[REN #118] Recession Stress Test for Banks and Real Estate Investors

If the nation experiences another recession, Fannie Mae and Freddie Mac could need as much as $127.6 billion dollars in bailout funds from taxpayers. That’s the number that was released after a recent stress test on the two government-controlled mortgage finance companies.

A stress test is performed annually on the GSE’s to measure their financial performance – which is a similar stress test required for banks, under the Dodd-Frank Wall Street Reform and Consumer Protection Act.

In this year’s test, the Federal Housing Finance Agency assumed a “worst-case scenario”, or even a “severely adverse scenario” to see how Fannie and Freddie would fare in a coming recession.

This stress test made these assumptions:

1 – The real GDP would drop 6.25% from the pre-recession peak by the beginning of next year.

2 – The unemployment rate would soar from 5% to 10%.

3 – The consumer price inflation rate would increase from .25% to 1.9% by the 3rd quarter of 2017.

4 – Treasury rates would also fall to negative .5% by the 3rd quarter of this year and remain at that low.

5 – Corporate financial conditions would continue to deteriorate.

6 – Home prices would decline by 25% in the 3rd quarter of 2018 and by 30% in commercial real estate.

7 – Global markets would affect the value of global assets.

If this crisis, or “severely adverse scenario” were to happen in reality, the FHFA determined that the Treasury Department would have to pump from $49 billion to $128 billion into the GSE’s.

The difference with the bailout numbers included the possibility of future tax reductions based on past losses. The stress test was run two ways: one eliminated the deferred tax asset, making the bailout amount higher. The other included it, and reduced that bailout number.

While no one wants a recession, we certainly have to plan for one since they historically visit every decade. Looking back, many of these recessions involved OPEC’s control of oil prices, interest rate manipulation and irresponsible banking.

A Little Recession History

In the 70’s, OPEC quadrupled oil prices, which coupled with the high cost of the Vietnam War, created stagflation. Stagnation happens when a country is experiencing high inflation even when the economy isn’t booming and is experiencing high unemployment. High oil prices and a stock market crash in 1973 created job losses, even as prices were rising with inflation.

In the early 80’s, the Iranian Revolution raised oil prices again, creating another energy crisis. We also had the Savings and Loan crisis, caused from banks engaging in high-risk activities such as commercial real estate lending and investments in junk bonds. It wasn’t actually risky to bankers since their deposits were insured by the Federal Savings and Loan Insurance Corporation (FSLIC).

The FSLIC became insolvent while $124 billion was spent on the bailout of junk bonds and the liquidation of more than 700 S&L’s by the Resolution Trust Corporation.

In the early 90’s we had another oil crisis combined with consumer debt that weakened the economy and brought us into recession. Rich and I bought our first house at the bottom of that downturn – just by luck. That home was $547,000. Just 10 years later, it appraised for $1.8 million at the peak of the real estate bubble in 2006.

In the early 2000’s, we had the dot com bomb. 911 also shook up the economy, though the recover was quick thanks to another stimulus and cheap home loans.

In 2007, the housing market came crashing down as those loans went bad, creating the Greatest Recession since the Great Depression. Some economists say that even without easy lending, there would have been a recession based on demographic changes. That was the first year baby boomers started to retire and pull their money out of the stock market – which may have contributed to the stock market crash of 2008, in addition to the mortgage meltdown.

In 2016, we had another oil crisis, a stock market bubble and some real estate bubbles in primary markets. This time the stimulus comes from low interest rates and massive quantitative easing. It appears we are due for another recession any day.

If this indeed happens, the stress test was performed to determine if there would be enough funds to bail out Fannie and Freddie. The Treasury Department is already committed to providing as much as $258 billion to the GSE’s in the case of a downturn.

Fortunately, the stress test showed that under the circumstances described above, and using the higher “worst-case” dollar amount of $128.8 billion dollar figure, there would still be another $132.2 billion dollars leftover.

That is good news! But is this tax payer money that’s being set aside to bail out banks once again?

Yes, it is. But it’s also important to remember that both Fannie and Freddie have been under conservatorship for about 10 years now, since the last big bailout. As part of the deal, the mortgage finance companies have handed over their profits to the Treasury Department.

The initial bailout was $187.5 billion dollars. The Treasury Department, or let’s say “the taxpayers”, have gotten back $246.7 billion dollars from Fannie and Freddie profit transfers to the Treasury Department.

That means taxpayers are “up” $59.2 billion dollars right now. If the low-end stress test bailout figure of $49.2 billion dollars is used, the government would still be $10 billion dollars in the black, based on those profit transfers alone.

Unfortunately, things are changing now. Both Fannie and Freddie are reporting a drop in profits and revenue this past quarter. They say it’s largely due to low long-term interest rates which make it difficult to make a profit.

Fannie posted a net income $2.9 billion dollars compared to $4.6 billion dollars a year ago. Revenue dropped 12% to $5.46 billion dollars.

The same goes for Freddie Mac, although the decline was more severe. Freddie reported a $993 million dollar profit in the second quarter. A year ago, it posted a profit of $4.17 billion dollars.

Thanks to strict lending requirements enacted since the mortgage crisis, both agencies are reporting very low figures for home loan delinquencies. Freddie reported delinquencies at just 1.0%. For Fannie, it’s 1.3%. That’s a far cry from the height of the foreclosure crisis when we were seeing delinquency percentages in the double digits.

So how should real estate investors interpret all this information?

First, it’s important to understand that markets cycle and recessions historically happen every decade. Fortunately, the government is preparing for the inevitability of a recession, and looking at it’s affect on government backed loans and the possibility of bailouts.

Is it fair that tax payers should have to continue to bail out banks? Why can’t they just lend more responsibly?

At this point, it’s likely that the federal government would still choose to bail them out in the event of another financial crisis simply because Fannie and Freddie are integral to the U.S. mortgage banking system. They provide liquidity for the industry by creating a secondary mortgage market, so that banks can sell off their loans they’ve provided to homeowners, and re-invest that money into more lending services.

New strict lending laws have been put in place since the mortgage meltdown to ensure that banks aren’t passing off bad loans like hot potatoes, but rather only selling loans from highly qualified borrowers with the “ability to pay.”

As investors, we need to perform our own stress tests.

Look at every investment you currently own or plan to own, and consider how it would perform during a recession.

If you hold property in bubble markets, you need to prepare for the possibility of a decline in value of at least 30%. And you might need to wait at least 5-7 years before those values came back.

If you hold stocks in companies that have inflated valuations not based on fundamentals, you need to consider the cost of a drop in value and the number of years it would take to earn that money back.

If you hold cash flow real estate, you need to determine which of your properties are in areas where there are recession-proof jobs.

And it’s comforting to know that if you’re investing for cash flow, the asset value is of least importance. What matters most is the monthly income. During the last housing crash, rents actually increased and landlords in the strongest markets actually experienced pay raises.

If you’d like a list of today’s recession-proof cities, join the network above.

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