'Fannie and Freddie Were Lenders': Part 2 - U.S. Real Estate Bubble Nears Its End.

[Discovery Fuel]

CONTINUED ...

How able are home-purchasers to finance the mortgage? Let us utilize a strictly standard arrangement. If a household were to buy a new home, at the median price of $174,000 (in the above example), on a 30-year mortgage, putting the (now standard) 10% of the home purchase price down in a down-payment, and financing the rest in a mortgage at the prevailing fixed interest rate of 7.04%, then its mortgage payment of principal and interest, would be $12,553 per year ($1,046 per month). On such home, the home insurance and home property tax would be approximately $1,920 per year. Thus, the total "home cost" would be $14,473 on an annual basis. If, according to HUD, the "home cost" should be no more than 28% of total household income, then $14,473 is 28% of $51,689. A household would need an annual income of $51,689 to afford the "home costs" of a median priced home of $174,000.

Sixty percent of American households do not have an annual income of $51,689. Three-fifths of American households could not afford to purchase and live in such a home.

Rising Market, Falling Living Standards
How is it possible for families to buy these homes, and for Fannie Mae to constantly boast that the rate of home ownership, including among minorities, is rising? Millions of households have bought homes by "getting in over their heads." They are paying 35%, 45%, and even more of their annual income, on the
home mortgage. This makes them dangerously vulnerable. Some think that if they own the house for 2-5 years, it will rise in price by $100,000 -150,000, and they will sell to the "next guy," in a rising real estate market. Soon there will not be a next guy. Many, many families hold two, two-and-one-half, or three jobs among the family's members to pay for the home. The next round of layoffs that wipes out one of these jobs, will leave them unable to pay their mortgage, leading to default. Some other families bought homes in the $350,000 to $1 million range, because they earned money from stock capital gains, stock options, bonuses in the financial and high-tech industries, etc. That is drying up on a large scale. For some households, the fact that they can borrow new money against the value of their home, each time the value of their home rises, keeps them in the game.

Overall, Greenspan has engineered relatively low interest rates, both to keep the financial markets going, but in large measure to keep the housing bubble afloat. The need to raise interest rates, for example, to prop up the collapsing U.S. dollar, would destroy the interest rate environment that is essential to keeping the housing bubble alive.

The key constraints, which govern everything, are living standards and the real physical economy's productivity. For the lower 80% of the population, living standards, measured by market baskets of consumer and producer goods, are falling. They appeared to be, falsely, propped up by stock capital gains, and the like. One cannot long increase home prices, such as in the Greater Washington area, by 15 to 38% annually, and increase the mortgage interest income streams which are to be extracted, by a similar percentage, from households whose living standards, in reality, are falling by 1 to 2% per annum.

If one clears away all the clutter, home prices have gotten much more expensive. One measure that EIR has developed is straightforward. The U.S. Department of Labor's Bureau of Labor Statistics provided information on the value of the weekly paycheck of the average non-agricultural worker. If this worker were to buy a new median-priced home, how many of his paychecks would it take for him to pay off the home, including the interest costs on a 30-year mortgage? The answer is shown in Figure 6. In
1963, it required 388 paychecks; in 2001, it required 804 paychecks. In terms of the employee's paycheck, the home is 2.07 times more expensive. The reason for this has to do with the fall in living standards, but also with the shooting-up of home prices.

In earlier periods, such as around 1980, in which the number of paychecks required to buy a home rose, this was due to a spike (Paul Volcker's deliberate spike) in interest rates. Today, when interest rates are relatively low, the fact that it requires a large number of paychecks to buy a home, indicates just how serious the problem is.

