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The Wall Street Journal‘s website — once again — pretty much summed up the current state of the housing and mortgage markets this week.
One key headline: “Fannie Mae Tightens Rules for Mortgages”
The other: “Senate’s Housing Gridlock Eases”
The first story talks about the latest goings-on at Fannie Mae, one of the two major government-sponsored enterprises that buy some loans for their portfolios and guarantee other pools of home loans known as mortgage-backed securities.
The upshot of the story:
- Fannie Mae is now establishing a minimum required credit score of 580 for most loans it will buy.
- It’s also reducing loan-to-value ratios for some types of mortgages.
- And it’s extending the post-foreclosure credit rebuilding period that borrowers have to go through before their loans are eligible for Fannie Mae purchase to five years from four.
In other words, Fannie Mae is tightening lending standards — and it’s not alone. Several banks have cut back on the wholesale loan programs they offer through brokers. Meanwhile, Wachovia reportedly is considering a halt on option Adjustable Rate Mortgage lending in parts of California.
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| As the real estate market plummets, Wachovia is moving to tighten lending standards. |
The second Journal story points out that Congress is closer to passing a mortgage relief bill, despite intellectual and philosophical differences among Congressional Republicans, their Democratic counterparts, and the executive branch.
Put simply: The battle royale between free market forces and government intervention continues to rage … and intensify … in the housing and mortgage markets.
The Fed has torn up its playbook and intervened more aggressively on Wall Street than at any time since the Great Depression. And the nation’s mortgage industry is moving farther down the path of quasi-nationalization.
Today, I want to talk in more detail about what’s going on, and what it means for both the short and long-terms.
Your “CliffsNotes” Version of the Latest
Mortgage and Regulatory Reforms
It’s been an active few months for the mortgage market on the regulatory and policy front. I’ve done my best to keep you abreast of the latest proposals, and this week was a real doozy for new ideas. So here’s my quick summary of the latest action:
Targeting Washington’s “Alphabet Soup” — Treasury Secretary Henry Paulson introduced a mega-plan earlier this week called the “Blueprint for a Modernized Financial Regulatory Structure.” Right now, different parts of the financial markets and different types of financial institutions are regulated by an alphabet soup of government agencies.
The Commodity Futures Trading Commission (CFTC). The Securities and Exchange Commission (SEC). The Office of Thrift Supervision (OTS). The Federal Reserve. The list goes on and on. And for industries like insurance, supervision and regulation is essentially in the hands of the states, with little to no federal oversight at all.
The focus of the regulatory plan is to sort this whole mess out by consolidating agencies and responsibilities. In Paulson’s words:
“Intermediate-term recommendations focus on eliminating some of the duplication in our existing regulatory system, but more importantly they offer ways to modernize the regulatory structure for certain financial services sectors, within the current framework. Recommendations include eliminating the thrift charter, creating an optional federal charter for insurance and unifying oversight for futures and securities.
“The long-term recommendation is to create an entirely new regulatory structure using an objectives-based approach for optimal regulation. The structure will consist of a market stability regulator, a prudential regulator and a business conduct regulator with a focus on consumer protection.”
Some credited this approach for instilling a bit of market confidence and optimism on Wall Street, helping spur this week’s rally. I’m a bit more skeptical on this front as it doesn’t look like many of these reforms will be instituted any time soon. But eventually, some heads will have to roll for what happened during this latest bubble — and this blueprint could provide some guidance on where the axe will fall.
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Further lending market reforms — Of all the mortgage reform programs being discussed, one in particular is gathering momentum in Congress. It’s a bill that would potentially:
Provide $4 billion in grants that would allow local governments to purchase foreclosed homes.
Moreover, a plan from House Financial Services Committee Chairman Barney Frank and Senate Banking Committee Chairman Christopher Dodd may be gaining broader acceptance. They envision a program where the outstanding loan balances of borrowers would be written down. This would ensure the existing lenders took some losses.
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| Powerful House Financial Services Committee Chairman Barney Frank is working on a mortgage reform plan with Senator Christopher Dodd. |
Then the borrowers would be refinanced into loans insured by the Federal Housing Administration, or FHA. Those loans would have smaller monthly payments because less principal would be owed. Borrowers would also be encouraged to stay put and try to pay off their homes, rather than walk away, because they would no longer be left “upside down”— owing more than their homes are worth.
But the borrowers wouldn’t get a free lunch. They would be required to offer the government “soft second” liens on their properties. What that means is the government would get a portion of its money back upon the sale of the homes down the road. The presumption is that by then, home prices will have gone back up and everyone will “win.”
To make it all work, FHA would be granted the ability to fund an extra $300 billion in mortgages.
Making the Fed a “Supercop” — A more troubling move underway in Washington is to make the Fed even more of a market “Supercop” than it has been acting like already. As the Wall Street Journal noted a few days ago:
“The Fed would retain, for now, authority to write consumer-protection rules on things such as credit-card disclosures and the terms of high-cost mortgages — despite accusations from consumer groups and Democrats that its failure to do so allowed many homeowners to get subprime mortgages they couldn’t afford.
“In Mr. Paulson’s ‘optimal’ scenario, the Fed eventually would surrender its supervision of state-chartered banks and bank-holding companies to the new agency and become a ‘market stability’ regulator. The Fed, Mr. Paulson said in an interview Saturday, ‘would have broad powers so they could go anywhere in the system they needed to go to preserve that authority.’
“In that role, it would be able to lend to any important institution while seeking information from them, which Mr. Paulson considers more reflective of a financial system spread among brokerages and other nonbanks as well as traditional, commercial banks.”
