Part II - "We Never Should Have Bailed Out FF"

Lest you all think that this crisis caught us all totally unaware, you can refer to this article for proof to the contrary.

What is the difference between a $150K house mortgaged at 15% for 30 years, and a $300K house at 6.5% for 30 years? In terms of payment? $0.46 a month. In terms of total expenditure over a 30 year period? $166.31. In either case you will end up spending $683,000 on interest and principal. So what's the difference? Well, as the prices are being run up, the potential for flipping houses, as we saw, was phenomenal. The initial cash outlay, however, is much larger, which means that saving for a home is more difficult, consumers are more dependent on credit to get into a house, and foreclosures are much more dangerous because the potential for loss is much greater.

The way to get out of this mess, is to back-track. Interest rates need to go up, and home values need to go back down. It would be great if we could wave a magic wand to acheive this, but that's not going to happen. It's going to be a slow and agonizing process.

As values decline, borrowers will have to stay in their homes longer before they have built up enough equity to sell their homes without falling short of their mortgage. The alternative is to foreclose or short-sale. Agonizing. But an interesting thing happens when homes are foreclosed or sold-short. The buyers of these homes produce a steady income to the banks, and they have the flexibility to sell the home because the value has dropped so substantially.

If enough borrowers are forced into foreclosure or short sales, the banks that lent them money will file bankruptcy. Stock-holders lose their investments. Large savers lose a portion of their life-savings. Agonizing. But again, an interesting thing happens. The banks assets are bought up for pennies on the dollar by other banks. Since these banks are collecting large revenues for smaller cash outlays, they are more able to absorb short-sales and foreclosures. Interesting how that works, huh? Let's say that WaMu made a $300K loan at 6.5% interest over the course of 30 years. Now let's say WaMu goes under, and JP Morgan Chase swoops in and buys all their assets, including that $300K mortgage, but they only pay $150K for it. That would mean that the initial outlay of cash on Chase's part is only $150K, and the effective return on investment becomes 15% instead of 6.5%. The market will not be fooled my friends. Your property will return to its real market value. The profits collected on your loan will reflect your real market risk.

It did not take long for the entire market to attempt to readjust and reallocate in one fell swoop. When Fannie Mae & Freddie Mac were on the brink of financial disaster, we had that chance. Fannie Mae & Freddie Mac hold more mortgages than any other entity in America. Their failure would have meant that most of the mortgages in America would have been sold for a pittance to... whomever. Banks could have bought out their own loans if they had the cash on hand. Solvent Banks like JP Morgan could have scooped up hundreds of loans that would have produced 15% ROI over the next 30 years.

All of this could have put the financial industry in a position to avoid freezing up lines of credit. Bank obligations would have been drastically reduced, which would have freed up capital for more profitable ventures. All of this would have taken place at the expense of Fannie Mae & Freddie Mac investors, who would have had to suffer a loss before moving whatever cash they had left to banks and enterprises that had purchased FF's assets and were now making out like bandits.

Now, this does not mean that we could have gone BACK to sky-rocketing home values at low low interest rates. Not at all. The absence of FF would create a sizeable gap in the available credit, which would result in an increase in interest rates. Interest rates would rise to more sensible levels. Many people would be stuck in overpriced homes, unable to sell without cash reserves in the tens of thousands of dollars, but that potential situation is no different than the situation we are in today. The key difference would be that savers would not have to worry about additional bankruptcies robbing them of their life savings. Eventually, these homes, too, would be liquidated, and the market could return to sensible and sustainable growth.

This notion that any organization is too big to fail is ridiculous. Was the British Empire too big to fail? What about the Soviet Union? These companies are not too big, they are too privileged to fail.

Allowing FF to fail should have been the first of many steps on the road to recovery. Instead, we bailed them out. Now we are offering to bail out an entire industry which will only have the same result as bailing out FF. Entities in debt will find no relief. Overpriced assets will not be written-down or sold. Stocks will briefly rally, as they did when interest rates were dropped in 1929 following the crash, but they will fall again as they did then. It won't be long before some politician, probably the next President, will stand at a podium in a month or so and say something outlandishly ridiculous like the following:

"All the factors which make for a quick and speedy industrial and economic recovery are present and evident. The Federal Reserve System is operating, serving as a barrier against financial demoralization. Within a few months industrial conditions will become normal, confidence
and stabilization in industry and finance will be restored."
- Herbert Hoover