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If it looks like a duck, quacks like a duck and walks like a duck, it’s a duck.
— Richard Darman – 1991

Mr. Darman was an economic advisor to George Bush pere. His quote was in reference to a tax increase — make that a revenue enhancement — that his boss was proposing. He didn’t want to use the word tax increase so he called it a duck.

Many economists and politicians have the same aversion to the word recession. In the late-1970s, Alfred Kahn, Jimmy Carter’s chief economic advisor used the “R” word in one of his discussions with the press and was sharply reprimanded by his boss President Carter. In his next meeting with the press, Mr. Kahn acknowledged the error of his ways by promising to never use the word recession. Instead he chose to use the word banana. He concluded his comments to the press by singing the Depression-era tune, “Yes we have no bananas, we have no bananas today.”

Herbert Hoover faced a similar problem in the 1930s. He did not want to use the word recession for fear of undermining business confidence. So President Hoover coined a new word to describe the problems the nation faced immediately following the stock market crash in 1929. In President Hoover’s own words, “We are not in a recession. We have only hit a small depression on the road to greater prosperity.” I guess it’s fortunate that they didn’t have speed bumps in those days because talking about the Great Speed Bump just doesn’t have the same resonance as the Great Depression. Well, we are not in a depression. But it very well may be close to being a duck or a banana or whatever other turn-of-phrase you want to call it.

The Financial Markets
If you want to understand where a capitalist economy is going, you have to look at how the markets for capital are faring. It is in the financial markets and the banking system that some idea of the direction of the economy can best be discerned. By their very nature, the financial markets and banking institutions must be forward-looking. More importantly, through their movements and activities, both the financial markets and banks shape the economic future by strongly influencing future levels of business investment and consumer spending.

While the movements of the bond market are not well reported, you would have had to have been under a rock for the past six months to have missed the problems that have been occurring in the sub-prime mortgage market. The worry now is that the problems that were once confined to the market for mortgage debt have now spread to the corporate sector and to international markets.

We had a similar credit market freeze-up in 1998. The difference then was there was only one firm with serious problems, Long Term Credit Management. The Fed and the Treasury were able to get the principals around a table and craft a solution. The credit markets were relieved, asset values were reestablished and trading resumed. The equity markets rallied and the economy, after experiencing a hiccup, continued to grow for another 30 months.

Today, there are dozens of firms that have been identified and very likely many more we don’t know about that are at risk. These institutions are getting into trouble because they have taken leveraged hedged positions in different classes of bonds that depend on these classes maintaining a relative value. Unfortunately, the normal relationships between certain types of bonds have been turned upside down. There are a number of funds that are being met with high redemptions because they are exposed to the sub-prime markets. But no one is buying the sub-prime debt, so they have to sell what they can to meet redemptions. And so they sell the higher-quality debt at a discount.

If you are another fund holding that same debt instrument that just traded down, you just saw the value of your high-quality bond drop. But because the lower-quality debt you sold as a hedge is not trading, there is not a price for it; since you can’t mark it to market, you can’t show the profit that should be on the hedged trade. Now, if the investor is not over-leveraged and forced to sell, it can wait a few weeks or a month and the normal relationship will come back. And they may even benefit as quality will rise even as the riskier instruments fall. But until there is a price made on the hedged low-quality asset, they cannot just make up a price based upon normal rational markets.

What we have is a banking system balance sheet problem. There is $900 billion in sub-prime paper on the balance sheets of the world’s banks, investment houses, hedge funds, and mutual funds. In total, there are 2,500 different sub-prime bond issues. Not all of them are bad. And even the bad ones will have some value. Most of this paper was issued in 2005-06. We won’t know for several years how bad or how good some of it is until there is a better track record of defaults. The average sub-prime issue has 2.5 percent of its mortgages repossessed, another 5 percent in foreclosure and another 12 percent 60 days overdue. Some are doing better, others worse. That will change over time; the fear is that falling housing prices will only make this worse as it takes away any incentive to keep paying the mortgage.

Future Scenarios
All of this is going to take time to work out. And during that time, the credit creation function of the banking system is encumbered in a way that hurts growth. Loans don’t get made, and terms and conditions are tightened. All of which leaves us with three possible scenarios, ranked by their probability.
Economic Hiccup: Much like 1998, all of this gets worked out fairly quickly. We have a flurry of bank bankruptcies and workouts but the financial system absorbs these losses, and the credit creation process is quickly reestablished with tighter credit. The result is a short period of weak consumer spending growth, perhaps a negative GDP number for Q4 2007.
Traditional Recession: Much like 1990-91 with a Resolution Trust Corp set up to help homeowners stay in their homes and banks get their balance sheets back in place. The result is two to three down quarters for consumer spending.
Japan-Like Recession: Much like Japan in the early 1990s, unable to figure out just what assets are bad and which institutions are tainted, the whole system grinds on slowly working through these problems. The result being slow to negative growth lasts for several years with home prices falling, consumer spending weak and domestic business investment in decline.

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