Fannie Mae and Freddie Mac, the two major government-sponsored mortgage lenders, are popularly held to be incapable of failure due to an implicit backing by the federal government. “The government backs them,” so the thinking goes, “so they can’t fail.”
That would be true if the government was economically all-powerful. But only one thing is economically omnipotent: the free market.
And because the government falls short of economic omnipotence, the same “guarantee” they offer to Fannie Mae and Freddie Mac is the underlying reason for the mess those companies are in, rather than the reason they will survive.
FNMA (Fannie Mae) and FHLMC (Freddie Mac) each behaved during the recent real estate market much like the irresponsible child of a wealthy but foolish parent. Even though they wanted to appear to be independent of the wealthy parent (the government), in the back of their minds Fannie and Freddie were well aware that if anything happened to them, dear old dad would bail them out.
And that appears to be exactly what’s happening - except the federal government doesn’t actually have the money needed to provide a financial backstop to the irresponsible children known as Fannie and Freddie.
And here we have the free market issue arising again. Fannie and Freddie are failing because they’ve made very poor decisions. They should be allowed to fail. It’s only through the cleansing offered by normal market activity that spoiled children like Fannie and Freddie learn to behave responsibly.
“Failure” for Fannie and Freddie would look very different than you might expect. They wouldn’t cease to exist. Rather, they would be absorbed into one (and probably many) company(ies) who are more financially capable of handling the problems that have been created by Fannie & Freddie’s poor decision making. After all, one man’s bankruptcy is another man’s opportunity…
…and one man’s foreclosure is another man’s investment…
…and there’s your opportunity - only there are millions of foreclosures with millions more on the way - each one representing an opportunity for you to make a good investment and in turn provide housing to well qualified buyers/renters.
Without the cleansing that happens as a result of people like you and me buying up the failed investments of others, nobody learns their lesson, and the pain is repeated over and over again.
That’s why Fannie and Freddie must be allowed to take their lumps.
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9 Comments So Far»
I’m not a big fan of letting the “free market” destroy a company. But what you’re saying makes a lot of sense. I guess somebody has to be responsible sooner or later.
Please watch Jim Rogers in this 8minute video if you want to be prepared,he knows what he’s talking about…
I suspect Fannie and Freddie are destined to fail as the big, overweight hippos they are. And while it would no doubt hurt in the short term, it would result in a healthier state for everyone moving forward.
Thanks for posting, Bryan!
…jp
Completely agree on this one Bryan. Whether it’s health care, social security, housing, or anything else, whatever the government gets in the middle of, ends up more dis-jointed and messed up than before. Energy & environmental policy is the next mess they’ll continue to make worse.
In a capitalist economy, winners must be allowed to WIN and losers must be allowed to LOSE. There is way too much socialism infecting our economy and general idiocy of the politicians. Privatizing profits and socializing losses will ruin our economy for decades.
I proposed the following changes in 2nd quarter of 2007, when
serious “cracks” were showing in the residential mortgage market.
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There are some simple steps that state and federal governments
can do to help with the foreclosure situation, in my humble
opinion:
1. Eliminate by law the “due on transfer” clause, thus
allowing full assumability of existing debt on property.
If the lender was happy getting a monthly payment on the debt,
then it should not matter who owns the property or who is
making that payment. An investor can take over the property,
fix it up, and sell it on a wrap-around without worrying about
the “due on transfer” clause. “Subprime” buyers can get the
financing they need, defaulting debtors get the debt relief
they need, and the lenders now have a performing loan on their
books.
2. Eliminate the IRS “Dealer Status” designation for
fix-and-flip real estate investors. This designation creates
an onerous burden on fix-and-flip deals, because the investor
cannot sell the property on terms. The investor must pay all
capital gains tax NOW on the sale even for an installment
sale (like a land contract or a wrap-around). By selling on
a wrap-note, the “subprime” buyer now has a new source of
financing for home ownership. Taxing the future gain before
it is received is too onerous for the fix-and-flipper to sell
on a wrap-note.
3. Eliminate the redemption period on foreclosures. If
the debtor cannot cure or re-instate the loan during the
cure period, then what makes anyone think the debtor can
entirely pay-off the loan during the redemption period?
Give a little more time on the cure period, but do not
impose an onerous burden on lenders to get what they’re
owed.
4. Eliminate deficiency judgments by modifying loans to
be non-recourse (no personal guarantee). If selling the
foreclosed property does not generate enough money to
satisfy the debt, then the lender should have required
more collateral (or a lower LTV) before making the loan.
It’s not the buyer’s fault for a changing market or lack
of proper due diligence by the lender to analyze the market
trend.
5. Eliminate the IRS “cancellation of debt” (COD) income
tax for short sales. The debtor never really benefitted by
the COD, because they lost their home.
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Item (5) has temporarily been enacted by the federal government.
I think it should be permanent. Item (3) has been enacted in my
state of Colorado, increasing the cure period to about 120 days
and eliminating the redemption period of the borrower. I think
all of the above changes should be permanent at the federal
level.
two cents worth, your mileage may vary.
In Response To Jeffrey Smith,
“Privatizing profits and socializing losses will ruin our economy for decades.” Can I get an Amen! You are right on Jeffrey. I don’t understand why so many others just can’t see this. Keep on posting. Loved your comments. I could never have said it better myself.
The big problem here will be what happens to the retirement accounts that are invested in the stripped loans? This will be worse than Enron if something isn’t done on that end (especially with Social Security going belly up.
Right on Bryan. (told you i would get here eventually). That why
OBAMA scares hell out of me. Promises to bail out any and every-body. Let the market take care of it. It always has, always will.
Best of Everything, Mel
I wish it was as simple as keeping Obama out of office, though I think it’s safe to say that an objective investor would have to prefer McCain to Obama. Problem is that McCain is no free market enthusiast either. Both candidates are an embarrassment this year. — Bryan Ellis
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