I am forecasting an 18-month recession.  The Fed, in their model, forecasts that the recession will be 8 months, a repeat of the 1991 recession.  This is not the case.  It will be more like 18 months, and the reason is the fundamentals are much worse than 1991.

To be optimistic is to say it will be like 1991.  That would be a pretty ugly situation, but manageable.  A big chunk of the banking system would not be wiped out.

A key indicator will be the health of the banking system, and the number of banks that are wiped out.

Small banks have, on average, 67% of their assets in real estate.  These small banks are in small towns, where everything is locally financed.  If the city goes – meaning that it suffers a major housing or real estate crisis - then the bank is wiped out.  There are 32 regional banks.  Right now, Wachovia looks worse than IndyMac.  Approximately one-quarter to one-third of these regional banks look bad.

Remember that, in 1991, when home prices fell 5%, Citibank was technically bankrupt, but survived because it got an exception from the Fed.  Now home prices have fallen 25%, and will ultimately fall 40%.  Citibank has a massive exposure to subprime debt.

“There is manipulation and the Fed is going along with it.  The fudging and forbearance is massive. You can’t believe any of the statements you are seeing from the financial sector.”Citibank is valuing its CDOs at 60% of face value.  But others, like Merrill, are valuing them at 20 cents on the dollar.  There is lots of fudging going on.  Banks are making assumptions on their CDO portfolios to get their desired level of writedowns.  There is manipulation and the Fed is going along with it.  The fudging and forbearance is massive. You can’t believe any of the statements you are seeing from the financial sector.

Monetary policy doesn’t make a difference.  Despite the cuts in the Fed funds rate, inter-bank spreads and credit spreads have not contracted and will get worse.  The problem is the looming insolvency of banks, hedge funds, municipalities, and other institutions.  Senior government officials realize that monetary policy has made no difference.

Fiscal policy has been similarly ineffective.  Of the $100 billion stimulus package, only one third was spent by consumers.  The rest went to pay off consumer debt.  It was spent in April and May, and consumer spending has fallen steadily since then.  All the data shows we are in a consumer spending recession.

The money spent on the GSEs and Bear Stearns has not resolved the fundamental problem, which is that there are too many homes on the market.  The only sensible solution is to write down face value of mortgages.  This was done in the Great Depression.  It will allow borrowers to refinance at fixed rates.  It will avoid foreclosures, which would lead to bank failures and government bailouts.

This has not been done yet.  The relief needs to be directed to the borrowers, not the lenders.  Fiscal and monetary policies do not make a difference.

The 2008 Frank-Dodd bill goes a step closer to my plan, but is not enough.  It relies on banks to voluntarily release the face value of their loans, which I believe is unrealistic.  The CDO holders will block certain actions.  The claims are too dispersed, and any CDO holder can stop an action.  The government must step in and orchestrate a bailout of the borrowers.

McCain’s approach is laissez faire, and to allow a disorderly workout of the crisis in the private sector.  Obama is more willing to provide public intervention, but has not advocated anything this dramatic.  He has been in favor of a proactive government approach.  I expect a Democratic President will be more likely to follow the recommendations I have laid out.