing the rate of looting through interest and principal mortgage streams, as we shall show.

The sharp jump in the collective valuation of all household-owned homes, makes it, along with derivatives, the chief element of the dynamic that is holding up the U.S. speculative bubble. Figure 2 shows the trajectory of the collective valuation of households' home real estate holdings versus that of the capitalization of all stocks traded on stock markets in the United States. With the rupturing of the New Economy stocks, between 1999 and 2001, $4.5 trillion of fictitious valuation of stocks has been wiped out. The collective value of U.S. households' home real estate holdings is now just $3 trillion less than the stock market capitalization of all U.S. firms.

According to EIR's estimation, $6 trillion of the $12.04 trillion valuation of household-owned home real estate is fictitious, debt and liquidity artificially forced into the housing market over the past few decades, especially since 1995. This gives an estimate of the amount of hot air which will be wiped out in this market in a collapse of the bubble, driving home prices down with explosive impact.

Cost and Quality
Two other characteristics distinguish the new housing market.
First, the cost of homes has reached a dangerous multiple of average income. Figure 3 shows the ratio of total home real estate valuation to total disposable (after-tax) personal income, complied by Ian Morris, an analyst at HSBC Securities. It now has reached 1.62, its highest level in this 50-year series. However, the cost of a home becomes even when the mortgage interest costs are figured in, which will be examined shortly below.
Second, the quality of homes. The homes of today have several glaring problems. The new homes that sell for $300,000 to $750,000 are frequently made with the shoddiest material. They are built with doors made of cardboard cores instead of wood; no cross-braces under the joists of floors to support them and prevent shaking; and the proverbial 2-by-4 piece of wood shaved down to 1.5 by 3.5 inches. Whereas 50% of the siding in houses in the 1970s was made of brick, today less than 30% of housing
siding is made of brick. Thousands of homes, priced at one-half million dollars and up, have their elegant looking facades made out of—stryofoam. The Maday family, for example, of Reston, Virginia, moved into a $522,000 home in late 1996, having been told they had an exterior of stucco (a mixture of cement and limestone), which is typically @c6 to 1 inch thick. They found that their house had a 1⁄4 inch coating of styrofoam. The styrofoam trapped water and developed a "99% moisture reading," and as a result, the walls rotted away. An Aug. 29, 2001 Boston Globe article exposed the fact that thousands of McMansions from northern Virginia, to Connecticut, to Illinois have been constructed with styrofoam fronts.

Figures 4 and 4A document, since 1950, the increase in the volume of U.S. household home mortgage debt outstanding. This grew steadily up to 1980, and then afterward, at a faster rate. Starting 1995, the banks, collaborating closely with Greenspan and the money-pumping of Fannie Mae and Freddie Mac, caused the level of mortgage debt outstanding to grow at an accelerating rate: Just between 1999 and 2001, it jumped by nearly $1 trillion, to reach $5.757 trillion. The more a home costs, the more cumulative interest a mortgage borrower must pay, and the more interest the bankers collect, even if the interest rate remains the same.

Figure 5 shows for the period 1963-2001, the total cost to purchase a new home, on a 30-year mortgage. The purchase price used for this demonstration, is the nationwide median cost of a new home, as reported by the National Association of Realtors. The interest rate is the fixed interest rate prevailing for that year. In 1963, the median cost of a new home was $18,000. The total cumulative cost to buy the new home on a 30-year mortgage, was $34,616: $18,000 paid in purchase price (which is broken down into down payment, and principal), and $16,616 paid in interest. In 2001, the median cost of a new home was $174,000. The total cumulative cost to buy a new home on a 30-year mortgage leapt to $393,986: $174,000 paid for the median purchase price, and $219,986 paid in
cumulative interest. So, today, the mortgage-payer must pay nearly a quarter of a million dollars in interest. The cumulative interest cost, which in 1963 was somewhat lower than the purchase price, in 2001's "low-rates" market was nearly 1.3 times greater than the original $174,000 purchase price of the house.

According to the U.S. Department of Housing, the total monthly "home cost" should not exceed 28% of a household's gross income. The "home cost" consists of the mortgage interest and principal payment, plus the home insurance payment, plus the home property tax due.