Special Report: How the Government is Setting Us Up for a Second Subprime Crisis
[Editor's Note: Shah Gilani, a retired hedge fund manager and noted expert on the global credit crisis, predicted this developing FHA debacle in a July 2008 Money Morning essay.]
By Shah Gilani
Contributing Writer
Money Morning
Is the government creating another subprime-mortgage bubble?
The first time around, the three-headed federal serpent – the Bush administration, the Treasury Department and the U.S. Federal Reserve – used Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) to “legitimize” trillions of dollars worth of toxic financial waste known as subprime mortgages.
The result was the worst financial crisis since the Great Depression – a mess that was global in nature.
And we’re now headed for a repeat performance.
Some of the players may have changed since the first subprime-mortgage crisis, but the game apparently remains the same. With banks currently unwilling to lend, the new federal triumvirate of the Obama administration, the Treasury and the Fed are trying to inflate the moribund U.S. housing market. This time around, however, the FHA is the weapon of choice.
Obama & Co. are making an all-or-nothing bet that the U.S. economy will recover and bail out the housing market before the final bill for this ill-advised gambit comes due.
When this bubble bursts – and it will – U.S. taxpayers will be on the hook for more than $1 trillion in government-guaranteed debt.
Ginnie Mae: Fannie and Freddie’s Once-Quiet Cousin
As a direct result of the real-estate meltdown, U.S. banks have become reluctant lenders. And they’ve raised their loan standards considerably. Federal officials knew they had to keep the mortgage spigot open, especially to suspect borrowers, so they turned to their new “secret weapon” – the FHA.
The FHA has been cranking out new government-insured subprime loans, which it packages into government guaranteed securities for sale to banks. This frightening reflation of the subprime bubble is being engineered for two key reasons:
- To put a floor under falling house prices.
- And to let banks swap toxic Fannie and Freddie securities for new toxic debt that is 100% guaranteed by U.S. taxpayers.
The almost inevitable insolvency of the FHA could rapidly undermine the fragile recovery of the U.S. economy. And it could plunge stock prices and bank viability to new lows.
Why the FHA?
That’s simple. In an era of increasingly stringent lending standards, the FHA’s standards are laughably lax.
Created by the National Housing Act of 1934, the FHA insures private mortgage lenders against borrower default on residential real estate loans. But its current allure is that it opens the door to prospective homebuyers who almost certainly wouldn’t qualify for a conventional home mortgage. These are buyers with no credit history, a history of credit problems, or not enough cash to cover the down payment and closing costs.
The FHA has quadrupled its insurance guarantees on mortgages in just the last three years, with the bulk of that growth coming in the past two years. Currently, the FHA insures $560 billion of mortgages.
Loans that are FHA-insured are pooled and packaged into mortgage-backed securities (MBS) by the Government National Mortgage Association, more commonly known as Ginnie Mae. Ginnie Mae insures the actual MBS pools composed of FHA loans. Ginnie Mae securities are the only mortgage-backed securities backed by the full faith and credit of the U.S. government.
Two weeks ago, Ginnie Mae proudly announced that it had issued a monthly record $43 billion in FHA mortgage-backed securities, and through the end of July held guaranteed securities with a value of $680 billion. It is on track to exceed $1 trillion worth of guaranteed securities by the end of calendar year 2010.
Ginnie Mae is a cousin of its better-known siblings Fannie Mae and Freddie Mac. Those two mortgage giants are technically insolvent, and were forced into government conservatorship at the height of the financial crisis – ostensibly due to concerns that foreign central banks in China, Japan, Europe, the Middle East and Russia might stop buying our bonds. As “government-sponsored enterprises,” or GSEs, Fannie and Freddie were only supposed to have the “implicit” backing of the U.S. government. But recent events have shown these to be fully backed by taxpayers.
The implosion of Fannie and Freddie severely threatened the mortgage market. It essentially shut down the two giant repositories that bought the loans banks and mortgage originators didn’t want to hold as assets on their own balance sheets.
