OK, here's where we need to get real careful. I want everyone to understand that what I'm talking about below is the banking/credit system, not the economy.

The economy depends on the banking system and available credit, but the economy is not the same as the banking/credit system.

I'll just talk about banking and let SeniorCitizen speak to your commodities issues, because he has a lifetime of experience in commodities/softs and I have none, zip, nada in commodities. Stocks, bonds, mutual funds and ETF's, yes. Commodities, zippo. I read everything SC says with great interest and hustle to keep up with with y'all who know the softs markets.

The economy, to date, is OK. Yes, retail sales slipped considerably in December. Yes, home sales are cratering into the dumper. Yes, tech spending is slowing down. Yes, the financial sector is laying off people by the thousands.

But so far, the economy hasn't shown signs of serious distress - yet. Just a slowdown. The speed with which the slowdown is happening, however, is something that worries me.

If the Fed can get in front of (and currently, they're behind) the problems in the banking sector, and get the credit markets working and lending money again, we can probably get through this with just a slowdown or slight recession into spring/summer of this year. This is why the Fed is doing 0.75% Fed Funds Rate cuts between meetings. This is why they'll likely cut 0.50% again tomorrow. They MUST get liquidity into the banking sector, before the banking sector quits lending money because the bankers are hoarding cash to build up their reserves for bad loans and losses on investments.

Banks have regulatory requirements as to levels of reserves and bad loan allowances. When the bankers see that they have a rapid increase in bad loans, they have to quit lending money and start hoarding cash to prop those reserve levels up. To do this, they quit turning cash into new loans.

If the Fed cannot get in front of the losses in the banking sector, if the derivatives linkages keep blowing up in ways that the older, more experienced folks in the financial markets don't expect, we're going to be in for some pain. Not S&L crisis pain. A level of pain that you'd better go ask your grandparents (if they're alive) what it was like.

If the linkages really blow up and start taking down banks (Countrywide Financial, the single largest mortgage lender in the country, would have collapsed by now if not for Bank of American buying them up three weeks ago), then we're going to see some real worry out there.

The most serious thing that could happen is a deflationary spiral. We all know what inflation is. Only the folks who are truly senior citizens (ie, lived through the Depression) remember what a real deflation looks like. We have never had a deflation in hard assets like real estate since the Depression.

Here's how a deflationary spiral goes. I'm sorry this is going to be kinda long, but I want to give everyone real-world examples, so that no one says "Oh Dave, you're just full of crap. House prices cannot fall that far that fast."

1. An asset bubble is created and inflated. Housing prices in California, Arizona, Nevada, Florida, the east coast, etc - were inflated to absolutely insane levels by an abundance of easy money, loaned out on really irresponsible terms with mechanisms that artificially pulled in people incapable of handling the debt. This is the sub-prime ARM that you hear about, yes, but it is SO much more than that -- there are "option ARM" loans to people with good credit as well, and that wave of loans peaked two years ago this summer, esp. in California. The sub-prime lending issues most everyone knows. What many people don't know are that there was a whole class of loans called "NINJA" loans -- as in "No Income, No Job or Assets" - or more officially "Stated Income Loans."

These worked like this: You asked the bank to loan you an outlandish sum of money. The bank then asked you how much you made at your job and what your assets were. You told the bank some numbers that you whipped out of your butt.

And the bank believed you. 

2. At some point, the excess liquidity that was fueling the bubble runs out. Without more and more buyers coming into the market, the valuations of the asset class are unsustainable. Translation: without more people taking out increasingly dubious loans, the housing market quits going up.

But wait - it gets worse here: in many markets, the developers kept developing - and in some markets, they're still building houses. Real estate developers develop; they really don't have a choice. Many of them have already bought the land, installed the infrastructure (roads, sewers, power, etc), they've paid for the permits and licenses, and they've contracted with the labor. They're stuck. They can either take a huge loss on their books as they try to sell the land (in whatever state/status) off to someone else, or they can push forward, finish the houses and minimize their loss by selling the houses at/near the cost of production. When this happens in proximity to already finished housing for which other people paid highly inflated prices, the prices of the existing housing craters. In some communities, I'm hearing of developers selling housing for 35 to 50% off what people paid for the exact same kind of housing only 18 months ago. In Nevada, they've held auctions for newly built (and about-to-be-built) houses where the developer and the auctioneers have excluded the press and anyone who wasn't qualified as a bona-fide buyer. They know that people who bought only a couple years ago will be hopping mad when they hear of the prices.

