This post first appeared in the September edition of: Cirios Trends: In Search of Real Estate Opportunities

Every couple months, the trials and tribulations of Fannie Mae and Freddie Mac (collectively known as the Government Sponsored Enterprises, or GSEs), appear on the national radar. This typically happens around earnings season, when staggering loss numbers are announced.

Once hailed as critical components to a robust housing market and easy access to mortgages for low income Americans, the growing sentiment of many inside housing finance is that the two mortgage giants should be fitted with toe tags.

Maybe its because policy makers aren’t sure what to do with the troubled companies, whether they should be publicly or privately owned. Perhaps its due to the staggering amount of money they’re losing: the GSEs are beyond broke, burning through $150 billion in taxpayer money to remain solvent. Last month, Freddie requested billions more after reporting its 12th straight quarterly loss.

Before delving into the quagmire that is “what to do about the GSEs?” a brief history lesson is in order. Fannie Mae was established by the federal government in 1938 to create a liquid secondary mortgage market that would allow loan originators to focus on creating more loans. Essentially, Fannie bought mortgages from lenders so that lenders could use the cash for new loans (sounds like the foundation of a bubble, or at least inflation, doesn’t it?).

By 1968, the federal government released Fannie into the wild when it morphed into a private, shareholder-owned corporation. By 1970, Fannie was authorized to purchase private mortgages in addition to federally insured mortgages, such as FHA and VA mortgages. That same year, Freddie Mac was created to provide some “free market” competition for Fannie. Importantly, while they were technically outside the government umbrella, the GSEs carried an implicit guarantee from the US government. That is, investors in Fannie and Freddie debt were led to believe that any repayment problems would be cleaned up by the federal government.

Though both were publicly traded companies, the federal government routinely passed regulations specifically directing their actions. In 1989 the government passed the Financial Institutions Reform, Recovery and Enforcement Act, subjecting both to oversight by HUD (the U.S. Department of Housing and Urban Development).

In 1995, more than ten years prior to the peak of the housing bubble, Congress granted the GSEs
affordable housing credits to encourage the purchase of subprime mortgage securities.

By September of 2008, as the housing market was in the throes of collapse, the GSEs were placed into conservatorship under the Federal Housing Finance Agency and have since been kept alive by regular injections of taxpayer money. So why are the GSEs even necessary? Why not just shut them down? Perhaps its because of how important a role they currently play in the financing (read: propping up of) the US housing market: Fannie and Freddie were the buyers of more than 70% of mortgages issued last year.

Essentially, the GSEs buy loans from mortgage originators, paying in cash or exchanging the mortgage for a mortgage-backed security comprising those mortgages. By doing this, Fannie and Freddie enable lenders to quickly sell their loans and use the money to make new loans.

The GSEs will also issue guarantees that mortgages will be repaid, which act as insurance against borrower defaults. Both companies also issue mortgage backed securities that come with a guarantee that the principal and interest payments will be paid on time to the investor.

The GSEs earn income from the interest rate spreads between what they pay investors to buy their securities and the interest collected on mortgages underlying them, as well as from fees for guaranteeing loans and assuming the aforementioned risks related to defaults.

The latter is why the GSEs were crushed when the housing market fell apart. When borrowers default on loans guaranteed by Fannie or Freddie, the GSEs owe the entire balance of the loan or guaranteed security. Now, explicitly not just implicitly, US taxpayers are on the hook for GSE losses resulting from mortgage defaults and home price declines.

Calls for reforming Fannie and Freddie are growing ever louder. However, despite these calls no right solution seems to exist. Moreover, it seems unlikely that any real resolution to problems with Fannie and Freddie will take place before November. Treasury Secretary Timothy Geithner has promised to deliver a proposal for housing finance reform to Congress by January 2011. Conveniently after the midterm elections in November.

As long as it is politically unacceptable to tackle this gaping hole in housing reform, the only thing that can save the GSEs is the return of private securitization. Which, as it turns out, may not be as far off as most “experts” think.

This post first appeared in the SPECIAL EDITION: Cirios Trends: A Decade in Flux

The books are officially closed on a decade which will be remembered for an historic real estate boom in the United States that busted in spectacular fashion, nearly taking the entire world financial system down with it.

Of course, the real story is a touch more complicated: Our housing bust was merely the most glaring crack in a global economy that grew far too dependent on cheap debt, where flows of money around the world magnetized to the hot asset, blowing bubbles first in stocks, then real estate, then commodities.

During each subsequent bust, governments rushed to the aide of markets, stitching them up with a patchwork of looser regulations, low interest rates and promises it would never happen again.

Late in 2008, the collapse of the credit markets culminated in the failure of some of this country’s most storied financial institutions. When the dust settled, Bear Stearns, Lehman Brothers, Merrill Lynch,
Washington Mutual, Wachovia, Fannie Mae, Freddie Mac, AIG, Countrywide and a host of smaller, lesser known entities had either gone bust or been bought for a song by stronger, better capitalized firms.

Some simply melted into this or that government agency, while many members of our financial complex survived only with historic government aide. Citigroup, Bank of America, Wells Fargo, JP Morgan Chase, Goldman Sachs, Morgan Stanley, GM and Chrysler are alive today thanks to massive taxpayer-funded bailouts.

But enough looking behind us; historians and journalists will be employed for decades slicing and dicing this most turbulent of decades.

Surveying the horizon, the primary fear among economists, investors and ordinary Americans is that the inflationary effects of pumping trillions of dollars into an economy must eventually come home to roost.

To be sure, there are those who remain firmly in the camp that believes the more pressing concern is inflation’s less-well understood counterpart, deflation. But even the most ardent deflationists believe theirs is a debate that is more accurately painted as one of time horizons, rather than absolutes.

The US dollar is in the crosshairs of this philosophic, as well as very practical debate. The greenback’s standing as the global reserve currency has been thrown into question as investors around the world scratch their collective heads and try to figure out how we’ll ever repay our staggering, ever-growing debt.

And now, as our economy appears to be slowly healing, the Federal Reserve faces the unenviable task of withdrawing its generous stimulus. In March, the Fed plans to scale back its purchases of mortgage backed securities, spooking more than a few market participants.

The fear, particularly for the housing market, is that any Fed pullback will push up interest rates.

Higher interest rates translate into lower purchasing power for buyers, curtailing the steady stream of homebuying demand that, coupled with ongoing foreclosure moratoria, has propped up prices in recent months.

We kick off 2010 with mortgage rates approaching the all-time lows set last spring. Sure, they could always go lower, but the smart money is betting it’s just a matter of time before rising prices force regulators to ease their foot off the monetary accelerator. Higher mortgage rates are likely on the horizon.

So as we begin the first true test of our nascent economic recovery, Cirios would like to take you through a bit of history. We’ll look first at the macroeconomic picture as it relates to home prices, inflation and interest rates. Next we’ll examine a few California real estate markets illustrative of the localized trends masked by most broad economic measures.

But first, a word of caution: As Mark Twain’s oft-cited saying goes, “History doesn’t repeat itself, but it often rhymes.”

It goes without saying that the financial upheaval of the past 24 months has been, in a word, unique. There is no historical analogue, no matter how neatly we try to jam this experience into some mold cast in the 1930s, 1970s or 1980s. By extension, any conclusions drawn from this historic perspective should be taken with a very large grain of salt.

Nevertheless, understanding where we stand and how we got here is essential to understanding where we’re headed. And understanding where we’re headed is essential to finding and taking advantage of the plentiful investment opportunities the previous decade’s turmoil has created.

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