It's a Long Road Back

With the bailout deliberations behind us and the plan moving forward, the question for all of us is "what happens next?" Unfortunately, one of the answers came in the form of the nonfarm payroll release for September which showed a 159,000 person drop from the nation's payrolls. Continued significant job losses going forward could lead to another leg downward in the current economy.

Though the second quarter grew at a pace of 2.8 percent, much of that was due to the economic stimulus checks doled out by the government - fleeting support at best. The fact remains that we are in a long-term downtrend in reaction to an over-inflation of the housing market, exacerbated by the destruction of the mortgage market.

Over the last 10 years or so, mortgages have been financed primarily by off-balance sheet conduits that funded themselves by issuing short-term debt. So, at the end of the day the entity had 30-year assets and 90-day liabilities. Beginning in late 2006, investors became scared of a potential bubble burst in the housing sector and began pulling their investments from the housing market. These 90-day liabilities began to go away as investors shied away from them at a reasonable rate. The conduits reacted by downsizing; unfortunately, by that time the entire mortgage market had become dominated by these same entities which found no buyers for their securities.

A downward spiral of mortgage prices ensued and was aggravated by the revelation that shifty lenders had made loans that should never have been made; and shifty borrowers had taken the same. Eventually, no one wanted to buy these assets and now the chaos ensues.

The pipeline that transports capital from those who have it to those who can afford to pay for it is broken. In the mortgage market, this is the off-balance sheet conduit which needs to be reinvented, remarketed and redeployed. The nationalization of Fannie and Freddie is one step of many in this process. The next step is deciding what to do with them - a debate that was put on hold last month when the credit markets began to seize up.

I believe it will take 18-24 months, at least, for any semblance of a mortgage market to come about. First, Wall Street has to reinvent the pipeline since one that funds itself with such short liabilities is certainly a non-starter. Second, they will have to sell this to the investors/lenders - not an easy task at all. And finally - and most importantly - investors' fear must turn into greed.

The first two of these steps are fairly straightforward, though a solution is certainly not yet in hand. The third is much more interesting. How long will it take for investment committees around the country - and indeed around the world - to begin discussing "return" once again instead of "risk" At a minimum it will take two quarters with no serious negative events - credit or otherwise - before this can happen. Only by the second quarterly meeting where these boards review a paltry set of returns and cannot think of any significant negative credit event since the last time they met will they then become interested in "outperformance" once again.

The primary risk facing the economy and the markets today comes from the jobs sector. Considering previous recessions, the economy "should" be losing between 120,000 and 170,000 jobs, instead of the 84,000 average pace to date. Homeowners have been forced to sell due to crummy mortgage contracts or the inability to refinance as they'd originally planned. We have not seen a multitude of homeowners forced to sell because they'd been let go of their jobs - unfortunately that fate may be on the horizon.

Nonfarm payroll losses reached a cyclical high of 159,000 last month. Should this trend continue, we could see another downturn in the housing sector that will reverberate through the rest of the economy.

Is the bailout bill too late or too weak? That remains to be seen, but even if it does promote liquidity in the credit markets, we still have Fannie and Freddie to fix. The time bought by earlier measures is running out. If confident investors don't step forward soon, we could be in for several years of recession.