Manipulating mortgages

The dust has settled a bit on the Treasury’s recent decision to give Fannie Mae and Freddie Mac a green light to nationalize our mortgage problem. Calculated Risk says the move was not necessarily done on Christmas Eve to escape notice. And it was not done to socialize future losses via Fannie and Freddie. It is just a precautionary move to make sure the economic policies already enacted stick in case of a “low probability event.” Calculated Risk feels this the decision is a “nothingburger.”

I take a more negative view.  I see Fannie Mae and Freddie Mac as a means of manipulating interest rates and distorting the allocation of resources and funneling precious capital investment into a housing sector which suffers a dreadful amount of overcapacity. This is bubble economics pure and simple and it will fail spectacularly.

First of all, Fannie Mae and Freddie Mac were always ridiculously undercapitalized. This gave them a lot of phantom profits during the boom years as a result of leverage.  However, when the bust occurred and they were nationalized, American taxpayers had hundreds of billions of dollars of losses foisted onto them – a perfect example of privatized gains and socialized losses aka kleptocracy.

So, Fannie and Freddie are now wards of the state – government agencies, if you will. Yet, incongruously, the heads of these government agencies may get $6 million salaries each. And none of the bonuses and stock option gains based on phantom profits of the last decade have been clawed back, now have they? Obviously, this is yet another example of crony capitalism in a bailout culture which enriches the well-connected at the expense of the middle class.

In my view, these agencies have always served a dubious purpose and should be wound down and eliminated entirely. Arnold Kling says it well:

Since August of 2008, I have advocated winding down Freddie and Fannie. Any other policy courts mischief.

For years, U.S. housing policy was to encourage the use of mortgage credit to the maximum extent by as many people as possible. We see the results. The new policy is to encourage as many people to stay in homes that they should not have bought in the first place for as long as possible. The result of this new policy, as I have predicted from its onset, is to perpetuate the crisis.

The significance of the unlimited backing of Freddie Mac and Fannie Mae is that it represents the unwillingness of policymakers to back away either from subsidizing mortgage credit or from trying to keep the wrong people in the wrong housing units with the wrong ownership arrangement. Instead, if they were to let the market work, those who cannot afford their mortgages but who could afford the rent would become renters, and those who cannot afford the rent would move out and rent elsewhere. Again, as a taxpayer I would gladly pay moving expenses for these people rather than pay to keep them in their homes as "owners."

Let’s put aside arguments over the alleged burying of news on Christmas Eve and the alleged expectation of future losses to be socialized. Almost nine of ten mortgages are now underwritten by Fannie Mae and Freddie Mac. Leaving this aside, the mortgage moves by Freddie and Fannie is obviously part of an orchestrated campaign to reduce long-term mortgage interest rates. The Federal Reserve itself has bought $1.25 trillion of mortgage-backed securities.  Federal Reserve officials openly admit this.  Witness recent comments by NY Fed EVP Brian Sack:

It is important to recognize that the LSAP programs differ from the Fed’s liquidity policies in terms of their policy intent. The LSAPs were not aimed at supplying liquidity to financial institutions or at reducing systemic risk. Instead, they were intended to support economic activity by keeping longer-term private interest rates lower than they would otherwise be.

The Federal Reserve is not only manipulating short-term interest rates but also clearly manipulating long-term interest rates as well. Their excuse? Trying to reduce artificially inflated risk premia aka credit markets still not reflective of the fundamentals. Risk premia or not, how is this a good thing? It is yet another command and control fantasy that will cause capital to flow erroneously to a sector that is already swamped with REO sales and potential shadow inventory. While some may think, this misallocation of capital is necessary and can work to arrest the decline in house prices (hence the happy talk about no further losses at Fannie and Freddie), I am not so sure.  House prices are still too high in many areas of the country relative to income, rents and other reliable long-term metrics. These policies to buy up mortgages only perpetuate this disconnect. Eventually, inflation-adjusted house prices must revert to mean as reflected in price to income and price to rent.  I do not see how they can do so without a real loss for taxpayers at Fannie and Freddie.