Where Will the Next Crisis Hit?

It’s official: The worst of the financial crisis is over. That’s what the World Bank says in its 2009 annual report, released Wednesday.

But that doesn’t mean it’s completely behind us.

The after-shocks of the subprime meltdown and the collapse of Lehman Brothers in September 2008 continue to ripple through the financial system and the global economy.

Two weeks ago, I predicted that there would be a “financial mini-crisis or two that ignites investors’ fears” in 2010. It would be “worse than Dubai, but nowhere near as bad as the fall of Lehman,” I wrote.

So, where could it take place? I called Carmen M. Reinhart of the University of Maryland to find some likely candidates.

Professor Reinhart, of course, is one of the world’s leading experts on financial crises. Along with Kenneth S. Rogoff of Harvard, she wrote This Time Is Different: Eight Centuries of Financial Folly—as definitive an account of financial crises as you’ll find.

Her view: The next flare-up is most likely to take place far away—or very close to home.

In their book, Reinhart and Rogoff show that a rapid build-up of borrowing is a necessary precondition for financial crisis—and the biggest problem in cleaning them up. Debt, debt, and more debt piled up in the good times become an albatross on borrowers and lenders alike when the wheel turns down.

“The fuel of bubbles is liquidity and credit risk,” Reinhart told me.

And this bubble was way off the charts. Households and companies amassed an astonishing amount of debt in the years before the crisis, and the depth of the crash compares with only the most severe financial crises, including the Great Depression.

Following the explosion of private debt in the 2000s, mostly connected with housing in several countries—the US, UK, Spain, Ireland, and others—governments poured monumental amounts of taxpayer funds into preventing another 1929. Governments accomplished that, but at a big price—horrendous sovereign debt hanging over most of the developed world. That could cause wrenching financial pain and subpar economic growth for years to come.

Which is why Reinhart sees some of the marginal debtor nations as among the most vulnerable.

Take Iceland. The tiny Nordic nation best known for its long nights and salted fish was turned by some financial cowboys into a giant leveraged hedge fund, and its currency became a favorite of speculators.

When the roof fell in, the value of the krona disintegrated and output plunged. According to Reinhart, Iceland’s total external debt is now a mind-numbing 924% of GDP—and half of that is short term.

Now, British and Dutch authorities are trying to collect over $5 billion from Iceland’s treasury to repay depositors from those countries who took a flyer on high-yielding Icelandic accounts. That amounts to 50% of Iceland’s GDP.

Iceland’s president put the issue up for a popular vote, which takes place March 6th. “It’s a referendum on whether they’re going to default,” says Reinhart.

If, God forbid, there were a similar crunch here, how many Americans would vote to repay, say, China trillions of dollars for US deposits that had plummeted in value? So, don’t be surprised if Iceland’s voters turn thumbs down, possibly putting a $10-billion multinational rescue plan in jeopardy.

Page 2: More crisis candidates

And then there’s Greece, a nation which is the opposite of Iceland in almost every way, except for their great heroic myths and sagas—and financial profligacy. 

The country, part of the Euro zone, has seen its debt balloon to a projected 12.7% of GDP this year—one of the world’s highest. The Socialist government has pledged to cut that to below 3% of GDP by 2013, but hasn’t spelled out how. “They’ve been lying consistently about their fiscal [situation],” says Reinhart.

Maybe that’s why Greece’s bond market saw a big sell-off Thursday, with yields soaring along with prices of insuring Greek sovereign debt against default. 

The euro also has been sinking against the dollar, in part because of fears about a debt crisis sparked by Greece. Could we be in one already?

Other possible flash points: Portugal, which the International Monetary Fund just warned about its deteriorating fiscal situation, and economically depressed Spain, whose official unemployment rate approaches 20%.

“Ireland is another one that concerns me,” says Reinhart. (Its debt-to-GDP ratio tops 700%.)

She’s also looking at Eastern Europe, particularly the Baltic states (Estonia’s external debt is 140% of external debt, she says), Hungary, and Romania, whose debt is a whopping 160% of GDP.

Of course, these are small, peripheral countries whose problems are no secret to investors. “Was Thailand central to the world economy [in 1998]?,” asks Reinhart. “Was Russia?”

A crisis in these “peripheral” nations could increase the strains on the euro and drag down stronger economies with them.

MoneyShow.com columnist Jim Jubak says even the United Kingdom may be vulnerable to a crisis. 

That, of course, would be at least as big as Lehman.

But you don’t have to go very far. Right here in the US, we have some serious debt problems that could flare up into crises. And I don’t mean the federal government, whose huge debt can be underwritten by the Federal Reserve’s running the printing presses, at least for now.

Reinhart is worried about big debt at the “subsovereign” level—state and municipal governments, which are on track to run up $370 billion in deficits over this fiscal year and next. She foresees credit crises in that area, too.

Actual municipal bankruptcies are pretty rare, although some of you might recall the brief defaults of New York City and Cleveland in the 1970s, as well as the actual Chapter 9 bankruptcy filing of Orange County, Calif. in 1994.

In her book, Reinhart points out in the late 19th century ten US states were in default, and she wouldn’t be surprised to see that happen again to some states or municipalities.

How about our largest state, California, with its $20-billion deficit?

“California and Greece have a lot of similarities,” says Reinhart.

And could Arizona, Nevada, New York, New Jersey, Illinois, or Michigan be far behind?

Personally I would expect the fallout from incidents of this kind to be brief: The Orange County bankruptcy didn’t stop the market’s rise in the mid-1990s. In fact, any resulting sell-off could become a buying opportunity—as long as the crisis is contained.

What happens next is anyone’s guess, but it just shows there are plenty of land mines in this market, and you have to watch where you’re going. As they used to say on that great cop show of the 1980s: Be careful out there.

Howard R. Gold is executive editor of MoneyShow.com. The views expressed here are his own.