By Jim Boswell, author of Crush Depth Alert
During the 15-year period between 1992 and 2007 American homeowners increased the total amount of their housing debt from $2.8 trillion to $10.2 trillion, almost a three-fold increase of $7.4 trillion! This increase in housing debt was greater than the increase of the better known National Debt, which went from $4.1 trillion to $9 trillion during the same time period.
The chart on the next page shows a 12-month running average plot of Freddie Mac single family fixed rate mortgages against the 12-month running average of the CPI between 1972 and 2008 (nearly the full period of time mortgage-backed securities had been issued prior to the recent financial crisis).
During the first quartile (1972-1981) shown above, the monthly average difference between the 30-year fixed rate mortgage and the CPI was 1.25%; during the second quartile (1982-1991) the average difference was 7.54%; between the third quartile (1992-2001) the average difference was 5.11%; and for the last quartile (2002-2008) the average monthly difference has been 3.54%.
Who was responsible for setting and controlling mortgage rates during this entire period? Of course, you would think that the Federal Reserve might have had something to say about it. But no, the Federal Reserve conceded its authority to the politically savvy and self-serving executives heading the Government Sponsored Enterprises called Fannie Mae and Freddie Mac, who through their oligopoly-like power and underwriting systems established mortgage rate policy for the United States instead!
Interest rate theory assumes that the Nominal Interest Rate is equal to the Real Interest Rate plus Expected Inflation. Using 18 years of data between short-term U.S. Treasury bills and actual inflation, Eugene Fama somewhat confirmed this theory by showing that the average Real Interest Rate return on supposedly "risk-free" Treasury notes was 0.2% above inflation for the period between 1953 and 1971.
Although the time period for Fama's analysis may seem ancient history; his findings are still relevant. Essentially, "risk-free" interest rate theory says that interest rates for notes or bonds that are guaranteed by the US Treasury (thus supposedly risk-free) need only be set high enough to cover the general cost of inflation in the U.S. with an additional fudge factor for the potential error in one's estimate of future inflation, which when based upon averages is assumed to be somewhat nominal itself.
And that leads us to a very important question. What is a mortgaged-backed security that carries with it the full faith and credit guarantee of the United States of America behind it, if it is not a "risk-free" U.S. note -- implied or otherwise?
The table above provides a 60-year history of inflation in the United States as represented by the Consumer Price Index. Note than in all but two of the 10-year periods in the top part of the Exhibit (including most of the period of Fama's study) that inflation averaged near or below 3% in the United States. Note also from the bottom part of the Exhibit that for the last 27 years (from 1983-2010) inflation as represented by the CPI has averaged 2.99%.
Based upon the previous exhibits and "risk-free rate" theory, it is long past time that we establish a Federal policy to refinance and guarantee "existing" U.S. homeowner debt for "risk-free borrowers" to 4%! Considering that half the world's population lives on less than $2.50 a day (World Bank statistics), there are ample opportunities to further globalization and contain "long-term" inflation within the United States at or below 3.0% for a long time moving forward.
Who are these risk-free U.S. borrowers? They are the same people (or heroes) that helped us divert what could have become a Second Great Depression into a manageable recession instead. They own at least 80% of the current $10.9 trillion in mortgage debt and are the people who continued to make their regular monthly principal and interest payments all through the recent crisis despite the fact that their own financial condition was constantly deteriorating. It is time to reward them.
One last refinancing cycle to 4% for 80% of our mortgage debt would: (1) add $100 billion in annual stimulation to our economy without government spending and without taxes; (2) increase homeowner equity to the tune of $1.6 trillion; and (3) actually lead to a reduction of U.S. Mortgage Debt and U.S. National Debt!
Who would buy this debt at 4%? The same people that currently own that debt, which includes the Federal Government, pension funds, foreign concerns, insurance companies, and any other institution that wants to hedge their bets and feel safe about having their money keep up with inflation.
Who should run the program? After abolishing the GSEs and creating a much smaller and financially conservative federal entity that includes the remains of the GSEs, and the Ginnie Mae, FHA, and the VA mortgage programs, the Federal Government should run the program.
Can the government be trusted to run such a program? Yes, and a lot better than the GSEs, who were nothing but "private entities" cloaked in public sector cloth. The only fundamental requirements would be to put a responsible financial leader (and not some political hack) in charge of the new entity and provide him or her with a new state of the art underwriting system with conservative controls.
There are two things we should learn out of this most recent financial crisis. One, the U.S. economy is too important to leave a very important and influencing sector of our economy in the control of Fannie Mae and Freddie Mac (or the leaders of our big banks). Two, it is better to control inflationary spikes with short term rates than long term rates.
Jim Boswell (MBA, MPA, BA) directed the analytical risk monitoring activities of Ginnie Mae's $500 billion portfolio of mortgage-backed securities for 12 years (1988-2000), including the period of the S&L crisis. His recent book, Crush Depth Alert, published by Fourth Lloyd Productions, explains in detail with supporting exhibits, graphs, and tables the factors that led up to the financial crisis while offering solutions on how to move forward.