Okay, anyone who has watched the news, or at least the financial news in the last week, especially after Bernanke’s testimony before both the Senate and the House has heard talk of an “Exit Strategy.”    I think that it would be well for us to take a few minutes and look at a couple of questions relating to that issue:

• What is an “exit strategy?”
• Why is an exit strategy necessary?
• What does it mean for the housing and mortgage markets?
• What should I do to prepare myself and/or my clients for what’s coming?

Before we get into those questions, here’s a clip from Bloomberg that talks about an exit strategy and what Bernanke might be thinking and planning.   This interview was done last week and was looking forward to Bernanke’s testimony this week.

Now, time to dig into the details of it.  What is an exit strategy? It’s pretty simple:

How in the world is the government going to get out of owning an insanely large share of the US economy and the US financial industry?

Seriously, we’ve got a big issue.   In order to keep the financial world from melting down completely (and I don’t believe I’m being melodramatic when I say that we were that close to a total meltdown), Bernanke and company had to throw everything they could at the problem to keep it from being a disaster.   So the government now owns large portions of many financial institutions, they are in the process of buying over $1 Trillion worth of Treasury bonds and mortgage backed securities, they are majority shareholders in 66% of the US car makers, and they have guaranteed billions and billions of dollars worth of bonds, mortgage backed securities and other very complex financial instruments.

Now I want to pause for a minute and say something about Fed Chairman Bernanke.   There are many people in the main stream media who like to bring up Bernanke’s comment in 2007 about the problems being contained in the subprime mortgage market and use that as an excuse for saying that Bernanke doesn’t know what he’s doing and shouldn’t be reappointed.   A couple of thoughts about that:

• Bernanke has a long standing reputation as a scholar and an extremely well educated member of the Federal Reserve, long before he was appointed to the “big office.”
• One of his main areas of his educational focus has been the Depression, what caused it, what was done during the Depression, and how the “solutions” made it worse than the original problems.

So, we’re dealing with someone who really knows what he’s talking about.   Is he a human?   Absolutely.   Has he made mistakes?  His “contained in subprime” quote is a classic example of a mistake that was made.   But in my mind, he has done more to prevent the terrible financial mess that we’re in from getting even worse than anyone else and deserves way more credit than he’s getting.

So we have a situation where we had to take emergency and heroic measures to save the economy from a total meltdown.   But now we have to figure out, once the market and the economy comes around enough, how do we get out of the situation we’re in:

• How do GM and Chrysler “buy out” the government from their ownership?
• How does AIG pay back the multi billions that they got from the government?
• How do the financial markets pay back the government?
• How does the Federal Reserve change their interest rate pattern and move it to a more “normal” pattern (rather than .25%) without tanking the economy?
• How is the Treasury going to change the 0% discount window that they are currently charging to banks to a “normal” rate?
• And how is the economy going to react as all of these things happen?
• And what is that going to do to the housing market?

Why do we need an exit strategy?

There are a couple of reasons that we need an exit strategy:

• Because socialism doesn’t work.   We are in a situation now where the government owns a substantial amount of our financial and auto industries and the long term prognosis of government run industry doesn’t bode well for our economic health.  I know what you’re thinking, “How well did capitalism serve us in the past 5 to 10 years?”   The answer, not so well.   But there’s a substantial difference between having the government institute rules and regulations regarding leverage, capital requirements and so forth, and the government actually owning the industry itself.   The one can work, the other won’t work.
• Because a 0% interest rate is and will eventually be inflationary. That’s right, the government is currently loaning money at 0% interest and eventually it’s going to come back and become inflationary.   Do I expect the inflation to show up soon?   More on that in the “what to do” section below.
• Because we have to pay the money back. That’s right, the government is borrowing all of the money that they spent on these bailouts and buyouts and we’re going to eventually have to start paying that money back.   The cost per tax payer would be simply unpayable.   If the amount is unpayable, then liquidation is the only way to go.   So, the government is going to start selling some of the Treasuries, mortgage backed securities and other collateral that they have purchased.