The FHA and its mortgage-backed securities “factory” – Ginnie Mae – have taken up where Fannie and Freddie left off, and are now the dumping ground for toxic mortgages. Using the FHA is the core strategy in the administration’s misguided effort to prop up mortgage origination and modifications, real estate prices and insolvent banks.
Warning Signals?
Administration officials might want to take heed of some eerie parallels between the current situation and the one involving Fannie and Freddie. They could serve as an early warning system.
First and foremost, the FHA has already started to acknowledge systemic fraud in its business. In the earlier subprime crisis, similar circumstances led to the revelation of massive fraud in the issuance, packaging, ratings and sale of subprime toxic mortgage-backed securities.
On Aug. 4, the FHA suspended Taylor, Bean & Whitaker Mortgage Corp., one of its largest approved independent mortgage originators, from making anymore FHA-backed loans. The suspension came one day after federal investigators raided Taylor Bean’s Ocala, Fla., headquarters.
Since 2007, the value of FHA-backed loan originations underwritten by Taylor, Bean had soared 117%. By contrast, the origination of conventional loans by the firm dropped 34% over the same period. Taylor, Bean subsequently filed for bankruptcy.
Earlier this summer, the U.S. Department of Housing and Urban Development (HUD), which oversees the FHA, raised concerns about FHA practices. On June 18, HUD released an internal inspector general’s report that revealed that the FHA’s default rate exceeded 7% and that more than 13% of its insured loans were delinquent by more than 30 days.
In a “Review and Outlook” piece, The Wall Street Journal reported that the FHA’s reserve fund dropped from 6.4% in 2007 to about 3% today, putting it dangerously close to its mandated 2% minimum. That translates to a “33-to-one leverage ratio, which is into Bear Stearns territory,” the newspaper report stated, referring to the now-failed investment bank that had been a central player in the original subprime mortgage crisis.
Bear Stearns is now owned by JPMorgan Chase & Co. (NYSE: JPM).
The HUD inspector general’s report stated that the agency’s growth makes it “vulnerable to exploitation by fraud schemes” and that it may need “Congressional appropriation intervention.”
In a recent article – “FHA Disputes Whispers of Capital Reserve Problems” – on the Mortgage News Daily Web site, HUD Secretary Shaun Donovan said in June that “there’s a better than even chance that we will stay above the two percent reserve threshold. That suggests, not just for the 2010 business, but overall for the portfolio, that we’ll more than likely to stay out of a broader need for any taxpayer funding.”
It may be more than a little disheartening to know that in a very uncertain economic environment, precisely due to fraud in mortgage lending and increasing borrower defaults, that our government is stretching a 50/50 wager on the backs of taxpayers.
That’s only part I of the FHA dilemma story.
Part II is even more frightening.
A Look Ahead
Banks are dumping Fannie and Freddie-backed securities onto the Fed’s balance sheet and replacing them on their own balance sheets with FHA-insured loans packaged into government-insured securities issued by Ginnie Mae. Banks aren’t reducing their net assets, they are aggressively swapping acknowledged toxic securities that no-one wants for a new variety that no one will want in the future. Why?
It’s not just that Ginnie Maes are fully backed by the U.S. taxpayers and Fannie and Freddie’s securities are only implicitly backed. All of them will be covered by taxpayers.
The devil is in the details.
Because Fannie and Freddie securities are only implicitly guaranteed, banks that hold these securities as assets on their balance sheets must “haircut,” or set aside reserves, based on a 20% risk-weighting assigned to the value of those holdings.
Because Ginnie Maes are explicitly 100% guaranteed, they are considered “risk free,” and on par with U.S. Treasury bonds, notes and bills. There is no reserve requirement, or haircut, on Ginnie Mae securities.
