Week of August 11--BANKS ARE INCONSTANT LENDERS

The debate over the housing bill and backstopping of Fannie Mae and Freddie Mac highlight a major fact. Commercial banks are inconstant lenders. This became evident in early 1980s when then Fed Chairman Paul Volcker hiked the fed funds rate to 19 percent in 1980-81. It caused many Savings & Loan Banks, who were the major mortgage lenders of that time, to stop originating mortgages altogether.

This was particularly true in California, where the biggest mortgage lenders of that time—such as Home Savings, Great Western Savings & Loan, Security Pacific Bank, United California Bank—found that their cost of funds exceeded the income from existing fixed rate mortgages.

And it was the secondary market for mortgages that stepped into the breach, of which Fannie and Freddie played a major part. So-called non-traditional investors, such as mutual funds, life insurance companies, and pension funds, funded 42 percent of the growth of mortgage lending during the 1990s, versus just 19 percent during the 1970s, according to a 1992 Fannie Mae report.

Today the share of mortgages insured by Fannie and Freddie has ballooned to more than 70 percent of total originations. This is because the mission of these Government Sponsored Enterprises (GSEs) has not changed; to supply liquidity to mortgage lenders when commercial banks would not, or could not, do so.

The Reagan Administration attempted to shore up the S&Ls’ balance sheets with the 1982 Garn-St. Germain bill that gave them broad latitude to make money by acting like commercial banks—making commercial loans, borrowing from the Federal Reserve discount window, issuing credit cards, and even investing in real estate—which in turn precipitated the S&L crisis of the late 1980s and the federal bailout of same.

The banks’ inconstancy is again an issue with the bursting of the real estate bubble. It is not the province of this paper to discuss its origins, but rather the fact that once again, damage to their balance sheets and capital base has caused the banks to pull back from their lending activities. In this case, it is almost any loan not guaranteed by Fannie Mae, Freddie Mac, the Veterans Administration (for Vets) and Federal Housing Administration (FHA).

Has dependence on the GSEs caused a severe strain on our financial system? Not according to a study by R Glenn Hubbard, George W. Bush’s first Chairman of his Council of Economic Advisors that was commissioned by Fannie Mae in 2005. Dr. Hubbard’s study found that in fact Fannie Mae had half the risk of insolvency of commercial banks—in large part because of a more conservative mix of loans. The GSEs do not buy or insure either credit card or installment loans, as well as riskier commercial mortgages (other than apartment loans) of commercial banks.

In fact, Hubbard’s report maintained that if Fannie Mae failed, its bondholders could expect to lose just 8.9 percent of its assets, whereas commercial banks stood to lose 22.3 percent of their assets.

Of course, critics of the GSEs, including Alan Greenspan, have maintained that because of a implicit government guarantee the GSEs would not be allowed to fail, and so could offer interest rates below comparable commercial bank loans. But what critics fail to take into account are the stricter government-mandated underwriting standards that require income and asset verification to determine a borrower’s ability to repay their mortgage.

This has resulted in default rates just one-quarter of those for all conventional mortgages. Freddie Mac’s CEO said in a recent press release that there is ample evidence that the GSEs have helped to keep a bad situation—i.e., the worst housing crisis since the Great Depression—from becoming even worse. And, they have managed to maintain their mission of improving housing affordability in the process.

© Harlan Green 2008

Week of July 28, 2008--IS THE ECONOMY IMPROVING?

The first ‘advance’ estimate of second quarter economic growth was 1.9 percent while prior quarters’ growth estimates were reduced slightly. The fourth quarter 2007 actually showed a 0.2 percent contraction in growth. So does that mean that we are in fact coming out of a recession? Real estate seems to be bottoming out, at least in some regions of the country.

If so, it is because a tremendous amount of stimulus has been put into the economy, not only by the Federal Reserve. The federal budget deficit is also stimulative. In fact, next year’s projected deficit of $482 billion—due in part to the rebate checks being sent out—is the total annual Gross Domestic Product of Belgium, according to one commentator. This means the government is spending more than it is taking in receipts, hence it is putting more money into the economy.

And more money in circulation should lower interest rates and stimulate businesses. Too much money in circulation also stimulates inflation, however, hence the tightrope the Federal Reserve is walking between its twin mandates of maintaining long term growth with low inflation.

The increasing unemployment rate—it rose from 5.5 to 5.7 percent in July—may belie any relief, but that is because more workers were kept on the unemployment rolls. Congress extended unemployment benefits for another 13 weeks, which has caused consumer confidence to increase in both the Conference Board and University of Michigan surveys.

The new housing bill may also provide some relief, though housing only accounts for 7 percent of economic activity. The conforming limits for loans insured by Fannie Mae and Freddie Mac that were boosted to $729,750 for a single unit this year, but will be permanently reduced to $625,500 as of January 2008. A $7,500 temporary tax credit for first time homebuyers should also help, given the fact that first-timers now make up 40 percent of homebuyers, according to the National Association of Realtors.

And the housing sector is beginning to work off excess inventories with new-home inventories back down to a 10-month supply, even though prices continue to decline. The good news is that some regions are showing price increases, after falling a cumulative 15.8 percent since last fall, according to the latest S&P Case/Shiller price index. Its survey showed that existing-home prices had actually risen in seven major metropolitan areas—but none yet in California.

Even the higher unemployment rate held some good news. The past 2 months showed 26,000 more jobs were created than originally estimated. And a major reason for the jobless increase was the temporary flood of summer youth 16-25 years old into the job market, with fewer able to find work. So the jobless rate could stabilize in the fall. The real estate bust has caused problems with our financial institutions that had over expanded into residential loans. Financial sector activity in general—including the activities of hedge funds, pension funds and the like—had ballooned to more than 25 percent of domestic (GDP) economic activity. It is now shrinking back to a more sustainable size. This will take time.

© Harlan Green 2008

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