STOCK MARKET WATCH -- Monday, 16 January 2012

[Demeter]

10. Everyone’s housing market profits were fictitious

http://blogs.reuters.com/great-debate/2011/10/27/everyones-housing-market-profits-were-fictitious/

A big clue something had become dysfunctional at Fannie Mae and Freddie Mac came in the first week of 2011, when the government mortgage market makers announced the terms of a settlement agreement they’d reached with Bank of America, and were immediately pilloried for extending the bank another “backdoor bailout” by the likes of Maxine Waters and the American Enterprise Institute...By the end of January an internal investigation had convened, all other settlement negotiations had been suspended, and Edward J. DeMarco, the acting Fannie/Freddie overseer pending the confirmation of his replacement, found himself suddenly faced with the challenge of replacing himself as congressional Republicans vowed to stonewall Obama’s pick. Part one of this series traced DeMarco’s unlikely conversion in 2011 from coddler of banks to unyielding litigator of bank fraud. It’s a rare shift in Washington, where “corruption” is a process that’s practically synonymous with “aging.” What’s often forgotten when bureaucrats fail as spectacularly as they have at Fannie and Freddie is the critical roles played by cluelessness, incuriosity, faulty reasoning and fraudulent economic logic as well.

Consider what the inspector general learned about the corporate procedures for pursuing “putback” claims in place at Freddie Mac. While purchase contracts entitle the GSEs to force banks to buy back any delinquent loan in which it finds evidence of fraud, Freddie restricted examiners to screening only mortgages which had defaulted within two years of origination, a tiny sliver of total foreclosures comprising less than one-tenth of defaults from the years 2004 to 2007—the vintage of the Countrywide loans. When one of DeMarco’s deputies noticed this apparent oversight and began warning executives that “Freddie could passively be absorbing billions of dollars of losses” merely by refusing to glance at 90% of their files, the enterprise … chose to absorb the losses, repeatedly resorting to a boilerplate argument justifying the two-year policy holding that:

loans that had demonstrated a consistent payment history over the first two years following origination and then defaulted in later years…likely did so for a reason such as loss of employment, which is unrelated to fraud.

Oh really.

The deputy spent six or so months attempting to politely introduce his colleagues to the concept of the “teaser rate.” Perhaps, he writes in one email, Freddie was failing to take into account that “from 2005 through 2007 there was a substantial increase in non-traditional mortgage products[which frequently featured ‘teaser’ rates initially resulting in low payments” which would “increase dramatically two, three, or five years after origination” when “rates reset and/or the repayment of principal began”—thus rendering virtually any deliberate fraud essentially “invisible” for the first few years of the life of the loan. The examiner, though, was either himself mistaken, or trying to be polite, because those dates are off by a few important years. As he might have gleaned from the company’s annual survey of adjustable rate mortgage trends, a 28-year-old Freddie Mac tradition available online, the “substantial increase in non-traditional mortgage products” began well before 2005; what changed in 2005 is that housing prices in the hottest markets finally, slowly began to edge down a bit, meaning that each passing month was rendering increasing numbers of borrowers “underwater” on their loans.

But when Freddie executives attempted to get themselves off the hook by blaming plummeting housing values for the uptick in foreclosures, the inspector general shoots them down in a fascinating footnote (emphasis mine):

Freddie Mac staff advised FHFA-OIG that they disagree with the senior examiner’s causation hypothesis. Alternatively, they attribute the reversed pattern of foreclosures shown in Figure 3 to falling home prices leading to negative equity or “underwater” mortgages. However, causation is irrelevant to the issue in controversy. Regardless of the cause of these defaults, the search for representations and warranties defects is the point of the loan review process; and if the search does not begin, then the defects will not be found.

Causation is irrelevant to the issue in controversy? Pretty bold statement for a professional investigator! If only it didn’t so elegantly articulate the widespread attitude of the political establishment toward the crisis itself: We get it, we get it, “it’s the economy stupid etc.” so do yourselves a favor and stop nagging us with demands for truth and justice while we’re trying to pass this freaking jobs bill… But imagine if someone involved here had paused to contemplate the irrelevant just briefly, pondering the methodology with which one might calculate the likelihood that a particular defaulted loan conforms with…

Foreclosure Causation Hypothesis A: Borrower can afford to make mortgage payment of X but defaults when faced with a payment of 2X after the introductory teaser rate expires

vs.

Foreclosure Causation Hypothesis B: Borrower’s mortgage balance is now 2X the value of his house.

…only to think, Holy Cow, what if it turns out that each causation hypothesis might also serve as a causation hypothesis for the other causation hypothesis? That is, what if the “teaser rate” enabled so many Americans to pay the mortgage on houses they couldn’t otherwise afford that housing prices kept rising artificially, in turn enabling borrowers to refinance their loans just before their payments were scheduled to balloon? That is of course, the central dynamic of the post-2001 housing market: people buying houses they could not afford with the help of kickbacks that collectively, over time, wound up rendering the whole housing market (artificially) unaffordable to just about everyone — unless you used one of those new mortgage products.

In the absence of any underlying economic fundamentals that might plausibly justify an unprecedented expansion of homeownership in an era of total wage stagnation, obscene gas prices and the whole litany of other hardships the 99% endured throughout the Bush Administration, it is a Ponzi scheme. Fannie and Freddie knew this....