Freddie Mac, formally the Federal Home Loan Mortgage Corporation, is a government sponsored mortgage company chartered by Congress in 1970. It was hit by a $2 billion quarterly loss in the fall of 2007. Though a government-sponsored enterprise, Freddie Mac is a stockholder-owned corporation. It buys mortgages from banks and other financial institutions that originate mortgage loans in order to support home ownership. Freddie keeps some of the mortgages, and also assembles mortgages into packages that it sells to financial institutions such as insurance companies and hedge funds. Freddie Mac sells bonds with a lower interest rate than corporate bonds due its credit guarantees and the implicit guarantee it has from the federal government. Its portfolio of mortgages is worth about $700 billion.
When borrowers can't pay the interest on their mortgages, they default, and the lenders lose money. That is what has happened to Freddie Mac in a big way. The company announced plans to sell $5 billion of preferred stock to raise cash. It is also selling $4 billion in bills, short-term debt.
Freddie Mac is the second largest housing finance company, the largest being Fannie Mae, also a government-sponsored enterprise that is now also owned by shareholders but has an implicit government guarantee. The losses from the mortgages will continue for the next couple of years as adjustable mortgage rates rise and marginal borrowers continue to default.
In fall 2007 there were also big losses by banks, brokerage firms, and other financial institutions. Colin Barr wrote an article in Fortune that was also in CNNmoney.com, entitled "Don't look now: Here comes the recession." Retail business was good the day after Thanksgiving Day, but consumption does not really drive the economy. Consumption pulls the economy, as production is for consumption, but production drives the economy, and the engine is economic investment.
Shareholders and chiefs of financial firms have suffered losses, but to the firm chiefs and financial analysts, this should have come as no surprise. Everybody should have known that the subprime real estate loans were risky, and that there has been a boom-bust cycle in real estate for the last two hundred years. The subprime mortgages — those made to lower-income borrowers — have had the most losses, but those loans are only the tip of the real estate iceberg.
While Freddie and Fannie have indeed helped lower-income folks buy their first house, ultimately this is a futile subsidy. Subsidizing housing ends up driving up land rent and the price of land. By expanding the demand to buy land, facilitating the secondary mortgage market ends up hurting the lower-income folks, as their mortgage amounts go up with the price of real estate, and by being induced if not fooled into buying a house, many just end up in foreclosure. Also many renters are being forced out of their homes, as "investors" and speculators sell or get foreclosed when real estate prices stop rising.
During a real estate boom, owners are mesmerized by the idolatry of ever increasing land values. Rising land value is the great bail out, as banks and owners figure they can sell out at a profit. But the rapid rise of land values is unsustainable. The bubble does not quite pop — it plateaus in some places and drops a bit in other locations. In places with many foreclosures, prices fall. Most sellers hold out for sales at previous prices, so the inventory of properties for sale gets large.
The deeper, and mostly unseen, problem of the real estate boom is the that the high cost of real estate, combined with higher interest rates, make further investment generally less profitable. For example, the construction of residential housing is in recession. As economic investment in capital goods falls, workers in those industries become unemployed, and their demand for goods falls, and the economy falls into a recession — falling GDP. This has not quite happened yet, but the financial waterfall looms in 2008.
The last real estate recession was in 1990, and real estate has been on an 18-year cycle, with the next downturn scheduled for 18 years after 1990, thus 2008. My article on the business cycle in 1997 predicted real estate trouble by 2008. Theory gives us the cause and effect, and history gives us the timing. But few people believe it, because most folks don't heed warnings. I don't blame them, since there are many voices pointing in many directions. Like former USSR president Gorbachev is reported as saying, "I have 100 economists and one of them is right, but I don't know who."
Only when the next recession occurs will some people pay attention to the real estate cycle story. But few will heed the really important lesson — how to eliminate the business cycle. There are two causes and two remedies. The financial cause is the manipulation of money and the interest rate by the monetary authority. We need to replace central banking with free-market money and banking.
The other, more important, cause is fiscal-sponsored real estate speculation. This market-hampering speculation is juiced by money expansion and by fiscal subsidy. Government public works pump up land values, and fuel speculative purchases. The remedy is to have landowners pay their way, by tapping land rent or land value for government revenue. Public goods generate land rent, so landowners would be paying back value received. That would take the subsidy out of landownership and calm the cycle.
Free banking and land-value tapping would eliminate the real estate and business cycles. But intervention is so deeply rooted in the economy that federal money and real estate swings seem natural to most folks. But there is nothing natural or free-market about depressions. Recessions and depressions are caused by statist interventions that distort the economy. Freddie Mac and Fannie Mae are themselves government-sponsored consolation prizes rather than free-market enterprises, and are ultimately part of the real estate problem rather than the cure.
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FRED E. FOLDVARY, Ph.D., is an economist and has been writing weekly editorials for Progress.org since 1997. Foldvary's commentaries are well respected for their currency, sound logic, wit, and consistent devotion to human freedom. He received his B.A. in economics from the University of California at Berkeley, and his M.A. and Ph.D. in economics from George Mason University. He has taught economics at Virginia Tech, John F. Kennedy University, Santa Clara University, and currently teaches at San Jose State University.
Foldvary is the author of The Soul of Liberty, Public Goods and Private Communities, and Dictionary of Free Market Economics. He edited and contributed to Beyond Neoclassical Economics and, with Dan Klein, The Half-Life of Policy Rationales. Foldvary's areas of research include public finance, governance, ethical philosophy, and land economics.
Foldvary is notably known for going on record in the American Journal of Economics and Sociology in 1997 to predict the exact timing of the 2008 economic depression—eleven years before the event occurred. He was able to do so due to his extensive knowledge of the real-estate cycle.