California v. Countrywide

Let the fun begin! I found this link to the draft complaint filed by California against Countrywide and its executives for deceptive practices in the mortgage market. California charges that Countrywide AND some of its executives knowingly used deceptive practices to lure customers into taking on riskier mortgages than they needed or could afford in order to increase the profit Countrywide made selling these mortgages into the securitization market. The complaint makes for interesting reading (to nerds like me). I like the fact that it provides examples of some of the loan payments and how the negative amortization features work.

By the way, flying through Congress is a plan to authorize FHA to guarantee refinancing of $300 billion of mostly subprime loans. Of course, the taxpayers stand behind FHA guarantees, so get ready to dig into your pocket to pay off the banks and investors who own the kind of bad loans described in the complaint. According to this Washington Post Report portions of this plan were submitted by Bank of America. Bank of America is set to purchase Countrywide and reportedly has the largest portfolio of mortgage securities of any of the major banks (call me a conspiracy theorist). I don’t always agree with WSJ Editorials, but if you take the political finger pointing out of this one it pretty much hits the mark. Here’s more from tomorrow’s WSJ. I reviewed this legislation last month and wrote a more detailed analysis here.

So far the Federal Reserve has advanced some $400-450 billion to banks and investment banks secured by mortgage securities (we believe but can't verify), FHA is already well into refinancing many bad loans and looks to be getting authorization for an additional $300 billion, and the Federal Home Loan Banks (funded through taxpayer guaranteed bonds) have advanced over $250 billion to banks for mortgages, all since this broke out last year. That’s $1 trillion, and that’s without counting any possible exposure to the largest mortgage companies we have, the government sponsored entities Fannie Mae and Freddie Mac, or the impact of negative real interest rates from the Federal Reserve (again). To put the $1 trillion into perspective, it is about 7% of our GDP and about 11% of our entire national debt. It’s a lot of money.

I hope the summer is treating you well!

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Sheriff John Green

I was reading this article in today’s Wall Street Journal, Online Edition and was struck by some of the conflicting messages it highlights for many. I am a student of financial markets and to some extend the Federal Reserve (the “Fed”), so I have a certain perspective on the whole subprime mortgage debacle that is no secret to anyone reading my column. I object to bailouts, whether it be for homeowners or Wall Street, and I have been writing that opinion since last October when I first started publishing my blog. But this article got me thinking about these Philadelphia residents who are being evicted from their homes because they can’t pay their mortgages. Circumstances have now changed, and they have changed because the Fed, no doubt with the blessing of Treasury, has bailed out Wall Street. (For more on this there is another article in today’s Wall Street Journal Online expressing one Federal Reserve Bank President’s concerns about the Fed’s recent actions and the market distortions that can be expected as a result.)

Admittedly bailing out Wall Street is good, in some ways, for everyone as it lessens the risk of a major economic blowup. But tell that to a resident in Philadelphia being evicted from their home who can understandably be thinking “they can bail out those Wall Street executives and their customers but they can’t help me?” Enter the Sheriff, John Green:

Sheriff John Green has spent 37 years in law enforcement. But these days he's best known around town for the law he won't enforce.

With the economy soft and thousands of Philadelphians delinquent on their mortgages, Sheriff Green this spring refused to hold a court-ordered foreclosure auction. His move raised eyebrows on the bench and dropped jaws among lenders and their attorneys, who accuse him of shirking his duty to enforce legal contracts….

Mortgage lenders, servicers and their attorneys thought Mr. Green was acting more Robin Hood than sheriff. "It's not his job to postpone things in favor of certain people," says Michael VanBuskirk, a Philadelphia attorney, who describes the city as a "legal free-fire zone." The city, he says, is "less attractive to business if you can't be certain that the sheriff won't invalidate a contract."

