Several years ago, a few of the Fed Governors were making comments such as, “we’re not going to save housing at the expense of the rest of the economy.”

They were wrong.

The Fed is caught not only in the bursting of the housing bubble but the connected spiral of mismanaged debt.

It now has no choice. The Fed still doesn’t want to save housing, but it must keep the banks from going under.

How did we get in this position?

Free credit.

If you think about it, it was endless. You could get credit to buy anything. Want that new dress in the shop window? You can charge it. Want a new $50,000 kitchen with a viking stove and bosch dishwasher? You took out a home equity loan on your house and you had it.

Americans could get virtually anything they wanted, regardless of income. If you were breathing, you could get credit.

It’s created a monster. Because now Americans don’t know how to save and don’t know how to say “no” to their every desire.

The Fed is not in a conundrum. Chairman Bernanke signaled loud and clear in his testimony before Congress that the Fed was going to cut interest rates in March, inflation be d*mned. And, oh yeah, he’s all for bailouts if the housing sector gets worse.

Congressman Barney Frank has already unveiled a $15 billion proposal to bailout up to 1 million homeowners. From the Arizona Republic:

Bernanke said he supports addressing the housing slump through private-sector efforts, reforming the Federal Housing Administration to refinance troubled mortgages and improving oversight of Fannie Mae and Freddie Mac, government-backed companies that are the biggest buyers of U.S. mortgages.

“We need to be thinking about different alternatives and preparing for contingencies,” Bernanke said in response to a question about the mortgage-purchase plan.

But wait- it gets better. Congress is floating plans that allow bankruptcy judges to modify mortgage contracts from the bench with a swoop of the pen.

Even Bernanke was against that:

Bernanke criticized a foreclosure-prevention measure that would let judges modify mortgages in bankruptcy proceedings.

The plan, part of legislation Senate Democrats aim to advance this week, would “have some conflicting effects” and lead to higher mortgage rates, Bernanke said.

But you can bet that Congress will do everything it can to try and “save” housing.

Too bad they don’t get it that once a bubble bursts- you can’t re-inflate it. No bubble in history has ever been reinflated. It must run it’s course, even with the intense pain that could bring. Housing prices will come down to where they are “affordable” again. Nothing Congress or the Fed does can stop that.

The numbers continue to be grim when it comes to housing. The New York Times just published these new stats from Moody’s Economy.com:

With the collapse of the housing boom, nearly 8.8 million homeowners, or 10.3 percent of the total, are underwater. That is more than double the percentage just a year ago.

Many of them, if they have to sell their homes for some reason, won’t be able to because they will owe more than the house is worth and they don’t have money to bring to the table. Banks and government officials fear that homeowners will simply “walk away”- that is, turn in the keys to the bank and drive off into the sunset since they owe more on the house than it is worth.

Homeowners actually did just that in Texas in the 1980s (when the oil bust crushed the housing market) and in San Diego in the early 1990s (when the defense industry went bust.)

But those were smaller, select markets.

These “walk aways” could happen on a mass scale everywhere in the country. And when they do, they will bring down property values on the houses nearby as the banks now have unwanted properties they have to try and dump at lower prices.

How do we bailout all of these homeowners and the banks who lent them the money?
Create a new federal agency!

Bank of America, which is in the process of acquiring Countrywide Financial and has potentially huge exposure, has circulated a proposal to create a new federal agency that would buy vast quantities of delinquent mortgages at a deep discount and replace them with fixed-rate federally guaranteed loans.

The bank warned that tightening credit conditions were leading to “escalating levels of delinquency and default among borrowers” and “an unprecedented number” of homes that would enter foreclosure.

Administration officials have given the Bank of America plan a cold reception. But the idea is similar to one proposed by Senator Christopher J. Dodd, Democrat of Connecticut and chairman of the Senate Banking Committee.

Love the Bush Administration or hate them, at least they’re holding firm on this principle.

A bailout of this magnitude only prolongs the problem.

Just ask Japan.

To see the extent of the housing problem, check out the stories in the article

This older woman, who should be retiring any day now but can’t because she’s broke, doesn’t even have $6,000 in order to sell her home and live an affordable life.

The home buying mania was so great, that normal Americans threw away basically their whole lives to live an HGTV life. And now they’ll have nothing.

The Memphis metropolitan area highlights the larger national trend, with the average first-mortgage debt, at $153,764, edging above the average home price, $152,815, for the first time. And that does not count refinancing and home equity loans, as well as closing costs.

Collie Tuttle, in her early 60s, is caught in this bind. Four years ago, she purchased a newly built four-bedroom three-bathroom house in the Memphis outer suburb of Olive Branch, Miss., for $270,000. She put nothing down, relying on her six-figure income from selling furniture to pay down the mortgage, reducing it to $248,000.

But then she lost her job, and in her next one — also selling furniture, but at lower pay — she is being forced to choose between her home and the rest of her life.

“It was a big mistake on my part to buy this house,” she said. Divorced, with two grown sons, she rattles around in it alone. She had thought the house would add to her wealth.

