The US economy is falling into a depression and the Fed’s response will lead to the highest levels of monetary inflation in the history of the United States.

Both of those statements warrant a full explanation and in due course I will do that, but this week I want to look at the solutions being proposed to help distressed homeowners, bankers and “investors”. I purposely highlighted investors since if you go around buying billions of dollars of packaged debt without a clue of the underlying quality of the assets, you should not be regarded as an investor. Unfortunately, these “investors” are the investment funds and pension funds that most people rely on for their retirement savings. That is just one good reason why you should never entrust your retirement savings to a total stranger who charges you a fee and a piece of the upside while you assume all the risk.

Moody’s Economy.com (a subsidiary of Moody’s Corp.) estimates that nearly 8.8 million American homeowners, or 10.3% of homeowners, are underwater in their mortgages -- meaning they owe more than the houses are worth. You would have to go back to the Great Depression to find another time in American history when such a large percentage of homeowners were underwater. According to the Mortgage Bankers Association, more than 1.3 million loans were either seriously delinquent or in foreclosure during the third quarter of last year. More than a million homes will go into foreclosure this year, up 300 percent from last year.

Hope Now (www.hopenow.com) is an alliance between counselors, mortgage market participants and mortgage service providers to create a unified, coordinated plan to reach and help as many homeowners as possible. The “Hope” in this case is not so much for homeowners, but that the banks, mortgage trusts and investors can forestall their own bankruptcy proceedings.

Countrywide Financial, Bank of America, Citigroup, J.P. Morgan Chase, Washington Mutual and Wells Fargo, all members of the Hope Now Alliance, also created a new program called Project Lifeline.  Together these six companies service roughly 50% of all mortgages and their plan is to contact homeowners who are more than 90 days past due on their payments to see if they can re-negotiate some terms.

These lenders said they would contact homeowners and give them the opportunity to stall the foreclosure process for 30 days while they try to work out a way to make the mortgage more affordable. Project Lifeline is designed to help sub-prime borrowers of adjustable rate mortgages who can at least afford the current starter rate on a sub-prime loan, but will not be able to make the higher payments once the interest rate goes up. Among the solutions offered is to freeze the interest rate on their mortgages for another five years.

While this plan does offer some help to those people who neglected to consider what would happen when their ultra-low introductory interest rates reset to market rates, I don’t think the plan is going to solve the problem. For most part, this plan is going to forestall the problem until later since nobody can afford to keep those people in their homes at the ridiculously low introductory rates. At some point they either have to pay market rates, or the lenders have to write down the net present value of those mortgages. It is the reluctance of “investors” to acknowledge that these mortgages are not worth what they are being valued at on their balance sheets that lies at the heart of the financial crisis. This plan does little to change that, at best it only postpones the day of reckoning.

Separately, Bank of America is trying to talk the government into creating a new federal agency that would buy vast amounts of delinquent mortgages at a deep discount and replace them with fixed rate federally guaranteed loans. It’s a great plan for Bank of America and all the other banks, mortgage trusts and “investors” who made billions in fees by giving money to anyone who applied for a mortgage without consideration of the credit quality or ability of the borrowers to pay back their debts. Now that they are sitting on hundreds of billions (or trillions) of dollars worth of losses, they want the government to just buy the mess from them so they can go on with business as usual.

Bank of America warned that because their (and other banks’) balance sheets are under stress, they are forced to tighten credit standards. This is escalating the levels of delinquencies and defaults among borrowers and therefore an unprecedented number of homes would enter foreclosure. Yes, we all understand that if you imprudently hand out money to anyone with a pulse then both the lender and the borrower will get into trouble. Why should hard-working taxpayers, who had no part in this folly, now have to pick up the bill? Remember, the government does not have any money. Any government bail-out has to be financed either by taxes or by creating inflation.

Fortunately, from what I have seen in the press, this plan did not receive a warm welcome in Washington. Apparently the Bush Administration said it opposes any bailout for people who borrowed more than they could afford or for banks that made foolish loans during the housing bubble. That is a stunningly sensible stance from the Bush Administration. I hope they can stay the course, but I doubt it.

The Federal Housing Administration (FHA) is trying to figure out a way to replace onerous sub-prime mortgages with federally guaranteed fixed-rate mortgages for consumers with weak credit. While the FHA has been in the business of helping people with poor credit get mortgages for a while, they have always had a relatively low cap on the size of the mortgages. According to most industry executives who have cared to comment on it, the number of mortgages that this plan will affect is too small because of the mortgage-size cap. There are proposals in the works to raise the cap from $362,790 to $417,000, but even then, the FHA is unlikely to be able to help enough people to materially make a difference to the current crisis.

While the FHA proposes to help people who actually have a hope of paying their mortgages, in other words, people who weren’t totally irresponsible, Credit Suisse is urging the FHA to bail out anyone who has made at least six mortgage payments. That would actually have been funny if it wasn’t so sad, but it shows just how desperate the banks are to get rid of the loans they originated.

