Photographer: Andrew Harrer/Bloomberg

An anti-foreclosure demonstration outside Fannie Mae headquarters.

Update: Fannie Mae today reported a record 17.2 billion profit for 2012, underlining the dilemma Clea Benson explained in yesterday’s story.

If there’s such a thing as too big to fail, no one qualifies more clearly than Fannie Mae and Freddie Mac. Together the two agencies own or guarantee more than $5 trillion in mortgages. After they were taken over by the government, the consensus was that we’re certainly not going to let the government take the risk of losses on the entire mortgage market again.

Not so fast. Bloomberg’s Clea Benson today reports that the government is trying to figure out what to do with the substantial profits collected by Fannie and Freddie. The two have now given back $50 billion to the government out of $187.5 billion in bailout costs. The question is how the government plans to run a profitable business that it never wanted to be in.

From the beginning, discussions of what to do with Fannie and Freddie have focused on getting the government out of the business of unlimited guarantees. A Treasury report on reforming the housing market two years ago outlined the problems with the agencies succinctly, noting their “profit-maximizing structure undermined their public mission.” Telling the agencies to do anything they could to make a profit, while also asking them to avoid irresponsible risks, plainly didn’t work.

What would be better? As yet, there’s no really good answer. One option is just to split up Fannie and Freddie into smaller pieces. That won’t be enough. It’s often claimed that lenders act recklessly when they’re too big to fail and can count on the government to step in when they get in trouble. The evidence for that is slim: the mass of smaller companies in the subprime industry happily drove themselves into oblivion with no expectations of government help (Roger Lowenstein has made a similar point). The problem with smaller financial companies, whether you talk about subprime lenders or, to go back in history, savings-and-loans, is that most of them make similar mistakes at the same time. When they fail, they all fail at once.

The invisible hand of the market alone isn’t going to fix that. Benson writes that proposals now focus on developing a private mortgage market, with a final backstop of direct government guarantees. Like it or not, some version of that last part is always going to be in play.

Photographer: Laura Segall/Bloomberg

In Phoenix, competition among investors has driven home prices up 35 percent, but it’s now sending rents downward.

Judging by investment news, there seems to be every sign that the housing market is heating up. Home prices are drifting upwards, cities like Phoenix are saturated with investors, mortgage-backed securities are back. Blackstone Group LP, the country’s biggest real estate investor–which has already invested $3.5 billion to buy 20,000 single-family homes – has obtained a credit line of $2.1 billion to buy even more. Meanwhile KKR & Co. just raised a $500 million fund for real estate investments. There seems to be no shortage of folks willing to provide money to invest in a housing upturn.

Only one thing is missing here: individual home buyers. Bloomberg’s John Gittelsohn and Prashant Gopal yesterday dove deeper into the housing revival, and found a market driven by big investors competing against each other. Some tellings stats: in Miami last year, institutional investors accounted for 30 percent of home purchases; in Phoenix it was 23 percent.

This latest report helps unravel a paradox of the current housing economy: With all the real estate investment action, you’d expect the number of new mortgage loans to be shooting upwards. No such luck. Look at the chart below, which shows new purchase mortgages through the 3rd quarter of 2012, using data from the Mortgage Bankers Association. For that quarter, buyers took out $129 billion in purchase loans. Not only is that much lower than the numbers from the boom, but it’s less the post-crash levels of 2009. You need to go back to the mid-1990s to get back to numbers like those (and they’re not adjusted for inflation).

In an earlier version of this post, for the TMN newsletter, I suggested that Blackstone has made a sophisticated move here, funding a bet on the long-term value of property by renting in the short term to buyers still locked out of the housing market. Gopal and Gittelsohn’s newest reporting, however, raises some questions about this strategy. Other investors are also crowding into rental housing. The consequence is that, as the story explains, rental prices are falling even as sales prices for the kinds of houses Blackstone wants — three bedrooms, built after 1990 — rise.

The bet on rentals does at least give big institutional investors an out if the housing recovery is not sustained. I suspect that’s a possibility many eager individual investors haven’t really considered. Every bust does reach a trough, but not every market climbs back to its boom-time high. Think of Nasdaq after the tech crash.

Right now we’re in the midst of a sharp decline in the home ownership rate. That might mark a temporary blip, or the beginning of a long period in which it is harder to secure a mortgage. If it’s the second, then players like Blackrock that are focused on properties they can rent at least have a backstop, while smaller investors counting on selling their properties in a big new housing boom will get burned.

Photographer: David Calvert/Bloomberg

The tracks in the Nevada snow? Underwater homeowners walking away from their homes.

Just as the housing market has started to turn up, Fanne Mae and Freddie Mac, the housing guarantee agencies are loosening the rules on homeowners walking away from their mortgages. It used to be that only way to get out of a mortgage was to stop paying and let it go into foreclosure. Now, as Bloomberg’s Kathleen Howley reported yesterday, a few homeowners will be able to walk away from underwater properties, with new policies going into effect in March.

