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A Ghost Story


Be afraid of mortgages. Be very afraid.

I was asked by a friend this week to remind him why we thought the problems we're facing began with Fannie Mae (FNM) and Freddie Mac (FRE), as he'd heard three years ago in a speech I gave. I went to the archives and dug up an old article I'd written in 2005.

I worked on Wall Street at the time and those two shops were among our largest customers, so this became nothing more than a mental exercise for me; it would never see the light of day.

But neither the attorneys nor my friend understood that I believed the problem wasn't Fannie or Freddie, it was much closer to home, perhaps proving my point. I thought I might share it for the first time, given unfolding events that show how this experiment might end.

There's genuine fear. Finally. But being scared is exactly what drove me to take out my first mortgage, as you'll read below, and then to work tirelessly to pay off. So perhaps the strange ending will be a new beginning - if we look in the mirror for a change. Below is what I wrote in 2005.

A Ghost Story

Remember when getting a loan used to be a grueling process? Most of us sat knee-to-knee with a banker in a navy suit and a red tie behind a mammoth oak desk with a little green lamp. The old joke used to be that loans were only available for those that didn't need them. But you understood, because it was supposed to be difficult to earn trust. You worked hard, saved as much as you could, and walked into that office and tried to prove you were worth the risk. You had to convince that bank you could pay them back for your new home over the next few decades. It was a system that made sense to you, motivated you to do better, and kept prices for homes in check - because not everybody qualified for a loan.

You drove past your bank often. You might see your banker walking his dog in your neighborhood. If you're like me, you can still remember the name of your parent's banker, and the orange lollipops you fished out of a bucket in the lobby.

An actual relationship existed, and with it came responsibility. We not only owed money to the bank, we owed gratitude to the guy who took care of us. When we saw him, the balance of responsibility and appreciation from us -- along with a little good old-fashioned profit for him -- made for mutual smiles and genuine trust.

Houses were bought and sold way back then just as they are today. More people came to our country than left, just like today. Beautiful beaches, better schools, and bigger closets were in demand, just like today. Everything's the same, yet we now sit on the edge of the tipping point's needle, which will pierce one of the most reckless pricing bubbles ever seen in history.

People in my business have a hard time putting their finger on why this happened. Theories and explanations abound. Here's mine: When's the last time you saw the guy who held your mortgage walking his dog?

Today, those dogs are walked by a ghost who goes by two names: Fannie Mae and Freddie Mac.

The improbable story that follows was authored jointly by a government made up of folks whose first job is to get elected and a co-conspirator who's been acquitted in every bursting bubble in history: the voters. Originally, their collective intentions were as pure as a first home and its white picket fence.

But then they got creative, and that's where the prelude to today's story and tomorrow's gory ending begins. Everybody's focused on the scandals and accounting problems at Fannie and Fred's own luxurious homes, but you won't read another word about those in this article. What's more dangerous, in my view, is what's happening in plain in sight, legally, every single day.

In the 1930s, Congress created the Federal National Mortgage Corporation (Fannie Mae) to encourage banks to make loans to low-income Americans by agreeing to purchase those mortgages from the banks, thereby removing any local bank risk. In 1970, Congress created a second agency, the Federal Home Loan Mortgage Corporation (Freddie Mac), to do much the same thing.

By the late 1980s, these two agencies were buying up and reselling 30% of new mortgages and packaging the mortgages to be sold as fixed income securities. In other words, a homeowner's mortgage payment became a bondholder's interest payment - a good deal for all.

Fannie and Freddie's size and influence was limited only by their ability to attract investment capital. In 1989, bank regulators let pension funds and mutual funds classify this debt as low-risk. As a consequence, investors practically threw money at Fannie Mae and Freddie Mac in the 1990s - and this became incredibly and consistently profitable. The government agencies used the new capital to buy up every mortgage they could.

We cheered again as Fannie and Freddie were allowed to insure ever larger mortgages. Never did we pause to remember the original goal; never did we ask simple questions like: How many poor people do you know with $359,650 mortgages?

As a result of the increased limit, Fannie and Freddie went from buying mortgages for low-income homes to buying those of the middle- and upper-middle class. Help for a small group of the poor has changed entirely: Now, Fannie and Freddie are standing behind the majority of all mortgages today - the number has doubled in the past 15 years alone.

I confirmed these figures with investor relations at Fannie Mae, not my banker (who disappeared into a risk-less transaction in which most banks or brokers don't keep the loan). A crucial piece of this puzzle has also vanished: a little something called risk. But not to worry: Risk tends to re-emerge in frightening way -, particularly for those who think it's disappeared forever.

