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