Nov122012

Obama’s second term: Will he reduce housing subsidies or reflate the housing bubble?

The current real estate market is the most heavily subsidized and manipulated in US History. More than 90% of loans used to buy real estate in the US carry direct government guarantees. The federal reserve embarked on an unprecedented policy of buying mortgage-backed securities to artificially lower mortgage interest rates on the government-backed loans. Add to that the manipulation of the market by the banking cartel which engineered a 60% reduction in available housing inventory, and it becomes obvious that we navigate a housing market which has little or no semblance to a free market.

In Barack Obama’s second term, he can guide policymakers in one of two directions. Either he seeks to reduce the government’s manipulation of the housing market, or he moves forward with the reflation of the housing bubble. Some proceed under the delusion that Dodd-Frank will somehow protect us from reflating another housing bubble, but there is nothing in that law that addressed the underlying problems. Even the most tepid attempt at reform, forcing loan originators to retain 5% of the risk on their own balance sheets, is met with howls of protest from a lending industry that wants to underwrite all manner of ill-conceived loans and pass that risk on to the US taxpayer. If Obama does not work to reduce housing subsidies and taxpayer exposure, as the recovery continues, lobbyists for the lending industry will roll back the few protections still in place, and we will inflate another housing bubble — but this time, after lenders rape the economy for profits during reflation, the US taxpayer will be completely liable for the losses when the Ponzi scheme finally blows up.

Of course, Obama has other options. He could encourage lawmakers to enact a strict interpretation of the “qualified residential mortgage.” This definition is important because loans that conform to this standard are eligible for government backing, and lenders do not have to retain any of the risk on their own balance sheets. Obviously, lender lobbyists are trying to get this definition to be as loose as possible to pass as much risk as they can onto the US taxpayer.

Obama could also roll back the conforming limit to its pre-bust levels of $417,000 or less across the country. Right now, here in Coastal California, the conforming limit is $625,000. This is an enormous subsidy to high wage earners who don’t need the help. If the conforming limit were lowered back to $417,000, private lending would step into the void left by the government. If prices continue their recovery, private lending will not fear excessive losses from a declining market, and they will make these loans.

Of course, private lending without the government guarantee will be more expensive. Investors in mortgage-backed securities with government backing have no risk of loss, so they will pay more for those securities, which keeps mortgage rates very low. Low mortgage rates helps prices move higher thus helping the banks recover their capital from the foolish bubble-era loans. Removing the government backing by lowering the conforming limit will cause investors to be more cautious because they will have risk of loss. As a result, these investors will pay less for mortgage-backed securities, and mortgage interest rates will rise. Rising interest rates will harm the recovery making it more difficult for lenders to recover their capital from their bad loans.

The inevitability of rising interest rates with the return of private lending necessitates a gradual approach. If Obama is committed to reducing the government’s footprint — which I hope he is — he would act to lower the conforming limit slowly over time to prevent a major disruption in lending that might push house prices lower once again.

Another option Obama has is to re-regulate the banks. Dodd-Frank does not address the biggest regulatory favor the banks received during the crash, the relaxation of mark-to-market accounting rules. At some point, lenders must return to an accounting system based in reality. The shadow inventory phenomenon is a direct bi-product of the relaxation of mark-to-market accounting rules. If banks were required to report these loans at their true resale values, they would no longer meet their capitalization requirements, and they would be exposed as insolvent. This would force bank regulators to step in, fire the management, and either sell the bank to a competitor or liquidate its assets — which is what should have happened to thousands of banks in 2008.

(Iceland’s Rock Bottom Approach to Debt Crisis: Let the Banks Fail)

Eventually, mark-to-market accounting will return. Regulators are waiting for the banks to reach a point of solvency where the return of proper standards won’t wipe out our banking system. All the struggling banks today are working under an unstated deadline to get their books in order. Those that don’t pull it off will become casualties of the next wave of bank consolidations likely to occur when banks are no longer allowed to run under the emergency measures that have been in place for the last five years now.

For Obama, Housing Policy Presents Second-Term Headaches

By PETER EAVIS — November 8, 2012

… as President Obama’s first administration comes to an end, the government is still deeply embedded in the mortgage market. In the third quarter, various government entities backstopped 92 percent of all new residential mortgages, according to Inside Mortgage Finance, a publication that focuses on the home loan industry.Mr. Obama’s economic team has consistently said it wants the housing market to work without significant government support. But it has taken few actual steps to advance that idea. …

Prices were falling from the day Obama got elected until the spring of 2012. It was very unlikely any substantive reform was going to take place until after prices stabilized because any pullback in government guarantees would cause prices to fall farther and longer.

Housing policy is hard to tackle because so many people have benefited from the status quo.

And the longer we wait, the harder it will be to change.

The entire real estate system — the banks, the agents, the home buyers — all depend on a market that provides fixed-rate, 30-year mortgages … And any effort to overhaul housing and the mortgage market could eventually reduce the amount of such mortgages in the country, angering many and creating a political firestorm.

