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19 Jun 2021 6:16
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  •   Home > News > Business > Features

    Can a bail-out work?

    The shocking fall in the markets this week are a necessary step on the road to recovery and one day there will be bargains to be had. However, I fear there is still worse to come. I like to say that a hangover normally reflects the extent of the party and in financial terms, the markets have been on a real binge for several years.

    Investment Research Group
    Investment Research Group
    The road to recovery could take quite a while, not least because the real pain has still to be felt in the property market.

    Our favourite economist, US based John Makin feels the same way. "We have reached a point in this highly disconcerting cycle at which a collapse of the housing market has totally frozen financial markets to a point at which banks are unwilling to lend to each other because they must conserve cash for fear of substantial withdrawals by panicky depositors.

    "To repeat, the collapse in the housing market could lead to a further weakening of the economy and a further collapse of housing. This dynamically unstable downward spiral must be interrupted," he said recently.

    He goes as far as describing things at present as an "extraordinarily difficult environment that rivals the financial and economic challenges of the Great Depression". He notes The US Treasury's proposal to Congress (assuming it is passed) to allow the purchase of distressed mortgage securities directly from banks, investment banks, and insurance companies will be difficult to implement.

    Such 'private label' mortgage securities are virtually impossible to value. Most institutions refuse to sell them at distressed prices because this would affect their balance sheet and raise questions about their solvency.

    However, holding requires financing. With house prices continuing to fall, the cost of financing has risen sharply and, in some cases, has become unavailable at any price. That is a key reason why banks and institutions are failing.

    If the Treasury pays too much for the distressed mortgage securities, the cost of any bailout will skyrocket. If offer prices are too low, more businesses will be insolvent. This tricky situation is the reason why Washington is trying to effectively nationalise the mortgage business at a cost (initially) of close to US$1tr.

    Makin is picking other support deals in response to the mortgage mess could cost a further trillion dollars. "There is a simple solution to the fundamental housing-bubble problem that lies behind the panic. An institution that makes a mortgage loan should be required to keep that loan on its balance sheet. That will mean higher interest rates on mortgages, but that is unavoidable. If policymakers understand why that is so, the problem need not be repeated. If they do not, we will have another housing bubble," he says.

    Where the US goes, NZ usually follows with a decent lag. On the positive side, our economy is less distressed than the US and our banks appear sounder and to have lent less badly.

    However, it is hard to see why people will want to buy property when there is the possibility - based on overseas trends - that prices will be lower in the future. Investors should keep reminding themselves that prices of property and shares will rise again one day and the best time to buy is when everyone else is selling. Timing such actions is extremely difficult, however.

    © 2021 David McEwen, NZCity

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