(James Saft is a Reuters columnist. The opinions expressed are his own)

Activity in the U.S. housing market has bottomed - a huge plus for the economy - but a recovery in prices will not be sustained and the threat from real estate to bank capital remains acute.

We are over the worst, but only because of massive official support, support that will soon ebb. That could lead to a relapse, especially among more expensive houses, but nothing along the lines of what we have suffered so far.

The news has been good.

Newly built homes sold in July at the fastest pace in ten months, up 9.6 percent, in U.S. Commerce Department data on Wednesday. This echoes a fairly good showing in last week's data on sales of existing homes which are selling at the fastest pace in almost two years.

Miraculous to say, prices now look to be rising, at least as recorded by the Case-Shiller home price index which rose 2.9 percent between the first and second quarters, the biggest jump in close to four years.

This all comes as a huge relief. You can construct an argument that we are now most of the way through the most painful adjustment in house values and sales activity since around the time great clouds of dust blanketed the mid-west in the 1930s.

There is no doubt that a pickup in activity, even from very low levels, will be helpful for the economy and will gently support the services and construction sectors as well as theconsumption of durable goods.

But the supply of housing, though it has dropped, remains high and is probably under-measured given a large "shadow" inventory of both repossessed houses and houses of frustrated sellers which will come back on to market to meet and probably exceed any pickup in demand.

In the more bombed out areas of the U.S. - think Las Vegas and Cleveland - it is easier to come to terms with the idea that prices will now rise.

Demand is coming not just from first time buyers but more importantly from cash investors looking, not to flip as prices rise, but to get a decent income stream from renting. These investors are a healthy part of the process of turning a marginal group of house-owners back into renters.

It is hard to look at the national data, especially at the higher end where inventory in many areas is measured in years of supply not months, and conclude that we will not see any more falls.

"Perhaps a respite is in order, but with the true underlying unsold inventory near 12 months' supply, which is double what would typify a balanced housing market, it would seem like wishful thinking that we have suddenly achieved a fundamental low in real estate values," David Rosenberg, of Gluskin, Sheff told clients.

THE GOVERNMENT GIVETH...

The recovery in housing, such as it is, has to be seen in the context of the absolutely heroic support it has received from government.

The Federal Reserve has slashed interest rates to unfathomable lows, and not content with that, also intervened directly in mortgage markets, buying something on the order of $750 billion net of mortgage securities in an attempt to drive down mortgage rates.

The Fed has a 2009 target of buying up to $1.25 trillion of agency mortgage backed securities, $300 billion of Treasuries, and $200 billion of agency debt, all of which is keeping effective borrowing rates 0.5 to 1.0 percentage points lower than they would otherwise be. That program may be extended into next year, but not in size, given a well justified fear by the Fed that such intervention invites tighter political oversight.

So, all things being equal, mortgage rates may rise relative to prevailing rates, unless of course the securitization machine rises from the dead.

An $8,000 tax fillip for first time buyers is definitely a factor behind increased turnover and improving prices, particularly at the lower end. But that program is due to expire November 30.

Like the "cash-for-clunkers" plan for cars these programs partly encourage pent up demand to get off the sidelines but also simply move some activity forward in time. Look for a bit of a slump as the effect, which is now at its height, wears off.

Late paying borrowers are proving far less likely to get back on track than they were in previous cycles, according to a recent report from ratings agency Fitch. This argues for a continuing supply of houses coming back onto the market as foreclosures, especially in light of the poor success of mortgage modification programs.

To be sure, things are better now than they have been and the very steep falls in price make housing less of a one way bet.

The real estate market is usually seasonal, with a spring spurt and a winter freeze. This year we've seen the return of the spurt, but the freeze to come may buckle some foundations.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. )

(James Saft is a Reuters columnist. The opinions expressed are his own)

A proposal to give banks, hedge funds and private equity firms "affordable" credit default swap-based insurance against market panics will be very effective: it will effectively encourage even more risk taking and turn the next crisis into one about government credit.

Global central bankers assembled at the Jackson Hole conference last week heard the proposal, by two Massachusetts Institute of Technology economists Ricardo Caballero and Pablo Kurlat. Their idea is that most of the damage in panics is due to a combination of investors overestimating the damage during a market seizure and policy-makers being too slow to pull the trigger on bailouts.

The solution, therefore, is to send the banks into the next panic ready armed with a Fed-backed get out of jail free card which the authorities can activate at a moment's notice.

This is akin to looking at a bunch of toddlers riding motorcycles and deciding that what will really improve the situation is putting them all in crash helmets.