By replacing their asset mix and holding Ginnie Maes, banks don’t have to set aside reserves. They can use the money they otherwise would have to set aside to actually leverage-up their balance sheets. And guess what they’re buying?
More Ginnie Maes, naturally.
The effect of the asset swap – basically one toxic pool for a replacement that’s not much better – creates the illusion that banks have healthier balance sheets and that they are meeting their reserve requirements. It’s such a good deal for the banks and actively promoted by the Fed and Treasury, that banks are using Troubled Assets Relief Program (TARP) money to buy Ginnie Maes.
But it’s all a façade.
Capital ratios are being manipulated and insolvent banks are being propped up.
The danger of relying on the FHA to prop up the shaky housing market by facilitating mortgage origination, modifications and refinancing to less-than-stellar borrowers will only result in more subprime loans being stockpiled on the Federal Reserve balance sheet.
Eventually, defaults will overwhelm the FHA. And the hoped-for floor in residential real estate pricing will be pulled out from under us all. The next down-round in real-estate values will expose bank balance sheets for what they really are: Over-leveraged and over-stuffed with junk. Already on the ropes, banks will lose capital and will have to tighten the credit screws on consumer borrowers even more.
We may be headed for another bruising round of real-estate and MBS-related depreciation. Even a mild financial-markets setback could put the economy and the stock market onto the canvas for a 10-count. Further pummelling of shaky consumer confidence accompanied by a couple of major bank failures could easily send the U.S. market down for the financial-system equivalent of a TKO.
Taxpayers, always the lowly cornermen holding the spit buckets, are already in place with the safety nets. We will catch the FHA loans because we insure private lenders against subprime borrowers with no skin in the game. We then will have to catch the buyers of Ginnie Maes, because we guarantee those MBS securities. And we will be forced to catch the falling banks, because we already insure depositors through the Federal Deposit Insurance Corp. (FDIC).
Perhaps our ultimate fate is that of the permanently punchdrunk veteran boxer, who rues his decision to stay in the game, realizing that he fought “one bout too many.” If that’s the case, that “one bout too many” could be Subprime Crisis II, arranged by the very market referees whose job it was to protect us from such beatings.
News and Related Story Links:
- Money Morning Investigative Report on the Bank Bailouts (Part I):
Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout. - Wikipedia:
Subprime Mortgage Crisis. - Associated Content:
National Housing Act of 1934. - SEC.gov:
Mortgage-Backed Securities. - About.com:
What is a Ginnie Mae Security? - InvestorWords.com:
What is Full Faith and Credit? - InternationalForecaster.com:
Great Doubts for the Benefit of the Stimulus Package. - Wikipedia:
U.S. Department of Housing and Urban Development. - Investopedia:
Government-Sponsored Enterprise. - The Wall Street Journal:
Taylor Bean Suspended From Making FHA Loans. - The Orlando Sentinel:
Ocala-based Taylor, Bean & Whitaker Mortgage files for Chapter 11. - Wikipedia:
Bear Stearns Cos. - Mortgage Daily News:
FHA Disputes Whispers of Capital Reserve Problems. - Money Morning News Analysis:
Inside Wall Street: That Ticking Sound You Hear Out in the Mortgage Market is the FHA.
Comment by Common Sense on 23 September 2009:
FHA and GNMA aren’t the devil — executive compensation and reliance on foreign workers are! Where’s the story about the real cause of mortgage defaults? When people don’t have jobs, they cannot pay mortgages. Get it?
Comment by BEM on 23 September 2009:
What a bunch of BS. To begin with, the loans being made today (what few there are), are nowhere near the same as the “toxic” loans of the past. To call these current FHA backed loans “toxic” is ludicrous.
The days of the Option ARMS, Interest Only, No Doc, 125% LTV etc. loans are gone. Todays borrowers have to meet income requirements, credit score limits, make at least a 3.5% down payment and, in some cases, submit DNA samples and sacrifice their first born. Not to mention the appraisals are being scrutinized beyond belief and reason.
