Sound of Penny Dropping

Reading the Washington Post in preference to the New York Times is starting to pay off. I read about the disaster with sub-prime mortgages and finally got it. I suppose what is happening was clearer to others but I finally have been let in on the news.

I had assumed that the problem was that there had been so many defaults and foreclosures. That is not the problem. The problem is that there are still so many mortgages, millions, out there in homeowner land with built-in interest rate resets scheduled to reset soon. The problem is that we have an absolute guarantee that there are going to be far more defaults and foreclosures in the near future.

Some are merely adjustables which transfer the risk of interest rate fluctuation from the lender to the borrower. These the Federal Reserve Board has tried to protect by lowering interest rates with two consecutive rate cuts so that the index rates on which they are based will stay low. They have made these cuts by risking inflation in the overall economy exactly when overall inflation pressures are mounting.

As the dollar sinks, the prices of imported goods, particularly oil, will rise. Domestic goods sellers, faced with reduced price competition from foreign goods will raise their prices too. So the Federal Reserve, faced with the risk of inflation by adding interest rate cuts to other inflationary pressures, and the risk of millions of additional defaults and foreclosures, has chosen to risk the inflation rather than the foreclosures.

[I know well how this works and how it feels. But I was lucky enough to have got an adjustable mortgage in the 1990's, an era of declining interest rates. I refinanced to a fixed at a low rate just as I had hoped I someday would. My strategy has always been to rely on dumb luck.]

Other mortgages reset to higher rates automatically just with the passage of time. These are not transferring risk, they are closer to outright fraud. People are able and encouraged to buy a house, i.e. a mortgage, with interest rates of 4% or 3%. How they will pay 7%, 8%, or 11% in two, three, or five years is left up to "somehow" and "we'll think about it then" or "maybe we will be able to refinance later".

The Chairman of the Federal Reserve, Ben Bernanke, has proposed to Congress that the government fund the hoped-for refinances in a variety of ways. With pressures from the banking industry pushing in ways that people with souls can't even imagine, and an election coming up, there is no knowing what Congress will do. But too little too late would be a good bet.