Sustainable Land Development Today - January 2009 - (Page 17)

some consumers to obtain home loans. Because of their GSE status, although the two companies are publicly traded on the NYSE, they are protected financially by the support of the Federal Government. These government protections include access to a line of credit through the U.S. Treasury, exemption from state and local income taxes and exemption from SEC oversight. aged financial instruments (e.g. CDOs and MBSs) “guaranteed” by credit default swaps (CDSs) and sell them around the world. The Current Problem The hybrid, public-private structure of Fannie Mae and Freddie Mac creates opportunities, unfair advantages, and temptations. As GSEs, Fannie and Freddie have a “public service” mandate to maintain a market for mortgages, buying loans from banks, repackaging them as bonds, and selling those securities to investors with a guarantee. This makes lending more tempting for banks because Fannie and Freddie assume the interest rate and default risk. Fannie and Freddie are also publicly traded companies, with the mandate of trying to maximize profits for shareholders. With implicit government guarantees, Fannie and Freddie have enjoyed AAA credit ratings although their balance sheets Repeating History in a Boom-Bust Cycle In pursuit of a construction boom during the 1980s, real estate financing by commercial banks grew rapidly to meet the demand because deregulation and other factors created an environment in which real estate lending was very lucrative for lenders. Competition among banks created a strong incentive to lessen underwriting standards. In addition, overly optimistic appraisals combined with relaxation of debt coverage (i.e. reduction in the maximum loan-to-value ratios) and the loosening of other underwriting constraints meant that borrowers had little or no equity at risk, putting the vast majority of the risk on the lender. The problem with this scenario is that the real estate market is, by nature, cyclical. Construction booms often leads to overbuilding and when the bubble bursts, real estate values decline sharply putting loan quality at risk. Because real estate projects are so highly leveraged (funded primarily by debt as opposed to equity capital by the investor), they are highly sensitive to changes in interest rates and overall credit and macroeconomic conditions. The problem is compounded when commercial banks tighten their belts to protect their already deteriorating balance sheets. Because real estate value is sensitive to the availability of credit, when financial institutions restrict lending, prices of existing properties fluctuate widely and the volume of new investments can be severely affected. If this scenario sounds all too familiar, it should. The main difference between the 1980s and now is that they didn’t repackage risky mortgages into lever- would justify a much lower credit rating. As a result, both Fannie and Freddie are able to borrow at super-low rates, a benefit they used to purchase and hold highyielding mortgage loans. The artificially fat spread between interest rates earned on mortgages and interest rates paid on bonds amounts to a big government subsidy, thwarting competition and undermining market discipline. As home foreclosures continue to drive down prices, the loan portfolios continue to lose value. Although their loans are better than the subprime loans that have created much of the mortgage crisis, the problem lies in their thinly capitalized balance sheets. Fannie and Freddie do not have sufficient equity capital to survive a major downturn. Combined, they have an equity cushion of slightly over $80 billion compared to the $5.5 trillion of mortgages they either own or guarantee. Although $80 billion may seem large, a mere 2 percent decline in the value of its assets ($110 billion) Circle 122 • or www.SLDTonline.com/webcard www.SLDTonline.com 17 http://www.aquamasterfountains.com http://www.aquamasterfountains.com http://www.SLDTonline.com/webcard http://www.SLDTonline.com

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Sustainable Land Development Today - January 2009 Contents Our Voice Your Voice The BottomLine SLDI in Focus Calendar Industry Rebound Will Require Balanced Approach What Happened to Fannie and Freddie? Added Value in Entitlements Industry Spotlights Technology Wastewater Innovation Classifieds Advertiser Index Editorial Board SLDT Resources Last Word

Sustainable Land Development Today - January 2009

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