Dec152012

The final bailout of the underwater homeowners will be from the Federal Reserve

This the final logical step of the housing bubble and the bailouts that followed.  The banking losses have slowly been transferred to the taxpayers, then from them to the Federal Reserve.   It’s been a long process and below is brief explanation the slow of transfer of losses to private banks all the way to the Federal Reserve with assistance the Federal Government over the course of five years.  We need to review a little bit to see how exactly did we reach this point and why the Federal Reserve bailout(s) will occur.trapped_underwater

A long crazy road

When the housing bubble first started to burst, the first entities to feel it were local banks or mortgage bankers like Downey Saving banks.  They were stuck with bad loans they originated, but could not package into a Mortgage Backed Security (MBS).  So, these banks were the first ones to feel losses. Just a little of ahead of the banks to feel the losses was the FDIC.  The FDIC (tax payer) started to pay larger insurance claims on deposits at banks that failed.    Well, the FDIC starting to merge troubled small banks with other small banks that were performing well and to slow down insurance payoffs. Well failures stared to hit larger and larger banks and the FDIC didn’t have resources bailout to these big banks.    Remember the bank run at Indy Mac?

The big banks have larger resources, but only to delay to bankruptcy not stop bankruptcy.   So, the Treasury Department stared merging big banks together, a strong bank with a weak bank.   WaMu was purchased by JPMorgan Chase, BofA purchased Country-wide (still paying for it), and Well Fargo purchased Wachovia.  To help sweeten the deal the Federal government created the TARP program that loaned money to these merged banks.  It was the first real direct big government bailout of the banks since 1930’s and the S&L of the 1980’s.  These loans were given to many banks and it made huge news in the day.  What was less know is the change in the mark to market accounting that allow banks bypass the fair market value accounting and keep the book value of mortgage, even it was in default or underwater.  Now banks could delay their loss reporting more importantly carry a bad asset on the books without reporting a loss.    However, it wasn’t the biggest bailout, but it was the one that made most news.

As more of these home loans failed, there were two government sponsored enterprises called Freddie Mac and Fannie Mae that started also having losses.  These agencies package loans called mortgage backed securities (MBS) from banks and sold them on the secondary market with federal guarantee on the MBS in case of major defaults.   So many loans were defaulting and losses increasing, the federal government did a outright multi-hundred billion dollar take over of Fannie Mae and Freddie Mac.  It purchased 79.9% in each agency and also did a cash infusion.  This event slowly transferred losses from banks and mortgage banks to directly to taxpayers.  In fact, their assets and liabilities should be booked on the US balances sheets because taxpayers are on the hook for losses .  The federal government now owns the secondary mortgage market.  The private mortgage industry never recovered as 90% of the mortgages passed through and guaranteed by these agencies.  However, it’s not fair to just to single out the banks.

There have several Federal Acts gave a tax credit to push home sales or acts for tax forgiveness on the discharge of debt to individual tax payers.  In 2010, if you purchased a home, the buyer was given tax credit as failed attempt to stop the housing bust.  Once the tax credit expired, sales dropped off and it was only temporary up swing in home sales.  In fact, if you purchased with a FHA loan the tax credit probably covered the downpayment for the loan.  But the key handout was the The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence or debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure  This allowed homeowners to walk away from the loan without the forgiven debt taxed as income.  However, the main the focus of the bailouts still occur in the mortgage market.

As the secondary market consolidated in Fannie Mae and Freddie it allows even more far reaching programs in conjunction with the Federal Reserve.  The Federal Reserve set the cost of borrowing to zero percent interest rate.  This sent mortgage rates down along with Certificate of Deposits rates.  Fannie and Freddie then used this opportunity start a loan modification program and principal reduction program called HAMP and HARP respectively.  The goal to is modify existing loans in fixed lower rates or even principal reductions some cases.  These programs failed to get number of homeowners to into permanent modifications.  There is one federal government that has been successful in generating new lending and up to 30% of the market share in new loans.

FHA was a program to assist first to time home buyers to purchase lower income homes.  However,  the scope of it’s business expanded to include middle to high middle income homes.  In addition, buyers could be eligible for another FHA loan after 5 years of ownership in your current house.  FHA was greatly expanded and it assumed the subprime mortgage role no longer present in the private mortgage industry. This new subprime role caused delinquencies to increase to 17% of all FHA loans.   As of this writing will be an FHA bailout and further insurance premium increases in 2013.

But it was the Federal Reserve QE program that tied it altogether.   The Fed prints money and then uses to purchase loans on the secondary market by Fannie, Freddie, and Ginnie Mae (FHA).  The Fed has comes in with so much cash that it has pushed down the mortgage rates, which also encourages underwater borrowers (and borrowers with equity) to refinance in the HARP and HAMP programs.   What has resulted is the Fed is now the investor 95% of new loans and the now the investor in refinanced loans, many of which are underwater.  The Fed has taken over whole mortgage industry.  Loans are originated by banks (using overnight loans with the Federal reserve); then they are package by Fannie, Freddie, and Ginnie all with federal guarantees; and then purchase in vast quantities in MBs by the Federal Reserve.  These MBS are no longer owned by mutual funds, banks, insurance pools, or pension systems; its being transfer the Federal Reserve and it wants to own $4 trillion mortgages by end of 2013.  Banks mortgage functions are now down to originate loans and then service the debt.

And now principal reduction

Now that a greater number of loan are owned by the Federal Reserve the easier the  principal process  since private banks won’t be included.  The loans are owned by the Federal Reserve.  The money that used to purchase loans was printed out of thin air.  The loans were packaged by Fannie, Freddie, and Ginnie and have federal guarantees.  There will be no tax money involved just the phoney fed money.  This I think this will be order of events that will start the Federal Reserve bailout.

The federal government will push for principal reductions via the new FHFA head through a third round of the HAMP and HARP programs.  When loanowner defaults on their loan or loan modification, the GSEs and FHA will cross check to see who is the investor of the loan.  If it’s the Federal Reserve you will get a principal reduction.  There wouldn’t be a payout of the guarantee fee, somehow it will be waved, then again why pay guarantee fee  when investor is basically yourself.  Word will get out, maybe even promoted by FHFA, and every loanowner that has negative equity will default on their loan to get a principal reduction.  Too far fetch…President Obama wanted to use FHA to modify non Freddie and Fannie loans that were underwater.  That would put almost negative equity loans under the federal guarantee.   This is the just the short term affects, the long term affect are much worse.

The long term affects is that it kills the idea of personal responsibility and opens the Pandora box of moral hazard to the nth degree.  You have huge swing in home prices in every business cycle and homeowners defaulting every time there is drop in home values.   This type of mortgage industry will require constant federal bailouts, loan modifications, and all the other associated programs.  You fact, you can’t have private mortgage industry that operates like a consumer debt industry without having consumer debt interest rates.  The purpose of the all this intervention is too keep rates low and home values high to bailout the banks.  This will ensure for foreseeable future there won’t be a private mortgage industry.