Halfway Through the Process

The first part of our national economic nightmare is over.

But only the first part. (Picture from Cashflowrollercoaster.com.)

What we've seen in stocks is a classic bear market. Prices fell roughly 20% from their highs, from over 14,000 to (briefly) under 12,000. They then re-traced about a quarter of that loss, and if they go higher still it's no all-clear signal. Most bear markets retrace half their initial loss.

What happens next is a test of the lows. This is just what happened nearly a decade ago in the dot-bomb. It's what happened in the "Asian contagion" of the late 1990s, and in nearly all previous bear markets. If the lows hold it's over.

But the lows don't always hold. That was true for Japan after 1987. It was true for Wall Street after 1930. And in this case there is real fear that the lows may not hold.

The reason is that under all this crap is the Big Shitpile, the mortgage derivatives created by unregulated markets over the last few years. Basically investment banks were creating money on their own, with no controls, by simply defining new securities based on these mortgages and selling them as though they were worth something. The ability to do this inflated home prices, because lenders didn't have to consider the risk a borrower wouldn't pay. The unregulated market was hungry for any new collateral.

Federal Reserve intervention staved off the first phase of panic, but there could easily be more to come. Millions of mortgages will re-set this year. Millions more are "underwater," more money owed than the value of the home. These are both opportunities for speculators to get-out, and since the bankruptcy law of 2005 made home debt less important than credit card debt (you have to pay the credit cards in bankruptcy now, but you can walk away from the home) there may be millions more foreclosures to deal with.

Each one of those foreclosures will have a ripple effect. Each mortgage is tied to other securities, all of which default or lose value when a homeowner walks away. How many are there? No one really knows.

So far home prices have dropped about 11%, and newspapers are saying this is a disaster, but it's really not a big deal. I think prices will fall by at least 20%, probably more, meaning lots more mortgages go underwater, as lenders tighten their standards, knowing they may have to hold the paper themselves for a while.

We have yet to see the second leg of this thing, in any market.

I agree with Nouriel Roubini (and CNBC's Rick Santelli) that these unregulated markets need to be regulated. We can't let speculators control our money supply, period.  I wrote the above paragraphs before seeing his warning that it's going to get worse.

That's why this panic is actually worse than anything we've seen since 1929. All U.S. financial downturns since 1929 took place in regulated markets.  I have to repeat. This is an unregulated market. Thus, it's bound to be more like the 1873 panic (the cartoon is from that year) than  anything those now living are used to.

But I disagree with Roubini on why it's going to get worse. He thinks it's because of global confidence. I say it's because of the slow-motion nature of the crash. In a liquid market, like stocks, you find the bottom fairly quickly, even if you get there in a panic, and then you start to rebuild.

In an illiquid market, and real estate is about as illiquid as it gets, bottoms are harder to find and take longer to appear. Any conventional analysis shows we're nowhere near the bottom in real estate, and with those loans tied to so many other instruments the crisis has to go on for at least another year.

Can the financial system handle it? Stay tuned.

UPDATE: A fascinating chart from Brian Jacobs (via The Big Picture) showing home prices in ounces of gold. Basically it's 100-200 ounces in the early 1990s and, even with the recent sickening price drop (and gold price rise) it's still between 200-300 ounces today. Note that prices in Charlotte (the light blue line) were up last month, and this was the market's only good news.