As we have noted often, in tightly coupled systems like our modern financial regime, efforts to contain risk typically make matters worse. As Richard Bookstaber explained in his Demon of Our Own Design, there are two reasons for this phenomenon. First is that processes move through a series of steps that cannot be interrupted, so certain interventions are impossible short of shutting down the entire system (or a fundamental redesign). Second is that any intervention cannot be localized. It inevitably produces other effects that are at best unintended, and generally not neutral.
The latest illustration: one of the big motivations behind the latest “let’s save the banks” initiative was (first) to get interbank lending going, but a second, important goal was to facilitate mortgage lending, with the hope that volumes would improve, and even better yet, rates.
Unfortunately, in another example of unintended consequences, the improvement in interbank lending in occurring at a glacial pace, while mortgage rates went in the wrong direction, and quickly to boot.
From the Financial Times:
US mortgage rates have soared this week in an unexpected reaction to the latest Treasury financial rescue plan, which has prompted investors to buy bank debt and sell bonds backed by home loans.
Interest rates on 30-year fixed-rate mortgages, as measured by Bankrate.com, rose to 6.38 per cent on Thursday from 5.87 per cent last week – before the Treasury said on Tuesday that it would take equity stakes in banks and guarantee new bank debt.
Investors responded to the new guarantee by buying existing bank debt, reckoning it could be refinanced with the new government-supported bonds. As they did so, they sold lower-yielding paper issued by Fannie Mae and Freddie Mac, the mortgage companies put into government conservatorship last month….
Fannie and Freddie had been taken into conservatorship by their regulator to help keep mortgage rates low and – it was hoped – revive the housing market.
However, the opposite is now happening, making it more difficult for struggling homeowners to refinance their mortgages and for prospective homebuyers to get financing. As a result, house prices may fall further before they find a bottom…
Some analysts believe that further government intervention in the housing sector could be forthcoming to push down the cost of borrowing and help prices recover.
“Weak housing remains at the heart of the economic and financial turmoil, and the policy imperative will remain improving housing affordability,” said Janaki Rao, analyst at Morgan Stanley. “The possibility of a policy response to what is obviously an unacceptable outcome for policymakers has increased, in our opinion.”
The conservatorship brought down the cost of funding for Fannie and Freddie by making explicit a previously implicit government guarantee of their debt, allowing them to buy more mortgages. Before they were taken over, the fragile state of their finances had limited Fannie and Freddie’s participation in the mortgage market.