The True Scope of the Housing Bust
Below is the transcript of an interview I conducted just a few weeks ago with Fannie Mae's first Chief Credit Officer, Edward Pinto. In our conversation, Ed painted a very clear picture as to why government policies were key in blowing up the housing bubble. In the time since our last discussion, he testified in front of Congress about the true scope of the problems which face us.
Well, on Tuesday, January 20th, he returned for a follow-up interview. Any sober-minded investor who wants to face reality, no matter how grim, needs to hear this expert tell why the current housing mess is so much more substantial than the real estate pain experienced even during the Depression. For example, get this: Pinto says that if current price/default trends hold, then by the end of this year we as a nation will have a loan-to-value ratio of nearly 110%! That would be a first in history.
Listen in to my latest conversation with Edward Pinto; you can't hear from someone who knows more about the housing mess.
And for background on what built this mess in the first place, read the transcript below:
I'm talking with Edward Pinto. He is a real estate industry consultant, speaking with us from his home in Sarasota, Florida. He's an expert on today's credit troubles and the housing burst because he spent five plus years at Fannie Mae from 1984 to 1989, including becoming the entity's first chief credit officer in 1987.
Ed, thanks for being here with us today.
Edward Pinto: I appreciate it, Chip. A pleasure to be here.
Chip: So prior to your experience with Fannie Mae, you also had 10 years of successful experience in affordable housing in Michigan. Can you tell us a little bit about that?
Edward: Yes. I worked for the Michigan State Housing Development Authority in Lansing, Michigan, for eight years. I was an attorney there and became general counsel after a couple of years. And was intimately involved in all of their operations.
I actually helped start and affordable housing program for home improvement loans that had designed and had gotten approval through the legislature.
The reason Michigan Housing, one of the reasons they were so successful, is when they had started a few years before in 1968, they had purchased a number of multi-family housing development packages, proposals, from HUD, that were insured by FHA.
They purchased six or seven or eight of these packages to get the pipeline filled up and moving while they put together their own business. And every single one of those HUD-insured developments ended up going back to HUD, reassigned to HUD and were foreclosed upon.
Chip: Every one?
Edward: Every single one. And so Michigan Housing on the multi-family side didn't do FHA-insured multi-family. Every home that it financed was uninsured. It had various subsidies, but they were uninsured.
And to my knowledge, and that which goes through 1982 and then a number of years after that, none of those multi-family developments were ever foreclosed upon.
Chip: Why? Because you had higher credit standards?
Edward: They were well underwritten, they were well designed. Part of it was the design. Actually the deputy director at Michigan Housing was an architect. And he required certain architectural standards to make sure that future upkeep would be minimized. The quality of the materials would be appropriate.
So there wasn't shoddy construction. Each set of plans was reviewed. We had our chairman, who was a builder, would sit in the board meetings and have the architectural review staff bring in the plans, and say, "Look, this is going to be too expensive to maintain. You've got to get rid of these corners," and stuff. It's just expense. And so they would do a little redesign.
And so it was that type of mentality on the multifamily side that led to a truly successful program. And they had similar success on the single family side. They'd be making insured loans through FHA on the single family side, and there the fault rates would be a small fraction of what HUD's would be in the same area.
Chip: It's a matter of applying some common sense.
Edward: A matter of applying some common sense and sticking to it, and also not having - and this is where it comes back to Fannie Mae and Freddie Mac - you cannot have political influence enter the process.
Chip: Let me ask you about that actually. Because we've heard a lot over the past few months, first with the takeover of Fannie and Freddie, and not the big bailout package that was passed last week. We've heard a lot about this problem being caused by Wall Street greed. Isn't Wall Street the prime culprit?
Edward: No. It's not. And let me go back to this issue of political corruption and the corrosiveness of political influence, and then circle back to your question.
At Michigan Housing I spent eight years there. I can say without fear of contradiction that I never, ever was asked or intimated to make a decision for political reasons. I spent five years at Fannie Mae. I can make the statement that the entire five I was there, it was never ever hinted that a credit decision or approving a transaction or a deal should be made or should be based on political influence or political circumstances.
Chip: That sounds hard to believe today. [laughs]
Edward: And that's not the way it is today. I can actually relate a circumstance where we had to, at Fannie Mae, severely reduce the amount of lending we were going to do in the entire state of Alaska. The entire state in 1985 and 1986, because of a crash of housing prices in Alaska brought about by over-zealous affordable housing programs that led to a 75 percent decline in house prices in certain areas of Anchorage and the rest of the state.
