Fannie and Freddie: Proving that insanity is good for business
Insanity is doing the same thing again and again and expecting a different result. Even a casual observer of the U.S. economy since its collapse in 2008 is likely familiar with the terms “toxic debt” and “default risk.” As it happens, the good people within the mortgage industry may need a reminder. Because of them, the risk of an earthquake-triggered mortgage default crisis in California appears to be set for an increase.
Recently, Fannie Mae and Freddie Mac, two large government-sponsored mortgage enterprises best known for their catastrophic, wealth-transferring, home mortgage lending habits that necessitated a taxpayer bailout to the tune of $187.5 billion, have determined it appropriate to both raise lending limits and to lower downpayment requirements.
What could go possibly wrong?!
For one, recession could result. Once again, individuals with the least ability to sustain mortgage payments will have access to homes beyond their ability to safely afford. In the event of a financial downturn, such individuals will again be prone to default en masse. While this is fantastic news for secured lenders and bureaucrats, the resultant stress of widespread default could have dire consequences for the U.S. economy as a whole.
But that is a story already well told. What is particularly alarming about the latest decision to increase lending limits is that the areas listed are the last places, geographically, that the government should be accruing greater mortgage exposure.
Furthermore, while Fannie and Freddie have chosen to maintain the national conforming loan limit at the same level (it is at $417k for the tenth consecutive year), loan limits have been raised in 46 high-cost counties. Four new California counties are subject to higher limits: Monterey, Napa, San Diego and Ventura. Those four counties join other high-cost California counties like Los Angeles, Orange and San Francisco.
But wait, there’s more. Virtually contemporaneously, Fannie and Freddie have also detailed plans to lower the minimum downpayment required to qualify for their mortgages from 5 percent to 3 percent.
California’s high cost of living provides a fig leaf of political cover for offering higher loan limits, but the case for lowering downpayment requirements beggars belief.
The merits of each decision aside, because some of the increases are in areas that are among the most catastrophe-prone in the nation, they ignore the fact that there is default risk associated with seismic activity that is currently underappreciated.
When a major earthquake next strikes California’s coast, the cost of the damage easily will run into the billions. It has in the past, as was the case with both the Loma Prieta and Northridge earthquakes, and it will happen again. Since the majority of seismic risk in California is, in essence, publicly held, individuals without private insurance or sufficient financial resources to rebuild their homes will have little option or incentive to avoid defaulting on their mortgage. When they default, taxpayers will again have to bail out Fannie and Freddie.
It bears noting that less than 10 percent of California homeowners currently purchase earthquake insurance, and that it is the one major catastrophe peril for which Fannie and Freddie do not currently require insurance coverage for conforming loans. Earthquake default risk is the stuff that bubbles are made of.
Taken together, by increasing the loan limit and lowering the downpayment threshold Fannie and Freddie are placing taxpayers, particularly California taxpayers, at risk.