The Intervention of Fannie and Freddie
What has kept the housing bubble functioning, especially since 1995, is the massive role of Fannie Mae and Freddie Mac. One must know how these agencies work. Fannie Mae presents itself in its public relations campaign as "Building the American Dream." It holds big events with legislators, in particular black and minority legislators, spending lavish amounts of money around the country. It puts more ads on the radio and in the newspaper, than almost any major corporation. It probably has one of the biggest patronage machines in the nation, reaching deep into every state. What does one expect of a private corporation, which, if it were a bank, would be the third largest bank in the world, and which makes money hand over fist in the real estate market? Fannie Mae is positioned as the key prop in the housing bubble (what is said of it applies as well to its smaller cousin, Freddie Mac). But Fannie Mae has as much "radioactive" financial risk as any institution in the world. Fannie Mae built up this financial risk in the process of constructing the housing bubble.

A crucial bank that has shaped the agenda of Fannie Mae is Lazard Frères investment bank, a powerful cog in the international Wall Street-City of London oligarchy. Fannie Mae Chairman Franklin Raines spent ten years working at Lazard. Lazard counts in its network the Graham family that owns the Washington Post. In 1995, Franklin Raines, working with the Post's Katharine Graham, established the Financial Control Board, which destroyed Washington, D.C.

Fannie Mae had started out in 1938, not as an instrument of speculation, but as part of President Franklin Delano Roosevelt's New Deal. As the accompanying box shows, in the short run, its function was to get the lagging home mortgage lending started again, and more broadly, to contribute to the growth of a financial market to make it possible to purchase affordable housing.

In the beginning, Fannie Mae existed as a government agency. In 1954, it was turned into a mixed, part-private, part-government agency, and in 1968, it was transformed into a totally private corporation, issuing its own stock, which was bought by private investors, and eventually became listed on the stock exchange. For the most part, all through this period, up to the mid-1970s, Fannie Mae fulfilled its original function: It brought liquidity into the housing market in moderate quantities, and
functioned as a subordinate agency in that market

However, starting in 1979-81, at precisely the time that then-Fed Chairman Volcker instituted the policy of "controlled disintegration of the economy," new lending policy changes were made at Fannie Mae. These changes were intended to bring eventually a flood of money into the housing market, from both outside "third party investors"— using the derivatives-like instruments called Mortgage-Backed Securities— and from the corporation itself. The seeds of the housing price explosion planted in 1979-81, came to fruition from 1995 to the present. Prior to the late 1970s, there had been two principal forms of lending; this transformation added a third.

The first and simplest form of lending is the primary mortgage loan. The second form is that involving Fannie Mae: A mortgage-lending financial institution makes a mortgage loan, but instead of holding onto it, it sells it to Fannie Mae, and uses the cash to make a second loan. It can repeat the process, of selling the second loan to Fannie Mae, and make a third, fourth, and so on, loan. In this manner, a mortgage-lending financial institution could make five loans for $150,000. It sells the first four loans to Fannie Mae (which buys them with proceeds from the issuance of its bonds) and keeps the fifth loan. At the end of the process, the mortgage-lending institution has one loan totaling $150,000 on its books, and Fannie Mae has loans totaling $600,000 on its books. These were the only two types of lending up to 1979-81, when the third type was introduced: Fannie Mae began creating Mortgage-Backed Securities. As the risk on the MBS became greater, the risk that Fannie Mae had became greater. But this is part and parcel of how the mortgage market, and thus the mortgage-bubble, expanded.

The Mortgage-Backed Security
In the case of the MBS, Fannie Mae gathers its purchased mortgages from different mortgage-lending institutions, and pools them together. For example, Fannie Mae may bundle a thousand 30-year fixed-interest mortgages, each worth roughly $100,000, and pool them together into a $100 million Mortgage-Backed Security. Fannie Mae puts a loan guarantee on the MBS, for which it earns a fee. Fannie Mae promises that in case there is a default on the MBS, Fannie Mae will pay the interest and principal "fully and in a timely fashion." The MBS, once it has Fannie Mae's guarantee on it, is sold to outside investors in denominations of $1,000 and up. The insurance funds, pension funds, and so forth, become the owners of the MBS, but if anything goes wrong, Fannie Mae is responsible. From the standpoint of those building the mortgage bubble, the MBS taps into a broader layer of funds to be used for housing, on the order of additional trillions of dollars. The sources of funds that can support the housing bubble have been extended very far into the U.S.— and international — financial markets.

