Why Uncle Sam's Help So Often Hurts

A frightening pattern has emerged in the financial world. It goes something like this: a bad event happens; the government swoops in to help; and then things wind up getting worse. The perpetual optimists among us may wish to believe that the help came just in time to keep a bad situation from getting worse.

Reality spins a different tale. The government has a radically different legal and financial playing field than an ordinary investor. As a result, even when it acts with the best of intentions, Uncle Sam's assistance often winds up causing far more harm than good.

The road to Hell...
That effect is so strong that there's even a name for it -- "The Law of Unintended Consequences." It's what happens when an action designed to do one thing winds up causing something else entirely.

For instance, Federal Reserve Chairman Ben Bernanke has been injecting capital at a furious pace since January in a failing attempt to stave off a financial meltdown. Yet rather than acting as an expensive lender of last resort, the Fed has been aggressively lowering rates and extending borrowing privileges to more companies.

The more aggressive the Fed has gotten, the tighter the credit market has become, especially when it comes to interbank lending. Supporters would have you believe the Fed's actions were the only thing keeping any liquidity in the market at all. Yet nagging questions remain:

With the government offering an essentially unlimited supply of cash at unbelievably cheap rates, why would any bank borrow anywhere else? Why would any bank with excess capital to loan try to compete by charging less? As long as the Federal taps keep gushing unlimited supplies of cash at such cheap rates, the interbank lending market may never recover.

...is paved with good intentions
Likewise, foreclosures provide three very useful features to the mortgage market:

  • They entice people to pay their mortgages even when times are tight, in order to keep their homes.
  • They enable banks to loan money to people with less than perfect credit. The home is the bank's collateral if the borrower defaults.
  • When homes are auctioned after foreclosure, the prices they fetch tend to be near or below the low end of what they may really be worth. By establishing a price floor, foreclosures provide a basis by which lenders can feel comfortable making new loans on similar properties.

Yet when the FDIC took over IndyMac, it stopped that bank's foreclosures. Likewise, Treasury Secretary Henry Paulson is pushing to limit foreclosures as part of his massive investments in the country's banks. As cruel as it may seem, foreclosures are a necessary part of keeping the mortgage market functional. The tighter the restrictions on foreclosures, the less banks are willing to lend.

For the mortgage market to reopen, banks need to know that their collateral is good. For that to happen, foreclosures need to be a credible threat to keep people paying, and they need to continue to establish the price floor for homes. Without them, the mortgage market may never return.

Reality bites
In fact, mortgage rates have generally been climbing, in spite of all the cash being thrown at the banks as an enticement to loan money. When good intentions get paired with bad policies, we all lose, especially those who play by the rules. 30 year mortgage rates for financially strong borrowers with a 20% down payment haven't been this high in a long time:

Bank

30 Year Mortgage Rate

People's Community Bank (Nasdaq: PCBI  )

7.375%

Bank of America (NYSE: BAC  )

7.125%

US Bank (NYSE: USB  )

7.000%

With all that help causing borrowing costs for strong loan candidates to rise, is there any wonder why property values still haven't bottomed?

Pick your poison
At this point, unfortunately, there will be more economic pain to come, no matter what happens. If we continue down the path of government "help", the lending market may never fully recover. On the other hand, if their Federal funding gets shut off, cash-hemorrhaging firms like Ford (NYSE: F  ) and General Motors (NYSE: GM  ) may be forced into bankruptcy protection.

Even bankruptcy has its upside, however. It would allow those companies to trim their excess capacity while restructuring their massive legacy costs and debt loads. Once they emerged from their reorganizations, they would be in a far better position to compete against the new automotive titans of Honda (NYSE: HMC  ) and Toyota (NYSE: TM  ) . If a domestic auto industry is important, in the long run, bankrupting GM and Ford may actually be beneficial.

Bernanke himself once admitted that bad government policies worsened the Great Depression. It'd be a shame for history to repeat itself due to the unintended consequences of all this Federal help.

What now? The Motley Fool is here to answer your questions about this financial crisis. Send us an email at AsktheFool@fool.com, and check back at Fool.com as we answer your questions and cover the latest on the Panic of 2008.