So, what does the need for an exit strategy mean for the housing and mortgage market?

There are a few things that it means looking forward:

• Bernanke said in his testimony on Capitol Hill this week that interest rates will stay stable and low for a substantial period of time.   I’m in total agreement with that statement.   I believe that we’re looking at most likely 12 to 18 months with stable interest rates.   I believe the overall trend during that period will be slightly higher, but not substantially higher.
• During that time period, the economy will begin healing.   It will eventually start turning around and become a decent economy.   As soon as that happens, inflation is going to become an issue.   When inflation becomes an issue, interest rates are going to spike and spike dramatically.   Am I willing to say how high?   Nope.   I’ll use the term substantially, but I won’t say how much higher than they are now.   Why not?  Because how high they go will depend in many ways on how the government does at unwinding all of the government interventions that have taken place.
• The law of supply and demand when it comes borrowing money for mortgages is going to make it harder to get a loan.   What’s that?   A couple of thoughts:  As the government unwinds their position in the Treasury and mortgage markets, they are going to flood the market with debt looking for a place to go.    If there is $100,000,000,000 out there looking for a place to go, it’s going to be easier and cheaper than if there is $500,000,000,000 out there looking for a place to go.    So, an investor has $20 Billion in his account and is looking to buy bonds.   He’s got choices of buying existing stuff from the government or buying new “stuff” that’s coming on the market.    The financial institutions that are coming out with new bonds and mortgage backed securities are going to need to make sure that their stuff is really clean (meaning good quality) and attractively priced (meaning higher rates) so that it can compete with what the government is trying to unload.

So we’ve got a situation where the likelihood is that over the next 12 to 48 months, we’re going to be looking at a government that needs to unwind their current positions in the financial markets and it’s going to create an economic situation where we’ve got higher interest rates, lower demand and the possibility of a double dip recession.

So what do you do to prepare for it?   And what do you tell your clients?   A couple of recommendations:

• We’ve got 12 to 18 months until interest rates go up. Any consumer, mortgage and business debt that won’t be paid off within the next 2 to 4 years should be moved to fixed rates. Why 2 to 4 years?  Because rates are so low that it’s going to take a little while for the “average rate” that you’d pay on a variable rate to catch up to what rates are going to go to.  Call me at (616) 209-8811 and let’s talk about how to go fixed on your debt.   E-mail me at tvanderwell@straighttalkaboutmortgages.com and we can take a look at things that way too.
• Take a look at your real estate holdings.   If you own investment properties, the time to look at whether you’ve got the right property and the right loan on it is not next month, next year or when Junior graduates from college.   The time is now.   Call my friend and real estate investment professional, Jeff, “Bawld Guy” Brown at (619-889-7100) or e-mail him at jeff@brownandbrowninc.com to get the input of someone who truly has your best interests and your retirement plan in mind.
• Take a look at your financial and real estate moves. Do you see the likelihood of wanting or needing to do anything in the next few years?   Buy a bigger house?   Downsize because the kids are moving out?   Move out to the country?   You might want to see if makes sense to adjust and tighten those time frames.

I have a confession to make, I didn’t see the scope and size of this economic crisis coming.   Yes, I felt that certain areas couldn’t continue to go up as fast as they did but the nearly nuclear meltdown, nope, I didn’t see it coming.   I do take some comfort in knowing that I’m not the only one who missed it.

But, I do see the unwinding of what we had to do to keep the ship floating as the source of trouble in the future.   Understanding and being prepared for what’s coming is a large part of handling an incoming storm.   And that’s why an Exit Strategy for the Fed makes a difference to the housing and mortgage market.

Stay tuned, I’ll be writing more in depth articles on Straight Talk – the Bigger Picture in the future to help us all adjust and prepare for the new realities that we are and will continue to face going forward.

Sincerely,

Tom Vanderwell