bubble.gov

this post relates to an op-ed i wrote, which appeared in the baltimore sun on may 9th. fortunately, i think it snuck in right before the recent bubble in bubble articles. (the word "bubble" just lost all meaning to me.) the piece is sort of anecdotal, and while i'd prefer to have written something objective, i think it works, nonetheless.

my only regret is having missed the opportunity to illuminate the dangerous (and, i suspect, ultimately disastrous) role of the federal government in creating and sustaining this bubble.

the main driving force of this bubble is too much credit. not too much in terms of raw borrower numbers and amounts, but too much by way of interest-rate only and adjustable mortgages that have precariously shifted interest-rate risk to unsophisticated homeowners and/or speculators.

in a natural setting, no sane lender would make these kinds of loans. the risk would either scare off the lender or drive up rates to accurately reflect default risk. but in the real world, the federal government underwrites every mortgage, unwittingly insured by the taxpaying population. so, when the baltimore sun asked one banker why anyone would make such loans, he gave them the typical response:

"'The customers are demanding it,' he says. 'We do them because the market is driving them. That's what the competition is doing.'"

that covers the demand, but what's left out of his response is the supply, and that no one would be competing in the first place if not for the fact that fannie mae and the federal government will purchase any mortgage up to around $300,000 (and, therefore, accept its default risk) with naught but a bare-bones credit check.

no one is actually sitting down to figure out whether or how borrowers will be able to pay.

quasi-governmental bankers will tell you that the loan is securitized, and that in the event of default, they can seize the house and sell it. sensibly, then, the amount of the loan is limited by the house's value, and all is well and good as long as the creditor can sell it off and minimize losses. but if everyone gets hit at the same time and the market dries up, the mortgage-backed securities will turn to junk bonds - utterly worthless.

meanwhile, fannie and freddie have worked out deals and created new and complicated derivative instruments that have them leveraged into the trillion-dollar range. given their due-diligence track record, i have some serious doubts about their ability to manage risk. my guess is that their worst-case financial scenarios, which they would use to paint a picture for government "insurers," assume rather generous salvage prices for properties in default.

the most pressing question is, how can those of us who survived the burst make money on the other side?

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here's an update: as part of the "reform" legislation that was originally conceived to reign in fannie mae, it now has permission to purchase mortgages up to $500,000. if that won't help the poor afford housing, i don't know what will.