But now, to sell it for the $269,000 a potential buyer was recently willing to pay, “I would have to come up with $6,000 from my pocket,” Ms. Tuttle said, explaining that she cannot afford to invade her meager retirement account. “All I’m asking is for enough so that I come out even.”

Her house payments and utilities come to nearly $2,400 a month. That is affordable, she said, on her present income. But very little is left over to replace her 11-year-old car, to travel, to pay down her credit card debt, or even to buy new clothes.

“I’m stuck,” she said. “I’ve tried everything and I can’t get rid of this house.”

The reluctance to sell at a loss helps to explain why the number of homes listed for sale in the Memphis area has climbed to more than 13,000 from 9,000 a year ago.

Poor Mrs. Tuttle. Can she not borrow the $6k from her grown children? And if she was making six figures when she bought the house- where has all her money gone over the years? That is RICH for a single person in Memphis.

Why don’t the reporters ask these questions?

Evidently, she bought into the myth that real estate can only go up.

The other stories in the article are disturbing as well. There is the one with the couple making $250,000 a year in Memphis but who can’t make their house payments because their “fixed monthly costs” are $14,000 plus $4,000 for their house (due to child support payments and other things.)

Sympathy?

Um…no.

Then there is the other couple who moved to another state but can’t sell their Memphis home because they’ll have to take a loss. Instead, they live in an apartment in the other state (where the husband has since lost his job) AND pay the mortgage on the empty house in Memphis. They have savings and are using it to pay the mortgage. But they refuse to take a loss on the house.

DUMP THE PROPERTY!

And the government thinks it can fix problems like these? Not on your life. The capitalist system created them, and now it has to fix them.

Come what may.

Rescues for Homeowners in Debt Weighed [New York Times]

Now that’s the way to make headlines.

Just announce that housing is headed for one of the biggest dives in the last 70 years and wait for to it to hit the wires.

That’s what Merrill Lynch did yesterday.

The article I saw on CNNMoney specifically mentioned “free fall” in the headline. It said:

The worst housing financial crisis in decades is only going to get worse, a Merrill Lynch report said Wednesday.

The investment bank forecasted a 15 percent drop in housing prices in 2008 and a further 10 percent drop in 2009, with even more depreciation likely in 2010.

That is far greater than most other housing analysts have predicted. That is a Great Depression style drop. But the rent versus own historical correlation is currently far out of whack.

But for those who think that the worst is over, Merrill Lynch said that housing prices still remain comparatively high. The brokerage believes that home prices are still far above historical norms when compared to other measures such as rent or GDP. “By our calculations, it will take about a 20 to 30 percent decline in home prices to correct this imbalance,” said the report.

Merrill Lynch believes that housing starts will most likely slide another 30 percent by the end of 2008 - a historic low.

And inventory is too big and still growing.

“The current supply/demand environment does not favor a swift recovery in the housing market, in our view,” according to the report.

This report reminds me of the reports that Goldman Sachs was issuing regarding crude prices in the last few years. Remember the $100 and higher crude prediction? People laughed at them then.

Crude hit $100 on January 3.

Sir John Templeton is a billionaire. He started the Templeton Mutual Funds many years ago. But his real claim to fame was buying up shares of stocks that were less than a $1 during the Great Depression. He saw opportunity where others saw financial ruin and it made him rich.

It also took a lot of guts (and instinct.)

He’s 96 years old and now lives in the Bahamas full-time. Occasionally you see him interviewed in magazines but the last time I remember seeing an interview was a few years ago so it could be that he’s simply not talking to the press anymore given his age.

But in 2003, at the height of the dot-com bust, he gave an interview where he talked about the American housing market. Many laughed at him then.

Who is laughing now?

It sounds eerily accurate:

Moving on to housing prices, Sir John comments: “Every previous major bear market has been accompanied by a bear market in home prices. . . . This time, home prices have gone up 20%, and this represents a very dangerous situation. When home prices do start down, they will fall remarkably far. In Japan, home prices are down to less than half what they were at the stock market peak.” Sir John adds, “A home price decline of as little as 20% would put a lot of people in bankruptcy.”

Sir John also had a few words about debt — a four-letter word that folks seem not to care about: “Emphasize in your magazine how big the debt is. . . . The total debt of America is now $31 trillion. That is three times the GNP of the U.S. That is unprecedented in a major nation. No nation has ever had such a big debt as America has, and it’s bigger than it was at the peak of the stock market boom. Think of the dangers involved. Almost everyone has a home mortgage, and some are 89% of the value of the home (and yes, some are more). If home prices start down, there will be bankruptcies, and in bankruptcy, houses are sold at lower prices, pushing home prices down further.” On that note, he has a word of advice: “After home prices go down to one-tenth of the highest price homeowners paid, then buy.”

You might still think he’s crazy. Prices to fall 90%? Ha!

But that’s what they told him before the great stock bust in 1929-32. Shares of the greatest American companies all for sale for under $1? Never.

Sorry to be so bearish during this time when the stock markets are also struggling. But bear markets create opportunities. Be ready.

Just ask John Templeton.