The U.S. Federal Reserve and the Treasury Department have been mulling over a plan that would obliterate all market signals from the mortgage industry. The plan demonstrates once again Washingtons perverse belief that the cure for decades worth of government distortion of the housing market is â€¦ more government distortion.
Normally, Washington doesnt directly control mortgage rates. Yes, the Fed helps control general interest rates for all kinds of borrowing through its interest rate policies. And the governments long-assumed guarantee of mortgage behemoths Fannie Mae (nyse: FNM - news - people ) and Freddie Mac (nyse: FRE - news - people ), until it quasi-nationalized the two companies last summer, also kept mortgage rates lower than they would otherwise have been for decades.
But now, the government may take a giant step further. The Fed and the Treasury may set home-borrowing rates in the next few months by purchasing mortgages directly from Fannie Mae, Freddie Mac and other mortgage lenders at a fixed price that would dictate an interest rate of 4.5% for new home buyers, as well as, possibly, for owners of existing homes who want to refinance their more expensive loans. After news of the tentative plan got out in December, mortgage rates plummeted to just above 5%, the lowest level in four decades. (Since then, the Fed has begun purchasing mortgages, but the government hasnt yet formalized the target mortgage rate.)
The governments reasoning is obvious, if wrongheaded. It wants to keep housing prices from falling further, which would drive homeowners into foreclosure and push banks and investors into deeper distress. To achieve this, the government has to scare up new home buyers, many of whom feel skeptical that prices have hit bottom. So the Fed hopes to lure buyers with dirt-cheap mortgages, just as they were priced during the housing bubble. The gambit could work--for a while. But in the long run, the federal plan will just make things worse.
Consider the downsides. First, the feds will further warp the housing market. Part of the reason that were in this mess is that government policies--from zero percent capital-gains taxes on house appreciation to mortgage-interest tax deductions, to support of Fannie and Freddie--have long encouraged borrowers and lenders to pour money into houses at the expense of more productive forms of investment. Making easy lending available solely for buying still-expensive houses adds yet another layer of capital deformation. It would be something like trying to reinflate the 1990s tech bubble by offering cheap government financing only to people willing to buy shares in Pets.com. This time around, such a distortion could delay recovery by directing capital away from where it could do the most economic good and toward yet more investment in houses.
The government may only be delaying an inevitable full correction of housing prices, moreover, since it cant determine mortgage rates forever. Remember, the government can “fix” rates by purchasing mortgages at a preset price, by bringing potentially hundreds of billions of dollars in mortgages onto either the Feds or the Treasurys books, or both. But the Fed and the Treasury cant warehouse these mortgages on their books forever.
Eventually, the market will figure out that the governments mortgage holdings are untenable, and it will push up interest rates on them as it anticipates their being dumped. (On debt instruments, when prices go down, as they would in a government sell-off, interest rates go up.) The consequence of such a sudden spike in mortgage rates might well be another big drop in home prices. Could the government engineer a “soft landing” here, carefully managing its sales of mortgages? It did a great job of engineering a cushioned fall when the housing bubble first burst, remember?
The governments aggressive action also could delay another inevitable process: “de-leveraging” or debt reduction. Mathematically, Americans simply cannot afford the debt theyve incurred over the past decade or so, and they must reduce it. Encouraging them to borrow more money to buy houses at artificially inflated prices is a very bad idea.
Finally, the governments cheap and easy mortgages could come with a hidden cost, just as all those exotic mortgages from the bubble era did. Washingtons plan assumes that the Treasury itself can borrow cheaply--that is, for less than the 4.5% of these mortgages--for as long as it takes to push these cheap loans. As the government adds its massive new debt to the private sectors own debt, however, the global markets upon which we depend for all this borrowing may grow queasy. They may figure out, eventually, that America is a democracy of debtors--and that the crudest way for a debtor nation to pay back lots of debt is to print more dollars, thus creating massive inflation.
Just the fear of inflation could push Treasury rates up suddenly, giving the Fed no reasonable economic choice but to end its cheap-mortgage program. Of course, politics might allow the Fed to continue it for a while. But the unavoidable result would put us right back where we started, with still-distorted home prices and even higher levels of debt.
Original Source: http://www.forbes.com/2009/01/14/mortgage-treasury-fannie-oped-cx_ng_0115gelinas.html