Fed policies to help rescue Wall Street firms have created distortions that have hurt many innocent bystanders in this debacle as savings rates plummet and inflation increases. In fact, the inflation in food and energy prices caused in large measure by negative real interest rates is likely a direct cause of many of the foreclosures as those consumers most at risk can no longer afford to pay all of their bills. So in keeping real interest rates negative to rescue the financial industry Fed policies are hurting many of those who would be hurt in a larger financial collapse anyway and the impact is falling disproportionately to the most vulnerable among us. To hear mortgage lenders now object to the Sheriff’s actions because they favor one group over another is, in my opinion, entertaining at best. In my view, looking to the public policy issues behind this story presents a very different picture than a simple issue of contract law.

I believe we are witnessing the spread of the bailout mentality that has been established by the Fed (and sanctioned by the Administration) in favor of Wall Street. Regardless of the ultimate consequences of allowing major Wall Street firms to fail, the general public will understandably view these actions as favoring those on Wall Street as opposed to them. Let’s do a thought experiment. The first part is to ask: “Why is it good for the Fed to bail out these Wall Street firms by providing credit at taxpayer risk?” The answer, of course, is that to do so will help avoid an economic collapse that would hurt everyone. The second part is to ask: “Why should the Sheriff refuse to sell foreclosed homes at auction?” The answer, of course, is that doing so helps avoid an economic collapse of the neighborhoods involved that would hurt everyone. So, is the Sheriff acting like Robin Hood or following the example set by the Fed? In the eyes of those on the ground I think taking the latter view is easily comprehensible.

The distortions caused by the Fed’s bailout of years of negligent lending activities by Wall Street and all of its subsidiary tentacles has set the stage for redistribution fights such as this one, and I don’t know how you put this genie back in the bottle. So at the end of this piece I have an unanswered question: Is the creativity demonstrated by Mr. Bernanke, with the certain blessings of Mr. Paulson, good for our society in the long run or just another example of how being too creative (ever heard of a CDO squared?) can really mess things up?

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Oil and Wall Street

I am in Seoul, South Korea on a teaching assignment. I have been here for a week and will be here for another. I haven’t had time to write anything useful, even though there is so much going on. Seoul is a great city and the people I meet here are very warm and kind. I also admire their willingness to stand up in protest as tens of thousands did last weekend in objection to the lifting of the import ban on US beef (which has now been delayed).

Although I don’t have time to write an analysis I wanted to publish a couple of links regarding the impact of speculation in the commodity markets on oil prices. There have been several hearings going on, and some hedge fund managers and others seem to be speaking out against certain trading strategies and deregulation dating back to Enron that could be causing significant upward pressure on energy prices. Here is a link to Michael Greenberger’s Congressional Testimony from this morning that I found stunning. He appeared today before the Senate Commerce Committee together with the well known hedge fund manager George Soros and others. It is not the easiest testimony to read but if you have 10 minutes I highly recommend you give it a go. You don’t need to follow all of the statutory references or read the entire document to get the drift of what he is saying so you can skip a lot of the detail and still get the message. Here is another link to some Congressional testimony by Michael Masters, a hedge fund manager, from May 20, 2008 that I think is also worth a read.

In a nutshell, some informed people believe that a large portion of the run-up in oil prices is a Wall Street phenomenon and federal regulators are simply looking the other way as US consumers are being separated from their savings. If Mr. Greenberger is correct then I believe this is an outrage of gigantic proportions and another monumental regulatory failure by our government. I hope our elected officials get to the bottom of this one quickly either way because the thought of paying $5.00 a gallon for heating oil next winter is bad enough, but to pay that much so that some investors can earn a nice return really twists my insides.

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Hope for Homeowners Act of 2008

I have reviewed portions of the Committee Print of the proposed GSE bill (the “Bill”) that came out of The U.S. Senate Committee on Banking, Housing, and Urban Affairs (the “Senate Banking Committee”)as announced by the Senate Banking Committee on May 19, 2008. In particular, I have read Secs. 401-403 of the Bill titled “Hope For Homeowners Act of 2008.” I believe this Bill is a recipe for disaster and likely the next big target of fraud against taxpayers. First, I will attempt to summarize how this plan works, and then I will comment on it based on my interpretations and opinions.

