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This evening, CNBC reported:

Treasury Secretary Hank Paulson briefed Congressional leaders on plans to address the "illiquid assets" on U.S. financial institutions' balance sheets, possibly including the creation of a government facility to take on financial firms' bad debts.

Such a facility would be similar to the Resolution Trust Corporation, which was set up in 1989 to take on all the failed thrift assets during the savings and loan crisis, sources told CNBC.

Paulson briefed House Speaker Nancy Pelosi and other congressional leaders at a meeting on Thursday night.

The historic experience with such entities suggests that stock prices might yet test new lows down the road, a recession remains a possibility, and home prices will recover more slowly than equities prices. Given the size of the nation's fiscal deficits, a huge RTC-type operation could run the risk of raising U.S. borrowing costs. Such an outcome would delay a return to robust economic growth and the timing of a complete recovery of home prices.

Stock Prices:
Upon a CNBC report this afternoon that Secretary of Treasury Henry Paulson was considering the creation of a Resolution Trust Corporation (RTC)-type entity to purchase troubled mortgage securities, the stock market surged. The Dow Jones Industrials rose 3.86% to 11,019.69. The S&P 500 rose 4.33% to 1,206.51.

Nevertheless, while it is strongly likely that stock prices will be higher than current levels in both nominal and real (after-inflation) terms within the next five years given the experience associated with the RTC, there is a reasonable possibility that stock prices may yet fall to new lows. For example, the S&P 500 bottomed out 7.7% below the figure on the day legislation creating the RTC was passed. In real terms, that amounted to a 14.0% decline. The Dow Jones Industrials bottomed out at 4.4% below the figure on the day legislation creating the RTC was passed and 10.9% lower in real terms. From today’s close, that would imply a low of about 10,535 for the Dow and 1,115 for the S&P 500. Given experience with a combination of past recessions and Bear Markets, it remains possible that the Dow could fall below 10,000 and the S&P 500 below 1,100 should a full-fledged recession develop.

Since stock prices peaked on October 9, 2007, the Dow has fallen to as low as 10,609.66 and the S&P 500 has reached 1,156.39. Both lows were achieved on September 17.

Home Prices:
The Resolution Trust Corporation was established just as home prices were nearing a peak. The S&L crisis was already intensifying at that time.



In contrast, any entity to purchase bad debt/toxic paper this time around comes after home prices have gone through their stage of sharpest decline.



As a result, one is not likely to see a sharp decline from home prices from this point on, though an extended period of sluggishness is likely until home prices bottom out. Nevertheless, the proposed entity is not likely to lead to a strong recovery in home prices. If one uses the 1989-94 housing bust as an example and adjusts for the timing of the creation of an RTC-type entity, home prices are not likely to recover to their pre-bust peak through at least 2012 in nominal terms and 2015 in real terms. Given the magnitude of the housing bubble and the accumulation of mortgage debt (> 100% of GDP), the full recovery in home prices (nominal and real terms) could take even longer than the minimum timeframe noted above.

Economic Growth:
Creation of an RTC-type entity is no guarantee that the U.S. economy will avoid a recession. During the RTC period, the U.S. experienced a mild recession from July 1990 through March 1991. During the height of the recession (1990 Q3-1991 Q1), real GDP contracted 1.3%. At an annualized rate, real GDP contracted by 3.0% from 1990 Q3 to 1990 Q4. Overall, during the period in which the RTC operated, real GDP grew 2.4% per year. Real annual economic growth averaged 3.1% from 1970 through 1989 and 3.4% from 1980 through 1989.

For the 20-year period ending in 2007, real economic growth averaged 2.9% per year. For the 10-year period ending in 2007, real economic growth came to 2.8%.

Research by the IMF has shown that below average economic growth typically persists for about 4 years following the implosion of a real estate bubble. During this timeframe, financial institutions rebuild their balance sheets and recover their appetite for risk. In its April 2003 World Economic Outlook, the IMF explained:

Asset price crashes or busts have often been associated with declines in economic activity, financial instability, and, sometimes, large budgetary costs from the recapitalization of the banking system…

[T]he price corrections during housing price busts averaged 30 percent, reflecting the lower volatility of housing prices and the lower liquidity in housing markets… [H]ousing price crashes lasted about four years, about 1 ½ years longer than equity price busts.

Even with the creation of an RTC-type entity, the U.S. is likely to experience a period of de-leveraging. Under such a deleveraging scenario, the U.S. economy could experience the onset of a structural re-adjustment in which personal consumer spending becomes somewhat less important to overall economic growth than it has been in recent years. The transition would entail a period of slower economic growth than would otherwise be the case.



Conclusions:
Based on the historic experience concerning the milder 1989-94 housing bust and the experience of the 1989-95 Resolution Trust Corporation, several points are likely reasonable:

• The stock market might yet reach new lows despite today’s broad-based rally.
• Stock prices are likely to recover more quickly than home values.
• No rapid recovery in home valuations is likely.
• Below average economic growth is likely to persist for at least the next few years.
• A recession remains a possibility.