At the time of publication, Fool contributor Chuck Saletta owned shares of General Motors and Bank of America. U.S. Bank and Bank of America are Motley Fool Income Investor selections. The Fool has a disclosure policy.


Read/Post Comments (14) | Recommend This Article (22)

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  • Report this Comment On October 16, 2008, at 3:16 PM, A3B wrote:

    This is the first sensible Fool article I've read since the atrocious mercantilist pleading to support the government 'bailout.' I had lost all respect for Motley Fool when I saw that email in my inbox. It is refreshing to read an article that actually starts to examine cause and effect.

    Governments can not create wealth, they only take and redistribute existing wealth. Unless Americans realize there is no magic money creation cure to the damage the Federal Reserve enabled fractional reserve banking system has done to our economy, policy mistakes will continue to sow seeds for another depression.

    Frank Shostak says it better than I can, so for those interested: http://mises.org/story/3151

  • Report this Comment On October 16, 2008, at 4:12 PM, Brettze wrote:

    Why is nobody blaming $150 oil barrels as a major cause of all the financial mess out there? Subprime borrowers stretch their necks to qualify for a loan based on the assumption that oil prices will not go up so much. maybe the government made a bad policy mistake of leaving Big Oil to its own devices. Our government is far more blind to the intangibles than tangibles which means that our government must keep tabs of current activities above and below the spectrum of visbility. Even if it may require second or third or fourth guessings of the ongoing events. so be it! This will throw in doubts into the speculative financial practices . No matter how bad a policy may be, speculators will be kept at home and scared as piss! Speculators are not likely to know facts first above of all, they tend to make quick bucks regardless of the morality. One day our government may intervene out of the blue will be enough to discourage slimy speculators off the boards... Citizens should be encouraged to speak out opinions to our government and the government can sift out the good opinions from the bad and useless and act accordingly on various levels of activities depending on the severeness of the speculator activities...I rather have a suspicious government than a dozed out knocked out watchdog...

  • Report this Comment On October 16, 2008, at 4:20 PM, Brettze wrote:

    Our police is so good at investigating crimes with those newfangled techologies that we saw on cop shows on TV of lately. Our government can be as good as our police at investigating crooked MBA style crimes as well. Somehow, we are not up to the task probably out of conflict of interests stemming from our own personal investments usually advised by corrupted full commissioned brokers and financial planners. The elitist class are supposed to rule our country fair and square , yet they are hoodwinking with the MBAs , CPAs, others for our own financial gains at great expenses on the lower classes of Americans. When things go wrong, we simply pulled the drain plug under the stock market.. whooosh! you are back to Stone Age! The elitist class are still doing okay, thank you!@

  • Report this Comment On October 16, 2008, at 4:26 PM, Brettze wrote:

    Dont you remember recently that we are arguing that higher oil prices are necessary to foster the so called alternate energy programs, or it wont take off... Al Gore came up with his fantasy film called "Inconventional Truth" just moments before the take off of oil prices into the stratosphere. Our government never bothered to enforce all car fleet to meet the antiquated 27.5 mpq CAFE for so many years. Car makers are more than happy to pay a fiine for every mpg under the minimum requirement. Our government had tried the capitalistic route since Reaganomics and it failed so miserably!!! It had been twenty years or more of capitalism since then and look at what we got now... Reagan won after 40 years of socialism under LBJ and Roosevelt as we had our fills of socialism.. I figure that 20 years of capitalism already whetted our appetite for more and I guess that we are in a great mood for a return to socialism! Thank you!

  • Report this Comment On October 16, 2008, at 4:27 PM, Brettze wrote:

    All the sufferings under Reaganonmics are swept under the rug as something INTANGIBLE TO US!! It is of no TANGIBLE VALUE TO US SO THEREFORE WE IGNORE THEM UNTIL THEY GREWO SO BIG AND OVERWHELMING TO A POINT WHEN OUR VERY STOCK MARKET CRASHED .. YEAH VIRGINAI, OUR STOCK MARKET CRASHED... Thank you!

