As it stands right now Fannie and Freddie issue mortgage backed securities, while FHA primarily guarantees to buy back bad loans as a form of insuring the loans made by private banks/investors. It is through these vehicles that the federal government (really us – the taxpayers) seeks to create liquidity and lower interest rates.
By using our taxpayer dollars, the federal government is in effect spending our money to back and guarantee loans. This way these loans carry a lower risk and have broader appeal to the investors who buy them.
It is only for these reasons that interest rates have remained so low. Basically just another form of privatize the profits – socialize the losses. So be it – it is what it is.
But now what?
The changes that the Obama administration has proposed will gradually (maybe 2-3 years) take the government out of the Mortgage backed securities and insurance business. This will be done by phasing down (or out) Fannie Mae and Freddie Mac and limiting the role of the FHA.
Right now – the government has nearly 95% of this market and these changes would bring their role down to possibly below 40%.
Without those guarantees in place on the other 60% of the market - Will investors continue to buy mortgage bonds and if so at what price? If last week’s market reaction was any indication – it is going to be a lot worse than we thought…
Nothing has actually been done yet – this was just the Obama administration talking about scaling back from the mortgage backed security business. Even though nothing has actually changed yet – just the mention of the idea of less government involvement here drove the market nearly 50 basis points the other way!
If this was the reaction just because they are talking about it – can you imagine how the markets will react if they actually do it?
Given the risks right now and investor sentiment when it comes to the housing industry, our current albeit artificially low interest rates could easily swing by 2 or 3 percentage points. This will certainly have a drastically negative impact at what is now and will continue to be an extremely fragile housing market at best.
The drop in purchasing power alone from such an interest rate hike could easily turn a decent housing market downwards. In our current state it could kill what there is of the market altogether!
Combine this idea with an impending bout of inflation, (how much money have we actually borrowed and/or printed) and the removal of these so-called safety valves and interest rates could go through the roof and lead us right into another recession. Can anyone say “Jimmy Carter”?
But it might be even worse as we have another factor coming into play which will only compound these issues further. Stay tuned for Part Two.