In yet another extension that growingly appears to be delaying or worsening an inevitable reckoning, the Federal Housing Finance Agency has extended Fannie Mae and Freddie Mac’s temporary ability to buy loans in forbearance until the end of December. Forbearance, or a state of reduced and suspended repayments for loans, has been induced by Fannie Mae and Freddie Mac since April 2020 in response to the March CARES Act in order to mitigate the impact of the pandemic on a precarious housing and rental market.
According to mortgage editor Ben Lane, of HousingWire, “The CARES Act stipulates that a borrower whose mortgage is backed by either the government or the GSEs who is experiencing a COVID-19-related hardship can request and must be granted forbearance of up to 180 days, which then may be extended for another 180 days… Under the new program [as of May], borrowers who took forbearance due to a coronavirus-related issue will not have to repay their missed payments until the borrower sells their house, refinances their current mortgage, or their mortgage matures.”
Forbearance, of course, does not forgive loans, as such a move would threaten the value of a not-so-cautiously centrally planned, secondary mortgage-backed security market. But what happens when the forbearance runs out? What happens if assets packaged by Fannie and Freddie on the basis of loans under forbearance, the controversial qualified mortgage patch, and other dubious instruments that fulfill institutional short-term goals at possible long-term risk to all; lose value as foreclosures resurge and delinquencies increases in response to a pandemic stricken economy and still intimidating unemployment? What if additional tools for monetary stimulus by the Federal Reserve are not enacted in time or fiscal stimulus cannot be guaranteed by the federal government? Could we observe something akin to a repetition of the disaster that occurred in the late 2000s despite regulatory efforts and is the situation perhaps much less secure than many analysts currently believe?
Much evidence now implies yes, we very well may.
According to the U.S. Securities and Exchange Commission October U.S. Credit Market Report, “Of the $54 trillion of credit in the U.S. financial system, $13.2 trillion of credit exposure is concentrated in banks, $9.4 trillion is concentrated in federal agencies and government- sponsored enterprises (GSEs), and $5.7 trillion is concentrated in investment companies…The institutional stability [from well capitalized banking], combined with and enhanced by the actions of the Federal Reserve and other governmental actions, in particular, the CARES Act, has enhanced market stability. However, long-term uncertainties about the economic effects of COVID-19 on the performance of credit remain. In addition to credit exposure, banks’ performance and health more generally depend on the economic health of their borrowers. Thus, banks and other financial institutions remain exposed to potential long-term adverse economic effects related to COVID-19.”
This economic health of borrowers, deemed by the SEC to be the “more general” factor determining health of long-term credit lenders, seeing its wellbeing expire in a shock could form the very spark signaling a possible disaster or at least powerful obstacle for the financial sector and, subsequently, the economy at large. The danger of borrower economic health being threatened may be even closer than many analysts are currently willing to admit.
Borrower health only appears more precarious in light of still high unemployment numbers around 6.9% according to the Bureau of Labor Statistics. This and a low labor force participation rate of just over 61% of the population may indicate a real signs that foreclosure, mass rent delinquency, and the danger of housing prices and other residential property values falling rapidly are not unrealistic at all.
Economist Michael R. Strain of the American Enterprise Institute, in some of the most recent research in this regard, writes as of October 2020 that, “the expectant realities of a wave of foreclosures are already evidenced by how, as of August, “over 10% of the eight million single-family mortgages backed by the Federal Housing Administration were delinquent by more than three months. According to the FHA, the reason for 86% of those delinquencies was “a national emergency,” a category that includes the pandemic. These delinquencies are heavily concentrated among loans associated with low credit scores.” What Strain has identified in part, may very well be an excess of loans with low credit scores specifically targeted by GSEs with the help of policies such as the QM patch and the ability to purchase loans on forbearance. Strain himself writes that a wave of 2021 foreclosures ought to “be expected.” However, the situation may even be worse than Strain concludes, as though he identifies the relief of high forbearance rates as a factor delaying foreclosures, this circumstance is compounded in danger by the fact that Fannie Mae, Freddie Mac, and even Ginnie Mae (the Government National Mortgage Association) have been continuing to buy loans under forbearance and adding them to their asset pool. Ginnie Mae, in particular, had a forbearance rate of nearly 12% by the end of May 2020, according to the Federal Reserve Bank of Atlanta, that recovery from remains uncertain.
The SEC additionally writes, in a further sign that it will not signal an all-clear for credit markets in response to the pandemic, that “While the timing and extent of any future effects are uncertain, the long-term impact of COVID-19 on the issuers and purchasers of long-term credit—i.e., corporations, households, local and federal government, pension funds, insurance companies, and other investors—is ultimately expected to manifest itself in long-term issuer- and sector-specific credit issues.”
In regards to GSEs, the SEC declares, “The federal agencies and GSEs retain most of the credit risk associated with the $9.4 trillion mortgage credit portfolio they intermediate. Large-scale unemployment in March–April 2020, due to the COVID-19 economic shock, has led to increased incidence of and risk of mortgage payment defaults as well as forbearance. Forbearance rates peaked at 8.55% of mortgages outstanding in June 2020. However, housing prices have remained relatively stable, likely due to a combination of the easing of mortgage credit, forbearance measures, and consumer-oriented fiscal stimulus, including the Paycheck Protection Program in the CARES Act. As with banks’ credit portfolio, the long-term impact has yet to unfold, but the uncertainty is a potential risk to be managed by the federal agencies and GSEs.”
