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Jan
03

Housing Surprises and The Bay of Pigs

Financial elites who advise politicians on housing often suggest that “housing problems” are “local.” That is, until they aren’t.  Like generals, these experts tend to fight the last crisis.  Today we have a government overly focused on regulations around mortgage lending operations, while the next potential banking collapse foments in revolutionary ways.

Iowa’s housing problems are less noticeable than those of the Southwest or Florida.  This is allowing Republican presidential candidates to avoid a head-on confrontation with existing and evolving housing issues.

The perversity of financial solutions in this area is that too much “good” credit can be a bad thing.  This kind of insurgency starts – counter intuitively – when interest rates are “artificially” too low.

When interest rates are low, bankers use leverage to create income.  They practice safe leverage (in theory) by lending to governments.  As we’ve seen in Europe, this works, until it doesn’t … and then the Castro’s come out of the woodwork.

American institutions now see this risk and tend to avoid lending to European banks.  However, all that American “risk avoiding” money must go somewhere.  As a politician, you might be encouraged to think keeping it in the United States would be a good thing.  It can be, if there is a private sector to manage the credit risk associated with such capital investments.  However, to make that happen rates must be higher than they currently are.

Since 2008, the FHA and GSE’s have dominated the “refinancing” of America’s best housing credits at historically low rates in an attempt to support housing and the economy.  Because these assets are liquid and are viewed as having little credit risk, banks are required to hold only nominal capital against these investments.  Through the magic of leverage, banks make billions and some consumers save a lot on their mortgage payments.  However our insurgency problem in this election involves “jobs.”  The answer to fixing housing or jobs isn’t another regulation, it isn’t more cheap money, it is market driven risk-adjusted profitable opportunity.

At present, no entrepreneurial firm in the world can compete with any US government enterprise or bank which can lose money in revolutionary ways – and remain in business.

Said another way, what banker will join a “revolution” if members of the government will pay him for simply financing their re-elected?

The system needs “democratic” not “government” reforming.

Our case in point, the Federal Reserve Banking system, hoping to stimulate job-creating lending has been buying government guaranteed debt from banks and pushing cash onto their balance sheets, but this only reinforces the risk-free lending concept.  Like overheated investment sessions of the recent past, banks only repeat the process of buying still more government guaranteed debt, driving prices higher and yields lower.

Now, as Edward Pinto points out in Bloomberg,[1] all of this government guaranteed  credit is sitting on the books of government guaranteed depository institutions where it is exposed to huge financing risk.  Is revolution in the air?

Perhaps.

Imagine a post-election environment where Congress collaborates no better than European sovereigns in the eyes of the world’s debt markets.  Bang – rates rise, driving government debt financing costs to the point that all social welfare programs must be cut or shut down.

At that point, the entrepreneurs are forced to become the lenders of last resort.

If, as in revolutions, the unexpected happens and mortgage financing costs were to double, we could find ourselves with housing assets worth $7 trillion less than the market peak 5 years ago and an insolvent banking system for the second time in less than a decade.

At that point the next President will probably enjoy his housing surprise the way John Kennedy enjoyed the Bay of Pigs.

More to come.

Permanent link to this article: http://www.patient-capital.net/2012/01/03/housing-surprises-and-the-bay-of-pigs/

1 comment

  1. bhc says:

    Bill Gross warns of “fat tail” unexpected market behavior in 2012. “Too much paper – note enough trust” http://www.reuters.com/article/2012/01/04/us-gross-market-outlook-idUSTRE80315F20120104

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