Issue 68 - March 03, 2011


What Ever Happened to Housing?

In the wake of the flood of high profile news stories bombarding investors in the first two plus months of 2011, housing related articles are now relegated well below the fold. It is no wonder. Forecasts since the fall of 2008 of a bottom in housing have each been met with yet another round of weakness. The problems that vex the housing market are deeply structural. Calls for a rebound this year or next project wishful thinking. They also show a lack of understanding of the mechanics of both mortgage finance and supply and demand. Before anyone should start calling for a bottom, let alone a rebound, there needs to be an honest debate about the future of home loan lending and the disposition of the two major government agencies, Freddie Mac and Fannie Mae.

Where Do Loans Come From?

The evolution in residential real estate lending is an interesting story, up until the point where it went entirely off the rails in the mid 2000’s. It is also critical to understand those advances that made for a successful market place as well as those that ultimately brought about its demise.

Fannie Mae was chartered in 1938 as part of the New Deal in an effort to inject Federal money into local banks so that they could provide more capital for home lending. Recall that up until even the mid 1980’s there was no such thing as interstate banking. Banks were an entirely local affair. They could make either home or business loans so far as their capital took them and not a heck of lot farther. There was no broad based secondary market to sell their home loans; the only buyer was Fannie Mae. While this reality certainly sharpened underwriting criteria, it also provided a strong governor on the pace and expansion of credit. In 1954, the ownership structure of Fannie Mae was converted to a public-private corporation and in 1968 it was fully converted to a publicly traded US corporation. In 1970, Freddie Mac was chartered to provide further liquidity to the secondary mortgage market. The world of mortgage loans was forever changed in 1981 with the advent of the first agency based mortgage backed security.

Where Do Loans Go?

The process of securitization was truly a financial innovation. A local bank could now use their capital to underwrite a local home loan according to specific guidelines prescribed by Freddie or Fannie. Combined with all supporting documentation these loans could be sold to the agencies which could then pool them together according to common characteristics such as loan rate, geography, or principal balance. These combined pools would then be sold as securities to an institutional community hungry for high quality fixed income assets. Our local bank having sold a well underwritten home loan would have the proceeds to go and repeat the process over and over again, dramatically increasing the capital available even on a local level for home ownership. Securitization was the innovation that made national capital available to individual home buyers. There was nothing nefarious about the process. It created a marketplace that matched providers of capital with the users on an unprecedented scale.

The Last Straw

How could a straightforward process like underwriting individual home loans and securitization lead to so much financial hardship? It wasn’t easy; it took some time, and there were very few sympathetic characters involved.

While there are certainly many factors that conspired to upend the residential real estate market, let us suggest three main culprits: The Community Reinvestment Act, the public ownership structure of Freddie and Fannie, and the structured mortgage finance product known as the CDO.

In 1977, congress passed what was known as the Community Reinvestment Act. Broadly speaking, the premise was to encourage lending in local communities, specifically those with lower incomes or that had been subject to past discriminatory behaviors. Banks were thus required to provide a percentage of their lending to their local communities as a condition of maintaining their charter. This act was revised over subsequent congresses to further require ever more targeted local, low income lending.

The fact that both Freddie and Fannie were publicly traded companies always presented a huge risk of a potential nasty moral hazard. Shareholders always desire the maximum growth in earnings possible. Having the well understood potential backstop of the US Government meant that traditional market discipline would not necessarily be as effective as in normal circumstances. This is of course a major understatement. Freddie and Fannie may have approached as much as 100 times leverage at the zenith of the market as they absorbed a torrent of loans.

The other key to understanding where the process went wrong is to recognize that all bonds are made up of simple cash flows. Mortgage backed bonds have an additional feature of monthly payments of both principal and interest. These cash flows could be modeled and sold off in their component pieces. Investors who might prefer to receive the more predictable monthly income piece could have that, while others could receive the less predictable payments made up of principal and prepayments. The process of slicing and dicing up the cash flows of pools of mortgages was well underway by the late 1980’s.

These three factors remained in place for many years without remarkable incident. The moral hazard of a publicly traded company charged with a mandate of promoting home ownership was held in check by rigorous underwriting. The sub prime market did not appear out of thin air in 2004. Lower quality loans had been part of the market for some time, thanks in part to the CRA, featuring fairly predictable loan losses of around 7%; about twice the market average. There was a market for these loans, albeit not a large market. These early sub prime loans were purchased by sophisticated institutional investors who could model and analyze the risk return profile of each transaction.

