Recession - Deflation - Happy Nation?

Sunday, Feb 10th
0002 hrs

I don't have a background in Economics but I've to keep record of these
50000 feet thoughts/musings as I find that it helps me in my trading -
does not let me get stuck in the well that is full of short term ebbs
and flows ie., financial markets during the day.

I spent a few hours doing some re-reading up on what happened in Japan
in the 1990s and also devovored some other literature on money supply
and the like. Here is some information that I will first regurgitate
for a background and then come up with some kind of logical conclusion
as to how things might play out. What I will do if things turn out one
way or the other, I won't say in terms of trading advice because I am
not a financial advisor and don't ever intend to be one. I see ticks,
I trade, I trader!

An asset price bubble burst in Japan in the early 90s which caused a
huge dent in their banking system. Japanese banks financed the asset
price bubble (real estate). Their debtors could not pay up as collateral
values went south. Properties were turned back over with values less
than the amount of the loans. With decline in the capital ratios of
the banks there was a seizing up of credit. The Bank of Japan cut rates
drastically.

A toxic brew of an asset price bubble, high levels of consumer debt,
over leverage and their interaction with the help of securitization along
the banking chain is being witnessed as I write this. The Fed has cut rates,
Congress will pass a sort of Neo-Keynesian tax rebate bill with the hope
that these stimulative effects will be passed on to the private economy.
However, in the past couple of days there has been talk of tighter lending
and even increases in rates of credit cards and the like. With the looming
possibility of a downgrade of mortgage insurers, banks will once again have
stresses on their balance sheets in terms of capital ratios etc., A further
drop in real estate and the spreading of the decline to other classes of
real estate (sub-prime to credit cards to commercial etc.,) the banking system
will sustain unprecedented losses like what happened in Japan. The Fed cutting
rates would have little effect on economic activity. Crippled banking and their
plumbing mechanisms does bring on deflation.

Here are my scenarios. From worst to best :

Scenario 1 : Housing recession turns to a depression. Insurer rescue measures
fail. SP/Moody cuts ratings of bonds that have been insured and in the process
banks get badly hurt, with their capital ratios under pressure. Fed steepens
the yield curve even further and cuts rates. Dollar falls. A few key Dollar
pegs are abandoned as some foreign states have to fight run-away inflation. Our
lenders decide to price debt and commodities in either a basket of currencies
or some other reserve because they don't want their purchasing power eroded.
There is a huge and massive run on the US Dollar. The Fed consequently has to
jack up rates to protect it, and because there is huge leverage in the US economy,
several banks fail. We fall into a sort of comatose state for several years just
like what happened in Japan. Outright Deflation.

Scenario 2 : Housing recession remains a housing recession. Insurers are rescued
partially on their Municipal bond portion (currently being talked about) and the
counter-parties take on blended tranches of risk and share pain. Fed cuts rates to
steepen yield curve to help out banks. Dollar falls. There is a general slow-down in the US economy and international commodity prices decline as growth in India and
China decline, too. We muddle through it all with several quarters of negative
growth.

Scenario 3 : Bond insurers are rescued by a combination of banks and an
international consortium of financiers, sovereign wealth funds etc., Housing
undergoes an orderly correction and damage is largely contained. A flush of money
flows into US financial assets (depressed prices relative to other countries) - similar to what Japan did here a long long time ago. US Dollar pretty much bottoms
out and changes its longer term direction to UP.

Ummmmm. Scenario 3 is a fairy tale. I think 2 or 1 is more likely.

- aLV