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The US sits atop a wobbly, three legged stool. As sturdy as it may appear, the cracking legs of the stool have forced its occupant from its perch time and time again. Yet after each slip from the stool, our leaders prop the legs back into place and hop back on. My dear, the three legged stool is broken.

Housing, economy, and banks—the three legs of the stool—are each problematic, and the relationship among the three has broad implications. The cause of our current situation can be argued ad infinitum, but I will offer a brief explanation: citizens elected governing officials who encouraged its citizens to spend-spend-spend and take on debt to purchase unaffordable homes. Now, the citizens are in rough financial shape from overspending and making poor decisions. Home price declines have rightfully become a casualty in the mess.

The gravity of the situation (consumer anguish and home price declines) is increasing the appeal of strategic defaults. The strategic default concept—consumers not paying a mortgage though financially able—has been reported in both the real estate and financial media, and it is implied from banks’ financial reports. The rise of strategic defaults has even prompted Fannie Mae to invoke new policies to discourage the practice. With such an increase in strategic defaults, banks must continue to foreclose homes. This results in an increase in available homes on the market (supply) with a concurrent drop in willing homebuyers (demand). Both of these send home prices falling. Moreover, the expiration of the homebuyer tax credit eliminates artificial demand, which moves home prices further downward. On top of all this, it is entirely possible (and indeed likely) that mortgage resets from Alt-A and Option ARM products displace many—a volume of casualties greater than the subprime fallout—from their homes. If this bomb blows up, even more supply comes onto the housing market with even less available buyers; the result is yet another double whammy for home prices.

But wait, won’t the economy keep us afloat?

The unfortunate truth is that the economy was pushed along by a government that empowered itself through increased monetary borrowing. The reality is that little of today’s economic activity sprouted from the private market. Further, redistributive policies (taxes, regulation) discourage economic production, and I fail to see significant progress ahead. In the immediate term, the Federal Reserve echoes a similar concern with a recent language change in the June FOMC Statement, “Financial conditions have become less supportive of economic growth on balance… although the pace of economic recovery is likely to be moderate for a time.” In my opinion, there is not nearly enough convincing data to argue for a sustainable economic recovery.

I further argue that zero private market economic growth or less is still a real possibility. Consider the strategic default phenomena; the corollary is a levered consumer who is disinclined to continue his spendthrift ways. Many economists argue that a drop in spending will hinder economic growth. Reasonably thinking, I contribute my own supplemental logic: a drop in consumer spending forces bank aversion of extending credit to small businesses. A withdrawal of anxious customers and lack of financing will continue to pressure unemployment. Fewer workers produce less, and less production, not less consumer spending, will detract from economic growth.

And through all this doom and gloom, we still must keep in mind budget crises of state and local governments. Fiscal and structural employment problems exist in the public sector beyond the federal government. The consequential economic fallout at the state and local level appends to the troubled economy prospective; the compounding evidence forces a pessimistic vision.

How do the banks fit into this equation?

In all of this, banks should worry. With all of the housing and economic problems, strategic defaults are unlikely to be resolved. Further, I agree with Meredith Whitney’s quote that strategic defaults lead to a “massive, rotting pool of assets on bank balance sheets.” And remember, the oncoming wave of mortgage resets would further destroy credit quality on bank loan books.

Now, all of this could be tempered if bank provisions, money reserved for expected losses, were growing at a similar rate. However trends at some of the biggest banks—Bank of America p34, JPMorgan p34, and Citigroup p2—are declining! The thesis of more housing induced credit problems has been mildly discounted by the banks. Therein lays the disparity. I refuse to believe that provisions (future loan losses) will descend over the upcoming quarters. Rather, I am convinced of increasing losses on bank loan books.

But wait, there’s more. As accounting standards have liberalized over the past 2-3 years, credit problems could easily be amplified. Banks are relieved from marking all of its assets to market prices; this could easily distort the value of what is reported by a bank versus what a buyer would actually pay for the asset. Also opaque, is the notion that banks can choose an impairment amount for nonperforming loans instead of reporting the entire loan as a nonperformer. Further, substantial discretion exists when valuing these types of assets that do not generate cash, and banks have no incentive to come clean on esoteric products. They would rather hide it, and they can. Lax accounting standards deepen credit quality mistrust, and losses have become easier to hide.

On the revenue line, banks may feel some alleviation from the Fed’s low interest rate policy. With low funding costs, ceteris paribus, banks are enabled to generate a healthier net interest income (revenue from the difference in lending rates). Further, since I believe rates are unlikely to rise this year, or at least before November elections, this game may continue for a few months. However, with treasury bonds and gold performing positively in tandem, there is discussion that Central Banks are rigging the yield curve. Although I consider this a long term calamity, it may, in the short-term, prevent (or perhaps delay?) the insolvency of the US banking system—yes, I think credit quality could be that bad.

Market participants have started to take notice. The three of the most-watched gauges of stability in banking: LIBOR, the overnight indexed swap, and credit-default swaps, have all moved into unsettling territory. The peripherals are anticipating trouble at the banking core.

The Next Recession may indeed be upon us. Housing problems are likely to accelerate. Economic activity has no roots. Bank assets are increasingly turning sour. Each of these are individually compelling reasons for a fundamental pessimistic outlook. The combination of these three maladies is even further daunting.


(The above reflects my beliefs, and I am grateful for the work and influence of John Hussman, Bill McBride, Diana Olick, Meredith Whitney, and The Economist.)

Disclosure: The author is short the market and housing; the author owns a bond fund and is long gold.