The government is moving forward on a plan to reduce foreclosures by guaranteeing some troubled mortgages after lenders agree to reduce loan balances. But while that $50 billion program will help some troubled homeowners, by consensus it will take a broader solution if the feds are to have any success in slowing the house-price declines that are wreaking havoc on financial institutions.
The answer, some market observers propose, is to bolster housing demand by bringing down mortgage rates. And one way to do that, believe it or not, involves another federal takeover of Fannie (FNM, Fortune 500) and Freddie (FRE, Fortune 500) - this time, for good. The mortgage giants were partially nationalized last month in an earlier, unsuccessful government-led effort to ease the problems in the housing market.
"If you're trying to stimulate demand, the best way is to bring down mortgage rates," says Len Blum, a managing director at New York investment bank Westwood Capital. "Doing that attacks two of the big problems in housing right now."
Blum sees three primary factors driving house prices lower. Sale prices, despite the plunge of the past year, remain above rental rates in most markets. Meanwhile the inventory of houses for sale remains near record levels, while mortgages are largely unavailable except for the most creditworthy borrowers. All of these factors tend to reduce either the pool of interested home buyers or the prices they'll pay.
Blum says one possible solution is for the feds to fully nationalize the companies, eliminating the public-private hybrid structure that survived September's partial takeover and bringing their debt onto the Treasury's balance sheet. Once Fannie and Freddie are explicitly part of the government, they should be able to borrow at Treasury rates, which are substantially lower than the rates the so-called government-sponsored enterprises have been forced to pay since their finances came into question earlier this year.
That should help bring down the effective cost of buying a house. A full nationalization of Fannie and Freddie could conceivably allow the companies to shave rates on 30-year conforming mortgages by as much as 2 percentage points, to around 4.5%.
Shaving 2 percentage points off the rate on a $200,000 mortgage could save the buyer around $250 a month, he says. The difference could be particularly telling for buyers who borrow through the Federal Housing Administration, which requires smaller downpayments than private lenders in midst of the credit crunch.
"A program like this allows more homeowners into the market," says Blum. Investment strategist Ed Yardeni, who advocates a similar plan, says adopting it should "revive the economy very quickly."
Another bazooka?There are risks, of course, as the Treasury learned in its earlier dealings with Fannie and Freddie. In July, Treasury Secretary Henry Paulson asked Congress for the authority to invest in the companies. Invoking his now infamous bazooka analogy, Paulson said he believed he'd never have to use the money, because the sight of a huge federal credit line would scare the companies' detractors out of the market and bring down the rates they were paying to borrow.
As it turned out, Paulson did have to fire the bazooka, putting the companies into government conservatorship - but even that didn't bring down Fannie and Freddie's rates for long. One reason lies in the mayhem that followed Treasury's takeover of the companies, including the collapse of Lehman Brothers and the near bankruptcy of AIG (AIG, Fortune 500). All these factors conspired to drive investors away from assets riskier than Treasury securities, including so-called agency securities - the bonds Fannie and Freddie sell to finance their operations.
This time around, the biggest worry stems from the fact that a full takeover would add to the federal balance sheet, at a time when taxpayers are already running a tab on the bailout of the financial industry and various fiscal stimulus plans.
For years, economists have warned that Americans' habit of spending beyond their income and borrowing the difference from overseas is unsustainable. At any time, the thinking goes, the foreign central banks that buy huge amounts of U.S. government debt might shy away, forcing interest rates here higher.
"That's really the $64 trillion question," says David Merkel, chief economist at Finacorp Securities. "How well are we able to borrow in that environment?"
But so far, so good. Despite the rising tab of cleaning up the meltdown, the U.S. for now remains in what appears relatively safe territory, with federal borrowing recently tabbed at about 83% of gross domestic product. Merkel says buyers of government bonds typically "tend to start choking" on new issues when borrowing reaches around 150%.
What's more, there has been no lack of demand for Treasuries during the financial crisis - a trend some observers expect to continue in what's shaping up as an era of rather limited investment options.
"The U.S. was supposedly the basket case nation with the massive deficits whose currency was destined to lose its reserve status and whose credit rating was going to get cut at some point," writes Merrill Lynch economist David Rosenberg. "It appears that the full faith of Uncle Sam must still mean something, even as contingent liabilities head to the stratosphere."
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