Edward: House prices went from $80,000 to $20,000. And because of that we had to basically make a lot of changes and retool what was going on up there. And as a result I had to go meet with Senator Stevens, for example - who is still a senator - personally, and explain what we were doing. I had to meet with Representative Don Young's office. I had to meet with Senator Murkowski, the father of the current senator.
I had to explain to them individually why we were doing this, what had happened, and what steps we were taking to address the problem.
Chip: But it didn't impact what you did. You'd explained it, but you did what you did.
Edward: My job was just explain what we were doing. You're not asking permission. You're not asking them for their input. And their response to a person was, "Hey, we're sorry this is happening. We're not going to go from the rooftops and announce it, but you have to do what you have to do, and we understand why you're doing it."
That is not the way it started working starting in 1990 or 1991.
Chip: I know you think the prime mover here is Washington, DC. So what changed then?
Edward: What changed is two things. One is Fannie Mae, and Fannie Mae started it. Freddie Mac sort of had to follow suit. And Freddie Mac was always sort of the junior partner; they were always pretty much smaller than Fannie. So they pretty much followed suit.
Fannie Mae, starting in the late 1980s, early 1990s, decided that in order to protect its charter from attack by Congress, and Congress is the only entity that can change its charter. The president has no power; Fannie Mae has no power.
Edward: Congress is the only entity. It's a congressionally granted charter. The only way to protect their charter and the provisions under it that were very, very valuable - the high leverage, the high portfolio that they could do, the implicit government guarantee, the exemption from taxes, the exemption from SEC oversight - these were all part of their charter.
And in order to protect that, the decision was made to embrace the charter and the strategy for protecting it was affordable housing. And Congress embraced that strategy with a vengeance.
Chip: Getting into it for the first time.
Edward: In 1992, put in a provision requiring Fannie and Freddie to do affordable housing in a certain percentage to be set by HUD. So now they had HUD setting the goals. And HUD has been a disaster when it comes to affordable housing.
Chip: And thus our first slide into this mess.
Edward: That's the first slide into this mess. And that goes on for the next 15 years. But the second thing that happened, that was going on at virtually precisely the same time...
Chip: Let me step in here, Ed. I apologize. As you can hear, listeners, we have much more ground to cover, and this is going to be a first on the Market Neutral Podcast. We're going to take a break and come back with Ed Pinto and our fascinating discussion on the Fannie and Freddie drift and Washington's influence and how we got into this mess right after a break. Stick with me, Ed.
Chip: And we're back, continuing our interview with Ed Pinto. Again, he is a long-time real estate expert, consultant in the industry, and was formerly the chief credit officer with Fannie Mae in the 1980s.
We were in the midst of a conversation there, Ed, a particular point where I had asked isn't Wall Street the prime culprit here? And you said no, that's it's a two-part answer. You already answered before the break what's part one. What's part two?
Edward: Part two, Chip, is that at the same time roughly that Fannie Mae is deciding to embrace this mission of affordable housing to protect their charter, it had cleared the way of all competition to whatever part of the market it wanted to control. It had beaten back every private competitor.
Solomon Brothers in the late '80s had endeavored to do something that Fannie Mae viewed as a threat. And Fannie Mae was able to defeat Solomon Brothers and get them to back off from that permanently.
Likewise GE Capital, through some of its subsidiaries, was trying to develop programs a develop businesses that might compete with Fannie and Freddie, and they were defeated. This happened a number of times.
The reason they were able to be defeated was these charter advantages. Fannie and Freddie had tremendous leverage. On their portfolio business, they could lever approximately 40:1. On their MBS business, they were able to lever 180:1 approximately.
Edward: And as the listeners would know, those are fantastic leverage levels. These companies have always been relatively minimally capitalized in terms of levels of capital. And it was that leverage compounded with the ability of that leverage to finance or support huge portfolios in both companies that threw off huge amounts of money and profits that could be used to subsidize affordable housing, which would benefit their supporters in Congress. Which would keep them from changing the rules to either reduce their portfolio size, put in a strong regulator, or raise their capital requirements.
Any one of those three things, just any one of them, would have endangered the ability of Fannie and Freddie to support affordable housing at the level that Congress wanted it.
Chip: So Congress created this mess with its desire to essentially throw caution to the wind, in the name of doing something good, and now they rail against Wall Street and fail to name themselves as movers in this issue.
Edward: Exactly. If you recall, in the late '80s, the Congress was always complaining about there isn't enough discretionary spending. We don't have enough. We're getting squeezed, we're getting squeezed. Well, HUD and affordable housing was in the discretionary spending bucket.
