The current economic debate really boils down to one essential question: “Will there be a recession?” To me, the question has about as much vitality as debating whether Roger Clemens will be inducted into the Baseball Hall of Fame. (With over 300 wins and more strikeouts than any other pitcher besides Nolan Ryan, the Rocket is a sure thing for Cooperstown). Similarly, a recession is not a question of “if??? but merely of “when.???
Most on Wall Street believe that a recession is unlikely because U.S. consumers can maintain their current spending levels. Given that vanishing home equity and escalating mortgage payments are now an undisputed fact, this faith rests on the belief that Americans will be able to go deeper into debt. However, the recent credit market contraction is a clear indication that those doing the lending are not signing on to the program, and that America’s spending spree is over.
After years of easy credit, many on Wall Street simply can’t conceive of a world in which credit is not available to anyone at any price. They do not understand that our current problems are the result of Americans having spent too much and now not being able to repay the money they borrowed to do so. The sooner Americans increase their savings by restraining their spending, the sooner we can begin to put our economic house back in order. The fact that such a shift will create a recession is unfortunate. Nevertheless it is necessary and inevitable.
Some high profile individuals have managed to put two and two together. This week in an interview on CNBC, Angelo Mozilo, CEO of beleaguered Countrywide Financial, connected the dots when he forecast a recession. The well-bronzed mortgage giant told Maria Bartiromo, “I can’t believe that when you’re having a level of delinquencies, foreclosures — equity has disappeared, equity is gone, the tide has gone out — that this doesn’t have a material effect, A, on the psyches of the American people, and eventually on their wallet.”
Others, including Ben Bernanke, claim to need more economic data before reaching a conclusion as to the fate of the economy. This is like waiting for the ship to fully submerge before admitting that there is a leak. To their credit however, the Fed has indicated that the overall effects of a recession can be healthy for the long term economy. However, from Wall Street’s perspective, any recession is immediately toxic as it will lead to lower earnings for the financial sector.
Interestingly, many of the financial luminaries sounding the loudest alarms are proposing solutions that will only make the situation worse.
In order to breathe life into the dying secondary market for non-conforming mortgages, some have suggested that Fannie Mae and Freddie Mac be allowed to buy jumbo mortgages. This overlooks the problem that many of these larger mortgages also feature adjustable rates that will likely show greater default levels when payments reset higher. Allowing Fannie and Freddie to buy larger loans now merely sets up a more expensive Federal bailout down the road, as both of these entities themselves will likely need to be bailed out when the conforming ARMs they already insure go bad as well.
Others, such as bond guru Bill Gross, have suggested that the Federal government itself establish a fund to bail out homeowners who can not afford their mortgages. Gross maintains that such a move would be necessary to prevent the biggest real estate price collapse since the Great Depression. If he truly harbors such fears, then he should know that creating such a fund will not prevent the disaster. Even if it means that millions of foreclosures do not occur, real estate prices will still have to fall substantially to return to normal levels and to be in conformity with traditional lending standards.
Setting aside the constitutional or ethical arguments against it, the cost of such a bail out would be staggering. My guess is that the price tag would exceed one trillion dollars (Gross estimates the cost at only around $200 billion). Even if Gross’ numbers are accurate, it still represents a significant sum which we would likely have to borrow from abroad. What Gross fails to consider is the moral hazard implicit in such a bail out. Were the government to create a program whereby anyone falling behind on their mortgage could have their loan restructured to some lesser amount with lower payments, one would have to be an idiot not to take advantage of it. If such a nutty plan were ever implemented, it would not be 2 million homes going into foreclosure as Gross fears, but 20 million.