Recession Time

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says the widely followed Patrick.net housing blog.

But the "don't just do something, stand there!" philosophy is overly pessimistic. Policymakers have an obligation to make sure the downturn doesn't gather speed and turn into something along the lines of the long and deep 1973-75 recession. It is extremely dangerous for there to be millions of homeowners who have a clear financial incentive to abandon their homes because they are worth less than the mortgages on them. Already there are signs that the stigma of abandoning a home is fading, as desperate homeowners flock to Web sites with names like walkawayplan.com and youwalkaway.com. "People hate the banks," says Paul J. Helbert, a senior analyst and co-owner of Walk Away Plan in Glendale, Ariz. The entire capital of the U.S. banking system would be wiped out many times over if everyone who was underwater on a mortgage turned the keys over to their lenders.

There's a social aspect, too. Concentrated foreclosures, voluntary and otherwise, can destroy neighborhoods because abandonment increases decay and crime. And the housing crash undermines the social compact. "Talk about the rich vs. the poor was to some extent buffered by rising house prices. Now all you have to do is stare at your paycheck and your negative home equity," frets University of Chicago Graduate School of Business economist Raghuram G. Rajan.

The most urgent task is making sure that the financial system isn't so crippled by losses that it ceases to perform its critical function of moving capital from those who have it to those who need it. Asset deflations can damage the financial system. Further complicating matters is that securitization and derivatives make it nearly impossible to figure out who's vulnerable to a big loss until things blow up.

The Federal Reserve is already on the case, intervening in a big way under the leadership of Bernanke, who earned his academic stripes studying the policy errors that led to the Great Depression of the 1930s.

The Fed's approach is double-barreled. Since last summer it has cut the federal funds rate from 5.25% to 3%, and markets are forecasting the central bank will cut to around 2% before it finishes. The Fed may need to go even lower, though, perhaps to 1.5% or even back to its 2003-04 level of 1%. Lower short-term interest rates allow banks to rebuild their damaged balance sheets by paying less for the debt they carry, and they should also pull down market interest rates, stimulating the economy with cheaper loans for homeowners and businesses.

The Fed's second tactic is to ease the credit crunch by convincing market players that suspect assets really are worth something. It's doing that by giving commercial and investment banks new options for backing up their loans. The Fed's Mar. 11 move is designed to help its primary dealers—20 huge firms at the core of the financial system. They will be able to pledge a wider variety of collateral—including AAA-rated private label mortgage-backed securities—in exchange for top-quality Treasuries. And the loans will be for 28 days instead of just overnight. One immediate beneficiary will be Bear Stearns, which will have an easier time getting its hands on Treasuries it can then use as collateral for loans from other financial institutions that have been increasingly concerned about its ability to repay.

But the Fed can't do it alone. Lower rates don't help homeowners who can't qualify for a new mortgage because their homes have lost too much value. Also, massive cuts raise the risk of inflation, which in turn pushes up long-term interest rates, partially neutralizing the Fed's efforts. The Bush Administration's $152 billion economic-stimulus package will help a bit, but economists expect the lift to fade by the end of 2008, not long after the November elections.

That's why many analysts say the federal government will need to intervene directly in the housing market. "A month ago or two months ago I would have said the critical thing is to stimulate the economy.