Banking has long been a beneficiary of legislative protections that have unduly exacerbated the industry tendency to seek ways to maximise its loan book. Which generally means finding means to minimise (read: circumvent the regulation governing) its reserve requirements. This is an inherently risk-happy approach for the key sector of any national economy.

The most successful banks at the game of tiny reserves are usually the first ones in trouble when things sour. A reserve is, after all, a deposit (in some form) and a liability. Yet however clever the regulatory-inspired off balance sheet construct no one has yet found a way to overcome the reality of double-entry bookkeeping. In the world of fractional reserve banking this skewed incentive is, unsurprisingly, a particular danger.

Yesterday’s bailout of Fannie and Freddie was not therefore the rescue of the free market from itself. It was a rescue of an industry with insufficient incentive to handle its own risks. It is as normal for business to fail as to thrive in an open market – banks included. But to implicitly guarantee a $5.3 trillion property game, as the US Federal Government did (and does), is to let mortgage sales teams everywhere off the leash. Supply will inevitably outstrip demand as speculation is encouraged up and down the line of credit provision. The normal cycle becomes prone to structural crises rather than cyclical ones.

This is essentially part of the Keynesian vs Austrian economics debate. But the reality is that Keynes is politics friendly (c/f Obama vs McCain) and it has become near impossible to align regulation with the capitalistic principle that economic agents must manage the risks they undertake - instead of living in the knowledge that they can be passed to another when the proverbial hits the fan.

This structure, so long as it lasts, will constantly require buttressing. And it will last: Mr Paulson, like Mr Darling before him, merely has to invoke the cause of rescuing the "little people" in order to line up political support. Which, unfortunately, leaves only the timing of the US Treasury intervention to discuss.

With the exception of 2001 previous recessions (or quasi recessions for sticklers) have seen US new home sales bottom out in the 250k-350k range. The relevance of the last recession on this line of reasoning is questionable – new sales in 2001 did not even break the trend they had held since 1991.

Exhibit 1: Sales of US new one-family houses. Recessions in pink.



The latest data point is for July and is 515k. I’d suggest this indicates the bailout may have come right on time politically but is too early in economic terms. The last 18 years have been characterised by extraordinarily low (sometimes negative in real terms) interest rates and a feverish churning of real and derived property assets encouraged by levels of mis-selling rarely before witnessed. Bailing before the supply side effects of this overselling bias have dissipated sufficiently to be at least comparable to demand will continue to reward economically distorted incentives, the refusal to manage risk and, overall, failure.

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