Where Fannie and Freddie Went Wrong

Wednesday, 01 October 2008 15:53

This article was recently brought to our attention regarding Fannie Mae and Freddie Mac.  It was originally published in the New York Times by Steven A. Holmes on September 30, 1999.

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The New York Times
By Steven A. Holmes
Published: September 30, 1999

In a move that could help increase home ownership rates among minorities
and low-income consumers, the Fannie Mae Corporation is easing the
credit requirements on loans that it will purchase from banks and other
lenders.

The action, which will begin as a pilot program involving 24 banks in 15
markets -- including the New York metropolitan region -- will encourage
those banks to extend home mortgages to individuals whose credit is
generally not good enough to qualify for conventional loans. Fannie Mae
officials say they hope to make it a nationwide program by next spring.

Fannie Mae, the nation's biggest underwriter of home mortgages, has been
under increasing pressure from the Clinton Administration to expand
mortgage loans among low and moderate income people and felt pressure
from stock holders to maintain its phenomenal growth in profits.

In addition, banks, thrift institutions and mortgage companies have been
pressing Fannie Mae to help them make more loans to so-called subprime
borrowers. These borrowers whose incomes, credit ratings and savings are
not good enough to qualify for conventional loans, can only get loans
from finance companies that charge much higher interest rates --
anywhere from three to four percentage points higher than conventional
loans.

''Fannie Mae has expanded home ownership for millions of families in the
1990's by reducing down payment requirements,'' said Franklin D. Raines,
Fannie Mae's chairman and chief executive officer. ''Yet there remain
too many borrowers whose credit is just a notch below what our
underwriting has required who have been relegated to paying
significantly higher mortgage rates in the so-called subprime market.''

Demographic information on these borrowers is sketchy. But at least one
study indicates that 18 percent of the loans in the subprime market went
to black borrowers, compared to 5 per cent of loans in the conventional
loan market.

In moving, even tentatively, into this new area of lending, Fannie Mae
is taking on significantly more risk, which may not pose any
difficulties during flush economic times. But the government-subsidized
corporation may run into trouble in an economic downturn, prompting a
government rescue similar to that of the savings and loan industry in
the 1980's.

''From the perspective of many people, including me, this is another
thrift industry growing up around us,'' said Peter Wallison a resident
fellow at the American Enterprise Institute. ''If they fail, the
government will have to step up and bail them out the way it stepped up
and bailed out the thrift industry.''

Under Fannie Mae's pilot program, consumers who qualify can secure a
mortgage with an interest rate one percentage point above that of a
conventional, 30-year fixed rate mortgage of less than $240,000 -- a
rate that currently averages about 7.76 per cent. If the borrower makes
his or her monthly payments on time for two years, the one percentage
point premium is dropped.

Fannie Mae, the nation's biggest underwriter of home mortgages, does not
lend money directly to consumers. Instead, it purchases loans that banks
make on what is called the secondary market. By expanding the type of
loans that it will buy, Fannie Mae is hoping to spur banks to make more
loans to people with less-than-stellar credit ratings.

Fannie Mae officials stress that the new mortgages will be extended to
all potential borrowers who can qualify for a mortgage. But they add
that the move is intended in part to increase the number of minority and
low income home owners who tend to have worse credit ratings than
non-Hispanic whites.

Home ownership has, in fact, exploded among minorities during the
economic boom of the 1990's. The number of mortgages extended to
Hispanic applicants jumped by 87.2 per cent from 1993 to 1998, according
to Harvard University's Joint Center for Housing Studies. During that
same period the number of African Americans who got mortgages to buy a
home increased by 71.9 per cent and the number of Asian Americans by
46.3 per cent.

In contrast, the number of non-Hispanic whites who received loans for
homes increased by 31.2 per cent.

Despite these gains, home ownership rates for minorities continue to lag
behind non-Hispanic whites, in part because blacks and Hispanics in
particular tend to have on average worse credit ratings.

