The Federal Reserve has rerouted the financial plumbing thru their auctions, since the Banks won’t deal directly with each other. This has resolved the short term liquidity crisis, but leaves the “shadow banking system” completely intact.

The part that scares me is that I see no movement anywhere to force the banks to come clean and take their true markdowns. The SEC is even making the problem worse: http://globaleconomicanalysis.blogspot.com/2008/03/sec-openly-invites-corporations-to-lie.html

Some banks are “walking dead” and would immediately be shown insolvent …but it is only going to get worse. Since most of the ARM resets are in 2008 …and it takes 15 months to end up at auction the worst is going to hit between 2009-Q1 and 2010-Q1.

I see three possible scenarios:
1) Banks come clean now. Since the SEC is making it easier to hide this seems unlikely.
2) Come clean in a couple years after the true damage from the housing bust is better understood (i.e. how far did housing prices drop?).
3) Drag this on for decades except for the ENRON-like exceptions that implode out of the blue from time to time.

Anyway, I am very scared that we are indeed setting ourselves up for a Japan style recession. Fraud and too much leverage brought us to this place, but I think the biggest issue now is Bank transparency …and either no one is getting it …or they are conveniently ignoring it.

Thanks again for another insightful post MAS!