Economic measures should right ship

When I taught my classes about the Great Depression, I always indicated that it was not the intensity but the crippling of the market structure that denied quick recovery from a severe recession and separated depression from recession.

Recessions are unfortunate adjustments to remove excesses that accumulate in expansions.

This time, the excesses in housing prices and ownership were intensified by the invention of debt instruments with teaser interest rates; zero principal paybacks for years; the piggybacking of 20 percent secondary loans on top of the traditional 80 percent mortgage; and other step-up payment products that virtually assured rising defaults and foreclosures if housing prices ever fell. In some cases, the borrower was expected to refinance in a few years because family income did not support any step-up in payments.

The new demand created by these financial instruments pushed housing prices well above justified levels relative to other assets. Remarkably, the financing gimmicks intensified even as prices became unjustified —- a 35 percent pricing distortion, according to my estimates.

Such excesses were bound to create a serious decline in construction activity and strain lending institutions.

The subsequent decline in lending capacity, about $9 trillion dollars; the forced reduction in borrowing for investment purposes; the erosion in stock values; and the ultimate decline in household wealth all were related to those excesses but were far larger than such excesses normally would require.

The question no longer is whether this is a recession.

Jobs have been lost every month this year. The October employment report shows job losses growing. More than 60 percent of all industries now are reducing job levels, so the adjustment has spread far beyond housing and construction.

As households adjust to their reduced wealth —- a loss of $8 trillion in the past year, according to some estimates —- weakness will spread even further.

I suspect that another six months of job losses in the 200,000-per-month range are likely.

Of course this is a recession.

As financial institutions teeter, I am wondering if this could be a depression. Have our bad underwriting of mortgages and mislabeling of the risk of bundled mortgages undone the financial institutions that must be able to provide resources while these adjustments take place?

Already, the Wall Street investment banking business has been converted into a bank holding structure that reduces the amount of lending provided per dollar of capital.

Banking loan losses are rising in consumer and commercial loans along with the construction loans. As a result, capital no longer is adequate to support the level of economic activity we had only a year ago.

Moreover, even those who have capital no longer wish to take risks. Investors are flocking into short-term Treasury debt.

Instead of bank runs —- although the FDIC may acknowledge that a slow run was happening at Washington Mutual before it was absorbed —- we have had account withdrawals from Wall Street investment bankers that threatened their existence, money market fund redemptions that forced commercial paper issuers to flee to banks, and hedge fund and mutual fund withdrawals that are creating the forced selling that continues to drive stock prices lower.

Fortunately, following the lead from Europe, the Treasury is beginning to bolster the lending capacity of banks. That has not yet bolstered the will of banks to lend, but it is a start.

Financial services could not be preserved on Wall Street when account withdrawals undermined investment bankers and runs on money market funds have not yet been curtailed, though deposit guarantees may be successful. However, Sheila Bair, head of the Federal Deposit Insurance Corp., has preserved bank services even as banks have failed.

We must do more work to remove destabilizing financial structures, such as those created by hedge funds using credit default swaps. Account redemptions leading to forced selling are the modern version of the margin calls that brought down stock values during the Great Depression.

While the risks remain elevated, some of the new policies should work. But damage has been done. Risk has gained respect. Even healthy firms will be shaving their dependence upon borrowed funds, meaning expense reductions and job losses.

There is a bottom, and it probably will be supported by what eroded the top —- housing. By next summer, our housing inventory excesses will be falling sharply. Builders will start anew, though cautiously and with cautious bankers looking over their shoulders.

I expect GDP to grow by summer and job losses to end before 2009 does. Unemployment probably will be over 8 percent and optimism will be near generation lows. Thus, recovery will be slow. Housing prices may not regain their 2005 price levels in many areas of the country until 2015. Stock values may not regain that October 2007 high until early in 2012.

We still have much work to do to avoid a repeat of such bad lending habits and to unwind some of the destabilizing investment processes and instruments that add to market instability. Confidence must be restored, and that is not helped by choosing who should fail.

I believe we have avoided the depression, but this is the first time in my lifetime that I even thought another depression was possible.

> Donald Ratajczak is a consulting economist for Morgan Keegan & Co.