President Biden Doubles Down on Housing

This guest commentary was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst. This piece does not necessarily reflect the opinion of Hedgeye.

As home prices approach truly silly levels and stress is starting to build in the housing finance system, the Biden Administration is preparing to double down on housing.

The fact that Biden's approval numbers are in free fall in national polls does not affect the progressive desire to make housing the latest American entitlement.

President Bill Clinton caused the 2008 financial crisis by excessively encouraging home ownership in the early 2000s. Specifically, Clinton allowed the GSEs to buy low-quality, private label mortgages, assets that eventually caused the GSEs to fail. The GSEs were the suckers in that housing cycle.

Now Joe Biden (or someone acting in his name) is again going to throw gasoline on the proverbial fire of asset price inflation. Gretchen Morgenson and Joshua Rosner wrote in Reckless Endangerment:

"Just as [former Fannie Mae CEO] Jim Johnson had recognized that earnings growth was essential to Fannie Mae's continued success, political influence, and his lush pay packages, [Angelo] Mozilo knew that he had to keep feeding the beast to keep his company's stock price high. In 2005, Johnson brokered a deal that would boost Countrywide's loan production overnight."

Since taking office, the Biden Administration has made over a dozen changes in the rules applicable to the Federal Housing Administration including broadening the eligibility for condo loans and making it easier for borrowers with student loan debt.

But these incremental changes were as nothing compared to what is coming.

Our sources indicate that the FHA is preparing to drop the 175bp upfront fee and the life-of-loan insurance surcharge on all government-insured loans. This will make the FHA market hyper-competitive vs the GSEs, Fannie Mae and Freddie Mac. Now that President Biden has removed Republican Federal Housing Finance Agency Director Mark Calabria, the GSEs will respond.

Acting FHFA director Sandra Thompson has already taken steps to align the GSEs with the Biden Administration’s policies to encourage housing even as the markets are showing signs of fatigue. After years of FOMC-induced asset price inflation, does the housing market really need more help? Clearly the Biden Administration thinks the answer is yes.

Earlier this month, Thompson suspended the changes made to the preferred stock purchase agreement (PSPA) between the GSEs and the Treasury, including changes to the amount of loans or MBS that issuers can sell via the cash window. Inside Mortgage Finance reports:

“The PSPAs, as most GSE watchers know, define the nature of the government backstop for Fannie Mae and Freddie Mac. In January, during the final days of the Trump administration, then FHFA Director Mark Calabria and Treasury Secretary Steven Mnuchin agreed to end the net worth sweep — however, only after taking steps to reduce what Treasury perceived as risky practices at Fannie Mae and Freddie Mac.”

These risky practices included the use of the cash window, as well as multifamily lending volumes and caps on the volume of mortgages the GSEs can purchase for second homes and investment properties.

FHFA also published a notice of proposed rulemaking that would dramatically revise the enterprise regulatory capital framework that governs the operations of Fannie Mae and Freddie Mac, lowering their capital requirements significantly.

Thompson has made no public statement about the risky practices cited in the latest amendment to the PSPA or whether her suspension of the PSPA changes means that these practices are now acceptable. Since these changes were made for specific operational reasons, and not ideology, one wonders if Acting Director Thompson has decided to forgive and forget.

We hear that there is a report by the FHFA Inspector General on the risky practices specific to the cash window that has not been released to Congress or the public. Specifically, during the Calabria term several issuers were using the cash window at Fannie Mae and Freddie Mac as a substitute form of warehouse facility. Instead of getting a bank credit line, the issuers figured out how to arbitrage the GSE cash window and, in effect, circumvent the capital rules for issuers while adding risk to the GSEs.

The GSE personnel who were responsible for these unsafe and unsound practices at the cash window have since left the building, but no public announcement was ever made by the FHFA OIG or Director Calabria. So far under AD Thompson, there has been no written guidance provided to issuers on whether the bad old days of using the GSEs to finance warehouse pipelines will be allowed going forward.

Given that the banks are charging sub-1.5% for secured warehouse lines today, one wonders why the FHFA feels the need to disintermediate the commercial banks. It’s not like lending volumes have crashed, although the latest projections from the Mortgage Bankers Association show a significant drop in refi volumes in 2H 2021.

Source: Mortgage Bankers Association

Meanwhile, as we noted in the most recent edition of The IRA Bank Book, signs of stress are mounting in the mortgage complex, with loss given default (LGD) for bank owned 1-4 family mortgages at -115% in Q2 2021.

The 40-year average new loss at default for bank owned 1-4s is 69%. An LGD of -115% on 1-4 family first liens means that, on average, banks are generating proceeds from foreclosures that are more than twice the loan balance.

Of even greater interest, however, is the fact that LGD for $500 billion in bank owned multifamily loans is now nearing 100% loss. Could it be that the progressive insanity of suspending rental payments for 24 months has created a credit problem in multifamily assets? Yes.

Remember, these multifamily bank owned loans are 50 LTV affairs that have been the gold standard of bank credit for decades, but now we see multifamily assets moving in the opposite direction of other housing loans.

Will we see buildings being abandoned by landlords in major cities around the US? The answer sadly is yes.

Source: FDIC/WGA LLC

As we did almost two decades ago in The Institutional Risk Analyst, when IRA co-founder Dennis Santiago observed in 2005 that Countrywide and Washington Mutual were starting to shrink, let’s put down a marker for future reference.

We think that the changes being contemplated by the Biden Administration at the FHA and FHFA to make housing credit even cheaper and more easily available will cause the next housing crisis.

Remember, the FOMC is already subsidizing residential housing to a huge degree via the massive purchases of government and conventional MBS. As and when the Fed begins to taper MBS purchases next year, mortgage rates will rise and so will the LGD for 1-4s and other housing loan categories.

Beneath the apparently calm and largely artificial credit surface in US housing lurks significant financial and economic hazards. Once the cost of credit in 1-4s is again positive, banks will again face financial and operational risk from residential exposures.

And as with so many things in business and in life, risk is about mean reversion.