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Peter Schiff: Low Rates, Big Problems



December 08, 2008 – Comments (10) | RELATED TICKERS: FMCC , FNMA

Government and mainstream economists have erroneously concluded that the key to reversing the financial free fall can be found in stopping the plunge in home prices. (I would offer the corollary that the key to reducing injuries in auto accidents is to suspend the laws of inertia). But to accomplish the improbable task of re-inflating the housing bubble, the government appears ready to announce a coordinated plan to push down mortgage rates to just 4.5%. Of course, this is precisely the wrong solution to the housing crisis, but when it comes to bad ideas our government has been remarkably consistent.

The plan would require the newly created Federal agencies of Fannie Mae and Freddie Mac to lower rates to 4.5%, and then require the Fed to directly buy the loans after they were made. The idea is that by lowering mortgage rates, current homeowners will be able to afford to make their payments, and new buyers will be more likely to qualify for larger loans, provided of course they do not have to come up with a burdensome down payment. If 4.5% is not enough to convince reluctant borrowers then look for the mandated rate to drop further. Perhaps there may come a time where the interest flows to the borrower instead of the lender. Anything to get Americans borrowing again.

But artificially suppressing mortgage rates will encourage risk taking and debt assumption at a time when consumers and lenders should be acting prudently. By setting rates below market levels, and buying mortgages that no private funder would want to touch, the government is creating a mortgage entitlement. Given the size of the home mortgage market, the program could eventually become one of the largest entitlement program on the federal books.

The most obvious problem is that the Government has no money. All it has is a printing press. So the more money it provides for cheap mortgages, the higher the inflation tax will be for all Americans. Higher inflation will cause the difference between where rates should be and where the government sets them to grow wider, and the entitlement to become more costly to provide.

Assuming $5 trillion in mortgages are refinanced at 4.5% in an environment where the unsubsidized rate would have been 10%. The annual cost to the government in such a scenario would be $275 billion. But the subsidy will have to be provided in perpetuity, as the minute it is removed, mortgage rates would surge and housing prices would plummet. Of course, the mere existence of the subsidy will continue to create demand for mortgage credit, which the government will be forced to provide by printing even more money. This would set into place a self perpetuating spiral of rising inflation and mortgage demand, with practically 100% of mortgage money being provided by the government. Ultimately the whole scheme would collapse, as run-away inflation would completely destroy what would be left of our shattered economy.

Some argue that since the government can now borrow for 30 years at 3%, issuing mortgages at 4.5% is a winning trade. There are three problems with this analysis. First, just because money is cheap does not mean we should borrow it-you think we would have at least learned that by now! Second, this analysis does not factor in default related losses. Finally, there is no way the government would be able to borrow that much money at the long end of the rate curve without driving interest rates much higher. The only reason long-term rates are so low now is that the government is concentrating its borrowing on the short end of the curve. So to pull of the trade, the government will have to finance it with treasury bills. If we turn the government into a massively leveraged hedge fund that cycles a multi-trillion dollar carry trade of short-term debt used to finance long term mortgages, then I think we already know how that movie ends.

In the final analysis the market must be allowed to function. If real estate prices are too high they must be allowed to fall, regardless of the consequences. Lower prices are the market's solution to housing affordability. Government attempts to artificially prop up prices will have much more dire economic consequences then letting them fall. Until we figure this out, there will be no escape from the economic death spiral the government is setting in motion.

10 Comments – Post Your Own

#1) On December 08, 2008 at 11:19 AM, binv271828 (< 20) wrote:

(I would offer the corollary that the key to reducing injuries in auto accidents is to suspend the laws of inertia).

That is fantastic line :)

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#2) On December 08, 2008 at 12:56 PM, giantSwan (< 20) wrote:

Agreed, this reminds me of when Hoover tried to prop up salaries during the Great Depression.  Rather then helping the problem, the companies couldn't afford the high salaries forcing them to lay off more employees.  This only increased unemployment.

