Fannie Mae and Freddie Mac are nationalized

Over the weekend, Fannie Mae and Freddie Mac were nationalized.  Over the last couple of months it was widely thought that this would be unavoidable, however it still came as a shock that it happened so soon.  Looking at the home price indexes that are published by the The Office of Federal Housing Enterprise Oversight (OFHEO) which oversees Fannie Mae and Freddie Mac, it is puzzling that such a small decline in values could bring the two large institutions to their knees.  The monthly OFHEO purchase only index is down only by 4.8% year over year.  The S&P Case Shiller National Home Price Index is down 15.4% year over year. 

Last May I compared the OFHEO Home Price index and the S&P Case-Shiller Home Price Index in this post.  There are four major differences between the OFHEO index and the Case-Shiller index.  The first is the geographical makeup.  The S&P Case-Shiller National index covers about 70.8% of the U.S. Real estate.  The second difference is the OFHEO index looks at both purchases and refinances whereas the Case-Shiller index only looks at purchases.  However, the OFHEO does issue a purchase only index.  The third difference is the OFHEO index discounts homes that have lengthy intervals between valuations more than the Case-Shiller index does.  The final major difference was the loan types.  The majority of ARMs and interest only loans were financed outside of Fannie Mae and Freddie Mac.  I also showed how the OFHEO index tends to lag the Case-Shiller index by about 6 months.  This is could be due to the fact that a typical appraisal may have comparables that are 4 to 6 months old by the time the loan closes but could be up to 10 months old.

This chart looks at home prices going back to 1890 adjusted for inflation.  It also shows how the CME Futures market is pricing how the home price index will look like in the future.  It appears that we are about half way through the housing crisis.  The first half of declines has dramatically changed the financial landscape.  It remains to be seen what the future will bring, but I foresee a huge burden to the U.S. taxpayer.

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30 year fixed rates jump to 6.71%; Congress has reached agreement on rescue bill

Interest rates on Conforming 30 year fixed-rate mortgages rose to 6.71% on Tuesday, up from 6.44% last Friday according to HSH Associates. For 35 year from 1967 to 2002, 6.5% was the lowest the rates had been. Rates reached 18.8% during the 1982 recession. Rates jumped because of concern about the financial health of Fannie Mae and Freddie Mac.

The government is actively firming up plans to make the implicit government backing of Fannie Mae and Freddie Mac explicit.  The federal government has already proposed a rescue plan and Congress has reached agreement on the plan on Tuesday per a report on Bloomberg:

Under a modified version of proposals made by the Bush administration, the Treasury Department would gain authority to inject capital into the two largest U.S. mortgage finance companies, through loans and equity investments.

The Treasury would be barred from providing aid that would cause a breach in the federal debt ceiling under the agreement, a constraint aimed at limiting any taxpayer losses. The debt limit would be raised to $10.6 trillion from the current $9.815 trillion.

The legislation would also raise the limit on the size of the mortgages the companies may purchase. The new cap would be $625,000, or the median home price plus 15 percent, whichever is lower, Frank said.

A Congressional Budget Office estimate released today put the cost of Paulson's plan at $25 billion, a figure below the total that some lawmakers had expressed concern about.

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The State of the Nation's Housing 2008

The Joint Center for Housing Studies of Harvard University released their annual report on housing: "The State of the Nation's Housing 2008." The 44 page report gives a detailed look at the forces currently causing the housing crisis. There is a wealth of information and graphs in the report. Here are a few excerpts:

Assuming the vacancy rate prevailing in 1999–2001 was close to equilibrium, the oversupply of vacant for-sale units at the end of last year was around 800,000 units, or 1.0 percent of the owner stock.

In addition, the number of vacant homes held off the market other than for seasonal or occasional use surged from 5.7 million units in 2005 to 6.2 million in 2007.

Despite production cuts rivaling those in the 1978–1982 downturn, the number of vacant for-sale homes on the market did not shrink in the first quarter of 2008. The weak economy, tight credit, and concerns over whether house prices had bottomed out continued to suppress demand and delay the absorption of excess units. Until this oversupply is reduced, housing markets will not mend.

At last measure in 2006, 39 million households were at least moderately cost burdened (paying more than 30 percent of income on housing) and nearly 18 million were severely cost burdened (paying more than 50 percent). From 2001 to 2006, the number of severely burdened households alone surged by almost four million. Because of the unprecedented run-up in house prices and lack of real income growth, over half of this increase was among homeowners.

Housing permits fell 24 percent nationwide in 2007, with single family permits down 29 percent and multifamily permits down 9 percent for the year. This brings the total decline from the 2005 peak to 35 percent, including a 42 percent reduction in single-family permits. The downturn has been widespread, with permits declining in 94 of the 100 largest metropolitan areas over the two-year period. Smaller metropolitan areas have also been affected by the construction pullback, with 214 of 263 posting reductions in permits.

To wipe out past appreciation, home prices have to retreat the most in once-hot markets and the least in cold markets. For example, the 6.7 percent drop in the median house price in Indianapolis from the third-quarter 2005 peak to the fourth quarter of 2007 was enough to cancel out appreciation all the way back to 2000. In Sacramento, by contrast, the larger 21.8 percent drop in the median house price from its peak in the fourth quarter of 2005 to the end of 2007 only erased gains made since 2003.

The report chronicles how housing starts plunge before and at the start of a recession and recover either right before the end of the recession or shortly after. Currently our downturn is being led by housing. It will be interesting to see if the housing crisis extends the length of the downturn, or if the economy recovers first.