Most people joke about the federal debt; they're whistling past an ever-larger graveyard. There's now more mortgage-backed debt held by investors than all U.S. Treasury debt combined. Most are blind to this ghost, because its operations are invisible to them. Fannie and Freddie are just nicknames we gave to the real ghost: The American consumer, whose most valued currency is his vote. Neither Fannie nor Freddie are responsible for creating the problem; they were just salesmen who helped us do whatever we were in the mood to do.

We should be forced to go through many moods, actually - but I don't speak for most voters. Fear is a mood I recall vividly. I was scared by plenty of the sights and sounds around my first apartment. A crazy guy routinely banged at my door - that was real, and scary, and great. Great because it made work me hard for years and dream of moving, just like some of you did.

Every single time a young person in my industry asks for my advice, or job help, I tell them the same thing: "Renting a rotten apartment for $500 per month, having no expenses, very little (okay, no) social life, believing in delayed gratification - those were the keys to long days of work." That's just a fancier way of saying: Work for nothing at first.

I often wonder what inspirational speeches must sound like these days:

"I was driven by motivation the moment I stepped inside my new 105% financed house. Two air conditioners were running full blast. We sat down and thought about a savings plan on the leather couch we don't have to start paying for until next year. It wasn't easy, mind you, we had to pay for those SUVs just like anyone else, which reminds me - we don't work at the car company how did we qualify for employee pricing?"

Years down the road (or perhaps sooner), this ghost story is going to sound even scarier - because it's true.

So how does it end? I'm not a big fan of story-tellers who aim only to terrify; in my business, I've read more horror stories about the housing bubble and its impending collapse than on any other collectively agreed-upon subject. The only problem: After reading them, I'm not sure what to do after fortifying my bunker, laying in canned goods and tacking up insulation to keep me cool while the fireball of debt lays waste to the rest of the country.

I guess the doomsayers will tunnel over to my shelter, we'll crack open a few beers and then start looking at good beachfront deals for after the end of the world.

As Amarillo Slim said: "If there's anything worth arguing about, either bet on it or shut up."

So, here's my bet: I think the ending will be much worse and much better than most have been expecting.

Worse? In 1999, if I told you that you could borrow 105% to buy stocks after making a down payment called a margin requirement, instead of borrowing 50%... And if I told you to trade as much and as often as you want, and we'll waive all taxes on gains back and forth, how much worse would things have gotten for certain technology stocks?

Well, the rules for real estate speculators -- nothing down and no taxes (on 1031 exchanges) -- make Cisco circa 1999 look like a utility stock. How can it possibly get worse? Don't forget how easy it was to unload 1000 shares of Cisco if you had to sell, even with the bubble bursting.

Unloading a condo takes more than a few keystrokes.

When it got really bad in the past and the risk of foreclosure loomed, it was still rather easy to deal with: If the bank got back one house in the neighborhood, it could find a buyer pretty easily.

The risk now is far different. If you owe your buddy $100, you have a problem. But if you owe him $1 million, he has a problem. At this point, the lender has a bigger problem than the borrowers; remember, it's not the bank on the corner holding most of these loans.

What if some neighborhoods don't have one house in foreclosure, but an entire street's worth of houses? In addition, their new lender is now in the awkward position of not only managing risk, but managing votes.

And just imagine being the "agent" for these new listings. You can't find buyers for entire blocks of homes, nor do you want traffic for your open-houses impeded by rioting in the streets. So, like any good salesman, you respond to the American consumer with those seven little words that work every time: "Have I got a deal for you!"

"Mr. Leverage Tothegills, instead of throwing you out on the street, how 'bout I keep you in your home - and, for being such a gentleman, we're going to lower your payments today! By just signing here, we'll simply work your payment plan to fit your needs. Now, that cruise with the Mrs. is even more affordable. The only difference is, your silly ole mortgage will last 40 years, instead of 20 - just until it's paid off."

The ink should be dry before the end of the pitch.

I made that silly prediction in early 2005. The 40-year mortgage was born shortly thereafter. My only adjustment: By next year, there will be a 50-year one to go with it. In my business, I think many of us overestimate voters' desire to own their own home. Many of them don't mind living month to month, and our calculations can't factor in this subtle shift, nor could their parents have imagined it. How much does it cost is less important than what the payment is. Building up equity and handing off a war chest to their heirs doesn't matter to most folks, and that might not be as dire as some would have you believe.

I actually think this is the easy part to predict, as silly as it sounds. We do silly quite well here in this country. The tricky part is figuring out who's going to buy that 40-year mortgage repackaged as a bond. And do I hear a bid for 50? We've made one thing perfectly clear: We're not going to stop ourselves.

The Ghostbuster is the one who no longer accepts our IOU's.

Risk can't be subtracted from capitalism. Rules on this ancient game are very clear. It can only be masked by a group that wants you to like them and vote for them. But it's not their fault. The ghostwriter of their script is the voter.

Democracy doesn't have the track record capitalism does for a reason.

Long: A 1950's house with only one AC, small closets and four big smiles.
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