In July, the Department of Housing and Urban Development proposed that
by the year 2001, 50 percent of Fannie Mae's and Freddie Mac's portfolio
be made up of loans to low and moderate-income borrowers. Last year, 44
percent of the loans Fannie Mae purchased were from these groups.

The change in policy also comes at the same time that HUD is
investigating allegations of racial discrimination in the automated
underwriting systems used by Fannie Mae and Freddie Mac to determine the
credit-worthiness of credit applicants.

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The following article was originally published in the New York Times by Steven A. Holmes.

 

Brock and Associates, LLC is fee-based financial planning firm specializing in comprehensive financial planning and wealth preservation.  For more information on the status of the economy and other financial related topics, please visit our financial planning blog.

 

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Crisis Investing: Considering 9/11

Last Updated (Tuesday, 30 September 2008 15:45)
Written by Hank Brock, CPA, MBA, CLU, ChFC

In our last post, we mentioned we would try and post a piece that was prepared for our clients on September 11, 2001.  It is entitled "Crisis Investing."  We hope that you will find this reposting both of interest, and reassuring.

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September 11, 2001

Dear Client:

Like you, we here at Five Star are saddened by the loss of countless lives at the hands of the terrorists in the attacks that occurred today. I am sure that all Americans, and all decent people throughout the world, will sympathize, condemn, and take the needed steps to lessen the likelihood of a repeat occurrence.

I am sure you are wondering what the impact of today’s terrorist attack on the World Trade Center might have on the stock market in the upcoming days.  Of course, neither the stock market itself nor any money manager can prepare itself for such an event any more than the general public or the most sophisticated security systems employed by our national security agencies can prepare for such an event.

But, it does help in times like these to step back and take perspective. I was just reminded about a conversation I had just three days ago (Friday), when I spent three hours visiting with one of the most highly regarded persons in the financial services industry and in Utah.  Over age 70, he observed, "too many people do not think things through adequately.  Think things through. And don’t over-react to events." 

To this end, I have prepared a sheet titled "Appreciating Crisis Investing."  Note that the average return during the year following a "bear" market is 32%, and the average return following a crisis that caused the market to plummet was 21%.

It is likely that those few who panic will drive the Dow Jones Average down 500-1,000 points (or more) tomorrow.  (At this writing, I have unconfirmed reports that the stock exchange might be closed as long as until next Monday, September 24th.  That would be wise.)  Regardless of a few who typically panic, the vast majority will keep their heads about them and ride this through – sometimes that’s all we can do.  Then, there will be a few who will rightfully see this as a further "buying opportunity," given that the market is already selling at what we believe to be a 40% discount. 

That great American financier, J.P. Morgan was once asked how he accumulated all his wealth. His response? "I buy my straw hats in the wintertime."  I can picture him in his Pullman Train Car heading from New York to West Palm Beach.  We all know people who do their Christmas shopping the week after Christmas, buy their snow-blowers in the

Spring and their lawn-mowers in the Fall. Why do we understand "Contrarianism" in the consumer realm, but don’t recognize it in the investment realm?  The laws of supply and demand remain the same, and make this a great buying opportunity, perhaps the best I’ve seen since Jimmy Carter was President some 20 years ago when the Dow was at 750 (now its around 10,000).  If you have money invested for the long-term that are in money market funds or CDs right now, it is probable that by the time you get back into the market, you will have missed 20-40% on the upside.  Now is the time to invest.

What if the terrorist had instead plowed the plane into the building of the New York Stock Exchange?  Or the Prudential Tower in Newark, NJ?  Or the John Hancock Tower in Boston?  Did you know that every day each of those organizations and virtually every other major company in America downloads all their data to a remote record-keeping site hundreds or thousands of miles away?  (I know that in Hancock’s case, it is in New Mexico.)  Most of the investing public is not aware of this.

In summary, there might be some stormy days ahead, but in time, the ship will right itself and all will be well.  The Number One Rule of the Successful Investor:  Patience.  There has been turbulence before, and there will be turbulence again, and those that keep their heads about them will do fine.  Keeping perspective breeds patience.  Study the attached sheet, and keep perspective.

