Some More Context on the Treasury's Plan to Drive Down Mortgage Rates

Yesterday, I analyzed the Treasury's plan to drive down mortgage rates to about 4.5%. I called it no different than any other plan for a price ceiling. Yesterday though, details were sketchy as to how the Treasury would attempt to accomplish this. Today, more details have been leaked and we should all be scared that the Treasury will actually follow through.

The head of the government's financial system rescue effort said Thursday
the Treasury Department is considering a program to encourage banks to make
mortgage loans at low rates to help revive the battered housing
market.

Under the proposal being pushed by the financial industry, Treasury would
seek to lower the rate on a 30-year mortgage to 4.5 percent by purchasing
mortgage-backed securities from Fannie Mae and Freddie Mac. It's unclear exactly
how much the plan would cost.

Asked about the proposal during his testimony before a Senate
Appropriations subcommittee, Neel Kashkari said that it was one of the options
the administration had under review.

Treasury is striving to use the
"right tools for the right job" in an effort to help as many homeowners as
possible, said Kashkari, the department official in charge of the $700 billion
rescue effort.

The goal of the industry's proposal would be to take advantage of the unusually large difference, or spread, between mortgage rates and yields on government debt. On Thursday, the yield on the 10-year Treasury note yield sank to a record low of 2.56 percent, while the national average rate on a 30-year fixed rate mortgages was 5.54 percent, according to financial publisher HSH Associates.

There are several reasons to be afraid. First, this plan is being pushed by the financial industry. Of course it is, the financial industry would be the beneficiary of such a plan. Politicians spend all campaign decrying the influence of special interests and yet this plan is the ultimate special interest give away. Second, no one at the Treasury knows just how much this is going to cost. The total value of the housing market is in excess of $10 trillion and Fannie/Freddie now account for about 80% of that. So in order to manipulate the market to reach 4.5%, the Treasury would have to spend hundreds of billions of Dollars.

Yet, it is the third part that is most troubling. The Treasury thinks they see an albatross situation because Treasury bond rates are so low, about 2.65%. The Treasury will borrow the money, they think, at 2.65% and buy bonds that will pay them in excess of 4%. If only it were that tidy. When the Treasury reaches into the Treasury money for hundreds of billions of Dollars more than they are already borrowing, on top of all of the extra borrowing they are already doing, what do you think will happen to Treasury rates? They will likely go up, way up.I've already warned about how explosive it maybe when Barack Obama asks form money for the hundreds of billions in new spending he wants. This plan will costs hundreds of billions more. Furthermore, since they will artificially drive down mortgage rates, the bonds they will hold will be worthless once their stimulus is through. As such, the Treasury will have to hold onto those bonds for the duration. This scheme won't work unless Treasury rates continue to be close to 2.65% for the duration of the period that Treasury holds onto these mortgage bonds. I have already shown that this very scheme will likely force Treasury bond rates way up. While the Treasury continues to get about 4% on their money, what will happen once the rate that Treasury bonds give goes up? Eventually, the Treasury will start to lose all sorts of money to do this.

In other words, the Treasury is willing to borrow hundreds of billions of more Dollars to take advantage of some hokey scheme that is normally reserved for quick buck artists. The Treasury was never meant to be used for this kind of market manipulation, and certainly not when it is predicated on some hokey idea like the CURRENT spread between mortgage bond rates. In fact, this particular article clearly lays out that Fannie/Freddie used a very similar scheme that wound up blowing up on them and put them into the mess they are in. In other words, the Treasury is about to attempt the same type of hokey scheme that blew up on Fannie/Freddie WITH TAXPAYER MONEY.

The problem again is that Hank Paulsen seems to forget that he is no longer an investment banker. He continues to treat everything at Treasury as though it was an investment banking deal. Playing spreads is the sort of thing an investment bank might try. That would be fine if the Treasury were an investment bank, but it isn't. Tax payer money was never supposed to be used in such a risky way. This is the worst sort of market manipulation. It's being done with tax payer money, and it's not only dangerous to our economy, but it's predicated on a very dangerous scheme.