July 9, 2008 (Housing Market Monitor)

Housing Market Monitor

Fannie and Freddie Take a Hit

July 9, 2008

By Dean Baker

"There is a large hidden inventory of people waiting to sell their home when conditions improve."

As I have frequently noted in the past, it was inevitable that Fannie Mae and Freddie Mac would run into trouble at some point. Given the carnage in the housing market, Fannie and Freddie were certain to see large losses on their mortgages and/or mortgage backed securities. Even though they avoided the worst of the subprime loans and the risky practices in the Alt-A markets, the unprecedented rates of default even in prime mortgages would lead to large losses.

The markets apparently realized this fact also, with both stocks plummeting by more than 15 percent on Monday. This is the other shoe in the housing market. Fannie and Freddie, together with the VA and FHA, are either directly or indirectly financing 80 percent of new mortgages. With their finances now seriously threatened, it is not clear how much longer they can play this role without a bailout from Congress. If Fannie and Freddie are wholly or partially sidelined, it will lead to further contraction on the demand side of the market.

Mortgage interest rates edged up slightly last week to 6.43 percent from 6.33 percent on a 30-year fixed rate mortgage. The general upward direction of mortgage interest rates over the last few months is yet another piece of bad news for Fannie and Freddie, since it further reduces the value of their mortgages and mortgage backed assets.

There is an item in the Congressional Budget Office’s (CBO) analysis of the Dodd-Frank bill that has been largely overlooked. CBO estimates that 35 percent of the 400,000 families who will be part of the bailout will eventually have their homes foreclosed. The reason for the high rate is the adverse selection problem with the banks able to decide which loans qualify for the bailout. If the CBO estimate proves right, then 140,000 families will face foreclosure a second time as a result of this program.

The pending home sales index fell 4.7 percent in May from the April level. The May level is still slightly above the lows hit in February and March, but it is 31.9 percent below the year-round average in 2005. The Midwest and South have been hit hardest in recent months, with sales down 4.7 percent and 13.5 percent, respectively, from their levels of 6 months ago. By contrast, sales in the Northeast are up slightly over this period and sales in the West are up by 15.0 percent from their level of last November.

The meaning of sales numbers at this point can be difficult to determine. The rate of foreclosure is highest in the West, with California and Nevada leading the way. Foreclosed houses are likely to be resold, so that could be inflating the totals for sales in the region.

Whether the increased rate of foreclosures fully explains the rise in sales in the West is difficult to determine, but clearly this is an important factor. The high share of foreclosures in the existing home sales numbers raises another important point about how these numbers should be viewed.

The current rate of existing home sales is slightly under 5 million. If 2 million of these homes are foreclosed homes, then this implies that less 3 million homes fall in the standard sales category. There will always be a substantial number of people who will be looking to sell their homes because of career, family, or financial considerations. In the early 90s, before the beginnings of the bubble, the number was close to 3.4 million a year. With a population that is close to 10 percent higher, we might expect normal sales to be close 3.8 million homes a year, perhaps a million higher than is implied by the recent data, after adjusting for foreclosure.

The implication is that a large number of people have delayed selling their homes, but intend to do so, if the market picks up, or they lose the ability to keep their home off the market any longer (e.g. they can’t afford to pay two mortgages). The homes that have been kept off the market are in effect a hidden inventory that will keep prices low and/or falling for some time into the future. 

Dean Baker is Co-Director of the Center for Economic and Policy Research, in Washington, D.C. (www.cepr.net). CEPR's Housing Market Monitor is published weekly and provides an incisive breakdown of the latest indicators and developments in the housing sector.

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