Back to www.stopthebailout.org
August 30, 2007

Freddie Mac's Profit Down 45% on Bad Loans
Is Congress Really Going to Ask Freddie to Buy MORE Bad Loans?

    Freddie Mac's profit fell 45% in the second quarter due to "unanticipated" losses on bad loans exceeding its $320 million set aside for losses.  Shares dropped $2.85 to $60.40 -- a loss of 4.5%.  More information can be found here: http://www.smartmoney.com/bn/ON/index.cfm?story=ON-20070830-000867-1210.

    Charles Schumer, Chris Dodd, and now Bill Gross all want the Feds to lift the restrictions on Fannie and Freddie and use them to buy up all of the bad loans that no one else wants to buy so that when those loans go delinquent, the United States government will foot the bill.  This is totally and completely different than the Savings and Loan debacle.  In that bailout, the US Government had legal liability for many losses because it insured deposits at the Savings and Loan institutions.  The Reagan Administration spearheaded deregulation of the S&Ls to allow them to invest in all sorts of things that had previously been prohibited.  Congress retained regulatory authority over the S&Ls because of FDIC insurance.  Here, the bad loans rotting all over the financial markets are in no way related to FDIC insured deposits.  The Federal Government bears absolutely no responsibility for the losses of private investors who bought bonds created out of zero down $750,000 loans given to illegal aliens working as delivery drivers.  Those investors expected a high rate of return on those loans and that's why they took the risk.

    The Federal Deposit Insurance Corporation (FDIC) was created during the Great Depression to insure deposits up to $100,000 per depositor, per institution.  So in many cases, joint accounts held by spouses can be insured up to $200,000 per institution.  The deal is like this, member banks pay a little into FDIC and agree to submit to its regulations in return for being able to display a sign on the door (or website) that reads "FDIC insured."  FDIC may seem quaint and perhaps unnecessary to the go-go credit driven economy of the post-millennium, but I assure you, it is not.  The recent run on Countrywide Bank could have gotten much, much worse if it weren't for the good feelings of security FDIC insurance brings.

    During the S&L crisis, mortgage finance worked much differently.  S&L institutions made loans and kept them on the books.  They didn't sell them to anyone.  They collected principal and interest and were therefore highly concerned whether the borrower would pay back the loan.  This meant personal interviews with loan applicants, a thorough review of documented income, debt, and employment.  The S&Ls like all banks before them funded their loans using depositor's money.  The banking game used to work like this -- depositor A deposits $100,000 at the bank and the bank pays him 4% interest and then loans out $100,000 of depositor A's money to borrower A at 8.5% making a profit of 4.5% on that money.  Reserve requirements for deposits of less than $100,000 are currently ZERO so that means banks can lend out every last dollar you deposit.  If there's a shortfall because borrowers withdraw money, the bank can borrow against the collateral of its outstanding loans from another bank to get the money it needs to return money to depositors who want their money.

    The post-S&L revolution in mortgage finance occurred when large investment banks like Goldman Sachs, Bear Sterns, Lehman Brothers, Morgan Stanley and many others began the business of pooling thousands of mortgages and then dividing them into "tranches" or sub-pools based on the risk of loss -- the riskiest tranches were the first to lose principal should the fund suffer losses from borrower defaults, the safest tranches were the last to lose principal.  The investments are not insured by anyone, just like investments in stocks, bonds, and many other investments are not insured by anyone.

    The problem resulted when the parties with knowledge about borrowers' likelihood of repaying loans began committing what can only be described as fraud.  The mortgage brokers, real estate agents, banks and investment banks packaging the loans had to know that they were package toxic sludge.  The goal was to close as many people in the largest loans possible.  If there weren't enough people buying, the they could get everyone in the country to refinance into dangerous loans with terms that made them near impossible to pay off.  The media isn't reporting that almost 90% of subprime loans were for refinancing and not purchase money mortgages.  That's highly significant because subprime is touted in the media as a "necessary evil" because it allowed poor people to own homes and was responsible for the 4% increase in homeownership over the past ten years.  That is a blatant lie.  10% of subprime lending increased homeownership by 4% and would not have been near enough to cause the credit market tumult we're suffering now.  The vast majority of subprime loans were designed to trick ordinary homeowners into taking on high risk loans that could be sold on the secondary market to investors for very high profits.

    The majority of homeowners who refinanced into subprime loans to "extract equity" were foolish to borrow against their homes for remodeling, new cars, vacations, and all sorts of unsustainable consumption.  But the media served as enabler.  Every evening news show and most economic commentators noted that "refinancing your revolving debt now to these ultra low interest rates makes great sense!"  They said it made sense for two reasons: (1) the debt could be held at a far lower interest rate as a home equity loan than as a car loan, credit card loans, etc., and (2) as a mortgage loan, the interest could be deducted from income -- a tax benefit unavailable for car loans, credit card loans, etc.  These benefits are true, but the harm outweighs them.  The harm is that (1) the lender can now take your home if you fail to pay for any reason, where before they had no right to do that, and (2) no matter how low the interest rate, financing the present consumption of depreciating commodities over thirty years is extremely unwise.  For example, you can only finance a car over thirty years so many times over thirty years.  A car may last five years if driven the number of miles commuting that the average man drives.  Financing a car using a home equity line of credit, or a cash out refinance means that when the car's useful life is over, the loan payments will remain for twenty five additional years.  Also, the total amount of interest you pay over such a long term is much more than you would pay with a far higher interest rate over a shorter loan term.  For example, a $30,000 car financed with a 2nd mortgage loan at 4% over 30 years results in the payment of $21,560.85 of interest -- almost the price of the car.  The same car loan over five years even at the stunning interest rate of 10% results in only $8,244.68 paid in interest, and a more normal car loan interest rate of 7.5% results in a more modest $6,068.31 paid in interest -- just more than 25% of the interest paid at 4% over 30 years.

    Television news talking heads focused on the big benefits of lower payments and suggested that they resulted from lower interest rates obtained through mortgage financing used to finance other purchases.  But the reason the payments were lower is because they were spread out over such a very long term and this dramatically increased the total amount of interest paid even thought the rate was lower.

    Fannie Mae and Freddie Mac are in store for all sorts of unpleasant surprises.  Both entities have significant accounting problems.  Fannie Mae's chief executive resigned in disgrace as allegations of fraud arose and Fannie has been unable to provide accurate accounting and SEC filings for a year.  It still is unable to reveal the extent of the lies on its own balance sheet -- and they may be very significant.  Furthermore, as defaults increase in subprime, Alt-A, and prime sectors, and as home prices decrease, Fannie and Freddie are going to have a lot of trouble staying solvent without taking on new debt.  Fannie and Freddie may already require a bailout without any new borrowing at all.  Congress, the lenders and the Fed would probably like to see their banker friends get to unload huge piles of bad loans that no one will ever collect on to Fannie and Freddie at top dollar and then when Fannie and Freddie head for bankruptcy, the same people will call for a bailout to "help America."

Don't you buy it.