Will Trump Get Out Of His Own Way If Another Mortgage Crisis Is Coming?

Senior Contributor
03.21.17 5 Comments

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It isn’t always adulation or disgust that keeps people tuning in to the latest goings on with the Trump administration. A lot of people just want to know how Washington’s daily power struggle is going to impact their job and their home. And that shouldn’t come as a surprise. While it’s natural to wonder, there’s maybe a little more incentive to worry considering all Americans have endured over the last decade.

In the crisis that began in 2007, thousands of families lost their homes, millions of Americans lost their jobs, and effects rippled across the world. But while we are, in many ways, still recovering, bad times may not be squarely in the rearview mirror. A former member of the Federal Reserve who struggled with the first crisis thinks it’s about to happen again: from houses going underwater to growth slamming to a halt and tax dollars being sucked into a suddenly gaping hole. And this time, it might be worse.

William Poole, to be fair, has been pointedly critical of government-sponsored enterprises like Fannie Mae and Freddie Mac for years. So his February 14 CNN op-ed approaches this from that perspective. Still, Poole has some points that government officials (and concerned Americans) should take notice of.

Then

To understand why Poole is worried, you need to understand what happened in 2008. Basically, it was a cascading set of dominoes. In the wake of the dot-com crash in the early ’00s, the Federal Reserve set the federal funds rate, essentially the price banks pay to borrow money from each other, to more or less nothing. That made banks eager to lend because, hey, free money! It particularly made popular the “adjustable rate mortgage,” which more or less tied the interest rate of a mortgage to the federal funds rate via Treasury bond yields. But there was a honeymoon period where your rate was guaranteed not to go up.

At about the same time, mortgage-backed securities (which carved mortgages into slices to spread the risk around) became popular on Wall Street. This drove up the demand for mortgages even more, since it reduced the risk for everyone involved except the little guy who actually had to pay the mortgage. In turn that drove up the value of homes, because anybody could get a mortgage, so why not squeeze the bank for everything it’s worth?

Jump to 2007. The market is awash in mortgages that hinge on the federal funds rate, $600 billion worth, in fact, and between 2004 and 2006, the Fed has been steadily increasing the interest rate, thus driving up the interest on all those mortgages. The honeymoon period ends and suddenly those mortgages skyrocket in price. People began defaulting in large numbers, which turned the securities their mortgages were based on into toilet paper. Those who didn’t default stopped buying things, which created an economic plague that affected millions.

And Now

So why are we about to see a repeat? Because, essentially, the only difference between 2007 and 2017 is that it’s the government on the hook for the cash, not Wall Street. Fannie Mae and Freddie Mac have just redefined a subprime loan as one issued to a person with a 620 credit score instead of a 660 score. To which Poole wrote:

[Fannie Mae and Freddie Mac] are wrapping new sub-subprime mortgages into the mortgage-backed securities they sell to the market. Fannie and Freddie guarantee these securities, and because the federal government stands behind the GSEs, there is little market discipline. Think about that: With regard to subprime mortgages we may now be in worse shape than we were before the crisis.

In other words, aside from the fact that this time Wall Street isn’t on the hook, we’re right back where we started. A whole bunch of mortgages might be on the verge of going sour, and they may push over this whole chain of dominoes again. Not helping matters is that the Fed, today, raised the funds rates for the second time in three months.

Adding to the problem is that the Fed holds a lot of bonds — both government issued and from Fannie and Freddie. It has to sell those bonds at some point to keep control of inflation, but if Fannie and Freddie are headed back into the toilet, it’ll struggle to do its job. Who wants the bonds of a company in the middle of yet another mortgage crisis?

That would make this prospective financial crisis worse for us, because not only would fewer people be buying products and services (which would hit companies and their bottom line), but it would also raise the risk of inflation, meaning the dollars that we earn wouldn’t go as far. Ironically, that would hit one-percenters like Trump far harder than your average man on the street. After all, having a giant pile of cash doesn’t mean much when you need a giant pile of cash just to fill the tank and put groceries on the table.

So, we know the history and we know the risk. Surely there’s some way of avoiding this same result, right? In this climate, it’s hard to say. Donald Trump has made it clear that he’s skeptical of the kind of financial regulation that might stop this before it happens. He’s even signed an executive order that asks the Treasury to examine whether laws like Dodd-Frank (the regulations passed to prevent another crisis) follow the “core principles” of his campaign, and delayed implementation of a rule that would require financial advisers to act solely in the best interests of their clients.

Similarly, Trump’s at least made gestures that he’d like to cut government spending (except when it comes to the military), and his campaign came out strong against the past bailout (even though he had some nice things to say at the time). So it’s not clear how Trump would handle the discovery that he’s suddenly responsible for potentially billions of dollars in IOUs and, quite possibly, a bailout with innumerable ties to the past business dealings of a lot of the folks who are in his cabinet and advising him.

Hopefully, this is much ado about nothing, but the bottom line is the elements are moving into place and because of that, risk is becoming more prevalent. Can the current administration move past cronyism and stubbornness to tamp it down? We’re all watching to find out.

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