Bailout: No cure for recession

ROAD TO RESCUE

• Home prices up for 1st time in 3 years
• New home sales: 'Really good news'
• Wall Street: Here comes the hard part
• 7 regional banks fail
• Banker: "TARP helped avert a global calamity"

Economist Nouriel Roubini is bearish on the bailout

When will they act?

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NEW YORK (CNNMoney.com) -- Even if the Bush administration's $700 billion bailout works, the United States still faces the longest and most severe economic stretch since the Great Depression, according to one economist.

"The recession train has already left the station," said Nouriel Roubini, professor of economics at NYU's Stern School of Business during a conference call Wednesday. "What this plan can avoid is a Japan-like, L-shaped recession," where the economy sinks and stays sunk, "that could last a decade or more."

He said a well-implemented plan could limit the heavy bleeding to 18-months.

To do it right, according to Roubini, the toxic credit held by banks would have to be bought up and taken off balance sheets so banks can start to lend again.

For the government to make that kind of investment, he added, it had to get something in return. Roubini suggested that should be preferred shares in the companies that later would convert to common stock.

Roubini also had a solution for the housing market: Reduce mortgage balances to market prices and refinance them to lower mortgage payments.

He pointed out that home prices are down 25% from their highs already and will probably fall another 15%. That would put a good 40% of all mortgage borrowers underwater, owing more on their loans than their homes are worth.

"More people will walk away from their homes," he said. "Even if only one in five walks away, that adds up to a $400 billion loss. If half walk away, it would be a trillion."

The impact of the housing crisis on the larger economy is everywhere. Stock prices are already down 20% from their highs - the definition of a bear market - and will fall another 15% to 20%, according to Roubini.

Consumer spending, which accounts for more than 70% of the national economy, has fallen for three straight months, after being temporarily boosted by stimulus checks.

Home price declines have lowered consumer confidence and removed a source of wealth. Few homeowners can now fund their purchases by tapping their home equity via a home equity loans or cash-out refinances.

"People can't use their homes as ATMs anymore," said Roubini.

Job losses have increased and the unemployment rate hit 6.1% in August, up from 5.7% in July, the highest in five years. Roubini is forecasting it to top out at over 8%, at least.

And mortgage lending problems have migrated into other lending vehicles and will spread further.

Roubini predicted that practically all lending will see increased rates of defaults in the coming months from auto loans to credit cards to commercial real estate loans to municipal bonds.

"We don't just have a subprime mortgage lending system," Roubini said, "we have a subprime financial system."

The next shoe to drop may be thousands of highly leveraged hedge funds, according to Roubini.

As nervous investors cash in, the funds will be forced to liquidate highly leveraged assets at a deep discount, he said, causing the collapse of hundreds of smaller funds that have taken on excessive risk.

Roubini said a massive shake-out of the industry is likely during the next few years.