The Hole is Much Deeper Than Currently Acknowledged for the 2008-2009 Recession

This is the first of a six part series, running this week, on why you can expect that the downturn will be deeper and longer than currently expected by most. Each day, I will post about one of the six reasons I have come to this conclusion. Here is Reason #1.

Any assessment of how long this downturn will last must begin with a realistic assessment of the starting point. That is, how bad is the current situation?

Most economists believe that downturns are a necessary "evil" for adjusting an economy. For reducing inflation, or for dealing with any other fundamental economic problem. Downturns are like draining the pus from a boil, or…in economic terms…curing the problems coming from a bubble.

So...to begin to understand how long this downturn will last and how deep it will go, one must first understand what is the problem that needs to be worked out and how severe is it.

Many point to housing prices as the bubble and the fundamental that must be worked out. I agree there is, indeed, a housing bubble that needs to be worked out. But, I believe that the Recession of 2008-2009 will go down as a poster child for problems with our credit markets. Those problems are unfolding, and will likely unfold further, in the coming months.

Much has been made, of late, of the problems of U.S. commercial banks and investment banks. But, I believe that the problems run deep throughout the financial services sector. AIG was just the tip of the iceberg of distressed insurance companies. Hedge funds are likely to be the next wave of distressed becoming a front and center problem, and it will not be just a handful. Mutual funds will be next as their values are ravaged by the losses on their investments in the financial services sector. And, the list will go on. And on.

The core problem is toxic paper. Trillions of dollars of it. Paper in the form of obligations, i.e., debts, for which there is no responsible borrower and/or adequate collateral.

Securitization made it possible for an originator to make a loan and to sell it off with little or even no recourse. Quite a change from days long since gone when as a banker I made a loan, I had to collect the loan. My career success depended on being able to collect the loan without any loss of principal. (What a novel concept that is in recent years.)

And, many loans since the advent of securitization were made with questionable borrowers, or on an effective non-recourse or limited recourse basis (as with equity sponsors who did not have to guarantee the debt of their portfolio companies).

The toxic paper problem has been exacerbated by all manner of creative parsing of the risks through many varieties of derivative products, thereby creating more toxic paper and ultimately piling toxic paper on toxic paper.

Now if the toxic paper problem is not enough, the problem has been compounded by the high leverage that has become pervasive in all manner of entities in our economy, from consumers, to businesses to financial institutions. At the 20X leverage that some financial intermediaries have been utilizing, even a 5% decline in collateral value means the equity cushion is effectively wiped out. At 10X leverage, a 10% decline in collateral means the equity cushion is wiped out. And, we all know that collateral value in homes, as well as with many other assets, are off by more than 10%. In many cases, by much, much more than 10%!

Now it is perfectly understandable why regulators are not standing on the mountain top and officially announcing that many of our financial institutions and intermediaries are insolvent using any measure of fair market valuation of assets. That is news that the financial markets do not need to hear from an official source. But, as every day, the regulators report on the need to deal with yet another troubled financial entity, it becomes ever clearer just how many financial institutions are insolvent. And, just how deep the hole is. It is very, very deep.

End of the world deep? Of course not! But quickly fixable? Not likely!

Up Next: The second of the six reasons; Recession Turnaround Efforts Not Yet Getting Real Traction Follow this series all week as I address one of the six reasons every day. And, remember that although I believe that tough times will be with us for quite some time, I also believe that with the right actions the agile can prosper.