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We are
being told loudly and repeatedly that the gargantuan mortgage bail-out package
is necessary because illiquid mortgage-backed securities are clogging our
financial arteries, threatening the economic equivalent of cardiac arrest. The
idea of the plan is to transfer these supposedly valuable, but currently
unmarketable, assets to the government so that private institutions can
freely lend once more. The monumental flaw in this argument is that the
mortgage backed securities are in fact highly liquid, just not at the prices
the owners would like to receive.
Mortgage
bonds are just like houses. They won't sell if the owners stubbornly refuse
to drop the price. However, they can find buyers if they acknowledge reality,
and lower their expectations accordingly.
The
government tells us that if these assets are held to maturity their full
value will eventually be realized, and that it is only because of a lack of
current liquidity that their value is not reflected in the market. However,
as many private transactions have shown us in recent months, these assets
will find buyers at the right price. These are not overly exotic assets but
relatively straight forward mortgage obligations. The inability to find
buyers is not a function of liquidity but simply of price. The government is
seeking to "create liquidity" by overpaying.
The
government's assumptions about the "held to maturity" value of
these mortgages completely understate the likelihood of widespread default. Some
of the "illiquid" assets represent tranches of mortgage-backed
securities that will be completely wiped out. Even the higher quality
tranches will suffer severe losses due to mortgages that will inevitably go
bad.
For
example, take a $500,000 adjustable rate mortgage on a condo in Las Vegas that has a current value of only $250,000. To assume that this asset can be
safely held to maturity is absurd, when in all likelihood the borrower will
default shortly after the rate re-sets, even if the borrower has not yet
shown signs of distress. Of course such a mortgage would be completely
illiquid if one tried to sell it anywhere near par, but would be extremely
liquid if priced to reflect a more realistic value; say 35 cents on the
dollar. But if the government pays prices that fairly factors in likely
defaults, it will bankrupt the very institutions it is trying to bail out.
Another
factor that has not yet been considered is that that the government has
already indicated that it will try to avoid foreclosures by reducing the
principal and interest rates on the loans it acquires to levels current
homeowners can afford. This will immediately eliminate the delusion of the
government recouping its "investment" as even if held to maturity
the mortgages will never be worth anything close to what the government pays.
Also
missing in the discussion is the concept of the time value of money. Even if
a substantial percentage of the $700 billion is eventually recovered, it will
still represent a huge loss for taxpayers who theoretically have to come up
with the cash today to buy the mortgages. Further, the inflationary nature of
the bailout ensures a substantial rise in long term interest rates. This will
further suppress the present values of the low coupon mortgages the
government will be restructuring.
The moral
hazard implicit in the government's willingness to re-write troubled
mortgages ensures that the plan will spark a wave of new delinquencies by
borrowers looking to cash in on the windfall. Since troubled loans will no
longer be foreclosed by lenders but instead sold to the government, the
rational choice for many homeowners will be to stop making their mortgage
payments and wait for a better deal from the government. This reality will
eventually push the cost of this bailout well above $2 trillion.
In
addition to the government bailout, distressed lenders are looking to the
suspension of "mark to market" accounting rules as a means of
salvation. These rules require institutions to value their mortgage assets
according to the most recently traded price. However, suspending these rules
will not make the losses go away. Rather it will simply allow lenders to
pretend that the losses do not exist.
Armed
with such fantasies, banks could pretend that their mortgage assets had more
value, and that their balance sheets were well capitalized. They would not
need to raise more capital in order to fund new loans. But, just as a person
with no sensitivity to pain runs the risk of catastrophic injury, such a move
would encourage financial institutions to take greater risks which, in the
end, will produce more bankruptcies and greater losses.
In fact,
the Senate version of the bailout bill, which authorizes a suspension of
mark- to-market, also increases the dollar limit on FDIC insured deposits
from $100,000 to $250,000 (with no extra money budgeted to fund the increased
taxpayer liability). Only in Washington would a bill pass which simultaneous
makes banks more likely to fail while increasing taxpayer exposure when they
do!
For a
more in depth analysis of our financial problems and the inherent dangers
they pose for the U.S. economy and U.S. dollar denominated investments, read
my new book "Crash Proof: How to Profit from the Coming Economic
Collapse." Click here to order a copy today.
For an
updated look at my investment strategy order a copy of my just released book
'The
little Book of Bull Moves in Bear markets." Click here
to order your copy now.
More
importantly, don't wait for reality to set in. Protect your wealth and
preserve your purchasing power before it's too late. Discover the best way to
buy gold at www.goldyoucanfold.com. Download
my free Special Report, "The Powerful Case for Investing in Foreign
Securities" at www.researchreportone.com. Subscribe to my
free, on-line investment newsletter, "The Global Investor" at http://www.europac.net/newsletter/newsletter.asp.
Peter D. Schiff
President/Chief Global Strategist
Euro Pacific Capital, Inc.
20271 Acacia Street, #200 Newport Beach, CA 92660
Toll-free: 888-377-3722 / Direct: 203-972-9300 Fax: 949-863-7100
www.europac.net
pschiff@europac.net
For a more in depth analysis of the tenuous position of
the American economy, the housing and mortgage markets, and U.S. dollar
denominated investments, read my new book "Crash Proof: How to Profit
from the Coming Economic Collapse." Click
here to order a copy today.
More importantly take action to protect your wealth and
preserve your purchasing power before it’s too late. Protect your
wealth and preserve your purchasing power before it’s too late.
Discover the best way to buy gold at www.goldyoucanfold.com
, download my free research report on the powerful case for investing in
foreign equities available at www.researchreportone.com
, and subscribe to my free, on-line investment newsletter at http://www.europac.net/newsletter/newsletter.asp
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