I've long been a gadfly to those who think that cheap money, Quantitative Easing, and all the other Voodoo Economic Spells by the Fed Magicians are the solution to America's financial woes. It just does not make sense to me that anyone could possibly think that devaluing a currency can have positive future effects. Hence I was taken a bit by surprise by a recent article in the financial section of the Beacon Journal which not only shared my concern about the direct valueless money was taking us, but also put forward a clear warning of a possible side effect that had escaped my attention : the future impact on the secondary mortgage market. In Scott Burns' blog post of 9/8/2012 Building the Next Financial Crisis, One Loan at a Time he concludes,"What’s worrisome here is what’s going to happen to the market value of all these mortgages when, and if, interest rates return to more normal levels. When that happens, the institution holding the mortgage will be holding a loan whose market value is far lower than it’s face value. Suppose, for instance, mortgage rates rise to 5 percent over the next 5 years. At that point a 3.5 percent 30-year mortgage that is new today will have a term of 25 years and an outstanding balance of $179,768 but its market value will be $153,627.As mentioned, THAT was something that had not occurred to me. What is unsaid is that the disaster is unescapable. The Fed's low rate policy cannot be maintained forever. Even without any substantial economic recovery inflation has begun to attack the daily budgets of American households and businesses. The day will come when rates will have to be allowed to rise in order to attract government bond buyers.
That’s a loss of 14.5 percent, a loss that would wipe out the equity of most lenders. If mortgage rates rise to 6 percent over the next 5 years, the market value of the mortgage will be $139,390. That would be a loss in market value of 22.5 percent.
The same holds true for shorter-term loans such as the 1.99 percent auto loans that are becoming common . Were interest rates to rise quickly to 5 percent, every $1,000 of new 1.99 percent five-year car loan would sink in market value to $928. That’s a loss in market value of about 7 percent, enough to threaten the solvency of the lender.
Note that we’re not talking financial Armageddon and runaway inflation here. We’re just talking about a return to interest rates that are on the low side of what we’ve seen over the last 50 or 60 years. Indeed, for some readers this will be a case of “deja vu all over again”— rising mortgage rates would be a replay of what was experienced in the 1970s, an event that culminated in the thrift crisis, destroyed the thrift industry and produced a financial crisis that paralyzed the real estate industry for years.
Can we find a silver lining somewhere in this dark cloud? You bet. First, let’s not fret about our financial institutions; they already own Congress and can take care of themselves. The silver lining is for younger families: higher future interest rates amount to a major wealth transfer. Lenders will lose, borrowers will gain. Younger households may be able to recoup some of their losses from the last decade as home prices rise and the true value of mortgages declines."[Red italics are mine.]
On that day the collapse of the secondary mortgage market will regain front and center position. Woe on that day to the investor who has a portfolio heavy in financial stocks. Why do I not share Burns' optimism about the banks escaping again? Congress has heretofore shown no will to reign in the Fed, but in the face of a second banking collapse, it will not provide easy bailouts to that sector as it did in 2008. The mortgage derivative market is a house of cards built from worthless Federal reserve paper, and there is a hurricane brewing in the Sea of Inflation.