The proposal emphasizes "Knightian uncertainty," which it says impairs markets during panics, as investors price in the worst about those risks which they cannot measure.  Remove this uncertainty, and hey Presto, you've cheapened the cost of the whole bubble business.

"The main antidote to fear is prime, government-backed insurance against what investors fear," according to Caballero and Kurlat.

"The silver lining of this diagnosis is that providing such insurance is inexpensive for the government, as once the panic subsides the real losses are much smaller than those initially feared by investors."

There are a few assumptions there, so let's take them one by one.

First, we don't know that markets were wrong to assume last year that bank losses would be catastrophic. Banks are performing better, but only within a context of having either an explicit or implicit government guarantee. We do not know how well their underlying assets will ultimately perform, or even if the assumptions made in the stress test will prove true. We only know that in making those assumptions and standing behind them, the government has removed risk for private investors.

Second, we do not know that the level of these losses will be affordable for governments to bear. Look at Iceland for a prime example of what can happen. The U.S. has taken on very real and very scary public liabilities in order to end the crisis. There is no guarantee that these are affordable or that U.S. creditors will keep faith.

THE FUTURE IS MORAL HAZARD

Caballero and Kurlat also say that the cause of panics is fundamentally unknowable, a surprise. While its hard to say now where the next one will come from, there are plenty of people out there who were patiently explaining where this one was going to be centered: real estate. People who ignored this advice did so for many reasons, but one thing in common many shared was that they were getting rich out of the bubble or hoped to.

This brings us to the main reason not to create these crisis swaps; they will only encourage people to take on more risk. If we effectively assume that all panics are essentially false alarms we will encourage an unwarranted confidence in risk managers and investors. Add in prospect of profits and bonuses and you have a prescription for ever expanding leverage, bubbles and crises.

The authors say that policy makers react too slowly, and compare their plan to placing defibrillators in public places to save the lives of heart attack victims. But unlike human beings, all of whom we want to save, sometimes its better if banks are allowed to die, much less hedge funds. Shareholders and bondholders, unlike life, are not sacred.

The proposal also argues that leverage in the system was not excessive, at least when compared to the last recession in 2001. But of course by 2001 the amount of leverage had already began to expand, helped along the way by deregulation. Try running the numbers compared to 1985 or 1965 and you will reach a different conclusion.

None of this is to say that financial innovation is a bad thing, or that leverage is to be altogether eliminated. But there is in markets a growing hope that we are all awakening from a bad dream. That's a delusion.

Financial panics are not nightmares to be ignored, but like chest pains, warnings to be heeded.

"In the end, the conventional common sense response to financial crisis - better regulation, rein in leverage, increase transparency, etc., is not such a bad one," Harvard economist Ken Rogoff wrote in response to the proposal.

I couldn't agree more. Let's get the kiddies off the bikes, and the sooner the better.

( At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

(James Saft is a Reuters columnist. The opinions expressed are his own)

Investors met the news that Japan's economy has emerged from a bone-breaking recession calmly and rationally: they sold shares quickly and in large amounts and made bets that consumer prices are going to be falling for years to come.

That's because Japan's recovery, coming as it does after a global bubble in the production of what I call, for lack of a more technical term, "stuff," is really not sustainable.

The fact that the consumer portion of the recovery is only a reflection of income transfers from government to individuals isn't very encouraging either.

More importantly, given that hopes for Japan were low anyway, the vulnerability of its recovery point to some important challenges the nascent rebounds in the U.S. and Europe now face.

Japan grew at a 3.7 percent seasonally adjusted annual rate in the second quarter, in data reported on Monday, quite a contrast with the almost 12 percent annual rate of contraction in the three months before.

The recovery was heavily dependent on consumer spending, goosed by government subsidies for buying hybrid cars and green appliances, as well as a heavy public works spending.

Public spending in a downturn is a good thing, but it needs to set the stage for private investment and consumption later, and in Japan this does not seem to be happening.

"Japan's return to growth in the second quarter is a prime example of a 'feel bad' recovery," Lombard Street Research's Michael Taylor told clients.

"Recovery may prove to be rather short-lived, as so far there are precious few signs that Japan is capable of sustained, domestically-driven GDP growth. The continued accumulation of inventories in Q2, albeit at a more modest pace than in recent quarters, also casts doubt on growth prospects through the second half of the year."

The underlying figures were ugly. Private capital investment fell 4.4 percent compared to the first quarter, and real investment in housing fell by nearly a tenth. Cash earnings for Japanese workers has fallen 7.1 percent in the year to June.