  • Report this Comment On October 16, 2008, at 4:33 PM, Brettze wrote:

    I dont think many of us will want to start all over again with our continued contributions to Keoghs and IRA accounts ever again... it is a waste of time and money despite tax benefits.. It is not worth our headaches.. We will vote to tax eltiists more for our trusty Social System !!! We trust God not Capitalists !!! God Love You , but Capitalists Do Not Love You! Than kyou!!!

  • Report this Comment On October 16, 2008, at 4:35 PM, Brettze wrote:

    I am posting comments all over urging readers to suspend their contributions to keoghs and IRA accounts so to keep filthy traders out of jobs!! We have no choice but to leave Wall Street fallow for years to come.. We are not going to believe that it is wise to wait years for our savings to be restored... We will elect to use our contributions to pay off credit cards, mortgages and then cut up credit cards and be free of the crazy fees and insane interest rates... thank youi!

  • Report this Comment On October 16, 2008, at 4:37 PM, Brettze wrote:

    the capitalist hyptonizing investors is broken!! We are free of our zombie like staggering arounds finally!! it is too bad that it takes a stock market crash to break the hyptonizing !!! We are awake now and we are now determined not to listen to hacking capitalists no more... thank you!

  • Report this Comment On October 16, 2008, at 9:40 PM, catoismymotor wrote:

    Government does not grow by seizing our freedoms, but by assuming our responsibilities. – Michael Cloud

    The national budget must be balanced. The public debt must be reduced; the arrogance of the authorities must be moderated and controlled. Payments to foreign governments must be reduced. If the nation doesn't want to go bankrupt, people must again learn to work, instead of living on public assistance. – Marcus Tullius Cicero, 55 BC

    The inherent vice of capitalism is the unequal sharing of the blessings. The inherent blessing of socialism is the equal sharing of misery. – Winston Churchill

  • Report this Comment On October 16, 2008, at 11:28 PM, denniswolz wrote:

    10/01/08

    Do you want to make a difference?

    If you do, read the following and send it to at least 8 people. Also send a copy to anyone in Government that you know and let them know what you are going to do on Nov 4th. Within a few days everyone will have read the following and hopefully buckle down and have faith that within a few years you and I will be better off than the rich greedy bastards that now run your government and businesses. Bring main street back to life!

    What is going on now is very good for Main Street.

    Oil came down again today. Corn, Cattle, Soybeans, everything except gold is down today. This has to happen, now or next week or next month.

    Until Commodities match wages we are simply living in a false economy and it cannot continue forever. No way, now how. In the last 10 years wages have hardly risen for the 95% of the working public, adjusted for the devalued dollar wages actually fell. Commodities have risen as much as 10 times in that period (oil from $10 to $150). Wages pay for everything and commodities make up everything, gas, oatmeal, eggs, houses, you name it, what you buy is a commodity. Their price has to be relative to wages or you have to buy less.

    Our government, your banker, your talking heads on the TV and radio talked you into buying a house you couldn’t afford, a car you couldn’t afford, a student loan that you couldn’t afford, a credit card you couldn’t pay down, all to line their greedy pockets. This money was given to you even though it didn’t really exist so that you could drive up commodity prices and line their pockets. It might have made you feel good but it is destroying our way of life.

    Given all this oil needs to be somewhere between $30 and $50 per barrel. In fact if we could get oil to $40 the other commodities will be back to where they were before all of this funny money started flowing 10 years ago.

    How do we get oil prices down? Demand is going to do it sooner or later because the global economy will shrink until that point. We could speed up this drop in price and pump the reserve dry if you had to. Conserve, conserve, conserve, drive only when you have to. Once we get it down the government can keep oil down by buying and selling in the market with the vengeance of a greedy commodities broker who gets rich on the back of others. Another way is to strengthen the dollar, the higher the dollar the lower oil goes. Quit spending on stupid things until you balance the budget.

    Once main street can afford to buy gas and shop for groceries, then and only then will the markets start to function again. Then we can start to talk about fixing the system again. Stocks used to be in the form of certificates, you actually owned a share. If you bought a barrel of oil you took it with you, you actually owned something, you didn’t just trade it to drive the price up or down. When this is all over we need to establish laws that control greed and dishonesty, not laws that line the rich and powerful.

