Foreclosure activity saw a huge spike in the third quarter, as one in every 475 U.S. homes either received a default or auction sale notice, or was repossessed by a bank, according a report released yesterday (Thursday) by industry group RealtyTrac. It was a 71% jump over third quarter foreclosure activity in 2007 and a 3% increase from the second quarter of this year.

Foreclosure filings actually decreased 12% in September from August, but not due to an improving housing market.

“Much of the 12% decrease in September can be attributed to changes in state laws that have at least temporarily slowed down the pace at which lenders are moving forward with foreclosures,” said James J. Saccacio, chief executive officer of RealtyTrac, in the statement announcing the results.

A California law that requires lenders to give homeowners 30-days notice prior to filing a notice of default led to a 51% drop in that state.

The U.S. Treasury Department is working to implement a program that will modify the loan terms of struggling homeowners and guarantee those loans for banks that participate in the new program. The incentive for the government to stem the flood of foreclosures includes much more than just helping people hold onto their homes.

“We have never seen a foreclosure cycle like this one before,” Rick Sharga, RealtyTrac senior vice president, told CNNMoney.com.

A slowing economy generally precedes periods of elevated foreclosure rates. However, “in this cycle, we have foreclosure problems that have caused an economic downturn,” Sharga said.

Speaking in testimony before the Senate Banking Committee yesterday, Sheila Bair, head of the Federal Deposit Insurance Corp. (FDIC) and Neel Kashkari, head of the newly formed Office of Financial Stability, both spoke in favor of government assistance to homeowners facing foreclosure.

“We are passionate about doing everything we can to avoid preventable foreclosures,” Kashkari said.

Bair outlined how the government’s $700 billion bailout legislation includes provisions to help homeowners.

“Loan guarantees could be used as an incentive for servicers to modify loans,” Bair said in her prepared testimony, The Associated Press reported. “By doing so, unaffordable loans could be converted into loans that are sustainable over the long term.”

Bair pledged the FDIC’s support for the eventual Treasury Department plan.

Source: Treasury and FDIC Team Up to Aid Homeowners at Risk for Foreclosure

“Given the exceptional pressures on the global economy and financial system, the damage caused by a default by Bear Stearns could have been severe and extremely difficult to contain.”

-Fed Chairman Ben Bernanke

“Was this a justified rescue to prevent a systemic collapse of financial markets or a $30 billion taxpayer bailout for a Wall Street firm while people on Main Street struggle to pay their mortgages?”

- Senate Banking Committee Chairman Christopher Dodd

From where I sit, far away from Washington, it seems like the bailout was both. Yes Mr. Bernanke is correct, had Bear Stearns gone under, there would have been massive panic in the world’s financial markets, not just the U.S. market.

Is it a bailout at the taxpayers’ expense? You bet it is. There is no way J.P. Morgan agrees to this deal without the Fed taking on the risk. Well, after the uproar of JPM paying just $2 per share for BSC and not taking on any of the $30 billion in bad assets, the deal had to be revised to $10 per share and now JPM is taking on the first billion of the risk with the Fed taking on the other $29 billion. Jamie Dimon, the CEO of J.P. Morgan, said in his prepared remarks that JPM would not have done the deal if the Fed had not agreed to take on the risk.

This sounds like a low down payment mortgage. I buy a house and put three percent down, the bank puts up the other 97 percent. If I go into default on the mortgage, I lose the three percent I put down and the bank is left with the rest of the risk. If it goes to auction, they might make money on it, but not necessarily.

The Fed believes that it will eventually make money on these assets, but as you and I both know, there is no certainty in investing.

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I was just on a radio interview with WMMB, the CBS radio affiliate in Chicago. They asked me what I thought of the Fed’s involvement with the JPM/BSC deal. My answer was that “I’m glad I didn’t have to make that decision.” Think about it, if you are Bernanke and don’t do anything, the world’s financial system goes into an all out panic. Or you can stick the U.S. taxpayer with a potential $29 billion bailout.

I still think JPM got a steal, even after so generously agreeing to take on the responsibility of one billion in losses should they occur.

I still can’t say whether or not the Fed should have done this deal. It might take several years to tell whether or not it was the right decision. For now, it was the right decision in that it kept stability in the U.S. and world financial systems. But if the assets they agreed to take on as part of the deal end up costing the taxpayer $29 billion down the road, then it was a bad decision.

The part that worries me is now that there is a precedent for the Fed to step in like this, when will the next time be? I read some comments from Todd Harrison, the founder of Minyanville.com, and I like how he put it. Mr. Harrison said it was like the situation in Iraq in that the Fed is engaged and can’t pull out now without some serious consequences.

I could not agree more. I know my colleague Rusty McDougal is usually the one railing on the government for getting involved in the market, and I usually agree with him, I just don’t usually express it here in the pages of IDE. But the words Laissez Faire mean nothing anymore. There is no such thing as a free market anymore.

I will wait to pass judgment on this particular Fed decision. Whether or not it was a good business decision is one thing and that will take time to figure out. But interfering with a supposed free market system is a no-no in my book.

Good luck and good trading,

Rick

P.S. To let me know what you thought of today’s article, send an e-mail to: feedback@investorsdailyedge.com.

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