The recovery in Japan is like a long lost and reputedly rich uncle who, now that he has come home, proves to be a poor bedraggled thing who rather than bringing hope and gifts only really wants to cadge a meal and a place to sleep.

WHY THIS TIME IS JUST NOT NORMAL

In a typical economic recovery, inventories, having been run down are rebuilt. This should prompt companies to make capital investments to gear up new production. People get hired, they spend money and so do others who are less fearful for their jobs. Companies become more profitable and the cycle reinforces itself.

But in Japan, and perhaps elsewhere, this recovery isn't really working that way. Capital expenditure isn't coming back. Company profits are being hit. Whatever profitability improvements we see globally are largely down to cost cutting.

This squeeze hurts already nervous workers who in their turn aren't spending much money. Unless, of course, they need to in order to get their share of a government handout.

Even with inventories being restocked, the amount of spare capacity in the global economy is very substantial. Company managers too will have been taught a lesson about leveraging up to expand: not only is demand not always there sometimes the banks want their money back unexpectedly and usually at the most inconvenient time.

Consumers, and not just in Japan, aren't very confident in the future of property and decide that what once looked like a prime investment now looks like avoidable consumption.

Policy makers in Japan and elsewhere understand these dynamics and they have made heroic efforts to break the cycle. Up to a point, they have succeeded.

It's not so much that the policies - huge increases in liquidity and massive stimulus - aren't appropriate but that our expectations for what they can do has been too high. We are no doubt better off than we would have been, but we have shifted the burden of re-making the economy and paying down the debt out in time. It will be a longer, slower process and will disappoint many investors who think we are back to the good old days.

One advantage Japan does have is its position in Asia, where it may be able to benefit if Chinese domestic demand takes off. But overall Japan is linked to global trade, which while it has bottomed, has made its recovery due to government spending which some day soon will have to be replaced.

As for Japan domestically, the fiscal stimulus will peter out in the first quarter of next year. What will arrive to take its place I cannot tell you, but if nothing does it will prove to have been a brief, miserable recovery.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. )

-- James Saft is a Reuters columnist. The opinions expressed are his own --

Rising pay in the finance sector in the wake of the global financial crisis is no surprise and is driven partly by the government's bailout itself and the underwriting of banks that are too big to fail.

News that some financial firms benefitting from government largesse actually increased the share of revenue they pay their employees sparked a lot of outrage but more heat than light.

The good news is this new bulge in pay may not be sustainable.

The bad news is it will probably only be stopped by further regulation, regulation which may never come.

To understand what is going on you need to understand the economic concept of "rents", essentially the extra money a given individual or industry is able to extract from its clients above what it would be able to if there was perfect competition.

A monopoly will charge a very high price for goods or services because, well, they can. Needless to say economic rents are not a good thing, unless of course you are in receipt of them.

Workers in financial services have been huge beneficiaries of economic rents in recent years. They sell products which are complex and poorly understood by clients. They have been very lightly regulated, and it has been hard in many areas for start ups to compete with large firms and drive down prices.

A study by economists Thomas Philippon of New York University and Ariell Reshef of the University of Virginia found that about 30-50 percent of the extra pay bankers get as compared to similar professionals is attributable to rents. <http://people.virginia.edu/~ar7kf/papers/pr_rev15_submitted.pdf>

In other words, banking is able to overcharge its customers and bankers are able to capture a huge portion of that for themselves. Why? Because they don't face enough competition, their products are too complex for clients to be able to understand and bargain effectively, and crucially because regulation allows for this state of affairs.

Rising complexity, in my view, has probably been fuelled at least in part because it drives margins and tilts power away from bank clients and shareholders and to employees.

"The more complicated the product the easier it is for people to hide the risks," Reshef said in an interview.

The study shows that excess pay in banking is very closely linked to lax regulation, as opposed to higher productivity or early adoption of technology.

Relative compensation in finance in the early part of the last century peaked not in 1929 before the crash but several years later just before the more stringent regulations kicked in. Relative compensation began to climb again in the 1980s as deregulation happened and rose like a rocket since 1990.

WHAT JUST HAPPENED??

The economic crisis, far from undermining circumstances that allow for rents and excess pay, has in some ways cemented them.

One area of complexity, asset backed finance, has been eviscerated but many others still sail on relatively unaffected.

Most importantly, the doctrine of too big to fail has confirmed and reinforced the superior market position of those banks and investment banks which still survive.

The U.S. has essentially made it known that the current players will not be allowed to fail. These banks had an advantage already based on their size, that advantage is now greater and carries an implied government guarantee.