Under the old rules, homeowners who kept up with payments were effectively punished for doing so: stuck in houses worth much less than they paid, they were nonetheless ineligible for foreclosure aid programs. The revised rules give those folks a break — although with a raft of restrictions. They apply only to homeowners faced with hardships such as illness or job changes, and then only if 55 percent of their income goes to debt payments. And in some cases they’ll be asked to pay part of what they owe.

In return, the agencies will not try to collect a “deficiency judgement,” pursuing home owners for the remaining debt. That small accommodation elicits indignation from commentators. As one puts it in Howley’s story, “It’s an extraordinarily generous approach for companies still in debt to the American public.”

Actually, it’s not. In an audit released last October the Federal Housing Finance Agency found that in 2011 Fannie and Freddie pursued deficiency judgements on 35,231 accounts (for comparison, they foreclosed on about 342,000 properties). The total recovery on those accounts was $4.7 million — just $133 for each deficiency, or 0.22 percent of what the agencies were owed. The money Fannie and Freddie get back in the typical case is so small that even a token payment homeowners make as part of a deal is likely to exceed it.

It’s well known that some “non-recourse” states, like Nevada and California, bar deficiency judgements in many cases. Less well understood is that even in cases where they are theoretically possible, the judicial procedure makes them impractical.

The deficiency judgement is a club held over the heads of debtors, a scare tactic far more useful in persuading debtors that they should keep making payments than in recovering money when they don’t. Nonetheless, the idea that homeowners might not be pursued for the money they continue to owe still creates outrage among those who believe it violates the moral principle that debts should be paid.

That outrage has been with us since the early days of the mortgage bust, with guardians of public morals decrying the dangers of letting deadbeats walk away from their loans. Sometimes that’s been accompanied by nostalgic claims that upstanding Americans of the past would never have simply walked away from their debts (not true: even the term “walkaway” dates at least as far back as 1962).

Leave aside that the reason deficiency judgements are so hard to collect in the first place is that states made it that way to avoid (obviously without success) the lending excess of past land booms. Worth asking here is what the deadweight loss to the economy has been of scorched earth efforts to squeeze the last bits of money from foreclosures. Homeowners already sinking into a debt trap end up letting utilities get turned off or cars break down, while options like moving to regions with better job prospects disappear.

So more debtors are pushed to seek direct or indirect support from the government, and ultimately the costs of that can easily a few extra months of house payments or the $133 recovered in a deficiency case. Having gotten $187 billion in taxpayer bailouts, it seems reasonable for Fannie and Freddie to take that cost into account, too.

Bloomberg News/ Laura Segall

A development in Gibert, Arizona, in the Phoenix metro area

Welcome to the Phoenix, Arizona, edition of The Market Now. Two Bloomberg stories in the past two days included powerful on-the-ground reporting in Phoenix. They make for a telling study in contrasts.

Today, Heather Perlberg reports on the Phoenix homeowners emerging from underwater mortgages. Perlberg kicks off the narrative with a homeowner who finally saw prices recover enough that she could sell the house her family had outgrown, pay off the mortgage and upgrade to a larger place. Though prices are still well below their 2006 peak in Phoenix, they’re recovering fast.

Also from Phoenix comes yesterday’s article by Jeff Green and Amanda J. Crawford about the increase in the payroll tax. They pull in tight on a high school teacher whose $60 a month payroll-tax increase means cutting bills by shopping for groceries in the junk-food aisles of the dollar store. Dinners out are out of the question.

The two stories together neatly sum up the mixed economy. Investors and homeowners have benefitted from low interest rates and the Fed’s efforts to jump-start the housing market. Big investors in Phoenix have known that for a while, as this Bloomberg story noted in October. Those improvements in the investment climate haven’t been matched by gains in middle-class income.

The chart above, using Phoenix data from the St. Louis Federal Reserve, gives you some idea of the long-term trend in incomes and home prices. The black line in Phoenix’s per capita income, the red is home prices. You can see just how far home prices outstripped incomes in the boom. There’s room for a recovery, but not to anything like those boom-era levels.

That’s the reason that, as regular readers know, The Market Now has been skeptical of the housing rebound. Low rates will boost housing, and perhaps easier mortgage standards may too as banks turn on the lending spigot. Over the long term, though, home prices will keep rising only if disposable incomes do, too.

A version of this post appears in the Market Now newsletter. Click here to register at Bloomberg.com and subscribe to The Market Now daily email.

Photographer: Chip Chipman/Bloomberg

Like some of Wall Street's clients, salmon return to their spawning grounds, where they are caught and smoked.

Two Bloomberg stories today beg to be read together in as perfect a study of the Law of Eternal Return (aka, what goes around, comes around) as you’re likely to get.

