In short, that taxpayers will throw good money after bad in a massive subsidy to the housing market, which is mostly made up of taxpayers. 

The acronym “GSE” is derived from the description of Fannie and Freddie prior to their implosion and government takeover as “Government Sponsored Entities”.  Before the fall, they were creations of the federal government that were intended to facilitate the funding of housing loans.   They were designed as profit-making entities, selling stock on the exchanges and borrowing money in the capital markets.  That was then.  Now they are simply pass-through entities, subsidizing the continuing insanities in the residential real estate market through big dollops of taxpayer money, dished out like clockwork, eleven of the past twelve quarters for Freddie Mac.   “GSE” should now stand for “Government Subsidy Engines” because that’s what they now are.

Well surprise, surprise.  Freddie announced today that it would need a $1.8 billion dollop of more taxpayer money due to losses the past quarter.  Knowing just a little bit about how these two giants operate and why they are in such dire straits can go a long way towards understanding the challenges facing any economic recovery (together they insure repayment or outright own over half of the roughly $12 trillion residential real estate mortgage market).

The reason for the losses are two-fold.  First, the mortgages they hold or insure are going bad at unprecedented rates.  From the Wall Street Journal:

At Fannie, the volume of nonperforming loans fell during the second quarter by nearly 3% to $217 billion, though that was still up 22% from a year ago. But nonperforming-loan volumes at Freddie continued to rise during the second quarter to $118 billion, up 2% for the quarter and 36% from a year earlier.

Second, and really the most powerful and longer-lasting drag on their balance sheet, is that the assets securing all the mortgages they insure or own are declining in value.  So when a mortgage goes bad and they have to write down its value, the anticipated recovery may be fifty percent or less, creating a big hole in the balance sheet.   Even their performing loans, in the face of real estate price declines, are woefully undersecured.

To make it simple, if they own or insure $6 trillion in residential real estate mortgages that are secured by houses that lose just twenty percent of their value, they will need subsidies of roughly $1.2 trillion dollars to fill the holes in their balance sheets.  The total tab for their rescue thus far is $138 billion.  We’ve a long way to run before the subsidizing is over. 

Now let’s follow the money flow in a homeower’s default and see how it impacts the GSE’s.  Let’s say the principal on the mortgage is $100,000 when the borrower quits paying.  When he finally gets kicked out of the house, he owes about $5,000 in unpaid interest and fees, and another $2,500 in legal expenses, making a total of about $107,500 that sits on the asset side of Freddie’s ledger.  On the debit side of the ledger sits whatever loan Freddie took out to fund the mortgage, presumably at an interest rate lower than that charged the homeower, along with the interest owed on this funding loan, and the bills for contractors hired to facilitate the foreclosure.   Any excess between the mortgage loan and the funding loan constitutes equity or retained earnings.   Any deficit is a loss.

But in foreclosure, the value of the funding loan is displaced by the value of the property securing it.  If the original property value was $125,000, making for a 20% equity cushion at purchase, then the property value could decline to about $115,000 and Freddie would just break even.   It would be able to pay off the mortgage note-associated costs ($107,500) and pay 7% or so towards the expenses (real estate commissions) of the sale. 

Note that even with a 20% equity cushion at purchase, i.e., even when the borrower came to the table with $25,000 plus whatever closing costs he was bound to pay, Freddie can only afford to have the property lose about 9% ($10,000) in value before a foreclosure puts it underwater.    There aren’t many places where property values have declined less than 10% over the last few years.   Freddie is in a pickle.   Rinse and repeat, with much greater price declines than 9%, many thousands of times, and the need for government assistance becomes clear.

But from where does this assistance ultimately arrive?  Go back to the homeower.  He indeed was able to break free of his mortgage obligation, but is now saddled with the prospect, like any taxpayer–presuming he pays taxes–of paying back through higher tax rates the losses his mortgage company had seemed to suffer.  

What does all this do for housing prices?  The future tax liability of the putative future homeower decreases the amount he can pay for housing.  The foreclosed properties awaiting sale (a combined 191,000 residences in inventory at Freddie and Fannie about now) further depresses prices. 

There are two ways to get at lower prices that the market seeks–through outright price declines or through lower interest rates, but either way, price declines are a disaster for Freddie’s balance sheet and profitability.  For assets that are generally bought via financing, reducing interest rates effectively reduces the monthly “price” (i.e., payment) being paid.  Outright lower prices bulldoze holes in the balance sheet.  Lower interest rates, i.e., a lower spread between the interest paid and interest received, provides less yield return to apply to credit losses, but this is the preferred method of reducing prices.  It is much less damaging to the balance sheet.  If there is no limit to the amount of money that can be lent, interest rates will eventually approach zero in an attempt to forestall price declines , and there will be no yield spread to apply to credit losses.

Which, as I’ve said before, is where I think we are heading–zero interest rates in a vain attempt to forestall actual price declines.  Once interest rates go as low as they can, then we’ll see the floor drop out from under prices, which though they have decreased something greater than ten percent in most areas, still have a ways to go to reach that elusive nirvana of equilibrium with supply.  

It has been theorized that all government programs eventually operate, no matter their original intent, to benefit the greatest number of people with a vote to sell.   The massive and ongoing subsidy of homeowers through the GSE’s surely fits the bill.    With the GSE’s, the whole of the taxpaying public directly and indirectly subsidizes a subset of itself that are homeowners and owers by artificially and temporarily preventing the market collapse that wishes to happen.  It will happen anyway, but in the meantime, extend and pretend season continues.