Gresham's Law hasn't been repealed, but it's taking on new forms in Washington these days.
Having put 'bad' money - printed by fiat or 'secured' by loans against taxpayers yet unborn - into the banking system in the first round of bailouts, the Feds now presume to rewrite not only future but existing loans. The consequences were on exhibit in Washington last week as financial genius Barney Frank and other politicians "...managed to demand more loans for consumers while simultaneously giving lenders new cause to wonder if they'll ever be repaid." They and other congress critters want to make it legal for bankruptcy judges to forcibly abrogate the terms of existing mortgages.
As pointed out in this WSJ article, most of the lending side of the credit market does not come from banks: "Most investors who lend in these markets are not recipients of financial bailout money, so Congress can't simply browbeat them into making another big bet on the American consumer. " These lenders have 'good' money that is still subject to the reality check of the market, rather than political exigency. But a move to retroactively rewrite credit contracts by government fiat will affect them as well. The result?
First, to make the world of collateralized mortgage debt tremble once again. While the consequences of foreclosures fall on the junior tranches of packaged debt - now mostly written off - in many case the results of forcible, retroactive modification of a contract's conditions would fall pro rata across all tranches, causing the value of those that are still standing to slide as well. Yet more fear to hang over new as well as existing mortgage backed securities.
Second, and not too surprisingly, the 'good money' investors want no part of this game.
The “real money” investors didn’t want to invest alongside the government. Their concern is that if things go south, the government will take 100% of the value left in the bank or whatever and leave private investors, including recent ones, with nothing. This is precisely what happened to recent investors in Fannie Mae.
See here for further pithy quotes from a recent financiers' conference, where the attendees were brutal to government officials wishing the good old days would come back.
Not if the government has much to do with it, at least in housing. Consider the calculation a 'good money' lender must now make to decide on a hurdle rate for putting funds into originating US mortgage loans, or buying securitized mortgages:
- Take the lender's costs of funds and add a desired base rate of return given the asset class. This is the basic calculation that is always done.
- Multiply in a factor representing risk to principal from defaults and foreclosures, with consideration of the current economic and housing market dynamics.
- Multiply in a further factor to represent inflation and/or exchange risk over the life of the loan. Consider the possible inflationary effects of the TARP, stimulus package and possible follow-ons to the US dollar.
- To our shame, now multiply in a further factor for political risk, an consideration heretofore limited to dodgy 3rd world countries known to abrogate contracts and treaties at whim.
By the time you get done, a rational lender might well be demanding a rate usually associated with scary early stage venture debt. Meanwhile, the Feds are trying to drive effective rates into the low single digits.
There's no way to resolve the rates on offer from the 'bad money' with those needed by rational, market driven 'good money' investors. The result is the good money will stay home. Home, in this case, mostly being China or the Middle East. The fraction of federally originated loans, already at 35 percent, is going to keep on rising, and it will done with more fiat money cranked out by the Feds.
The politicians are trying to reinflate the housing market. Their irresponsible behavior is instead likely to leave that market deflated by driving out the good money, while debasing the currency and piling up debt for the productive and future generations.