August 31, 2007
Bush Mortgage Plan Balanced and Targeted
The assistance to mortgage borrowers President Bush suggested in his Rose Garden speech today appears to offer more targeted help to homeowners without reaching the grand proportions of a true bailout. Mr. Bush's offer to amend the tax code to exempt from taxable income forgiven debt on short sales, foreclosures and mortgage workouts, is a targeted benefit to homeowners. Some commentators note that this provision could be an inappropriate handout to investors. On the contrary, it provides far less a handout to investors than using Fannie and Freddie to buy up bad loans. Any concern about speculators reaping inappropriate tax benefits can be addressed by allowing this as a one time benefit only to a single home per taxpayer. And perhaps that's just what the President will do.
Stop the Bailout views a real bailout as one of two courses of policy: (1) the federal government purchasing mortgage backed securities, CDOs, CLOs, and mortgages at higher than the market price, and, or combined with (2) exceedingly loose monetary policy. A bailout encourages not merely irrational risk taking, but outright fraud. Companies like Countrywide fought tooth and nail to put as many prime borrowers in subprime and other risky loans as was possible and earned huge profits doing so. A bailout will directly reward companies like Countrywide and the investors who bought their securities seeking high rates of return on these risky assets.
Economic commentators keep referring to an "irrational panic" in the credit markets where "people won't loan against even very safe collateral." That's a lie. The market has re-priced risk and the people holding risky assets don't like the new price. It's a simple as that. It's possible to borrow on the market against assets today, but not at the rates that the holders of those assets would like. The new price of risk contemplates high default rates over the next several years in American mortgages and it also re-prices future demand for mortgage backed securities and related instruments.
These new prices for risk cannot be changed using a bailout or monetary policy. The new price is more likely the correct price than the old price. Last year's price for risk was based on Ponzi-scheme-like market expansion. Last year's risk price assumed a high rate of residential real estate price appreciation that would render risk less expensive because defaults and foreclosures could quickly be sold into the market, perhaps even at a profit to cover fees and costs! That type of "insurance" is only available during the expansion phase of a financial bubble as every possible outsider is lured into the investment class. It's the Ponzi aspect of a financial bubble because risk is cheap in the expansion phase precisely because new outsiders being drawn in provide the cash to allow people on the inside to sell out at ever higher prices.
Using Fannie and Freddie to buy up bad loans is the worst sort of fraud. Why? Because those loans aren't worth anything near what Fannie and Freddie will pay for them. The peak in delinquencies and foreclosures will likely be reached summer 2008. The peak month for loan payment adjustments in the United States is believed to be March 2008 when more than $100 billion in loans will dramatically adjust payments in that single month. Default notices and foreclosure proceedings take time to initiate and thus we can expect that July or August 2008 will be the worst of it -- provided, of course, that prices do not drop significantly after that time.
The market doesn't want mortgage backed securities except at a premium interest rate. The market doesn't want to loan against mortgages as collateral for other loans -- like business loans, short term financing, commercial paper, and other loans. Why? Because it is unreliable collateral. It has a price in the market, but that price is too low to allow investment bankers and corporations to go about their remarkably dangerous habits as they have for more than five years.
The Federal Reserve has said "bring us your mortgage backed securities and we will lend against them at low and attractive rates" to provide an example to the market that such collateral is no trouble at all. Perhaps the Fed itself is going to suffer repayment problems on loans handed out through the discount window since they aren't really secured by sufficiently valuable collateral. No statement by the Fed is going to restore value to mortgage backed securities as collateral because those loans are obviously impaired. A functioning market will result in higher rates permanently for such loans. It won't be the end of the world, but it will mean higher borrowing costs and thus somewhat more restrained borrowing. That's not a bad thing to try to stop, it's an inevitable thing that no one can stop.
Dropping the Federal Funds Rate will not help real estate, it will help the stock market by reducing the cost to big investors of buying stock on margin. Each drop in their borrowing costs allows them to buy more stock with more imaginary money. It will certainly make the stock market rally for a little while until such loose money policy has a more powerful effect on the economy. The negative effects of a lower federal funds rate in a high inflation environment like we have now is higher long term interest rates. Rates for 30 year fixed jumbo loans hit 7.4% this week and it is reasonable to assume that cutting the FFR will cause the dollar to drop further and result in more inflation. This risks serious long term problems because the market and the economy cannot handle higher long term rates -- when inflation is expected, 30 year fixed rates will easily pass 8.5%. Increased long borrowing costs will drive up the federal deficit, as well as business and consumer borrowing costs. And the enormous expansion of business and consumer debt over the past five years -- to historically unprecedented levels -- presents unpredictable consequences should rates rise abruptly.
A lower FFR in the next few months may make the markets cheer hooray! But by next year, as long rates rise and inflation expectations become more pronounced, it will have seemed the worst possible course of action. But by then it will be too late.