For some time now, the government owned mortgage finance companies known as Fannie Mae and Freddie Mac have been secretly making commitments to purchase loans from Provident Funding Associates that are financed by NattyMac, a Florida mortgage company. Now this complicated structure is set to be expanded nationwide in a bid to bolster the borrowing power of indepdent mortgage companies, according to the Wall Street Journal.
Do we even have to tell you that this will be a disaster?
Fannie and Freddie are corrupt operations that exercise abysmal risk management during the housing boom. The accounting scandal at Fannie would have put it out of business long before the housing bubble popped if not for the implicit government backing that ensured its creditors that they did not need to worry about how badly the companies were run. Both crippled themselves by blindly taking on mortgage risk during the housing boom. In the end, they wound up costing taxpayers more in a single year than all the savings they had ever provided to home buyers.
They represent one of the worst policy disasters in American history. In the market, the consequence of extreme failure is going out of business. But for government sponsored entities, it is expansion.
So let’s take a closer look into this Fannie and Freddie expansion into supporting the funding for independent mortgage companies.
What problem is being addressed? The cost of funding independent mortgage companies–the price they have to pay to borrow money–is viewed as too high by the operators of those companies and certain government officials. How do they know it’s too high? It’s the ideology of Market Dislocation again: the bureaucrats think they know better than the market and want to push things back toward the “old normal” that prevailed before the housing bust and mortgage meltdown.
How do the mechanics of the program work? In an ordinary market process, the mortgage lender borrows money from banks, bond investors and on the commercial paper market at a market rate. Typically, the company borrows cheaper short term loans that it must frequently turn over. It then lends out longer term mortgages at interest rates that are slightly higher than its cost of borrowing. The cost between the rate it pays and the rate it lets out–which is boosted by the borrow short, lend long strategy–is its profit. Its borrowing cost is essentially a function of the market’s view of the riskiness of its business model–its opportunities, management and the riskiness of its mortgages.
Under this program, Fannie and Freddie are indirectly subsidizing the independent mortgage companies in a way that allows them to borrow more cheaply. Fannie and Freddie commit to buying the mortgages from the mortgage lender, taking away risk that the lender will lose money if the mortgages default. This, in turn, takes away risk that the mortgage lender will default on its own obligations, making it less risky to lend to them. Creditors to the mortgage lenders should then be more willing to lend more cheaply since they face less risk. Apparently under this program, creditors will have some supervisory role of making sure the mortgage lender is only making loans that meet the criteria for lending set out by Fannie and Freddie.
Why are independent mortgage companies having such trouble borrowing? The basic problem is that right now independent mortgage companies are viewed skeptically by the credit markets. They proved to be much higher risks than anticipated. This means their cost of borrowing is higher than it used to be, higher perhaps than is sustainable to keep them in business.
What does this do to the mortgage market? In the last year, the mortgage lending business has shifted away from independent mortgage lenders to the largest banks. In this year’s first half, the three biggest mortgage lenders — Wells Fargo & Co., Bank of America Corp. and J.P. Morgan Chase & Co. — accounted for 52% of new home mortgages, according to a trade publication cited in the Wall Street Journal. Just two years ago, the top three had a 37% share.
Why are the big banks winning? Take a look at the three largest mortgage lenders. Each received massive amounts of tax-payer funding and have access to a myriad of support programs from the Federal Reserve and the Treasury Department. Perhaps more importantly, the market believes each is too big to fail and is backed by a government guarantee. This means that they have access to cheap funding, which allows them to make cheaper mortgages.
This about it this way. If we ran ClusterMac as an independent mortgage company, financing our operations would require us to borrow at market rates because no one thinks the government will bail us out if we fail. We will pay very high interest rates, which means we can only make a profit if the money we lend out also has high rates. Our competition, however, is Wells Fargo, which can borrow at below market rates and profit from even mortgages with very low rates. The end result is that ClusterMac is screwed.
So it’s the government backing of big banks that is screwing the indepedent mortgage lenders? In large part, yes. Although not entirely. We actually don’t know exactly how the market would view the relative risk of the big banks versus the independent mortgage lenders because the guarantees and Fed credit windows so badly distort the market.
That seems like a pretty good reason for Fannie and Freddie to give them a hand. We see what you mean. It does seem unfair that the business model of independent mortgage lending is getting crushed by the government guarantee of the Too Big To Fail lenders. The better solution would be to put in place a credible policy that the creditors to even the largest financial institutions will not be rescued by the government, which would push their rates back up to market rates.
So what could go wrong? Let us count the ways.
- It’s too complex to work. The structure puts financing the mortgages in one company, actually making the mortgages in another and taking the risk from the mortgages in yet another. This is a recipe for financial irresponsibility.
- Taxpayers bear the risk. Because Fannie and Freddie are buying the mortgages, the taxpayers are ultimately on the hook for the risks that should sit with the mortgage lenders and the creditors who finance the lenders.
- Risk shifting makes responsible lending impossible. There’s no way a mortgage lender can evaluate the riskiness of the mortgages it makes without feedback from the capital markets. It can build all the models it wants to tell it about the risk but those models are damn near worthless. The best risk management is built on the Darwinian market process that raises borrowing rates of companies that take on too much risk. What this program does is take away this feedback from mortgage lenders and their investors and creditors. They simply won’t know they are making mistakes about the credit risk of mortgages.
- Fannie and Freddie cannot measure risk. The explicit government backing of these two companies means that they borrow at risk-free levels. Any alleged risk controls put in place by Fannie and Freddie are decided bureaucratically, rather than according to market processes. If they guess right and the models work correctly, everthing could work out swell. The odds are very strongly against this.
- Fannie and Freddie take on too much risk because of politics. Making matters even worse, Fannie and Freddie are subject to inordinate political influence that forces them to buy loans to meet political goals such as increasing low-income and minority home ownership. Judging by the fact that the pilot program for this new operation started in St. Petersburg, Florida, the government may also attempt to use it to boost lending in some of the areas hardest hit by the housing bust.
- We’re expanding the credit market distortions. Instead of buidling a healthier mortgage market, we’re making it far more difficult to even know what a healthy mortgage market looks like. The market price of mortgages will become even more opaque, and the risk incurred less visible.
In short, this is the opposite of progress in the mortgage market. It’s a disaster in the making.