Will a Governmental “Bad Bank” Cause a Dip in Mortgage Rates?

The financial world is abuzz with the pending new stimulus package proposed by the Obama administration. That package will encompass many areas of the economy, with a major focus on the financial sector. One potential new program of the stimulus would be aimed at the bad debts held by banks. Yes, originally, the TARP program was supposed to do just that, buy-up bad mortgages held by banks, in an effort to stimulate new lending. Unfortunately, the plan failed upon implementation and the government instead, decided to invest in the preferred stock of banks and financial institutions.

The “Bad Bank” proposal does sound like a promising proposal to help banks to get the bad debt off of their books. This, in theory any way, would free up the banks to begin more liberal lending from short-term loans to long-term mortgages. The problem is, that banks are likely to continue hoarding cash unless their bad debt reprieve comes with an important string attached. Namely, that they won’t have their junk mortgages cleared off the books by the government, unless they begin lending on more liberal terms.

Whether this program gets off the ground is anyone’s guess, but it will most likely come down to an agreeable method used to price these bad assets. It is possible that, if the pricing model is done wisely, that both the banks and the government (taxpayers) will make out very well in the long run. The banks will receive a sound balance sheet, creating more leverage to fund low to moderate risk loans at low interest rates. This in turn, will aid in stabilizing the housing markets, which will benefit everyone, including the economy. The government will receive underwater mortgage securities that they can hold until they are even or above water once home appreciation begins again. Yes, the taxpayers could actually make a profit on the deal, long term.

So, how would a bad bank setup affect current mortgage rates? Most likely, we would experience a significant dip in mortgage rates, at least for the short term. With more clear bank funds available, and a government kick in the butt to make home loans, the mortgage spread would probably decrease from it’s current high levels and directly be reflected in lower offered mortgage rates.

If this stimulus creates more demand for housing, then stabilization for housing prices could finally be achieved. With home prices stable, mortgage risk decreases, and the spread will decrease in kind.

Yes, a bad bank can be a good thing for us all.

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