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Since the United States' credit rating was downgraded, stock markets around the world have been manic. Down big one day and up the next. And it's not just the downgrade there were riots in England and a rapidly deteriorating eurozone to swallow. Add to that some generally depressing economic statistics and the talking heads are talking more about a double-dip recession.

The stock markets, and indeed the world economies, are fragile. Everyone knows it, which is why companies aren't hiring and traders are so skittish. Financial markets, businesses, and entire economies are all functions of confidence. In short, if we are confident that things will get better and not worse, we invest. When we are confident that the housing market will get better, not worse, we buy homes.

A large element of forward-confidence is faith in the system. Before you can be so sure things will improve from where you are, you've got to be confident that "where you are" is legitimate. A shaky foundation may hold for a while, but don't expect to build on it.

Watching the financial news this week and reading all of the blogs, it is clear that the real issue today isn't if things will improve in the coming months or years, but whether our current economic status is indeed legitimate, or simply a quantitative mirage. Housing and economic bulls are quick to share data points that indicate underlying strength. Housing and economic skeptics are quick to point out that the positive data was induced by artificial stimulus and accounting gimmickry, not core organic strength.

A Quick History Lesson

In 2008, our financial system was on the verge of collapse. Our banks were insolvent. There were bank runs. It was ugly. The problem at the time was simple; banks, businesses, individuals, and governments around the world all owed huge amounts of money. Most of this debt was highly-leveraged (zero-down mortgages to banks with almost zero capital reserves). Literally, the whole world was levered 10, 20, even 45-to-1, gambling everything that home prices would never fall.

Simplified, a bank with $10 billion worth of mortgages, held that figure in it's books as a $10 billion asset. Against that $10 billion, it may have $9.7 billion worth of liability (they borrowed that money to make the loans and have to pay it back). The difference - 3% - is their cushion. And, banks never intended to hold many of these loans for very long. These mortgages were sold to other investors - notably Fannie Mae and Freddie Mac.

By 2007, home prices were in free-fall and a mortgage, once worth 100 cents was now worth 40. Or less. That $10 billion asset was now only $4 billion, but the liability was still $9.7 billion. Just like 3% down wasn't enough to cushion the blow for homeowners, 3% capital reserves weren't enough to save the banks.

Accounting Smoke and Mirrors

With the passage of the Economic Stability Act of 2008, banks were given a respite with regard to valuing their assets while the SEC tried to decide what to do. Then, in April of 2009, the Federal Accounting Standards Board (FASB), under pressure from The Treasury, officially suspended "Mark to Market" accounting rules. Maybe the mainstream press thought it was too complex for a broad audience. It didn't get discussed nearly enough at the time.

In a nutshell, standard accounting practice had been that banks had to value assets at what they are actually worth. But now, with "Mark to Fantasy", they could value their assets at full value, claiming that they would hold them to maturity. Which, for real estate, is absurd. Hardly anyone stays in the same house for thirty years, paying off their original loan. Heck, a lot of these loans were probably interest only!

The banks were insolvent, but the world was given official permission to pretend they weren't. Remember all of the bank write-downs? This is why they stopped. Remember how, suddenly, all of the big banks were recording record profits? This is why. The same bank from our example above could declare on their books that the $4 billion asset WAS indeed worth $10 billion. And if they had already written the value down, now they get to write it back up. Even better, if a big bank swallowed up another bank that had been forced to write down their assets, now that big bank can claim huge profits!

The analogy isn't perfect...it's not the same as you owing $600,000 on a $300,000 house that you could then sell for $600,000 because of an accounting gimmick. The banks aren't selling the loans, because if they did, they would have to recognize the loss. It's the same for the homeowner the paper loss is only realized when they sell. However, it is somewhat analogous because banks could include the asset at full value on their books, holding it as collateral to make more loans.

In other words, where the homeowner is screwed and stuck, the bank can continue with business as usual so long as they don't sell (or foreclose on) any of the loans.

Our Ponzi Economy

Fast-forward three years and the disconnect between Wall St. and Main St. has only widened largely because of the suspension of mark-to-market accounting. The tentacles of this accounting change extend everywhere from car sales to the day to day financing of businesses.

The housing market hasn't been flooded with foreclosures largely because banks have little financial incentive to foreclose and be forced to actually recognize their loss.