Sincerely,

Hank Brock, CPA, MBA, ChFC
President

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Follow-up: Understand the Commotion in the Economy

Monday, 22 September 2008 09:00

Dear Clients and Friends,

Thank you for your responses to our email message to you of the other day.  I would like to make a few additional observations about recent days. But first, I would like to share something. Typical of the responses to our email has been the following email from a client (who spent a 30-year career as a banker):

“Thank you VERY much for sending out this update!  Interestingly enough, both R____ and I have been able to watch the recent "financial game shows" without worry or stress. Like I said when we started our working relationship together, we don't mind if our funds do not grow very much, or they stay static; we will be content as long as we do not lose any principal.”
--D. A., St. George, UT  9/18/08

I would like to emphasize that we have every expectation that anyone with traditional-fixed or indexed-fixed annuities will be receiving a respectable return on their account, and not just stay static, but this person had the right perspective because they were focused on the safety of their principal. My main point in  the message of the other day was to reassure you that your principal is not at risk.  In fact, always remember that before anyone can ever get any return on their account, they must first protect their principal!   It’s the principal that must be protected!

Especially if you are a retiree, you must continue to emphasize safety and protection of principal before anything else.  As comedian Will Rogers once said, “I am more interested in the return of my principal than the return on my principal.”  This is what you have hired us to accomplish for you, no matter the tossing about of the economy.  We would like to emphasize that there is no place else, in our opinion, that assures you safety of your principal in the days ahead than how we have positioned your assets… not bank savings accounts, not money market funds, not gold or precious metals, and certainly not stocks, bonds, or real estate. 

So, now is not the time to take risks, no-matter what some newsletter might be saying about “how to profit from the coming crash”!  Stay away from those that would point out some road to easy money at this time.  Many people are especially vulnerable in times like this to “inside tips” in newsletters or late-night infomercials because people will invest on the “hope” of making a gain through some “secret” strategy. Don’t fall for it!  Stick with tried & tested approaches with a proven track record through times like this.

So, while all about us in the economy are losing their heads and panicking, and therefore will be the ones most hurt in any volatility, let’s keep ours planted firmly in the most sensible and safest solutions available to us.  As the couple above noted, you must ignore the sensationalism of the press that must keep their ratings up. (As you know, in my other articles I have not said there isn’t a problem in the economy; quite to the contrary.  I have merely emphasized that you are positioned in the safest place available, a place that rode through the Great Depression without loss of principal.)

Our firm has been through many of these period before: the 79-81 hyper-inflation period, the 87 market crash of 23% in a single day, the 89-91 Savings & Loan debacle, the 2000-2002 prolonged crash after the over-speculation dot-com burst of the late 1990’s, and several bear markets in between.  We have yet to see anything like what we saw in those periods. You’ve hired us as professionals to take you through these periods.  We will do this.

Once again, keep current by visiting our website often where we will occasionally post commentary to our blog.  This week we will post to our blog a piece titled “Crisis Investing.”   It is a piece I prepared on 9/11/2001, and my staff had it mailed out to all clients by 4:00 PM that day. You will find it of interest, and reassuring.

Sincerely,

Brock and Associates, LLC
435-673-9599

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Understand the Commotion in the Economy

Thursday, 18 September 2008 09:00

Dear Clients and Friends,

We have received a number of calls asking what’s going on with all the commotion in the economy these past few days.  To address this, we thought we would write you to explain a little of what’s going on.  I have yet to see a good explanation in the news, mostly only finger pointing that is avoiding the mention of the underlying problems. 

For a more exhaustive explanation, yet in a reader-friendly format, please go to our website at www.brockfc.com, then click on the archive of our firm’s newsletter, “Making Sense.”  Then click on the newsletter for March, 2008.  In that edition I wrote an extensive article explaining exactly what is going on in our economy now, and the fundamental causes of what has happened with Freddie Mac, Fannie Mae, Lehman Brothers, Merrill Lynch, and AIG.  In fact, whether you have any concerns about our existing economic environment or not, I would ask that you read or re-read this article because it will explain many things. Also, we posted articles on our website blog regarding these issues blog several weeks ago, on August 26th (What You Should Know About Today's Economy) and on August 29th (One More Time...Let's Understand This Economy Now).  We ask you to visit our website and explore it to learn more.