In one,  Jody Shenn looks at the performance of mortgage backed bonds. Those who’ve been keeping track know that mortgage bonds have been among the most successful recent investments. February’s Bloomberg Markets magazine profiles Deepak Narula, whose mortgage bond investments propelled his Metacapital Management LP to the top of the hedge fund rankings. Now, Shenn reports, the bonds that have been sent skywards by Fed buying of mortgage debt are sliding, as buyers look ahead to the end of Federal Reserve support.

Meanwhile, Sarah Mulholland reports that with investors looking for higher yield than traditional commercial mortgages now offer, property-backed CDOs — pools of sliced and diced mortgage bonds — are suddenly back. Sales of property-backed CDOs should be up to $10 billion in 2013, nothing like past peaks but ten times this year’s level.

In other words, just as mortgage bonds themselves start to slip, complex investments built from such bonds return. The Market Now will skip further comment here. When fish are packed this tight in a barrel, shooting them is a waste of bullets.

A version of this post appears in the Market Now newsletter. Click here to register at Bloomberg.com and subscribe to The Market Now daily email.

*Update: Clarified the definition of property-backed CDOs.

Photographer Will Wintercross/Bloomberg News

Dangerous as they can be, prop traders weren't the gorillas who beat up Wall Street.

Bloomberg’s Max Abelson today reports on Goldman Sachs’s Multi-Strategy Investing unit — in effect a hedge fund within the bank that bypasses the Volcker rule’s limits on proprietary trading. It’s a great story. It also raises a question: Is prop trading really the problem with Wall Street?

Before you answer, remember what caused the collapse of Bear Stearns Cos. and Lehman Brothers Holdings during the financial crisis, as well as the massive losses at Merrill Lynch and other banks. Obviously all of them took stupid risks with their own capital. It’s just that the risks didn’t come from the sort of trading the Volcker rule addresses.

An excellent succinct discussion of the pattern comes in Jake Bernstein and Jesse Eisinger’s 2010 Pro Publica article about the huge mortgage losses at Merrill, now part of Bank of America Corp. Merrill’s loss came from CDOs that the bank itself had packaged from mortgage-backed bonds. As Bernstein and Eisinger make clear, Merrill’s mortgage traders were the buyers of last resort for derivatives that Merrill bankers had created and no one else wanted.

That’s not the proprietary trading that regulators fear. If anything, it’s the opposite. Instead of letting traders freely choose their own investments, Merrill, like Bear and Lehman, had them stuff their portfolios with the mortgage bonds and CDOs that came out of the bank’s own underwriting and derivatives business.

In their Atlantic cover story this month, Eisinger and Frank Partnoy take apart bank income statements and focus on hat kind of risk with a discussion of “customer accommodation” trading, dryly pointing out that

“at many large banks, customer accommodation can be a euphemism for “massive derivatives bets.”

If banks want to disguise proprietary trading as “hedging,” it’s easy enough for them to do it. Maybe worse, if they want to build up massively risky positions in the service of banking fees, as they did with mortgage bonds, they can do that too. No variant of the Volcker rule stops them.

Before the mortgage meltdown, it was feared that a big hedge fund (like Long Term Capital Management) or a bank prop trader could set off a chain of dominoes that took down the financial system. The Volcker rule responds to the fear, and it’s a legitimate one. It’s just not the crisis that actually happened.

Photographer: Alessia Pierdomenico/Bloomberg

There's no bucket in the world big enough to fill the sea of mortgage losses.

Can you ever count paying out billions of dollars to settle claims as a victory? When it comes to mortgages, you sure can. Today brought two big mortgage settlements, one for homeowners, and one for Fannie Mae, which is getting billions of dollars from Bank of America Corp. The Market Now has had a bit of time to delve into the Bank of America settlement.

It looks like a good deal for Bank of America when you look at the number of loans involved. And probably an even better deal when you think in terms of the overall damage to the economy that came from bad mortgage loans.

The settlement with Fannie has Bank of America making two payments to Fannie. One, for $3.6 billion, covers losses that Fannie Mae has already realized on loans originated by Bank of America and Countrywide Financial Corp, the mortgage giant Bank of America bought in 2008. The other, $6.75 billion, covers 30,000 loans that Bank of America is buying back, at face value (that is, the total remaining principal of $6.51 billion, plus some interest).

What looks at first glance like a $6.75 billion price-tag is actually lot less. Those loans are certainly worth less than the principal balance, but these are not the worst of the loans that were made in the mortgage boom. Virtually all of the loans that Bank of America is buying back have been modified, are now delinquent, or both (you can see the full breakdown here). But they are not in foreclosure, and Bank of America stands to make back a significant share of what it paid.

