by Scott Pape - July 19th 2008
Question: Fannie Mae and Freddie Mac are?
(a) A couple of washed-up 1970s porn stars.
(b) US mortgage houses that preside over $5 trillion in American mortgages.
(c) The potential trigger for a decline in worldwide housing prices.
Three Simple Points
If you’re perplexed about what happened on Wall Street this week, you’re not alone. In three simple points, here’s the Barefoot lowdown on what’s really going, and how it might affect you.
1. Sub-prime
Sub-prime loans were a symptom of the housing boom, not the cause.
After the tech wreck, the US Federal Reserve slashed rates from 6.5 per cent to 1 per cent. This made borrowing to buy houses (and plasmas, and plastic surgery) very attractive.
The masses went on a property-buying binge, financed from the equity in their existing homes or by getting cheap new loans.
Towards the end of the boom, the big banks started scraping the bottom of the barrel, offering the infamous sub-prime loans – 100 per cent loans to people who couldn’t afford them.
They fiddled the affordability figures by heavily discounting the “honeymoon period” for the first few years of the loan.
And when the rates reverted back to normal, as they were always going to, it was not uncommon for an already struggling homeowner’s repayments to double, or even triple, seemingly overnight.
Surprise!
The unemployed dude who sits on his couch all day playing Xbox and smoking doobies soon defaulted on his sub-prime mortgage. Duh!
Then all the Wall Street wizards who lent him and his mates the moolah were forced to write off hundreds of billions in losses. Double duh!
After that, Wall Street went into a funk. Banks stopped lending to each other. They called it the “credit crunch”.
Everyone blamed the Xboxers – but it’s important to remember they were simply the final (irrational) act of a long, drawn-out housing boom. The problem began with the prime (standard) mortgages.
2. Prime
The boom really began with average people taking out average loans. More than half of these mortgages were ultimately financed through two institutions – Freddie Mac and Fannie Mae.
These financial institutions were set up in the 1930s to buy mortgages from lenders. This process freed the banks up to lend more money than they otherwise could – typically $10 for every $1 of capital. Stay with me.
Today Freddie and Fannie are public companies that are owned by shareholders. Yet because they control around $US5 trillion (that’s with a T) in mortgages, the US Government has always implied that it would back them up if there were any problems.
So, if you were the chief of a publicly listed company whose losses would be picked up by the government, what would you do? Well, you would probably ramp up the risk to get a better bonus (and in the process lose billions), pay yourself a fortune (last year $US13 million), fudge the figures (Fannie Mae was implicated in accounting scandals in recent years), and then wave the white flag when things went pear-shaped.
While not technically “sub-prime”, many of the loans that Freddie and Fannie oversaw had their own multi-year honeymoon rates.
Analysts estimate that some $US300 billion worth of these mortgages will jump to higher rates between now and 2011.
Consequently, house prices have fallen 20-odd per cent (the largest drop ever, with much further falls forecast) and a chain reaction has begun – more people are defaulting on their loans, and because of this there are fewer buyers wanting American mortgages.
Now there’s a very real chance (which hit the headlines this week) that Freddie and Fannie would need to call in a favour from the Fed.
It’s been said that the US can’t afford not to bail out Freddie and Fannie if things get really bad – to do so would be tantamount to the US defaulting on its debts.
The three-step plan that the US Government came out with this week was designed to bolster confidence.
Still there are those who argue that if the housing market continues to slide, the Government may be forced to nationalise the companies – at huge cost.
The real loser would be the American taxpayer, and the US dollar would continue its downward slide as American politicians fire up the (already overworked) money-printing presses. Good news for the kids who want to go to Disneyland, bad news for dad (particularly if he’s an exporter).
3. The (potential) Aussie fallout
Anyone with a variable mortgage understands that we in Australia are not insulated from the US credit crisis. All our major banks have ratcheted up their rates to counter increased funding costs.
Fifteen basis points between friends is fine, but if the US mismanages this latest crisis, and falls into a deep recession, the implications would be felt from New York to Newcastle.
This boom was born on the back of consumers spending money on credit, but using your house like an ATM is so 2004.
In its place are tougher times for many people both in Australia and around the world; they’re heavily in debt at a time when asset prices are falling. They’ve got little savings. Their income is being eroded by rising prices (especially the cost of petrol).
The biggest financial risk for these people over the next few years, other than the bank jacking up rates even further, is losing their job – triggered by a slowdown in the US.
If this happened, bills would pile up. At the worst, their home could be repossessed. They would stop spending, which would eventually cause more people to lose their jobs.
What happens next in the world’s largest economy is out of our hands, yet the risks of this financial crisis are real for everyone.
Now has never been a better time to batten down the hatches, pay off consumer credit, and start a solid savings program.
Tread your own path!
Photo: www.flickr.com/photos/leecullivan/4003290106/in/set-72157594159048772/
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