So how inflated were prices? Here's a good way to guesstimate what the market can now support. Noodle around on this site and look at the upcoming auctions and where they're starting the bidding.

http://www.ushomeauction.com/ 

3. OK, now we start to hit the skids: people who are "upside down" in a mortgage note on a highly inflated house that has lost 10, 20, 30+ percent of the value - and  often have no equity, no down payment in the house at all -- start to realize that there is no upside on paying these mortgages that are a) resetting to higher interest rates and payments on b) a house that will take 20 to 30 years to regain that lost appreciation.

So these people start to simply turn over the house to the banker and quit making payments.

This creates a loss for the bank. This is a default on a loan. Because the owner has voluntarily turned the house back to the bank before they defaulted on the note, it is much less damaging to their credit rating than a foreclosure, and far less damaging than a bankruptcy.

http://www.youwalkaway.com/index.html

This is Not Good^TM. I never thought I'd see lawyers setting up shop to churn out advice to people to just walk away from their mortgage obligations - but there it is, big as day. Where there is one lawyer making money, you can bet your last dollar there will be twenty in a couple weeks.

4. Now the banks start to take serious losses, even if we were back in the days prior to CDO's, CMO's, credit default swaps, etc. The banks have mortgage losses walking in the front door and in the mail every day; they're having to hoard cash to increase their bad loan reserves, so the bank quits lending to new borrowers, even borrowers who have good to excellent credit and would be very good at paying the bank back. When the default rates go high enough, the bankers cease worrying about lending and start worrying about merely surviving. So as this first wave of defaults starts coming in, the less well capitalized banks quit lending entirely, some will go out of business completely. We've seen over 200 small mortgage lenders go out of business or quit lending completely to date. Even some large, well-capitalized lenders have ceased lending - ResCap, who was backed by GMAC - quit. Countrywide Financial, as I mentioned earlier, was on the cusp of going belly-up, and was snapped up by Bank of America. Some people say that the Fed and US Treasury asked BofA to finish the deal, since BofA was already into Countrywide for $2+ billion dollars. I say that BofA's management knew if they didn't want to lose all of that $2B, they had to throw in another $4+ billion and just buy it up completely. This doesn't solve Countrywide's problems; it just provides more capital cushion to buy BofA time to clean up the mess.

5. This means that there is a significant decrease in new money going out into the real estate sector to buy properties, even at the reduced price levels. So with a reduced pool of buyers, the prices come down yet more on unoccupied, defaulted or repo'ed properties, which in turn reduces the value of the rest of the real estate in the area, which can result in more people walking off, or banks demanding more capital be put into the loan when the loan resets. Many times, these people who came in on the teaser rate with almost nothing down have no money to put into the loan, so if the bank asks the borrower to put up some money to bring the "loan to value" ratio of the loan back to something close to 100% (ie, where the bank isn't lending $500K on a $300K house), the borrower will default at this point.

It doesn't take much for these problems to put a hex on real estate values in a neighborhood. Just a couple of unoccupied, defaulted/foreclosed/repossessed properties in a neighborhood have a significant downward pressure on the valuation of all other houses around them. 

6. Go to step 3. Repeat. And repeat. And repeat.

This is what actually happened in the Great Depression - with housing, commercial real estate, farmland, you name it. Banks had lent a lot of money in the 20's, and created quite the tidy boom in assets - both stocks and real estate. The stock asset class deflated first in 1929, and took down investors in equities - but much of the panic selling was reversed in 1930. 

But then came the real estate deflation after that, and banks started to tighten credit/lending very harshly in 1930 to 1932, which then caused real estate to crater yet further. 

Here is what didn't happen in the 30's: The crappy debt, the mortgages of low quality, have been sliced and diced into pieces ("tranches") of debt and re-packaged with some better debt and some derivatives that are then called a "Collateralized Debt Obligation" (CDO) - a synthetic mortgage bond. These instruments were rated as "AAA" debt by the ratings agencies - just as safe as US Treasury bills/notes - and sold to everyone and their pet dog. I mean sold everywhere. Here in the US and overseas.

CDO's suffer from two problems: First, they're just utterly stupid instruments. There are mathematical assumptions made on the rates of default and inside the derivatives that are supposed to counter-balance the losses in the CDO that are just the stuff of dope-smoking flights of fancy. I won't get into the math here, but suffice to say, there's a lot of finance guys wandering around who think they know a lot more about probability and statistics than they really do.

And everyone who has purchased their products is learning this - the hard way.

The second problem is that unlike conventional bonds, stocks, etc -- there is a very thin and illiquid market in CDO's. If you want to sell a big bunch of CDO debt, you're likely going to take a price hit. When Bear Stearns had two hedge funds get a margin call last August, Bear was levered up 12:1 in one fund and 16:1 in another fund holding CDO's. Merrill Lynch was the margin lender.

