And The Bubble Goes POP!

What happens in an inflationary economic expansion? Credit comes into a market, getting sucked into ever-larger speculative ventures, driving up pricing in an asset class to the point where people check their good sense at the door in exchange for a shot glass full of hysteria. But unfortunately, growth fueled by speculation requires ever-more speculation to sustain it, and eventually the level-headed start to grow in number. When that happens, those holding the bag look for somebody, anybody to sell it to, but nobody’s buying, and the bubble bursts.

A lesson that Countrywide is learning all too quickly:

Countrywide Financial Corp. survived the first phase of the mortgage meltdown this summer thanks in part to a $2-billion investment from Bank of America.

But the Calabasas-based lender suffered a major new setback Tuesday when mortgage giant Freddie Mac posted a big loss and said it needed new capital — which could curb Countrywide’s ability to make loans.

When the mortgage crisis began last summer, Countrywide said it would cut back making higher-risk loans to concentrate on the safer loans it could sell to Freddie Mac and Fannie Mae, the government-chartered buyers of home loans.

That approach is now looking dicey in the wake of Freddie Mac’s surprising $2-billion loss and its announcement that it must raise more capital before its regulator will allow it to step up purchases of loans from lenders such as Countrywide, said Fox-Pitt Kelton analyst Howard Shapiro, who downgraded Countrywide shares.

“Countrywide’s survival strategy has depended on access to the secondary markets” — the companies that, like Fannie Mae and Freddie Mac, buy loans and bundle them into securities for sale, Shapiro wrote. The approach won’t work so well when Freddie Mac and Fannie Mae “are capital-constrained and may need to shrink.”

The merry-go-round has stopped, but Countrywide can’t get off.

In a world with real money, this doesn’t seem to be a problem. If you have to actually hold real money to loan it to somebody else, there is not enough fuel for the speculative fire to burn. In our current world, though, money is effectively free. It can be created out of thin air, and cannot bear to sit in a lake. Much like a river, it needs to flow, and it flows downhill to whoever is offering the greatest returns. Our housing crisis was created by cheap money. When prime lending wasn’t enough to lure the money, subprime and alt-A offered the returns it needed. The money kept flowing until it had saturated the market, and nobody was left to buy. And now it’s flowing elsewhere (perhaps commodities), leaving empty shells of former worth in its wake.

What’s the only way to hide the destruction? More money! And that’s what the traders are clamoring for. Ease the credit crunch! Lower interest rates! Bail-out! But all they’re asking for is air to pump a bubble that’s got a hole in it. They can’t repair the hole, so they desperately hope that if they blow enough air into the bubble, it might remain inflated.

The blame will go far and wide on this one. Unscrupulous lenders. Uninformed consumers. Not enough government regulation. There will be congressional investigations, maybe even some indictments and perp walks.

But only those of us in a tiny minority understand the truth: When money is free, it must expand and remain in motion to survive. It flows from asset class to asset class, but can never stay in one place long enough to be a store of value. Those who understand this– get rich. Those who don’t– get foreclosed.