If you’re still confused, as I was, about what exactly led to the failure of just about everything financial, here’s a video made by a Senior Editor at Marketplace, explaining what happened with a clever metaphor:

Crisis explainer: Uncorking CDOs from Marketplace on Vimeo.

Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation) are companies that buy mortgages from lenders. Those lenders, by selling loans to the companies, have more cash on hand to lend to other individuals. Fannie Mae and Freddie Mac then “repackage” the mortgages and sell them as securities to other investors. These are guaranteed investments. Investors will receive the returns promised regardless of the quality of the underlying mortgages.

Those promises have been in danger lately, as news traveled that without intervention, Fannie Mae and Freddie Mac might fail. The companies were having trouble making their obligations to investors.

Backed by the government or not?

While Fannie Mae and Freddie Mac are government sponsored enterprises, the government until recently did not back the companies and guarantee that investors would be paid in the event the companies failed. That was changed recently when the Federal Housing Finance Agency, a government organization, took the two organizations under conservatorship. Shareholders in the two companies will find that their shares will be devalued even beyond the recent declines in order to help the companies pay their obligations. The U.S. Treasury now has the ability to provide funds directly to these companies to ensure their stability.

Interestingly, Herb Allison will be the new CEO of Fannie Mae. Astute Consumerism Commentary readers recognize this name as the former CEO of TIAA-Cref. Many reports from current and former TIAA-Cref employees tend to agree that Mr. Allison did not do such a great job of cleaning up the mess left by his predecessor at that company.

The possible effects of the takeover

Dean Baker, an economist with the Center for Economic and Policy Research, a think tank in Washington, D.C., says, “I think that the immediate impact will be somewhat positive. You’ll see some drop in mortgage rates because it’ll decrease the uncertainty” that had pushed mortgage rates up this summer.

Baker says he can imagine a drop in mortgage rates of around a quarter of a percentage point, give or take about 5 basis points. A basis point is one-hundredth of a percentage point. “It’s something,” he says. “It’s not going to make a huge difference.”

Why aren’t people buying homes right now? It’s not because interest rates are too high and it’s not because the majority can’t qualify for loans (though I’m sure many people in fact cannot). House prices are still too high. Well, a buyer perceives prices to be too high for what he or she believes to be the real value of the house, but perception is reality. If they believe the price to be too high, they won’t buy, regardless of the mortgage interest rate.

I’m not an economist, but I think in general prices need to fall farther before the housing market picks up and people start believing there is a “buyer’s market.” I don’t think a drop in rates of a quarter of a percentage point will make that big of a difference.

If this takeover amounts to not much of a difference in the lives of Americans, is it really worthwhile for the government to seize these semi-private, semi-public corporations? Remember that now that they are backed by the government, taxpayers are footing the bill for rescuing investors in Fannie Mae and Freddie Mac (that is, the lenders). Perhaps, if you consider that the alternative—letting the companies fail—might have a more devastating effect on the economy.

Photo: respres
How the Fannie and Freddie takeover affects you, Bankrate.com via MSN MoneyCentral

I really enjoy good “data visualization”, which is a fancy, but more succinct way of saying “a way to look at information as more than just numbers.”

Last year, before most of us were aware of the “mortgage crisis,” some enterprising individual took a list of average housing prices in the United States since 1890, adjusted them for inflation, and then plotted them as if they were altitudes on a roller coaster ride. Watch the video, and you won’t be so surprised why the housing market took a downturn:

The Catholic Diocese of Brooklyn is concerned that the recent rash of foreclosures, if it continues, will degenerate the neighborhood into its recent crime-ridden past. To combat this possible future, the church has now begun offering “Housing Crisis” workshops alongside its Sunday school religious lessons.

Are pastors and Sunday school teachers extolling the values of living within your means, buying only what you can afford, and negotiating with creditors to manage your mortgage payments? No, the church is bringing in housing experts, unaffiliated I would assume, to speak to the congregation.

This program seems to be a good idea on the surface. I don’t think the religious setting would cause too much conflict. I think secular schools and other community institutions would benefit—and it would benefit their communities as well—by offering adult education courses following this example.

