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I don’t mean to be chicken little about the coming recession, but Bill Gross, the largest bond buyer in the US (PIMCO) has just published his January Investment Commentary. He writes about “The Bank Of Shadows” the unregulated banking system born of the Reagan era where reserve requirements are quite lax. Its a truly frightening piece. Here’s a sample:

According to the Bank for International Settlements (BIS), CDS (Credit Default Swaps) totaling $43 trillion were outstanding at year end 2007, more than half the size of the entire asset base of the global banking system. Total derivatives amount to over $500 trillion, many of them finding their way onto the balance sheets of SIVs, CDOs and other conduits of their ilk comprising the Frankensteinian levered body of shadow banks.

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The withdrawal of deposits from our new age shadow banking system has frightening potential consequences because a thinly capitalized banking system is always at risk relative to its more conservative counterpart. Visualize, as does Chart 1 (above), in crude yet understandable form, today’s shadow system versus that of two decades ago.

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Market based, regulation-lite American style capitalism, seemingly so ascendant after the dot.com madness nearly a decade ago, has met its match with the subprimes and the poorly structured and supervised derivative conduits of today’s markets. Financial innovation will inevitably march forward, if not in distinctly new forms, then into new asset markets and even unexplored continents. For now, however, its current surge is spent. Investment survivors will have to learn to live in a different world, filled with new risks, lower leverage, and at some point, hopefully greater rewards.

I have tried to suggest for the past few weeks that the notion that we can borrow our way out of this problem is ridiculous. Look at this chart of household indebtedness:

This is simply unsustainable. As a country we are going to have to live within our means. Mrs. Clinton was out today proposing the government loan a great deal of money to homeowners to stave off the inevitable foreclosure. This is not a solution, this is a political prank. It was the financial deregulation signed by her husband that allowed Investment Banks and Money Center Banks to merge, from whence the explosion in financial derivitaves sprang. The Clinton’s are not part of the solution, they are part of the problem.