Ladies and gentleman, this is your banking recapitalization program: an unfair playing field. I might be able to swallow that as the economy needs a banking system. But, if you believe Reshef and Philippon's data, a goodly part of the essentially unearned money that should be going to recapitalize the banks is ending up instead overpaying the bankers.

It is true that part of the reason banks are paying their best people so much is that a tectonic shift in banking will place a higher premia on the most talented. Fair enough, but only if we see a shrinking pool of compensation money being tilted towards a smaller elite.

The rise and rise of the rents extracted by bankers from the economy will only really be stopped by government intervention, since, given we have a system of bank insurance, it only really can exist with government connivance.

You could make good progress controlling excess compensation and banking rents by placing limits on size, by taxing complexity (which after all hasn't really served us well), and by limiting the use of leverage within the parts of the system that can make a call on the taxpayer.

If you look at the Great Depression, this process will take about four years. We've not made a very encouraging start.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. )

(James Saft is a Reuters columnist. The opinions expressed are his own)

If you thought the U.S. housing crash could be blunted if only lenders would cut delinquent borrowers a break, it is perhaps time to move on to another vain hope.

That's right, the loan modification movement - pushed by the U.S. administration and others as a means of keeping non-paying borrowers in their houses, keeping those same houses from flooding the market as foreclosures, and even helping beleaguered lenders - is running into a reality-shaped wall.

An exhaustive study of loan modifications by economists at the Boston Federal Reserve, under which delinquent borrowers are given lower rates, more time, or even cuts in the principal amount owed, showed fundamental problems with the way that idea works when put into practice.

Looking at data that covers about 60 percent of U.S. mortgages the authors, Manuel Adelino, Kristopher Gerardi, and Paul S. Willen, came up with two important conclusions.

First, securitization, whatever its other shortcomings, is not an important factor in stopping loan servicers from cutting deals with delinquent borrowers.

Second, and even more importantly, lenders don't renegotiate for a simple, unanswerable reason: it is not in their best interest financially.

Virtually every rescue plan in the U.S. since the crisis began in 2007 has been in part a loan modification program, the most recent being the Making Home Affordable plan the Obama administration unveiled in February.

The thinking is that, as a foreclosure can cost the lender between 30 and 50 percent of the value of the loan, deals can be struck with borrowers for a lot less than that leave everyone better off.

Sadly, very few loans are being modified - only about 3.0 percent of delinquent loans - with many blaming securitization, which can make a loan modification toxic for one class of lender but beneficial for another.

Seeing as how securitization was part of the way finance spun of control and the bubble was inflated, this was a satisfying narrative, but a false one according to the Fed study. They found no significant differences in the rate of renegotiation among loans that were in private-label securitizations and those actually owned by the servicer doing the negotiating with the borrowers.

NEITHER A BORROWER NOR A MODIFIER...

The real issue is that, in the vast majority of instances, banks are better off not modifying.

For one thing, about 30 percent of borrowers who become delinquent get back on track before foreclosure. Since its very hard to know which borrowers will become payers again, this implies that 30 percent of the money expended in modifying loans is wasted, at least from the lenders point of view.

Secondly, a huge percentage of borrowers who are given new improved terms go and become delinquent all over again. A whopping 40 to 50 percent of borrowers who get modified loans are 60 days delinquent again six months later.

For them, and for their banks, it is just delaying the inevitable, and expensive to boot, as falling property prices make putting off foreclosing and liquidating costly.

The implication is that unless the government wants to pony up much larger amounts of money to entice lenders to modify loans, we are not going to make much of a dent in the wave of foreclosures washing across the economy. This could be done, and possibly support house prices in the process, but at a very high costs.

The real issue is that there are too many houses for the supply of credit worthy borrowers. The re-default rate shows that, as does the low clearing price when banks sell foreclosed houses.

Housing needs to fall in value, less of it needs to be built, and more people should become renters. That is going to continue to eat away at bank capital and act as a drag on growth.

Beyond that, there is a real question about the long-term consequences of mass loan modification. If the incentives are there more borrowers will become selectively delinquent and fewer who become delinquent will in the end catch up with their payments. Why should they?

That means higher loan rates than would otherwise be the case.

The thinking behind loan modification has interesting parallels in the rest of the economy, where policy makers are following similar strategies for banks and corporate borrowers.

Rather than simply cutting back on leverage, probably via default, there seems to be a consensus for stringing struggling borrowers, and lenders, along, hoping that something turns up.

Ultimately, it seems likely that strategy is about as successful in the rest of the economy as it seems to be in housing.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

(James Saft is a Reuters columnist. The opinions expressed are his own.)

