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Subprime Mortgage Crisis #2 in the Making?

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
July 26, 2011

IN THIS ISSUE:

1.  Fannie & Freddie: Root Cause of the Financial Crisis

2.  New Book Dusts Off the Truth About Fannie/Freddie  

3.  Subprime Mortgage Crisis #2 in the Making?   

4.  Treasury Debt vs. “Agency” Debt – Which is Safer?

The On & Off Again Debt Ceiling Debate

Before we get to our main topics this week, let me briefly comment on the debt ceiling debate in Washington. Last Wednesday, it looked like a compromise had been reached between House Speaker Boehner and President Obama on raising the debt ceiling, a deal that included $1.6 trillion in spending cuts and $800 billion in revenue increases (tax hikes). But then on Thursday, Obama insisted that the revenue increases had to be hiked by 50% to $1.2 trillion, and Boehner called off the talks. Good for him.

Of course, in Obama’s press conference late Friday, he made no mention that he had changed the deal at the last minute. Instead, he placed ALL of the blame on Boehner and the Republicans. Obama ordered congressional leaders back to the White House on Saturday morning to no avail. Nothing new on Sunday either. As this is written, Boehner and House Republicans have a new two-part debt ceiling deal, which Obama says he will veto, and the Senate Democrats apparently have a new debt ceiling deal of their own, which is not likely to pass either.

I still believe that something will get passed before next Tuesday’s supposed deadline, but it remains to be seen if Obama is prepared to let the country go into a debt “default.” I personally believe that next Tuesday, August 2nd is not the drop-dead day, and that the US will not default on its debt if a deal is not passed by that day. The stock and bond markets agree with me, by the way – they have not crashed to this point. More on this next week.

Fannie & Freddie: Root Cause of the Financial Crisis

In May 2009, President Obama authorized the “Financial Crisis Inquiry Commission” (FCIC) to investigate the causes of the financial crisis of 2007-2009. The FCIC is a 10-member commission appointed by the White House and is chaired by Democrat Philip Angelides. The FCIC held its first public hearing on January 13, 2010 with the presentation of testimony from various banking officials. Over the next year, the FCIC reportedly heard from some 700 people in business, finance, academia and government.

In January of this year, the FCIC reported its findings and concluded:

“The crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserve’s failure to stem the tide of toxic mortgages; Dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk; An explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis; Key policy makers ill prepared for the crisis, lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels.”

Basically, the Commission put the blame for the financial crisis on lax regulation, greed on Wall Street, faulty risk management at banks and other financial firms and on households for taking on too much debt. That was the very same story put out by government sources since 2008 and widely accepted in the media.

Other than “lax regulation,” there was no mention in the FCIC report that the government played any role in causing the financial crisis. The FCIC’s Democratic majority placed the blame for the financial crisis on the private sector and dismissed the idea that government housing policy could have been responsible.

US housing policy is largely directed by the Department of Housing and Urban Development and the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. Yet the FCIC majority report stated that HUD and the GSEs contributed only “marginally” to the crisis. In fact, the report stated that Fannie and Freddie “followed rather than led Wall Street and other lenders” into the subprime and other risky mortgage lending that ultimately caused the financial crisis.

That’s hogwash! Many of you will remember that I wrote extensively on how Fannie and Freddie were among the main causes of the financial crisis. In my May 18, 2010 E-Letter, I pointed out that Fannie and Freddie were huge political contributors, and the Democrats in the House and Senate blocked President Bush’s efforts to reform these giant agencies back in 2003 and President Clinton before that. If you did not read that E-Letter, you definitely should go back and take a look.

Obviously, the FCIC purposely ignored the evidence that the government – via HUD, Fannie and Freddie – was in large part to blame for the financial crisis. The Democrat majority on the FCIC wanted to continue to lay the blame at the feet of Wall Street and the banks. Interestingly, this conclusion didn’t stir up much controversy back in January. But that may be changing.

