Bernanke Bites the Bullet

***This is long, I originally wrote it for 9-21-07, but discovered that I had UNDERestimated some of the figures and have just now gotten it fixed for human consumption. In hindsight, I may have been too optimistic, considering the $100 BILLION slush fund that CitiBank, JP Morgan, and Bank of America are putting together to buy up bad loans...***

BBB may not stand for Better Business, Buster as much as Bungling Boogers in the the Boardroom.

The U.S. American consumer is getting the closest haircut in quite a while. What generally goes unsaid is that the Federal Reserve System is a private banking group which exists for the benefit of its member banks. The Fed regulates borrowing between banks, and in doing so, adjusts the availability of credit for commerce throughout the country.

Ben Bernancke's recent move to lower the discount rate is going to have some serious repercussions for the consumer. A major market for bonds has been foreign investment, and American buying habits have created a huge imbalance in the flow of dollars. Foreign governments now hold a significant share of our currency, and they have been watching our credit market woes.

The lenders (read investors in mortgage securities, with heavy emphasis on banks as the primary conduits for lending) are beginning to have trouble with their cash flow. In order to keep the economy running strongly in the aftermath of 9/11, the Fed reduced the discount rate to its member banks and they in turn were able to loan money at lower than what should have been market rates. To cover their potential future earnings, the lenders strongly emphasized adjustable rate mortgages, and in the race to compete with one another, added incentives to borrowing such as interest-only balloon loans with 5-7 year terms and adjustables with teaser interest rates that were far below market. In those crazy days it was not unusual to see a lender that could, itself, borrow at 5%, turning around and loaning the money at 2%.

While this may leave the ordinary person scratching his head over what appears like a losing scenario, the lenders had a plan. They were counting on the rates to increase in the future; the adjustables were set to begin increasing at 1%-2% increments per year after the 12-24 month teaser period ended, and the adjustments would follow the market rates current at the time of adjustment. To be sure, there were caps on the rates, but let us take a look at what is and will be happening.

Let's create a fictitious homeowner, Danny Dumkopf. (No offense to anyone named Danny, I just like the alliteration.) Danny has a house in Anytown, which he bought in June 1990 for $100,000. He put 20% down, and borrowed $80,000 at 10% for 30 years (which was an acceptable interest rate back then since we were just recovering from the Savings and Loan bailout.) His monthly payment was $702 and a few cents. In June 2005 Danny was feeling like buying a new car and taking a vacation and doing some remodeling around the house. He was offered a chance to refinance his home with a 30 year adjustable rate mortgage at 2% introductory rate with a 6% cap and 2% increments; the adjustments would begin in 24 months. He understood that the maximum interest rate he could possibly pay was 8% by 2009. That seemed like a good idea in 2005, when he was still thinking about the 10% rate he had gotten in 1990.

He had already been paying for 15 years, and he had significant equity -- but he still owed about $65,000 and had 15 years to go at $702/month. The new car would cost $25,000, the vacation $10,000, and the new kitchen and bath and carpet and windows and siding would cost another $60,000. Average sales prices were up, there was data to indicate the house was worth way more than the $100,000 he had paid for it, (the refinance appraisal said the house was worth $206,000, which was what was needed by the lender to make the loan) and Danny was approved for a $165,000 refinance, including the closing costs. His monthly payment would drop to about $610, a savings of almost $100/month!! No-brainer, dude!!

It is now June 2007. His mortgage is about to reset. Rates are hovering at about 5.5%; Danny's rate will increase by 2%, to 4% for the next year. In two years' time he has paid back about $8,200 of the loan and his principle is now $156,800. His monthly payment will go to $776 for July 2007. Ooops. He goes back to the bank to refinance, at 30 years again and a 5.5% rate, and the appraisal on his house comes back at $200,000 (the market is down, but even this appraisal was tailored to "hit the number"). And he finds that his monthly payment would jump to $890, which he cannot afford. He sticks with the $776/month payment, in the hope that the market will come back up and rates will go down.

The Fed knows we are now in trouble, and will attempt to manipulate the rates. However, they can only do so much, because such huge chunks of our currency are in foreign hands. The foreigners are already shying away from our bond markets because they are worried about the stability of our currency. Ultimately, either our interest rates must rise, or inflation must increase. Rates will have to gradually rise, and an 8%-10% discount rate is more than reasonable. In fact, it is what the lenders were counting on in the first place when they loaned that money at the teaser rates.

Back to Danny. It is June 2008. He has another reset to face, and still owes $153,700. The Fed has held the line on the rates as best it can, but they are still at about 6.5% and Danny's rate will reset to 6%, or a payment of $959/month.

Some other things to consider. Danny bought the house in 1990. He put $20,000 down. It is very likely that a buyer of a $100,000 home at that time, who had $20,000 cash to put down, was probably in his early to mid-30's. Let's say Danny was 35 then. He is 62 today. He may even be retired already. His pension or Social Security could handle the $610 per month payment, and maybe that is what he was looking at when he made his stupid move. However, it may not be able to cover a $959 per month payment. He will have to sell his house.

That could be a problem. While mean and median sales prices have certainly increased since 1990, those figures have been skewed upward by new constructions and resales of the newer homes. In terms of actual appreciation, there are very few places in the country where existing homes have appreciated by more than 25%-40% over the last 25 years. Danny's home may actually have a market value far less than what the refinance appraisal said, even if that was supposed to be market value at the time.

If the market is still soft (and the projection is, that with so many people in the same boat as Danny, it will be) the sale plus closing costs may allow him to break even, at which case he is without a home on his retirement income, or worse, still owing money on his refinance. His other option is to walk away from the home and let the lender foreclose. There will be many Dannys who do that, and the foreclosures will add to the depression of the market. If you do not like the word depression, I advise you to learn it and get used to it.

Back to the foreigners. They are the investors who bought so heavily into our mortgage securities and government bonds. The mortgage securities are now causing havoc in the credit market, and credit is tight because investors are hard to find (they don't want to increase their risk, and the mounting foreclosures are telling them the risk is real.) Mr. Bernancke is trying to keep the funds flowing and bail out his member banks, and to do that, he has lowered the discount rate so they can borrow from the government more cheaply. This causes inflation to increase; the government basically has to print more money to feed the banks, and the foreigners, seeing the devaluation of the dollar, are now shying away from U. S. government bonds and securities and selling their U. S. dollars to buy Euros and gold, which they think are now more stable. The Loonie is now at parity with the USBuck, and a 2x4 which formerly cost $2CDN and thus perhaps $1.80US will now cost $2US; the price of new construction, remodeling, and repair is about to go through the roof.

I hope Danny enjoyed his car and his vacation.