How it works (if passed as is):
This plan authorizes FHA to provide guarantees for mortgages up to an aggregate of $300 billion. These mortgages get packaged and sold through the Government National Mortgage Association, or GNMA, and the securities sold by GNMA are backed by the full faith and credit of the United States (and that means the taxpayers).

Who can borrow under the plan:
These loans will only be made to borrowers who “provide a certification to the Secretary [of FHA] that the mortgagor has not intentionally defaulted on the eligible mortgage” and the current borrower debt to income ratio must be GREATER THAN 31 percent! So, we are talking about people who cannot pay their mortgages because they have too much mortgage debt relative to their income (I note that the Bill states “mortgage debt to income” as the ratio, but I am assuming it means to say “mortgage debt service to income” as a total mortgage debt to income ratio of 31% would make no sense in this context). Bill Sec. 402(e) The penalty for falsely stating that you did not intentionally default on your mortgage can be steep, including fines and prison time (how one proves this and what it means is beyond me – if one intentionally buys food instead of paying the mortgage is this an intentional default?)

How is this a bailout for investors?
Once a borrower is qualified, they can borrow up to 90% of the appraised value of the home to refinance their existing mortgage, assuming the mortgage holders (including the holders of the first mortgage and all subordinate loans) agree(s) to a full satisfaction of all of the borrowers obligations from the proceeds of the new loan. So if this is a better deal for the mortgage investor than foreclosing on the property and realizing larger losses, the investor should buy into the refinance. That’s where the bailout comes in – investors would be liquidating their positions at favorable recoveries based on taxpayer guarantees. In order to protect taxpayers, the Bill provides that the appraisal must not be influenced by an interested party (curiously there are no stated penalties for a breach of this requirement and no absolute limitation on using related parties). There is also an insurance fund to back these loans before taxpayers would be on the hook.

The insurance is provided through a new insurance fund, the Home Ownership Preservation Entity Fund, to be used by FHA to carry out its mission that states, in part, “to allow homeowners to avoid foreclosure by reducing the principal balance outstanding, and interest rate charged, on their mortgages…” Bill Sec. 402(b)(2) The fund is funded through an initial payment of 3% of each loan amount, paid from the proceeds of the loan, plus an annual premium of 1.5% of the remaining principal balance of each loan. Bill Sec. 402(i) Now I admit that I am not a mathematician and have not constructed a detailed quantitative model to figure out the risk that this fund will be insufficient to cover losses. I do, however, have serious doubts that this fund will support losses from these loans and I believe it is likely taxpayers will eventually be on the hook.

I wonder how the premium rate of 3% plus an annual 1.5% of non-defaulted loans plus a share of a share of future equity appreciation compares to default rates on refinanced defaulted loans? I don’t think the data exists to make this calculation, but I could be wrong about that. Even if they do, however, I wonder how any assumptions regarding default rates hold up when this plan is full of incentives for abuse by almost everyone involved:

1) FHA - FHA wants to show results and will actively try to guaranty a lot of loans. Unfortunately, as discussed in this Congressional testimony, there is already serious concern about FHA’s ability to manage its existing portfolio, let alone a huge new program like this one. That means quantity over quality – a recipe for trouble in any lending business. One other point I would like to mention is that back in December I wrote about a plan to reform the FHA. In that piece I linked to the website of the Senate Banking Committee for a copy of congressional testimony by Basil Petrou from Federal Financial Analytics that discussed many weaknesses of the plan and the FHA. That link has been taken down, and I have had to replace it with a link to the Federal Financial Analytics website. Curious. If you are interested you can now find that testimony here.

2) INVESTORS - Existing lenders want out of their bad loans and that provides incentive to push borrowers into this program thereby limiting their losses. Again we have the quantity over quality problem.

3) APPRAISERS – Appraisers are under pressure from their clients, lenders, because they appraised so many properties for too high a value. These appraisers have a strong incentive to help the lenders exit these loans at the highest possible recovery, and that means highest appraisal.

