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Government Bailouts (Part 2 of 3)

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William-CoxRecap of Part 1

Part 1 discussed the current situation of the Fannie Mae and Freddie Mac bailouts. This second installment will cover the events leading up to the bailouts. You may recall the following passage from part 1:

Fannie Mae and Freddie Mac borrowed $116.1 Billion and $71.3 Billion respectively for a total of $187.4 Billion from the United States Treasury; as of March 31, 2016 the GSEs had paid the United States Treasury a total of $245.8 Billion in dividends, but have not paid off any of the original loans; the original $187.4 Billion is still outstanding. In addition, the United States Treasury is currently taking 100% of the profits from Fannie Mae and Freddie Mac and sweeping these funds into its General Fund.

The housing crisis of 2007-2010 was due to several factors that combined to cause an 18-month long economic recession in the U.S. from December 2007 through June 2009. The recession put a severe strain on the GSEs and the government was pressured to bail them out due to their critical role in the housing market. The main factors that contributed to the housing crisis are summarized below.

Lax Underwriting Quality

“NINJA” (No Income, No Job or Assets) loans which did not require borrowers to have documented income from a job or any assets (also known as no documentation loans) caused the proportion of subprime borrowers to increase while also lowering the quality of the loans that were packaged into mortgaged backed securities (MBS). More than 90% of subprime loans were rated AAA once they were securitized. In addition, many of the loans were adjustable rate mortgages (ARMs) with little money down. This made it easy for high risk borrowers to purchase homes that were more expensive than they could afford. This scenario was obviously precarious and one could have foreseen a problem if housing prices were to go down and/or if interest rates were to rise. In this instance the monthly payments would increase beyond the borrower’s capacity to pay and due to the lower home value the borrower would be unable to refinance at a lower interest rate. The belief in ever increasing home values and the ease of securitization prevented a commonsense review of the quality of the mortgages.

FIGURE 1

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Easy Funding for Loan Originators

Deregulation, the public policy goal of increasing home ownership, and the demand by investors for investment returns were only some of the causes of the rapid growth of subprime lending leading up to the financial crisis. The non-depository banking system (investment banks, insurers, hedge funds, mortgage lenders, etc.) grew to exceed that of the traditional banking system, but operated without similar regulations. This allowed mortgages that did not meet traditional underwriting standards to be originated, securitized, and sold to investors, and those facilitating the process did not retain any of the risk. Without the retention of risk there was no incentive to do anything but to originate as many loans as possible. From the originator’s perspective, the borrower’s ability to repay the loan did not matter as the risk was passed to the buyer of the securitized product.

Belief that Housing Prices Would Continue to Increase

Due to the steady rise in home values from 1991 through 2006 borrowers were willing to “stretch” to buy a larger house than they could comfortably afford due to the belief that housing prices would continue to increase. Some less sophisticated buyers may have validated their action of buying a bigger house on the belief that because the bank was willing to approve a mortgage, the bank believed that they could afford the loan. Many borrowers were viewing their home purchase as an investment with the intention of making a profit on home price appreciation (flippers). Others didn’t want to be left behind as they saw friends and neighbors profiting. This increased demand and in turn increased prices, which then further increased the leverage of buyers. When housing prices began to decline many borrowers were left with mortgages that were larger than the value of the house and were unable to refinance or sell the property without a loss.

FIGURE 2
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Bailouts Required for GSEs

The severity of the housing crisis was exacerbated by a downward cycle that brought about further declines in home prices. As prices began to decline, many of the homeowners who had taken out these mortgages were underwater (the remaining mortgage was greater than the value of the house) and often the homeowner would decide to simply “walk away” from the property. Doing so increased the supply of homes and put further downward pressure on prices. The value of securities that had mortgages as collateral started to decrease as well and as investors anticipated further declines in home prices the market value of mortgage securities declined further. The GSEs were hurt both by losses on the large portfolio of mortgages which they held and also by all the claims on failed mortgages which they guaranteed. The assets for the GSEs decreased and their liabilities increased putting the remaining capital at risk. Investors started to lose confidence in the GSEs and because they are such an important part of the U.S. economy, the federal government believed that a bailout of the GSEs was needed to stabilize the economy.

 

Senior Preferred Stock Purchase Agreements (PSPAs)

Section 1117 of the Housing and Economic Recovery Act of 2008 (HERA) provides the United States Treasury temporary authority to purchase securities and obligations issued by Fannie Mae, Freddie Mac, and any Federal Home Loan Bank. This is the legal authority that allowed the Federal Housing Finance Agency (FHFA) to initiate the bailouts. The bailouts themselves have gone through several iterations with changing terms and amounts. The following is a timeline of the GSE bailouts.

FIGURE 3

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During 2008 the FHFA, in an attempt to support the GSEs, entered into a Senior Preferred Stock Purchase Agreement (PSPA) with Fannie Mae and Freddie Mac in the amount of $100 Billion each. After three amendments, the current version of the PSPA reduces the maximum mortgage assets held to $650 Billion and replaces the 10% dividend to the U.S. Treasury with a 100% sweep of net income. The net result of the bailout was to reinforce the belief that securities issued by the GSEs are essentially government securities with an implicit government guarantee. Part 3 will look at how the GSE bailout impacted the markets.

 

William Cox, CMA
Investment Analayst

 

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