The newly announced Term Securities Lending Facility (TSLF) and Representative Barney Frank's proposal that mortgage lenders write down mortgages to current market prices in return for F.H.A. guarantees are the latest in a long line of panic-driven proposals that have failed to stem the seven-month long credit crisis, the worst since the depression. The great global credit boom is over and the cleanup is under way. The layer upon layer of leverage that propelled the ponzi-like expansion is now operating in reverse and the leverage is being unwound—albeit at a reluctant pace since few are willing to admit as to how dire the financial and economic situation actually is. All great booms are followed by a bust, and this was one of the greatest booms in economic history. It won't end with a few Fed rate cuts, multi-billion dollar stimulus plans and a relatively insignificant and brief drop in the stock market.
Since the crisis unfolded last August we have been successively bombarded with 225 basis points of Fed funds rate cuts, the Paulson super SIV plan, the interest rate freeze program, the TAF liquidity facility, the F.H.A. authorization to lend to subprimes, MBS acceptance at the discount window, the tax rebate program, the proposed rescue of the bond insurers, project lifeline to halt foreclosures, the federal mortgage guarantee proposal and numerous large injections of liquidity in various forms. The TSLF plan and the Frank proposal are the latest efforts, but won't be the last. Seven months after the credit crisis emerged a solution still seems far off, and a systemic melt-down is still a distinct threat to the global financial system.
The quick succession of moves by the Fed, Treasury Department and Congress indicate a problem so severe that it may be beyond the government's ability to solve without further serious damage to the economy. The jerry-built financial system took years to evolve and will take time to undo. Even Secretary Paulson, in his remarks this morning, indicated that the complexity of the structured finance instruments had gone beyond the ability of both sellers and buyers to understand them. Not only did buyers not understand what they were purchasing, but sellers did not understand what they had created.
Unfortunately the long line of various proposals does not address the underlying credit problem, does not improve solvency and does not stop the price of houses from continuing to decline. With inventories of both new and existing homes at record levels and demand low, only substantial additional price declines can clear the market. A number of mainstream economists now believe that home prices would have to decline another 20%-to-30% in order to clear inventories and bring prices in line with current incomes. Economist Nouriel Roubini estimates that every 10% drop in prices knocks another $2 trillion off total US. housing values. If he is right—and he has been dead-on so far—the total value of houses could drop by another $4 trillion to $6 trillion. Even now the current market value of 10% of all homes are at or below the amount of their mortgages. This will get far worse as prices drop and force hundreds of billions of dollars more in write-downs. Given this backdrop it is no wonder that the authorities are desperate to find a solution. We're afraid, however, that nobody really has the answers.
Given the extent and depth of the crisis it is far too optimistic to think that the economy will recover in the second half and that the stock market is bottoming now. The economy is faced with declining jobs, decreasing wealth, lower retail sales, less borrowing, high energy prices and near-record debt. It's also a stretch to say that the market is cheap when the S&P 500 is selling at almost 20 times trailing reported earnings. Some say that the market is only selling at 13 times estimated 2008 earnings by using an estimate for operating earnings that assumes a 43% jump in year-over-year earnings for the second half. We're not kidding! That's the consensus bottom-up number as calculated by S&P. Is there anyone who really believes that?
