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This post derives, in part from wtfdik's post in the 'What supports multifamily pricing' thread:

Dan wrote:
The problem is many people are buying homes and investment properties with cash from banks and federally insured loans all of which comes back to you and me eventually through the FDIC. The entire process of evaluating the value of real estate is typically based on the sale value of near by properties by many appraisers. As long as you have one idiot bidding up properties in an area, regardless of too much supply, you can have the bubble keep on expanding.

So you get a default that is evaluated at 300,000 market value that has a real value of 200,000 when it is sold again. The bank, in theory, eats the 100,000 difference. The problem is if it is government insured, we as tax payers, eat it. If the bank is an a geographic location with enough defaults, the bank itself could go under, at that point FDIC comes in, and we, through our taxes, pick up that tab.

Although I've been presenting the bull case for real estate, I'm not convinced that the bear case is wrong . . . to a point. I can see a real estate bubble bursting; I can't see it bringing down the banks.

Oddly, the savior in this case is the same duo that is the nemesis in so many other scenarios: Fannie Mae and Freddie Mac.

So that it's clear that I'm not picking on Dan, who almost certainly knows more about real estate and finance than I do, and so that it's clear that I'm out of my league, I'd also like to address in this post some of Jiml8's points about the consequence of getting more people into mortgages.

OK, I'm sure all of the regular posters know plenty about Fannie and Freddie, but for the benefit of lurkers and those, like me, who pretend to know things that they don't, let's do a quick review of Fannie and Freddie. For all those of you who already know this, skip to the 'skip to here' heading and save yourself some time.

The Federal National Mortgage Association (FNMA, or Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac [I have no idea]) were created in the late 1960s to standardize and reduce the cost of mortgages. They were chartered by Congress, but are private corporations, owned by stockholders. For this reason, they are sometimes referred to as government-sponsored enterprises (GSEs). Congress created Fannie and Freddie as a duopoly to create a new market, the secondary mortgage market.

What they do
The secondary mortgage market is pretty basic: Fannie and Freddie buy mortgages from banks (actually any originator, but let's keep this simple). They take these mortgages, put them together in batches of thousands, and sell bonds backed by the mortgages. These bonds are often called mortgage-backed securities (MBS's).

For example, Fannie buys 1000 $100,000 30-year mortgages. Each mortgage carries 7.5% interest. Fannie makes $100 million offering of 30-year MBS bonds backed by the mortgages. Fannie guarantees the princple and interest payments for the bondholders and it sells the bonds with 6.5% interest rate.

The bondholders are happy because they get a bond that pays more than the 30-year treasury bill but is just as safe (more on this later). Fannie is happy because it gets to keep the difference between the 7.5% the mortgages pay and the 6.5% it passes through to the bondholders. More importantly, the bank is happy because it doesn't have to wait 30 years to get the money it loaned back. Since it can lend the money again immediately (and sell that mortgage to Fannie, and so on), it can offer a lower interest rate on the mortgage, which, in turn, makes the mortgage applicant (you) happy.

What this means
What this means is that mortgage rates are lower than they otherwise would be. Because of Fannie and Freddie, the supply of capital for your mortgages is the entire capital market, instead of just the deposits on hand at your local bank. Basic economics: supply increases drive prices down.

It also often means that your bank doesn't hold your mortgage, so if you default, your bank isn't the one left holding the bag.

Problems with this set up
There are a few problems with this set up. The one that we are most concerned with is that the only way for Fannie and Freddie to increase their profits (and please their shareholders) is to buy more mortgages. The only way for them to buy more mortgages is to accept mortgages from applicants who are less creditworthy. Banks usually determine whether they will make a mortgage by asking Fannie and Freddie if they will buy it. Over the past few years, Fannie and Freddie have been agreeing to buy mortgages with lower and lower credit scores. Banks have therefore been making them, so lots of people who couldn't get approved before can get approved now. Only, maybe there was a reason they couldn't get approved before . . .

