Steps to a Depression

Well, according to Bloomberg the federal government is going to force the purchase of bad mortgages by Fannie Mae and Fredie mac. Where are the fiscally responsible in government? Certainly there will be pressure to not just buy the bad debt but to perform more social engineering. Wait until Congress suspends or slows foreclosures. Non-performing loans will skyrocket.

The shallow (feel good) analysis is this will support the institutions with bad mortgages, help borrowers, and prop up the housing industry. Sounds good but it won't work. It will certainly appear to work. The unintended consequences will be people who have financial problems will support unsecured loans (car, credit card) and not pay the mortgage. This also makes homeowners upside down. If there is equity sharing, then at sales time the non-supported (responsible) borrower will build wealth substantially faster. Supported homeowners will also be less mobile since they will have covenants attached to there equity (if any). At least some of these borrowers will be very house poor even after discounting. The worst incentive to all this is that the prudent borrower (and taxpayer) supports the imprudent. Schemes like this have serious long term negative implications.

Let the loans fail. This is how the economy clears the excess and will start allocating resources away from bad and toward the good institutions. This policy distorts (capital) resource allocation into the poor performing and away from the (potentially) well performing.

Propping lenders and borrowers with taxpayer money is foolish. We tried this in the 1929 recession, did that turn out well? Nope, bad policy exacerbated the depression. Maybe we could look at Japan? Nope, zombie banks, zombie companies, and a lost decade. Ben Bernanke (Chairman of the Board of Governors of the U.S. Federal Reserve ) is a student of the depression yet we are heading down the path towards one.