Administration has admitted recession coming but how bad will it be?

What is happening to the economy?

Now that we know to expect a recession in 2008, how bad will it be? I've written before about the bind the federal reserve is in. If the economy slows down, the prescription is to lower interest rates. If inflation starts (and the dropping dollar and rising price of oil are pressing for inflation) the prescription is to raise interest rates. The fed can't do both at once, so it is hoping it can "muddle through" with only a little pain and no more rate cuts, and that the economy bail them out by turning back up so that they aren't faced with inflation that demands an interest rate increase.

Can the Fed make this work?

Throw in the current credit crunch as a monkey wrench in those Fed hopes. Jim Jubak at MSN Money points to the differing views of Wall Street and the Federal Reserve. Wall Street is of the opinion that the subprime mortgage credit crunch is just the tip of the iceberg. The Fed has already been pushed into making one interest rate cut it didn't want to make, and Wall Street thinks that there is a 90% chance that they will be forced to make another this year at their December 11th meeting.

The Fed believes U.S. economic growth can rebound in 2008 without another interest-rate cut and that cutting again raises the risk of igniting inflation and further weakening the U.S. dollar. Wall Street believes the debt markets and the big banks that support them are in such bad shape that disaster looms without another rate cut and another and another. Inflation be damned, Wall Street argues, the economy is at risk.

But what if there are more scary monsters hidden away in the securitized mortgages that the banks have been selling investors as investment grade investments that pay junk bond interest rates? And what about the survival of the companies who have purchased those investments and then borrowed money on them to make further investments?

The causes of the current problem

As we now know, those so-called investment grade securities paying junk bond interest rates were really junk (meaning high risk) in disguise. But a lot of investment companies treated them as low risk investments because that's what everyone else was doing. Jon Markman also at MSN Money, has written a report on hedge fund manager Mike Burry who recognized the mismatched risks and learned how to make money on the collapse of the mortgage market. He bet against the

fly-by-night mortgage brokers and major banks taking what he deemed "extremely unsuitable risks," using outlandish interest-only and adjustable-rate mortgages to get customers into houses they could not otherwise afford.

After listening to quarterly earnings conference calls by companies such as Countrywide Financial (CFC, news, msgs) and Washington Mutual (WM, news, msgs) and reading real-estate journals, Burry came to realize that home-price appreciation was the assumption behind every decision by borrowers, lenders, insurers and ratings agencies. He figured that once California home prices started to fall, the entire lending apparatus would fail and a credit crisis would ensue.

"It became clear to me that many people never expected to pay their loans back and depended on a rise in home values every two years to allow them to refinance," he says.

Burry has made about a 400% return on his bet this year as the mortgage crisis has become clear.

What's next?

The companies that bought those investments borrowed against them and loaned out that money also. When a lot of he investments default within a short time, those companies will also become insolvent and fail.

"I think we're headed into a deep recession, the worst since the Depression, as dozens of banks will fail," Burry says. "With massive foreclosures, there are homes that won't see the prices of two years ago for decades." And with the $500 billion home-equity spigot turned off, the money to pay off credit card debt, student loans and auto loans has evaporated. "We're looking at a lot of pain ahead."

How large is the problem?

This goes way beyond just subprime and ARM mortgages sold to people who can't pay the monthly mortgage after the ARMs reset. Merrill Lynch recently avoided hiring their first choice for their new CEO when he set a precondition that they determine how risky their investments were first. The Merrill Lynch Board of Directors would rather not know just how bad their investments really are all together. They just want the bad ones to pop up a few at a time so that they can be handled. It is my opinion that if they ever found out all at once how bad it is, the Board feared they would have to admit they were insolvent. Burry is not through shorting the credit market.

Burry remains short the corporate debt of major U.S. financial institutions, as he believes several will collapse under the weight of their write-offs. Optimists believe a Fannie Mae (FNM, news, msgs) or Citigroup (C, news, msgs) may be too big to fail, but Burry asks, "How many too-big-to-fail companies can fail at the same time?"

"Too big to fail." That means that if a company is so large that its failure threatens the existence of the market itself, the Federal Reserve will organize a rescue operation. But if too many companies that size fail at the same time, there will be no one left to bail out the ones that are failing.

That is a recipe for the worst recession since the Great Depression. I don't yet know if such a financial disaster is on the horizon. I do know that the experts expect a recession next year, and I also know that they tend to speak in very positive tones so as to not cause runs on the banks simply by acknowledging that there are financial problems. So I assume that the story that the recession is expected to be a mild one is the best possible scenario, not the most likely one. So I expect a reality that is somewhere between the disaster Burry says he expects and the mild recession the Bush administration Financial experts have admitted we should expect next year.

So with recession, there will be no inflation. Right?

One thing that seems very likely to be, though, is that along with the recession of next year we can expect inflation. The Fed is being forced into lowering interest rates, the dollar is dropping, oil prices are rising, and that all should lead us to expect inflation, unless by some miracle the economy turns around quickly and bails the Fed out. Exports are rising as the dollar drops. Unfortunately, employment is not increasing very fast, so the consumer (who provided 70% of the demand in the economy) is not getting any more money to spend.

A best case scenario would have the economy increase as exports increase, followed by an increase in total employment that exceeded the number of new workers entering the economy, and at the same time a lot of people who had given up looking for work would reenter the economy and keep the the unemployment rate around 5%. The real purpose of the unemployment rate measure is to predict the likelihood of inflation. If it drops below about 4%, then that is another pressure on the economy towards inflation.

Stagflation?

Unfortunately, the most likely scenario that I see gives us the combination of recession and inflation that lasted from the Ford administration through the first three years of the Reagan administration and was called Stagflation. That will be the direct result of the working out of the credit problems and the simultaneous actions by the Fed to lower interest rates to head off the worse recession and satisfy Wall Street.

So my present expectations are a worse recession than we are being warned to expect, together with extended Stagflation until the Fed clamps down on the economy and lets the bad securities take out the insolvent investment companies.

The blame

And this will be somewhere between bad and really bad. Who's to blame? It is the greed of a bunch of wall street investors and mortgage brokers who were unrestrained because of the Republican free trade mantra (most of the bad mortgages never should have been made), the rating agencies who were bought by the sellers of the junk securitized mortgages (the security seller would give the business of rating the security to the company that offered the best rating - again something that only government regulation could have prevented), Alan Greenspan who allowed the housing bubble to exist and did not clamp down on it because to do so threatened the reelection of Bush in 2004, and the Bush administration who knew what was happening but fought off either regulation or exposure of the problem just as they had in the Enron crisis.

Preparing for the future

Sensible people right now are getting out of credit card debt, paying down their bills, and saving what they can for emergencies. Anyone with a choice will want to be paid in Euros. Don't refinance a house with a fixed rate mortgage if you can afford the payments, because you may be able to pay off the home with inflated dollars soon. Just the uncertainty of what is happening is going to cause problems.

A lot of people will be making adjustments in their lifestyle. Start now and live more cheaply. The powers-that-be will be urging everyone to go out and spend more, in hopes that such spending will help the economy. the fact is, people who follow their instructions will be thrown under the bus when the real problems hit, and the free market conservatives will blame the individuals who listened to those who told them to spend.

Who knows? Maybe I am just acting as a Casandra. Maybe just a pessimist. But we know a recession of some level is coming, so this is not a time to be taking financial risks.