Vertical and Horizontal Contagion in a Globally Synchronized Recession that Came after a Financial Crisis

"First the governments bail out the banks who were (are) basically insolvent. Then these governments, especially in Europe, see their balance sheets explode and face escalating concerns over sovereign default. The IMF now predicts that the government debt-to-GDP ratio in the G20 nations will explode to 118% by 2014 from pre-crisis levels of around 80%.

Now, the ball is put back onto the banks because many have exposure to the areas of Europe that are facing substantial fiscal problems right now. According to the Wall Street Journal, U.K. banks have $193 billion of exposure to Ireland. German banks have the same amount of exposure and an additional $240 billion to Spain. Many international bond mutual funds also have sizeable exposure to sovereign debt of Portugal, Ireland, Greece and Spain as well. Contagion risks are back. Stay defensive and expect to see heightened volatility.

In a nutshell, toxic assets have basically been swept under the rug in the hopes that we will outgrow the problem. Leverage ratios across every level of society are still reaching unprecedented levels as the public sector sacrifices the sanctity of its balance sheet in its quest to stabilize the dubious financial position of the household and banking sectors in many parts of the world.

Whatever bad assets have been resolved have almost entirely been placed on the books of governments and central banks, which now have their own particular set of risks, as we have witnessed very recently in places like Dubai, Mexico, and Greece, not to mention at the state and local government level in the United States. We simply have not seen a reduction in the percentage of properties with mortgages that are “under water”, hence the FDIC has identified 7% of banking sector assets ($850 billion) that are in “trouble”, so how can it possibly be that the financial system is anywhere close to some stable equilibrium?

When accurately measured, including the shadow inventory from bank foreclosures, there is still nearly two year’s worth of unsold housing inventory in the United States, and commercial vacancy rates are poised to reach unprecedented highs, and this excess supply is bound to unleash another round of price deflation and debt defaults this year. The balance sheets of governments are rapidly in decline across a broad continuum, and it is particularly questionable as to whether Europe is in sound enough financial shape to weather another banking-related storm"