In the January 12, 2009 issue of Newsweek magazine, Jane Bryant Quinn, in the article "The Case for Walking Away" makes the argument that people often refuse to declare bankruptcy and hang on too long. These individuals often tap into things like retirement savings, which would be protected in bankruptcy, only worsens the inevitable losing battle to stay solvent and jeopardize their future. This article, in a mainstream magazine, maybe more of a sign of the times than people think.

It is undeniable that the housing market was in a bubble. Yale University's economics professor Robert Shiller's housing data (shown below) provides a red line representing the inflation adjusted house prices from 1890 through the mid year 2008.

As we can see, with the exception for some time during the Great Depression and a pair of World Wars, house prices adjusted for inflation are fairly consistent. It's only in the last ten years that we see the run-up, with an obviously large correction that needs to take place. Using the most recent data available, released December 30th, 2008, the October, 2008 house prices approximately equal to historical data of May, 2004. As can be seen, to get back to 2000 and equilibrium with historical averages, housing prices would have to fall another 30%.

Banks realize the problem, and are hoarding their cash to buffet against future foreclosures. Ironically, this is hurting the banks further. For example, a bank lends $500K for a house. The value falls to $400K and the owner walks away. Per, the agreement, the bank seizes the collateral (the house), and pays fees to get it sold. However, since buyers are having difficulty getting loans from banks, there are few buyers. With lots of houses on the market, we all know what happens when there are too many sellers and not many buyers: prices decline further.

How prevalent is this? According to RealtyTrac Inc., a California based data tracking firm, more than 2.3 million properties (1.8 percent of American homes) in 2008 got a default or auction notice or were seized by lenders. There are those that cannot afford their mortgage such those who lose their jobs in this ever increasingly difficult economy and those that had "teaser" rates that are expiring and are facing huge increases in their mortgage. Others are voluntarily walking away from their mortgages especially those that realize they have no home equity or have negative home equity and those that realize they can get a lot more house for the same mortgage payment.

The government's first attempt to fix the problem was with the Troubled Asset Relief Program (TARP) which provided money to banks. The idea was to get banks to open the spigots back up - to get banks lending to house buyers again. With more easy credit, more house buyers might come out, and it might slow falling house prices and provide a "soft landing" as house prices move into line with historical averages.

Unfortunately the banks realize they will likely continue to see losses, continue to hoard, rather than lend, the money. Banks realized house prices have quite a bit more to fall and so after being burned so badly by the current run-up in housing, why would banks lend money for assets that are likely to decline in value? Furthermore, they need the money to maintain liquidity requirements and cover future losses not only in the housing front, but as we'll see, in the business and personal finance world too.

Since attempting to support the demand side of the equation by trying to spur banks to lend money hasn't worked, there is growing consensus that the emphasis should be on the supply side. Buy up houses or take over the toxic loans into a single "bad bank". Even if this strategy is successful, it only deals with the housing crisis - not the next two problems that are about to provide a one-two punch to an already reeling banking industry: company debt and consumer debt.

Business loans are defaulting too, and the number is expected to more than double next year. In a recent report Standard and Poor's is estimating that 14% of companies are going to be in default on their debts in 2009. According to S&P's "base scenario," to which it assigns a probability of 60 percent, 209 companies are expected to default over the next 12 months, a steep rise from 2008's 94. Furthermore, S&P predicts that high U.S. corporate bond default rates will continue well into 2010.

