AS THE U.S. and British housing bubbles continue to deflate, leaking stale gas like an air-bed blown up when you're… … drunk, just how much trouble will come from government schemes aimed at saving over-geared debtors and over-lent lenders?

“Too many unaffordable mortgages are causing a never-ending cycle – a whirlpool of falling house prices and limited refinancing options that contribute to more defaults, foreclosures and the ballooning of the housing stock.”

So said Sheila Bair – head of the Federal Deposit Insurance Corp. (FDIC) – in a speech at the Brookings Institution in Washington D.C. last Friday. Spying the same problem that the British government here in London now faces, she wants to see the housing slump fixed – even though it's not strictly within her brief – and quick.

But seeing how the FDIC has closed three US banks already this year, and given its own claim that lenders lose 40% or more of each mortgage that falls into foreclosure, maybe it's worth asking: Just how worried is the FDIC about the housing slump turning into widespread financial failure?

Because for an agency charged with protecting cash savings, it's sure got a weird way of defending the value of cash today.

“We are now undergoing a self-reinforcing cycle of default, foreclosure, home price declines, and mortgage credit contraction,” says the FDIC's full proposal on its website, “the likes of which we have not experienced since the 1930s.”

The FDIC itself, of course, was born during that decade – but only after more than 5,000 banks went under in the United States, often destroying people's entire life savings as they sank. To climb out of the Great Depression, the US then needed a deposit insurance scheme, said President Roosevelt in March 1933, because it “had a bad banking situation.

“Some of our bankers had shown themselves either incompetent or dishonest…[using] the money entrusted to them in speculations and unwise loans.”

Now the FDIC – along with the Federal Reserve – is trying to contain the mess caused by “speculations and unwise loans” once again. Off-plan flippers and mortgage-backed bonds have taken the place of shoeshine boys and Wall Street investment trusts. But the nuts and bolts remain the same – “excessive leveraging, misrepresentation, insider conflicts of interest, non-transparency, and the triumph of engineered euphoria over evidence,” as Robert Kuttner, editor of the American Prospect, put it in testimony to the House Financial Services Committee last October.

“The financial economy…is dangerously unsound,” he went on. “And as every student of economic history knows, depressions – ever since the South Sea bubble – originate in excesses in the financial economy, and go on to ruin the real economy.”

Desperate times call for desperate remedies, of course. Witness the ever-muddled response from the British government here in London, for example. Both timid and bold as always – and therefore impotent at great expense – Gordon Brown is opting to buy unsold units straight from the home-builders, and then rent them out to lower-income young buyers.

But the prime minister's only putting up £200 million ($389m) of taxpayers' money, enough to buy a mere 2,000 properties at current prices. And while offering first-time buyers an extra cash gift of £1,500 (some $2,900) to help with their costs, that won't even cover the sales tax he then claws back on completion.

Similarly in the United States, unsold houses – dumped on the market as a result of record high foreclosure rates – are now depressing home prices, thus denting new loans and refinancing still further. That dents house prices once again, leaving 11 months worth of unsold units sitting on home-builders' balance sheets last month, an all-time record surfeit.

None of which does anything to boost incomes or profit in the finance industry, strung out as it is on “innovative” consumer credit. Nor does unsold inventory help the construction industry – source here in Britain of 8.2% of annual economic output, according to the Dept. for Trade & Investment.

One in every 14 employees in the UK, it adds, now works in the building trade. So the whirlpool that Sheila Bair sees in the US threatens to pull down more than just Florida condos.

“Frankly, things may get worse before they get better,” said the chair of the FDIC in Washington on Friday. “As regulators, we continue to see a lot of distress out there.” And as a regulator, of course, she can't see a problem without offering taxpayers' cash as the answer – and it's those loans which were “unaffordable” right from the start she wants to see tackled. The FDIC is asking the US government to put taxpayers on the hook for $50 billion. The very worst mortgage loans of 2004-2007 will benefit.

“We need to help those who can't afford their mortgage as opposed to those who just lost value,” as Bair explained to Mike Benbow of the Everett HeraldNet last week. The cash-saver's champion wants the Treasury to issue “Home Ownership Preservation” loans (or “HOP” for short), which will let home-buyers who took out an unaffordable loan pay off 20% of their mortgage instantly.

“Mortgage holders [meaning lenders] would get the cash and restructure the remaining 80% into fixed rate, affordable payments,” says Bair – “and they would agree to pay the government's interest for the first five years. That way, the HOP loans would be interest-free to the borrower for the first five years.”

If you're interested in enjoying an interest-free mortgage until 2013, then…

#1. Check that your mortgage was approved between New Year's Day 2003 and the end of June 2007. During that window, average home prices in the 10 biggest metropolitan areas rose by one half. They'd already risen by 73% over the previous five years, however;
#2. Make sure your mortgage now equals no more than 125% of the average home price in your local area. For fancier homes in fancier areas, it can run up to 175% if local house prices are deemed “high cost” by the Federal Housing Administration (FHA);
#3. Finally cast your mind back – you could not afford this mortgage right from the word go, correct?

To help you with Step Three, the FDIC – which will play no part, it seems, in funding or administering this scheme – sets a simple hurdle:

Did your monthly housing costs, back in the very first month of your loan, total 40% or more of your gross monthly income?

Bair reckons she'll help one million home-buyers on this metric, funding “unwise” loans to keep foreclosure rates down. This ratio of repayments-to-earnings measures your “front-end” debt to income (DTI) alone; it doesn't take any other debts or monthly repayments into account. It simply includes your direct home-buying costs – mortgage payment, property tax, home-owner's insurance, plus any housing association fees.

Most lenders like to see a front-end DTI around 28%, says John Crenshaw – the loan officer from Southern California behind Truthfullending.com. So the FDIC's proposals, starting with that $50bn loan from the Treasury, would seem to target only the most speculative loans made by US mortgage originators.

But hey, that's where the trouble sits, right?

Never mind the precedent this scheme sets for future lending and debt. And who cares what this $50bn injection – pumped right into the heart of the mortgage crisis – will do to the value of the cash deposits that Bair's organization insures on behalf of more prudent savers?

Like the US Dollar itself, they're getting precious little protection from the Federal Reserve; not with interest rates now almost 2% below the rate of consumer-price inflation. And whether this scheme means foreclosure averted or merely delayed, we can't see here at BullionVault how this big money fix will ever prevent speculation in unaffordable mortgages in future.

We also wonder why the FDIC is asking government to inflate away the value of cash savings, increasing the supply of money to lenders who made what were very “unwise” decisions between 2003 and mid-2007.

Maybe the FDIC knows something we don't? Ah, but as Sheila Bair herself said HeraldNet last week, “people are trying to scare others so they can sell them Gold and stuff like that.”

Whereas the FDIC wants to scare people into approving a $50-bn package for over-geared debtors and lenders.

Adrian Ash
BullionVault

Formerly City correspondent for The Daily Reckoning in London and head of editorial at the UK's leading financial advisory for private investors, Adrian Ash is the editor of Gold News and head of research at BullionVault – where you can Buy Gold Today vaulted in Zurich on $3 spreads and 0.8% dealing fees.

(c) BullionVault 2008

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it.