GDP and Extended Low Rates

Mises Daily: by Doug French

The revised news from Washington is that the economy grew at a 5.6% rate in the 4th quarter of 2009. The folks who grind the numbers at the Commerce Department credit huge inventory adjustments, robust business investments and recovering consumer spending for the fastest pace of economic growth in six years.

This is one day after Fed Chief Ben Bernanke testified that he needs to keep rates low to help the economy recover. In prepared testimony for the House Financial Services Committee, he said, "the economy continues to require the support of accommodative monetary policies." And responding to questions, Bernanke reaffirmed that the high level of unemployment and low rate of inflation will continue to justify very low rates "for an extended period."

So evidently the Fed chairman either doesn't believe the phony numbers produced down the street from his office, or he has something to "support" with interest rates just north of zero.

That something is, among other things, the trillion-plus dollars' worth of second-trust deed loans on the books of the nation's banks. Now maybe a trillion bucks doesn't sound like all that much, but again, these aren't loans originated and then thrown into some sort of mortgage stew, called AAA, and ladled out to hungry buyers the world over. These are loans held by US Banks by the boatload. In its current issue, Grant's Interest Rate Observer points out that HELOCs (Home Equity Lines of Credit) and other junior liens at four of the nation's biggest banks are extraordinary percentages of Tier 1 capital at these banks: Wells Fargo 114%, BofA 93%, J.P. Morgan 55.7% and Citigroup 44.5%.

That is considerable exposure to loans that even House Financial Services Committee Chairman Representative Barney Franks realizes likely have no value. "[T]he first liens are well underwater, and the prospect for any real return on the seconds is negligible," Frank wrote in a memo to the CEOs of the big four banks.

Of course, Representative Franks' agenda is to goad the banks into recognizing their losses on the seconds they hold so they'll be more inclined to allow modifications to the first-trust deeds in front of them, which many folks are underwater on and screaming to their elected officials for relief from.

The curious payment data for the seconds is that people seem to be paying on them with more regularity than on their first mortgages. Grants runs through a number of reasons why this is so. But the most compelling explanation is that these banks have an ongoing relationship with their HELOC customers and are more likely to work on modifying a second for a customer they know. Plus, Representative Frank's point that these loans are essentially unsecured is not lost on at least some alert bankers who know they have nothing to foreclose on and are better off negotiating.

Besides, as mortgage and housing consultant Mark Hansen tells Grants, "The true default rate in the second liens has been obfuscated by the ability of banks to benchmark their rates against their borrowing rates." Hansen explains that banks can modify a second-lien loan to keep it "performing" (and not have to charge it off) by lowering the borrower's rate to one percent and require just interest-only payments. With the Fed charging rates just above zero, the big banks still make money on the spread, but more importantly the loan is considered performing and no hit is taken to capital, keeping the big banks in business.

And while the big banks are in business, they aren't currently in business making loans to businesses or any other private parties. Commercial and industrial loans are down 18% over the past 12 months. And as David P. Goldman writes, "American banks have reduced their loan book by US$350 billion — more than a fifth — since early 2009 and bought $300 billion of Treasury securities." Meanwhile, as Washington goes on a spending spree, the world's central banks "have not increased their holdings of US government securities to a significant extent," Goldman explains. "Their net purchases are running at a modest $20 billion a month, or an annual rate of $240 billion."

So no matter what GDP numbers the Commerce Department spins out, the interest rate Chairman Bernanke controls will stay low "for an extended period."