Repeat after me: "I believe in a strong dollar as the primary global reserve currency, I believe in a strong dollar as the primary global reserve currency."

Better hope it works, because the current debate over a far-in-the-future new monetary system may bring on a here-and-now dollar selloff and a whole new leg of the crisis.

Sadly, what worked when the children espoused their faith in Tinkerbell may not for a currency backed by the full faith and credit of a debtor nation which has socialised its banking system's risk and needs to sell trillions in further debt to pay that and other bills.

Russia, India and, most significantly, China have all questioned the U.S. dollar's central role in global trade and currency reserve management in the run-up to this week's meeting of the Group of Eight industrialized nations in Italy. The future, it seems, is not greenback.

Russian President Dmitry Medvedev termed the system based on the dollar "flawed." Suresh Tendulkar, a top Indian economic advisor said he was telling India to reduce the dollar's weighting in setting the value of the rupee, comparing the situation to the classic "prisoner's dilemma."

It's a good comparison, and as such makes his advice, and his choosing to make it public, puzzling. In the prisoner's dilemma, two people are held for a crime and, being held apart, must decide whether to rat the other out. If both remain silent, they each get six months' jail time, if one implicates the other he goes free and the other gets ten years, if both turn on one another they both get five years.

If holders of U.S. dollars can somehow maintain confidence in the currency, the value of their reserves will be protected, but the temptation to get a first mover's advantage and get out while the getting is good may be overwhelming, though it will only work for that individual if everyone else more or less keeps faith.

Because, if they don't the selloff could be so disorderly and damaging to the global economy that it will make concerns over the value of reserves look silly.

China, for its part, seems to be furiously paddling in both directions at the same time; saying that the dollar will retain its central status for "years to come" while also doing things like setting up a system to allow companies to settle cross border trades in yuan.

Writing in a newspaper published by the Chinese central bank, Li Ruogu, Chairman of the state-run Export-Import Bank of China said that Special Drawing Rights (SDRs), a unit of account used by the International Monetary Fund, could be molded to serve as a more representative global settlement unit, based on a basket of currencies. This echoes suggestions made by Chinese officials in March and can leave little doubt that the Chinese are preparing for a very different future.

"The financial crisis caused the global economy to suffer heavy losses and it also let us clearly see how unreasonable the current international monetary system is," Li, a former central bank vice governor, said.

WHAT'S THE ALTERNATIVE?

He's right, the old set up under which China kept its currency weak and U.S. borrowing rates lower than they otherwise would be made it too easy for the U.S. to load up on debt and almost surely was the fundamental underlying driver that led to the sub-prime mortgage crisis. It created conditions under which the huge risk management failure within banking was more likely. After all, when money is cheap and people are desperate for a bit extra yield, bad loans will begin to look safe.

Of course there are no credible current alternatives to the dollar at this point; not the euro, which might fracture or grow, or the yen or even the Chinese yuan.

And there is the danger: the very knowledge that the current dispensation is under review, and for extremely sound reasons, means that there is a small but dangerous chance that it unravels, that holders of dollars and buyers of U.S. debt lose faith leading to an uncontrolled fall in the dollar and in dollar-based assets.

It is all very similar to the banking crisis. A bank is only sound so long as we believe it to be, and the dollar, given the U.S's weak fundamental position is only strong and worth holding so long as holders keep faith.

Really all we are observing is the continuation of the banking crisis on another plane. Last year the world lost faith in the U.S. banking system. The U.S., feeling it had no alternative, stepped up as effective guarantor of its banks and its financial system.

Well and good, and here's hoping it works. It only will succeed however if faith in the U.S. and its dollar remain.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

-- James Saft is a Reuters columnist. The opinions expressed are his own --

Come good news or bad, the U.S. treasury market is taking a sell now and wait for inflation later strategy.

Since May 21, Treasuries have been battered, sending the yield on 10-year bonds up by nearly 40 basis points to 3.53 percent, an enormous move in bond market terms.

This is where the real action is, not in speculation about whether credit ratings agencies will cut the U.S. AAA rating in a year or two; by the time they get around to saying what everyone already knows is true, the damage will have been done.

The U.S. is in the process of reflating, really re-leveraging its economy, but this time using the public purse and printing machine to replace private demand.

This may be necessary, it may even work, but what it is without doubt is risky. The Federal Reserve's massive direct intervention in credit markets will have to be unwound if and when it works, with unforeseeable consequences, and the government's funding needs are in the meantime intimidating.

Investors in Treasuries rightly fear the risks of inflation and of being left, eventually, holders of what the Fed is selling rather than what it is, at least for now, buying.

