Today I would like to welcome John Bougearel as a guest blogger at Real Estate Investor Girl.  He has written a post based on one that he recently ran on his blog, Successful Trading Tips With John Bougearel.  John is an expert in the field of financial futures and equity marketing.  His article today gives real insight on the credit crisis and the possible effect on the economy.  In advance, I would like to thank John for his contribution.





     The housing market has been complicated with over-levered homeowners with more debt than they can handle.  The situation is gripping the US economy in a manner similar to the Great Depression during the early 1930's.

    What is at stake here are the risks of another debt-deflation spiral like we had in the 1930's.  Even if the Fed won't speak of these risks in more than an opaque sense, others are beginning to sound the alarms.

     Consider this:  "In the fourth quarter of 2007, new foreclosures averaged 2,939 a day, double the pace of a year earlier. 

     US mortgage foreclosures are set to top 1 million this year and home prices are falling at the fastest pace since the Great Depression.  Bloomberg reported that the median home prices peaked in July 2006 at $230,000, and as of January 2008, the median home  has fallen to 9.5% to to $208.400 eighteen months later.

     Economist David Rosenberg sees "potential for another 25% to 30% downside over the next two years", in home prices on top of the already 9% drop.  A 35% drop from the peak median home price of $230.000, essentially  reprices to $151,000 in 2010.  Many homeowners at risk have no money down in their home."

     Amidst soaring debt burdens, financial institutions are starting to liquidate these unwanted assets at firesale prices.  Deutsche Bank sold a house in Virginia for $150,000 in December, less than half its last sale price of $315,000 in the spring of 2005.

     If the median home price declines anywhere near 25%, this could spell T-R-O-U-B-L-E for the U.S. economy.  "Keep in mind, says Merrill's, Rosenberg, that the relatively puny price decline to date has already pushed home loan delinquencies to their highest level in 20 years."

     Lehman Brothers, Thomas Russo said "The direction we are heading isn't a good one.  We need significant fiscal and monetary intervention.  The measures being taken by the "Hope Now" program to freeze ARM resets being advocated by everyone from Treasury Secretary Henry Paulson, to GS, JP Morgan, "just aren't enough" says Russo.  Nor is Project Lifeline, which delays the foreclosure proceedings by 30 days for some consumers.

     "About $550 billion of subprime loans will reset before 2009 and most borrowers will have no option except to walk away because the drop in home prices and an increase in lending standards will prevent them from refinancing or selling."

     State agencies already offering help homeowners are finding that "more than 50% of subprime borrowers are rejected by state programs because their homes have lost too much value or they have accumulated too much debt. Often the borrower just has too much debt and the home does not have the value to support the refinancing" said Geoffrey Copper at MGIC.

     It is for reasons like this that Alex Pollock, former president of the Federal Home Loan Bank of Chicago, is urging "the creation of a federal lending agency based on the Home Owners Loan Corp., or HOLC. created by Congress during the Great Depression."

     General economic theories about 'overinvestment' and over indebtedness' suggest that once a boom ends and the contraction begins, the economic downturn is accompanied by deflation.

     Economist Wilhelm Ropke described the phenomena as follows, "the credit expansion setting the boom going proceeds by way of the interest rate being 'too low'...are created [not out of savings but] out of nothing through the banking system." - Crisis and Cycles, 1936

     Elaborating on the solutions attempted by the government and Federal Reserve during the 1930's, Freidrich Hayek observed that, "To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about - because we are suffering from a misdirection, we want to create further misdirection." - Monetary Theory and the Trade Cycle, 1933

     A century before John Stuart Mill held the opinion that "in all the more advanced communities, the majority of things are worse done by the intervention of government than the individuals most interested in the matter would do them, or cause them to be done, if left to themselves."- Principles of Political Economy, 1848

     Echoing economists of yesteryear is Pimco's, Mark Kiesel.  He was recently quoted as saying that 'rescuing borrowers will only worsen the economic misery for everyone.  Keeping the market from correcting itself only prolongs the problem...The housing market will find its own bottom, without a government bailout."  Which is, I think, another way of saying that the market forces today are simply far more powerful than any interventionists measures can hope to achieve.

     Irving Fisher, another economist who lived through the 1930's Great Depression, believed the 'great cause of over borrowing' was easy money.  The depression grew out of a boom, which started in a credit currency boom  There were international debts of every description, long and short, public and private, the obligations running in every direction."

     The heavy debt burdens borne by subprime borrowers and banks today are fast becoming heavier with falling home prices and ARM resets.  The big fear today is that falling home prices amidst ARM resets they can ill afford will lead to more distressed selling which will further depress already falling home prices - creating the very same debt deflation spiral that Irving Fisher gave witness to 70 years ago.

     Irving Fisher went on to say that "if liquidation for some reason gets into a stampede, it wipes out credit currency, which lowers the price level and reduces profits, which forced business into further liquidation, which further lowers the price levels and reduces profits and so on and on - a tail spin into depression,...We now come to the paradox that if the debt gets big enough, the very act of liquidation puts the world deeper into debt than ever.  Payments could not catch up with the 'real indebtedness - the more we paid the more we owed." 

     As the props to consumption are flattened out, the downward risks to consumer spending and 'underconsumption' begin to mushroom.  The only viable prop left to the economy may just  be a huge increase in gov't spending says Bill Gross.

     Bill Gross proposes a 'return of depression-style economics, saying;  in the form of consumption has been artificially and fictitiously stimulated in recent years by financial engineering run amuck.  There is a legitimate question as to where its black hole imploding destructiveness can be totally countered with another dose of lower yields and deficit spending packages.  The $150 billion "return to sender" deficit plan advanced by Bush and the Congress, for instance, amounts to just 1% of GDP and is of marginal benefit to long-term prosperity'...

     'The U.S. needs a "demand-based" fiscal package alright, a $300-$500 billion permanent one, because as the system of modern day levered shadow finance slows to a crawl or even contracts at the edges, its ability to systemically fertilize economic growth must be clled into question. To provide a stable recovery path, government spending needs to fill the gap - not consumption.  Public works programs, badly needed infrastructure repairs, as well as spending on research and development projects should form the heart of out path to recovery.'

     "As Keynes theorized, when private demand falters, it becomes the responsibility of government to fill the breach.  Because it likely will not do so effectively until after a new Administration is elected in late 2008, the U.S. economy and its somewhat coupled global companions will sleep walk for some time and a resumption of prosperity as we knew it will be dependent on reform of monetary and fiscal policy resembling the 1930's, more than our past decade." - Gross' emphasis not mine.

To read the full article, go to:

Can Overindebtedness in the Housing Industry Lead to a Deflationary Spiral and Collapse of the US Economy????

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