Wade Armstrong

• Latest
• Archives
• Links
• About Me
• Projects
• Contact Me

Bernanke's Gift to the Banks

Posted Wednesday September 19, 2007 in Business

On top of their mostly-symbolic cut to the discount rate a month ago, the Fed has now cut the Federal Funds rate, hopefully lowering lenders’ interest rates and saving the economy from a Real Estate bubble-fueled recession. This is a dangerous game: the added credit availability may not trickle down to homeowners or other consumers, and the new liquidity may simply allow predatory and irresponsible lenders to cover their own losses while not learning a thing. This cut is a gift to the lenders — and shows that what we need is a policy solution to this housing crisis.

Who Did a Bad Thing

There’s plenty of blame to go around here. Sure, there are tens of thousands of homeowners who irresponsibly treated their houses like ATMs. But how many of these had advanced degrees in finance, like the wizards behind their mortgages? Maybe the borrowers should’ve known better (although, given that nobody teaches budgeting in junior high, maybe not). Certainly the lenders should have. They knew they were taking big risks by providing mortgages to sub-prime applicants. They may even have known about the predatory lending. The lenders have no excuse here.

Life Preserver, Anyone?

And it’s the borrowers who, right now, will pay the biggest price. Sure, sub-prime lenders have gone under, and bank stocks have been hit hard. But many times more Americans own houses than own substantial stock portfolios. In a downturn, every American homeowner stands to lose. And the money that American homeowners lose? That’s what’s currently keeping the economy going, with rollicking consumer spending on everything from Wal-Mart clothes to Japanese sedans to organic produce.

Foreclosures — and even a substantial, long-term housing market decline — will directly impact consumers’ ability to buy these products in the short-term, and willingness to buy them in the long term. For a borrower who has suffered foreclosure, the dark spot on their credit may prevent them from even trying for homeownership again for ten years; for a borrower who has lost years of savings, the disappeared cash my be unrecoverable and the dream of homeownership gone forever. The banks? They’ll do fine, either way, writing down losses on taxes for years to come.

The Problem With a Rate Cut

The problem with a rate cut is that it most immediately impacts banks; only if the banks then modify their lending policy, or their existing loans, then this impact trickles down to consumers. But why should it trickle down? Banks and lenders and hedge funds all desperately need cash just to keep from writing down their existing assets. It’s a safe bet that a lot of the new liquidity will go not to homeowners — who need refinances, or at least to keep the interest rates on their ARMs down — but to hedge funds who need cash to cover redemptions, and to banks who want to keep portfolios afloat so that they don’t have to report big losses on their balance sheets. This new liquidity undoubtedly will spare many lenders from having to feel the full consequences of the excessive risk they took on, while not saving many borrowers.

Let’s Try Policy, Not Markets

And that’s a problem. We need both responsible borrowers and responsible lenders. That means both parties need to feel appropriate levels pain, such that they learn, but aren’t ruined. It’s not the Fed’s fault we’re here; they don’t have many tools and are using the ones they have to try to do good. No, I’m with PIMCO bonds guru Bill Gross: the Federal government needs to do something.

The good news is that the Federal government has a lot more tools. They have, to some extent, Fannie Mae and Freddie Mac. They have the ability to raise new money through their own, very low-cost, debt. They can pass laws and mandate new behaviors.

It’s important to not bankrupt too many Americans, to not destroy the hard-earned dreams of too many. So, the government can capitalize Fannie Mae to buy distressed, exotic mortgages, and replace them with longer-term, less-volatile agreements. Homeowners will see how little they could actually afford, and pay the price for their overextension by spending their hard-earned dollars on a mortgage that they’ll barely pay off in time for the rest home. Some will have to be foreclosed upon, but perhaps the terms can be managed such that the event is painful but not ruinous.

Of course, Fannie Mae will buy the distressed mortgages at a discount, befitting the risk for default. In many mortgages, that’s extremely high right now. So lenders will pay the price financially, but there will be a ceiling on their possible exposure. And lenders will learn that they don’t want this to happen again, so they’ll provide credit responsibly next time. We’ll save consumers, we’ll save lenders, and we’ll end up with more responsibility on both ends of the equation in the end. That’s much better than the Fed’s current non-solution solution.