The Treasury Department is looking to wind down Fannie Mae and Freddie Mac, but without these organizations, there would be few buyers for 30-year fixed rate mortgages in the secondary markets. The 30-year mortgage was created during the Great Depression as part of the New Deal to help revitalize the real estate market. Prices have risen in real estate over the decades because this length of time. It has allowed people to leverage their future earnings today bringing forward 30 years of income.
What will happen if Fannie Mae and Freddie Mac are shut down? It is unlikely that the bankers will step in. They are transactional based, not relationship. If they cannot package and resell mortgages, then they will not write 30-year mortgages. Bankers will be glad to offer short-term mortgages with floating rates shifting the risk of interest rates to the American public who is the least capable to handle such a profound change or understand the risks. The net result of this type of change will more likely than not set in motion the second decline of the cycle.
Housing prices will decline for the average American if buyers cannot use 30 years of future income today. If there were no 30-year mortgages, housing prices would collapse to perhaps 10-20% of current levels for nobody could buy except for cash. Talk about a major depression – boy, the Great Depression would look like a block party.
During the Great Depression, farm land, which had been sold for $2,00 an acre in the mid 1800s fell to 25 cents at auction during the 1930s. Nobody had cash so the assets collapsed to levels where people with cash were willing to buy.
Just keep in mind that real estate may not hold its value in the years ahead. The lack of mobility is critical. This is why I suggest grabbing 30-year mortgages NOW while you can. That is a hedge that in the darkest of days you can always walk away from. Paying cash may not be very wise at this point in the cycle. It would be far better to hedge a 30-year mortgage shorting sovereign bonds than perhaps waiting to buy at pennies on the dollar if its all crashed and burned.
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Livio S. Nespoli has been a broker, registered investment advisor, and financial publisher since 1985.