4) HOMEOWNERS - Homeowners love this even if they don’t plan to stay in the house. If you are a homeowner with two mortgages, default notices, foreclosure threats, and all of your other personal assets at risk because you are under water, would you love to get one of these loans and make all of those problems go away? The trade-off for making it all go away is being obligated for one loan that’s guaranteed by the taxpayers. Sounds like a nice value proposition for the homeowner to me. In furtherance of this perverted incentive structure, the Bill provides that any equity in the home that is realized through a later refinance or sale is shared between the homeowner and the FHA (a portion of which, if applicable, is for distribution to any subordinated mortgage holder who took a loss). If the home is sold or refinanced in the first year any appreciation goes to FHA, in the second year 90%, third year 80%, and so on to 50% after five years and forever thereafter. So, refinance with FHA at no cost or very little cost, get all of the lenders off your back, then walk away from one loan guaranteed by the taxpayers leaving them with the problem.

Lets review. What the Bill proposes is to find mortgage borrowers who cannot afford their mortgage payments and are in default. Then, an appraisal is secured through an appraiser (the same group that got values completely wrong the last time around and are likely conflicted because of their relationships with lenders). The FHA then guarantees a loan to refinance the existing mortgages up to 90% of the appraised value. All parties have incentives to do these transactions that are unrelated to the resulting credit quality. In fact, the worse the credit quality is the greater the incentive for the investor/appraiser and the homeowner to participate. Then, once the FHA is on the hook, the homeowner is given the disincentive to remain in the house because under the best of circumstances they will realize only 50% of any future equity appreciation in the home. Under these circumstances is 3% plus a share of a share of future appreciation plus 1.5% per year (on loans that do not default) enough to cover the losses on this impending portfolio? I, for one, am not convinced that it is. Of course I could be wrong and this plan could turn out to be a great idea, but I see too many conflicts and perverse incentives in the current draft to believe this plan will actually work to the benefit of taxpayers. Instead, I see too much opportunity and incentive for quick transfers of bad loans from investors to taxpayers under the inadequate supervision of FHA and, as a taxpayer, that concerns me.

[There are other issues with the Bill that, for the most part, are left to FHA to figure out. For example, does a home improvement add to the homeowner’s equity or is the value added by improvements shared as future equity? The Bill also describes future equity in a very strange way: “any equity created as a direct result of such sale or refinance”. I suppose you can consider a sale the creation of equity although that is arguable. I certainly do not see how equity is “created” through a refinance. Another issue is that the Bill provides for refinancing up to an amount not exceeding 132 percent of the old conforming loan amount – in other words jumbo loans.]

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Understanding the Inflation Report

The Bureau of Labor Statistics (BLS) reported today that inflation was contained in April, with prices rising only .2% (this would be about 2.4% on an annualized basis). This was welcome news for the equity markets that responded positively to the report. Sounds good, except we have the usual adjustments and assumptions built into how this number is calculated. The biggest standout in this report is Transportation, which is down by .7 percent in April. Lets take a look at this category to try and understand how these numbers work.

Here is the report’s discussion of why Transportation prices fell by .7% in April:

The transportation index declined 0.7 percent in April, reflecting a 2.0 percent decrease in the index for gasoline. The index for new vehicles declined 0.2 percent and was 1.3 percent lower than in April 2007. The index for used cars and trucks declined 0.3 percent in April, but was 1.8 percent higher than a year ago. The index for public transportation declined 0.4 percent in April, reflecting a 0.5 percent decrease in the index for airline fares. (Prior to seasonal adjustment, airline fares rose 0.9 percent and were 10.1 percent higher than a year ago.) (Gasoline prices rose 5.6 percent in April. Compared to a year ago, these prices were up 20.9 percent. Gasoline prices increase seasonally during the first five months of the year, with the largest increases occurring in March and April and decline seasonally for the remainder of the year).