So in effect Congress decided, well, if we can't get it through spending that's on-budget, what if we get to it with spending that's off-budget. And Fannie and Freddie could put trillions into this. In fact, in 1994, Fannie Mae announced its first trillion-dollar affordable housing initiative, by Jim Johnson.
And then it was followed in 2001, I believe it is, that Frank Raines had a follow-on, a cumulative $2 trillion program. And Freddie Mac had a companion $2 trillion program that year. These were multi-year programs. But I've now named $5 trillion of initiatives.
That swamped anything Congress could have done through HUD.
Chip: Right. And only a government-ordained institution could go on and make such messy loans, throwing credit standards to the wind, in a way that no private institution that actually cared about getting its capital back would ever do. Correct?
Edward: Exactly. Because again, Fannie and Freddie had a dual personality. On one side it was a shareholder-owned company. On the other it had this charter that gave it basically a governmental aura. And they needed the support of Congress to keep that dual personality in place.
However they needed to raise their earnings in order to keep their shareholders happy, they needed to spend some of the earnings on the affordable housing to keep Congress happy, eventually it became a very insidious problem, because every time they'd meet these goals that HUD had set, and this was over about a 15- or 16-year period of this goal setting.
Every time they'd meet them, HUD would say, "Thank you very much." They probably didn't even say thank you. They'd say, "OK, we're going to raise them." So eventually the goals got to somewhere in the mid-50 percent range.
And when I say goals, they're actually very complicated. There's multiple goals, and their sub-goals, as only the government can do. And so Fannie Mae and Freddie Mac would end up with dozens of little boxes they had to fill, and quotas. And it was very much managed by HUD. HUD was the manager of this.
Chip: Boy, it sounds like it took on this billowing effect that it was almost taking on some characteristic of a Ponzi scheme in its growth. It makes you wonder that, as bad as we all think this situation is, that underneath it's probably much, much worse. A truly epic situation.
Edward: Well, it's funny that you should mention epic situation. Up to the present day, the most serious single family real estate failure ever to occur was by a company called Epic. And in 1985, they had 16,000 loans in their portfolio, and on a single day in 1985, they defaulted on all 16,000 of them, $1.6 billion.
Chip: Every one of them?
Edward: Every one of them. Solomon Brothers lost money. PSFS lost money. The oldest thrift in the United States, founded by Benjamin Franklin, went out of business. Tycore Mortgage Insurance went bankrupt. And Fannie Mae had a loss of probably $30 or $40 million. But it had turned down additional loans from this Epic, because it had an individual who was my mentor, and had hired me at Fannie Mae, who said, "No, this business is not good. It will fail."
In fact, he actually said, "They will never have a single delinquency. If they ever have a single delinquency, every loan will go delinquent." And he said that well over a year before it actually happened. Fortunately Fannie Mae avoided that second piece, but it still had the piece that had been done before he had gotten to Fannie Mae and before I had gotten to Fannie Mae.
Chip: Some would say all this has been worth it - or maybe they wouldn't say that now, but it was always the case, because the case was, well, many of these loans helped further the goal of affordable housing. But in fact it's done nothing of the sort, right?
Edward: It's absolutely done nothing of the sort. In fact, when I was at Fannie Mae, I worked with Gail Cincotta who was the founder of National People's Action, which is a community group very much like ACORN, much, much smaller.
And she was instrumental in getting the CRA Act, the Community Reinvestment Act, passed. And she really hated FHA and HUD and the tremendous default rates that they had and what it was doing to default rates in Chicago, Detroit, St. Louis, all around the country. And she's on record in front of Congress talking about this for many years.
Chip: So an affordable housing advocate who actually wanted solid lending standards.
Edward: She wanted solid lending. She wanted lenders to have skin in the game. And do her vision of CRA was you'd have lenders that actually were lending their money, not HUD lending the taxpayer's money. Lenders lending their own money, and they would keep track of this.
When Fannie Mae got involved, I put that same requirement in, that the lenders had to keep skin in the game, had to take that first loss, had to participate fully in that first level of losses. And the idea being that that would keep them attentive and the programs would be successful.
Chip: Common sense again.
Edward: Common sense lending for affordable housing. That requirement was changed in one or two months after I left Fannie Mae, it was changed. Because that then enabled a huge expansion very quickly of the affordable housing programs.
The way I'm describing, it takes time. You can't announce a trillion-dollar program and do it that way. You have to do it transaction by transaction, bank by bank, and look at each transaction and look that it's properly put together. But that takes time. People didn't want to take the time to do that. They wanted to do it the easy way, the fast way.
As you know, when you start making credit decisions that are based on political expedience and loose lending, it may take five or ten years for the problems to actually surface. They're just sort of sleeping. Housing prices are going up, which they were for the most part of the '90s. Particularly starting in about '93, all the way to 2005 or 2006.
Well, a rising tide raises all ships, and it basically masked what was going on with the loose lending. But the balloon can only keep blowing up for so long. Ironically, as Fannie and Freddie were feeding this market, house prices started going up even faster. And so Fannie and Freddie and were under even more pressure to do affordable housing because housing was becoming more unaffordable. Think about that.
Chip: Wow, that's unbelievable. We're running little long here, so one last question or thought here. And that's the question of where we're heading. I look at what's taking place in Washington, DC, today and it doesn't give me one bit of comfort. In fact it makes me feel like we're trying to build a similar mess once again.
On September 25, Mr. Lockhart said he was going to try and force more bad loans through the system. Can you talk a little bit about what you're seeing and where we're heading?
Edward: James Lockhart is the conservator of Fannie and Freddie. He's the regulator, he's the one who put them into conservatorship and named himself conservator. I took that as a positive sign. In fact, he early on announced that there was a plan to reduce over time the size of Fannie and Freddie's portfolio. Which is one place you have to start. There's a lot that has to be done here relative to Fannie Mae, but that's certainly a minimum place to start.
Well, I was astounded when I read his testimony of September 25, 2008. That's two weeks ago! And it was before a committee chaired by Representative Barney Frank. The listeners may be aware of Barney Frank's involvement in Fannie Mae for many, many years.
And here you know have the regulator/conservator in front of Barney Frank. And he told the committee and the chairman that A) he was fully cognizant of his dual authority of both safety and soundness regulator of Fannie and Freddie, and as mission regulator for their affordable housing mission, and he was not going to forget that.
Edward: Number one. And that was a change that had just been passed last year by Congress out of Barney Frank's committee. Number two, he basically said that Fannie and Freddie, the old regime, the one that he put out, had tightened up on underwriting in order to protect themselves and protect homeowners.
However, they had gone too far in tightening up, and that he had instructed the new CEOs that he had named to review all of those tightenings and make sure that Fannie and Freddie's affordable housing mission was not compromised. And of course make sure that of course their safety and soundness isn't compromised. But we know...
Chip: They don't mean that.
Edward: In 17 years, nobody has cared about their safety and soundness relative to affordable housing. Thirdly, and this is one of the really astounding pieces here, thirdly he goes on to say that Fannie Mae and Freddie Mac, he had to take them over not because they had created mayhem across the fruited plain with defaults and foreclosures and junk loans to the tune of $18.5 trillion. No, that wasn't the reason.
The reason he had to take them over was because their ability to proceed with their affordable housing mission had been imperiled. How had they been imperiled? Well, lenders were no longer originating -- in bureaucratese - "goal-rich loans." Goal-rich loans are ones that meet affordable housing quotas.
And he turned the New York - the blame game, they've been blaming New York. All of the sudden the problem of Wall Street is that...
Chip: They're not doing them.
Edward: That they're not doing sub-prime loans. The sub-prime loans were goal-rich for Fannie and Freddie. So Fannie and Freddie have been hamstrung because Wall Street isn't able to sell them sub-prime loans.
And thirdly, FHA's volume has exploded because Congress has greatly expanded FHA's abilities, and that is now competing with Fannie and Freddie. And therefore Fannie and Freddie have to redouble their efforts in order to compete with FHA. So you now have one government-owned entity, Fannie and Freddie, competing with another government-owned entity because they both need to do goal-rich loans.
The last point he made was he assured the committee that he had already started meeting with national housing advocacy groups to develop a plan to make sure that Fannie and Freddie would be able to implement and meet their affordable housing goals.
These are the same groups that have been pressuring congress, and congress has been willingly agreeing for the last 20 years.
Chip: Wow. Only in Washington, huh, ED?
Edward: Only in Washington. I'm from Washington and I'm here to help you.
Chip: [laughs] Classic. Well, what a fabulous discussion. I'm sure our listeners are very, very impressed. Thanks again. We've been talking with Edward Pinto. Thanks once again for being here, Ed.
Edward: You're welcome, Chip, enjoyed it. Thank you very much.
Chip: And that does it for this special edition of Market Neutral. Thanks again to my guest Edward Pinto for being here with his one-of-a-kind insights into Fannie Mae and the true culprit in this debacle. The one that now claims to have the cure, our fearless leaders in Washington, DC. What a mess. I wish it could be a more upbeat story and one with a brighter outlook, but at least it's better to know the truth of what's going on here, and we've got to hold these guys in DC accountable.
Thanks again for joining me on the Market Neutral podcast. We'll be back next week with a full show. Take it easy and be careful out there.