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Wednesday, December 3, 2008

Treasury Plans a Very Dangerous Move

The Treasury has announced that they are developing a new plan to stem the tide of foreclosures.

The Treasury Department is considering a plan to revitalize the U.S. housing market by reducing mortgage rates for new loans, according to people familiar with the matter.

The plan, which is in the development stages, would use mortgage giants Fannie Mae and Freddie Mac to bring loan rates down as low as 4.5%, a full percentage point lower than the prevailing rates for 30-year fixed mortgages.


Now, what the Treasury is proposing is no different than any artificial price ceiling

A price ceiling is a government-imposed limit on how high a price can be charged on a product. For a price ceiling to be effective, it must differ from the free market price. In the graph at right, the supply and demand curves intersect to determine the free-market quantity and price.

Imagine if the government set a price ceiling for cars at $20,000. What this would do is create more demand for cars then there is supply. Car makers wouldn't want to make that many cars if the most they could charge was $20,000. Yet, consumers would rush out in droves to buy these cars. What this would create is a shortage of cars.

The same thing would happen here. At 4.5%, there would be no shortage of willing buyers, and refinancers if this is available for them as well. Yet, Fannie Mae would have all sorts of trouble finding folks to buy the bonds. If Fannie Mae only charges 4.5% for the mortgages, they would then have to lower the premium that they paid out on these bonds below what the market wants. In other words, if Fannie Mae were to give an interest rates on their mortgages that is below market, they would also have to give an interest rate on their bonds that is below market. On the mortgage end of it, someone is paying the rate. On the bond end of it, someone is receiving the rate in payment. So, while there would be no shortage of willing consumers ready to get these below market rates, there would be a significant shortage of willing bond buyers willing to accept that rate. That means that no one would buy these Fannie Mae bonds.

This is nothing short of a recipe for disaster. Fannie Mae would be stuck with mortgages below market and they would also be stuck with mortgage bonds below market that they simply couldn't sell. This plan is a one way ticket to ruin for the mortgage giants and since the government would have imposed this on them, it would mean yet another bailout of Fannie Mae and Freddie Mac.

I thought I had seen all I would see as far as government intervention in free markets with the bailout but this plan really is taking things to another level. Right now, we already have mortgage rates at their lowest levels in four plus years. Yet, this isn't enough for the government. They are so determined to stem the tide of foreclosures that the federal government is willing to totally disregard basic economics. There is a simple reason why all price controls fail. It creates a disequilibrium between supply and demand. In this case, there will be far more demand for the mortgages then there will be for the bonds that are created as a result. This is very basic and very simple and anyone in any basic economics class can point out why this will fail so badly. Yet, those entrusted with navigating our economy are giving such an idea serious consideration.

3 comments:

Anonymous said...

The worst news would follow when the bond market goes on a buyer's strike. They would have to pay 10 pct on the money they lend and lend it out at 4.5 pct. Only Washington can see how that will make money in volume.

Anonymous said...

Hi Mike,
I enjoy your blog.

I don't know too much about this issue except to ask one question.

If the plan, as you put it, is so obviously flawed, why would the govt want to do it. Are they that stupid?

I know you might say simply - "yes".
But what is the motivation for this it is so unworkable?

Thanks in advance.

mike volpe said...

I think that the government is so focused that they are blind to the consequences of many of their actions. That is my theory for why they are doing this. I can tell you that price controls always blow up. That's what this plan is and that's what will happen if they insist on this.