The recent partial shutdown of both government services and benefits adversely affected millions of Americans across our great nation. Is our government deficit truly close to the reported $16 + trillion? If so, how do we hope to reduce this deficit while continuing to hopefully expand and improve our national economy?
In our nation’s entire history, we have never had the U.S. government actually default on their financial obligations. A significant reduction of government services or benefits (i.e., Social Security, Food Stamps, subsidized housing, etc.) could negatively impact all types of investments both here and abroad such as stocks, bonds, mortgages, and real estate.
Why can’t the banks bail out the government as a repayment?
Do you know that the Federal Reserve and the U.S. Treasury supposedly has “lent” out over $16 trillion as well to many of the largest banks and investments banks in America since the near financial implosion of the world’s entire financial system, back in September 2008? These banks included Bank of America, JP Morgan Chase, Wells Fargo, Citibank, and several other well-known financial institutions.
The primary reason for allegedly lending, gifting, or partnering up with these same financial institutions by way of the $16 trillion cash infusion of “emergency funds” was to help keep these “Too big to fail” financial institutions from collapsing. Had any of the Top 5 “Big Banks” imploded between the Fall of 2008 and present day, then their on and off balance sheet derivatives investments (i.e., Credit Default Swaps, Interest Rate Options, etc.) may have cascaded like a falling domino chain across the world.
In theory, shouldn’t these same banks which received $16 trillion in bailout funds since September 2008, have to pay back the same $16 trillion if and when they ever get healthy enough again? If so, then these banks and investment banks could pay off the $16 trillion deficit by themselves? At the very least, the Big Banks’ monthly payments back to the Fed and / or U.S. Treasury should cover the U.S. government’s monthly budget obligations for many years to come.
What’s a Derivative?
Why should you care about derivatives (a hybrid of an insurance and financial contract)? A derivative, once again, is a glorified form of a financial “bet.” In the bet, one party wins while another party loses. The winner may happily earn returns of 10 to 30 + times their original investment amount. The loser, sadly, may also lose upwards of 10 to 30 + times their dollar amount invested, which can financially wipe them out.
For example, an Interest Rate Option derivative investment “bet” may be placed by Party A, who believes that the LIBOR (London Interbank Offered Rate – one of the world’s primary benchmark rates) interest rate will drop in the near term. If Party A bets that the LIBOR rate will continue downward and then the LIBOR rate increases, then Party A may lose his billion dollar bet plus upwards of at least 10 times that amount. If so, that $1 billion investment can turn into a $10 billion loss in a very short period of time.
The ongoing LIBOR Scandal in which numerous banks and investment banks rigged the directions of the LIBOR interest rates is a prime example of the potential fraud involved in the derivatives and financial markets. In this LIBOR Scandal, it has been alleged that several large banks knew what the exact LIBOR rate would be in the near term, so they could place their derivatives bets accordingly. How can you lose a bet if you know the outcome ahead of time?
Some financial analysts and economists suggest that the total combined value of all of the world’s derivatives combined may equate to over $1,500 trillion. As a comparison, the combined value of all of the world’s stocks, bonds, and real estate may be closer to just $175 trillion. As such, the derivatives markets dwarf all combined assets on planet Earth by a multitude of times. Any potential derivatives market collapse would, obviously, negatively impact potentially most or all of the world’s assets either directly or indirectly.
Bond Yields and Interest Rates
If our government would have, or may soon potentially default on payments made to Treasury Bond investors either here in the USA or abroad, then Bond Insurance ratings companies such as Moody’s or Fitch could downgrade USA’s Treasury Debt from “AAA” (the highest and safest bond rating) to “AA” or some other worsened rating. When an investment is downgraded such as U.S. Treasuries, due to perceived increasing risk, then the interest rates paid on those same investments may increase too.
