I have been expecting a near-term bottom.  We may have gotten it.

Unfortunately, it may not last.

The big news today was two-fold - first, that the government is considering a solution to the bad debt crisis by setting up a Resolution Trust Corporation-like entity to buy the banks' bad mortgage debt; and second, that the government is considering a ban on short sales. 

The idea behind RTC II is probably a necessary one.  America has a long history of the government bailing out the financial system and acting as a lender of last resort.  The financial problems of the housing bubble are as massive as this country as seen, perhaps ever.  It is no surprise, given the US government has now become the largest mortgage company in the world via the nationalizations of the GSEs, one of the largest insurers in the world given its nationalization of AIG, and given that three-quarters of the Federal Reserve's balance sheet is now comprised of risky securities, that the government was going to step in in a big way to try to stop the rot.

The question now is will it be successful?

If the idea is to stop the panic in the financial markets, the answer is probably "yes," but that answer is not unequivocal.   This is now the fifth attempt by the US government to address the meltdown of the housing bubble - slashing interest rates, bailing out Bear Stearns, extending the Fed's balance sheet to risky assets, the bailout of AIG, and now the creation of RTC II. 

Each of the previous four actions have been more dramatic than the prior.  Each failed. 

Now, perhaps the government is going to be fifth time lucky. And simply because four prior attempts failed does not condemn the fifth to failure too. 

But what if it does fail?   What then?

The government is beginning to use very big bullets.  It does not have many shots that do not lead to dangerous and destabilizing inflationary pressures in the future. 

The proponents of RTC II argue that as RTC II takes bad loans off the books, capital will be freed so banks can start lending again.  That may be, but there are two problems with this line of thinking. 

First, home prices are still too high! The NAR affordability index has been falling this year.

Despite falling home prices, incomes have been falling faster thus making homes less affordable.

At around 6.5% for a qualifying mortgage, mortgages are currently not expensive.  Increasing mortgage availability and/or lowering interest rates on mortgages as a solution to halting the decline in  (over-valued) home prices is tantamount to lowering margin requirements and rates as a solution to falling stock prices during the unwinding of the tech bubble.  More credit availability does not solve the problems of over-supply and over-valuation.

In fact, I will make the bold prediction that when the housing market bottoms, the country will be awash in liquidity, and getting a cheap mortgage will be no problem.  We are far from that scenario yet.

More debt is not the answer because there is already too much debt.  The consumer is undergoing a multi-year deleveraging process.  The consumer simply has too much debt.  The excess consumer debt is being worked down.  The consumer will not collapse but the consumer is impaired and will not the driving force of the world economy as the American consumer has been for the past decade.

Within the financial system, the conduits of credit creation have been impaired.  The securitization machine is not broken but it is severely damaged.  The aggregate financial system is going through a period of deleveraging.  Balance sheets are broken at many financial companies and the focus going forward for the next several years will be to strengthen those balance sheets. 

This makes 2008 very different from the early 1990s.  Back then, neither leverage nor valuations ever got as high as it did this decade.  This is a period of asset deflation and credit deleveraging as we unwind the excesses.

It is staggering to think how much money the government has thrown at this problem.  Tallying up the loans given to companies, the facilities offered by the Fed to swap impaired assets for Treasuries, the tax rebates and the reported $500 billion the government is apparently going to commit to RTC II, well over $1 trillion will have been thrown at the problem.

Yet I am not convinced any of this will halt the inevitable.  Housing prices must continue to fall.  If they do not, home inventories will remain high, the market for credit will not be allowed to clear as banks delay writing down loans, and we could find ourselves in a Japan-style sclerotic environment. The problem is so large, the edifice is most likely to continue falling on itself.

And like Japan, the current environment is very deflationary.  Falling asset prices and contracting credit is evidence of a deflationary environment.  

Thus, the tell for the success of the government actions may be the gold price.  I had written off gold, thinking that the multi-year bull market for the yellow stuff may be at an end.  Now, I'm not so sure.

Ironically, a rising gold price may signify that the government's actions are working. 

Gold has been skyrocketing on fear.  I expect gold to fall off over the next few days as fear dissipates.  However, the government's actions are very inflationary.  If gold starts rising again, it may signal that inflation is re-entering the economy, and bad debts are being deflated away.

However, if gold continues falling, it may signal that the government's actions are fruitless, and that despite over $1 trillion thrown at the debacle, asset prices continue to fall.  That would be very bad.

Possible broad restrictions on short-selling are a desperate measure, and even more so a signal for investors to sell stocks.  The hedge funds are massively short, but short restrictions do absolutely nothing to fix the problems in the economy.

The government is pondering this restriction to alleviate the pressures on the brokers, which they believe are under attack by the hedge funds.  That may be, but why the government would restrict shorting, say, Microsoft, is beyond me.  I can understand restricting shorts on the brokers if the allegations about the hedge funds are true.  But then, if the brokers are permanently impaired, a bounce from the restrictions would be a gift to the long only funds to sell and would merely be a transfer of wealth from the shorts to the longs.  If the models of the brokers are truly broken, restrictions on shorting will allow the longs to dump their positions, driving the stocks to zero anyways.  It just may happen a little slower.

As I write this, Dow futures are up another 200 points.  That would put the rally off today's lows at 7%.  I have been expecting a bounce, but I think much of the bounce may be finished.

I have been very short this market, and had planned to start covering a few percentage points below this week's lows.  I do not think I will get the chance. 

We are running into resistance, however.  Much, if not all of this bounce is being driven by short-covering.  RTC II and restrictions on short selling could provide a great bounce that merely allows sellers an opportunity to exit, thus setting up the next downleg and the re-test of prior lows.