Tuesday, April 8, 2008

Case for L Shaped Recession

Credit hedge funds are now the weakest link in the chain, Morris says. Their equity stands at some $750 billion and is so massively leveraged that "most funds could not survive even a 1 percent to 2 percent payoff demand on their default swap guarantees," he writes.

Morris sketches a scenario in which hedge fund counterparty defaults would ripple through default swap markets, triggering writedowns of insured portfolios, demands for collateral, and a rush to grab cash from defaulting guarantors. The credit system would suffer "an utter thrombosis," he says, making the subprime crisis "look like a walk in the park."

What he fears is that the U.S. will instead follow the Japanese precedent, seeking to "downplay and to conceal. Continuing on that course will be a path to disaster."

What's not debatable is what will happen if $1 trillion is written off. And that is the other "D" word: "deflation". A $1 trillion debt writeoff can hardly mean anything else. Furthermore, a $1 trillion writeoff will affect a whopping $10 trillion in future lending.

If the Fed and Congress drag this out, which at this point seems likely, we will see a severe "L" or "WW" shaped recession playing out over several (or more) years.