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The Daily Reckoning Presents: George W. Bush announced his subprime plan last Friday, which he hopes will limit the number of borrowers defaulting on home loans as rates on adjustable mortgages adjust higher. Of course this plan relies on even more debt. Adrian Ash explains...

George W. Bush's Plan to Bail Out Subprime
by Adrian Ash

"The markets are in a period of transition," said George W. Bush in his speech from the Rose Garden on Friday. "America's overall economy remains strong enough to weather any turbulence." But just to make sure, America's financial Commander-in-chief put the credit of the entire US nation on the line.

In an effort to halt America's credit crisis in its tracks, Bush opened the Treasury's checkbook and grabbed the Presidential pen. He did not commit America's entire credit all at once, of course, he just flashed some green.

By promising to absorb the $100 billion in subprime real-estate losses forecast by his top monetary wonk, Ben Bernanke, Bush is in effect doing what many small-town US banks did during the early stages of the '30s Depression: Putting all the money where passers-by will see it, right there in the front window, just to prove that the money exists. That way, or so the logic runs, anxious depositors will see their money's still there... and they'll wait a while longer before forming a queue to empty the bank in a panic.

The big difference this time - besides the sheer size of Bush's bail- out - is that Washington is putting America's credit out front, rather than hard cash. The US government doesn't have any cash to put on display; instead, it owes the better part of $9 trillion already. George W. Bush is going to add the cost of subprime debt defaults on top - absorbing this summer's crop of late-paying home buyers, while establishing the expectation of unlimited future bailouts. These massive governmental rescue operations have a nasty way of exceeding initial forecasts. Today's $100 billion bailout, therefore, might easily become tomorrow's $200 billion bailout.

As the scope of Bush's intervention grows, what will become of international demand for Treasury bonds? Will foreigners continue to line up to buy American debt?

During the credit market turmoil of August 2007, professional money managers had fled into the apparent "safety" of US government debt. This massive "flight to safety" drove prices higher and yields down to multi-year lows. But the Bush bailout threatens to put an opposite trend in motion. Treasury bonds may become less safe than imagined. In a worst-case scenario, Treasury-bond buyers will get "shellacked".

The line of credit put on display in the Rose Garden on Friday is merely the credit of the US government itself. But that credit only exists for as long as US Treasury bonds find a bid at auction.

It's a bold move to be sure, and Bush likes to be known as "The Decider" according to Bill Gross, head of Pimco, the world's biggest bond fund. Taunting Bush's man-of-action self-image last week, Gross suggested that Bush step into the subprime disaster - "write some checks, bail 'em out."

Come Monday, Larry Summers of Harvard University joined the chorus, too. "Now is not the time for the authorities to get religion and discourage the provision of credit," he wrote in the Financial Times. Add the top academic economist outside the Fed to a guy that's running $692 billion, and that makes some chorus, right?

We can only guess at the phonecall that Ben Bernanke took from the West Wing mid-week. "The government's got a role to play," they must have agreed - a line Bush repeated on Friday. And in dredging up credit to bail out the US economy, the Decider's three-pronged plan is going to "shellac" bondholders three times over.

FIRST, as Washington's overnight briefing to the press explained, the Federal Housing Administration is going to guarantee loans for delinquent US borrowers. Set up during the Great Depression, the agency already acts to insure mortgages for low- and middle-income borrowers. Now anyone more than 90 days behind with their payments will get government-supported finance at lower, more favorable lending rates.

In other words, Washington is going to stall foreclosures by lending money to distressed debtors.

SECOND, Bush is going to ask Congress to suspend - but only for "a limited period" according to the Wall Street Journal - a US tax provision that penalizes borrowers who lose their homes to repossession or who try to reduce the size of their loan by refinancing.

Meaning that the government's going to cut its own tax receipts.

THIRD, the US government - through an initiative led by the Treasury and the Housing & Urban Development department (HUD) - will identify home-buyers at risk of defaulting between now and 2009. For them, it will create "more favourable" loans, working with private lenders and insurers to reduce rates in the market and reverse the move away from higher-risk borrowers.

Put another way, Washington is going to underwrite the next two years of subprime re-financing, actively seeking out defaults before they happen.

That means more new government-funded loans still. Because if the private banking sector can't raise funds to keep subprime US consumers in credit, then the US Treasury will. Or so Wall Street clearly believes.

The last time America faced a severe credit crisis - during the late '70s - inflation ate both equity and fixed-income investors alive. Gold, on the other hand, rose by 510% for Dollar-based buyers.

Of course, past performance is no guarantee of the future. But Spot Gold Prices just closed August '07 up more than 4% from the end of last year to record only the 11th month ever to top $650 per ounce. Six of those months have come in 2007 - and the global bid for gold only looks set to grow stronger as the panic of August rolls into September.

As a flood of dollars spills out of the U.S. Treasury, gold demand quietly surges. Global demand for physical gold rose by 19% between April and June according to the WGC's data. China's gold demand surged by nearly one third, says a Reuters report, while Turkey's gold imports could set a new record and gold buying in the Middle East and India is also on the rise.

"The early indications are for a very, very strong year for India's gold demand," said Philip Olden, managing director of the World Gold Council, on Thursday. Looking ahead to the traditionally strong gold- buying festival and wedding season now about to begin, he forecasts Indian gold demand in 2007 will rise by one-half from 2006, hitting record levels.

"We are seeing a very significant restocking process going on in the markets, primarily for India, as we are heading to the heavy festival season," says Andy Montano, a director at Scotia Mocatta, the bullion bank, in Toronto. "I suspect as we move towards the latter part of the year, the buying pressure will increase in line with the fact that we are heading towards the Christmas period [and] the Chinese New Year," agrees Darren Heathcote of Investec Australia.

George W. Bush just put the entire credit of the US nation right there, out front in the shop window, for the whole world to see. The gambit didn't always stave off a run on the bank in the 1930s. But you never know. It might work this time - for a while.

Adrian Ash
for The Daily Reckoning Australia

Editor's Note: City correspondent for The Daily Reckoning in London, Adrian Ash is the editor of Gold News and head of Gold research at Bullion Vault - where you can buy gold today vaulted in Zurich.

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