Taking a closer look at this part of the report, it states that the gasoline price index is down 2 percent in April. This would probably surprise most drivers. In fact, gasoline prices were up 5.6 percent in the month, so how can they be down 2 percent? Well, the government expects gasoline prices to go up 7 percent in April as people drive more, and then go down later in the year as people drive less. Because prices only rose 5 percent, the seasonally adjusted price index fell 2 percent. This assumes that gas prices will, as the report states, decline seasonally from June through December. We know, however, that oil prices have risen for future delivery and gasoline prices are expected to go up, not down. Based on the seasonal adjustment figures, prices should go up about 3.5 percent in May, then drop for the rest of the year. So should the gasoline number be seasonally adjusted downward by 5.7 % even though oil futures are up? I suppose what that means is that future inflation numbers will be worse.

The next subcategory is new vehicles. According to the report new car prices fell .2 percent (the seasonal adjustment for this category is .22 percent, so prices must have fallen by approximately .4 percent). This is interesting, especially when Toyota just announced price increases for their new vehicles in the U.S. These increases will reportedly become effective later in May, so this price decline will likely also reverse next month or in June. That’s bad news because based on the seasonal adjustments, car prices are supposed to go down .32 percent in May and .33 percent in June, so once adjusted this category could look even worse.

The drop in the price of used cars and trucks is not surprising given that we are in the midst of a shift to more fuel efficient vehicles. Used vehicles, which would tend to be high fuel consumption vehicles, are declining in value. If a person goes to buy a new car, don’t they usually trade in the old one? So if the value of the old one declined, the actual cost of a new car, on a net basis, has not declined by .2 percent because the buyer will get less credit for the trade-in. So this is good news for used car buyers but not as good for people who buy new cars.

Finally, airline fares declined! That’s news to me. Before seasonal adjustments they were up .9 percent. So if the reported number fell .4 percent, we know the expected seasonal rise must have been 1.3 percent (there are rounding issues – the actual adjustment is 1.44 percent). Because they rose only .9 percent, on a seasonally adjusted basis they were down .4 percent! What about the fact that the Easter holiday was in March this year but April last year? The seasonal adjustment is down a bit from last year, from 1.95 percent to 1.44 percent, but so is the March adjustment, from 1.23 percent to 0.97 percent. These changes do not reflect adjustment for this point as far as I can tell. Airline prices may reflect this increasing a seasonally adjusted 3% in March and decreasing a seasonally adjusted .4 percent in April.

Seasonal adjustments do make sense to me on a normal ongoing basis, but when we have better information (such as futures prices for oil) perhaps we should take that information into account. Then again, there is a lot to be said for consistency, so making adjustments to adjustments may not be such a great idea. Finding the real story, however, requires work.

In the unlikely event that you would like to look at other categories in this way you can find a lot of information at the BLS. The way to do it is look at the seasonal adjustment table for 2008. The expected change is the percentage change in any given category from one month to the next. If you get a 1 percent increase, then an actual increase of 1% will be reported as a zero percent increase. If you are a statistician and want to get into the calculation of the seasonal adjustments you can start with this report.

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Subprime and the Bush Administration

What did the Bush Administration have to do with the credit crisis? I keep hearing people say that a president does not have very much influence on the economy and they are given too much of the credit or blame when the economy fluctuates. I disagree for two reasons. The first is that fiscal policies can have a rather dramatic and immediate impact on economic activity as the President is making clear today by touting the fiscal stimulus plan. Tax cuts and government spending certainly impact the economy in a direct and timely way. The other reason is the general regulatory oversight that each administration is responsible for. For example, who heads the SEC and what are the priorities given it by the administration? What about the Treasury Department? I believe these policies have a direct impact on economic activity and are responsible for a lot of the fluctuation in the economy as well as income distribution from one administration to another. Here is an example.

As hedge fund investor David Einhorn laid out in his recent remarks, ”Private Profits and Socialized Risk” the SEC, under the Bush Administration, altered the capital requirements for broker-dealers. Einhorn concludes that the result was a lower capital requirement leading to higher leverage. The higher leverage, as we know, leads to higher risk and that higher risk culminated with the failure of Bear Stearns. So, is this why we have the credit crisis? Wait, there’s more.