In addition to these concerns, the SEC even directly identifies instruments issued by GSEs such as credit risk transfer securities, or CRTs, that would potentially spread mortgage credit risk when CRTs are passed on to other financial markets and used as collateral. The structure already closely mirrors the reports of how financial markets in 2008 were further flooded with toxic assets due to the spread of collateralized debt obligations (CDOs) and synthetic collateralized debt obligations spreading risk through investment portfolios that had not been adequately priced in. “The CRTs account for the credit risk of a reference pool of approximately $2 trillion of mortgages.”
When one considers the past research of CEI scholars such as Daniel Press and John Berlau regarding the risk-enhancing dangers of furtive practices such as the Qualified Mortgage (QM) Rule patch, the pathway for a disastrous translation from a possible wave of foreclosures and delinquencies poisoning the valuation of levered assets in financial markets becomes all too real of a possibility, and may make the risk of housing and financial woes even higher than the SEC has currently evaluated them to be. In regards to how the QM patch would enhance risk beyond what markets may be aware of when mortgages are packaged by Fannie and Freddie, Press writes in 2019 that, “Title XIV of [Dodd-Frank] required the bureau to establish a Qualified Mortgage rule to define certain minimum mortgage terms. Those criteria as defined by the bureau include assessing a borrower’s “ability to repay” a loan, such as requiring a debt-to-income (DTI) ratio of 43 percent or less, prohibiting “risky features” such as negative amortization or interest only payments, and prohibiting large points and fees,” all the while however, an exemption referred to as the “QM patch,” has given according to Press, “an exemption to the QM rules for loans eligible to be purchased by the government-sponsored enterprises Fannie Mae and Freddie Mac, as well as loans eligible to be insured by other government agencies such as the Federal Housing Administration (FHA).”
Press goes on to cite American Enterprise Institute scholar Edward Pinto as revealing, “true to the government’s long history of promoting excessive leverage, [the QM rule] sets no minimum down payment, no minimum standard for credit worthiness, and no maximum debt-to-income ratio” on the loans that the GSEs can purchase.” This exemption, according to the Urban Institute, is set to expire on January 10, 2021; but has been in place for several years and left the degree to which it has filled financial markets with high-risk mortgage backed assets that have not been adequately priced into the packaged assets generated by Fannie and Freddie an open question. The ability of Fannie and Freddie to purchase loans under forbearance only adds to the uncertainty of whether these assets are as valuable as they have been presumed, and whether the payments from borrowers that their value is predicated on will materialize as they need to.
Further complicating fuel to this fire includes a growing body of economic research, such as that of Gupta in 2019, in which the author concludes that, “large lenders will temporarily increase high-risk activity at the end of a boom. In the model, lenders with many outstanding mortgages have incentives to extend risky credit to prop-up house prices. The increase in house prices lessens the losses they make on their outstanding portfolio of mortgages. As the bust continues, lenders slowly wind down their mortgage exposure.” Considering that housing prices have sharply increased in recent months per the research of Strain at AEI, and the corresponding behavior of GSEs towards acquiring forbearance ridden mortgages and QM patch mortgages, present conditions are ripe for a test of Gupta’s theory, which theoretically points towards the end of the current housing boom soon on this basis. Lax underwriting standards for GSE mortgage backed securities may, thus, finally be reaping the consequences of their continued and systematic moral hazard.
One possible additional culprit for an inflated and fragile state of affairs in the mortgage financing industry, yet again, may be due to a series of surreptitious activities engaged by government sponsored enterprises or GSEs including Fannie Mae and Freddie Mac through the assistance of federal agencies such as the Federal Housing Administration or FHA, but not as obviously or directly. Rather, how GSEs influence mortgage and credit markets is not limited to their own actions, but behaviors that they compel from private lenders and creditors in response to their actions. As economists Gregory Dempster and Anthony Carilli have argued as early as 2008, a banker or firm loses market share if it does not borrow or loan at a magnitude consistent with current interest rates, regardless of whether rates are below their natural levels. Considering evidence that Fannie Mae and Freddie Mac, through their provision of easier, government backed credit, have the effect of lowering interest rates under government conservatorship, modern economic theory such as that of 21st Century Austrian Business Cycle Theory predicts that private lenders will loan at suboptimal rates collectively in order to prevent being pushed from their remaining market share by GSEs – even if these rates of lending are ultimately unsustainable. Thus businesses are forced to operate as though rates were set appropriately, because the consequence of a single entity deviating would be a loss of business.
With mortgage insurance backed by the FHA, Fannie and Freddie, in possible long-term detriment to the housing market, have been able to maintain competitive advantage and market dominance over competing lenders in packaging and offering liquidity to many lower-income mortgages even since the late 2000s financial and housing crises that the GSEs are widely implicated in.