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OFHEO indexes lag S&P Case-Shiller indexes

The Office of Federal Housing Enterprise Oversight (OFHEO) announced their quarterly home price indexes for the U.S., the 9 Census divisions, all individual 50 states, and 381 Metropolitan Statistical Areas (MSAs).

The OFHEO analyzes the mortgage records of Fannie Mae and Freddie Mac's conforming mortgage transactions (currently $417,000 maximum loan amounts and "temporarily" up to $729,750 in high-cost areas). They analyze repeat transactions to determine the home price index. Unlike the S&P Case-Shiller index which only uses purchases, the OFHEO analyzes refinances and purchases. They also issue a purchase only index for the U.S., the Census divisions and the individual states.

Before seasonal adjustments, the U.S. index was virtually unchanged versus a year ago with a decline of 0.03%. The U.S. purchases only index showed a decline of 3.07%. In contrast, the S&P Case-Shiller Composite-10 index was down 13.6% versus a year ago in the latest reading. This is quite a disparity.

The first reason for the disparity is the geographic composition. The S&P Case-Shiller Composite-10 is an index of 10 cities: Los Angeles, Miami, Washington D.C., San Diego, Las Vegas, San Francisco, New York, Boston, Chicago, and Denver. There are a lot of cities in that index that had a huge runup in home prices followed by a large decline. The composite-10 covers 30.2% of U.S. real estate. The rest of the country did not have as large of a swing. The S&P Case-Shiller Composite-20 adds Tampa, Phoenix, Seattle, Portland, Minneapolis, Atlanta, Charlotte, Dallas, Cleveland, and Detroit to the list. The spike up and down in these cities was not as dramatic. The composite-20 covers 42.5% of U.S. real estate. Finally, S&P Case-Shiller put out a National index that covers all 9 Census divisions and covers about 70.8% of the U.S. Real estate. Fittingly, the National index did not move up and down as the other two indexes. The OFHEO, having a national composition, had the flattest curve of all the indexes.

The OFHEO issued a research paper detailing the major factors for the disparity between the S&P Case Shiller index and the OFHEO index. They found that besides the geographic makeup, there are 3 major differences accounting for the other variance. The first major difference is the fact that the OFHEO's index looks at both purchases and refinances whereas the S&P Case-Shiller index only looks at purchases. Purchase transactions are considered to be more accurate. For one, it is the price at which the buyer is valuing the property. The buyer does not want to pay more than a fair price. In a refinance transaction, there may be pressure to overinflate the value (to maximize cash out, or a certain value may be needed for the transaction to work). The refinance values are also staledated. An appraisal can usually be up to 120 days old by the time the property is completed. The appraisal uses comparable sales to value the house. The comparables that the appraiser uses are sometimes up to 6 months old. A typical appraisal may have comparables that are 4 to 6 months old by the time the loan closes but could be up to 10 months old (120 days plus 6 months). In an update to the study, the OFHEO found that on average their figures were 6.87% higher than the S&P Case-Shiller year over year declines for the 10 cities in the Composite-10. By eliminating refinances from the data, the discrepancy was reduced by 2.38%.

The second big factor in the difference between the two indexes is the weight that is given to homes that have lengthy intervals between valuations. OFHEO discounts homes with long intervals between valuations more than the S&P Case-Shiller index does. This led to a bigger variance by 1.35%. The biggest difference between the two indexes was the omission of homes that sold with financing other than Fannie Mae and Freddie Mac loans (subprime loans, jumbo mortgages, VA, FHA and other types of financing arrangements). This led to a variance of 2.85%. The majority of ARMs, and interest only loans were financed outside of Fannie Mae and Freddie Mac. Borrowers with this type of financing may have overpaid on their purchases. For example if a borrower wanted $2000 a month payments and the interest rate was 6%, then loan amount for an interest only loan would be $400,000; a fully amortized loan would be $333,583. An interest only loan would give more buying power. Moreover, ARMs usually had a lower rate inflating the possible loan amount at those payments even more. Another reason for the variance in non agency loans was the lack of skin in the game, or 100% financing. A borrower without a vested interest in a property is apt to take more risks. If a borrower overpays on a house and puts 10-20% down, then they risk losing their money. A borrower that puts 0% wins if the property shoots up in value. If it drops in value they lose, or in today's world they walk away. 100% financing also led to overinflated purchase prices in some cases. For example, if a borrower wanted to buy a $200,000 house, but had no money for a downpayment or closing costs, they might structure the purchase at $205,000 with a seller credit to the buyer for $5,000 to cover closing costs. They would get a loan for $205,000 and basically have the bank finance the closing costs. A borrower putting 10-20% down might not want to do this. Surprisingly the loans that were not eligible for sale to Fannie Mae and Freddie Mac due to loan amount (over $417,000 loan amount) did not contribute to the larger declines in the S&P Case-Shiller index (they lessened the decline by 0.19%). It was the lower and mid priced homes with non-agency financing that led to the variance of 2.85%. This is contrary to the common assumption that the reason for the variance is the loan size constraints.

Here are graphs of the 10 cities in the composite-10 comparing the S&P Case-Shiller index to the OFHEO index. The OFHEO index (includes refinances) lags the S&P Case-Shiller index by around 6 months. Amazingly the peaks reached were very similar across the board. The lag between the indexes was also fairly consistent.

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