Just as Congress passed the financial reform bill to prevent
another financial meltdown, top government officials are currently
trying to unwind destruction in the housing market from 10 years of
over-stimulation - and trying to prevent another systematic
That's right, the subject of who makes loans and who gets loans
are both at the center of the debate.
If you were looking for specific small cap investment ideas
today, stop reading now. I don't have them. But if you're
interested in understanding one of the major factors that will
determine market direction over the next couple of years, I
encourage you to read on. We'll get back to specific stocks later
this week. Housing is a hugely important issue, and you need to
know what's going on.
***Yesterday, the Obama administration, led by Treasury
Secretary Tim Geithner and Secretary of the Department of Housing
and Urban Development (HUD) Shaun Donovan, began discussing how to
repair the housing finance system. The conference represents a
first step in developing a new approach to lending in the U.S.
Central to the discussion is how head officials can decrease the
impact of future recessions on the housing market. As you likely
know, back in September 2008 our government took over
Fannie Mae (
Freddie Mac (
- two organizations (notice that I did not call these shell
organizations 'companies') that are now at the center of the
Ok, maybe I will mention two small caps. Fannie Mae and Freddie
Mac both have market caps under $400 million. Problem is they both
have enterprise values over
. No typos here. Recall that enterprise value is a company's market
cap, plus debt, less cash. It's essentially what a private equity
firm would pay to take a company private.
Point is these are shell companies - bound to fail but propped
up by a failed mortgage finance system. Check out these companies'
5 year charts - any takers out there?
To understand where lending could be headed, you must understand
how we got into this mess. Back in 1992, Congress passed an act
that essentially forced Fannie Mae and Freddie Mac to make housing
affordable. Their mission was to provide liquidity and stability in
the mortgage market. These 'companies' would buy mortgages and
package them into securities with a no-default guarantee.
They then began issuing mortgages, many to low-income Americans
who could barely afford their monthly payments. Why? Because big
government decreed that home ownership was a right.
***The question now is whether or not the government should
continue funding these companies to provide stability in the
housing market. Or should the government reduce its role and allow
a private market to take over. Call me a cynic, but I think the
folks at Merriam-Webster have already crossed out the term 'free
market' for their next dictionary release. But I digress...
Tim Geithner believes the government could remain involved in
the mortgage market - guaranteeing money to investors in
mortgage-backed securities regardless of whether or not the
But he also said that Fannie and Freddie will undergo
"fundamental change". Geithner even went so far as to state the
possibility of giving these two companies an "elegant funeral" -
implying this would eliminate the government's role in the housing
But many analysts oppose this idea, saying that the government
plays a significant role in the housing market, especially during
economic downturns like the one we've been in the last two
"Without such support [from the government], the risk is that
future recessions could be more severe because the financial system
would not have the capital to support mortgage lending on an
Mark Zandi, economist at Moody's Analytics, discussed the
repercussions if the government decreased its role saying,
"The hit to the economy [from the recession] would have been
. His statements indicate that with the government's implicit
backing of these mortgage giants, credit was allowed to continue
flowing - even as home prices plummeted and private sector lending
***Top officials heard both sides of the debate yesterday.
Republicans stressed the importance of limiting the government's
role in the housing market while Democrats advocated government
spending in order to provide stability - and give the average
American an opportunity to own a home.
The debate will only gain momentum in early 2011 and could
determine if, and how quickly, the housing market, and thus the
economy, will recover.
A few weeks ago Fannie Mae requested around $1.5 billion in
funding after reporting a second quarter loss of $3.1 billion.
Freddie Mac is in the same situation. The company had $118 billion
in bad loans in the most recent quarter, up from around $15 billion
at the end of last year. It also reported that it owned more than
62,000 foreclosed properties, up from just 35,000 a year
What to do, what to do...
Obviously these organizations aren't viable institutions - so
the choice becomes (1) do nothing and keep the 'shells' until the
debt can be wound down, or (2) take action to move the government
further away from the center of housing finance.
If the government totally pulls out of the housing and lending
markets, that could hurt the economic recovery and credit could dry
up. It could also have a negative impact on the stock market, as
investors will most likely be turned off by the news of a credit
crunch. But if it stays in, then nothing changes.
***I don't think this is an all-or-nothing decision. According
to the Mortgage Service News, Fannie, Freddie, and Ginnie Mae (the
Government National Mortgage Association) were behind 98 percent of
all mortgages in the U.S. so far this year. Some are worried that
eliminated any support to these agencies is like pulling the rug
out from under the entire housing market.
There is no way government can get its act together to offload
trillions of dollars in mortgage debt, and billions in bad loans,
in an orderly fashion all at once. And no private institution would
take on that level of risk. What we would wind up with is literally
thousands of organizations, many of which would likely be hedge
funds and private equity funds, taking comparatively large bets on
the future of housing prices and interest rates.
That's not a scenario I favor - even though I'm a staunch
advocate of 'free' markets. This mess is too big, too deep, and too
pungent to shovel onto the private sector in short order.
I believe we are in for a long transition period during which
Fannie and Freddie (or some similar shell organization) will exist
to house the majority of mortgage debt. We need a disciplined step
down plan through which government's over-control of the housing
market is wound down. Let's start with reducing government mortgage
debt ownership from 98 percent to 90 percent, then 80, then 70 -
The precedent for public-private partnerships has already been
established - not only in the housing market but in all types of
organizations ranging from natural resource protection to
technology development. No need to reinvent the wheel right
The complexity of this problem will most likely be solved by
similar means - bringing the private and public sector back
together and transitioning ownership, and responsibility, from one
to the other. But that won't happen quickly.
Expect this huge economic challenge to be a major driver, both
up and down, of market direction for the next several years. I
can't tell you how it will end, but I will keep you updated as it