America is now entering its fourth year of struggling real estate markets. Yet the financial market’s crisis only just began its second year, and the nation’s overall economic recession is less than 12 months old. As financial weakness has spread through different sectors of our economy, the damage it causes has increased.

What began as a housing bubble took a vicious turn. Instead of being contained, the financial wildfire started engulfing lending institutions in fall 2007. From Wall Street the calamity now has spread to Main Street. Consumer spending is falling, which creates layoffs as companies react to reduced revenue. Higher unemployment then creates more foreclosures, which keeps the downward spiral alive.

The National Association of Realtors report that the index of pending sales of previously-owned homes fell by 4 percent in 2008 and over 7 percent in some regions, reaching its lowest level since 2001. This has resulted in a decreased demand for loans even though average rates had just fallen to 6.16 percent on a 30-year mortgage. Mortgage brokers struggling with reduced volume also are working differently now, due to changes in the secondary market.

Boom to Bust
Subprime lending entered its growth phase in 2004, and analysis by Harvard University’s Joint Center for Housing Studies shows that it was a last-gasp effort to keep the housing boom alive. Low rates, economic growth, and stable house prices following the 1990-91 recession were the main causes of rising home sales up to that point. Automated underwriting also helped approve more borrowers, causing homeownership rates to rise dramatically during the boom years.

Lenders wanting to keep the good times rolling and consumers worried that they wouldn’t be able to afford a home in the future turned to subprime products and relaxed underwriting standards in 2004-06. Yet by 2007, origination of these products decreased drastically as the housing markets fell.

Payment-option mortgages and other aggressive loans weren’t prominent as housing gathered strength, so why did they play such a big role in bringing real estate markets down?

A major reason is the way these products spread throughout the financial sector. Investment banks and hedge funds weren’t able to earn much return on low-rate bonds after the Fed lowered rates early in the decade, so they eagerly paid up for the higher yields on subprime mortgages.

More dubiously, these institutions borrowed heavily to purchase large quantities of mortgage-backed securities. Because home loans traditionally have low delinquencies, these investment vehicles were regarded as conservative, despite the risk.

Delinquencies began rising as the real estate boom slowed, however. Many holders of subprime loans didn’t really understand the risks involved in those products. Just a 5 percent delinquency rate could wipe out the capital of a financial firm whose assets were 30 times as large as its reserves.

A bust, which was hoped to be confined to the real estate markets, began infecting financial institutions. Trust evaporated as institutions ran into trouble, since no one knew for sure who had exposure to troubled assets. Soon it became apparent that national treasuries had to take action to keep the global financial infrastructure from collapsing. Only national governments were strong enough to re-establish order and confidence in the markets.

Yet panic in the financial world also brought concern to consumers and businesses. An already-fragile economy was pushed into recession last fall as spending evaporated across the board.
Fortunately, federal authorities understand that at the base of this mess is a struggling real estate marketplace. Some of the measures they took were designed to strengthen that sector. To date, the U.S. gave a tax credit to first-time homebuyers, began programs to help delinquent homeowners, and lowered rates from the Federal Reserve.

More Changes Coming
Obviously the rescue of the world’s financial system still is a work in progress. Strains remain evident, as seen in the $29 billion third quarter loss announced by Fannie Mae. Even though it’s operating under government conservatorship, the company voiced concerns about its ability to obtain the financing necessary to continue operating. More influxes of cash from the U.S. Treasury could be necessary soon, say officials at Fannie.

Additionally, lenders and brokers are reporting that Fannie Mae and Freddie Mac are stepping up loan repurchase demands. Some loans that are several years old—and are not delinquent—are not being repurchased after underwriting reviews.

Lurking beyond all this current activity is a debate about how Freddie and Fannie will function in the future. It’s an important discussion, since the two enterprises will remain large players in the mortgage business. Business practices Fannie and Freddie adopt in the future will play a big role in determining how mortgage brokers operate.

Federal Reserve Chairman Ben Bernanke recently gave a speech in which he outlined several possible paths for the two firms. He encouraged the idea of looking at alternatives to the previous structure in which Freddie and Fannie were privately owned but operating under a government charter.

Bernanke acknowledged the conflict between maximizing profits and fulfilling a public policy function. A desire to grow earnings caused Fannie and Freddie to increase their borrowings, even though they could fulfill their congressionally-chartered roles simply by working as conduits between originators and investors. Holding loans in portfolios allows the lenders to earn the difference between what those securities yielded and their borrowing costs.

Privatizing Freddie and Fannie private would eliminate those concerns, and also give companies wider range to innovate than they would have while operating as part of the U.S. Treasury. Yet their weak financial condition makes it clear they need government backing to survive. Bernanke explains that “almost no mortgage securitization is occurring today in the absence of a government guarantee.”

As a result of the current crises, America is taking a step back toward greater regulation in many areas of the economy. We often forget how structured U.S. companies and industries were 40 years ago. Airlines and trucking were strictly regulated, which resulted in higher costs and more restrictions on business practices. Banks also operated under set guidelines for the lending and investing products they could offer.

Since that time, the economy has grown through greater competition and increased innovation. However, within a more-structured business environment companies were more likely to have the means to provide health insurance and pensions for their workers. Loosening the bonds of regulation can be seen as removing consumer safeguards as well. Results of regulation range from the unpleasantness of air travel to the problems ordinary citizens have in saving for their retirements.

Government Control
Fully nationalizing Fannie and Freddie would increase market confidence in them. It then would be easier for the firms to sell their debt, and interest rates most likely would drop as a result. That would be beneficial to Americans interested in buying, selling, or refinancing a home.

Such a prospect undoubtedly will be considered, since Freddie and Fannie now have a larger impact on the mortgage business than ever.

Bernanke recently stated, “the financial crisis has upset the linkage between mortgage borrowers and capital markets and has revealed a number of important problems in our system of mortgage finance, including weaknesses in the structure and oversight of the GSEs and perhaps in the originate-to-distribute model of credit provision itself. With the securitization market for private-label mortgage-backed securities shut down. Fannie Mae, Freddie Mac, and Ginnie Mae currently are the only conduits through which mortgages can be securitized and sold to investors. By contrast, in 2005, these three entities represented only about 50 percent of the securitization market.”

Another approach would be to replace the role of Fannie and Freddie with the European model of using covered bonds to raise funds. These bonds are issued by banks and kept on their balance sheets. Lenders then know they are responsible for the credit quality of their loans. Risks are further reduced by heightening the legal and regulatory oversight of the banks which issued covered bonds.

In his speech, Bernanke also considered ways the GSEs could operate with “even closer ties to the government, with or without shareholders.” One way would be to run Fannie and Freddie like public utilities. Although they would remain private with shareholders, a public board would provide oversight. Government regulators would establish business rules regarding pricing and profits, rather than simply monitoring for capital adequacy and sound practices. Such an approach would encourage Fannie and Freddie to continue innovating in order to provide returns for shareholders.

If the government opted to run Fannie and Freddie without shareholders, it could consolidate those firms with FHA, “with all securitization undertaken by a Ginnie Mae-type organization,” added Bernanke. Or lenders could cooperatively own the GSEs, as is the case now with the Federal Home Loan Banks.
Certainly the role of brokers could change under these different scenarios. But we’re living in times of great turmoil, and change should be expected.

“We must strive to design a housing financing system that ensures the successful funding and securitization of mortgages during times of financial stress but that does not create institutions that pose systemic risks to our financial markets and the economy,” Bernanke concluded. “Achieving the appropriate balance among these design challenges will be difficult, but it nevertheless must be high on the policy agenda for financial reform.”