The innovative straw that broke the mortgage market’s back began back in the mid 1990’s with the advent of the Collateralized Debt Obligation or CDO. In the CDO, cash flows could be “tranched” into senior and subordinated layers. The buyers of the lower layers of the security would be the first to absorb the losses and so on as you traveled up the capital structure. In this way, you could even stack together a series of sub prime loans and (in theory) have the top layer of the security be AAA rated due to the subordination rather than the intrinsic value of that loan. Talk about silk from a sow’s ear!

In the early 2000’s the perfect storm began to form.

Ultra low interest rates mandated by the Federal Reserve in response to the bursting of the technology bubble and the coincident recession drove demand for housing. Congress in an effort to promote ever higher levels of home ownership required more lending to those who had previously been unable to qualify and shareholders of Freddie and Fannie were delighted to see their investments reflect the strength of the housing market. Wall Street provided the alchemy in the form of CDO’s whereby they could supply almost a limitless supply of subprime lending money as these loans could now be “structured” into AAA securities. Strict underwriting standards quickly became a thing of the past and the outcome in hindsight should have been obvious.

The Path Forward

The residential real estate market is now facing the biggest challenges of the modern era. The supply of homes in foreclosure exceeds two million. The supply of homes which are greater than 90 days delinquent exceeds an additional two million. This is in addition to what now passes for normal supply of unsold homes. We know that 40% or more of current mortgage payers can not refinance due to insufficient credit scores or more importantly a lack of home equity. This has become the classic chicken and egg problem and the market has entered a downward equity spiral which needs to be arrested. There is a strong desire in Washington DC to wind down Freddie and Fannie and to see the banks have more “skin” in the residential lending cycle. These are both admirable goals but they are fraught with practical realities. There is simply no where near enough capital in the private markets to replace the agencies’ role in single family lending which now stands at 90%+. Even if there were sufficient funds, asking banks to retain or hold back even a small percentage of their underwritten loans would dramatically raise the cost of credit for everyone including the very best credits in the market. Further complicating matters is the state of the economy and what now appears to be a persistently high level of underemployment.


In our November Newsletter we included a section which we entitled “Dear Mr. President”. In it we argued for a program for those homeowners who are current on their loans but lack sufficient equity to tap the private market for a refinanced loan. If they could be offered a lower rate with the same monthly payment terms they would be able to dramatically shorten the term of their loan and more importantly build desperately needed equity in a much quicker time frame. Not to be flippant, but this strikes us as one of the easiest and most powerful remedies. We have just spent the better part of 4 months stoking the stock market through the Federal Reserve’s QE2 program. Consider the exponential staying power of using those dollars to stabilize a large swath of homeowners and the downstream results that could be expected.

Clearing Mechanism

To state the obvious – we have to get through the foreclosure inventory. It is not realistic to expect the current level of foreclosed homes or those in the queue to be absorbed by an economy with 15%+ underemployment and with an impaired credit process. We also know, from experience, the credit pipeline will not improve until the banks clear their balance sheets and there is very little incentive for the banks to clear their balance sheets while accounting standards don’t require a mark to market. For those who worry about what the impact of “dumping” the foreclosed homes on the market – consider what we are now suffering through. It is NO secret that these houses are all going to come on the market at some time. The sooner we find clearing prices the sooner we can begin rebuilding equity. Private capital could play a significant role in helping through this process, provided prices reflect the total inventory situation. Multifamily investing, aka apartments, has seen a renaissance as private pools of capital have been strong buyers of apartments and what were once unsold condominiums. Given the impaired nature of individual credit, the vast majority of the foreclosed homes are going to have to go the way of the condo and become rentals. There is ever reason to believe that there could develop a strong market of home rentals and one that will be reinforced by both the current and potential future requirements for down payments.

Restart Your Securitization Engines

Securitization has become the whipping boy of the real estate crisis and this strikes us as unfair and also unwise. The packaging of well underwritten loans was a sound financial innovation. The packaging of what were effectively fraudulent loans into AAA securities was a travesty. Without securitization, credit will remain at the trickle pace we see now. Consider our “Dear Mr. President” program; these loans could be securitized with the Federal Reserve holding a subordinated interest if such was required. Packages of foreclosed homes could be sold ala an apartment “building” and there is certainly enough inventory to justify a marketplace for loans made in this regard.

