Is this the housing storm breaking?
I was talking with a real estate investor friend over the weekend, who said she has been lowering her debt ratios and generally preparing for a downturn for months. "I can just feel the storm coming," she said. Today, we see that Freddie Mac, the second largest mortgage finance company has fired its CEO because he did not fully cooperate with an internal review of the company's books. The Chairman and the CFO are out, too. And the stock is down 13 percent at this writing.
Freddie Mac and its larger home mortgage sibling, Fannie Mae, have been wildly profitable during these times of low interest rates, as consumers mined their equity to keep spending. This is the source of the continued, albeit relatively feeble, health in consumer spending as unemployment rose. Should the process of refinancing become harder or more protracted due to increased uncertainty about either Freddie or Fannie, the result could be a cascading debt crunch as bills are suddenly not payable with ever-cheaper loans and consumers lock down spending more than they have.
Federal Reserve Chairman Alan Greenspan said on April 30 that "As part of 2002's process of refinancing, households "cashed out" almost $200 billion of accumulated home equity, net of fees, taxes, points, and commissions....Federal Reserve surveys of the disposition of cash-outs indicate that a substantial amount--perhaps half--was used to finance home modernization and personal consumption expenditures, outlays that directly affect GDP and jobs, and that likely was the case again last year. Low mortgage rates doubtless motivated much of this spending, but the ready availability of home equity for extraction appears to have also played a substantial and independent role in prompting additional household expenditures. Even as recently as the late 1980s, a family that wanted to use housing wealth to finance consumption would have faced an expensive and time-consuming process."
The odd thing about this restatement of earnings for 2000-2002 is that it actually increases the earnings for those periods, because interest rates were falling faster than the company was lowering its rates and allowing it to create greater returns on derivatives based on mortgage-backed securities. Technically, the company is better off than expected.
Yet any hint of scandal or impropriety can be deadly in a market as inflated as housing is at the moment. This is a situation to monitor closely.
Greenspan, who speaks before Congress on the economy this week, has raised concerns about the capitalization of both Freddie Mac and Fannie Mae. He argues that the public believe the companies are guaranteed by the federal government, which is not the case, exactly. Freddie Mac's mortgage-based securities are backed by some federal agencies, who effectively lend their guarantees on performance of mortgages they sell to Freddie Mac. Fannie Mae can borrow from the U.S. Treasury to build its portfolios of mortgages,which does place the feds in line in case of a default. In other words, the public could end up with some of the costs of a financial melt-down.
Greenspan did make clear in his April 30 speech that a housing "bubble" scenario is "a rather large stretch," saying that any bubble would be local, not national. However, he noted, "even modestly declining home prices would reduce the level of unrealized capital gains and presumably dampen the pace of home equity extraction."
In other words, without the equity growth perceived by consumers, which is fueled by easy money through Freddie Mac- and Fannie Mae-facilitated mortgages, consumer spending is at risk. So, a bubble need not burst for a serious reversal in consumer spending to take place.
Posted by Mitch Ratcliffe at June 9, 2003 09:31 AM | TrackBack