The second punch will be consumer debt. According to a December 31, 2008 report by Standard and Poor's, credit card charge-offs (debts the credit card companies no longer expect to collect) has increased 44 percent since November last year. As an example, Capital One a large credit card company, had predicted $5.6 billion in loan losses for 2008; it ended up losing $6.4 billion. Furthermore the company expects $8.6 billion in loan losses in 2009. In an attempt to shore up its finances to brace for the oncoming onslaught, Capital One has announced an acquisition of Chevy Chase Bank to enable it to increase deposits assets and to access bail-out funding. Capital One is a virtual pure-play credit card company, but the same damage is being done to banks which issue credit cards. Once again, banks are continuing to horde their cash to brace against the consumer credit card storm, and once again their actions are compounding the problem. Banks and credit card companies are tightening credit, stopping to extend credit, and otherwise trying to improve collections. Keeping in mind that consumers represent two thirds of our economic spending, the workhorse that has kept our economy humming over the last decade. U.S. household debt, which has been growing steadily since the Federal Reserve began tracking it in 1952, declined for the first time in the third quarter of 2008. American's savings rates had been declining in the past couple of decades and even turned negative at times as consumers took out home equity loans and rang up credit card debt to pay for goods and services. Not coincidently, U.S. consumer spending growth declined for the first time in 17 years, and will cut an estimated 5% off the GDP in 2009. So the consumer is tapped out. People felt rich, figuring they could rely on their house equity for retirement or if in a pinch, now are realizing they it may not be there. Compounding and pushing consumers ever closer to bankruptcy Credit Card issuers are revoking credit, squeezing credit, and creating even more onerous terms for those carrying credit card debt.

Since December, 2007, considered the start of the recession, 2.55 million people have lost their job. The U.S. unemployment rate was 7.2% in December, and a record number of new claims for unemployment benefits has been reported in January, suggesting that joblessness is rising. On January 26, 2009 alone, Home Depot announced 7,000 layoffs, Spring/Nextel announced 8,000, Pfizer/Wyeth is planning 19,500, and Caterpillar a whopping 20,000 jobs will be shed. Earlier in the month, Circuit City announced it was unable to find a buyer and was liquidating, putting 34,000 employees out of work. Not only are companies cutting their payrolls or going out of business, they are also implementing cost cutting moves such as suspending 401(k) matches. People are understandably scared in this uncertain environment and are saving for a rainy day. Ironically, although saving as a hedge against the loss of one's job is the right thing to do individually, to keep the economy moving we (collectively) need more people to spend, not save. Saving, rather than spending, means few goods will be sold, less need for manufacturing capacity, and more job losses. A vicious cycle.

Credit Card squeezes and layoffs mean that an ever increasing number of consumers will not only be defaulting on home loans, but also on credit debt. Which brings us back, full circle to the Newsweek article. The one thing that did keep people from going bankrupt was the stigma. Friends and family that find out that you are in over head and the shame of having to claw your way out. However, if it becomes mainstream and acceptable, blamed on the economic crisis, banks may find these default rates on house, company, and credit card debt low - spiraling the economy lower.

Right now, it all rests on a several hundred billion dollar stimulus package, one that may ultimate break the trillion dollar mark. The idea is that if companies are cutting back, individuals are cutting back, and banks aren't lending, the government will step in and spend. The hope is that companies responding to government demand will start hiring, more people will be working which will cause fewer defaults, which could get banks lending again. Unlike the Iraq war, which also cost $1 trillion dollars, this package will be aimed squarely at improving the long neglected American infrastructure. We have to hope it works.

They say in the stock market that a bottom requires capitulation. A point where almost everyone throws in the towel and gives up. Only then do the savvy players sitting on the sidelines with cash realize true bargains and step in. It is possible that the doom and gloom expressed in this article and seen in widespread sentiment in the news media and general public may represent a closing in on that bottom.

So what will happen? One can hope that a bottom comes soon and the stimulus package works. Our best guess is that we will continue to see declines, an ultimate capitulation, and then a very slow recovery as the stimulus plan slowly works its way through the economy. In regards to the stock market, it would not be unexpected to see it fall to a Dow Jones of 6,000 or even break the 5,000 mark (for reference the Dow Jones average has been trading between 7,000 and 8,000). However, the banking industry will not survive in its current form. The Glass-Steagall Act of 1933 passed as a result of the Great Depression, prohibited a bank holding company from owning other financial companies and was repealed on November 12, 1999, by the Gramm-Leach-Bliley Act. Predictably banks moved from boring low risk and low reward traditional banking activities and into the much more lucrative and speculative business of investment banking. Once again, we'll see a separation. No longer will banks have in-house trading accounts that bet allow banks to make bets with depositor money. In fact the banking sector will likely look nothing like we've seen it. Already, we hear talk of "zombie banks", banks that will enviably go under and are only being kept alive with government bailout money. With politicians shift focus from trying to get banks to lend again, to removing the toxic assets themselves, we'll inevitably see banks go under or be merged in shotgun marriages. Just as venerable investment banking names like Bear Sterns and Lehman Brothers have disappeared, we will likely see a number of marquee names in the banking industry disappear. New banks will ultimately emerge, but under new rules with the strict charter of collecting deposits and lending money.