I agree, there will be defaults, but nothing near what we have seen in the past. Get real.
This guy has always been a Grim Reaper in the past, after all he’s a hedge funds guy. The more fear out there, the more money he makes.
Comment by Richard Ulrich on 23 September 2009:
It is evident that the rating agnecy are at the forefront of this problem. It must be the buyers of the MBS that should be paying for the rating and not the sellers. Untill the rating agency are regulated, this will continue to be a problem. The lax underwriting and risk taking will contuniue throughout this industry, which will cause a mortgage crisis similar to the one we just had.
Comment by John Walker on 23 September 2009:
In 2006 we had Obama and some 20 other lawyers from Acorn going to banks that were not making bad loans and threatening large lawsuits if they did not make bad loans, as specified under the 1994 Federal Fair Housing Act signed into law by Clinton, and sponsored by Barney Frank and Chris Dodd. This law was the means for destruction. I think you will also see many defaults on Auto loans from the glunker program. Many people bought that would not have otherwise.
Comment by Paul Basil on 23 September 2009:
I am wondering what role, exactly, Shah Gilani believes Fannie and Freddie played in the subprime situation. Fannie and Freddie are not and were not subprime entities. They are ‘prime’ entities. This whole article is pretty ignorant though. To suppose that our financial crisis is the result of the subprime meltown is like supposing the cough causes the cold.
Further, FHA standards, though lower than Fannie and Freddie are nothing like subprime standards, if one can even use that word for subprime. FHA has increased its down payment requirements and tightened its credit requirements since 2007. FHA has also increased their insurance premiums substantially since 2007 in order to support their mission of being self-sustaining.
I don’t disagree with Gilani’s belief that we will see another huge wave of foreclosures, but Gilani’s focus on the symptom versus the cause and ignorance about how residential lending actually works leads me to suggest Mr. Gilani write about something else.
Comment by Thomas DeClue on 23 September 2009:
Dear Mr. Gilani,
If you research, you will find the sub-prime mortgage crisis began under the Clinton administration. Fannie Mae announced in 1999 that it was lowering requirements for mortgages for those with lower incomes. You can find the article by going to the link below.
http://www.nytimes.com/1999/09/30/business/fannie-mae-eases-credit-to-aid-mortgage-lending.html
Your article is misleading, and like so many others blames the Bush administration for the mortgage crisis that began under the Democratic administration of Bill Clinton.
Sincerely,
Thomas DeClue
Comment by Gordon E. Owens on 23 September 2009:
The saddest part of this story is that all the self seeking on the part of those who have the fiscal ability to prosper from this situation is that we as a country are witnessing the economic takeover of our country’s resources and our economic position in the world. It is the same effect as if we went to war and lost and are now a conquered nation, without having fired a shot! The shame of it all is that many are within our own ranks that helped this situation to come about to this sad estate. During war, we hold people who are traitors accountable with their very lives. Today, we have allowed those responsible to go essentially unscathed and my children will pay through taxes and loss of prosperity for what I consider to be very insidious rape of our country!
Comment by Hal (GT) on 23 September 2009:
I would note that the Fannie and Freddie woes didn’t start during President Bush the 2nd’s time but during the Clinton years. Though I agree he failed to do something about it. Him and Congress.
The Mortgage problems continue today according to this Reuters article http://www.reuters.com/article/ousivMolt/idUSTRE58K29E20090921
And I would suggest that they are going to increase to an even higher rate because of the unemployment rates that continue to rise across the country. Remember the “good news” that the gov keeps feeding is us that less people were laid off, not that more people were hired. So the job loss is increasing not decreasing.
Add to all this a dollar that continues to bleed and inflation is not far behind as gold – an inflationary leading indicator – shows us.
