The Great Deformation (76 page)

It goes without saying that nonrecourse mortgage loans with token down payments, in the context of what turned out to be a decade-long bubble in housing prices, were a recipe for disaster. While it took the GSEs time to chip away at their traditional underwriting disciplines, one signal breakdown occurred several years later when Fannie Mae introduced its “Flex 97” product. That bit of affordable housing lunacy permitted borrowers to post a mere 3 percent down payment, and it didn't even have to be their own cash.

This initiative was symptomatic of Washington's truly foolish obsession with promoting home ownership, especially in the face of housing prices which were rising preternaturally. In those circumstances, the GSEs should have significantly boosted, not eviscerated, their required down payment ratio in order to provide a cushion against subsequent market reversals in the value of housing collateral.

The true evil, however, did not lie in the affordable housing mandate per se. Conservative critics were wont to complain loudly that the GSEs were being saddled with inappropriate “social policy” missions, but that was an oxymoron; the GSEs themselves were social policy undertakings and they had always been inappropriate, owing to the inherent danger of crony capitalist capture.

Accordingly, what the ill-defined and elastic “affordable housing” mandate actually did was unleash full-bore crony capitalism in home finance. Indeed, in only a few years' time stock-option-crazed executives turned Freddie and Fannie into housing bubble machines funded by Uncle Sam's credit card.

HOW THE STOCK OF FREDDIE AND FANNIE SHOT THE MOON

For a moment in time, the stock prices of Freddie and Fannie took on the trajectory of a moon shot. Yet these billowing Wall Street valuations were always preposterous, a truth eventually punctuated by the hapless Hank Paulson. Standing knee-deep in the carnage of the GSEs in July 2008, he
vainly attempted to prop up what remained of their stock prices by claiming that he had a bazooka in his pants pocket.

Still, this failed moon shot had taken a quarter century to run its course. When the House Republicans rescued the GSEs from the threat of free market economics in 1981, the market cap of Fannie Mae was less than $1 billion, and Freddie Mac was not yet even publicly traded. By the time George H. W. Bush signed the misbegotten housing bill eight days before the 1992 election, their combined market cap amounted to only a few billion.

Soon thereafter, however, the stock prices of Fannie and Freddie went parabolic. As it happened, the 1992 statute was virtually a blank check of authority to promote home ownership, and thereby perfectly suited to the agenda of the genuine liberals Clinton installed in the Department of Housing and Urban Development (HUD) and the GSEs. HUD Secretary Henry Cisneros soon devised the “National Homeownership Strategy” and launched it with much hoopla at a conference in August 1994 attended by crony capitalists and community organizers in equal numbers.

Since Uncle Sam was picking up the tab, the two sides found themselves in remarkable unanimity. In a strategy document that was embraced by both ACORN (Association of Communities for Reform Now) and the mortgage bankers, it was agreed that huge gains in home ownership could be achieved if only the inconvenience of down payments and monthly mortgage payments could be overcome! In a fit of blinding insight, the document thus noted that “the lack of cash to accumulate the required down payment and closing costs is the major impediment to purchasing a home” and that many households “do not have sufficient income available to make monthly payments.”

The answer to this roadblock was “financing strategies, fueled by the creativity and resources of the private and public sectors.” The obvious “resource” in question was the balance sheet of the GSEs, which expanded by one-half trillion dollars during the next four years.

Yet the thing which really grew was the market cap of Freddie and Fannie. By 1997 they had a combined market cap of $80 billion, and by early 2000 Wall Street was valuing the stock of the GSE twins at an astonishing $140 billion. Here was the jet fuel that ignited the final housing craze.

While the miraculous ride of the GSE stocks stirred the speculative juices on Wall Street, the real mania broke out right inside the C-suite of Freddie and Fannie. Stock options exploded in value, causing top GSE managers to become as obsessed with their stock price as the most myopic dot-com executives; and that, in turn, meant feeding Wall Street increasingly higher earnings and ever more spectacular feats of growth.

