We've all heard about the big financial institutions, especially the investment banks, reporting enormous writedowns. According to Bill Gross, the manager of the largest bond fund, the total writedowns across the financial system could amount to as much as $1 trillion. When you consider that there is about $5 trillion in home mortgage loans, that's a significant number; the question is, what does it mean for the economy as a whole.
Well, if you've every studied fundamental accounting, then you'll be familiar with the concept of balance sheets and balancing inflows and outflows. When a company writesdown some assets, then that necessarily means that it has reduced one part of its balance sheet that directly affects its liquidity and ability to raise additional capital, no to mention its ability to pay its bills. In order to offset that lost liquidity, the company will sell assets or reduce lending. Reduced lending, of course, is the equivalent to the tightening of monetary policy Federal Reserve, which essentially works to slow down the growth of the economy by making borrowed funds that much more expensive (i.e. higher interest rates).
To make things worse, we're only at the beginning of the story. Firms are still announcing more writedowns and the consensus is that we're still going to see at least double of what we've seen thus far. When you think about this in terms of a domino affect, then this is still the first part of the domino chain; only after the financial institutions perform the compensatory actions that they'll need to after the writedowns, will the economy begin to feel the full effects of what we're seeing reported in the financial press. Bottom line: we've still got a great deal of pain ahead of us and it will simply take time for there to be a real recovery - no matter what the folks on CNBC would like us to believe when the market rallies.
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