Hedge funds and derivatives will be regulated. The argument against regulation is that hedge funds only allow a limited number of high net worth individuals to participate. Likewise, derivatives are essentially bets that derive their value from something else. Enron famously proposed Weather Derivatives where people could bet on the weather. There are some useful purpose to derivatives, for example, a farmer might use a weather derivative to hedge against droughts or a oil company might want to hedge against an unusually warm winter. Derivatives were considered exotic instruments, being traded among sophisticated private investors and hedge funds - and therefore, the argument went, they didn't require oversight or a central clearing facility. After all, these rich investors knew the risk and could afford the losses. The now-famous Credit Default Swaps (CDSs) and Collateralized Debt Obligations (CDOs) that were the heart of the current crisis were forms of derivatives and shows how false this assumption was. The failure of these instruments have had an effect well beyond the rich, striking at the heart of main street and saddling the US taxpayer with an ever increase debt.

Likewise hedge funds claimed that they didn't need oversight, after all they are a limited number of rich people using exotic trading strategies and leverage to goose profits over boring, but reliable, mutual funds. The collapse of Long-Term Capital Management (LTCM) should have debunked this myth. Although two of its principal players were Nobel Prize winning economists, in 1998 using computer models, LTCM made a large unhedged and leveraged bet on Russian government bonds. When Russia defaulted in August of that year, LTCM found itself with $4 billion of losses. The US government, fearing their losses could collapse the market engineered a $3.65 billion bailout. Furthermore, hedge funds have been blamed on market volatility, including the run up of oil to $140/barrel and part of the decline of the stock market as hedge fund managers either shorted stocks (an action not available to mutual funds) or dumped stocks to honor investor redemptions. Hedge funds work on what's called a 2 and 20 principle. Investors agree to let the hedge fund managers take 2% of the hedge fund value each year to pay to run the fund and 20% of any profits. The problem is that the hedge fund managers don't share in any losses. Once a hedge fund goes negative, there is only added incentive to make even larger and more risky bets to try to get positive - leading to a moral hazard - one which caused investors to run for the exits when the going got tough in 2008. Large redemption meant hedge funds had to liquidate holdings, selling into an already declining stock market. It is likely that hedge funds will be regulated, and will no longer hold the cache they once had.

We'll also see additional oversight from federal agencies. There is a confusing alphabet soup of oversight agencies that often have overlapping responsibilities, or at times left loopholes. Recent administrations, in a pro-business belief, further undermined these regulatory agencies by appointing industry insiders and lobbyist to many of these agencies. The Madoff scandal has only re-emphasized the error of lax oversight. The freewheeling days, when bankers and CEO made large bets and got paid hundreds of millions of dollars may be over. Led by memories of our current economic difficulties, the current set of bankers and CEOs will be replaced by more a new, more conservative generation.

No one has a crystal ball, but at PartyofCommonSense.org we hope we are wrong, but we believe the current housing crisis storm still has some time left to batter our financial shores, and we're seeing two smaller, but still significant storms just starting: corporate debt defaults and individual credit defaults. Countering these destructive storms we have the stimulus package, we might deaden some of the pain, but not eliminate it. Banks may collapse or be forced to merge, companies may default, and individuals will likely default, but in the end, America will recover. Once the storm passes, we will, as we have in past, get out and rebuild. Until then, at earliest in 2010, it appears we're going to have some tough times ahead of us in 2009.