In other words, the best person to fundamentally change how housing works may be a president who won’t be running for office again.

I always hold out hope that a second term president will do something bold and meaningful, but I have been consistently disappointed. Most second-term presidents become concerned with their legacy, and since they aren’t facing reelection and the rest of Congress is, Congressional leaders become increasingly unwilling to accommodate the president. Add to that, the mid-term elections for second-term presidents are nearly always brutal to the president’s political party, a president’s second term is usually one of decreasing influence and effectiveness.

Most immediately, the housing market has to be strong enough to deal with a government pullback. Some analysts think it’s ready. “I think the housing recovery is far enough along that they can start winding down Fannie and Freddie,” said Phillip L. Swagel at the University of Maryland’s School of Public Policy, who served as assistant secretary for economic policy under Treasury Secretary Henry M. Paulson Jr.

DiMarco is decried by politicians on both sides of the aisle, but he has done a great job of liquidating most of the GSEs portfolios. The GSEs have a small fraction of the assets today than they did four years ago. Unfortunately, their liabilities through their loan guarantees are still enormous.

The administration can take smaller steps first. Mr. Lawler, the housing economist, thinks the government could start to reduce the maximum amount that it will guarantee for Fannie and Freddie loans. In some areas, like parts of the Northeast and California, it is as high as $625,000. Before the financial crisis, it was essentially capped at $417,000.

The big question is whether the private sector — banks and investors that buy bonds backed with mortgages — will pick up the slack when the government eases out of the market. If they don’t, the supply of mortgages could fall and house prices could weaken.

As I mentioned above, that’s why any pullback will need to be gradual.

…The temptation will be to make the definition of what constitutes a qualified mortgage as broad as possible, to ensure that the banks lend to a wide range of borrowers. But regulators concerned with the health of the banks won’t want a system that incentivizes institutions to make potentially risky loans…. Resolving the conflict between mortgage availability and bank strength may depend on the person who replaces Timothy F. Geithner as Treasury secretary. Mr. Geithner is stepping down at the end of Mr. Obama’s first term.

There is no real dilemma faced by regulators. One on side, you have an army of banking lobbyists who want to pass as much risk as possible onto the US taxpayer. On the other side you have a few concerned legislators and bureaucrats who understand what’s at stake but find it difficult to resist the financial power of the lending industry and their lobbyists. In our current corporate-dominated crony culture in Washington, I expect these regulations to overly favor bankers.

The Obama administration faces other daunting decisions.

One is how to deal with the considerable number of troubled mortgages still in the financial system. … “If you don’t ever deal with these problems, you may never get to where you want to go,” said Mr. Lawler, the housing economist.

To help tackle that issue, the new administration might decide to make its mortgage relief programs more aggressive. It might even aim for more loan modifications, writing down the value of the mortgages to make them easier to pay. The Federal Housing Finance Agency, the regulator that oversees Fannie Mae and Freddie Mac, has effectively blocked such write-downs on the vast amount of loans those entities have guaranteed.

A new Obama administration may move to change the agency’s stance on write-downs, perhaps by replacing its acting director, Edward DeMarco. If that happened, it would be a sign that the White House had a taste for more radical housing actions. The agency declined to comment.

If the Obama administration starts widespread principal reduction, the resulting moral hazard will ensure another housing bubble. Rampant Ponzi borrowing and subsequent default or principal reduction on the back of the US taxpayer will be the best financial decision a family can make. Why would anyone be the slightest bit prudent when they know they can borrow and spend every penny of equity as it appears and receive principal reduction when the Ponzi scheme unravels?

Then there’s what to do with the Federal Housing Administration, another government entity that has backstopped a huge amount of mortgages since the financial crisis. The housing administration was set up to focus on lower-income borrowers, and it backs loans that have very low down payments. Its share of the market has grown since the crisis. The F.H.A. accounted for 13 percent of the market in the third quarter, according to Inside Mortgage Finance.

The new administration has to decide whether it wants the F.H.A. to continue doing as much business. The risk is that a big pullback by the F.H.A. could reduce the availability of mortgages to lower-income borrowers. Banks almost certainly won’t want to write loans with minuscule down payments since they are considered riskier.

Ultimately, housing policy comes down to one question: Which borrowers should get the most subsidies?

Why not eliminate all subsidies? These subsidies do nothing but inflate house prices in the market. Subsidies do not even benefit the groups that they target because the increase in market prices caused by the subsidy negates the effect policymakers are after.

Right now, the government largess encompasses a wide swath of borrowers. But most analysts believe government support should be focused on lower-income borrowers.

If we are going to subsidize any group, low-income borrowers would be the most worthy. The current system of subsidizing everyone is both unfair and untenable. It’s unfair to renters to subside all loan owners, which is what’s happening now. It’s untenable because continued government backing will lead to another housing bubble and potentially trillions of dollars in taxpayers losses.

Obama has many housing options in front of him. Let’s hope he chooses the right ones.

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