Another major problem is the perception of Freddie and Fannie. The two of them make it possible for more people to own homes (no question about that), and they are among the most successful government programs of all time, by almost any measure. Therefore, Congress (especially the Democrats) loves them. This, combined with the fact that they were intially supported with lines of credit from the U.S. Treasury, has led the bond market to believe that the U.S. Government would not let Fannie or Freddie fail. Since the principle and interest on the MBS's they sell are guaranteed by Fannie and Freddie, this means that the market perceives those bonds to be approximately as safe as Treasury Bills. Fannie and Freddie love this because it means that they can raise money cheaper than any other companies, and it is this advantage that allows them to maintain their duopoly. Unfortunately, it means that the market is probably not accurately accounting for the risk in these mortgages as Freddie and Fannie move farther down the credit spectrum, and it means Fannie and Freddie have little disincentive to keep taking on riskier loans.

Skip to here
So, now that we know about how the mortgage market works, I'll address the points that I started this post with.

In reverse order . . .

1) To the extent that Freddie and Fannie bring down the price of loans without taking on credit risk (through capital market access and efficiency), there will be people on the margin who can become homeowners who could not have afforded mortgages at the higher rate.

Though I'm quite sure the Jiml8 knows this, I bring it up as a minor counterpoint to his points about programs to increase home-ownership necessarily leading to a higher default rate. For those out there trying to make your own assessment of where the bubble will finish deflating, keep in mind that Fannie and Freddie do create real, sustainable increased marginal demand for single-family homes by pricing more people into the market

2)Because the banks do not carry many of the mortgages they originate anymore, the prospect of real estate deflation leading to FDIC bailouts is very removed.

I think that increased default rates on common mortgages would hit Fannie and Freddie first They guarantee the mortgages to the bondholders, so the bondholders would only suffer if Fannie and Freddie were unable to meet their obligations. Many banks may be MBS bondholders, but the before they suffered serious losses in their MBS portfolios, Fannie and Freddie would be in such serious trouble that the banks would be the least of the government's concern.

3)To fully address both of the above points, I ought to be considering FHA loans.

Brief interlude on GNMA and FHA
FHA loans are guaranteed by the Government National Mortgage Association (GNMA, Ginnie Mae). In contrast to Freddie and Fannie, there is no question that the government would bail out Ginnie. Ginnie Mae is part of the government, a wholly owned corporation of the Dept. of Housing and Urban Development. It was formed around the same time as Fannie and Freddie but addresses a different part of the market.

Ginnie Mae serves low-income homebuyers. It buys and securitizes (sells MBS's backed by) FHA and VA loans. These mortgages are made by private lenders but insured by the Federal Housing Authority (FHA) or the Veterans Administration (VA). Both the FHA and VA mortgage insurance programs were created in the 1930's, and today there is a private mortage insurance industry as well, but they all work basically the same: they insure the lender for enough of the risk so that the lender is willing to make the loan. Often the lender is not willing to accept the risk for more than 80% of the value of the property being mortgaged. The FHA program is much larger than the VA program, so it is more widely focused on.

Back to the point
Anyway, the point is that in these cases the taxpayer has relatively direct risk to a real estate bubble deflation. FHA has to pay out on its mortgage insurance policies if the lender can not recover the full value of the loan. And GNMA has to pay out if the money coming in from the mortgages is less than the payouts to bondholders. Both of these entities make money in good times (FHA on the insurance premiums, GNMA on the spreads between the mortgages and MBS rates), so both can absorb some hit before going to the taxpayers for help, but the taxpayers are not far removed, and a serious deflation could trigger a bailout.

In addition, these entities are likely responsbile for much more of the mortgages that Jiml8 disagrees with. GNMA has special programs set up for teachers, policemen, and firefighters where they are not required to make any downpayment at all. Although the desire to help more public servants to own their own homes is understandable (and, depending on your political affiliation, perhaps laudable), these people may simply be unable to afford home ownership, and the result may be an artificial and unsustainable increase in demand (as opposed to my point 1 above) that only leads to a temporary bubble followed by higher default and foreclosure rates.

Please comment on/add to my manifesto once your eyes stop bleeding from staring at the screen for so long.

Rock Chalk,

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