    Get rid of the IRS and go to value added. A rich fat cat buying a 10 million dollar home would pay 1 million dollars in tax to the government at 10 percent. You and I would have to pay the government 30 dollars if we bought a lawnmower for $300, 10 cents for a loaf of bread. A 10 percent tax would more than finance any government worth its salt, do away with the rest. The state would collect the money just like it does the sales tax every month and send it to Washington. Congress could make this happen overnight, but they will not because most of the money will come from the 10 percent at the top who are your congressmen and bankers and greedy CEO’s, your voice will never be heard on this matter.

    Have your government pass a law to cut all government employees by 33%. The waste in our government is criminal, criminal, criminal. By reducing government by a third you would actually speed it up and get out of deficit spending (balance the budget and spend real money again).

    Take interest rates to +-1%. Banks giving you money at 7 or 8 percent when you get less than 1 percent on your savings only builds more and more banks. Banks and your government do not have to be rich fat cats. Banks could lend money at 1 percent over their cost and still get by. The government could lend to the banks at zero, therefore interest rates at 1 percent.

    The cost of money causes inflation. High interest rates are simply passed on to the consumer in the form of price increases thus causing inflation and higher prices. Control the supply of money and you control inflation. Control the deflation of the dollar and you control inflation.

    Lower interest rates and save mortgage holders, a zero principal mortgage would owe how much every month at a zero interest rate, zero. Even the person that is over their head with a $500,000 mortgage would owe less than $900 per month at 2% interest. This would fix most foreclosures and be enough to pay for any work the banker is doing on your behalf. It will not pay his 10 million per year salary but who cares.

    The best way to fix this mess is to form a new Independent party and get rid of Republicans and Democrats. But we don’t have time to do this right now. The next best way to let our government know we are serious about a fix is to remove anyone in office on November 4th. Forget your political allegiance, anyone in government has to understand that we want change. Having all new faces in all units of government from the county rep to the state rep to the federal rep will send a message heard around the world.

    My vote in November is to vote anyone in out, it is a shame that Bush isn’t up for reelection so that I could take him out also. By the way I will be glad to be president, write me in as your candidate for president. I will do the job for free.

    Send this to anyone in government you know and wish them good luck in finding a job come January

    Thanks for your attention to this matter.

    Dennis

    Send me an email and let me know what you think – denniswolz@att.net

  • Report this Comment On October 16, 2008, at 11:38 PM, redneckdemon wrote:

    Well quoted.

    People don't want to hear things that may inconvienance them. I'm not a home owner, though I am planing on buying soon.

    As a military member, I have the luxury of cheap housing while I save up enough cash to buy a home outright.

    Everyone hates the idea of foreclosures, even banks, because it means that everyone except the guy buying it at the auction is losing money. But it is for the same reason you tried to stay out of trouble when you where a kid, and the same reason you try to obey the law today: consequences!

  • Report this Comment On October 17, 2008, at 3:02 AM, dividendgrowth wrote:

    Vote for Obama, get wage inflation, screw the stock holders(dirty evil capitalists), and your world will be perfect again!

  • Report this Comment On October 17, 2008, at 5:51 AM, Nomadizer wrote:

    Good article.

    Indeed, why believe the government's claims that they will be able to avert a depression.

    It is clear by now that they hadn't taken any lessons from the 20's deregulation and bubble.

    So then why they would have learned anything from the 30's...?

  • Report this Comment On November 06, 2008, at 12:19 PM, pthlsstrvld wrote:

    Reaganonmics have help more people than any government program ever. It has created real wealth across so many lines. The Market is crashing because the new administration is promising the end of Prosperity in America. It will be great to have cheap gas when you do not have a Job to go to. Yes we should be happy food prices are falling, those evil farmers out there are just steeling all our money. The path we are on right now and promised for the next four years will destroy Main Street also if we let it. Great Article, I want Government in my life as little as possible! If you are more than 6 years away from retirement, you should jack up your IRA contribution to as much as you can afford it will reap great rewards in the end. The market will be back it always does come back.

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