What’s good, What’s bad,
And What’s Ugly in All of This …
So what are my thoughts here? Do I think the Fed and the feds are on the right track here?
First off, the policy of the Fed over the past several years has been to take a “hands off” approach to asset bubbles and regulation during the boom times. There was no move to raise margin requirements during the stock market bubble, for instance.
And as the housing bubble expanded, Fed policymakers spent more time questioning the very existence of a bubble rather than lambasting lenders and speculators for helping inflate it. They didn’t jack rates up aggressively to calm things down, either. In fact, they implemented clearly telegraphed, quarter-point hikes over a span of several quarters instead.
What about the regulatory response? Sure, there were a bunch of mealy-mouthed “guidances” on high-risk lending from the regulatory agencies, including the Fed. But they had no teeth and no on-the-ground impact.
Yet now that things have gone to hell, it’s suddenly time for an “all hands on deck” approach!
The Fed is willing to slash interest rates dramatically, and throw huge helpings of money at the very same companies and individuals that helped cause the mess in the first place. And all those high-minded principles we’ve been hearing about — you know, like Larry Kudlow’s favorite slogan: “Free market capitalism is the best path to prosperity?” They get thrown out the window in the interest of expediency.
Heaven forbid someone raises his hand in objection to some of the ideas being thrown around, either. Those folks get labeled as “Herbert Hoover” wannabes. Or worse, they’re told that they sound like Hoover’s Treasury Secretary Andrew Mellon.
He believed a hands-off approach to the stock market crash and the subsequent recession was appropriate, and was famously quoted as saying “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate” in order to “purge the rottenness” in the system.
Instead, we are told to just all rally behind the Fed — let it pull every lever and bend (or break) every rule to save the world. Or in simple terms: “The ends justify the means. Stocks can’t be allowed to suffer a short-term crash. Recession must be avoided at all costs. Get over it.”
Look, I am NOT averse to offering targeted aid to deserving borrowers. I have talked about some of the ideas I like before.
I’m pleased to see that despite all the pressure coming from government officials, Fannie Mae and Freddie Mac actually seem to be keeping standards relatively tight … and even tightening them … to reflect the very real risk of further price declines.
And the Frank/Dodd proposals make sense in many ways. That’s because they would require lenders to take some losses, while also making any borrower who receives help pay FHA back for that aid by surrendering a chunk of any future appreciation.
But let’s stop and take a deep breath here about some of these other steps. Maybe, just maybe, Wall Street is getting its just desserts for throwing an easy money bacchanalia the past few years. Maybe, just maybe, we should allow the bad debts to be purged and yes, allow the firms that took on the most risk to suffer the worst consequences.
Would we have seen a 1,000-point down day in the Dow if the Fed hadn’t arranged a shotgun wedding for Bear Stearns over that fateful weekend? Maybe. But you know what? Maybe that would have been just the cleansing we needed to flush out the last of the crud and get on with a healthy, rebuilding process.
At the very least, a good flush would have created some real bargains for investors who have acted prudently in the past several months, who didn’t load themselves up with vulnerable financial stocks, and who were sitting on hefty cash levels.
Furthermore, I have real reservations about what’s happening today and what it means for the longer term …
For starters, the Fed has done a poor job of preventing and fixing bubbles over the past several years. It failed to recognize and/or tamp down the dot-com bubble in advance. Then it reacted to its bust in such an aggressive manner that it created an even bigger bubble in housing.
Yet some are considering deputizing the Fed as a financial markets Supercop? Am I the only one who thinks there’s something wrong here?
Second, there’s the whole moral hazard risk of this Bear Stearns transaction. The term refers to the risk that bailouts just embolden people to take even bigger risks down the road, knowing the Fed will save their bacon if they get into trouble.
Critics say there’s just no time for this kind of argument. Their view: Desperate times call for desperate measures. But let me ask you a question: Has each successive crisis that the Fed has tried to paper over (Orange County, Long-Term Capital Management, the dot-com bust, and so on) been bigger or smaller than the one before it? I think the answer is clear: Bigger. And I think one — though certainly not the only — reason for that is clear: Investors know that the Fed ultimately “has their backs.”
Third, we have to consider the law of unintended consequences. Did the Fed mean to create a housing bubble to replace the dot-com bubble? I doubt it. Policymakers probably thought they were doing the legitimate, proper thing.
But the reality is that while the Fed can create excess liquidity and cut interest rates, it can’t channel that liquidity to specific markets. So we keep getting this “rolling bubble” scenario, where the “cure” for the popping of one asset bubble ends up creating a fresh asset bubble “disease” somewhere else.
I don’t know where the next big bubble will be. But I can guarantee you this: If the Fed continues to pump like mad to “fix” the housing market, it’s going to come back to haunt us. I’ll have to write another column like this … and we’ll have to debate yet another bailout program … sometime in the 2010s!
The bottom line: Policymakers need to carefully consider the details of any and all bailout plans — and the long-term consequences of their actions. It’s not “Mellon-esque” to let economic nature run its course, to the furthest possible extent. That’s what capitalism is supposed to be all about, right?
As for investors, the question that’s on the table now is quite simple: Will all of the efforts by the Fed and the feds work? Will they be able to counteract the fundamental economic problems facing the housing and mortgage markets?
You know I’ve been skeptical, and I remain so. But I’ll keep my eyes open, my ear to the ground, and be sure to let you know if that changes.
Until next time,
Mike
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