Many places I read that the defaulting borrowers who cannot, or choose not to, pay their mortgages are victims and should be “bailed out” in one way or another. They are held to be innocents, insufficiently expert in finance and cheated by an industry which held an information advantage. The debate is mostly about how to bail them out, not whether or not they should be bailed out.

I think the sympathy for the poor incompetent subprime borrower needs to be tempered with the small matter of fraud. For example, most of the mess started with mortgage companies disappearing because they could not fund buybacks triggered by early payment defaults. Those defaults were most likely fraud by people who had no intention of making any payments after a cash-back transaction was completed. The spread of defaults from subprime to Alt-A is most likely due to the abuse of stated income, where survey data indicated that almost all borrowers lied to one degree or another. I’m sorry, but when people lie on a mortgage application, that is a deliberate crime, not incompetence.

Having said the above, it was inevitable that the gravy train would come to an end and the Ponzi borrowers left high and dry. But neither borrowers nor lenders believed this, any more than bulls believed the bear case in the stock market in 2000.

What about all the folks who believed the analysts about tech stocks? And who are believing them today? Should they all be bailed out too, because they are incompetent morons? I’m sorry but there is such a thing as assumed risk. If you make the choice to play, there are risks that you take that cannot and should not be socialized away.

The Case/Shiller index of house prices announced this morning for the second quarter registered its largest loss ever, 3.2%. The lower grade ABX indices tumbled further as defaults spiked in July. Sob stories about people who can’t sell their houses (can’t mostly means unwilling to lower price expectations sufficiently) are a daily feature in the newspaper. Credit card defaults rose significantly in the first half of 2007, and in June and July we see credit card debt rising at a rate not seen since the last recession.

The brutal facts are that we have a large segment of people whose lifestyle has been funded by debt. But now their “equity” is gone, either lost to depreciation or just spent. They are going to have to change that lifestyle, often dramatically. So far, they’ve just switched to the plastic, but that’s a desperate strategy given the cost of credit card debt.

No amount of government bailouts of existing debt is going to re-inflate the bubble. Lenders have been decimated and are in full retreat. It will be a long time before the mania returns. Consumption must fall, the savings rate must go positive even as incomes decline, giving a “double whammy”. My guesstimate is that consumption needs to fall by 20-25% in real terms. It is hard to imagine the consequences of such a crash. But on the other hand, everywhere I see extremes of extravagance, just like in the 1920s. Huge, powerful cars, enormous houses, more superyachts than ever before, luxury goods of every kind being sold in quantities to the aspiring nouveaux riches. It’ll be a doozy (Deusie). Yes, I’m a curmudgeon and not ashamed of it.

Sometimes I read things in the press that just make me shake my head in despair. This piece is a prime example.

“Two brothers, Antonio and Pedro, and Antonio’s wife, Isabel, bought a three-bedroom home in the East Oakland flatlands five years ago. They saved up a 3 percent down payment from the brothers’ jobs at a vegetable market and Isabel’s part-time work cleaning houses….

…The house is now worth $425,000, $100,000 more than they owe on the mortgage.

Now the Sanchezes want to follow the same trajectory as other first-time homeowners, trading up to a bigger house near their relatives in Woodland (Yolo County), in a better neighborhood with good schools for Antonio and Isabel’s two young children.

But the chances that they can sell their home, which has been on the market for four weeks, are slim.

“Luckily, they have equity,” said their Realtor, Mary Dresser of Prudential California Realty. “But if they can’t sell, they don’t really have any equity, or at least they can’t gain access to their equity….

Even cutting the price wouldn’t help, Dresser said, unless it were a “fire-sale” slashing of $100,000. “Then they’d have no house and no money,” she said.”

Get a clue, Mary. If cutting the price $100K would get the house sold, then that is what it is worth. These folks may have had “equity” at some point. But they don’t have it any more. I know, they are entitled to a $100,000 profit, at someone else’s expense, so they can “move up the property ladder”. Well heck, they’re hardworking after all, that means they get a freebie, right? Hello. That game is over, we ran out of “someone elses” when the last batch of “someone elses” couldn’t pay their debts. Those big profits in real estate came at the expense of people who shackled themselves to huge debt burdens, that even if affordable will keep them house-poor for a very long time and in many cases drive them into bankruptcy. Yes, they did so willingly, but people need to realise that trading houses doesn’t add any value to the economy, your profit is someone else’s expense.

When people expect a house to pay for their retirement, or their kids’ college education, or whatever, they need to understand that means someone is working to pay that money.

The Ponzi game of inflating the prices of houses with ever-expanding mortgage debt turned out to have a limit. The next stage of the game is already underway as the debt industry implodes. The really smug cities, like New York and San Francisco, that are the money (debt) centers are particularly vulnerable because they have had it so good for so long.

Since the selloff a little more than a week ago, and the subsequent emergency Fed intervention (lowering the discount rate, inter alia) the share market has recovered strongly. It is easy to understand why people are buying. The last two Fed emergency interventions were in 1987 and 1998. In both cases, the bull market resumed and share markets rallied strongly in the ensuing months. But before you assume it is all done, a little history might be instructive.

In October 1987, the S&P 500 fell from a high of 328 on October 6th. to a low of 216 on Oct. 20th., a 34% decline. It then rallied back 18% over the following 10 trading days to a recovery high of 256 on November 3rd, and then retested the low at 221 on December 4th. Following the retest, the bull market re-established itself.

In 1998, the July high was 1187 on the 20th. By September 1, the market had fallen 21% to a low of 940. It then rallied 15% over 16 trading days to a high of 1066 on September 24th., followed by a retest and new low of 923 on October 8th. The bull market then resumed.

In 2007, the S&P 500 made a high of 1552 on July 16th. It then fell a mere 12% to a low of 1371 on August 16th. 6 trading days later, the recovery high is up 7% from the low at 1464 on August 23rd.

Leaving aside the fact that the decline so far is minor by comparison, even if the bull market is going to continue (which I beg to doubt), history says there will be a retest of the lows. If the market turns up again strongly from there, decisively passing the previous recovery high, then the bull has a new lease of life. But not now. Not yet.

I posted this once before, back in May, but the situation is even more extreme now so I mention once more the following quote from George Soros: “I have come to distinguish between normal conditions and far-from-equilibrium conditions. In normal conditions, there is a tendency for the participants’ views and the actual state of affairs to converge or, at least, there are mechanisms at work to prevent them from drifting too far apart. I call these conditions “normal,” because that is what our intellectual traditions—including philosophy and scientific method —have prepared us for. I contrast them with far-from- equilibrium conditions, where the participants’ views are far removed from the actual state of affairs and there is no tendency for the two of them to come together. ”