Recession, and how to limit it.

if we are not in a recession, it is a darned good imitation of one; we are in an unprecedented real estate and credit crisis that is whipping its way through the U.S. economy.

--Kevin Giddis, managing director, fixed income trading, Morgan Keegan & Co.


Joanne Morrison of Reuters offers signs that our economy is in a bad spot:

• While a decline in U.S. home prices is needed to attract buyers back and end the housing slump, there is no bottom in sight. Policy-makers like Federal Reserve Governor Frederic Mishkin fear potential home buyers may wait on the sidelines for an extended period. Even though U.S. home prices fell last year for the first time in a generation, sales continue to slow, only adding to the glut of inventories.

• "We're not near [the bottom] yet so people are going to continue to wait on the sidelines," said JPMorgan economist Michael Feroli. "The Fed should forget about everything else now and just do whatever is necessary to bring a bottom for home prices into sight," said John Lonski, chief economist at Moody's in New York. The Fed's latest data shows that the net wealth of U.S. households in the final three months of last year fell for the first time in five years, and the percentage of equity that Americans have in their homes sank to the lowest since 1945.

Is there a way out? Martin Feldstein of Harvard, chairman of the Council of Economic Advisers under President Reagan, thinks there is. He says a voluntary loan-substitution program could reduce the number of defaults and dampen the decline in house prices—wihout violating contracts, bailing out lenders or borrowers, or increasing government spending.

Feldstein calls current housing-related risk greater than anything we have seen since the 1930s. After house prices exploded between 2000 and 2006, rising some 60% more than the level of rents, the inevitable decline since has reduced prices by 10%,with an additional 15% to 20% decline needed to correct the excessive rise. Yet these lower prices will mean widespread defaults and foreclosures, unemployment, and declining economic activity.

To limit the damage, Feldstein wants public policy to reduce the number of homeowners who will slide into default. Since house prices still have further to fall, this can only be done by reducing the value of mortgages. Here’s how Feldstein’s government program might work:

The federal government would lend each participant 20% of that individual's current mortgage, with a 15-year payback period and an adjustable interest rate based on what the government pays on two-year Treasury debt (now just 1.6%). The loan proceeds would immediately reduce the borrower's primary mortgage, cutting interest and principal payments by 20%. Participation in the program would be voluntary and the interest payments would be, like mortgage interest, tax deductible. The current mortgage servicer would collect both on the primary mortgage and on the government loan, remitting government payments to Washington. Homeowners will participate if they prefer the certainty of an immediate and permanent reduction in their interest cost to the possibility of defaulting later if the price of their home falls substantially.

Feldstein says the government must act quickly to reduce potential mortgage defaults, using something like his loan substitution program.