New Book Dusts Off the Truth About Fannie/Freddie

A new book entitled “Reckless Endangerment” tackles the causes of the financial crisis and reaches many of the same conclusions I did. Specifically, the authors, Gretchen Morgenson, a business reporter and commentator for the New York Times, and Josh Rosner, a financial analyst, make clear that it was Fannie Mae and the government housing policies it supported, pursued and exploited that brought the financial system to a halt in 2008.

The authors point out that after James A. Johnson, a Democratic political operative and former aide to Walter Mondale, became chairman of Fannie Mae in 1991, it became a political powerhouse, intimidating and suborning Congress and tying itself closely to the Clinton administration’s support for the low-income lending program called “affordable housing.”

The affordable housing program virtually required subprime and other risky mortgage lending because it was targeting lower-income Americans. Since this was desirable on political grounds, at least to most Democrats (and even some Republicans), it enabled Fannie and Freddie to resist privatization or significant regulation until 2008.

The authors of the book correctly state: “Under Johnson, Fannie Mae led the way in encouraging loose lending practices among banks whose loans the company bought. . . Johnson led both the private and public sectors down a path that led directly to the financial crisis of 2008.”

Far from being marginal players, Fannie and Freddie were the primary source of the decline in mortgage underwriting standards that eventually brought down the financial system. Indeed, they led rather than followed Wall Street into risky lending which eventually caused the financial crisis.

Yet these facts did not appear in the FCIC majority report in January. Even worse, James Johnson, the chairman of Fannie Mae, was not among the more than 700 witnesses the FCIC claims to have interviewed. If not already obvious, it is clear that the FCIC had no intention of finding the real causes of the financial crisis, much less disclosing them publicly.

But it gets worse. Last year, Edward Pinto, a former chief credit officer of Fannie Mae, presented evidence to the FCIC showing that by 2008 half of all mortgages in the U.S. (27 million loans) were subprime or otherwise risky, and that 12 million of these loans were on the books of Fannie and Freddie.

The research he gave the FCIC also showed that two-thirds of these subprime or risky loans were on the books of government agencies or firms subject to government control. But these facts were left out of the FCIC’s majority report. They did not fit with the narrative that the financial crisis was caused by the private sector. More importantly, these facts moved the blame uncomfortably close to the powerful figures in Congress who had supported the GSEs and the affordable housing goals over many years – and the same people who appointed the majority of the FCIC.

This is how things work in Washington – cover up the facts if necessary to protect your backside. As such, one might conclude that the FCIC final report was simply distorted by partisan considerations. But the FCIC report didn’t stop there; it went on to urge that more regulation of banks and other private-sector financial institutions could have prevented the financial crisis, and might be necessary to prevent another one. This was the rationale for the massive Dodd-Frank Wall Street Reform and Consumer Protection Act passed last year.

Surprise, surprise – the principal sponsors of that Dodd-Frank Act, former Senator Chris Dodd and former House Financial Services Committee Chairman Barney Frank, were also the principal supporters and political protectors of Fannie Mae and Freddie Mac. The government housing policies they implemented largely led to the financial crisis.

It is little wonder then that legislation named after them would place the blame for the financial crisis solely on the private sector and do nothing to reform a government-backed housing finance system that will increasingly be seen as the primary cause of the devastating events of 2008.

All of the above is not meant to imply that Wall Street, the big banks and mortgage companies were not also to blame for the financial crisis. Somebody had to sell these subprime and other risky loans to a lot of people who could not afford them, and then package them into complicated securities to sell to investors. So there’s plenty of blame to go around. My point today is that the financial crisis might not have occurred were it not for the abuses at Fannie and Freddie and the politicians who protected them.

The true causes of the financial crisis that I outlined for you in 2010 are being verified in spades now over a year later. Even so, the government is now up to new tricks in providing home financing for those who can’t afford it.  Read on, as it gets even worse.

Subprime Mortgage Crisis #2 in the Making?

In what could be a repeat of the easy-lending cycle that led to the housing crisis, the Justice Department has demanded that regional and community banks and mortgage companies again relax their underwriting standards and approve home loans for buyers with poor credit as part of a new crackdown on alleged lending misdeeds.

