Thursday, March 06, 2008
Today's Flow of Funds report from the Federal Reserve provides evidence that Ben Bernanke might be onto something with his idea to save the economy by having banks slash the principal owed by homeowners who are losing their home equity.
Things seem to work best in the U.S. when household assets rise faster than household liabilities - this is the very foundation of our consumption-based economy and life as we know it - so, if you can't keep asset prices rising (which seems pretty obvious now) maybe cutting liabilities at an even faster pace would be the next best thing.
If the red line could plunge down below the orange line in the chart above, then the economy will surely get a boost - things would be back to normal, sort of.
The difference would be that, instead of assets rising faster than liabilities are rising (life as we've come to know it) liabilities would be dropping faster than assets are dropping.
It would have the same effect - homeowners would feel wealthier.
For example, suppose you bought a house in California three years ago for $500,000 and then you heard that the one down street sold for $600,000. Then the bank called and wanted to increase your home equity line of credit by $100,000.
That's the way things are supposed to work.
What's been happening lately is that houses down the street have been selling for $400,000 and then banks have been calling to tell you that they've reduced your home equity line of credit by $100,000 or they've cut you off completely.
That's no way to run an economy.
Under the proposed Bernanke plan, even after the house down the street sells for just $400,000, then the bank could call to tell you that they're increasing your home equity line of credit by $100,000 because they've just reduced your outstanding principal by $200,000.
Do you see how this could work?
In a worst case scenario, this process could be repeated over and over where homeowners' outstanding principal could be reduced in $50,000 increments "freeing up" more and more home equity.
Of course, there is probably a lower bound there somewhere as the bank is not likely to call you up and tell you that they now owe you - the homeowner - money.