The Free Market 19, no. 5 (May 2001)
In the parlance of finance, liquidity refers to the readiness that an asset can be converted to cash without a significant loss in value. Examples of liquid assets include money market shares, US Treasury bills, and bank deposits. Throughout most of American history, the most liquid financial instruments have been those markets dealing in federal government debt instruments.
Next to government debt in terms of liquidity is the swollen market for residential mortgages. As author Charles Morris observed in his book, Money, Greed, and Risk, “Measured by volume, the second most important American financial instrument over the past half century, by a wide margin, has been the lowly residential mortgage.
“In 1996, the outstanding value of residential mortgages was about $3.8 trillion, a number not much less than the value of the federal debt in the hands of the public, and some two and a half times bigger than the value of outstanding corporate bonds.” The value of outstanding mortgages currently is in the neighborhood of $5.5 trillion.
How did this massive amount of debt come to be? The primary culprits of this expansion of credit have been the Government-Sponsored Enterprises (GSEs), specifically Fannie Mae and Freddie Mac, the largest mortgage lenders in the country. Grant’s Interest Rate Observer notes that in the last three and one-half years, Fannie Mae’s mortgage assets alone (which include mortgages and mortgage-backed securities) have grown from $800 billion to $1.2 trillion.
The basic thesis here is that this credit expansion is an unnatural one fueled by federal intervention and that consequences to underpricing the risks of mortgage lending are being overlooked during this time of prosperity.
Indeed, it can’t seem to get any better for the GSEs. In what was otherwise a tough market for US equities, Fannie Mae (NYSE: FNM) shares increased 39 percent during 2000. Freddie Mac (NYSE: FRE) shares did even better, with a 46 percent increase. Credit losses are at historically low levels. Gene Spencer, vice president of investor relations for Fannie Mae, was quoted in Grant’s as saying, “Credit risk is not a real issue for us at this point.”
The old cliché about being unable to improve upon perfection is applicable here. For Fannie, and for Freddie, it can only get less perfect. Unless the economics of credit-induced booms no longer apply, the current mortgage bubble is bound to burst at some point.
The standard form of the American mortgage owes its existence to government intervention. Mortgages averaged six years or so prior to the intervention of the 1930s. Even as late as the 1950s, the saving habits of Americans had not yet been destroyed and debt had not yet become an entitlement. In 1950, fewer than half of American homes had outstanding mortgages. And of those that did, the average loan represented only 36 percent of the value of the home.
The long-tailed, highly leveraged mortgages of today were first created by various government efforts. (For more on this, the welfare state of American credit, see James Grant’s book, Money of the Mind: Borrowing and Lending from the Civil War to Michael Milken.)
Encouraging home ownership has always seemed to occupy a special place in the hearts of government planners. The federally chartered and federally insured S&L industry owed its existence to New Deal legislation. Mortgages themselves, however, were not liquid assets. There was no secondary market for mortgages as there is now.
New Dealers recognized that without a secondary market for mortgages, lending would stop once an S&L had lent up to the limit of its current deposits. To get around that limitation, they created the Federal National Mortgage Association (Fannie Mae), whose mission it was to create this secondary market for mortgages. In other words, replenish the S&Ls by purchasing mortgages from them and giving them cash. In this way, the lending boom could continue.
Freddie Mac was created in 1970 when mortgage growth slowed. Like Fannie Mae, Freddie Mac is supposed to be a private corporation operating under government supervision. Ginnie Mae, too, was created in 1970, but unlike the other two giants, Ginnie is a government agency that explicitly carries the guarantee of the federal government.
The lending boom of today is undoubtedly fueled by special advantages enjoyed by the GSEs. The first and most well-known is that the GSEs enjoy the implicit guarantee of the federal government. It is widely thought that Congress would never allow its federally chartered darlings to default on their obligations. This perceived guarantee allows the GSEs to borrow money at cheaper rates than a true freestanding company would be able to.
Less well-known, the GSEs enjoy subsidies. (See “Freddie, Fannie Subsidies Up Sharply, Lawmaker Says” by Kathleen Day and Sandra Fleisman in the January 5, 2001 Washington Post.) The Post reported that Fannie Mae and Freddie Mac receive about $10 billion per year in federal subsidies. The GSEs are exempt from state and local income taxes, and they do not have to file financial information with the SEC. These subsidies have come under fire recently because competitors such as Citigroup and GE Capital say that it gives the GSEs an unfair advantage.
Thus, the capital markets are distorted with more money flowing into mortgages than otherwise would be without the guarantee. It is probable that without the guarantee, the secondary market for mortgages would shrink and the yields demanded by holders of these securities would rise. But with the guarantee, investors are willing to take a little less since the credit risk seemingly has been eliminated.
Lenders take less, too, because they know that these assets can be sold to the GSEs with relative ease. Then the lenders earn their fees and get their cash back from the GSEs so they can lend again.
Since the lender no longer needs to hold these securities, the lender can take risks that might not otherwise be taken--hence, lower down payments and higher leverage. The marginal house is built. The marginal borrower is satisfied. The home-building industry enjoys the prosperity.
So the government’s implicit guarantee has set in motion a credit boom by underpricing, or subsidizing, the risks of mortgage lending. But all credit-induced booms eventually meet their end, and so, too, will the mortgage boom end in ruin.
Home prices cannot continue to rise forever. Once prices fall, many homeowners will find themselves under water. A decline in price of only 5 percent will wipe out the equity in a $100,000 home purchased with a $95,000 mortgage. Such wealth destruction will not pass without some repercussions across the economy.
Governments far prefer rising prices to falling ones. It is easier for them to water down the purchasing power of the dollar by inflating the currency than it is to live by the long-standing fiscal rules abided by most private individuals and corporations.
Thus, nominal prices may rise, showing the homeowner an illusory gain--which, of course, he must pay taxes on when he sells. In this scenario, the holders of the debt will be left holding the bag, so to speak. The largest holders of mortgage debt are currently the GSEs and investors of their securities. The GSEs, assuming that Congress will not allow them to default on their debts, are really a façade behind which stands the much-abused American taxpayer.
Worse, the mortgage boom has taken place in the context of a much larger credit bubble. Doug Nolan, financial markets strategist for The Prudent Bear Fund, recently dubbed the illusory nature of late-1990s prosperity as “the seductive manifestations of this historic credit bubble.” He recounts the “surge in issuance of asset-backed commercial paper, unprecedented expansion in money market fund assets, and ballooning Government-Sponsored Enterprises.”
When it will all end is anybody’s guess, but falling stock prices may be just the beginning. What should be done is to stop inflating. The GSEs should be cut loose. Government should get out of the picture altogether. The inflationary boom will end abruptly. However, as Rothbard pointed out in his essay, “Economic Depressions: Their Cause and Cure,” “The longer the government waits for this, the worse the necessary adjustments will have to be.”
Christopher Mayer is a commercial lender for Provident Bank in the suburbs of Washington, DC.