Obama’s Justice Department led by Attorney General Eric Holder is prosecuting banks based on theories of racial discrimination.  Because the targeted banks are mostly local or regional, they don’t have the money to fight the Feds, and most are agreeing to settle by promising to make home loans to low income families even if they don’t qualify.

And it gets even worse. The Justice Dept. is demanding that when these banks consider a loan, they must count any income received from government assistance programs as legitimate income. Specifically, unemployment benefits, welfare payments, food stamps, etc. must be counted as real income to qualify for a home mortgage.  This is simply unbelievable!

And here’s the worst part! As part of the settlement deals, prosecutors have required banks to sign "nondisclosure agreements" barring them from talking publicly about the methods DOJ used to allege discrimination. Bank lawyers contend the prosecutors are trying to hide the shaky legal grounds on which the cases are built.

Quite simply, the Holder Justice Dept. is taking civil rights into uncharted territory and doing it very covertly. No wonder so many small and regional banks are going out of business. There are many more troubling details to this story, but space doesn’t permit me to go into them today. I have included a link in SPECIAL ARTICLES below where you can find the details. Be sure to read it.

Treasury Debt vs. “Agency” Debt – Which is Safer?

Most investors know that official US Treasury debt is backed by the “full faith and credit” of the government. Treasury debt is counted as a part of our national debt. But what about so-called “Agency Debt,” the debt issued by the various government sponsored enterprises (GSEs) such as Fannie Mae, Freddie  Mac and the Federal Home Loan Banks, etc.?

The question is, are the bonds and other debt instruments sold by the GSEs as safe as Treasury debt? That’s a very interesting question! Officially, the debts of the GSEs are not backed by the full faith and credit of the government. Officially, their debts are not counted as part of the national debt. And historically, these agencies have had to pay higher interest rates than Treasuries to sell their debt.

Yet for years, brokers and others in the financial industry have encouraged investors to buy these agency bonds, with their higher yields, by assuring their clients that these instruments are just as safe as Treasuries when it comes to default risk. In the wake of the financial crisis of 2008, it appears that these assurances about default risk were correct.

But before exploring that question further, let’s do a little homework on the history of agency debt.  In 1970, Treasury debt held by the public was $290 billion. Agency debt was small by comparison, totaling only $44 billion. But by 2006, at the height of the housing bubble, while Treasury debt was up to $4.9 trillion, agency debt had inflated to $6.5 trillion. Treasury debt had increased 17 times during these years, but agency debt had multiplied 148 times!

At the end of 2010, Treasury debt was $9.4 trillion, and agency debt was $7.5 trillion. Keep in mind that Treasury debt illustrated in the chart below includes only the debt held by the public. If we include in the additional Treasury debt owed to the various government agencies – estimated at apprx. $5 trillion – then you come up with the current national debt of over $14.3 trillion.

Agency vs. Treasury Debt, 1970-2010

[Thanks to the American Enterprise Institute for bringing this chart and the one below to my attention.]

Also keep in mind that agency debt does not count toward our national debt because, officially, it is not backed by the full faith and credit of the US government. But if we add the agency debt of roughly $8 trillion to the official national debt of $14.3 trillion, you get a total of $22.3 trillion!

Now let’s return to the question of whether agency debt, in reality, is as safe as Treasury debt. As noted above, many in the financial industry have promoted and sold many hundreds of billions of these agency bonds over the years by assuring investors that they were just as safe as Treasury debt, in reality, and they paid a higher coupon.

US commercial banks certainly bought into this preference of agency debt over Treasury debt.  As you can see in the following chart, commercial banks fell in love with agency debt beginning back in the late 1980s, while keeping their Treasury portfolios roughly steady.

Agency vs. Treasury Securities Held by Commercial Banks

Now let’s fast-forward to the financial crisis of 2007-2009. In September of 2008, the Director of the Federal Housing Finance Authority announced that Fannie Mae and Freddie Mac were being placed into the conservatorship of the US Treasury Department. Initially, the Treasury Dept. committed $200 billion to keep them afloat.