There is certainly a path forward for residential housing, but it will most definitely look different than the path we have traveled. It will require innovative solutions but that has always been the capital markets strongest suit. The sooner we move forward the better, as the current system is both stagnating and destructive.

Best Wishes –

Jen & Patsy


In this Edition

  • What Ever Happened to Housing?
  • Where Do Loans Come From?
  • Where Do Loans Go?
  • The Last Straw
  • The Path Forward
  • Equity
  • Clearing Mechanism
  • Restart Your Securitization Engines

Huntington Steele

925 4th Avenue
Suite 3700
Seattle, WA 98104



Past Issues

67 - 01.10.11
Curiosity of the Federal Reserve/ Complacency & Fragility

66 - 11.12.10
Phew/ Taxes and Employment/ Quantitative Easing Returns/ Incentives & Unintended Consequences/ Dear Mr. President

65 - 09.28.10
Progress in the Absence of Milestones/ Changing Nature/ Correlations & Valuations/ Synthetic Securities

64 - 08.18.10
A Tricky Diagnosis/ Traditional Treatment/ Bad Medicine/ New Age Medicine/ Homeowners/ The Banks/ Pension Plans/ Bull Flattening

63 - 06.17.10
Hip & Groovy/ The Trouble with Zombies

62 - 05.24.10
Next Sequel/ 2012

61 - 05.04.10
Intensity/ Principles versus Rules

60 - 04.01.10
Grand Isle to Lincoln
/ Mile Post 312/ Mile Post 353/ Mile Post 399/ P.I.G.S. are a Problem

59 - 02.17.10
Surprise, Surprise, Surprise/ P.I.G.S. Matter/ Leverage vs. Debt/ Going Forward

58 - 12.29.09
2009-The Year in Review/ 2010 - The Year of "The Exit"/ Deflation or Inflation?/ 4 Cylinder Economy/ Rates and Returns

57 - 11.04.09
Banks-Back to the Future/ Navigating the Tsunami/ TARP 3.0/ Implications

56 - 09.15.09
Are We There Yet?/ The Beginning? The Present/ The Journey is the Destination

55 - 08.04.09
A Transformation is not a Recovery/Not All Economic Data is Created Equal/
Smallest, Lowest, "Shortest"

54 - 06.24.09
Aftershocks/ Fragility/
Inflation and the Fed

53 - 05.29.09
A Brave New Road to Recovery/ Vehicle Choice/ Speed Limits

52 - 04.07.09
The Things We Know/The Things We Don't Know/Savings and Sensibility

51 - 03.25.09
The Correct Problem/ The Need for Speed/ No Good Deed Goes Unpunished

50 - 03.05.09
Rebuilding Credit/ Under Repair/Problems Persist/Big Chore

49 - 01.12.09
The Year in Review/ The Path Forward/ 2009

48 - 12.15.08
An Old Fashioned Swindle/ Who,What, Why, & How/ The Lure/ Getting Back to Fundamentals

47 - 12.05.08
Unwinding/ The Past/ The Present/ The Future.

46 - 10.07.08
History/ Changing Hands/ Dominos/ The Road Block.

45 - 07.02.08
Black Gold/ The Federal Reserve, The Banks, & The Earnings/ Moving Forward/ The Recovery

44 - 06.03.08
Shallow Waters/ Odds and Evens/ Changing Times

43 - 04.09.08
Q1 2008/ The Call/ The Response/
Investing Opportunities

42 - 02.27.08
Credit Hangover/ Busy Banks and Brokers/ Insurance Cleanup
Risk vs Reward

41 - 01.02.08
2007-Year in Review
2008 - Outlook



More Past Issues
can be found in our

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Market Highlights



12/31/10 12/31/09 12/31/08 12/31/07 12/29/06 12/30/05 12/31/04
11,578 10,428
S&P 500 US


1,258 1,115


Nasdaq US
2,653 2,269
EAFE Int'l Equity
1,658 1,581


5 Yr Treasury 2.14 2.02 2.71
5 Yr AAA Muni 1.81 1.75


10 Yr Treasury
3.38 3.92
10 Yr AAA Muni
3.44 3.26
30 Yr Treasury 4.49 4.325
30 Yr AAA Muni 4.74 4.9
EUR Currency 1.38 1.34
JPY Currency 81.80 81.32


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