Rule Change

Today in an attempt to help stem home foreclosures and restore housing affordability, the government announced a new plan where homeowners who refinance mortgages through Fannie Mae and Freddie Mac can get a loan equal to 125% of the home's value. That means that if your home is worth $100,000, you can refinance for $125,000. Makes sense.....

Here is the article on CNBC.com.

The government has wrongfully concluded that falling home prices are the problem and the cause of the current economic crisis and recession. The government's solution is to prop up home prices through artificially low interest rates, rescue programs sponsored with taxpayer money and socialized housing schemes such as giving a 125% loan to value mortgage. What the government doesn't seem to understand is that it was exactly these same government schemes/scams in the past that caused the housing bubble that led to the economic collapse. While the government has passed around the blame for the crisis and pointed many fingers at greedy Wall Street bankers, speculators and hedge funds, ultimately Uncle Sam can point the finger right back at himself. Of all the misguided economic programs launched by the government in recent decades, the chief culprit and main cause of the crisis is the Federal Reserve, which has provided the economy with cheap credit and easy money for the past two decades in the form of artifically low interest rates.

After reaching an all-time high of 5132.52 on March 10th, 2000, the Nasdaq bubble burst and reached it's low of 1116.76 on Oct 10, 2002. When the Nasdaq bubble collapsed, the technology, communications and internet sectors of the economy were decimated. The result of every artificial credit boom is a bust that results in asset deflation and a credit crunch. The U.S. needed to experience a massive recession in 2001/2002 to "purge the system" and cleanse the economy of the malinvestment brought on by the internet stock bubble. Instead of allowing this natural market correction to take place and in order to stimulate the economy out of recession, the Fed aggressively cut interst rates down to 1% in June 2003 and left them at the then all-time low rate until June 2004. Notice how low interest rates remained even after the recession ended (recession highlighted in grey).


The result of all time low interst rates? Mortgage rates also fell to an all time low.


Not surprisingly, the low interest rate/low mortgage rate combination led to an explosion of borrowing and lending (and spending), specifically in the residential real estate sector. Commercial banks more than doubled the amount of real estate loans they made from 2002 to 2008.


Cheap money had to be loaned out in the frenzy as literally trillions poured into the mortgage market. "Home prices never fall" was the favorite saying in those days. Artificially low interest rates enabled the securitization market to thrive from 2005 - 2007, which further increased demand as investor appepetite for "riskless" U.S. housing investments shot through the roof.

How could these assets be riskless? The Government Sponsored Enterprises Fannie Mae and Freddie Mac contributed to the housing bubble by insuring mortgages and also buying mortgage securitities. Unlike the private mortgage market, the U.S. government's implicit backing of Fannie and Freddie guaranteed moral hazard and malinvestment, because if backed by the U.S. government, the securities purchased by Freddie and Fannie were rated AAA, meaning almost zero chance of default and essentially no credit risk. Alan Greenspan admitted the inherient moral hazard in this 2005 speech. Of course, with the collapse in the sub-prime housing market in 2007, the country quickly realized that these "riskless" assets owned by Fannie, Freddie and other commercial and investment banks were not AAA securities, but were actually worthless.

The problem today is not that home prices are falling. The problem is that artificially low interest rates triggered a massive credit and housing bubble, causing home prices to rise artificially above historic norms of growth. The housing boom was not real growth or wealth creation, but was simply an artificial boom created by credit growth injected by the Federal Reserve. As previously mentioned, the result of every artificial boom is the inevitable bust. Austrian Business Cycle Theory explains the boom and bust economy the U.S. has experienced over the past few decades. Not surprisingly, Austrian economists were some of the few who correctly predicted the housing collapse and the subsequent global recession. Regrettably, the terribly flawed Keynesian economic model that inspired the misguided thinking of our leaders in Washington continues to be followed as if it were gospel, apparently the only philosophy capable of rescuing the world from total collapse.

Of course Keynesian economics is total nonsense, and in order for our economic woes to come to an end, the government must come to its senses and realize that the solution to the problem is not to maintain housing prices at artificially high levels via Keynesian stimulus. As painful as it may be, the real solution is that we must let home prices fall to their natural level, or the historic trend-line. When homes become affordable again, due to lower prices, buyers will be enticed and will return to the market and in time, everything will be back to "normal". The housing experience from 1997 to 2007 was not normal, as the following inflation-adujsted U.S. home price graph demonstrates.

The problem with more government attempts to stimulate housing is that it was precisely these same government interventions and mistakes by the Federal Reserve and Congress that brought about the current crisis. More and stronger attempts by the government to prop up home prices and stimulate demand will have the exact opposite effect intended, and instead of stimulating, interventions will further distort the already fragile market, delaying the ultimate correction for another day.

Unfortunately, as with all the government stimulus' of the past, the effects of the current stimulus, which is the largest in the history of the world, will inevitably lead to worse economic consequences than those we have experienced in the past. Unlike the past however, when credit growth inflated assets like the Nasdaq and housing market, temporarily benefitting those who owned these assets, the current round of stimulus and credit creation will only destroy the value of the dollar. As a result, the cost of living for Americans will skyrocket and the average citizen will be most harmed by the stimulus that was championed by the government as the only possible way to save them.