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Finance

A Vicious Cycle

October 2008, F&I and Showroom - Feature

by Steven Palmieri

The U.S. government’s historic seizure and expected 5.2 trillion bailout of mortgage finance titans Fannie Mae and Freddie Mac on Sept. 7 was the latest example of mortgage industry’s fall. And while many auto finance experts maintain auto finance and the mortgage industry took different paths, recent announcements regarding leasing does reveal some parallels. Tracking the life cycle of a subprime mortgage and analyzing its impact on the typical consumer also exposes some similarities.

There are four components that affect the subprime segment: lender, home builder, realtor, and customer. Of these four, lenders can have the greatest influence on the economy because they deal with a form of money that’s difficult for the Federal Reserve System to control.

The Federal Reserve recognizes four types of money, or monetary aggregates, which are classified by M0, M1, M2 and M3. M0 is actual currency such as cash that is directly controlled by the Federal Reserve. Cash is the most liquid form of money and the easiest to control by the Federal Reserve. M1 represents money that is held in bank reserve vaults and checking accounts. M2, which we’ll call “bank money,” includes savings accounts, money market accounts, and certificate of deposits. M3, which we’ll call a “financial instrument,” represents instruments which provide evidence of ownership of interest backed by a debt, such as a home mortgage or auto loans.

And as the auto industry has come to realize, a lender can create a financial instrument that, in large enough quantities and under the right conditions, can create a chain reaction large enough to slow the economy. That’s because a financial instrument is the least liquid form of money. So, in a sense, lenders can gain a level of economic influence that overrides the authority of the Federal Reserve.

A great visual is the chart compiled by Mr. Mortgage and Foreclosure Radar called the “Financial Engineering of Payments.” The chart shows the median house price from 2000 through 2008. Note that as home prices more than doubled, the mortgage payments only rose slightly as a result of “exotic” financial instruments. These instruments allowed people to purchase more home than they could afford, similar to what long-term financing, flex-buy payments, leases, and balloons did for the auto industry. And if you don’t think there are any similarities, listen to this response from one Chrysler executive the day the company’s finance arm ended leasing.

“One thing that’s not in the best interest economically is that leasing gives you a chance to have a lower payment because you’re just renting the vehicle and you’re only financing the piece that’s the difference between what the residual value is the and the cost of the vehicle,” said Jim Press, vice chairman and president of Chrysler, in response to a reporter’s question during the company’s conference call with the media. “It has been used to try and bring customers in who cannot make a high payment and through leasing their payment is lower. But at the end of the contract they own nothing. They’re not building equity.”

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