The $3.6 billion payment will likely turn out to be the bulk of Bank of America’s cost. That seems like a surprisingly good deal, since it settles Fannie Mae’s claims on loans with an original outstanding balance of $1.4 trillion (yes some of that would already have been paid back or refinanced; still that’s a very big number). That doesn’t seem like much. Think of it this way: Bank of America is buying back 30,000 loans for $6.75 billion, or about $225,000 for each loan. At $3.6 billion the settlement on two million loans costs Bank of America about the same as buying back 16,000 loans that have gone to zero.

What exactly does that $3.6 billion represent? It’s hard to say. Jerry Dubrowski, a spokesman for Bank of America, described it as the outcome of negotiations over how much of the loss came from bad underwriting and how much from the housing bust — as Dubrowski puts it, “What drove these losses? Was it economic? Was it the fact that this person lost their job?”

“It gets to the point,” Dubrowski says, “where I no longer want to sit here and sort through the laundry dividing the hot water from the cold.” So the $3.6 billion is an alternative to going through each individual loan. That’s a fraction of Fannie Mae’s losses; Dubrowski says it’s in line with Bank of America’s other settlements with loan buyers, which Dubrowski says have come in around 10 or 15 cents for each dollar of losses.

Photographer: Jay Mallin/Bloomberg News

Angelo Mozilo, CEO of Countrywide. Most of the loans at issue were originated by Countrywide, bought by Bank of America in 2008.

Is that a fair deal for the bad loans that Fannie Mae bought? If you think simply in terms of how many loans had “underwriting problems,” perhaps it is. Fannie Mae held some of the better quality loans that Countrywide originated; they didn’t include many no-doc liar’s loans that didn’t qualify for Fannie Mae’s backing and were sold to mortgage-bond investors; Bank of America and others still face plenty of liability over those.

There’s a better way to think of the mortgage bust, though, than adding up individual misdeeds. The press tends to concentrate on liar’s loans, bogus subprime teaser rates, and sleazy fees tacked on to the bills of struggling home buyers. All those were indeed scandalous.

However, the whole is a lot more than the sum of the parts. The bottom-line problem here is that virtually every party involved in the housing boom — from banks to mortgage brokers to investors to Alan Greenspan — did their best to drive up housing prices to a point at which they were sure to blow up. The net effect was a lot greater than the damage that can be traced directly to unfair fees or improper underwriting.

Unfortunately, Fannie Mae and other mortgage buyers are not ideally positioned to build a case around the deep damage banks did with all the actions that inflated the housing bubble. Banks and mortgage underwriters may have been cynical and reckless players, but most everyone involved was to some extent a willing participant, sometimes down to the home buyers who were told, “Sure, it’s okay to buy that $500,000 house, it’ll go up in value overnight.” If you add up not just of some particularly egregious loans but the full costs of the bubble, all the banks put together can’t come close to covering the losses.

Photographer: Daniel Acker/Bloomberg

John Stucker, a Purdue University student must pay back $80,000 he borrowed.

What’s going to be the bigger drag on the economy over the next years: the overhang of unpaid mortgages or the burden of student loans? At Bloomberg today, some unexpected answers.

First, the mortgage front. Yesterday Bloomberg’s Dan Levy reported on the upswing in property values in Las Vegas. The Market Now speculated that some of the shift has come from banks cutting down on foreclosures that dumped properties on the market at rock-bottom prices.

Today John Gittelsohn and Prashant Gopal take a deep dive into the national real estate market, finding that the foreclosure flood has ebbed nationwide. Banks, as one analyst puts it, have managed to “slow walk” the process, and “bleed through” the overhang of defaults over a long time. That’s limited the damage to the economy.

Compare that to what’s happening with student loans. Above, a chart from Bloomberg’s David Wilson shows that as mortgage delinquencies have fallen to near the 6 percent mark, student loan delinquencies have risen sharply. Eleven percent of student loans are now 90 days late or more; that number is now higher for student loans than for credit cards, reversing a pattern that has held for years.

Wilson points out that the delinquency number understate the share of borrowers who are drowning in debt because it doesn’t include the nearly half of student loans that aren’t due for repayment. For-profit schools, it’s worth noting, have been especially adept at making sure that students who can’t pay their bills get postponements that keep those numbers down. Eventually these borrowers, too, will default on their loans.

As the mortgage crisis diminishes, the student loan crisis builds. As one report that Wilson cites puts it, “student loan debt crowds out other consumption.” So the damage here hits the whole economy, not just overburdened students and grads. Unlike other debt, student loans don’t get erased in bankrupty; the unpaid debt lurks in the wings of the economy more or less forever. The Market Now is betting that eventually there will some sort of student loan bailout plan; it won’t happen, though, before there’s a lot more pain.

A version of this post appeared earlier in the Market Now newsletter. Click here to register at Bloomberg.com and subscribe to The Market Now daily email.