What does a rapidly deteriorating U.S. housing sector have to do with the global economy? Answer: everything. The question was asked in the Rick’s Picks chat room yesterday, so perhaps it’s a good time to consider the implications. Let’s begin by acknowledging that the housing market is suffering not from a touch of flu, nor from a more serious malady that can be treated with powerful drugs, but from pancreatic cancer. And it doesn’t take a specialist to see that ominous shadows on the X-ray are beginning to overwhelm the host.

How do we know this is so?  For one, even the optimists, taking their cue from shell-shocked home builders and a wave of high-profile bankruptcies in the lending business, are no longer trying to buck us up with feeble speculation about how and when the distress might end. Rather, they seem to be bracing for still worse news ahead, uneasy because there is no way to tell how much worse things might get. Keep in mind that these are the same guys who a year ago…six months ago…three months ago…assured us that the bottom was in. Now, evidently not wanting to further embarrass themselves, and having run out of evidence to buttress even the most timidly upbeat outlook, they’ve gone practically mute.  

Rally or Else…

More immediately troubling is that credit spreads have begun to widen dramatically, signaling that risk is once again a concern to investors after many years of blithe indifference. If so, the cure of higher real rates that awaits us will be like chemotherapy – toxic enough, perhaps, to kill the patient.  The situation is dire, since there are virtually no buyers for subprime mortgage paper right now, and debt markets are getting increasingly nervous about it. The central banks of Europe and the U.S. have been in overdrive trying to head off a liquidity crunch, but their concerted efforts will grow increasingly futile if the world’s bourses don’t start acting soon as though they fervently believe our worst troubles are past.

Just last week, the ECB injected an astounding 96 billion euros into the banking system in a single day – more than after 9/11. The Fed ran amok as well, pumping out a gusher of fresh reserves when the Federal Funds rate pushed above 6% one night. This is the rate banks charge each other for overnight loans to square their books, and the Fed has tried to keep it at 5.25 percent. But with so many banks holding mortgage paper that could turn worthless by the next sunrise, it’s no mystery why they would be less eager to lend to each other.

Chinese Fire Sale

So why is the U.S. housing market so crucial to the global economy? Simply because asset inflation, chiefly in real estate, has been the most potent force buoying the domestic economy. Let home values continue to fall, though, and it will trigger a severe recession in the U.S. with effects that would reverberate around the world. China, for one, unable to idle hundreds of millions of workers, would glut the world with distress goods. That would be extremely deflationary, but even moreso would be the ratcheting up of interest rates on virtually all forms of debt. One result is that carry-traders who have borrowed short to lend long will get crushed, since short-term rates would skyrocket.  Using enormous financial leverage, they’ve been a major buyer of U.S. Treasurys, but that source of demand would dry up instantly when the yield curve goes “rad”.

If home values continue to fall, as seems likely, the consequences are almost beyond imagining. Most people believe the Fed will come to the rescue, but any such effort is doomed to fail unless consumers start borrowing money again like crazy. With home prices falling throughout most of the U.S., no such madness is even remotely possible.