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Tuesday, February 3, 2009

Some Perspective and Consequences of the Republican's Plan to Offer 4.5% Mortgages

As the Democrats turn the stimulus bill into a pork barrel spending bill that appears to be nothing more than a pay off to their major constituencies, the Republicans didn't want to be outdone in proposing terrible legislation. The Republicans addition to making this stimulus bill a terrible bill is their plan to drive mortgage rates to 4.5% or even lower.

The Treasury Department's latest prescription for the ailing housing market could turn out to be more placebo than cure, and a costly placebo at that. Some economists question whether just lowering interest rates to a historically low 4.5% will be enough to boost housing sales or prices. What's more, the plan could end up costing $25 billion a year, using up valuable funds needed to fix the housing market and providing no relief to the millions of homeowners now facing foreclosure.

If this plan were ever to be put into effect it would have serious, far reaching, and long term consequences for our economy and the nature of our country.

There are only two ways to do this and both will cost an obscene amount and likely will into the trillions of Dollars. Either the Treasury will begin to buy up Fannie/Freddie bonds in order to drive rates to 4.5%, or the Treasury will simply subsidize these mortgages. Since the Feds now own both Fannie/Freddie, the Federal government can force rates below market value.

The first option is rather dicey. No matter how many bonds the Feds buy, that will only keep rates low temporarily. In order to have a real effect, these rates would have to stay low for months. As such, the Federal government would have to consistently buy billions of Dollars worth of bonds daily and continue to do it for months. Even if they did this, there is no guarantee that rates will stay down.

The second can be done but it would cost trillions and those costs would last for years. This way the Federal government would force low rates regardless of what the market dictates. In this way, the Federal government would subsidize the losses incurred by Fannie/Freddie on any bonds issued on these reduced mortgages. Normally, mortgage rates are determined based on the underlying bond rates of Fannie/Freddie bonds. In this scheme, Fannie/Freddie would buy mortgages at 4.5% or less regardless of what their bonds are selling at. As such, they would take losses on all of these bonds. The implications of this scheme are massive. First, this would cost trillions and this cost would continue for years. The mortgages last 30 years and the bonds are issued for 5 years and more as well. If Fannie/Freddie is losing money on each bond, the government will have to cover the losses.

If Fannie/Freddie are taking losses on years of mortgages, that also means that both Fannie and Freddie will have to be owned by the federal government for years. The federal government can't very well let these two loose and become private when they have now saddled them with losses that they will incur for years. What is the consequence of this? Between Fannie/Freddie and FHA, this means the federal government will be backing nearly 100% of all mortgages for the indefinite future. If this scheme goes into effect, we will effectively have socialized mortgages for the next generation.

The next consequence is that this scheme will eventually create an unnatural and sustained real estate boom. If rates are lowered artificially to 4.5% and below, millions of borrowers will take advantage. When rates settle to their normal levels, they will be that much less motivated to move from this loan. As such, millions of people will hold onto property for years longer than they would have without these artificially lower rates. As such, there will be an imbalance between buyers and sellers. Since these loans are going to be good for 30 years, we will feel some effect of this imbalance for the next generation.

Finally, this scheme will soon lead to out of control inflation. It's very likely that such an artificial stimulus will spur the economy. It will definitely spur refinancing and it will likely spur purchases as well. The mortgage brokers, banks, appraisers, and title companies will all see a massive increase in business. It's very possible that such an artificial move will in fact stimulate the economy. As soon as it does, it will lead directly to out of control inflation. The cost of this scheme could be trillions. The more effective it is the more it will cost. As soon as the economy moves, the effects of out of control borrowing will be felt. That effect is out of control inflation. Since this scheme will also guarantee long term deficits (by subsidizing long term losses of Fannie/Freddie that the government will have to cover) the inflation will only get worse as the economy gets better. It's likely that interest rates, with mortgage rates, will shoot up into the sevens, eights, and worse.

As such, all those that didn't take advantage of these artificially low rates will in effect be financing those that did because the artificially low rates will eventually lead directly to artificially high rates caused by all the borrowing to make these rates low. As such, the winners will be all of those that took advantage of the rates or made money in real estate. The losers will be everyone else.

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