Tuesday, August 17, 2010

Back Door Deficit Spending

The best kind of deficit spending, if you're the spender, is the kind other people (like taxpayers) don't see. Even though deficit reduction is now the political flavor of the month, acolytes of John Maynard Keynes still work their agendas quietly.

With mortgage rates now running 4.5% and even lower, courtesy of the Fed's 24/7 money printing presses, proposals are being floated to consciously spur mortgage refinancings--not to increase homeownership levels, but to put more cash in the hands of existing homeowners to spend. This would add who knows how many billions of consumption to the economy. Of course, it would entail a relaxation of lending standards. One proposal is to allow homeowners with mortgages guaranteed by Fannie Mae or Freddie Mac who are current on their payments reduce their rates to 4% and borrow up to the appraised value of their homes, regardless of the value of their homes or their current financial circumstances. (Presumably, only those who aren't underwater could increase the principal amount of their loans, but those that are underwater but current could get a lower rate.) There is a name for this loan: the no doc loan. We had problems with it during the financial crisis, and some of those problems still burden us today.

Despite repeated denials by the Federal Reserve, the Treasury Department, the President's economic advisers, and other notable officials, scholars and experts, there still isn't such a thing as a free lunch. If mortgage refi standards are relaxed to spur consumption, investors currently holding the mortgages that would be refinanced would be losers. Early prepayments would cost them money because the refinanced mortgages available to investors would pay a lower rate. Overall interest rates have been falling as well, so investors wouldn't have attractive alternatives. They'd simply end up with less yield. Refinanced homeowners would have more to spend, but mortgage investors would have less to spend.

Other losers would be--guess, and you have only one chance, but you'll get it right because there's no possible answer other than--taxpayers. That would be you and me. We're already on the hook (line and sinker) for Fannie and Freddie because they've been nationalized. Nationalizing them has already cost us over $300 billion. That's more than the economies of most countries. Relaxing underwriting standards means a higher risk of loss--a lesson from the 2008 financial crisis that some seem to have forgotten. Early onset Alzheimer's must be prevalent in economic policy circles. Throw a lot of cheap refi money at people who aren't demonstrably able to repay it, and guess what? Some of it won't be repaid.

Because Fannie and Freddie remain "private" corporations in a technical sense (you can still trade their stock if you're in a mood to speculate), their balance sheets are not incorporated into the federal government's financial statements. Indeed, Fannie was privatized back in the 1960s because Lyndon Johnson wanted to indulge in massive (for the times) deficit spending in order to advance his Great Society program while fighting a major war in Southeast Asia. Keeping Fan on the federal balance sheet would have been a political roadside bomb. So Johnson did the expedient thing (imagine that, an expedient politician) and turned Fannie over to private investors. Everyone pretended not to notice the market assumption that the government implicitly backed Fannie, and we were launched on the trajectory that led to the 2007 mortgage and credit crisis.

So using Fan and Fred as refi vehicles to stimulate consumption is likely to add to their liabilities, and in turn to the federal government's liabilities. Not all deficit spending is necessarily bad, even now. But it should be done out in the open, where all can see it and discuss its advantages and disadvantages. As long as Fan and Fred's liabilities aren't incorporated into the federal balance sheet, it's hard to notice a refi giveaway driven increase in deficit spending. For those of the Keynesian persuasion, it's an elegant solution (as academics would put it). Look for mortgage bankers, who have the most to gain from this proposal, to quietly lobby for it. And keep your hand on your wallet. There's always somebody ready to take your money and those somebodies are on the prowl.

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