In 1979-81, the Volcker polices caused Fannie Mae some losses, like those of the S&Ls. In 1981, David Ogden Maxwell became chairman of Fannie Mae. Maxwell overhauled the corporation and began issuing MBS, which had not been issued except in minuscule volumes before then. Maxwell's career path led into the circles of Lazard Frères investment bank: Today, Maxwell is on the board of Washington's Urban Institute, which is run by the Graham family of the Washington Post, itself part of the Lazard network.

However, not satisfied with "plain vanilla" MBS, Fannie Mae found that it could take these securities and pool them once again, into an instrument called a Real Estate Mortgage Investment Conduit (REMIC) (which is also known as "restructured MBS" or a collateralized mortgage obligation [CBO]). These REMICs are derivatives, of increasing complexity. They are pure bets, although they are also sold to institutional investors, and individuals, to draw money into the housing bubble.

There are many types of REMICs; we will look at two of them. There is a REMIC called a STRIP, in which the interest payments on the mortgages underlying the REMIC, are stripped from the principal, and the interest stream is sold separately as one REMIC instrument, and the principal amount is sold as another. In fact, the principal amount itself can be broken up into several instruments reflecting different time-periods during the life of the mortgages, called tranches, each of which is sold separately, and has a different level of risk.

There is a REMIC called a "floater," in which the interest rate on the instrument floats in direct proportion to the movement —up or down— of the international interest rate called the London Interbank Offered Rate (LIBOR); there is an "inverse floater," in which the interest rate of the instrument floats in inverse proportion to the LIBOR. Approximately half of all Fannie Mae's MBS have been transformed into these highly speculative REMIC derivative instruments. Thus, what started out as a simple home mortgage, has been transmogrified into something one would expect to find at a Las Vegas gambling casino. Yet the housing bubble now depends on precisely these instruments as sources of funds.

The 1995 Bubble
By 1995, Fannie Mae had been transformed, the MBS and REMICs were widely marketed and in use, and the housing market had been totally changed. The old days of the financing of a home at an affordable price were gone. The plan of the banks, and Alan Greenspan, was to create a bubble: to finance homes at increasingly fictitious prices. Simply put, to realize a fictitious increase in home price, say from $100,000 to $250,000, there had to be an increase in mortgage size, and not just one mortgage, but tens of thousands of mortgages. This, in turn, required a gigantic inflow to the housing market, of funds which had had nothing to do with its functioning.

During the bubble period 1995-2001, the volume of mortgage loans in the United States increased by $2.249 trillion. But the volume of mortgage loans by the primary mortgage-lending institutions, such as commercial banks and S&Ls, which they held on their books, only increased by $592 billion. They generated only one-quarter of the increase in the volume of mortgage debt during this period. The remaining three-quarters of the loans were conveyed to Fannie Mae, Freddie Mac, and cousins like the Federal Home Loan Bank Board. Fannie Mae took the dominant role, accounting by itself for 35.5% of all the money that flowed into home mortgages since 1995. But this was not an act of largesse: During this period, Fannie Mae raked in $25 billion in profits, and the financiers achieved their purpose of setting off a hyperinflationary housing bubble. Yet, by its very "success," Fannie Mae turned itself into a time-bomb, completely contaminated by the cancer of housing speculation it made possible.

To understand the root of its crisis, look at the rapid growth of its four key parameters. Figure 7 shows Fannie Mae's ownership of mortgages, which it purchased from mortgage lending institutions; by the end of 2001, this stood at $705 billion. Figure 8 shows Fannie Mae's debt, mostly its bonds, which it principally incurred to raise the cash to buy the mortgages it now owns; by the end of 2001, this reached $764 billion. Figure 9 shows the Mortgage-Backed Securities that Fannie Mae created through pooling of primary mortgages; by the end of 2001, this reached $859 billion. Finally, Figure 10 depicts the "regular" derivatives obligations Fannie Mae contracted, such as interest rate swaps (but not counting the above MBS), and which it claims are necessary for doing business; by the end of 2001, this reached $533 billion.

