Fed Vows to Maintain Public Financial Health

Extend and pretend...

That's the government's way of handling the crisis. Extend credit and cash to those who don't deserve it. Then, pretend that everything is okay...

But the problems don't go away. They just get stretched into the future...

What did the feds do for GM? They took over the company. They extended cash and credit. They put in place a "Cash for Clunkers" program to encourage people to buy cars. Then, they pretended that the problems were solved.

But yesterday's news tells us that "August car sales plunged."

They hadn't really solved the problems at all. General Motors still needed to be restructured. And there weren't really anymore qualified auto buyers than there had been before. They had merely been encouraged to buy sooner...rather than wait until their cars were really worn out.

And look at what happened in the housing market.

July sales set a new record low. Why? Because the feds had encouraged people to buy earlier - by giving them cash incentives, via tax credits. For a while, it looked like the housing industry was picking up. But had any of the real problems been solved?

Nope.

Nearly 15% of all mortgage loans are either overdue or in foreclosure. And nearly one in four houses with mortgages is underwater. Another 5% barely have their heads above water, with equity of 5% or less.

When a house sinks under the waterline - that is, when its market value is less than its mortgage - the owner goes through the usual pattern of disbelief, denial, defeat and eventual desperation. If he loses his job or gets divorced the timeline is shortened. Either way, he ends up in the same place - desperate to get back on the surface where he can breathe again. It takes time. It's painful. But the longer the housing market takes to recover, the more these people give up and default on their mortgages.

The US financial system is still holding hundreds of billions worth of mortgage debt that isn't going to be repaid. Who's going to take those losses?

The feds have already made it clear - it won't be the big banks. They extended cash and credit to the banks and pretended everything was okay. The Fed itself bought up much of the big banks' bad mortgage debt already; it holds it in its vault and calls it an "asset." And the US government nationalized the biggest, most reckless and irresponsible lenders - Fannie Mae and Freddie Mac. So now the taxpayer takes the losses - even if he never bought a house...and never invested a penny in the housing industry.

And we're only talking about the domestic housing market - not about commercial loans. All together, the problem is still huge...and still there...

..and if housing prices fall - almost certain to happen as this "shadow inventory" hits the market - one out of every three mortgaged houses is likely to sink underwater, with millions of new defaults, foreclosures and distressed sales.

Extend...and pretend...and maybe the problem will go away. Or maybe the situation will become so confused that nobody knows whom to blame or what to think!

Ben Bernanke is hoping for the former and counting on the latter. He answered questions in Congress yesterday. At least one of the politicians wanted to know: "If you're so smart how come you told us that the subprime crisis would be 'contained.' How come you didn't seem to have any idea what was happening or what to do about it?"

"Okay...well... We were wrong about subprime...and we missed some signals," said the former Princeton professor of Finance, in so many words, "but you can count on the Fed to regulate the financial industry from here on. No problem."

Bernanke went on to describe how he thought financial problems got into the system and how they became hard to control.

"They are like bacteria...like e-coli..." he said (or words to that effect...we don't have the transcript in front of us, just the press report). "It is always dangerous. But you can control it if you use the proper procedures. Once it is out in the bloodstream there's not much you can do. It can be fatal."

Once again we see the same delusion...that corrections are alien invaders that can be fought and beaten...diseases that can be controlled and cured...problems that can be corrected.

Bernanke misunderstands the most basic and simple nature of an economy. With its new regulatory powers, he imagines the Fed as the Bureau of Public Financial Health, carefully inspecting the meat and making sure the kitchens are clean. If he does his job well, he implied, we won't have to worry about financial crises ever again. All we have to do is to get the bankers to wash their hands after making a loan!

Uh uh... That's not how it works. The problem was the bubble economy. It was caused by miscues and phony signals coming from the Fed (along with some other circumstances over which the Fed had no control).

The solution is the correction... In other words, the correction is the good part of the cycle. The bad part of the cycle was what created the need for it.

Once the mistakes have been made, they need to be corrected. A correction is not a disease - it's the treatment. Mistakes are inevitable...especially when you have Greenspan, Bernanke et al misleading investors and business with their phony money, artificial lending rates and crackpot theories.

Thank God there are corrections to fix them.

The correction will set things right...if it is allowed to do its work. Unfortunately, the apparatus of the feds is at work trying to block it...

Extend and pretend...

The idea now is to finance more errors - while supporting the old ones - with money from the federal government. If the feds can pretend that everything is okay...by extending enough cash and credit...then everything will BE all right...

..until the federal government itself runs out of money. Then, the whole thing blows up.

In the meantime, who can say he's not having fun?

*** Here's a thought from Bloomberg. The news couldn't get much worse, the analyst reasons; so it must get better. How? No double dip recession:

The US economy is so bad that the chance of avoiding a double dip back into recession may actually be pretty good.

The sectors of the economy that traditionally drive it into recession are already so depressed it's difficult to see them getting a lot worse, said Ethan Harris, head of developed markets economics research at BofA Merrill Lynch Global Research in New York. Inventories are near record lows in proportion to sales, residential construction is less than half the level of the housing boom and vehicle sales are more than 40 percent below five years ago.

"It doesn't rule out a recession," Harris said. "It just makes it less likely than otherwise."

The possibility of the economy lapsing into another contraction during the next year is 25 percent, he said in a Sept. 1 report. Harris cut his forecast for growth this year by 0.1 percentage point to 2.6 percent and lowered his 2011 estimate by a half point to 1.8 percent, according to the report.

We're not so sure. So far, this correction only took 4% off the economy at its worst point. Not very much, really. Stock prices are down. But stocks still aren't cheap. Unemployment is at 9%; it could be worse.

We ain't seen nothing yet. So far, it looks like we are following in Japan's footsteps. If so, the bottom won't come before 2018 or so...

Which is why you'd better enjoy this correction. It will be with us for a long time.

Regards,

Bill Bonner
for The Daily Reckoning Australia

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