Tuesday, February 24, 2009

4% Mandatory Mortgage Rates and 40 Year Terms. Why They Won’t Work.

This post cold easily be title “just how screwed we are.” But know that I have a suggestion that would get us out of this mess. It will have to come in a later posts, but if I can figure it out, the people on the hill are much smarter then me will. Right?

One of my favorite and most quoted cliché’s is, "common sense is often common, but rarely makes sense." This is true when listening to people make wild thoughtless suggestions on how to fix the economy. The phrases that send off my B.S. detectors are things like, "It's economics 101" or "it's about supply and demand" or "you are over complicating". First there are very few "or's" in economics and accounting. Capital generally follows the laws of conservation. For every action there is an equal and opposite reaction.

Two prevailing suggestions I have seen posted in the last week or so to "help the ailing housing market" and help out home owners are about the same. One is to lower everybody who needs it to 4% mortgage rate. The second one is to extend the mortgage out to 40 years? Neither of these things make economical sense, and/ or follows the free capital everybody is treated equally spirit of the country.

First let us address the 4% suggestion that has been going around. It basically says tell "the banks" they can only charge 4%. We will get to who "the banks" actually are at the end of the post. Let us say you got your loan and you agreed to a 7% interest rate, right? (Numbers don’t matter here really. All things are relative.) Your $100,000 loan was worth about $240,000 when the loan goes to fruition. The mortgage broker immediately sells that loan to Fannie or Freddie for about $140,000 leaving the new lender to make $100,000 profit over 30 years. (You probably didn't even send one check to your mortgage broker) Essentially Fan or Fred just paid 28.5% plus administrative cost for the loan. We could call it 3%. Quick basic math tells us the 7%-3% is only 4%. As any lender knows not everybody pays you back, and in the real-estate game for the big banks, I would think that 1% of the money lost to default would be a low norm. With today’s market that has even gotten worse. But even at just 1%. The banks are now down to needing to make 5% interest on those loans just to break even (3% they paid plus covering losses and administrative costs.) Telling them to only charge 4% is the same as telling them to close their doors. (That is a big problem we will get to later.) Also, the first 5 to 10 years of a mortgage is all interest. The amount you owe on that house is not changed much. The value on the other hand, well that has.

This is a good time to move to the problems with the extension of the loan solution that is equally bad. First we know that time equals money. As mentioned before the giant lender banks are in the business of selling time. They make you pay for their part of the investment up front. Fannie and Freddie sit on the loan for 30 years and count on collecting “X” amount every year. They count on that return to in turn buy more loans and make more investments. If you extend the loan, at the end of 30 years instead of the projected capital of $240,000 to use to offer more loans, they now only have $220,000. Would you take that deal? "Well, I know you were panning on retiring when you were 65, but now you will have to wait till you are 75. Hey, we will throw in an extra 10 grand for your trouble."

There are other questions too. Do contracts have to be redrawn up? They can’t just send you a letter saying, “oh we just extended your home loan, from here on out just send us the smaller house payment.” If you let them renegotiate and scrap the contract, there is no way you would buy the house at the price you paid for it 5 years ago, and there is no way they would lend you the money to do so. It does nobody any good to “invest” in a house that is priced 30% below market value. The second you open the contract you would have the legal equivalent to a “Mexican Stand-off”. Not to mention the operating cost and the original amount they paid for the loan ate into their profits from before. This causes other problem equally dysfunctional to the system. The reductions in income would ultimately cause the banks to stall and go belly up. What would you say to somebody who owes you $1000 and says they can pay you $20 a month for 50 months? Exactly. What if you counted on that 1000 bucks to pay your own bills.

One last point on the loan extension solution. A $100,000 loan at 7% is $665 a month without taxes and insurance costs that the bank has no control over. Extending that to 40 years only lowers the payment to $621. Is $44 a month going to save the average home owner? Who is to say that fuel prices and tax increases won’t eat that new savings?

Well I also promised to enlighten the reader on “who the banks really are.” I have on occasions heard people say, “So what, let the banks go bankrupt.” I too have been guilty of this naivety myself when this all first hit. Believe it or not, my background is in system design, not economics. I didn’t realize how the whole thing worked. So it took awhile to identify the trouble being cause by banks. So I did some research, some asking, and lots of listening. Then I added 2+2. You can say, “We don’t want to nationalize banks” all you want, but in the end, the US mint is “the bank”. Ask yourself this question. (It is the one that was the epiphany for me.) How does the US mint get money into the system? Well let me tell you. They don’t load up a plane, fly it over a trouble spot like Cleveland, and just open the hatch. I am betting many of you have heard terms like “Prime Interest Rate”, “Federal reserve board”, “Fed Chairman”, and even had “Prime” described to you are “the interest rate at which banks loan each other money”. Now why would banks with their highly educated CEOs worth billions of dollars themselves in a perfectly good free capital system need a government body to tell them what the market price should be for their loans? Because the reality is that “Prime” isn’t the price banks charge each other. It is a good “suggested retail price”. No “the Prime Rate” is the rate at which the US mint lends money to the big “time sitters”. Where do you think these banks got their trillions of dollars to pay for the mortgage that the pizza delivery boy turned mortgage broker got you into and then sold to one of the “big banks”? Right Fannie and Freddie got that money from the US mint. So what happens if somebody owes you money then goes bankrupt? Right again, they pay you only a fraction, if any at all, of the money they owed you. So what happens if Fanny, Freddie, US bank, go belly up. They pay the government only a “fraction, if any” of the money they owed the US mint. (remember how secure t-bonds were as a kid?) Real quick, in the US who runs the US mint? Right, the government. So who is “the government”? Oh yeah, they are “by the people, for the people.” So when these banks don’t pay back their debts, who are they not paying them to? “We the people.”

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