Of the four parameters, the first is the only one that represents an asset for Fannie Mae. It represents a steady stream of interest and principal payment that Fannie Mae collects. The other three parameters represent obligations, which are very risky. These three types of obligations fed, and fed off, the housing bubble's constant rapid growth of the last six years in particular. But a wave of mortgage defaults is inevitable. As that occurs, the three risky obligations amplify the crisis, and threaten the bankruptcy of Fannie Mae, and the housing market bubble which depends on Fannie, Freddie, et al.

The Threat of Leverage
Consider the first of the three risks: Fannie Mae's bonds, which make up over $700 billion of its outstanding debt total of $764 billion. The sole source of income, from which Fannie Mae can pay the interest and principal to its bond-holders, is from the interest and principal that it collects on the mortgages that it owns. If a portion of these mortgages goes into default and ceases to pay interest or principal, Fannie Mae will not have sufficient cash to pay the holders of its bonds. If the situation worsens, Fannie Mae will default on its bonds. So, whereas before one had one economic catastrophe —the default of some mortgages— because of the way the housing market is structured, this produces a second catastrophe— the default of Fannie Mae's bonds.

Fannie Mae's bonded debt is at least ten times greater than that of any corporation in America. No company in America has ever defaulted on as much as $50 billion in bonds, and Fannie Mae has over $700 billion. With a bonded debt of that magnitude, a default would put an end to the U.S. financial system, right then and there.

Yet a second obligation compounds the problem. In addition to the mortgage bonds, Fannie Mae has put its guarantees on $859 billion of Mortgage-Backed Securities. In a crisis in the housing mortgage market, Fannie Mae could never meet the terms of its guarantee, that it would pay "the full and timely interest and principal," on the mortgages to which it gave a guarantee. By the time it made payment on $5 to $10 billion of the principal and interest of the MBS which it guaranteed, Fannie Mae would go bankrupt from this source, if it had not already defaulted on its bonds. The pension or other funds which had bought the MBS on its guarantees, would suffer tens of billions of dollars of losses.

Finally, Fannie has derivatives obligations: $533 billion in hedges, allegedly to protect it from risks, which themselves could go into default against its bank and other financial counter parties. Fannie Mae's three risky obligations total over $2 trillion, vigorously used to inflate the housing bubble. Now, an increased default level among the $5.757 trillion in home mortgages, which by itself were not enough to bring down the whole housing market, would create a radioactive reaction inside Fannie Mae, causing it to bring down that market by defaulting on hundreds of billions of obligations.

While Fannie Mae was building up its risky obligations, so was its crony Freddie Mac. Freddie Mac's total of these three risky obligations is $2.91 trillion. (The smaller Freddie Mac's total is bigger than Fannie Mae's, because it has a much bigger derivatives portfolio.) Other institutions which perform functions similar to Fannie Mae, such as the Federal Home Loan Bank Board and private issuers of MBS, have approximately another $0.7 trillion in risky obligations. Thus, the total of housing-related high-risk obligations is roughly $5 trillion. It should be kept in mind that if one starts with $5.757 trillion in mortgages, these $5.0 trillion in risky obligations are distinct from and in addition to the mortgages, and a total of $10.757 trillion is laden onto the homes and attached to the incomes of America's homeowners. A Mortgage-Backed Security is an instrument with its own risks, independent of those of the underlying mortgages. For example, a dramatic change in interest rates or even a significant increase in pre-payments of mortgages can wipe out MBS value, quite as efficiently as the increase in mortgage defaults. In the case of the REMIC portion of MBS, this risk is considerable. Fannie Mae's financial paper is a ticking time-bomb threatening to bring the whole leveraged operation down.