We've "extended" and "pretended" perhaps as far as we can. Almost all of the debts we, globally, had in 2008, we still do. And it fact, we've added even more debts since then to keep the Ponzi scheme running (that's what "liquidity" is).

Where once we could paint over our problems with a few more borrowed dollars, now there are more serious cracks appearing in the system. Greece, Italy, Spain and Portugal are perilously close the the abyss. There are riots in the streets of London, and France is facing potential downgrades because of it's exposure to banks outside the country. Germany will be forced to bail out the rest of Europe on the backs of German workers, or blow up the euro entirely.

Domestically, bank stocks have been crushed. BofA (NYSE:BAC) stock is down about 50% over the last year, and Citigroup (NYSE:C) is down a third in just the last month. There have even been rumors floating of Bank of America spinning off Countrywide as a part of some sort of pre-packaged bankruptcy. The government is so desperate they are considering keeping the foreclosures and become the world's biggest slumlord. Home prices are falling again and social mood is darkening.

All of the mechanisms that gave us a boost over the last few years - low interest rates, tax credits, and foreclosure moratoriums have been used up. And, without home prices rising, there is little reason to believe the overall economy can improve much.

Lost Confidence

Our economy is perilously perched on a crumbling foundation, over a gaping sink-hole of unserviceable debt. We've looked the other way for three years now, but maybe time is finally catching up with us. Where once we had faith, trust, and confidence that we could pull though this, those feelings are now replaced with the recognition that our entire "recovery" so far has been fake.

We are likely headed back into a recession that could be longer and more miserable than the last one. There are too many headwinds, and not enough horsepower to pull through.

To be clear, I don't expect Armageddon, but rather a continuation of the slow slog we've been on, only with less optimism, and for longer. And I don't expect home prices to collapse overnight. I do expect the slow bleed to continue until national prices return to nominal mid-90's levels, give or take. Given what we earn, what everything else costs, and all of the additional debts we service, I figure that's about right. That also takes us back to before the bubble began.

Of course, real estate is local and we'll all be impacted differently. Your home may be close to bottom, or it may still have a long way to go.

And, given that this process is already more than five years old, it could take another five years before finally resolving itself. Consider the latest Case-Shiller data. Given what lies ahead over the next few years, would you be surprised to see the blue line below 100? We'd be there already if it weren't for all of the intervention over the last three years.

Here is a similar graph, with notations, showing Case-Shiller data for the San Francisco Bay Area:

click on image to enlarge

The process would be painful, but result in a healthy, organic new beginning: A sturdy foundation of affordable housing where we can trust it's integrity and have confidence that things will get better. No accounting gimmickry. No shenanigans. No smoke. No mirrors. All of the bad loans made good with all of the foreclosures either processed or prevented.

To be clear, I'm not advocating rolling back government spending, but spending it more wisely. I favor orderly bankruptcies over bailouts. And I would favor investment in jobs and infrastructure over wasting more money trying to prop up home prices.

We've got to get through this. Let's focus on coming out stronger on the other side rather than clinging to the past and prolonging the pain. Keeping a sense of humor some of the best information and perspective into our economic mess can be found in the comments at Calculated Risk. I thought I would include some of the smarter ones from the thread discussing the suspension of mark-to-market accounting:

I guess burying your head in the sand really does feel like a day at the beach.

I applied the same rules to my own finances and increased the value of my 401k and the value of my home. As a result, my net worth has increased significantly and my retirement is now secure. What a relief!

Spent this morhning trying to figure out the best way to re-flate a balloon that has a hole in it. The hole just keeps getting bigger and bigger, and I'm all out of breath.

I can hear it now. The Bank called and said I am over drawn! Can't be, my Mark to Fantasy accounting system says I got plenty of money! They are crazy!

Remember the guy in the original Matrix that wanted to be put back into the Matrix because the Matrix steak was so muce better than the gruel they were eating on their ship?

The accounting profession is now complicit in the ultimate failure of the republic. I am trained as an accountant. I am ashamed of my profession and its completely gutless leaders.

Let’s all sit around in a circle and pretend that Citgroup and Wells are solvent. Let’s suspend the accounting rules and live in a fantasy world where we never acknowledge losses. I’m sure if we all hold hands and slowly chant I believe... I believe... that everything will work out fine.

Source: A Housing Recovery Without Confidence: Economic Headwinds Ahead