The US government’s takeover of mortgage giants Freddie Mac and Fannie Mae is a defining, but not the closing chapter in the credit crisis. New legislation is already on the table and wise men and women in Washington and all around the world are talking about greater government influence in what once was the number one free market in most of the Western world.
Commercial real estate in the US exploded after the housing prices went in an upward spiral in 1995. The markets in New York, Florida, California, and Greater Washington, D.C knew record increases. In Washington, D.C. proper, in 1999, the average price of a home was $264,668. In 2002 it had jumped to $367,676, a compounded annual rate of increase of 16%. (During this time, the median home price increased at a compounded annual rate of 15%.) Anyone who still rented was dubbed an idiot. During 2001, home prices for the entire states of California, Florida, and Massachusetts, rose by more than 10%, and in portions of New York, by more than 15%. Freddie and Fannie were at the hub of the frenzy. Between 1995 and 2001, Fannie and Freddie acquired almost three-quarters of the $2.25 trillion in new mortgage loans that combined banks in the US had made. Upon getting cash from Fannie and Freddie, the banks made new housing loans. Since 1995, Fannie and Freddie accounted for almost three-quarters of all housing mortgages.
To gain even more profits, Fannie and Freddie started to pool the mortgage loans together in Mortgage-Backed Securities (MBS). They put a guarantee on it; and sold it to third parties—such as mutual funds, pension funds, or insurance companies. The cash from the pension funds, or mutual funds went into the housing market. That cash was drawn into that market by Fannie Mae and Freddie Mac in the first place because they issued securities that provided cash to primary lending institutions like Lehman and Bear Stearns.
What is ironic is that the internet bubble is repeating itself. The keywords are “intrinsic value”. During the dotcom craze, companies that only existed for months could rake in billions in cash without any proven business plan or even a suggestion how to repay all those investors. It didn’t matter; as long as it was on the net, you had to get a piece of it. The same will happen if you build houses without looking at quality (who said that only the Chinese build bad housing?)
With real estate prices going through the roof, contractors were put under pressure to build as fast as possible for as low a price as possible. This resulted in inferior houses that were worth far less then the asking price. The real value didn’t go up but went down as any item that is used and can’t withstand the wear and tear. It didn’t bother the mortgage providers at all. The idea was to live in your own house for a year or two, then sell it to “the next guy” who would pay substantially more. The problems started when the banks let people borrow against the fictitious market value of their house instead of the real intrinsic value. These home equity loans had a temporary beneficial effect on the economy. People could spend all that extra cash on cars, television sets and other luxury items.
They forgot that even good houses need maintenance and that the extra dollars were better spent on paint then on an extra stereo. In the long term this decision turned out to be disastrous. As oil prices rose and the dollar weakened more and more people discovered that they simply couldn’t afford their mortgage anymore. What was worse, there appeared to be no “next guy” anymore. With more houses for sale and demand declining, the only way housing prices could go was down. The result is the by now well known mortgage crisis. The demise of Northern Rock in the UK, Bear Stearns in the US and many smaller financial institutions was only the tip of the iceberg. Much further down, we now find Freddie and Fannie, who have been trying to keep the failing mortgage market afloat and almost collapsed under the weight.
The US government had little choice but to nationalize the two Frankensteins it had created. The alternative would be to seek outside finance but that would leave the door open for the previously discussed Sovereign Wealth Funds and other venture capitalist. I doubt if Washington wants the domestic housing market controlled by Abu Dhabi, the UAE or Russian billionaires.
