The Fed has pumped $2 trillion into the banking sector and housing market over the last year and a half (see the Bailout Scorecard) to keep the banks running smoothly and to jump start the housing market.  These initiatives are unsustainable and will fail.  It may be next month or it may be next year.  But the Fed is running out of weapons in its arsenal.  The housing market will crash again, and when it does, we'll be in a new financial crisis.  Banks will cut off lending, businesses and people will panic.  The politicians will demand action.  And the Treasury and Fed will relaunch their 'scare the s**t out of them strategy' that worked so well last time: if we don't take immediate multi-trillion dollar action right now, there will be economic Armageddon.

Here's my response: I'll take Armageddon.

The housing market will crash again.  Although home prices have fallen 30% from their peak in 2007, they still have further to go, perhaps another 20%, before they return to their historical levels of the 1990's.  Vacant housing inventory is still very high - 3% for homes and 10% for rentals.  The price for housing now should be much lower, but it's kept artificially high by $2 trillion of government support, which represents a significant portion of the $14 trillion overall mortgage market.  When it will crash is impossible to say.  In March, the Fed plans to wind down its $1.25 MBS purchases.  However, this role can now be taken over by Fannie and Freddie, which by the Christmas Eve 2009 decree may continue to increase total assets.  The homebuyer tax credits will end in April 2010, and this may trigger the crash as well.  Regardless, whenever it happens, we must be prepared.

Another crash would devastate the zombie bank industry that is loaded up on mortgage-backed securities (so-called toxic assets).  It would force them into insolvency, requiring a huge taxpayer bailout of FDIC insured funds (the puny FDIC insurance fund is inadequate to handle losses at this level).

Unfortunately there is no easy way out of this problem.  It's going to be painful no matter what.  But the longer we wait, the longer the zombie banks will accumulate more deposits and government guarantees, making the ultimate bailout more expensive.  Until then, economic activity will be anemic and unemployment will remain high due to uncertainty in the business environment, and as banks restrain lending for growth, hoarding money in preparation for the day of reckoning when they must reveal their true losses.

The only solution is to allow the big banks fail, as was done with Lehman.  This will be very expensive, as big banks like Citigroup and Bank Of America are propped up on all sides by government funding and guarantees - FDIC insurance on deposits and bonds, and the Fed discount window.  But they must be allowed to fail, and their assets slowly sold off or assumed by a healthier bank.  Yes this will be very disruptive to the economy.  But these banks are zombies and will never return to life.  Supporting these banks is throwing good money after bad.

When the housing market crashes again, there will be fear and panic.  Media will foretell the end of the world.  The government will come to the rescue, with TARP and a raft of other government programs that worked so well last time.  However, first of all, TARP didn't actually work.  Although most of the money was paid back, it was done primarily by borrowing money cheaply from the Fed.  If TARP is done again, it will result in direct losses as bank equity goes to zero, or in backdoor losses as banks simply borrow more to pay it back.  Secondly, there are about $1.3 trillion in non-TARP government programs currently supporting the market with taxpayer backing (see the scorecard), and the Fed has bought over $1.5 trillion in mortgage related debt.  These programs are still actively underway, and the only way to keep the patient alive is to increase them further. So while they'll claim that the programs worked, in fact they have succeeded only in postponing the crisis and increasing taxpayer liability.

These programs are not sustainable.  The market will crash, and the sooner the better.

So when the Fed and Treasury ask for more money, threatening financial Armageddon, we must be prepared to say, 'We'll take Armageddon'.  The worst thing would be to panic.  Be prepared for a period of difficult economic conditions as the big banks fail.  Put your money in healthier banks (Move Your Money).  Accept the market correction.  Perhaps it will be an investment opportunity for you.

Bernanke is a student of the Great Depression, and the lesson he seemed to learn is that the Fed must maintain stability of both asset markets (like the housing market) and the banking sector at all costs.  But the real cause of the Great Depression, as most economists agree, is not the crash of the stock market in 1929.  It was a combination of tight monetary policy, the requirement of a balanced federal budget, an impaired banking system, and adherence to the gold standard.  The Fed has an important role in providing easy credit during a recession - for all assets, not restricted to propping up the housing market.  But it was not necessary to specifically support zombie banks and the housing market as they are doing.  In fact it is counterproductive as it only delays the inevitable and increases the national debt - a huge price that will be passed on to future generations.

After the crash and correction, the American people can start to rebuild the economy in earnest, relieved of the burden of a dysfunctional banking system.