Worse still, in spite of rule changes offered by the Dodd-Frank Wall Street Reform and Consumer Protection Act, there is strong evidence that the overall mission of Fannie and Freddie that incentivized their behaviors contributing to the housing crisis has remained fundamentally intact. Just as before when their role in the late 2000s was criticized by researchers such as Berlau, the mission of Fannie Mae and Freddie Mac has nonetheless remained, with Fannie Mae’s own website writing their mission as providing, “liquidity,…stability, and affordability in U.S. housing,” sounding as strong as prior to 2008.
Though these efforts sound noble and the general benefits of market liquidity in times of downturn is agreed upon by economists such as Scott Sumner, for example, stability in one market at the cost of risking the financial health of others through various tools may be ultimately antithetical to the GSE mission statement, and systematically putting at risk for the long-term what Fannie Mae and Freddie Mac have dedicated to protect in the short-term. The fact that the overall incentives and structure of Fannie and Freddie have remained indicate that, though Dodd-Frank changed the rules of the game, the efforts to get around these rules dangerously in the same direction that fueled the late 2000s crisis are still encouraged by the GSEs to the possible coming endangerment of the larger housing market. In short, the rules of Dodd-Frank may have been demonstrably not enough to quell dangerous behaviors by these GSEs based on strong incoming evidence.
One of the key lessons missed from the financial and housing crises of the late 2000s may be that bureaucratic and government-sponsored enterprises widely held responsible for disastrous outcomes should not be expected to fundamentally change their behavior if the same fundamental system and mission of those organizations is still in place. Fannie Mae and Freddie Mac for example, were widely argued by economists and established by researchers to have drastically worsened the sub-prime lending crisis fueling housing and financial woes in the late 2000s. As Berlau wrote in 2008, “They guaranteed or invested in $717 billion of subprime or near-subprime Alt-A mortgages, according to the New York Times. Even more importantly, through their market power generated by their quasi-government status, they lowered standards even for prime or ‘conforming’ mortgages. Without the existence of Fannie and Freddie as buyers of lower-quality mortgages, many of the loans that have caused so much of the current turmoil would not have been made.”.
One of the proposed band-aids in lieu of totally ending Fannie Mae and Freddie Mac for their role in the financial and housing criss inflating and packaging sub-prime securities, for example, has been to issue the QM or qualified mortgage rules issued by the Mortgage Reform and Anti-Predatory Lending Act under Title XIV of Dodd-Frank. This regulation supposedly ensured strong standards across the entire mortgage market restricting “risky loan features” such as negative amortization and “balloon payments”. In reality, however, the mission of GSEs such as Fannie and Freddie to provide the American public with “liquidity, stability, and affordability,” in the mortgage market beyond what the market can sustainably provide for longer than a business cycle has remained.
Incentives for Fannie Mae for example, including the measures by which they determine the success of their operations, are calculated in terms of beating market percentages and benchmark percentages for successfully housing various thresholds of low-income borrowers in a year. Essentially, Fannie Mae is structured and rewarded for packaging securities such that they are able to house more people without any inherent regard in their calculus for if such measures are sustainable. Money is made and assets sizes are accumulated regardless of the larger market effects on the economy until, as much economic theory fears, a financial reckoning due to the inherent weakness of GSE financial instruments and practices come home to roost. If the expectation for any too-risky to hold assets is that they will be purchased by the Federal Reserve as they were in ’08 through quantitative easing, the incentive for GSEs to securely and carefully price these securities and avoid toxic assets may just as well have been left to evaporate in these asset markets.
As the Federal Housing Finance Agency writes on their website,
“The single-family goals defined under the Safety and Soundness Act include separate categories for home purchase mortgages for low-income families, very low-income families, and families that reside in low-income areas. Performance on the single-family home purchase goals is measured as the percentage of the total home purchase mortgages purchased by an Enterprise each year that qualify for each goal or subgoal.”
Hypothetical fears of a chronically unstable housing market without the so-called stabilizing influence of GSEs such as Fannie and Freddie (at least in their current, state-run form) are likely far from reality, as some of the newest economic theory on business cycles, including sequestered capital models by economists McClure, Thomas, and Spector (2019) https://osf.io/preprints/socarxiv/ajdnq/ in fact, may be applied to predict that entities such as credit expanding and interest rate lowering GSEs may be some of the primary factors leading to long-run instability in the first place. Though the authors do not highlight the late 2000s crisis or GSEs as matching their model by name, Fannie Mae and Freddie Mac’s relative protection from entrepreneurial pricing signals in their asset packaging and pricing that is present in other stages of capital investment matches the fundamental properties of sequestered capital, theorized as being the impetus for drastic malinvestment and warping of the business cycle to the detriment of the wider macroeconomy.
Overall, though it may be too late to prevent all of the consequences of GSEs and the regulation that they have successfully circumvented, lessons can be derived for the future, and a long-run change that ensures greater prosperity for generations long after the short-term pain of current economic fears has ended not only remains a dream worth chasing, but a reality worth investing in. Beginning the privatization of Fannie and Freddie while ending the government guarantees for their purchased loans and financial instruments may one of the single greatest steps for drastically improving long-run stability if we dare enough to make our bravest changes.