After you read that article, I would like to stress the following points:

1.     This is a problem primarily within the Investment Banking Industry.  This industry is regulated by the federal government through the Securities and Exchange Commission.  “Investment Banks” are also known as “broker-dealers” that specialize in raising capital for companies, either by taking companies public, or by raising additional capital through issuances of stock or corporate bonds. 

2.    It is also a problem, to a lesser degree so far, within the Commercial Banking Industry. This industry is also primarily regulated by the federal government through the Treasury Department and the Federal Reserve Board (the “Fed”). “Commercial Banks” are what we usually think of as banks, such as Bank of America, Wells Fargo, J.P. Morgan, CitiCorp, etc. that lend money to businesses and consumers.

3.    This is not a problem of the Insurance Industry, in spite of what you might read about AIG (more about this in a moment).  This industry is regulated by state governments through their Insurance Departments. The Federal Government does not regulate the insurance industry. The insurance industry is not a holder of “sub-prime mortgages” and derivatives. The States have been conservative and prudent in administering their duties. 

4.    This is a similar environment the financial industries faced in 1929—during the Great Depression—when the stock market lost 90% of its value and there were “runs” on banks, but have you ever heard of there being “runs” on insurance companies during the Great Depression?  No, they kept right on paying their dividends. 

5.    In my humble opinion, as I have maintained for years, the Federal Government and the Fed has been delinquent in their duties regarding this matter. For example, Alan Greenspan, Chairman of the Fed from about 1987 through 2005, insisted that derivatives (a) did not need federal regulation, and (b) did not need to be disclosed to the general public or investors on Balance Sheets or other financial statements. They were what’s called “off balance sheet transactions.” Read my article in our March, 2008 newsletter for more on this.  

6.    Unfortunately, as I pointed out in March, this is a problem of massive proportions that has received little discussion by the press or media, on Wall Street, by regulators, in Congress, by candidates, or anywhere else. This is the first I have finally heard it spoken of, and even now, they are not addressing the underlying problems.

7.    In spite of what you might read about the “sub-prime” crisis, the real underlying problem is the massive leverage that  has been taken on by these institutions through a tool called “derivatives.”  This problem is beyond the size of the U.S. Government, or any coalition of governments, to resolve, and it will likely take five years to unwind the problem. The “sub-prime mortgage” crisis is not the great problem in our economy as it is being portrayed.  But, it has exposed the problem, and exacerbated it by being the trigger that has started the dominoes falling.

8.    As I mentioned in my newsletter article, and above, this is not a problem of the insurance industry. State Insurance Commissioners have not allowed insurance companies to invest in derivatives. What about AIG?  AIG is the parent company to many subsidiaries. Some of those subsidiaries are profitable and financially strong insurance companies, such as American General and others that issue life insurance policies and annuities. The parent company (AIG) also has other subsidiaries that are banks or others that have invested in derivatives. Because the insurance companies are regulated by the states, the states and laws do not allow the parent companies to access the assets of their profitable subsidiaries. Thus, these companies are distinct entities that are “walled-off” and maintain their own financial strength ratings. If you will note, some news organizations have reported that AIG wanted to “borrow” $20B from their profitable subsidiaries and have portrayed this as “borrowing from itself.” This is a false characterization. Having said this, there are a number of issues to consider with AIG, and so if anyone has a contract with AIG, we ask that you call us to discuss your specific circumstances. (Incidentally, I personally own several life insurance policies issued by subsidiaries of AIG.)  We also recommend that you call us if you have contracts with Sun Life Assurance for recent news there.  

