Now for the biggest challenge facing President Obama, the economy. The near collapse of our financial system last year and the ensuing “Great Recession” has captured more media coverage than health care, Afghanistan or climate change. The economy is the 800 lb gorilla in the room. So far we have seen recovery in almost all indicators to the point that Fed Chairman Ben Bernanke issued a “cautious” statement that the economy is recovering. And indeed it is, as I have been saying since last May. Again, when all is said and done the pivotal date will be 2 April 2009 (see my blog of that date).

However, there are some remaining problems that must be resolved quickly or they will come back to haunt the Dems in next year’s election - regulation of our financial markets and unemployment. But before addressing these let me rehash some important things to understand about the recession.

All agree that the “Financial Meltdown” of 2008 and the “Great Recesssion of 2009″ stemmed from the massive growth of credit in the world produced by innovative new sources, i.e. collateralized debt, mortgage backed securities, credit defaults swaps and some that have remained under the radar. I call all of these “securitized” debt others use the generic term “derivatives.” The basic idea was solid, loans were packaged into bonds that were sold to many, thus dispersing the risk widely. The problem lay in the fact that these investment instruments were outside the open markets we use for stocks and bonds and commodities. They were hidden from public view and thus no one fully understood the size and nature of what became the principal source of credit.

As I have stated, the financial world liked having the market for these investments opaque so that insiders could control access and thus charge whatever they wanted in fees. But the lack of clear understanding of the size and nature of the market led to erroneous valuations of these investments. By being essentially “terra incognita” for most, the smallest glitch became magnified beyond any reasonable amount. Thus the panic because of adjustable rate loans, subprime mortgages, iffy commercial loans, and so on. The panic fed massive devalutions of the investments based on debt, that in turn destroyed bank balance sheets, that caused credit to freeze up, that caused consumption to decline, that forced reduced production, that led to massive employee layoffs.

The Feds in the persons of Hank Paulson, Ben Bernanke, and Tim Gaithner properly analized the situation. They called for massive Fedearal Government intervention in late 2008 on an unprecedented level. The Congress approved the TARP plan to shore up bank balance sheets by buying their “troubled assets.” The managers quickly realized that this would be a slow and tortuous path to follow and switched to simply injecting capital into the banks. At the same time the Federal Reserve also injected its own resources into banks. The plan worked, the banks were saved and the freefall was arrested.

The next step was to prod the economy back to consumption and production. Enter President Obama’s Stimulus Plan. It is already producing new jobs, but too slowly. I say too slowly because the body politic is still demanding more action.

The body politic is also demanding better regulation and control over our financial markets. Everyone now realizes that the basic problem was lack of transparency and regulation of the securitized debt market. Unfortunately the public is seized by the high compensation paid to the creators of this “credit bubble” and has focused on controlling their pay and bonuses. I believe this is the wrong approach. We should focus on making the market transparent and regulated, as with stocks and bonds and commodities. A transparent market will take care of bringing compensation into line with real performance.

So President Obama and his party have two critical issues to resolve, getting control of the securitized debt market and improving employment prospects, as soon as possible or these issues will hurt them in next year’s election.

While on the subject let me lay to rest two terrible misconceptions that lead to poor decisions. First, the TARP, the takeover of Fannie Mae and Freddie Mac, the takeover of AIG and GM, the Federally assisted resetting of mortgages, and the Stimulus Plan have not used one dollar of taxpayer money. They have all been done with borrowed funds. More importantly, it appears as though the Feds earnings from these programs may cover the interest charges on these borrowed funds. In essence the taxpayer is the ultimate guarantor on this borrowing, but so far he has not paid one dollar.

I would also hope that we finally understand that the housing market per se is not the asset represented by mortgages. The loan itself is the asset. As long as the loan is repaid on time, the asset is sound, regardless of what direction prices of property may take. Again, the foreclosure rate for mortgages in 2008 never exceeded 3%, which means in my book that these assets were sound.