Made for walking

Buttonwood

Mar 8th 2005
From The Economist Global Agenda

House prices and America’s mortgage-finance giants have both grown too big for their boots. Will one trip up the other?

BUTTONWOOD had to chuckle at the photos of Martha Stewart, the world’s most tasteful jailbird, just released from Cupcake Correctional Facility last weekend. Adorably dressed, she looked suspiciously botoxed and understandably cheerful—if only because shares in Martha Stewart Living Omnimedia had more than doubled in price during the previous seven months (though they are down this week). She would be a role model, were it not for the record.

It is hard to know whether the shares have risen at the prospect of her manicured hand profitably on the tiller once more or because home-furnishing companies usually rise when the housing sector flourishes. And flourishing it is. The price of residential housing in America rose faster last year than at any time since 1979, says Freddie Mac, one of the two big government-sponsored entities (GSEs) that provide mortgage liquidity. The ratio of house prices to rents is now a third above its average level from 1975 to 2000, on calculations by The Economist.

Though the pace is likely to slow a bit this year, people keep on buying, and borrowing to do so. There are all sorts of tempting mortgages on offer, including 110 LTVs (110% loan-to-value mortgages), which lend the full price of the house plus a bit extra for transaction costs. Turnover is frenetic: as one commentator puts it, “Day traders in shares have become day traders in real estate.”

Does all this amount to a bubble? Without a doubt. Alan Greenspan’s attempt to save capitalism from the burst dotcom bubble in 2000 (and the effects of terrorist attack in 2001), by cutting short-term interest rates from 6.5% in 2000 to 1% in 2003, produced a new bubble in the credit markets. One sign of that is the compression in bond yields, with riskier assets paying investors only slightly more than governments and blue chips. Another is the debt-fuelled explosion in property prices.

What is less clear is the link between America’s huge and hugely troubled mortgage-finance behemoths—Fannie Mae and Freddie Mac—and the house-price bubble. If these custodians of $3 trillion in securitised mortgages back out of the market—either because there is further bad news to emerge from within them or because their masters make them—could this prick the bubble by making mortgages scarcer and dearer? And would Fannie and Freddie go bust if the bubble popped?

The GSEs, created by statute but both private-sector companies these days, are supposed to pump liquidity into the lower end of the housing market. They do this by buying mortgages from banks and other lenders, most of which they then pool as collateral for marketable securities, collecting a “G-fee” for guaranteeing repayment. Some mortgages and mortgage-backed bonds, however, they hold in their own portfolios. The difference between what they pay to borrow (just a little more than Treasuries, as they are assumed to be guaranteed by the federal government) and what they make on their holdings (less the cost of hedging against interest-rate risks, plus the G-fees they earn) has made both companies among the most consistently profitable of the S&P 500.

But those profits have been called into question. The agencies’ regulators have stumbled more than once on accounting fiddles at both and are now making Fannie Mae restate four years of earnings, slow the breakneck pace of growth in its portfolio, and strengthen capital. Mr Greenspan seems keen to get mortgage lending back into the hands of banks whose behaviour he can influence. Congress, meanwhile, may enact stronger controls over Fannie and Freddie. Economists at the Federal Reserve reckon that the GSEs pass on to consumers only seven basis points of the 15-18 point spread between the mortgages they buy and ordinary mortgages. Richard Baker, a Republican congressman who sits on one of the committees considering the GSEs’ future, says he worries that Fannie and Freddie have forgotten their mission to help low-income people and instead have become “a very sophisticated hedge fund which uses its leverage in the marketplace given by the taxpayers to yield significant profits for shareholders”.

If the agencies are cut back dramatically, how much will it affect the markets? Looking at it another way, how much is the house-price bubble due to the availability of this huge pool of cheap credit? Not much, some would say. After all, many other countries, including Britain, have managed to produce perfectly good house-price bubbles without Fannie and Freddie, so the condition may have more to do with general global liquidity and tax breaks.

More specifically, house prices in America galloped merrily on in 2004 while Fannie and Freddie were less active than they had been in years. Rising house prices pushed the size of many mortgages up through the limit ($359,650 at present) that the GSEs are allowed to buy. Many borrowers chose more complicated mortgages, such as hybrids (partly fixed-rate, partly floating), which the GSEs find harder to buy up and securitise. The result of all this is that the GSEs’ furious pace of securitising mortgages slowed in 2004, and their portfolios were virtually flat. Since then, Fannie has slimmed its portfolio by another 17%.

It is too soon to know whether the GSEs can really absent themselves from the market without its noticing. Despite everything, says Jim Vogel, senior vice-president of FTN Financial Capital Markets, “everyone out there still assumes that there’s a put [option to sell] at some price back to Fannie and Freddie.” And there is plenty of money around to lend at the moment. Though Fannie’s shares, unlike Martha Stewart’s, have fared unhappily over the past few months, yields on its long-term debt have been reasonably resilient.

If house prices dropped and defaults rose sharply, could that seriously trip up Fannie and Freddie? That would depend on how sharp the changes were. The agencies are prohibited from buying mortgages that represent more than 80% of the value of the house. Prices would have to fall by more than 20%—by much more, in areas where prices have risen most—before Fannie and Freddie took a serious hit.

All this is not to say that a sharp change in either the agencies’ status or house prices would not roil the markets. But it seems that Congress could dare to be bold, paring back the GSEs’ portfolios and giving a new, stronger regulator broader powers. The boldest move of all, of course, would be to give up altogether on subsidising the American dream of home ownership for all. Surely Congress would not go that far? Buttonwood thought not—until a colleague pointed out that Britain had had a similar dream, financed through tax breaks on mortgage interest. Where are those tax breaks today? History, pure history. Just like Martha Stewart’s time inside.

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