9.    Those invested in the market have lost lots of dollars, and they are on a wild roller-coaster ride. Unfortunately, some in the news are reporting this as a “buying opportunity,” and to just “stay put.”  We believe this is a long-term economic problem that will take a long time to unravel, and we are only at the beginning stages. 

10.    Recently, some have been dismayed that their “indexed annuities” have shown a zero return during the past year.  This is because the market has been down.  But, no-one’s accounts are down, no-one’s annuities have lost money, no-one has seen their principal erode as have the vast majority of those with retirement assets. Isn’t that better than losing your principal? Our clients that have money in indexed annuities are not losing their money.  So, this crisis does not apply to you.  For those of you that might think you have too much in the stock or bond markets, we invite you to call for an “annual review.”

11.    Remember, that your annuities also have a “fixed” account that has a minimum guarantee of 3% annually that you can transfer your assets into should you so desire.

12.    Also, within the past few months we have had a few individuals that have been persuaded by their stockbrokers to keep their assets in the stock and bond markets, when we had recommended that they put “ safety and preservation of principal” as a higher priority. To those, we recommend that you call us to schedule an appointment to discuss things in light of recent developments. 

13.    Our office is currently doing a study to identify all insurance companies that are subsidiaries of other parent companies, and whether or not that parent holds derivatives. Then we will report our findings to you either in our monthly newsletter or on the blog on our website.

In summary, if you have followed our advice and your assets are in life insurance or annuities through us, either traditional fixed annuities or indexed annuities, you have not lost any capital during this financial crisis.  Your principal is safe. For more on this, please see the press release below issued today by NAIC, the National Association of (state) Insurance Commissioners.  Your annuities do not perform like stocks, bonds, mutual funds, or variable annuities, nor do they perform like real estate which can also go down in value. You have a long-term program designed to insulate you from economic volatility.

We would like to stress that we believe this is a long-term systemic problem that may take years to unravel (This does not necessarily mean that the market won’t have up years in the interim. We would be happy to explain why, and how you can better position yourselves for the years ahead.  If you are prepared, you have nothing to fear.  We have done our best to position each one of you for such an occurrence. We invite you to call for a review of your program in light of recent economic developments.        

Sincerely,

Brock and Associates, LLC
435-673-9599
Since 1979

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Financial Update: Current Economic Conditions

Last Updated (Wednesday, 17 September 2008 13:27)

Dear Friends,

As the financial climate on Wall Street continues to deteriorate, we wanted to take just a moment to address some of your growing concerns.  The recent collapse of Lehman Brothers and then the subsequent Fed bailout of AIG this week has many concerned about their financial prospects.  We would like to offer some comfort and encouragement to our clients regarding these recent developments.

If you are a client of ours, most if not all of your assets are already separate from the securities industry, banking industry, and stock market industry.  And while these industries are facing some real challenges, the insurance industry is just fine.  These troubled banking industries are regulated by the Fed, which happens to be one of the primary reasons for the problem.  The insurance industry on the other hand is regulated on a state level.

There has been some concern regarding insurance policies with AIG.  The policies that are with AIG are actually insured by American General.  AIG is the parent company, with American General as a subsidiary of AIG.  The parent company dollars and the insurance dollars are segregated from each other, and cannot be accessed by the parent company.  So despite these troubled companies best efforts to get out of the mess their derivatives have created, they are unable to access the dollars from the insurance sides of the company.  Insurance policies owners are safe from the problems of the parent company.

Insurance companies, regulated by the states, have always taken a conservative approach to their investment portfolios.  Unlike securities, banking, and stock market, the insurance industry has avoided derivatives that have caused this financial crisis.

While the financial climate is unsettling, you may rest assured that you have appropriately prepared.  The insurance industry is doing fine, and is not subjected to the same type of collapse occurring in other industries.  We suggest that you review some of the economic discussions that Hank Brock has written dating back to March and April of this year. Below is link to these two articles for you to review.

Sincerely,

Brock and Associates, LLC

What You Should Know About Today's Economy

One More Time...Let's Understand This Economy Now

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