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Special Report : The Bush Plan 12/09/07
(Or how politicians can scare us and the markets.)
Here is the first (hopefully of many) Special Report from the EconomyGuy. The topic this time is President Bush's Plan to maintain current interest rates on sub-prime mortgages. There is so much to say about this topic that this report could be too long. I will keep it shorter by making some simplifying assumptions, and drawing conclusions on what the plan means. One thing is way too obvious. It is very hard to find DETAILS on how this plan will be implemented. That omission in the news tells me that either people don't want to talk about it, or it hasn't been fully worked out yet.
The plan is very simple to understand. Some sub-prime mortgages (partial definition below) that adjust upwards after 1/1/08 will maintain its current interest rate instead.
The Bush Plan was voluntarily agreed between the banks and the government. Wow. This is a whole topic in itself.
The anticipated end result of the Bush Plan is to create a stable financial industry sector, and end the liquidity crisis for real.
Where is the Self Interest ????
First and foremost, please understand that the Bush Plan is political. Its thrust and its timing are political. This is a 5 year initiative. Why start in 2008? Well, 2008 is a presidential election year and the beneficial, social image of this initiative is meant to help the President's party. Why 5 years? In 4 years there will be another presidential election year, and the program will be continuing.
Not to be missed, there is the Bush legacy to be considered. There is undoubtedly a true desire to help some poor schmuck that got sold a lousy sub-prime mortgage.
Lastly and on the surface only, it appears that the banks are being saved from having to foreclose on these bum loans. So, on a shallow thinking economic basis, it could be concluded that Bush is trying to help his big business friends. I personally don't believe this last assertion.
Who is getting helped ????
The headlines say that 1,200,000 mortgages will be able to take advantage of the Bush Plan. The Center for Responsible Lending counters that only 145,000 mortgages will take advantage of it. Big numbers make better headlines.
To qualify you must have one of the rate adjusting sub-prime mortgages, have obtained you loan from 2005 through July 2007, have made all (or all but one) of your payments on time, be adjusting after the first of the year, not have a "no doc loan", and the mortgage can't be held by a speculator (non-home owner), have a credit score of less than 660, have the increased interest rate be at least 10%. That eliminates a lot of people, and can be viewed as "unfair." You will probably see a lot of news and TV stores coming out over the next month on the lack of fairness in the plan. Those pieces will be politically motivated and should be ignored. Think about it awhile. Any plan that any human could create to try to help the folks holding sub-prime mortgages would be "unfair" to someone. Taxes are unfair. Life is unfair. Get over it.
I believe that a large part of the sub-prime mortgage problem is held by speculators - big and small. During the big real estate run up, lots of people were caught up in the greater fool theory (a greater fool will come along and buy it from you), and were left holding the bag. To speculators, I say: "Pay the piper."
Equally, a large number of people bought a more expensive home because they could afford the monthly payments using the "teaser" interest rates. Most of these people knew their rates would go up in the future. Some of these people were "sold" a pig in a poke, and didn't fully understand the ramifications of the "teaser" rate. I have a lot of compassion for this latter group - and my classic answer would be to find a good lawyer (and there should be some big class action suits coming out of this.)
The REAL problem for all of these people - especially if their homes are in the quickly depreciating states (FL, CA, AZ, NV, MI and others) - is that they maximized the amount of their loan (like 100% Loan to Value), and their house is now worth less than they owe. Lots of these people are just walking away from their houses and loans. The Bush Plan won't fix the problem that someone owes more than the property is worth. That's another reason for the 5 years. The White House is HOPING that the real estate market will turn around by then, and make these loans whole again. The plan is also HOPING that people won't walk away as fast. (My years of experience tells me that HOPE is not a good basis for any plan.)
The financial industry estimates that half of those who qualify for the Bush Plan will "freeze" their interest rate, and half will refinance into a fixed rate mortgage. The latter half aren't being saved by the plan because they could refinance anyway.
Who would someone approach to keep their interest rate from rising? The only place they can go is the "collection agency, aka loan servicers" that takes their mortgage payment. I wonder how motivated those folks will be when the phone starts ringing. Herein lies the beginning of some bureaucracy. For an entrepreneur, there has got to be a big potential to make money in this service industry. For con artists, there is a windfall coming up.
Who are the winners ????
That's easy. The lawyers. There will be many different types of lawsuits coming out of this plan. Also, those people who actually take advantage of the frozen interest rates may become a winner, but that has yet to be seen. The details of their renegotiated, frozen mortgage have yet to be seen.
What about the Banks and Financial Institutions ????
This is where some of the real story resides. The headlines state that the government got the banks to volunteer to take this action. What banks? Yes, there are some banks (like Bank of America) that make and hold their own mortgages - and those banks have the business authority to negotiate a change in the terms of their loans.
However, many, many, many sub-prime loans were purposely funded and bundled and sliced/diced and sold on as bonds by our glorious Wall St. financial institutions. Who owns those mortgages? Does the bond holder own the mortgage? Who can agree for the owner (whoever the owner is) that the terms of the notes/mortgages they own can be changed? That is a fundamental question that lawyers will ponder and litigate. Lawsuits have the potential of stopping this initiative.
What is the impact on the markets ????
Well, the stock market loves it --- so far.
