D.C. & Mortgages

Two seemingly unrelated developments in the nations mortgage mess this past week. They both point to how difficult it will be to bring some stability back to the system. I am wondering if they are connected.

The first came as a surprise to me. Mr. Joseph Smith was supposed to be confirmed as the Director of the Federal Housing Finance Authority. Smith was a state banking commissioner from North Carolina. He was a White House pick. Up until last week I thought he was a shoe-in for the job. Kaboom.

Smith is out. Nixed at the last minute by none other than Richard Shelby (R. AL). The ranking member of Banking, Housing and Urban Affairs waved his arms and sent Smith back to North Carolina. Senator Shelby had this to say:

Shelby's main concern was that Smith would be a “lapdog” to outside pressure to use the GSEs, at taxpayer expense, as vehicles for large-scale homeowner assistance programs.

Lapdog? Maybe, I don’t really know. But I doubt that is the reason for canning Mr. Smith. This is politics. Senator Shelby wants his own guy running things over at the FHFA. It is much easier to steer the outcome that way. The early talk is that Mr. Smith is going to be re-nominated. I doubt it. Come Jan. 1 there is a new set of voters on this. If Shelby is saying "no" in December; the majority will say no in January.

We need a very strong hand in this position. 2011 will be the year that Fannie Mae/Freddie Mac get put on the operating table and decisions will be made what role these two dogs will have for the next decade or so. Needless to say this is a critical step if we are to have an outcome that moves us away from socialized mortgage finance. At this point the D.C. lenders are 95+% of the new mortgage market. One way or the other that number is coming down. How our dependency on Washington for the loot that keeps the real estate market alive is resolved will be make or break for the entire economy.

Normally I would say the side show political fight over this appointment was just normal D.C. fun and games. Not the case this time. Keep an eye on this fight, it will provide clues on the direction this is headed.

I have seen again and again where a study by the Congressional Budget Office later becomes the basis for legislation. The CBO put out a report on 12/23 that dealt with Fannie and Freddie. The paper is long and does not contain much new information. The following is the cover page. I thought it sends a terrible message. When I look at it all I can think is, “The Federal Government is lending against every one  of these homes!” Not the image they should be going for.

The CBO tries to layout all sides of the argument on this critical issue. They are quick to point out that an extreme outcome is undesirable. We can’t continue with the government providing nearly 100% of all mortgages, and we can’t expect that the government’s role will fall to a small number anytime soon. The CBO conclusion is that we have to move toward the middle. They call it a Hybrid Market.

I think the CBO is right. While I would love to have Washington’s role in the mortgage market eliminated altogether, that is just a pipe dream. If we shut Fannie and Freddie down on new lending the economy would tailspin into chaos.

The CBO did have one recommendation that I thought could be very useful. They want the government to recognize UP FRONT a mark to market cost of providing a mortgage. This cost would go on the budget as a current expense. The Administration and Congress would fight over all aspects of the budget (as usual) but if they had an agenda for housing (stimulus/support) they would have to appropriate the money and vote on it where all could see the results.

The concept is relatively simple. Assume that the private market for a 30-year mortgage was 6% for a “good” borrower who has 20% equity down payment.

Now assume that in its wisdom Washington wants to provide a stimulus to the housing market. Fannie and Freddie are willing to provide the same 30-year mortgage at 5% and they are will to do it for a lower rated borrower and they are willing to do it at 90% of the purchase price.

Clearly this is a subsidy that will ripple through the system. The suggestion by the CBO is that government would record a charge UP FRONT equal to the difference between the actual terms of the loan and the market terms for the same financing. As the F/F loans have a high advance rate they would get a higher return than the 80/20 deal. If the market rate for the 90/10 deal was 7% then the cost to the government would be the Net Present Value of the 2% over the life of the loan (average 15 years). In this case the government would have to recognize a current cost of ~$15 for every $100 they lend.

My example might be a tad extreme. The point of the mark to market is to force Washington into recognizing that there is a cost to their lending. For years we went by thinking that all that cheap money was in fact without a cost. 2007-10 proved how wrong that was. Fannie and Freddie will cost the taxpayers more than a half trillion before this is all done.

Nothing will move Washington out of the lending business faster than if they have to pay for it. Recent history shows beyond doubt that there are real costs to subsidized mortgage lending. For the current budget to take a hit that approximates the fair value of mortgages would be the smartest thing we could do. The reserves created would go a long way toward assuring that there would never be a blowup and conservatorship again. If the reserves prove unnecessary after a period of time they could be returned to the taxpayers as a bonus. From the CBO report:

CBO believes that treating Fannie Mae and Freddie Mac as governmental entities for the purposes of the federal budget, and accounting for them on a fair- value basis, accurately reflects their current status. That treatment also provides more timely and relevant information to policymakers considering options for the future of the GSEs.

For instance, if legislation required Fannie Mae and Freddie Mac to increase subsidies on guarantees to first-time home buyers through a new program, the program would show an immediate cost under CBO’s budgetary treatment.

If you’re a conservative and you want to see a smaller role for government the CBO proposal on mortgages is the ticket for you. I can’t help but connect the dots between Shelby’s "no" vote on Thursday and the CBO report from the same day.

Something along the lines described by the CBO is coming. Barney Frank does not have the influence or the votes to stop it. Strong hands like Shelby will get their way. While the actual outcome is cloudy there is one conclusion you can take to the bank. Mortgages are going to be more difficult to get and they will cost more in twelve months. That will hurt, but it is a good thing.

Note: Edward DeMarco is the acting director at the FHFA. He has had this ‘temporary’ position for two years. Ed has done a good job. I believe that his policies and actions have consistently taken the side of the taxpayer. Exactly how it should be. DeMarco deserves a shot at the job. I doubt he will get it. Another mistake.