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The Story of "The Path to Responsibility"

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The Path to Responsibility, Part I


Subprime lending, as a means for alternative home financing, has taken quite a hit. It started two years ago when the data started coming back on ARM loans - that they were going belly up faster than other loans. Which should have been no surprise, actually. These people came into their loan at one rate, only to have the rate move significantly higher later, and that pushed some borrowers beyond affordability. Kind of a no brainer that a decent percentage of folks would be stuck between the rock of relatively fixed income and the hard place of deflating / static home values.

I worked for a mortgage lender not long ago. My job was Strategy Consultant. My task was to think differently - to push innovation. The problem is that despite every innovative twist I could conjure and for which I might fashion a business case, just about every idea I proposed hit the brick wall of Fannie and Freddie. Becaue the lender was tied to the 800-lb gorilla's secondary market purchases, if these government entities didn't have room for the innovation proposed, any idea became, as I was told, "a product without a home."

One bit of my advice at that time was simple: "We're a one-crop farmer. If something happens to Fannie / Freddie, we're deeply hurt. We need to start developing secondary market channels outside of Fannie / Freddie." While my manager agreed with me, it ended there. Not that I was coughing up the solutions that would have solved or prevented the financial crisis from happening. That's not the point. The point is that the banks to which we trust our money and our financial security can't innovate or respond to the market without the approval of Fannie / Freddie. That's a weak position - a surprising stance for the expected firm ground of financial institutions. (And this is industry-wide, not just my former employer.)

It's a good thing that Fannie and Freddie will survive. But what I hope is that banks will reduce their risk in the market through such a heavy reliance on Fannie / Freddie. Guess what's become fashionable these days, instead of Fannie / Freddie? FHA lending. More government. Do we really think that is somehow more sound?

Banks - which are private entities - need to wean themselves off the government teat. When the government becomes the main vehicle for homeownership, it's a recipe for problems. Government is never efficient, with the exception of the military, because the military encounters competition all the time. Deadly competition. But government agencies? There is no competition to drive efficiency. Therefore, the government agencies / solutions will bloat and lack accountability and oversight, as happened with Fannie / Freddie.

I'll write more on this later, but I wanted to get these first thoughts out about this now...


Tags: mortgage
by Brett Rogers, 9/21/2008 12:41:44 PM



The Path to Responsibility, Part II


Why is there no private sector version of Fannie Mae? Why did Fannie Mae, a government-sponsored entity, become the big dog in home mortgages?

From Wikipedia and Mises:

Fannie Mae was founded as a government agency in 1938 as part of Franklin Delano Roosevelt's New Deal to provide liquidity to the mortgage market. For the next 30 years, Fannie Mae held a virtual monopoly on the secondary mortgage market in the United States.

In 1968, as a part of Lyndon Johnson's societal engineering agenda, Fannie was converted into a private corporation and the ability to guarantee government-issued mortgages was switched from Fannie to the federal government's newest creation, Ginnie Mae (Government National Mortgage Association). This meant that Fannie would begin to operate with private capital on a self-sustaining basis. Fannie was growing up, and she was going on to bigger and better things.

In 1970, Richard Nixon authorized Fannie Mae to purchase conventional mortgages, launching a national secondary market for home mortgages. As Fannie's foray into the conventional mortgage market began to surge upward, in the 1980s it began to purchase second mortgages and adjustable-rate mortgages, and it also commenced its mortgage-backed securities scheme.

It started out as a government-sponsored entity in the Depression, blossomed into a government-esque entity that could accept private funding while getting subsidies from the federal government. The implicit guarantee here is that the government will stand behind Fannie Mae.

I recently became a bank, myself. I loaned my money out, at $50 each to four borrowers, at an average of 18% interest for three-year terms. That sounds like an amazing rate, doesn't it? I think most people, when they hear of an 18% interest rate, think that's better than a stock return - especially since it's a locked rate for as long as the borrower pays me back.

But it's actually quite the opposite of an investment. And that 18%? It's not what it seems. Follow the math...

If I put money into an account that returns 18% anually, then my principle becomes larger with time. My $50 becomes $59 at the end of the first year, almost $70 by the end of the second year, and over $80 by the end of the third year. That's a whopping 64% return!

But if I loan it out, interest only accrues on the principle that remains, which is paid down over time. At the end of three years, my $50 only grows to become $65 when I loan it out at 18%. In three years' time, it's a 30% return. Still quite good, but only half that of an investment. That's a very distinct difference.

Nobody borrows money for a house at 18%. The going rate? For the sake of this discussion, let's say it's 6.5%. If I loaned my money out at that conventional rate, then I barely make a 10% return in three years. If inflation is a modest 3% annually, it's a wash. My money didn't grow relative to the market.

So I'll ask the question I started with: why is there no private sector version of Fannie Mae? Because at these rates, there is no real profit. No one is business would do this. It's a recipe for bankrupcy, which is why subsidies are the only way this could work for decades. It's all been a big taxpayer-subsidized smokescreen, and we're about to pay for it.

There was a way to make money on this, but the numbers still didn't add up, and I'll go into that in Part III.


by Brett Rogers, 9/22/2008 11:42:20 AM