Wednesday, April 9, 2008

Subprime Freezes Over

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

In December of 2007, the Bush administration proposed freezing the rates on adjustable subprime mortgages for 5 years. This program was 'voluntary'. Indeed the U.S. government had no legal authority to void valid contractual commercial transactions between parties, one of the most fundamental underpinnings of our economy. Nevertheless, presidential candidates Hillary Clinton and John Edwards both immediately criticized the proposal as not doing enough and advocated an even longer freeze on rates.

While the alleged purpose of this program was to help the 'struggling homeowner', an examination of the details indicated otherwise. Homeowners with fixed-rate mortgages got no relief. Homeowners with non-subprime variable-rate mortgages got no relief. Why were just sub-prime adjustable-rate mortgage holders singled out? The answer is simple, these mortgages were defaulting and would be defaulting at the highest rates. Many of these had been granted at the end of the mortgage boom and were for a substantial percentage of the house price at the time of sale (up to and even exceeding 100%). Mortgages for 100% of equity, especially when housing prices are falling, are the last thing banks want to take back and have to write off on their books. These are guaranteed losses for the bank since the foreclosed house would likely sell for much less than the amount of the mortgage. Any bank that had a large number of this type of defaulted mortgages could become technically insolvent fairly quickly. Mortgage bond holders, many of them big banks and brokers, who had bought bonds containing these loans would also lose out. It is a much better deal for banks to foreclose on mortgages that have been substantially paid down, since they make a big profit on these. These homeowners were the most deserving and required the least assistance, so they should have been the centerpiece of any mortgage relief program - but they weren't. Helping them would mean hurting bank profits.

The proposed freezing of sub-prime mortgage rates also represented the first attempt at price controls on the part of the government. Price controls are an almost universal response to inflation by the authorities and prices for necessities are the most likely to be controlled. While the rise in mortgage payments was preplanned and the exact amounts were known in advance (rarely the case with most inflation,) this was no different from any other attempts to dampen rising prices by freezing them. it was not surprising that this took place first in housing either since it is one of the most basic of necessities. Unfortunately, price controls always have negative consequences. In the case of the mortgage freeze, anyone offering loans in the future would have to demand higher rates to compensate for the possibility that rates might be frozen. Or lenders seeing higher risk in the market would simply not offer loans at all. In both these scenarios future mortgage rates will be higher than they would have been. The government could then solve this problem that it created by offering subsidies (a common second response to increased prices for necessities), most likely through Fannie Mae and Freddie Mac. These government supported enterprises would then wind up dominating the mortgage market so much that it would effectively be completely socialized. By the end of 2007, it looked like this was already taking place.

NEXT: The Fed's (long) Term Auction Facility

Daryl Montgomery
Organizer, New York Investing meetup

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quality stocks said...

G7 Cuts Growth View, Shows Worry On U.S. Dollar Drop

With the G7 talking about steping in to help the dollar (even though they are worried about Growth) do you feel concerned about the price of gold? Do you feel it would fall if all 7 decided to try and keep the dollar stonger than it is now?

New York Investing meetup said...

Yes, I do think that if all the G7 decided to support the dollar that this would make the dollar go up (as long as the intervention went on)and gold, silver, and probably oil go down. Eventually, this will happen, but they will make their intentions clear when they have decided to do this. Please see New York Investing meetup's video, "Economic Predictions for 2008" on You Tube, where this is discussed.

quality stocks said...

Thank you....I did watch the Economic Predicitions for 2008 and enjoyed the video. In that video you state that the G7 would talk about lifting the dollar but it would porbally be just words. So in your view will gold still be measured in thousands "with an s on the end?" Can 5,000 really happen if the G7 steps in? Do you think China could threaten the US by pulling all of its money out of dollars? If they do this gold will be fine. Just trying to think thru some ideas. Thanks in advance. I enjoy the Blog and videos.

New York Investing meetup said...

The $5000 to $10,000 prediction for gold prices is a long term prediction - somewhere between a few and 15 years. There will be ups and downs along the way. Currency intervention - and this will happen, possibly more than once - will cause gold and silver to go down while it is happening.In the long-term, it will not work.


Great take on economics and the markets.