The SEC regulations applied to the broker-dealer world. What about the commercial banks? What have they got to do with all of this? Well, as I wrote about last October, the rules regarding commercial bank capital requirements were also altered back in 2004 through rules promulgated by the Federal Reserve and Treasury as regulators of the commercial banking system. In effect, these rules said to banks they could move loans and other assets from their balance sheets to off-balance sheet conduits and reduce their capital requirements. Banks love this because it allows them to – guess what – leverage! They set up something called a conduit that purchases assets from the bank and/or a bank customer. The conduit gets the money for the purchase by issuing securities, like commercial paper. The rating agencies rate the commercial paper based, in part, on the fact that the bank typically provides a line of credit to the conduit so that if the commercial paper market dries up the conduit can borrow to repay maturing commercial paper. This is a very general description and these structures can get very complex, but this is the basic idea. So how does this increase leverage? The rules promulgated in 2004 established that under this structure banks could provide these credit lines to back these conduits but hold only 10% of the risk based capital they would hold against the same assets if they were on the bank’s balance sheet. You can find the announcement of the rules here. So, using this structure, banks can leverage their capital in multiples. Eureka – a way to get around the sound banking principals established by the regulatory framework over the past 90 years! The regulators behind these rules included the Office of the Comptroller of the Currency (Treasury), The Federal Reserve System, The Office of Thrift Supervision (Treasury), and The Federal Deposit Insurance Corporation.

Lets review. According to Mr. Einhorn, in 2004 the SEC relaxed capital rules for broker dealers, placing more of the regulatory requirements in the hands of the banks and allowing them to use more leverage than before. In the very same year the Federal Reserve and Treasury codified the rules that permitted commercial banks to leverage through off-balance sheet entities. (In case you were wondering, Congress had hearings on many of these issues as well.) All of this turned out to be extremely profitable for the banks, brokers, and rating agencies.

Suddenly, there is an incredible credit bubble that begins with loans and ends up as securities in the portfolios of, among others, the investment banks, banks, and off-balance sheet bank sponsored conduits. I wonder if there is a link between these events? Now, to be fair, the credit bubble began a little before these regulatory changes. But these changes must have accommodated a huge demand that was unsustainable. The graph accompanying this post illustrates the credit bubble I am referring to.

What really caps all of this off is the cries from many of these agency heads now about what should be done to fix this mess. For example, Sheila Bair, head of The Federal Deposit Insurance Corporation, has been calling for months for a bailout of subprime borrowers. First, back in October, she called for a freeze on interest rates for those who had adjustable rate subprime mortgages. She is now lobbying for loan modifications to reduce principal for those subprime borrowers whose mortgages exceed their property values. From her recent comments before Congress

Permanently forgiving part of the principal amount can provide a better financial result for investors than foreclosure by creating long-term, sustainable solutions that will allow borrowers to stay in their homes. This approach also has the added benefit of limiting the overall adverse affect of declining property values on communities.

In closing, Ms. Bair states

Congress, the SEC, the Treasury Department, as well as federal bank regulators have expended considerable time and effort to assure that the industry has authority under tax and accounting rules to modify loans proactively. The industry needs to demonstrate greater commitment to using those authorities.

They should be expending all the time they possibly can and they should never mention it because these agencies are collectively, in my opinion, among the most culpable groups in this entire debacle.

To be fair to Ms. Bair, she was appointed to head the FDIC in 2006, after these regulatory changes. She was, however, on the FDIC’s Advisory Committee on Banking Policy. Donald Powell was FDIC Chairman in 2004, John Snow was Secretary of the Treasury, William Donaldson was Chairman of the SEC, and our old friend Alan Greenspan was Chairman of the Board of Governors of the Federal Reserve System. Who appointed these people?

