America mortgaged at an adjustable rate

By Peter Schiff , invest­ment advisor –

The Fed­eral Reserve ran another “stress test” on major finan­cial insti­tu­tions and has deter­mined that 15 of the 19 tested are safe, even in the most extreme cir­cum­stances: an unem­ploy­ment rate of 13%, a 50% decline in stock prices, and a fur­ther 21% decline in hous­ing prices. The prob­lem is that the most impor­tant fac­tor that will deter­mine these banks’ long-term via­bil­ity was pur­pose­fully over­looked – inter­est rates.

In the wake of the Credit Crunch, the Fed solved the prob­lem of reset­ting adjustable-rate mort­gages by essen­tially putting the entire coun­try on an teaser rate. Just like those home­own­ers who really couldn’t afford their houses, our bal­ance sheet looks fine­un­less you fac­tor in higher rates. The recent stress tests assume mar­ket inter­est rates stay low, the fed­eral funds rate remains near-zero, and 10-year Trea­suries keep below 2%. Why are those safe assump­tions? His­toric rates have aver­aged around 6%, a level that would cause every major US bank to fail!

The truth is that higher rates are the biggest threat to the bank­ing sys­tem and the Fed knows it. These insti­tu­tions remain lever­aged to the hilt and depen­dent upon short-term financ­ing to stay afloat. While Amer­i­can fam­i­lies have had to stop pay­ing off one credit card by mov­ing the bal­ance to another one, this behav­ior con­tin­ues on Wall Street.

In fact, this gets to the heart of why the Fed is keep­ing inter­est rates so low. Despite endors­ing phony eco­nomic data that shows the US is in recov­ery, the Fed knows full well that the Amer­i­can econ­omy can­not move for­ward with­out its low interest-rate crutches. Ben Bernanke is try­ing des­per­ately to pre­tend that he can keep rates low for­ever, which is why that vari­able was delib­er­ately left out of the stress tests.

Unfor­tu­nately, rates are kept low with money-printing, and those funds are start­ing to bub­ble over into con­sumer prices. Bernanke acknowl­edged that the price of oil is ris­ing, but said with­out jus­ti­fi­ca­tion the he expects the price to sub­side. This shows that Bernanke either doesn’t know or doesn’t care that the real cul­prit behind ris­ing oil prices is infla­tion. McDonald’s, mean­while, is elim­i­nat­ing items from its increas­ingly unprof­itable Dol­lar Menu. A dol­lar appar­ently can’t even buy you a small order of fries anymore.

Unless the Fed expects us to live with steadily increas­ing prices for basic goods and ser­vices, it will even­tu­ally be forced to allow inter­est rates to rise. How­ever, if it does so, it will quickly bank­rupt the US Trea­sury, the bank­ing sys­tem, and any Amer­i­cans left with flexible-rate debt.

That is why the Fed feels it has no choice but to lie about infla­tion. If it admits infla­tion exists, then it may be pres­sured to stop it. How­ever, if it stops the presses, it will bring on the real crash that I have been warn­ing about for the past decade. Just as the Fed’s response to the 2001 cri­sis led directly to the 2008 cri­sis, its response to 2008 is lead­ing inevitably to either deep aus­ter­ity or a cur­rency crisis.

Imag­ine this scenario:

When the banks fail as a result of higher inter­est rates, the FDIC will also go bank­rupt. With­out access to credit, the US Trea­sury will not be able to bail out the insur­ance fund – which only con­tains $9.2 bil­lion as of this writ­ing. So, not only will share­hold­ers and bond­hold­ers lose their money next time, but so too will depositors!

Amer­i­cans are much less self-sufficient than they were in the Great Depres­sion. One only needs to look at Greece to see how a service-based econ­omy deals with this kind of eco­nomic col­lapse – crime, riots, van­dal­ism, and strikes.

There are a few coun­ter­mea­sures left in the government’s arse­nal, includ­ing sell­ing the nation’s gold, but there comes a point at which the cha­rade can go on no longer. The sharply widen­ing cur­rent account deficit shows that we are becom­ing even more depen­dent on imports that we can­not afford. Just as home­own­ers had a good run pulling equity from their over­val­ued prop­er­ties, Wash­ing­ton and Wall Street will soon find the music turned off. And there will be no one there to help them clean up the mess left behind.

I pro­pose a new rule of thumb: until true eco­nomic growth resumes in the dis­tant future, the fed funds rate should also be used as the “Fed­eral Reserve cred­i­bil­ity rate.” We’ll use a scale of 1–20, which is approx­i­mately how high rates went under Paul Vol­cker to restore con­fi­dence in the dol­lar. So, until the end of this cri­sis, if the fed funds rate is near-zero, all the Fed’s state­ments, fore­casts, and stress tests should be given near-zero cred­i­bil­ity. When rates rise to 5%, the Fed’s words can be assumed to be ¼ cred­i­ble. When they hit 20%, that would be a Fed whose words you could take to the bank – if you can still find one.

Posted by Randa Wagner on Apr 17 2012. You can follow any responses to this entry through the RSS Feed. Both comments and pings are currently closed.