A Sunday school lesson in mortgages [Marketplace]

This article was written for Consumerism Commentary by Adfecto, a mid-20s guy with a masters degree in engineering. He aspires to be wealthy and writes frequently for his own blog, Adfecto Abundantia.

When I purchased a home it was not a lifetime commitment. I view a person’s choice of housing first as a financial decision and second as a lifestyle decision. A house gives you place to live and the added bonus of potential price appreciation and tax deductions. If it is cheaper to rent then by all means that is the way to go. Owning your own home can also give you a tangible increase in your standard of living, but personally that is considered a distant second when compared to the financial benefits. What I find interesting is that so many people tend to make emotional decisions about the home rather than rational ones.

Frequently, when home owners find themselves with a little extra cash at the end of every month, the idea of paying off the mortgage is often brought up. Is early payment the right way to use the money? Should the money be invested instead? Is my real motivation to build wealth or to play it safe?

The first step in analyzing this decision is to compare the interest rate on the mortgage to expected investment returns. Historically the S&P 500 with dividends reinvested has returned 10.43% annualized from January 1926 to December 2007, and the current rate for a fixed 30 year mortgage is about 5.76% according to www.bankrate.com. Based on this simple comparison it is plain to see that in the long run you will build more wealth by investing than by prepaying your mortgage.

If you want to further hone this comparison of rates, next you can consider not just the entire history of the stock market, but also every 30 year rolling period of stock market data. Since 1953 the S&P 500 has returned at least 9.34% over every 30 year period which is again well above the interest rate for a 30 year mortgage. Plowing your money into prepaying your mortgage has a huge opportunity cost that will hurt your ability to build wealth.

Why then would people consider prepaying their mortgage? Most people consider their home as a safe investment, and paying off a mortgage as a guaranteed return. A certain piece of mind comes from owing the bank less money. There is a big problem with this argument; there is still a great deal of risk involved with your primary residence!

Additional risk comes from the fact that until your loan is paid in full, the bank still holds the mortgage on the property. The bank will not give you credit for the extra payments made to pay down the debt if you start to struggle further down the line. Even if you are way ahead on your mortgage, a hardship may cause you to miss payments. The bank can foreclose even if you spent years paying down the mortgage balance early.

Investing your free cash into your mortgage is very similar to investing in a bond. It may seem odd, but you are literally investing in a fixed income asset, the mortgage, lent to yourself. The return you get will be equal to the interest you would otherwise pay on your mortgage. One problem that arises is that the bank has first crack at the collateral; your house. Even worse, your mortgage isn’t even a very good deal when compared to the types of bonds; for example, Toyota AAA rated bonds currently pay as much as 7.652%. I bet your mortgage rate isn’t that high.

Furthermore, understanding the nature of your mortgage as a bond brings to light another risk; improper asset allocation. Mortgage prepayment shifts your asset allocation to rest more heavily in fixed income type investments than you might otherwise consider. A 40 year old person should have at least 60% but more likely 80% percent of his/her portfolio in stocks, but add in all of that mortgage prepayment in the bond category and you may find yourself far out of line from you ideal asset allocation.

Another risk related to mortgage prepayment is a lack of diversification. You may think that your mortgage is not very risky because you believe in your own ability to pay. This personal bias can cloud a person from see the true risk factors such as job loss, poor real estate conditions, natural disaster, and a plethora of others. A single unfortunate event can wipe out a large chunk of the equity. A single job loss may bring about a short sale or foreclosure that could wipe out the value of your home. Would you advise someone in your circumstances to invest in individual mortgages? I sure wouldn’t, and neither should you.

Deciding whether or not to prepay a mortgage is another financial and lifestyle choice which depends on several factors, but most of all it is a choice between building wealth (logical) and piece of mind (emotional). People who focus on paying off their mortgage seem to be more in love with their house and the idea of having it paid off than the goal of building wealth. These people are also blind to the risks that come from investing too much of their finances in a single residential structure. I think that for the majority of people the ‘right’ decision would be to keep the mortgage and invest the extra money.

Image credit: Oracio
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