The New Housing Bubble

Banks look fine on the surface, but the system is as fragile as ever

Construction at the Hudson Yards Redevelopment Project which is developing Manhattan's far West Side along the Hudson River, in New York on August 16, 2013. Spencer Platt/Getty Images

Financial bubbles are not accidents. Our asset-backed banking system creates bubbles by design—they’re an inevitability.

Imagine a homeowner who owns a $1 million house free and clear. The owner goes to a bank and borrows $800,000 against the house. This credit money springs into existence as an accounting entry of a private bank. The borrower goes out into the market and starts purchasing other assets: stocks or a weekend house. The new money drives prices higher, including the assets that form the collateral of the banking system.

Since collateral values now have increased, the banking system is happy to increase its loans to borrowers, which pushes prices yet higher, and so on, in a positive feedback loop.

A Hidden Bubble

In 2018, housing may not feel like a bubble. We don’t read the same amusing anecdotes of “adult entertainers” flipping houses by the dozen. One reason is that the panic of 2008 resulted in a further concentration of wealth—the banks were saved and the people ruined, and since then, non-banks have taken over the lending from banks.

The Chicago Tribune reported in June last year: “Several major lenders are offering 1 percent down payment loans, and now a large national mortgage company has gone all the way, requiring absolutely nothing down. Movement Mortgage, a top 10 retail home lender, has just introduced a financing option that provides eligible first-time buyers with a nonrepayable grant of up to 3 percent.”

The mortgages are then sold off to government agency Fannie Mae, which then sells the repackaged loans to the banking system or the Fed and guarantees the payments. However, despite the initial popularity of the Movement Assistance Program, partner Fannie Mae halted the program at the end of 2017. Too much risk after all?

Maybe. But it looks like the lessons from the 2008 housing crash have been erased completely: a quasi-government agency, which operates under federal conservatorship, is guaranteeing loans made by reckless institutions to shaky borrowers. The difference is that the reckless institutions are not banks but non-bank lenders.

U.S. banks supposedly are a lot healthier post-2008 because new rules prevent them from engaging in the rampant subprime lending that nearly collapsed the financial system. Indeed, non-bank lenders now account for 64 percent of mortgage originations (up from 30 percent in 2013) and service borrowers with lower median credit scores than banks.

Too Big to Fail Transfer

The good news: While a 20-to-1 levered bank that loses only 5 percent on its investments puts its depositors’ funds, and therefore the financial system, at risk, no one does or should care if a bunch of hedge funds loses their equity investment in a non-bank lender.

And yet, if we follow all of the credit tributaries back to their source, we see that this system is more malignant than ever. The banks are, in fact, still funding mortgages, just surreptitiously. In the new normal mortgage transaction, the non-bank lender funds its loan to the borrower by in turn borrowing “warehouse loans” from a bank.

These banks loans are secured by the new mortgages and are extremely short-term, generally for only 15 days, which is the time needed for the non-bank lender to flip the mortgage to one of the government-sponsored enterprises (GSE, such as Fannie Mae or Freddie Mac) or Ginnie Mae. These GSE then securitize the incoming mortgages into mortgage-backed securities (MBS) and guarantee the payments “to increase affordable, sustainable lending,” Fannie Mae claims.

The market treats the securities as near-sovereign debt because Fannie and Freddie truly are too big to fail. Not only would mortgage originations grind to a sudden stop, destroying the housing market (and the local tax base), but the final owners of the securitized instruments would take severe losses.

And who owns most of the $7 trillion of outstanding MBS? The Federal Reserve owns 25 percent and banks another 27 percent.

The Risk Remains

So, it’s true: Banks are much less exposed to default risk than they were in 2007. Since mortgage payments are due every month, it is impossible for borrowers to default on the 15-day warehouse loans (unless the GSE suddenly stop buying them), and the MBS, which do remain on banks’ balance sheets, are insured implicitly by the government.

Nevertheless, this vicious circle creates a bubble in housing. The banks remain the ultimate creators of credit for housing loans; the more credit they create, the higher housing prices can go; and the higher housing prices go, the more collateral gets fed to the banks through the MBS system. The more collateral the banks have, the more credit they can create.

The problem is not just on the MBS market: real estate loans in total make up 49 percent of the banking system’s assets.

Banks may have shifted mortgage default risk to the government, but this only means the next housing crisis will be absorbed by the government and the U.S. dollar directly through the government-sponsored agencies. Don’t think the outcome of this bubble bursting will be any less painful.

Dan Oliver is the principal at gold mining fund Myrmikan Capital.

Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.