One of the fundamental principles in market economy is the risk-reward tradeoff – investors are free to take greater risks and win big or lose their shirts if the big payoff doesn’t happen. Today that axiom has been thrown to the wind in the U.S. mortgage markets with the nationalization er, I mean “conservatorship” of the nation’s largest mortgage backing institutions, placing effectively 6 billion of the nation’s 12 billion total real estate-backed holdings either in direct or indirect government holding.
Here’s a good discussion form CNBC which sums up the situation nicely:
You might be wondering why a blogger about startups, cleantech, and China is writing about the socialization of the mortgage market. The reason is this move will affect not only the value of the dollar (and hence the valuation of startup businesses to would be foreign investors), but also will contract the amount of credit available to new business owners.
As it stands, the current administration and White House have decided that bailing out homeowners assuming irresponsible levels of debt is unwise. I mostly concur, but I’m flummoxed that the congress and president don’t hold the inverse to be true. This nationalization move will bail out lenders assuming irresponsible levels of lending. The sham cover story to the American people will be something to the effect of “stabilizing Fannie Mae and Freddie Mac will cost taxpayers less because it will dampen the damage to our economy”. Rubbish, I say; the move will achieve the exact opposite effect. To see why, simply follow the process through to its conclusion. Nationalization of Freddie and Fannie will have to be followed specifically by a write off and pairing down of all outstanding debt held by both organizations (we wouldn’t want taxpayers to assume even higher risk). So we’ll rehabilitate the mortgage giants by shrinking the total amount of mortgages outstanding. That in turn will drop the valuations of current homeowners, who will be hard pressed to sell without deep discounting when the easy mortgage money is gone. That’s why commentators are calling this socialism for the rich: the only net effect of this is a direct transfer of funds to Fannie and Freddie supported by borrowing by the taxpayer.
I have a funny feeling I know where the borrowing will come from, at least in part. I suspect the Federal Reserve print out dollars as fast as possible to pump liquidity into an already over-stimulated credit market. Those dollars will eventually have to deflate in value accordingly, and houses will become even more expensive relative to the dollar. When houses sit on the market unsold, the discounting begins. And voila, we have both a devalued dollar and a devalued housing market – we’ll go from a sub-prime mortgage system to a sub-prime financial system.
We created this problem by pumping too much easy money into our economy to hold up an unsustainable growth rate, but markets of course correct themselves in time (this isn’t a downturn as much as it is a return to where we should have been). Unfortunately the current congress and president seem content to patch up the situation and pass the stink bomb to the next congress and president. We’re headed for a mortgage market contraction either way – the only difference here is that taxpayers assume the cost of investment risk, instead of the investors by bailing out Fannie and Freddie. All of this makes investment in start ups and innovators less attractive (and more expensive for entrepreneurs) if real estate is now a zero-risk proposition, and angel investors burned on asset holdings pull back.
Well, It’s a good thing Web 2.0 economics provides a pretty quick path to ramen profitability.
Update: Quint Cobb has a good play-by-play primer on the secondary mortgage market and why the cost of mortgages is about to go up for everyone, as well as some good investment principles to follow in the wake of everything that’s happening now.