Consider too how banks are leveraged. Check out this article on the FHLB which is leveraged close to 25 to 1. http://www.caseyresearch.com/displayCdd.php?id=227
Comment by Bob Veigel on 23 September 2009:
No surprise here. Almost everything the government does is to set the taxpayer up for another fiasco. It has been doing just that for almost 100 years. Why would it change it’s spots of deceit and nation destruction now? Wake-up Americans.
Comment by oversupply in housing on 23 September 2009:
‘1994 Federal Fair Housing Act signed into law by Clinton, and sponsored by Barney Frank and Chris Dodd’ was the shot in the head to the housing market, one of the moving parts in the housing crash, not to consider the sep 11 terrorist attack that sent the us economy into a short recession making the FED to put interest rates lower, so there was a lot of factors coming into play in the ‘perfect storm’.
Comment by Uncommon Sense on 23 September 2009:
Hate to break it to you common sense and BEM but FHA has had massive fraud throughout its history. Maybe its a good example of how easy it is to perpitrate fraud on Gov’t agencys. September 2008 unemployment was 6.2% at the time. Massive layoffs etc. started happening once the market tanked so how can you possibly make an argument that it was a lack of jobs that caused the 1st crash. Even though FHA is a full income check loan (unless its a rate & term refi) their credit standards are far below conventional standards. All in all I believe the writers case has potential to come true!
Comment by Rich F on 23 September 2009:
Without doubt, the efforts to prevent fraud on gov’t (taxpayer) backed FHA loans should be of first priority. But to suggest that FHA loans may lead to the next big sub-prime melt down might be going to far. As a commentor noted, these aren’t 125%, negative amortization, no documentation loans (this loan actually existed at one point). The primary reason that FHA loans have increase so dramaticly is that FHA loans require a much smaller down payment (3% to 5%) than conventional loans (20% to 25%). It can argued whether this is a good thing or not … borrowers should have some “skin in the game” vs. the decline in real wages over the last generation makes it more difficult for avg people to save for a large downpayment.
The credit requirements for FHA aren’t as stringent as the banks, but they are far from the non-existent requirements of the sub-prime days. PLENTY of people are turned down for FHA loans.
At the end of the day, the gov’t has two choices, not expand FHA usage and let the market shake everything out or expand FHA and try to soften the downturn by supporting home purchases, but potentially create a future problem. Rightly or wrongly, politicians are always under pressure to “do something now” to help … regardless of whether their actions actually help or not. Allowing the market to sort things out would take to long and require a continued downturn in the real estate market. Not acceptable political options … don’t blame politicians for looking out for their own short term interests … we (citizens) encourage this behavior!
Oh, BTW, while the 1994 Act that John Walker noted in his comment did help create the problem, don’t just blame Obama, ACORN and the Dems for it … industry favored the law too to because it removed a lot of restriction from them and allowed them to CREATE sub-prime products. The Dems got more (many unqualified) people into homes and the Repub/Industry got to make rediculous profits from it … EVERYONE was happy. Furthermore, it was INDUSTRY (AIG, etc) that pushed the law (signed by Clinton in Dec 2000) to allow CDOs (Collataralized Debt Obligations) to be issued without ANY regulation! Drop the political posturing John Walker and realize EVERYONE had a role in creating the mess we got into!
Comment by Aprov on 23 September 2009:
Blah, blah, blah!
Interesting, but not particularly actionable news, for people who have lots of time on their hands and live on the internet.
Blah, blah, blah!
Yikes!
Comment by Gary Wardell on 27 September 2009:
Explain to me why any body is interested in subprime. Subprime is 5% or less??? Almost any other investment should meet or exceed 5%.
This is a question not a comment.
Pingback by Will Taxpayers Have to Bail Out the FHA? on 12 October 2009:
[...] “In an era of increasingly stringent lending standards, the FHA’s standards are laughably lax,” Gilani said in a recent Money Morning editorial. “The almost inevitable insolvency of the FHA could rapidly undermine the fragile recovery of the U.S. economy. And it could plunge stock prices and bank viability to new lows.” [...]