Mortgage News

Yesterday's announcement by Hank Paulson, US Secretary of the Treasury that they were planning to use covered bonds as their preferred method for solving the mortgage mess is really nothing more or less than relying on an old fashioned game of "chicken" to save the Federal Reserve system.

Covered bonds are virtually unheard of here in the United States, although they are used extensively in Europe. There are two factors which distinguish them from other mortgage-backed bonds. First, the issuing bank has to guarantee that it will pay back the bond if the mortgages lose some or all of their collateral value. Second, the bonds have stricter limits on the loan-to-value ratio of the mortgages used in them than other mortgage-backed bonds and are not used to fund higher risk borrowers.

That's the fly in the ointment. The entire current financial mess was caused by lending to higher risk borrowers over the years. The lending was mandated by Congress through a variety of legislation over the yaers and funded by the Federal Reserve System. Lenders are now unwilling to make higher risk loans (for good reason). This isn't just about so-called "subprime" borrowers. As I drew to your attention three days ago, roughly $5 trillion of U.S. home loans (roughly half of the entire market) are either of the subprime variety or are rated Alt-A, a classification of mortgages where the risk profile falls between prime and subprime.

Effectively, Paulson is saying that half the mortgage market won't be covered by this bailout. Most people don't realize this is what he's saying, because he's counting on the usual governmental smoke-and-mirrors act to distract people from this crucial fact. It amounts to sweeping the evidence of the crime under the rug and hoping that no one will notice.

When half the entire family trash is under a rug, it's pretty hard to ignore the huge lump in the middle of the floor, yet that's precisely what Paulson is hoping everyone will ignore.

On the other hand, he could "expand" the definition of a covered loan to include Alt-A grade mortgages, but if he does that he effectively undermines the ability of the banks to guarantee those mortgages. I'm guessing that's what he's going to try to do, and he's hoping that bond buyers won't notice that the banks don't have the resources to cover those loans themselves. If the banks had those resources, there'd be no crisis in the first place! Will bond buyers be that stupid? Maybe. They've bought a lot more stupid ideas in the past (such as Fannie Mae and Freddie Mac), so there's no reason to believe they'll stop now.

None of this does anything to prevent the ultimate scenario where the Fed accelerates the creation of money out of thin air through more "stimuluses" which will certainly increase our inflationary suffering as a nation. Hyperinflation is getting closer and closer.

If the banks start to fail because of all this, you can be sure that the government will blame them and will continue to behave as if they are our "saviors." In fact, they have been our architects of ruin all along. Nothing less than the survival of the dollar as a fiat currency is at stake here. Of course, that might not be a bad thing in the long run if it leads to a specie-backed system of currency as a replacement, but in the meantime the ride is going to be pretty bad, particularly for those who live at less than the median income levels in our society and for those who bought those houses at inflated values in the first place.