It is important to pay close attention to Bond Rating agencies’ possible downgrades of our Treasury debt here in the USA. 30 year fixed mortgage rates are tied to the directions of the 10 Year Treasury Yield. As demand for Treasuries decreases from third (3rd) party investors such as retired Americans, Chinese or Japanese investors or governments, or the Federal Reserve themselves, then Bond Prices will fall. As Bond Prices fall, then 10 Year Treasury Yields will increase, since they are inverse to one another. These rising Treasury Yields will then, in turn, lead to increasing mortgage rates.
Government Backed or Insured Loans
Over the past several years, approximately 97% of all funded residential mortgage loans were either government backed or insured loans. The vast majority of these funded loans were FHA, VA, or USDA, and were also sold off in the secondary markets to Fannie Mae and Freddie Mac. Fannie and Freddie typically purchase the bulk of funded residential mortgages nationwide in the secondary market.
Without Fannie and Freddie’s presence, then banks would not be able to sell off their funded loans in their portfolios. This would have, in turn, led to much less loans originated by both small and large financial institutions. As many investors should know, banks eventually run out of money if they cannot sell of their loans in the secondary market.
A few years ago, the U.S. government had to bail out both Fannie Mae and Freddie Mac after they were on the verge of financial collapse too. What many people do not know is that one of the primary reasons why Fannie and Freddie almost collapsed is that they held highly leveraged derivatives investments in their portfolios, which were imploding due to their incorrect financial bets. I still do not understand why Fannie and Freddie were allowed to invest in risky derivatives back then.
The recent government shutdown led to a short term problem with FHA, VA, and USDA processing all of their paperwork, since their affiliate government agencies were unable to provide lenders or brokers with the updated financial information necessary to fund the loans. As a result, many home sales or refinance transactions were delayed due to this reduced access to government data. Once again, we need more non-governmental money back in the mortgage markets so that we are not so heavily dependent upon the government for mortgage loans.
Do we inflate or deflate our way out of this financial mess?
My perspective and belief is that we will continue onward with our “Quantitative Easing” (QE) strategies in that the Federal Reserve creates more money “out of thin air” in order to keep acquiring financial assets like stocks, bonds, and mortgages. The primary reason why the Dow Jones continues to hover near or above 15,000 in recent times, as opposed to closer to 6,500 back in March 2009, is related to the Fed’s QE policies, which include purchasing U.S. stocks on a large scale.
In recent times, the Fed was purchasing about $85 billion per month in bonds and mortgages. Don’t be surprised if the “QE Infinity” dollar amounts increase on a monthly basis, in order to allegedly boost financial prices and values. If the QE policies continue at the same pace or even at a more rapid pace, then mortgage rates may remain near historical lows which will be continued good news for real estate investors.
What is the lesser of two perceived evils as it relates to our shaky and questionable financial markets? Is it asset deflation or inflation? The best answer will be tied to whether or not you own real estate, or hope to buy it at very low distressed prices.
If the government ever defaults, then there actually may be more distressed assets for individual investors to acquire for potentially cents on the Dollar. Yet, our oxymoronic “Fiat Money” (assets backed by nothing) and Fractional Reserve Lending System may help our country move forward one way or another as long as we continue to have access to the “printing press.”
It is truly interesting times that we live in today when an investor or borrower is more worried about the financial strength of his or her own bank and / or government as opposed to their own financial stability. Let’s hope that the government gets their act together so that we may all prosper as much as possible one way or another during this ongoing, convoluted, and opportunistic “Credit Crisis” (www.thecreditcrisis.net) time period.
Author: Rick Tobin
Rick Tobin has a diversified background in both the Real Estate and Securities fields for the past 25+ years. He has held seven (7) different Real Estate and Securities brokerage licenses to date.
Rick has an extensive background in the financing of residential and commercial properties around the U.S with debt, equity, and mezzanine money. His funding sources have included banks, life insurance companies, REITs (Real Estate Investment Trusts), Equity Funds, and foreign money sources.
You can visit Rick Tobin at RealLoans.com.