Hover Craft

"Mr Preston, this operation will be a failure if we all die."
--Major Brad Little (Fire Birds)

Late last week rumors began circulating that the Obama administration, desperate to gain political points ahead of the Fall elections, might try something novel in the mortgage markets in order to light a fire under the economy. Over the last day or so, the chatter has been getting louder.

The rough idea as I currently understand it is that the federal government would order lenders to forgive some portion of mortgage principal for those borrowers who are upside down on their houses. Because the government effectively controls the two big guns in the mortgage market, Fannie Mae and Freddie Mac, it could effectively use them as conduits for swallowing the writedowns or reimbursing lenders for the forgiven mortgage amounts.

Presumably, the mortgages would then be refinanced at lower, government suppressed rates, and the commensurate lower principal amts would translate in lower monthly payments. How much lower would depend on who would qualify and how much principal would be forgiven.

Obviously, the underlying thesis is to put more money in the hands of consumers and to reverse the sour social mood w.r.t. consumption.

I have seen no figs on the cost of such a program but it would be big. Just to toss a number out there, if 10 million homeowners are upside down by an average of $50,000 and all of that difference is forgiven, then that would cost half a trillion dollars.

Such a progam would certainly be radical. Largely immeasurable would be systemic costs related to loss of confidence in contracting and to moral hazard effects--both of which would likely be larger than anticipated. My instinct tells me that the long term damage that such a program would would be devastating.

Moreover, there is some question whether the underlying thesis of this program would be validated. In other words, it is possible that consumers will use all that newfound cash to save and pay down debt--rather than spend it. Stated another way, we could wreck the system all for naught.

To cornered politicians however, desperate situations require desperate measures.

While I've been favoring a deflationary theme to how things evolve over the next year or two, the prospect of a Armegeddon-like response like this now finds me wanting to hedge my bets a bit. Bought some SLV today and will be keeping an eye on gold and silver as the inflationary canaries in the coal mine.

position in SLV