FREDDIE AND FANNIE:

PURE ECONOMIC PARASITES, ALL THE TIME

Unfortunately, the GSEs had only one route to achieve growth, and that was reaching deeper into the sludge at the bottom of the nation's potential mortgage credit pool. This dubious route to higher financial postings was, in turn, a function of the dark truth of the GSEs; namely, that they were not real businesses, nor did they contribute any value added to the US economy. Accordingly, they had no honest way to grow and couldn't possibly have been worth $140 billion, or even $14 billion, or really anything at all.

Despite their massive balance sheets and towering Wall Street valuations, the GSEs were essentially economic parasites which harvested rents by deploying the public credit of the United States at no charge from the Treasury. The smoking-gun evidence that they produced no economic value added was hidden in plain sight on their income statements: the GSEs had virtually no cost of production beyond the trivial head counts which were needed to man and maintain their data processing systems.

During fiscal 2000, for example, Fannie Mae booked $7.0 billion of interest income and guarantee fees but had only $900 million of operating expenses, resulting in 87 percent gross profit. In truth, there was nothing behind the imposing brick exterior of Fannie Mae's headquarters except a toll booth where fees were collected in return for stamping “guaranteed” (implicitly by Uncle Sam) on pools of conforming mortgages.

Based on pure accounting theory, of course, the GSEs' true cost of production was future losses, similar to any other insurance company. Every time they stamped “guaranteed” on another pool of mortgages, therefore, the GSEs should have incurred an expense for loan loss reserves. Yet during fiscal 2000 it set aside only $100 million for future losses, a trivial 1.7 percent of revenues.

It was on this obvious point that the era of bubble finance made a shambles of GSE financial reporting. Virtually from the day of the Clinton administration's August 1994 housing conference, housing prices started rising and never looked back. At the same time, the newly launched national crusade to increase home ownership pushed GSE credit quality into its relentless cycle of deterioration.

This confluence carved a toxic path into the future. On the one hand, the GSEs' historical credit loss experience became increasingly irrelevant to each year's new book of lower-quality business. At the same time, briskly rising housing prices were masking growing losses owing to continuous refinancing of delinquent mortgages.

THE MOTHER OF ALL CREDIT BUBBLES:

130 STRAIGHT MONTHS OF HOUSING PRICE GAINS

Beginning in July 1995, national housing prices rose every single month for nearly eleven years. By the midway point at the end of 2001, the Case-Shiller index was up by 60 percent, and at the final peak in May 2006 it had gained 195 percent. In short, under what was an utterly freakish financial deformation, even if it was one that the nation's monetary politburo insisted, ludicrously, could not be detected, housing prices rose at a compound rate of 11 percent for eleven consecutive years.

As a result, the true credit losses owing to the home ownership crusade were nowhere to be found in the GSE performance data. When borrowers got behind, their mortgages were simply refinanced, usually with a big enough increase in principal to re-pay the arrearage. Serial refinancings and the constant churn of the existing housing stock temporarily buried the growing GSE losses in Alan Greenspan's monetary bubble.

The tailwind of rising housing prices and negligible actual default losses enabled the GSE management teams to book exceedingly minimal reserves for future losses. Accordingly, they continued to book nearly 90 percent profit margins on a soaring volume of business. These sterling results caused their stock prices to rise by further leaps and bounds, providing powerful incentives for management to drive GSE underwriting standards still lower and mortgage volume ever higher.

Thus, in 1998 alone, the combined GSE balance sheet grew by $200 billion, or by the amount of total footings that had existed at the time of the Reagan challenge. Three years later, the GSE balance sheets expanded by nearly $400 billion, bringing their total outstanding mortgage credit exposure to $3.1 trillion. In the face of soaring volumes and virtually no charges for future losses, Freddie and Fannie were literally minting profits.