Bear tried to liquidate everything they could to meet the margin call - which was prompted by a rating downgrade on the CDO's in the portfolio. Bear sold stocks, bonds, everything but the CDO's - because they could not find a market for the CDO's. Merrill came in and tried to sell off the CDO's - which is what you'd expect a margin lender to do.

Merrill quietly shopped the CDO's around the debt markets and decided that taking a 60 to 85% hit on the valuation of the CDO's was too much pain, so they kept them. That's what illiquidity  and complexity do to a security in times of worry and panic.

Because of the "AAA" credit rating attached to these complicated and illiquid mortgage securities, they were sold all over the world. The AAA rating with a higher-than US 10-year T interest rate attracted a lot of people. A lot of people trusted the credit rating agencies (Fitch's, S&P, Moody's) and assumed (wrongly) that the SEC wouldn't allow these to be sold if they weren't legit.

Yea, well, the ratings agencies mis-rated a lot of junk debt in the 80's, and the SEC allow that to be sold too. 

There have been money market funds in Luxembourg that have blown up from CDO's being downgraded - a money market fund that one day, announced to investors that 35% of their money was just 'gone.' Public pension funds have started to take hits. State cash funds have taken hits from CDO's.

And the banks - good God, the banks have had to take huge write-downs on these CDO's. But worst of all, the banks have not been able to come clean all at once -- they keep finding more crap in their portfolios, in wave upon wave of write-downs and losses. So the banks are hoarding cash. 

Now, the impact on the economy comes from two sources: The first, I mentioned when banks quit lending, many corporations lose access to the capital necessary to fuel expansion and job creation. Worse than the banks ceasing lending would be the bond insurers no longer have the capital to insure entire classes of debt in the market. Without bond insurance, the ratings on the bonds go down, the cost of borrowing goes up, and it is like the entire debt market gets an interest rate increase without the Fed having made a interest rate increase.

The other issue in this case is that banks are very, very scared to do home equity lines of credit in this environment. A lot of people had been pulling equity out of their houses to improve their housing, make major purchases, etc, etc. That liquidity is now pretty much gone - you can see it in how big-ticket "consumer discretionary" items like Harley Davidson bikes are no longer selling. You can see it in the numbers for Home Depot and Lowes - home improvement sales are way, way down. You can see it in rapidly declining sales of things like pools, hot tubs, etc.

The possible bad/worse case scenario is that the credit markets seize up and shut down. This, the Fed wants to avoid. If that happens, the Fed truly is in firefighting mode and is clearly responding to events rather than leading them. This is why I believe the Fed is out there pushing rates down - fast. The Bernanke Fed is literally inventing new ways to get liquidity into the banking system as we speak, trying to keep the system functioning, even if lending is impaired.

Fortunately for us, Ben Bernanke is a man who has studied the history of the banking system from 1928 to 1940 - extensively and at great length. I would hope he translates some of his considerable academic knowledge of that period to the issues today, and heads off a 1933-type deflationary depression that follows a wide scale banking crisis.

Unfortunately for us, the Fed has started to realize the scope and scale of the problem about six to nine months too late. This is largely because the bankers themselves have not realized just how widely and deeply these CDO's and sub-prime tainted mortgage-backed debt have permeated debt portfolios all over the world. Further complicating the issue are these derivatives, covenants  and counterparty contracts designed to offset the risk of defaults. These are invisible to the Fed - they're not reported outside the banking/credit/bond community. So the truth is, the Fed is operating with very incomplete information here as to the consequences of mortgage defaults. The secondary and tertiary effects are becoming about as rude a surprise the the bankers as if they'd tee'ing off at their members-only golf club, getting in the golf cart to go to the third tee, and rolling over a land mine.

The Fed is on the sidelines, watching body parts and golf clubs falling out of the sky, wondering "Who the heck put land mines on a members-only golf club green?!" 

I believe the Fed was faced with a very poor choice last Monday: the futures markets were starting to price in a HUGE Fed rate cut. The Fed didn't want to deliver a 1+ percent rate cut all at once - because that smells of sheer panic on the Fed's part. So they kicked the 0.75% cut out last Monday - and took the PR hit. They'll probably cut by 0.50% tomorrow, which is what the futures markets indicate, and then maybe another 0.25% at the next meeting, depending on what they see.

The Fed's job in this situation is greatly complicated by the non-stop financial press around the world now. They need to size these rate cuts and their open market operations in such a way as to not spook the credit markets any more than they already are. 

Sorry for the length of this...