Mortgage Mathematics

Recent news that the Federal Government will be backing away from insurance of high cost loans has created a high level of concern by many who own, sell, and finance high-end homes. The mathematics behind this decision and its implications will be felt throughout the economy.

The first thing to understand is that the Federal Government currently guarantees nine out of every ten home loans that are made. This means that the losses stemming from home value declines has ultimately landed on the government. As these losses continue to mount, it is becoming more and more apparent that the system of government guarantees for private market activity is economically unsustainable.

The implications of this insight are very far reaching, since the government guarantee of mortgages has resulted in much lower interest rates than would have been available if banks were taking all of the default risk themselves. This meant that many people were able to afford much larger houses than they otherwise would have the income pay for at higher rates. In turn, this meant that there was room for home prices to grow because of this influx of new borrowers who could afford to purchase more expansive homes. This effect created a 'bubble' where people bought homes they could not pay for based on the assumption that the prices would continue to escalate indefinitely. When the point was ultimately reached where prices stopped rising and people were unable to pay their mortgage obligations, the bubble collapsed.

This is not a particularly surprising event for those who have studied market bubbles in the past, since all bubbles inevitably crash. The thing that makes this bubble especially unique is that the government is only making token efforts to avoid the creation of another bubble that is similar to the last one. Simple mathematics says that if loans are guaranteed by the government, riskier loans will be made for higher amounts than would have resulted if prices were set by market forces instead of based on administrative fiat.

This has created a bit of a monster for politicians, since most are aware that the current mortgage model is unsustainable but none of them want to be the ones to remove mortgage subsidies for the large middle class voting block. Thus, the first step in this slow regression toward reality is removing loan subsidies for high-end homes. This action can be justified on populist grounds by saying that it will only affect those who are already affluent. And it will most certainly effect people with high-end homes. The lack of government guarantees will almost certainly raise the cost of borrowing through higher interest rates and decrease the amount of home that buyers can afford. This will ultimately result in less buyers bidding for properties and lower prices for people who are selling.

Most people will not feel a terrible degree of sympathy for people who purchased an $800,000 home that is now worth $500,000 since the government lacks the resources to subsidize these people's loan activities. However, there is a critical nugget of insight that this analysis begins to uncover. This insight is that the government lacks the financial resources to subsidize anybody's loan activities. It's just that the people in charge have been too cowardly to admit the mathematical reality. This reality is that the resources required to fulfill promises made by multiple generations of politicians simply do not exist.

Thus, it is very true that the government cannot afford to subsidize wealthy homeowners. But it is equally true that the government cannot afford to subsidize all of the other homeowners as well. The accumulated losses from the real estate bubble are placing a financial burden that is being financed with borrowing and inflationary money expansion. The stark reality is that current levels of government spending are unsustainable. This mathematical fact will eventually come to bear in one manner or another. Thus, while the context of a discussion may be about loan subsidies, tax credits, or whatever proposal is in the cross-hairs on a particular day, the real discussion needs to be about when the government will finally acknowledge mathematical reality.

In short, mortgage mathematics work out such that the cost of borrowing for high-end homes will become more expensive, and then be quickly followed by the cost of other borrowing becoming more expensive. The implicit subsidy to home prices that have been provided by the government has lulled many people into a belief that the economy is on a road to recovery. The truth is that this road stretches on for much farther than we have been led to believe, and still has many more bumps left in it.

What people must come to realize is that these adjustments are inevitable. They will either come sooner and be smaller or come later and be larger. One way or another, many of the promises, guarantees, and other explicit or implicit subsidies granted by the Federal Government will need to be pulled back. When this eventually happens, it will result in an economic shock as entities that have come to expect government aid struggle to survive on their own. However, this shock will result in the systematic allocation of capital by investors toward projects with a higher natural rate of return, instead of being steered based on the availability of subsidies.

The bottom line is that many people will be quite unhappy when the point of final capitulation is reached, and reality is finally accepted by the government. However, the marketplace that emerges after this inevitable period of difficulty will be more robust and resilient. Ultimately, this adjustment will prove to be a necessary step for continued economic growth. If is not a comfortable message to digest, but the sooner that we internalize this reality, the sooner we can reverse our course of chasing after market bubbles and return to a trajectory of long-term growth.

Sincere Thanks,
Douglas J Utberg, MBA

Founder - Business of Life LLC:

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