Professor Cole's Finance Blog

Today, the Wall Street Journal published an article Uncle Sam Bet the House on Mortgages, which documents how yet another back-door bail-out of the Big Banks (Bank of America, Chase and Wells Fargo) is taking place at taxpayer expense, but largely behind the curtains of public scrutiny.

The scam works like this: "Big Bank" (BofA, Chase or Wells) makes mortgages that it would never carry on its own balance sheet because the loan doesn't pay enough interest to cover the loan's risk. (The article quotes the CEO of Wells Fargo: "We're not putting on 30-year [fixed-rate] mortgages at these rates.")

Big Bank then uses the FHA to guarantee repayment of the loan and GNMA to securitize the loan, which is then sold to . . . get this . . . the FED!!! 

According to the article, the three big banks made more than HALF of all mortgages in the U.S. during the first half of 2009, the FHA or another Treasury-backed entity such as Fannie or Freddie insured 85% of all mortgages made during this period, and then the Fed BOUGHT 80% of the securities into which these mortgages were packaged.

What was in it for the banks? More than $14 BILLION in fee income on mortgage servicing during the first half of 2009.

Who bears the risk on these loans? The FHA.

In another article today entitled The Bailout Bill Comes Due, Vexing Agencies, the NY Times reports that the FHA's cash reserves has fallen below 2% for the first time, as the percentage of FHA mortgages that are now delinquent has risen above 14%, more than double the 6.4% rate for prime agency mortgages. Why? Because the FHA has become the new Countrywide--that is--the FHA is now the primary source for "subprime" mortgages. Unlike other lenders, the FHA requires only 3.5% down payment and lends to borrowers with bad credit scores. As a result, the FHA's share of the mortgage market has skyrocketed from less than 5% to more than 40%. Americans know a sucker, er, bargain when they see one!

But now the day of reckoning is at hand. The FHA now faces the strong likelihood of needing a government bailout at a time when the American taxpayer is fed up with bailouts. How big the pricetag for this bailout will be is open to speculation, but one thing is for certain:

The pricetag is rising each and every day.