Stephen Lewis, of Monument Securities in London believes the surge in prices of things the Fed was buying was by definition short-lived:

"Investors quickly realised that, unless the Fed intended to be a permanent holder of the securities it had bought, or of an equivalent amount of similar securities, the favourable shift in the supply/demand balance would be only temporary," he wrote in a note to clients.

"Sooner or later, it would give way to an unfavourable shift as the Fed unwound its holdings. More than that, even the cessation, or diminution, of the flow of Fed asset purchases might leave the prices of those assets high and dry...The prospect then would be of a sickening plunge in market prices."

The irony on Tuesday was that bonds were hit hard even despite a successful auction of $40 billion of 2-year notes, with performance getting worse the further in the future the bonds are due for repayment. But a further series of tests are upcoming, with another $60 billion being sold this week and more to follow as far as they eye can see.

An optimistic gloss on the bond sell off on Tuesday is that better than forecast consumer confidence data had touched off a rally in stocks. Happy days, fill your boots with equities and sell those bonds. A steepening yield curve is supposed to be a sign of a recovery, right?

TREASURIES WEAKEN, OTHER VARIABLES CHANGE

That analysis is tough to reconcile with recent events. Last week, bad news and a fall in the stock market coincided with bonds tumbling. Britain was put on warning by Standard & Poor's that it could lose its AAA rating, supposedly sparking a read-across of the same implication for the U.S., the jobs numbers looked a bit ropey and, hey presto, bonds and stocks, well really U.S. assets, fell in concert.

Moody's on Wednesday said the U.S.'s AAA rating was stable, but strangely the rally on the back of this was not forthcoming.

But to understand why bond markets aren't pleased with the U.S. fiscal situation, you don't need to read-across from the British model, just read the Congressional Budget Office data.

The CBO predicts nearly $10 trillion of new debt in the decade from 2010, which will leave it at more than 80 percent of GDP. These are just astounding numbers, and while we can't be sure, the real risk is that the bond market is telling us this is unsustainable, unfinancable over the long term.

The data may well be looking up, and I do think a tepid recovery in the second half of this year is on the cards, but surely not a recovery that is worthy of inspiring a 12 percent plus move in government interest rates in 10 days or so, and not while the Fed is busily doing its best to keep rates artificially low by buying debt directly.

The central scenario is probably a volatile bond market, a jittery one which sees inflation behind every tree but in the end keeps faith with the U.S. and with its ability and resolve to manage the economy.

The tail risk is that the bond market loses faith, and in some combination with a falling dollar begins to not reflect events but dictate them.

It is a small risk, but the bond market could be the story of the summer.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. --

-- James Saft is a Reuters columnist. The opinions expressed are his own --

California's fiscal train wreck should be watched warily by investors in U.S. Treasuries; as the start of a trend among states seeking bailouts, as a source of pressure on Federal funds and as a harbinger of hard choices at national level.

California voters last week rejected a finance bolstering proposal, setting the stage for billions of dollars worth of  cuts in services, layoffs and a shortened school year.

It also leaves the state with a budget shortfall of more than $21 billion, an exacerbated seasonal revenue shortfall and a fragile reputation in the bond market.

These are just about the last things a state needs when unemployment is high and recession is deep, but California is trapped between its own high cost base, bond investors unwilling to give it the benefit of the doubt and a Federal government that is loath to play Santa Claus. Of the three, the last is most likely to give way, and if the U.S. does widen the bailout it is already giving to states it will have potentially profound consequences.

Treasury Secretary Tim Geithner knocked back, equivocally, a request from California Treasurer Bill Lockyer to use TARP funds to backstop the issuance of bonds by California. Lockyer fears that investors and banks will impose punitive costs on new borrowings, costs that will only worsen its overall position.

Though Geithner was right to say California wouldn't fit under the TARP, saying in essence that this was not the purpose of the vehicle, he was far from final on the whole issue.

Asked to rule out categorically a California bailout, Geithner told Congress:

"We will have to do exceptional things, as we have done already, to fix this mess ... That's not putting on the table or taking off the table any specific thing like that. But I just want you to know that there are things that we've had to do I would never have contemplated doing."

Christopher Thornberg, of Los Angeles-based Beacon Economics, thinks the stakes for California and the U.S. economy will prove too high.

"I don't think the Feds can afford to say no to California just now."