Mortgage Financing Props Up Consumer Bubble
This is already far too dangerous, but the financier oligarchs decided to extend the housing bubble to do double duty, to support consumer spending, to halt the rate of economic decline. It thus serves now not only as a bubble for housing values in their own right, but the Wall Street-City of London circles are encouraging homeowners to borrow against the increases of fictitious value in their home to extract "wealth" with which to engage in consumer spending. This is known as the wealth effect. While it is commonly thought that stock market capital gains have held up consumer spending, a recent study by a team led by Yale economist Robert Shiller, shows otherwise. In the study, entitled "Comparing Wealth
Effects: The Stock Market Versus the Housing Market," Shiller shows that for every 10% gain in the stock market, there is a 0.2 to 0.3% gain in consumer consumption; while for every 10% gain in the housing market, there is a 0.62% increase in consumer consumption. Whether or not the numbers are precise, the rough comparison of boosts in consumer spending, is two to one in favor of the housing bubble.

Households are finding two ways to get their hands on some of the fictitious value of their homes: cash-out refinancing, and home equity loans. Under cash-out refinancing, a homeowner takes out a new, larger mortgage on his home, whose value has been artificially pumped up by general speculation. With the new cash, he pays off his first mortgage, pays off his credit card debt, and has money to buy a spate of consumer goods. According to Fannie Mae, in 1993, homeowners extracted approximately $28 billion in cash, from cash-out refinancing; but this tripled to $80 billion in 2001. With an equity loan, the homeowner borrows against a portion of the equity existing in his house (rather than refinancing the entire mortgage, as with cash-out refinancing).

The amount of home equity loans outstanding stagnated between 1990 and 1995, only rising from $235.9 billion to $289.3 billion. Then, as "Bubbles" Greenspan et al. pumped the bellows, the amount of home equity loans soared, reaching $701.5 billion in 2001. The amount of home equity loans is larger than all borrowing by credit cards in the United States. A Federal Reserve Board economist told EIR that half of the value of all home equity loans does not go for home improvements, but for consumer expenditures and paying down credit card debt. Others indicate that as much as 60% of home equity loans—over $400 billion a year— is for consumer cash and credit card expenditures. The banks have made it very easy to get home equity loans since the mid-90s, and now promote "home equity lines of credit," where the homeowner borrows, not a fixed amount—as was the case with the old home equity loan—but an almost unlimited amount of credit.

Write It Down Before It Falls Down
The housing bubble, represented by $12.04 trillion in homeowner home real estate valuation, and $10.757 trillion in original home mortgage and secondary housing market paper, is the biggest such bubble in history. It has more than doubled its size since 1995. Signs now exist of an increase in mortgage problems: In the first quarter of 2002, more than 4.65% of mortgage loans nationwide were delinquent (30 days past due), the highest level in ten years, and the rate of mortgage defaults is rising. Fannie Mae has taken extraordinary measures to roll over troubled homeowners' mortgages, in order not to have the level of defaults show up. But the housing bubble cannot be sustained. The principal boundary condition is reality: Households with declining real standards of living, are not able to take out of their incomes what is necessary to pay rising home prices, and the demands of ever larger mortgages.

Lyndon LaRouche has proposed putting the financial system through Chapter 11 bankruptcy reorganization, as part of the process of a New Bretton Woods monetary system. That would include writing down a good part of the mass of U.S. housing paper. If that is not achieved, as mortgage defaults increase, beyond the ability of Fannie Mae and Greenspan to control them, the leverage that has been built into the housing market will come undone, with lightening de-leveraging of the entire market. Six trillion dollars of fictitious real estate value will deflate rapidly. Mortgage defaults will intensify, and millions of families will be devastated. The grand payoff is that the housing bubble's puncture will bring down consumer spending, and the U.S. financial system which Greenspan et al. built it to sustain.