On June 2 of this year, the Congressional Budget Office delivered a report to the House Budget Committee which stated that the federal government has now poured at least $317 billion into Fannie and Freddie, instead of the $130 billion cited often by the Obama administration. And there is no end in sight, apparently. The CBO also stated that it has always treated the mortgages held by Fannie and Freddie as “guarantee obligations of the federal government.”

Other sources believe that the CBO estimate of $317 billion is considerably too low and put the true cost at upwards of $400 billion. This makes sense because on December 24, 2009, the Treasury announced that it was removing the $400 billion cap necessary to keep Fannie and Freddie solvent. Who knows how much more money has been injected since then?

Fannie and Freddie represent apprx. 70% of all new mortgages according to the American Enterprise Institute and others. Both Fannie and Freddie have a combined debt of $5 trillion, most of it secured by actual mortgages, but some $1.5 trillion is not secured but considered to be guaranteed by the US government.

Fannie and Freddie bonds were sold all over the world and, as noted above, and investors were told it was the same as buying US Treasury debt but with a higher yield. While the shareholders of Fannie and Freddie were effectively wiped out with the government takeover, the bond holders have had no losses – thus far.

Treasury Secretary Geithner stated earlier this year that the Obama administration wants to “wind down” Fannie and Freddie over time. I would question this suggestion primarily because that would make government smaller, and that’s not President Obama’s MO. Even if they were serious, it won’t be easy, and bond holders could be affected negatively. But again, I seriously doubt that Obama will shut them down.

Conclusions

It is nice to see the true story of what primarily caused the financial crisis coming back into the light. Fortunately, Chris Dodd, co-sponsor of the sweeping Dodd-Frank bill, is no longer in public office, but Barney Frank continues to be a mover and shaker in the House. Never mind that Barney Frank’s lover was a senior executive with Fannie Mae during the years leading up to the financial crisis (see this story in SPECIAL ARTICLES below).

Since the government takeover, Fannie and Freddie have tightened their lending standards in terms of requiring higher FICO scores, raising their fees and requiring larger down payments. These changes are falling disproportionately on lower income people who do not have the down payment or a high enough credit score, or both, to qualify for mortgages.

Maybe this explains why Eric Holder’s Justice Department is coercing regional and community banks to grant mortgages to people who can’t afford them! Could Holder’s crusade result in another subprime crisis? Time will tell.

In closing, I received a TON of e-mails in response to my July 12 E-Letter which ended with me reaffirming that I am a staunch conservative on most issues, and my opinion that President Obama is a liberal ideologue. I’m happy to report that most of the e-mails were positive and polite, but it did also confirm that we have our share of readers who still think Obama hung the moon. I appreciate all (well, almost all) of your responses in any event!

Very best regards,

Gary D. Halbert

Special Invitation:  On Thursday, July 28 at 2:00 PM Eastern Time Halbert Wealth Management will be sponsoring an online webinar featuring Cliff Montgomery, CFA, developer of the Scotia Partners Growth S&P Plus Strategy.  S&P Plus is an aggressive mutual fund strategy that uses leverage and long/short trading to offer the potential to do well in in both up and down markets.  This webinar will allow you to hear Cliff describe his approach to the market and ask questions about his strategy.   

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To attend the webinar, click here to register.

Hope to see you there!  If you cannot attend, a recorded version will be available early next week on our website at  http://www.halbertwealth.com/.

SPECIAL ARTICLES

Subprime Mortgage Crisis #2 in the Making (prepare to be really annoyed)
http://finance.yahoo.com/news/DOJ-Begins-Bank-Witch-ibd-2567602920.html?x=0&.v=1

Barney Frank Helps Ex-Lover Get Fannie Mae Job
http://www.dallasblog.com/201105261008111/dallas-blog/barney-frank-helps-ex-lover-get-fannie-mae-job.html


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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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