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#3) On December 08, 2008 at 4:19 PM, engstocker (54.72) wrote:

The one way I see this working well is if the only people that can qualify for these 4.5% loans are the people with great credit....say 750 or above and have the cash to put 20% down. In a way this could provide a reward to the Americans that save and are deligent in paying their bills....the same Americans that are paying with their hard earned tax dollars all the foolish bailouts.... and the same Americans not foolish enough to buy overpriced housing.

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#4) On December 09, 2008 at 3:21 AM, jgseattle (26.12) wrote:

engstocker - the program is only for new buyers.  How do you make it fair for people that purchased with 20% down in the past that are in mortgages that are not government subsidized?

I think the market needs to see some pain and the sooner the pain is inflicted the less it will be and the faster we can recover.  Look at Japan and I think we are going down the same path. 

I find it very ironic that the US advised Japan to let zombie companies fail but we cannot let our zombies go.  C, AIG, GM, F and how many others.

As for housing I am now saving agian, in gold and silver and the 
Canadian dollar, in the hopes that housing does fall to a point that I can buy a bigger house and rent this one. (who knows.)

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#5) On December 09, 2008 at 8:35 AM, martyshellsy (< 20) wrote:

I love it when people who have had homes sold by short sale or have them taken back by the banks because of bad loans given by the banks are bad future credit risks while the banks that made the bad lons can go belly up, get money from the person who lost there homes tax money as a gift from the Fed's & go out & buy more banks while the poor slob who lost the home gets letters from credit card companies raising interest rates to 27%. Now these same banks who got these tax dollars won't loan the cheated people money for a new home or a credit card. WHY do the peoples credit count when the banks does not. WHY is it that only the poor slob that pays the tax's is the only one hurt credit wise ???  Marty

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#6) On December 09, 2008 at 8:39 AM, martyshellsy (< 20) wrote:

One way & one way only to fix the loan problem in this country.

A. Fed's make new loans at 4 1/2% of the NEW real value of every home in the US.

B. Banks can buy these loans from the Fed's after they are in place.

C. The amount of money that the lenders lose due to the new loan is picked up by the Fed's.

D. ALL (100%) of all negitive credit information will be removed form the 3 credit companies. (Starting from 2005)  Shelley 

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#7) On December 09, 2008 at 9:23 AM, engstocker (54.72) wrote:


From what I've read it hasn't been set in stone yet whether it will be for new buyers only or will be able to apply to refinancing as well. Even if it is for new buyers only....great. If you were not foolish enough to buy into a housing bubble you should have equity in your home if you've owned it awhile. Simply sell your house and buy a new one (possibly bigger if your ready for an upgrade, especially if you bought a starter house a few years ago and now have a family that is ready for an upgrade) at the 4.5% rate. This plan can reward smart people and punish the foolish (the people who bought into the housing bubble and will not be able to take advantage of this "gift")...this is capitalism at its best.....taking away assets from the foolish and rewarding the not so Foolish. Again this should only apply to people who have great credit and have saved to be able to put money down or otherwise were back in the same boat that started this mess.



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#8) On December 09, 2008 at 6:37 PM, SouthieGirl (< 20) wrote:

Helloooo –  You're missing re-investment benefit..  We have a 4-unit property, 20 years equity [LTV 0.3] and want to do $350,000 of upgrades, which will provide revenue/jobs to local construction.   But, I am turning banks down until we get a mortgage rate that is a fair spread over bank cost.  Now, my variable has dropped to 4.99%, so I can wait.  I’ll pay a little more for the right fixed loan…  Gee - the economy growing by ordinary people doing ordinary thing - what a concept.  Sigh…

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#9) On December 10, 2008 at 11:01 AM, aspexil (< 20) wrote:

I agree.  All this credit is useless if people don't have jobs. 

 Why have we not seen anyone recommend suspending the payroll tax for the foreseeable future?  The only way we're going to get this economy going is if people have money (not credit) in their hands.  The quickest way to get money into people's hands is to suspend all federal and state payroll income taxes.  Those people then have money to pay off their debts and to go out to dinner at the restaurant or order out a pizza.  I'm tired of watching all this credit talk when the real talk should be about getting money where people can use it.

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#10) On December 10, 2008 at 11:00 PM, DallasLoanGuy (< 20) wrote:

If the Fed is involved.... It will be wrong.

There..... I condensed your article.


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