AS THE BAILOUT ROLLS

The economic and social impact of California's spending cuts are unpleasant. Also of concern is the health of the municipal bond market itself, the continued smooth functioning of which is systemically important and could force the government's hand. To be clear, Californian 10-year debt is still yielding a fairly reasonable 4.4 percent, a lot higher than equivalent Treasuries at about 3.3 percent but not ruinous. There are well founded fears about what the price will be going forward.

Treasury and Federal Reserve officials are understandably reluctant; after all, look at the mortgage market which continues to be hooked up to a government sponsored ventilator. Clearly too if Federal assistance were given to help California  sell bonds, other states and localities would quickly get in line for their share.

And while California makes the headlines, the finances of other states are also dire.

Forty-seven of the 50 states face budget deficits in fiscal years 2010 and 2011 totalling a hefty $350 billion, according to the Center on Budget and Policy Priorities.

Much of that will be resolved through higher taxes and spending cuts, but a chunky part could end up being bankrolled in one way or another by the Federal coffers, which should give pause to Treasury investors already absorbing massive issuance.

California is in some ways a special case: it requires two thirds majorities to pass tax increases. But its political inability to get to grips with a set of unpleasant choices is perhaps a warning for the U.S. as a whole.

There is precious little consensus in Congress for more bailout money and even if another tranche of support for states on top of the $140 billion already offered makes economic sense, it may not be forthcoming. It's not hard to see political paralysis in Washington if more money is needed, for whatever reason.

Secretary Geithner has been lucky or smart to the extent that markets have decided that his tools and bankroll are equal to the task as far as banks go. That consensus may or may not hold and may or may not continue to matter.

If states or municipalities mean he must go back to a refractory Congress, confidence could ebb as rapidly and dramatically as we have seen it grow.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. --

- James Saft is a Reuters columnist. The opinions expressed are his own –

The pig that is British property is furiously flapping its wings, but despite signs of a recovery in prices and activity, rest assured there will be no take-off.

The country, which witnessed a property bubble that made the U.S. seem sober and sensible in comparison, has seen prices fall by about 20 percent but still faces a tough recession, rising unemployment and serious short and long term questions about the price of financing.

In the face of this, Britons seeking to sell their property last month turned again to a tactic that worked so well in the boom years: they raised prices, with property website Rightmove recording a 2.4 percent rise in asking prices in May.

“While some of the impetus behind the increase of over 5,000 pounds in average asking prices will be due to ambition or optimism, it will also be out of necessity as new sellers attempt to scrape together enough equity to move,” Miles Shipside of Rightmove said.

Just how ambitious can be seen by comparing Rightmove’s average asking price of just over 227,000 pounds with an average April selling price in the Halifax survey of 154,000 pounds.

House sellers are choosing a price that will give them enough cash not only to pay back their existing loan but stump up the 25 percent or so for their next house that banks are now requiring in order to give the best mortgage deals.

Because it is hard or prohibitively expensive to get a mortgage with a low down payment, this means that in the absence of a similarly optimistic or charitable buyer, many will be unable to sell at a price that allows them to move.

On the face of it, this is a bit surprising; after all prices more or less tripled in less than ten years, why would a fall of only 20 percent cause such a squeeze?

Firstly, because many people continued to move and kept their leverage at a constantly high level, and secondly because so many people simply borrowed their paper housing gains from the bank and, well, did something with it.

There has been some regional variation in house prices, with London falling only about 15 percent, perhaps partly explained by the fact that for foreign buyers active in the centre of the capital, the discount from the peak is closer to 40 percent in currency adjusted terms.

THE GROWTH OF THE MARGINAL SELLER

The two pieces of evidence most often cited as an indication that house prices will soon right themselves are an increase in buyer enquiries and a bottoming in mortgage approvals.
The Royal Institution of Chartered Surveyors’ monthly survey showed new buyer enquiries rose for the sixth month running and at a pace not seen since August 1999. Recent Bank of England data showed that mortgages for new house purchases rose in March and were the highest in ten months.

All well and good, but the data has to be seen in the correct context. Mortgage approvals even having climbed are still a third lower than they were a year ago and, according to consultancy Capital Economics, about half of the level that has historically been consistent with stable, much less rising, prices.

And the marginal buyer who arguably drove the bubble, the buy-to-let investor, remains remarkably quiet. The amount of money advanced by banks to buy-to-let landlords fell 78 percent in the first quarter from a year before, though a steep fall in interest rates has perhaps meant fewer have thus far been forced sellers.

Forced sellers ultimately will end the standoff between asking and selling prices, and in the old fashioned way, as a lousy economy and the unemployment it breeds bring a wave of properties on to the market in the second half of this year and in 2010.

