US housing bill will not save the economy

Congress finally passed the housing bill and the President signed it, but champagne corks have not been popping. The president dropped his threat to veto the bill, presumably when his Treasury Secretary explained that, without the Fannie and Freddie bailout that it now encompasses, there would be a financial meltdown. The general view is that the bill is better than nothing and better late than never.

But it is not going to avert a whole lot more pain in housing, the credit markets and the economy.

While the mortgage refinancing piece of the bill is usually cited as designed to head off 400,000 foreclosures, it turns out that it's really more like 240,000.

The other 140,000 borrowers who use the provisions to re-negotiate their loans are expected to default on their new mortgages, too. That double default prospect is a depressing thought for taxpayers who will pick up the tab, and for anyone expecting much relief for the housing market. Worse still, whether the measure just passed averts 400,000 or 260,000 extra homes being put on the market, it seems likely to be a drop in the bucket. Dean Baker at American Prospect expects five to six million foreclosures this year and next.

US house prices at the end of May were down 18 per cent from their July 2006 peak, according to the Case Shiller index just out. It seems prices have quite a way to drop still, even if a 30 per cent drop does turn out to mark the bottom, as most commentators still predict. The Congressional Budget Office wants to think the Fannie and Freddie bailout, which was wrapped into the bill at the last minute, will 'only' cost the government $25 billion (Dh91.7bn).

But fund manager John Hussman points out that with foreclosures mounting, it's pretty reasonable to expect four per cent of the relatively conservative loans covered by Fannie and Freddie to default. Recovery on foreclosures is running at about 50 per cent of the loan amount on the homes. That comes to a two per cent loss on the book of loans. Two per cent of the $5 trillion of mortgages backed by the two behemoths is $100bn. The Budget Office said there was only a five per cent probability of that magnitude of loss hitting the US taxpayer. Soothing words to make it easier for Congress to go along? Just in case, Congress has raised the ceiling on the allowable amount of the national debt.

Several heavyweight economic policy leaders, including Joe Stiglitz and Larry Summers in the Financial Times, have condemned the Treasury's appearance of protecting both management and shareholders of Fannie and Freddie while taxpayers take on the losses. The Treasury approach is untenable because it creates moral hazard, except as a short-term fix that was the only one that was politically practical. But the voters are probably too befuddled by all this high finance to discipline the system into behaving responsibly even in the medium to long term.

Bill Gross, the ever-witty Pimco bond fund pundit, sees losses in US housing value of a trillion dollars. For Fannie and Freddie to be stuck with $100bn, one-tenth of the total housing loss, does not seem outlandish. The investment and commercial banks have taken some pain, with more to come, and homeowners will absorb plenty more.

Gross passes on the encouraging suggestion from a friend that the government should simply blow up a million empty homes to erase the glut.

Gross sees the Treasury's actual strategy as being to hope that home prices rise again before all these losses have to be recognised, but he wonders how that is going to occur. Mortgage rates are actually a bit higher now than when the Federal Reserve started slashing the short-term rate last fall.

And Gross thinks that only lower mortgage rates are likely to get house prices to reflate.

Well, if lots more young people started to form new households, that would also bid up demand. Young Americans spend most of their lives plugged into i-Pods and i-Phones, but does that mean they have not noticed the housing crisis? It seems a bit unlikely that they will hurry to lock themselves into assets that still have plenty of room to go down in price.

Nor will there be a lot of young families in a strong position to buy homes if jobs start being harder to find.

So far, US employment has held up amazingly well, given the sharp slowdown in housing and finance, but time does not seem to be on the economy's side.

Merrill Lynch may have tried to play for time, but their time appears to be up. They have now off-loaded a $30bn portfolio of mortgage securities to a distressed-assets fund for a miserable 22 cents on the dollar, and, at that, Merrill had to provide the financing for the deal. Each time Merrill wrote down that pool of mortgage debt over the past few quarters it proved to be insufficient. The planned re-capitalisation of Merrill announced at the same time as this truly ugly house-cleaning also looks quite modest, since the broker's plunging stock value requires them to make the last recap round's investors whole.

Temasek, the sovereign wealth fund of Singapore is putting more money in, but not much more. Without significantly replenishing their capital, Merrill will not be doing much lending. Merrill is not alone in its embarrassment, since banks always play copycat in their strategies and the risks they take.

More bad news from the other big names seems fore-ordained and there may be no more enthusiasm for injecting additional capital into them than there has been for Merrill. Since a lot of banking activity in this decade was destructive of wealth, removing that capacity would be no bad thing, except for the bankers themselves.

The economy, like Merrill, seems to be caught in a bind. With so many financial institutions floundering, credit is inevitably squeezed. The US needs to wean itself from easy credit and pay its way in the world, but weaning is best done slowly. Sudden withdrawal of credit would hit US consumption so hard that steep and prolonged global recession might be unavoidable.

It seems time for the surplus-running countries to take a lead. The Federal Reserve cannot solve the world's economic problems by itself. The petro-powers should be investing heavily in real business assets around the world, not necessarily into Wall Street bank capital, but into productive businesses somewhere. Meanwhile China has to raise its domestic consumption fast.

Otherwise, global output and employment could really tank. Some argue that rocketing commodity prices are telling us that global demand has outrun supply and that a slowdown would be healthy.

So how does one of the grand old men of economics see things turning out? Edmund Phelps, the winner of the 2006 Nobel Prize for Economics and a Columbia professor, has been a major thinker since the 1960s on where and why economic output and employment find their equilibrium.

His approach uses terms like natural rates of unemployment and interest that are no longer the fashion. Underlying that is the idea that macro-economic policy cannot alter the fundamental level of unemployment, an unpopular view that may be about to prove itself true again.

Phelps is here to tell us that the internet boom of the late 1990s and the housing boom through 2006 were a happy time that allowed unemployment to run at lower levels than us

ual without sparking runaway inflation. Now those booms are over and that pushes the inflation-neutral unemployment rate up.