Paulson, interviewed on the Fannie/Freddie debacle, indicated that the scale of the losses to be absorbed by the taxpayer would depend on how long it takes for housing to “come back.” Certainly there are a lot of people waiting out there for housing to “come back.” What I don’t understand, is what does this mean? Housing is here, it hasn’t gone away, in fact there is more than enough for everyone… but really what people - including Paulson, I assume - are thinking, is that the bubble pricing is coming back, and somehow, miraculously, all will be well again.

Oh sure, after a long period of time, those prices will be seen again, just by the inevitable process of government deficit spending and inflation. But we’re probably talking twenty or thirty years from now, certainly not soon enough to bail out over-committed borrowers in the near future. Housing prices not only aren’t going back to bubble levels in the near future, they’ve still got a long way to go on the downside as the recession starts to bite and real, honest borrowers find themselves unable to pay. Only when the deleveraging process has run its course will prices stabilize, and even then it will take a long time for appreciation to resume, simply because of the lack of credit.

The Federal government put Fannie Mae and Freddie Mac into “conservatorship,” essentially the same as Chapter 11 bankruptcy. New capital will be supplied by the taxpayer, with the intention of keeping the money pumps going. 

As far as I can tell, Fannie and Freddie have been corrupt enterprises for years. It appears to me that the value of the implicit Federal guarantee, now explicit, has been, in effect, skimmed off to pay huge sums to executives and rich dividends to shareholders while keeping lawmakers quiet with extensive “lobbying activities” - read cash. Supposedly these will all stop. We’ll see.

In any event, there was no real choice. The bailout was inevitable and could have been much worse from the moral hazard point of view. The real question is, where is the accountability? This is a huge train wreck, and yet the train drivers are getting away without even a slap on the wrist. Clearly there has been systematic misrepresentation of the financial state of these companies. Perp walks are required.

At the end of the day, it doesn’t matter. The deleveraging will not stop. There will be more failures and more bailouts. Probably the most significant part of the announcement is that the Treasury will directly buy GSE MBS. This means that mortgage rates will now be set by the Treasury, and in effect the mortgage market is now completely socialized. That usually works well, doesn’t it? But Bill Gross got the bailout he was whining for and looks to have a winning trade on his hands. I guess you can never underestimate the willingness of politicians to mistrust markets.

During the 1930’s Great Depression, nearly half of all residential mortgages went into foreclosure. According to the Mortgage Bankers Association, 9% of all residential mortgages are currently either delinquent or in foreclosure. But the banks and financials are being bought today.

In any event, this isn’t your grandfather’s subprime anymore. This, per Jay Brinkmann, MBA’s Chief Economist, is USDA prime:

“Subprime ARM loans accounted for 36 percent of all foreclosures started and prime ARMs, which include option ARMs, represented 23 percent. However, the increase in prime ARMs foreclosure starts was greater than the combined increase in fixed-rate and ARM subprime loans. Thus the foreclosure start numbers will likely be increasingly dominated increasingly by prime ARM loans.“

Emphasis mine.

Probably the most powerful meme in the market today, held by both bulls and bears alike, is the belief that the Fed can inflate at will. Of course, to some extent it is always true. The Fed can print physical currency in vast quantities, which leads to the pictures of people buying their groceries with wheelbarrows (Weimar Germany) or backpacks (Zimbabwe) full of bank notes of staggering denominations.

However, it is my opinion that, despite his words, Mr Bernanke doesn’t want to be associated with Mr Mugabe’s economic theories and so he will not resort to physical currency printing on that scale. Therefore, if he is to inflate the “electronic money” supply, he needs to work through the banking system, because the “electronic money” supply is credit - bank credit. Just as a reference point, M2 is about $7.7 trillion, and the currency supply is about $0.77 trillion, so the “electronic money” supply, at least basis M2, is about nine times as large as the currency supply. Arguably, there are many other liquid assets that fill the role of money but the essential point is that any expansion of the “electronic money” supply depends upon an expansion of bank balance sheets. Which depends, in turn, on an expansion of the banking system’s capital base. With 60% or more of their collective assets dependent on real estate-related lending, the banking system is losing capital, not expanding. This is exactly what happened in Japan. The BoJ flooded the banking system with reserves, but banks crippled by loan losses could not expand their lending and deflation lingers to this day. In the end, the Japanese government took steps to recognize the losses with a program very similar to the RTC which cleaned up the Texas S&L massacre, and re-established a healthy - but smaller - banking system. It is worth noting, by the way, that M2 has essentially stopped growing since March of this year, and M3 has begun to fall.

But, you say, the price of just about everything, especially food and energy, is going through the roof. True enough. But that’s not inflation. “Inflation is always and everywhere a monetary phenomenon” said Milton Friedman, and they gave him a Nobel Myrdal prize, so he must have been correct. And even price inflation is about the “general” price level. While the prices of corn and crude oil have been going up, the prices of houses have been falling - about 15% in the last year, according to the S&P Case-Shiller index released this morning. Housing constitutes 23 percent of the CPI, but is measured with a ludicrous and arbitrary measure called “Owner’s Equivalent Rent“. If the CPI were calculated with a proper measure of housing costs, core price inflation would probably be negative, although food and energy price increases would have kept the headline number higher.

But the food and energy price increases are probably transitory, because they are primarily a result of speculative activity. Yes, China and the rest of the developing world have increased their consumption of resources, but the price signals have been doing their work and Americans have been reducing their consumption by, for example, reducing their driving by more than 5% over the last year. The inflation meme has led a lot of people to want to hedge their assets against inflation, leading to the creation of “real asset” or commodity index funds which simply stay long various commodities, usually by rolling huge futures positions. These funds of course have driven up prices, because the commodity supply couldn’t increase fast enough to absorb the influx of money into these funds. Then of course the folks who put money into these funds thought they were incredibly smart as they caused the inflation that they set out to hedge against. There couldn’t be a better example of George Soros’ reflexivity idea:

The key feature of these events is that the participants’ thinking affects the situation to which it refers. Facts and thoughts cannot be separated in the same way as they are in natural science or, more exactly, by separating them we introduce a distortion which is not present in natural science, because in natural science thoughts and statements are outside the subject matter, whereas in the social sciences they constitute part of the subject matter. If the study of events is confined to the study of facts, an important element, namely, the participants’ thinking, is left out of account. Strange as it may seem, that is exactly what has happened, particularly in economics, which is the most scientific of the social sciences.

It is ironic that this whole idea of real asset funds was started by Jim Rogers, who was Soros’ right hand man for many years. But I digress. Price signals in commodities adjust both demand and supply. Energy is probably one of the slowest to respond, but it is well established that supply responds to price signals with a two to five year lag and five years ago, crude oil was under $40. This is not to say that we don’t have a long term supply issue with oil, we do, but for the time being I expect to see energy prices continue to fall. This will bring price inflation more in line with monetary inflation - moving from disinflation to outright deflation.

The true threat to the economy is not the Fed printing currency, it is the slow collapse of the financial system, starving consumers and businesses of the credit that has been the fuel of growth, bringing about an economic dark age. It is, however, the Fed that caused the collapse of the financial system, by encouraging it to over-extend itself. 

The mainstream press and the victim-seeking politicians continue to understate the role that fraud has played in the property bust. A CNNMoney piece calls out the ongoing lying and scamming: 

With the housing market in turmoil and lending standards tougher than ever, you’d think that the kind of unscrupulous activity that helped plunge the industry into crisis would be a thing of the past.

You’d be wrong. Mortgage fraud is still soaring, according to a new report from the Mortgage Asset Research Institute (MARI), a division of ChoicePoint.