And while mortgage interest rates may seem low, courtesy of a 50 basis point base rate from the Bank of England, the typical spread above that on offer to new and existing borrowers is about 350 basis points, according to Capital Economics. That is a function of the risk of the loans, the capital of the banks and the supply of savings, and cannot be counted on to improve markedly soon.
This brings us to two crucial differences between the U.S. and UK markets, both of which make the UK a worse bet for potential buyers.

Unlike in most U.S. states mortgage lenders have recourse to the rest of borrowers’ assets. There is no walk away and post the bank the keys option, at least if you care about your car and retirement fund.

More importantly, British borrowers almost always bear some or all of the interest rate risk. There is no government subsidized fixed rate market there, unlike in the U.S.

That means if inflation, and with them mortgage rates, rise buyers will feel the shock.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

(Editing by David Evans)

-- James Saft is a Reuters columnist. The opinions expressed are his own --

Sure, seeing your economy shrink at a 15 percent annual clip is depressing, quite literally, but if you believe in even a tepid global economic recovery in the second half, then Japan is actually attractive.

There is no way to sugar coat the first quarter Japanese gross domestic product figures released on Wednesday: they are breathtakingly bad viewed from virtually any angle.

The economy shrank by a record four percent in the quarter, or an annualized fall of 15.2 percent, leaving the economy no bigger in real terms than it was in 2003. Net exports fell sharply, by themselves pushing GDP 1.4 percent lower and, perhaps even worse, capital spending shrank by more than ten percent and private consumption fell by 1.1 percent.

What's more, stocks of inventory remain high when compared to sales, so there is plenty left to sell without placing new orders.

But just as global trade, and with it Japan's economy, had an extended and sudden plunge in the wake of last year's panic, there are signs already of an improvement.

Industrial production in March in Japan actually rose from the month before, up 1.6 percent, a rise echoed softly in the Reuters Tankan survey of confidence among manufacturers which showed less gloom than the month before.

A recovery will require a substantial recovery in exports, industrial output and household spending, according to Julian Jessop, chief international economist at Capital Economics in London.

"The strong rebound in the survey evidence confirms that this is realistic," Jessop wrote in a note to clients. "The extent of the previous declines in exports and investment also leaves plenty of room for a decent bounce."

That decent bounce could result in a nice return on Japanese shares, which have rallied in sympathy with global stocks.

Significantly, Tokyo shares actually rallied after the GDP news even despite a rise in the yen which crimped the competitiveness of exporters. And measured on a price-to-book value basis, Japanese shares, especially smaller cap issues, are among the world's cheapest, implying decent potential for gains if the economy as a whole surprises.

Japanese shares as a whole are trading on a one year prospective price-earnings ratio of about 30.

LEVERAGED TO CHINA AND U.S.

Japan's economy is very highly leveraged to global trade, making this perhaps the key call in any bet on a recovery there. Japan's position is better than it might seem because those things which it does still successfully export are of high quality and technical specification and less vulnerable to cheaper substitutes from China or elsewhere.

A Barclays Capital composite leading indictor for Japanese exports, which tends to be three to five months ahead, has recently turned positive after a sustained and precipitous drop.

The index includes U.S. stock prices, commodity prices, new orders in the U.S. in both transport machinery and information technology, Chinese auto production and the relationship between U.S. inventories and sales.

Efforts by China to jump start auto sales seem to have worked particularly well, recording an 18.5 percent gain in April from the year before. Similarly, there is a reasonably good chance we are in the midst of a U.S. recovery of some sort, though the risks are it is short lived or chronically feeble.

As this happens look for a rebound in exports and production in Japan and even, at some point, in actual investment. This leaves us with the 20-year running sore that is Japanese domestic consumption.

The fear, and it is not a small one, is that employment and income suffer after a downturn of depression size and that already falling consumption retracts further. The gap between Japan's output and its capacity is eight or nine percent now, making the risk of deflation, and with it the possibility of a negative spiral in spending, quite high.

Balancing that is the fact that Japan's healthy savings rate gives its consumers an option less available to their U.S. peers when income falls, they can make up some of the shortfall by simply saving less.

Further, Japan is feeling the impact of a substantial fiscal stimulus, with at least some of the tax cuts finding their way into shopkeepers' hands. Japan also has front loaded infrastructure spending.

As with all such spending, the impact of this is transient and, with the possibility of an election soon, there is no guarantee that further extra budgets will be forthcoming.

It won't be glamorous, in part because the engine of growth will be elsewhere, but between now and the end of the year a rebound could be surprising and, depression-era style economic statistics notwithstanding, surprisingly profitable.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund --