lending advice

By Mark Levine

If the mortgage industry were an apartment building, it would be in need of some serious capital improvements. It has not fallen down completely, as it is built on a solid foundation that has withstood the test of time. It will not fall down in the future, as the state of our economy and nation is aligned with keeping it standing. However, there are many sections which have fallen apart and the industry is suffering as a result.

There are certainly debates as to how the industry got into this predicament in the first place. Some people argue that there was massive fraud on the part of “evil” mortgage companies, and borrowers were completely innocent victims. Others contend that the mortgage companies did not necessarily behave criminally, but that they inappropriately pushed ill-suited mortgages on naïve customers. Still some, including myself, believe that it was simply a matter of greed from all sides of the table. Lenders got too aggressive on their terms in order to boost profit; borrowers got too aggressive on their leverage in order to boost returns; and regulators just looked the other way.

But enough of yesterday’s news. Today, the task is repairing and then maintaining the massive building that is the mortgage industry. Where do we start? First of all, it is very important to recognize that some vital parts of the building are still standing. In fact, Government Sponsored Enterprises are thriving right now. In the
mortgage business, the two major GSEs are, of course, Fannie Mae and Freddie Mac, both of which play extremely significant roles in the residential and multifamily housing industries.

Just as “subprime” became a household term in the second half of 2007, you may have noticed that “Fannie Mae” and “Freddie Mac” seem to be the buzzwords so far this year. That is because the GSEs are one of the primary arrows in the government’s quiver, which it uses to influence the mortgage and housing industries. There certainly are other tools that are being contemplated—and that I’ll discuss later—but thus far, supporting the GSEs has been the major activity. A cynic would say that the government’s active participation in the industry is only due to the fact that we are in a heated election year. A realist, however, would remember that GSEs were created exactly for times like this.

Fannie Mae and Freddie Mac are both publicly traded companies, adding some confusion to their relationship with the federal government. It is important to remember that the concept of GSEs began back in 1938, when Fannie Mae was actually created as a division of the government, in order to facilitate home ownership. It wasn’t until the late 1960s that both it and Freddie Mac became owned privately, but chartered publicly by Congress. In other words, despite the fact that the GSEs were no longer a division of the government, they would still be regulated and influenced by the government. This structure continues today.

So, in times of major turmoil, such as our current mortgage crisis, Fannie Mae and Freddie Mac are encouraged to thrive in various ways. First of all, we are reminded that the loans originated by these companies have an implied government guarantee behind them. While other mortgage pools, such as Commercial Mortgage-Backed Securities and Collaterized Debt Obligation bonds, face rapid downgrades and thus rapid price devaluations, Fannie Mae and Freddie Mac commercial mortgage bonds remain much more stable in the marketplace. The government can also essentially control the volume of loans originated by these companies, through dictating maximum individual and aggregate loan amounts. With much fanfare on various occasions this year, the government has raised the maximum individual loan amount, as well as increased the overall volume of outstanding loans that can be purchased by the GSEs. The latter of these processes was accomplished by significantly decreasing the ratio of reserves that must be held, down from 30% to 20% (of their existing portfolios).

Through all of the detail—and controversy, depending on who’s talking—the important takeaway is that the government has the power to keep a large section of the U.S. mortgage industry standing. In today’s market, this is resulting in a stable mortgage environment for multifamily loans, with historically low interest rates and relatively aggressive terms. Similarly, single-family loans continue to be available to the majority of the public, albeit at somewhat more conservative credit terms. Contrast this with the remainder of the commercial mortgage industry, which continues to flow at a trickle due to its reliance on the secondary market, which is still hiding under its desk.

Looking beyond the GSEs, there is much public debate about how to further repair and maintain the mortgage industry. As discussed earlier, the issues are certainly getting much more attention this year due to the election season, and to the fact that major media outlets have decided to make the debt crisis a top story. It seems that whenever one of our political candidates makes a speech these days, he or she has another way to solve the issues facing our industry.

One obvious method is to lower interest rates. The most visible way of doing this is for the Federal Reserve’s Federal Open Market Committee to lower the Fed Funds Rate, which it has done numerous times over the last several months. At the beginning of 2008, the Fed Funds Rate was 4.25%. By the end of March,
it was down to 2.25%, with expectations that it could go lower. Clearly this is an
actively used method of market influence by the government.

So how does this help repair the mortgage industry? The Fed Funds Rate is the rate banks charge each other for loans. It has a very direct impact on borrowing costs for banks, and therefore a direct impact on what banks must charge the public for their loans. As the Fed Funds Rate decreases, so do the interest rates charged by banks on most loans, including residential and commercial mortgages. Of course there are other factors—the most important of which is credit risk—which influence rates, but in a vacuum, mortgage rates move with Fed policy changes.

In theory, lower mortgage rates help to repair the credit crisis in two important ways, both of which are related to borrowers being able to obtain more debt. First
of all, it enables borrowers to refinance existing debt more readily. Many of the problems facing the industry these days revolve around borrowers not being able to pay off existing highly leveraged debt. In addition, lower interest rates generally translate into lower capitalization rates and higher property valuations. This would result in returning some of the lost equity that property owners had built up in their real-estate investments.

On a different note, there are countless numbers of proposals being advertised by various regulators or politicians as quick fixes to the mortgage crisis. Most of them are instead just hasty moves to appease the public and get some free airtime. For example, several proposals revolve around the notion of lending government money to securities firms to enable the purchase of existing mortgage-backed securities, which are quickly growing stale.

I am not sure what this accomplishes, aside from allowing certain mortgage issuers to offload their bad investments or bad loan originations at artificially inflated prices. It certainly would not teach anyone a lesson, and prices would just go back to depressed levels after the money is spent. It also seems extremely unfair to those institutions that earlier offloaded billions of dollars of depressed securities because they made a good bet that prices would continue to fall.

In my opinion, time is the best method for repairing the mortgage industry. The government makes strong impacts through the GSEs and interest rate movements, and those influences are working well. The problems were not created overnight, so regulators should not expect to fix them overnight. That is not to say that we should not be focused on how to continue repairing the industry, since it is vital to so many of us and to our economy as a whole. But I believe that the energy should be focused on the maintenance side of the equation, and how to come out of this crisis with a stronger industry once it is repaired. After all, that should be the focus of any good real-estate professional: instill a proactive and high-quality maintenance plan, so that future repairs will be minor and will not disrupt the normal flow of business.

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The opinions expressed in this article are those of the authors and do not necessarily reflect the viewpoint of SFAA or SF Apartment Magazine. Mark Levine is a vice president in the San Francisco office of ARCS Commercial Mortgage. He can be reached at 415-981-9700 or Mark_Levine@arcscommercial.com. Copyright © 2008 by SF Apartment Magazine. All rights reserved.