Freddie Mac Scandal Could Hurt Housing Market

June 12, 2003


Most people have never seen a bear market--in home prices. But then, until a few years ago, many investors never experienced a bear market in stocks.

But just because no one remembers doesn't mean it can't happen again. In fact, that lack of experience is just what often causes the extremes that lead to a market bubble bursting.

There's an old Wall Street saying that no one rings a bell to signal the end of a bull market. But in hindsight, there's always a reason or event that stands out as the turning point. In the case of the housing market, I believe we'll look back on the headline events of this week surrounding Freddie Mac as the trigger for a change in attitude about homes as an investment.

Who is Freddie Mac, and why should a corporate governance scandal and an SEC investigation, as well as a criminal investigation into Freddie Mac, impact housing prices?

Who is Freddie Mac?

Freddie Mac is involved in financing one of every six home mortgages in the United States. As a "government-sponsored" entity, Freddie Mac and its sister agency, Fannie Mae, sell mortgage-backed bonds to investors at low interest rates. Then they turn around and use the money they get from selling bonds to buy more mortgages from banks and other lenders. The banks use that money to make new mortgages, and keep the housing finance system going.

But this latest scandal threatens to change the way the agencies operate, which, up till now, has been fairly independent of regulatory controls and supervision. Any increase in ongoing regulatory costs could cause mortgage rates to rise--even in the midst of a low-interest-rate economy.

And that would be bad news for housing--the one investment that, at least in recent memory, has continued to gain in value every year.

You say you don't see housing prices as a bubble? Well, that's what everyone says when they're standing inside a bubble! But here are a few statistics that might give you pause:

* Housing prices--adjusted for inflation--have gone up more in the last five years than in any five-year period since the end of World War II.

* In more than 100 cities, housing prices have climbed twice as fast as household incomes in the last five years.

* Although roughly 40 percent of American homes are owned free and clear of a mortgage, Americans on average have less equity in their homes than at any time since the Great Depression.

That last point is particularly troubling. Over the last decade, home buying has become a highly leveraged transaction. Low down payments, as little as 5 percent down, have become acceptable. And as home prices rose, homeowners tapped into that rising equity with easily obtained home-equity loans. Finally, as interest rates dropped, people refinanced and took equity out of their homes to spend on other things.

As a result, very few Americans have that piggy bank of home equity to tide them through tough times.

Frequently, two incomes are required to make the mortgage and home equity payment. Rising unemployment could force some homeowners to sell. It's like buying stocks on margin: Everything is OK when times are good and prices are rising. But leverage cuts very painfully when times get tough.

In any bear market, the first step is denial. Prices stay up but level off, and everyone is complacent. But when leveraged investors are forced to sell, prices tumble quickly.

It happened here

Did it ever happen in Chicago? You bet. In the early 1970s a young couple who were friends of mine purchased a four-bedroom apartment on Chicago's ritzy East Lake Shore Drive. The cost was around $100,000. I've since lost touch with them, but today those apartments are worth well more than $1 million.

So what's the lesson about falling home prices? I remember how shocked we were back then to learn that the apartment they had just purchased had once sold for nearly a million dollars--in early 1929!

What goes up can come down. That's the lesson of bear markets. The bear market in stocks was a calamity. At least if there's a bear market in home prices, you can always live in your mistake, as long as you have the income to make your monthly payments. And that's The Savage Truth.

Terry Savage is a registered investment adviser and is on the board of directors of the Chicago Mercantile Exchange and McDonald's Corp. She appears weekly on WMAQ-Channel 5's 4:30 p.m. newscast.

Copyright © Terry Savage Productions

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