This pell-mell volume and earnings growth did wonders for the stock price of Freddie and Fannie, which in turn generated fabulous management bonuses and stock option gains: several billion dollars over the span of 1990–2002. In a financial folly that had no precedent, a housing-crazed government had thus turned over the public credit of the United States to a small cadre of GSE executives and Wall Street punters who then gorged themselves on ill-gotten windfalls.

Needless to say, when the housing price bubble peaked and reversed direction in 2006, the hidden losses buried in the GSE mortgage portfolios began to emerge—slowly at first and then with an explosive rush after mid-2008. Accordingly, the nearly $200 billion of losses recorded by Freddie and Fannie since then have wiped out all of the profits they ever booked historically, and then some.

CRONY CAPITALISM AND THE FOUNDATION OF SUBPRIME

Apart from the unearned windfalls that were bestowed on Wall Street punters, the preposterous $140 billion market cap of the GSEs had another untoward impact. It gave Freddie and Fannie so much walking-around money that there was literally no one they couldn't buy in Washington and throughout the byways of the housing-industrial-finance complex. The creation of the Fannie Mae foundation from the sale proceeds of a tiny fraction of its red-hot stock became a $350 million slush fund. It flat-out bought policy support from housing sector participants ranging from academic researchers to city councils and community organizers.

ACORN, the controversial poor people's housing advocacy organization, was virtually a wholly owned subsidiary of the Fannie Mae foundation. The foundation even nakedly invaded Capitol Hill, providing direct funding to the nonprofit arms (so-called) of the congressional black caucus and the congressional Hispanic caucus.

By the end of the 1990s the fatal nexus was in place. Through its foundation, Fannie Mae was actually funding a vast mobilization of housing advocates and cronies to bring lobbying pressure on exactly itself. The gambit was to claim it had been “forced” by political pressures to reduce its own underwriting standards and to virtually eliminate down payments.

SECRETARY CUOMO'S EXCELLENT ADVENTURES ON K STREET

At the same time, the Clinton administration's home ownership strategy had been turned into a sweeping crusade, especially after it was taken over in 1997 by HUD Secretary Andrew Cuomo. A cynical political power broker, Cuomo saw home ownership as a vehicle for liberal Democrats to lock up business support throughout the housing finance complex. More than fifty separate “national partnerships” with K Street lobby organizations were thus established to promote easier credit standards and higher home ownership rates.

These so-called public-private partnerships amounted to crony capitalism on parade. There were separate partnerships with the Appraisal Institute, the Mortgage Bankers Association, the National Association of Home Builders, the National Association of Real Estate Brokers, and many more. All of these capitalist lobbies had their oars in the water and were rowing in the direction of a statist coxswain, Secretary Andrew Cuomo, in nearly perfect rhythm.

The K Street lobbies had more in mind than the civic satisfaction of getting poor people into their own homes. What they were actually seeking was more brokerage commissions, housing starts, mortgage originations,
property appraisals, title insurance policies, etc. The route to a higher volume of business in the housing complex, however, always led back to the same place: reduced down payments and weakened underwriting standards.

Indeed, the Clinton administration's charter for this crusade was laid out in a HUD document aptly entitled
The National Homeownership Strategy: Partners in the American Dream
. The “dream” part of it was baldly evident in the hundred distinct policy actions which this document embraced. Among these were such gems as “Subsidies to Reduce Downpayment and Mortgage Costs.”

It goes without saying that a “subsidy” to reduce a “downpayment” is an oxymoron: it defeats the very purpose of home owner “skin in the game.” In fact, all of these policy actions amounted to financial dreaming because they ran smack-dab counter to the powerful underlying macroeconomic current previously identified; namely, the harsh wage deflation flowing from the “China price.”

Its corrosive impact on middle- and lower-class incomes and contribution to rising job insecurity undermined the ability of these households to shoulder the financial cost of home ownership. More broadly, these wrong-headed measures provide another poignant illustration of why crony capitalism wreaks havoc with both the free market and rational public policy.