Government intervention into Freddie and Fannie, leveraged by private investors and other lending institutions, has reduced 30 year home loans to interest rates of less than 5%. This is great news for potential buyers or for those who can refinance to reduce interest rates. In fact, those who can refinance should jump at the chance, they will make out like bandits!
However, it is disastrous news for the Federal Government’s ability to eventually extricate the economy from its present mess because these loans will become toxic assets within a few years; assets that could add trillions $ to bailout costs. The reason is simple. An asset based on lending long (i.e. 30 years), such as a bond or mortgage, becomes toxic for either of two reasons: when there is a drop in the underlying value of the property which secures the asset or when the cost of attracting short term money to fund the loan exceeds the interest paid on the loan. The housing bubble savaged the mortgage market for the first reason, the S&L crises some 20 years ago was due to the second reason. This time however, the pain will be much greater than from the S&L crises because the differential between short term costs and long term income will be much greater and our government is much weaker.
Why do I assert this? Because, as certainly as night follows day, we will enter an inflationary era within the next 4 years. We can reasonably expect an extended period of inflation in excess of 5% per year as a result of government debt, government spending and the eventual loss of confidence by other nations in our collective will to adequately tax ourselves instead of sucking capital out of their economies. Once job losses level off and once economies outside the USA decide to bail on a collective solution that benefits our economy to their detriment; chronic inflation, perhaps even hyperinflation, will be part of our economic reality.
Short term interest rates will rise significantly to attract money from other economies and to put a lid on our rate of inflation. Then, banks and other institutions which made these 20 or 30 year fixed rate loans earning 5% will find themselves required to continue funding them with short term capital costing 7% to 9%, or perhaps even more. Freddie and Fannie, will carry on with the help of government bailouts, putting the government even deeper into debt as private capital flees those institutions. (Note: At this time I believe the government must pursue a policy of increased spending… but unless there is an immediate and substantial increase in taxes, particularly on the wealthiest 5% of our population, there is no possibility that we will achieve a healthy economy. I will elaborate on this in the future, for now I suggest a peek at Paul Krugman’s comments about wealth concentration and economic health.)
I’m actually an Obama supporter; he’s the best chance we have to get through this mess in a constructive way; the first president in my adult life who is capable of strategic thinking. But the problems are far deeper and intractable than we, as a nation, understand. In the five step process of moving from old, unsustainable economic beliefs and actions, to a new sustainable set, government bailouts and low interest loans are step 3, painless bargaining. Most of us are still stuck in steps 1 and 2, either by denying the overwhelming reality of our situation or by blaming the problem on “them” rather than placing the responsibility for change on “us”. They do need to change, but so do we, all of us. As a nation, we must move on to step 5, sacrificing old beliefs and old habits to develop, and reconstruct a healthy economy one day at a time. I fear that we might choose to be stuck in steps 1-3 and fail miserably. I hope to present constructive, but painful, paths to step 5 and sustainable health over the next few weeks.
