Housing Part 2

Regarding my last post, a friend asked:

"I do not understand how in the world this refinance at 125% makes any sense. We know the house isn't worth as much as they paid for it so we're going to say its worth even more? Am I getting that right?"

You are exactly correct. Again, that's saying here is a house that is worth $100,000. The owner would like to refinance his mortgage, so Fannie says great, here's $125,000.

The over-inflated loan-to-value ratio is not the real problem, but is an underlying symptom of it. The real problem is that because Fannie and Freddie are now government run entities, they can continue to provide mortgage loans with an interest rate and loan to value ratio that would never be allowed in a free market mortgage system. What we have to understand is that credit is currently scarce in the private market for a reason. Despite what the government would like for us all to believe, credit is not created out of thin air, but comes from the savings of businesses and individuals. Unfortunately, Americans are broke and we have a proportionately tiny savings pool from which to derive credit for our massively indebted economy. Lack of credit is the reason for the collapse in economic activity. As President Obama has stated on several occasions, credit is the "lifeblood" of our economy. What the President failed to mention is that when an economy is built on credit that is artificially created by the printing press of the Federal Reserve, the lifeblood can quickly turn into a cancer that will inevitably kill the patient when the bubble they created bursts.

The free market solution to the scarcity of credit is to make credit more expensive, so that only those individuals and businesses who need credit the most will be willing to pay the now much higher cost of capital. The result is that credit will be "scarce" for non-essential things like credit cards, car loans, and overpriced real estate. But this is a good thing. Because scarcity has made credit more expensive, Americans will be rewarded for savings with higher interest rates, and thus higher returns on their savings - a great incentive to save, especially when you consider the current 1-2% interest rates. As savings are built up, credit will become less scarce, interest rates will fall, and the economy will rebuild itself through simple market forces - in this case the supply and demand of credit. The imbalances in the U.S. economy are a major contributor to the current economic situation. Our economy is 70% consumer spending, while exports and investment makes up a tiny percentage of GDP compared to other economies like China and Japan. Personal consumption expenditure and housing growth were vital to the U.S. economy. But as mentioned in my previous post, this growth was largely artificial, driven by the Fed's cheap money and the inflation that resulted from it. Because the majority of our economy was driven by two sectors - consumer spending and housing - whose growth depends on ever increasing credit in the form of debt, when the debt stopped coming, and then contracted severely, the wheels came falling off.

For the past 20 years, the government has approached every recession in the same way. Interest rates are lowered for an extended period of time and some type of stimulus, whether a tax cut or direct injection, adds additional liquidity into the market, allowing the government to sustain unsustainable asset prices. The result is a temporary easing of economic hardship that masks the underlying problem. It is unfortunate that these past excesses continue to be swept under the rug because they always rear their ugly heads only a few years down the line. This is the explanation of our boom and bust economy. Government efforts to stimulate the economy never fix the underlying imbalances that caused the problem in the first place. In fact, the past stimulus's have only made the problems worse, resulting in the economy we find ourselves in today. The reason is because the artificial credit provided by the government distorts the self-correcting market mechanism. Imbalances continue on indefinitely, as the government's artificial supply of credit causes market actors to make poor decisions, based on credit that does not actually exist in the economy.

In conclusion, continual efforts by the government to stop the contraction in credit serve only to increase the imbalances in the U.S. economy and further weaken its foundation. My last post attacked the most recent attempt by the government to sustain artificial credit by increasing loan to value ratios to 125% for loans refinanced through Fannie and Freddie. This latest effort may seem unique or resourceful, but in reality it is simply another means for the government to keep our economy flooded with credit and debt that it doesn't need. In this case, supplying our economy with more artificial debt is like giving the drug addict in remission more drugs. The drugs may delay the pain for a while, but the artificial high will not last forever.