Tuesday, October 30, 2007

Oh, So That's Where They're Getting the Mortgage Money

If you're like me, you've been wondering: Okay, if credit markets have seized up, where are these new mortgages and refinancing deals getting the money? Why isn't Countrywide going bankrupt? I know they've received a $2 billion infusion from Bank of America, but that can't be enough.

The answer is, it's coming indirectly from you and me. Our tax dollars have just become collateral behind newly created bonds that the government has made available to the likes of Countrywide.

peter to pay paul
[Thanks to solomonsrose.com for the image.]

When companies like Countrywide found in August that they could no longer continue their operations for lack of funds to borrow, the government got busy trying to find a way to unlock the situation, and they found one. The solution they hit upon is to open the wallets of the Federal Home Loan Banks and of two semi-government entities, Freddie Mac and Fannie Mae.

These banks and mortgage institutions are basically government-guaranteed semi-private companies that deal in mortgage loans. Heretofore reticent lenders believe that the government (i.e. your tax dollars) are behind these companies. This means that these entities will manage to sell bonds to these reticent lenders, whereas other market operators won't be able to. With the cash in hand from these bond sales, the government can offer hard-to-find money to the real estate lenders who need it, backed by your and my guarantee. Without this deal, Countrywide might be dead by now.

This brings us to the question of whether or not the government should be saving the hind end of those like Countrywide who made bad business decisions. Personally, I think not, because it creates what economists call "moral hazard." In other words, the government is acting on what we believe to be good intentions (saving the general economy), when in fact we all might be better off if they just let Countrywide (and numerous others) bite the bullet (perhaps the economy could withstand it, and even should withstand it).

But the government does not like to be in power when things go awry; so they fix it, get the credit for fixing it, and then allow a changing of the guard, so that the next government can take the blame for the more long-term fallout (potentially: inflation through excessive credit creation, the survival of unsavory business practices like the poor-quality lending that went on up until 2007 and the housing boom/bust, and a flight from the dollar).

The details are explained in my previous post, and in this article at Bloomberg by James Tyson and Jody Shenn.

Other problems can also arise from two different sources: First of all, the semi-governmental companies who are doing the lending were themselves already overextended before this new lending began. All of them have been readjusting their accounting and books to correct severe past mistakes, and are only recently back in the clear (or at least we believe they are).

Secondly, if the new loans default, the only remedy will be for the government to spend your tax dollars to cover the hole.

Opinions differ about the degree of risk involved; but personally, I hate it when someone promises to pay their debts with my money, don't you?

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