The bond market hates it --- period and forever. You see, the bond market only loves certainty. The bond market started a meltdown of its own last Wednesday, and accelerated on Thursday and Friday. All caused by the Bush Plan. Here is how the bond market thinks. A bond - any and all bonds - have a face value, interest rate, and period of payment. These "terms" are known. They are constant. The value of the bond is easily calculated (using some complicated equations) and taking into account prevailing interest rates (think US Treasuries) and the rating of the bond (think risk associated with paying back the principle and interest). Yes, there is a market for all these bonds, and the prices fluctuate around this calculated value - but the bond market doesn't have the "irrational exuberance" (overvaluation or undervaluation) of the stock market. That is fundamentally why bonds are considered boring.
So, the government comes along and convinces someone (who????) that the "terms" of these sub-prime mortgage bundles can change without the approval of the true owners. That introduces a LOT of uncertainty into an otherwise certain bond market.
The bond market is made up of people - from ordinary people like you and me all the way up to Central Bankers. Would you like to make an investment in the bond market only to find out that someone decided to change the game? No, of course not. That "uncertainty" has spooked the bond market, and fewer people are currently willing to purchase bonds, and some bond owners are selling.
Let's look at a foreign Central Bank US Treasury purchaser. You definitely would be saying to yourself: "If the US Government can change the terms of sub-prime mortgage securities, they could change the terms of US Treasuries." And you know, she's right in thinking that terribly negative thought. Governments are sovereign and can do whatever they want.
It's too early to understand the impact on the currency markets. Why would there be any impact? Well, if there is a meltdown (think higher interest rates leading to a certain recession) in bonds, the dollar would initially get stronger. Higher interest rates traditionally attracts money. However, these higher interest rates would also come with some "uncertainty", so that should lessen the dollar's attractiveness, but it would still increase in value. If there is no meltdown (the probable scenario), but just a little higher long-term interest rates, there should not be much of an impact. In an extreme lack of faith in US Treasuries, Central Banks would dump their US Treasuries and the dollar would collapse (also an unlikely scenario). Aren't currency exchange rates interesting --- pun intended??
The commodities market would be driven more by fundamentals. If we're driven into a recession, commodity prices will fall (demand falling). If the dollar falls, non-US produced commodities like oil would increase in price to maintain their value.
What can you conclude from all this ????
The Bush Plan is a bureaucratic mess in the making. A few people will take advantage of it (if they can find someone to talk to about it).
A bunch of people will walk away from their loan because their home is worth less than the mortgage.
The financial industry is praying that the securitized asset market stabilizes. If that happens, the lousy investments they made using sub-prime mortgages would stop going down, and they could create a real balance sheet. That would have positive ramifications for the financial industry as a whole, and more confidence would translate into greater availability of money for loans. This would be the beginning of an upward spiral for that industry. Meltdown would transform into a phoenix rising from the ashes.
Ownership of the sub-prime mortgages in question has yet to be determined, and lawyers will get rich answering it.
A lot of foreclosures will continue to happen. People will walk from their loans. Many people are excluded from the Bush Plan, and will be unable to make their payments. If only 200,000 people take up the offer, that will not make a dent in the foreclosure wave that is coming. The housing market will continue to crash in selected areas, and values will continue to decrease. Buying foreclosures will be a great way to make money in about a year or so.
What happens after 5 years. Let's assume the old loan terms come back into effect. The payments will ratchet up, and the foreclosures will happen then. So, under those circumstances, the Bush Plan only delays the inevitable. And for only a small number of houses.
I'm predicting that the "uncertainty" in the bond market will go away as more of the unknowns are known. This could take another month or two to play out. In the meantime, interest rates could get pushed up, and that would make the US economic slowdown worse. The Fed will be pushed into dropping the Fed Funds rate next week as they are trying to avoid that slowdown. You see, if a plan could have been pulled off without the "uncertainty" introduced by this initiative, the Fed might have had a reason to NOT lower the Fed Funds rate --- as a real plan to solve the liquidity crisis was in place. As it is, they're stuck. (Remember that only fools make predictions. Caveat Emptor.)
The real market to get hit will be the mortgage market. It is now a given that the terms of a mortgage can be overturned by the government. Why would anyone make a loan? Well, they would to the right person for the right house. Loan conditions will be strengthened, and many currently qualified folks will lose out. I wouldn't be surprised to see ARMs disappear, but I don't believe that will happen. The conservative inside me says that tightening up on loan qualifications is a good thing. After all, look what happened when anyone or their dog could get a mortgage --- assuming the dog has a social security number. Not as many people will "own their own home" - and the American dream will be slightly smaller.
Maybe in the end, all of this is a good thing. Only time will tell.
My last conclusion is that the Bush Plan will create a mess; could have the positive side benefit of better lending practices; and is dangerous because it introduced "uncertainty" in the securities market. This is like opening Pandora's Box - you really can't predict the true end result. Let's hope it's all a lot of hot air to the majority of Americans.
Now you can watch this news story on TV or in the newspapers, and have an inside understanding behind the various machinations as they occur.
Tom Harvey is the Economy Guy at http://economyguy.com A retired aerospace executive who now resides in Arizona and Hawaii, Tom's passion is educating people on what the TRUTH is behind all of the big media financial news most of us read or watch. His hobbies are commercial real estate and bond market investing. He is also a 3 time alumni of the Maui Mastermind conference.
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