In These New Times

A new paradigm for a post-imperial world

Bailout cure worse than disease

Posted by smeddum on July 28, 2008

Asian Times
By Peter Schiff

With President George W Bush no longer threatening a veto, the subprime mortgage and Fannie and Freddie “bailout” bill was able to sail through the US Congress. In anticipation of its enactment, congress had the foresight to raise the national debt limit to US$10.6 trillion. Who says that politicians don’t plan ahead?

Once signed into law, the budget-busting legislation will hand the administration a blank check to prop up the ailing home lenders. The ultimate cost is anybody’s guess. I believe that the price tag will be higher than just about anyone imagines. Treasure Secretary Henry Paulson’s Bazooka will be locked and loaded with enough fire power to blow what’s left of the US economy into the dustbin of history.

Though the government and Wall Street assure us that these bold moves will save the housing market, and the economy as a whole, from collapse, the reality is that the solution is far worse than the problem. As painful as the failure of Freddie and Fannie would have been, bailing them out will hurt even more. In other words, it’s not the disease that will kill us but the cure.

Ironically, while government is rightly criticizing mortgage lenders for ditching lending standards during the boom (well after the horses had left the barn), the new law will actually encourage lenders to be even more reckless than before.

By taking all of the risks out of mortgage lending (provided of course that the loans are conforming), the government is telling lenders not to worry about the loans they make because if borrowers do not repay, the government will.

Since this bailout eliminates all market-based deterrents to reckless lending for conforming loans, the only checks remaining will be those imposed by Freddie and Fannie themselves through the criteria they set for those loans. And although they have taken some steps over the past few months to tighten their minimal “standards”, the political agenda behind the bailout will cause this nascent effort to lose steam. In essence, the government’s main goal is to prop up home prices. Since American homes are still overvalued given the fundamentals, their prices can only be pushed up with reckless lending and inflation.

As a result of this bailout bill, the share of mortgages owned or insured by Freddie and Fannie will likely swell from near 50% today to over 80% within a year or two, turning a $5 trillion problem into a $10 trillion fiasco. If the government succeeds in keeping real estate prices propped up, it will only do so at the cost of sending all other prices through the roof. More likely, real estate prices will continue to decline despite government efforts to levitate them, compounding the problems and the losses.

The grim reality is that trillions of dollars were borrowed and spent that will never be repaid. No government program can alter that fact. Someone is going to have to pay the piper for all those granite counter tops and plasma TVs. The price tag is staggering and for all the bailouts and stimulus packages, all the government can do is exacerbate the losses and shift the burden through inflation. Nor can the government resurrect bubble home prices and the fantasy of real estate riches that went along with them. One way or another, rational home prices will be restored and the myths of our asset-based, consumption-dependent economy will be finally discredited.

CNBC once nicknamed me “Dr Doom”, but compared with what I see coming now, they should have then called me “Dr Sunshine”. Take a look at a presentation I made back in November 2006, at the Western Regional Mortgage Bankers Conference. There are eight clips in total, and though the entire presentation is worth watching, most of the real estate comments begin with the fourth clip. (Click here to watch the video on YouTube. )

Every real estate prediction I made at that conference, which was considered outrageous at the time by those in attendance, has already come true. As confident as I was then about this impending crisis, I am even more confident now that the government has just thrown gasoline onto the fire

Peter Schiff is president and chief global strategist of Euro Pacific Capital. He is the author of Crash Proof: How to Profit from the Coming Economic Collapse (Wiley & Sons, 2007) and his second book is scheduled for publication in early 2009. Euro Pacific Capital commentary and market news is available at It has a free online investment newsletter.

(Copyright 2008 Euro Pacific Capital.)

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