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Some Hidden Costs of the Credit Crisis

The Federal Reserve (the Fed) is likely causing dramatic distortions in the markets by lowering interest rates below the level of inflation and the impact may only be evident in retrospect. One side effect of the Fed's actions is a massive shift of the costs associated with the credit crisis from borrowers to savers. While negative real interest rates are helping some homeowners keep their payments down they are also fueling inflation resulting in a tremendous loss in value to those who have saved for retirement. Artificially low interest rates are also causing pain for those living on a fixed income through both inflation and loss of investment earnings. Here are a couple of hypothetical situations based on real stories I am hearing from friends and relatives to illustrate these distortions I am referring to.

The first story is about a hard working middle-class family headed by Dick and Jane. Dick and Jane grew up in the 1950s and 1960s. They have worked full time for almost 40 years, raised a family, a dog and several cats, and have been preparing to retire. They have contributed to Social Security from every paycheck they have ever received, and have been frugal and lucky enough to put aside some money for retirement. They purchased their home 30 years ago and have paid off the mortgage through 360 consecutive monthly payments of principal plus interest. Everything was going along according to plan until, suddenly and without warning, the earnings on their investments began to plummet.

They couldn’t understand what was happening at first. Because they were getting close to retirement they had allocated much of their portfolio to fixed income investments, and some of those were falling in value at the same time they could not get more than a 3% return on CDs and Treasury securities. They went to their bank to get advise and were told that because the Federal Reserve had lowered interest rates safe investments were yielding very low returns. They took out their calculator and figured that if inflation is around 4% and the real interest rate is 2.5%, they should be earning 6.5% on a risk free investment. Instead they are being offered 2.5% on a CD, so the cost to them is 4%. Based on their retirement portfolio of $750,000 they are losing $30,000 per year! Even if they can get a 3.5% return the cost is still $22,500 per year. But that’s not all. If we believe that these low interest rates are also causing inflation in basic goods such as energy and food, the value of their retirement savings is declining. Where $750,000 may have been enough based on all reasonable forecasts just a year or so ago, now it is not enough because of the cost of living increases.

Confused and angry, Dick and Jane reconcile to the fact that they will likely not be retiring as planned unless they cut back dramatically and save as much as possible. They will delay any major expenditure until absolutely necessary, and because of inflation they have less to save. The $1,100 fuel oil bill drove this point home last week. A portion of their retirement has disappeared through no fault of theirs, and they wonder why. Why is it that with inflation getting worse interest rates are going down? Shouldn’t it be the other way around?

The second story is about Cathleen, a neighbor of Dick and Jane. She retired from her clerical position ten years ago. Her husband passed away several years back and she now lives on Social Security and the income from the $250,000 portfolio of treasury securities, money market accounts, and CDs left from their lifetime savings and her husband’s live insurance. She can’t understand what is happening, but for the first time since retirement she must liquidate some of her retirement portfolio to pay all of her bills. Her Social Security income of $1,500 per month doesn’t come close to covering all of her expenses so she has relied on the interest from her portfolio for the rest. Last year her interest income was $13,750, giving her total income with social security of $31,750. This year her interest income was $8,750 giving her total income of only $26,750. Adding the rising costs of her medications, property taxes, food and energy she is for the first time concerned that she could run out of money. She wonders why, and she has decided she must cut back to only the necessary expenditures.

While lower interest rates are helping some homeowners with adjustable rate mortgages they are hurting savers and those living on a fixed income. Inflation also harms savers but benefits borrowers. At the same time, as between the average savers and the average adjustable rate mortgage borrowers it is the latter who have more culpability for the crisis in the first place. It is clear that the American people are paying the price of this credit crisis one way or another, and the question at hand is whether the distortions resulting from the remedy are making things better or worse as the burden is shifted from borrowers to savers?

There are at least three reasons for the Fed to be lowering rates right now. Let’s take a look at each of the primary reasons for the Fed to be lowering interest rates.

The first reason to lower interest rates when the economy is soft is referred to as the wealth effect. When interest rates are lower asset values tend to be higher. If mortgage payments are lower house prices can be higher because it is more affordable based on the payments. This applies to financial assets as well. As interest rates fall, in general, the value of financial assets rise. In practice, this effect makes people feel better off because their assets are worth more and this is good for the economy because when people feel wealthier they tend to spend more. This sounds great, but there is dark side.

When inflation becomes a problem rising asset values tend to be offset by rising costs. While keeping interest rates depressed may help support the value of certain assets it is also fueling inflation, and the inflation is countering the wealth effect. Low interest rates don’t always spark inflation, but in the current global economic situation commodity prices are rising dramatically and inflation is becoming a real issue. Lower interest rates in the US hurts the value of the dollar and sparks price increases in dollar denominated commodity prices. Anyone who goes to the grocery store or drives a car or heats a home knows that inflation is a rising problem today. So assuming low interest rates are in fact supporting asset prices the resulting inflation could be countering the impact because real values (adjusted for inflation) are not changing or are, perhaps, even falling. Is the wealth effect of lower interest rates working this time? I question its efficacy under current conditions when real interest rates are negative AND we have supply shocks in energy, food, and metals all at the same time.

The second intended effect of lowering interest rates is to spur business investment by making it less expensive for businesses to borrow and invest. This should also lead to increased employment as businesses hire more workers. Before businesses invest, however, they must believe that consumers will consume. Helping to keep mortgage payments down for a portion of the population will certainly help consumer sentiment, as will the resulting benefit of slower price depreciation in housing. But there is also a downside to consumers of low interest rates and the inflation we are now seeing. The retirement savings of the baby boom population are losing value to inflation, while at the same time low interest rates are cutting into the income of those living on their savings. The loss of real savings and real income (from both depressed interest rates and the impact of inflation) to the population of savers and spenders is likely to have a negative impact on consumption, especially as those close to retirement increase savings and those in retirement are forced to cut back on spending. This, in turn, could offset the positive impact of low interest rates on consumer sentiment. Consumers also have more debt as a percent of their personal income now than at any time in the past several decades and probably need time to pay it down rather than consume more. So will lower interest rates spur investment under these circumstances or simply prolong the reckoning while causing a very troubling inflationary spiral? There is certainly room to question the efficacy of further rate cuts on business investment in the current economic climate.

The third reason for lowering interest rates right now is to help rescue the financial industry in the US and prevent a collapse of the financial system. A major meltdown of the financial industry would certainly be a problem that would have a negative impact on all of us because it could result in a severe recession or even a depression. If the banking system becomes insolvent (meaning the banks do not have capital and cannot make loans) then anything people purchase on credit could suddenly experience dramatic reductions in demand, while at the same time businesses would find it very difficult to obtain funds for investment. When things get really bad you get deflation because there is simply not enough demand for anything to keep prices from falling. This may sound OK at first but in fact it is worse than inflation in many ways. Who will lend you money to buy a house if the value of the house is expected to decline next year? The same logic holds for a car or any other major purchase. Imagine your mortgage payment staying the same while your home value and wages drop – that’s deflation and it can spiral down the same way inflation can spiral up. At the same time unemployment would rise dramatically because businesses facing falling demand and lack of funds for investment would be laying off workers. This is certainly a situation to be avoided. So how does lowering interest rates help us lower the risk of this happening? Aside from the wealth effect and business investment helping the economy stay afloat, the lower interest rates help to support the value of assets on banks’ balance sheets (remember these are interest bearing financial assets). That means fewer write downs and, in turn, lower losses and more capital. The low interest rates also reflect banks’ cost of obtaining funds to lend, and when their costs go way down their profits can go up. More profit means more capital and more incentive to lend. So lowering interest rates helps the banks to preserve and add to their capital helping to lower the risk of financial system insolvency. Of course, if this is truly the reason for lowering interest rates right now one must wonder why banks continue to pay dividends to investors. If they are under-capitalized that should be the first place they go for capital preservation, not to the policies of the Fed. This is especially true when the Fed policies are creating distortions in the market and may not be helping to support the economy for reasons discussed above. If the financial system is in fact under-capitalized perhaps the Fed should be reaching back into its bag of tricks and figuring out another way to add capital to the banking system.

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