The banks generated billions of dollars in fees while paying no regard to the quality of the loans they originated because they were going to sell them to “investors” within weeks of origination. Now that the loans are going into default and there are losses they have to acknowledge on their balance sheets they want tax payers to make them whole again. Ultimately the tax payers are going to have to bail them, mortgage trusts, “investors” and homeowners out, I realize that, but it shouldn’t be done without some retribution to to those whose indiscretion caused the problems.

John Reich, the director of the Office of Thrift Supervision also has a plan. He suggests a voluntary system whereby mortgage lenders would reduce the debt of homeowners to reflect a more realistic value of the underlying homes. This would then also reduce their monthly mortgage payments and would hopefully make many distressed mortgages more manageable. The portion of the mortgage that gets written off remains as a “negative amortization certificate”, a lien against the house that would be recouped if the house is later sold for its original mortgage value, or more. The problem is that these negative amortization certificates will not be worth very much and will therefore represent large losses to the lenders. It will force the lenders and “investors” to acknowledge their losses and many of them are reluctant to do that, since it will immediately become obvious who is bankrupt.

Another problem is that when a homeowner sells a house for less than the existing mortgage, and the mortgage balance is forgiven by the lender, then the amount of debt that is forgiven becomes taxable income for the homeowner. Most homeowners who cannot afford their mortgages and would love to sell and get out are unlikely to be able to cope with the tax on what is written off. This is preventing many people from selling or abandoning their homes and mortgages. So there is now a proposal that would eliminate these taxes.

The flip side is that these taxes are keeping a lot of people in their homes and if the tax is eliminated it would open the way for many more people to simply abandon their homes with negative equity, and that would exacerbate the problem for the banks and mortgage trusts. So if the taxes are eliminated it would actually exacerbate the crisis in the short term.

The correct solution to the problem is to let the “investors” acknowledge the losses they have incurred as a result of their reckless and greedy behavior, for the banks to accept the losses they have caused as a result of their undisciplined and irresponsible business practices, and for the homeowners who bought houses they couldn’t afford to relinquish them to their lenders. They weren’t ever homeowners anyway -- if you buy an asset for more than its worth and finance it entirely with debt, you don’t own the asset, you are merely a sophisticated squatter.

Unfortunately this won’t happen either, for two reasons.

The first reason is rather comical: in many cases the banks are having great difficulty foreclosing on delinquent homeowners because they cannot prove who owns the mortgages. Judges in at least five states have stopped foreclosure proceedings because the banks that pool mortgages into securities, and the companies that collect monthly payments, have been unable to prove they own the mortgages.

More than $2.1 trillion (about 19% of all outstanding mortgages) have been bundled into securities and those loans may have been sold several times before they were securitized. Then the securities could have been sliced and diced and sold several times over again. Some of the paperwork done by original lenders does not even exist any more because some of the original lenders have gone out of business.

Now that the banks, mortgage trusts and service providers have to go to court to foreclose, they find that they don’t have the paperwork to prove they own the mortgages so they file a lost-note affidavit instead. But defense lawyers and judges are now balking at these lost-note affidavits which have become the norm in foreclosure proceedings.

So we see that the same institutions who made loans, or bought loans, with incomplete documentation are now finding out that they cannot get their money, or the houses, back without complete documentation. In the end, though, they will prevail. It is just that it will cost more and take longer for mortgage owners and banks to foreclose.

But the real reason why neither the borrowers nor the lenders will ultimately pay for their imprudent behavior is that it would not be politically expedient. The latest FOMC minutes spell out just how worried the Fed is about the current situation.

So instead, Ben Bernanke is going to try to create so much monetary inflation that the prices of homes will start to rise again. After all, if home prices were to increase then homeowners might be willing to stay in their homes (if they can afford to), negative equity will evaporate and the financial sector can start marking up those mortgages again.

While this is all but a foregone conclusion, the disadvantage of this plan is that it will destroy the living standard of everyone in America and ultimately cause far more harm than letting the market sort out the mess. But since the effects of inflation are unlikely to show up during Ben Bernanke’s term, and definitely not in Bush’s term, who cares?

Ben Bernanke and the government will send out checks, absolve the irresponsible from their responsibilities and finally ensure the banks survive by creating massive amounts of new money and steepening the yield curve. This environment is what we have to pay attention to: it poses the most significant threat to our capital and will cause the greatest decline in our standard of living.

We can expect taxes to increase, inflation to increase dramatically, and the economy to remain depressed. Under such an environment the prices of assets go up, but not necessarily in real terms. And it is this that we need to understand: real inflation, real asset prices and how to navigate through an inflationary depression.

I will do my best to tell you what I think is most likely to transpire, and why, and in a broad sense what I think could be done to protect our financial well-being.