The Next Trouble Spots

10/16/2008 1:00 pm EST

Focus: MARKETS

Gary Shilling

Columnist, Forbes

Gary Shilling, editor of INSIGHT, says leveraged loans, commercial real estate, and hedge funds will lead the next wave of defaults.

With economic activity declining here and abroad in coming quarters, many nonfinancial companies will suffer major revenue and profits reverses. And the likely further strength in the dollar will make foreign earnings worth less in dollar terms and impede exports.

In this environment, junk bonds and leveraged loans will be in trouble, and there are lots outstanding, many owned by financial firms. Furthermore, a substantial number of investment-grade issues will be downgraded to junk status in this environment.

Default rates are just beginning to rise, but junk bond spreads vs. Treasurys are already wide due to the financial crisis and in anticipation of default. Woes in this area will create major problems for the financial institutions involved and for those that have written credit default swaps against junk bonds as their prices plummet.

Commercial real estate is another area with lots of outstanding loans. The problem is not overbuilding in recent years but shrinking demand in future quarters. With the collapse in residential construction and consumer retrenchment, mall sales will drop, new malls will be superfluous, and anchors and other tenants will flee.

A weakened consumer won’t buy as many imports, so warehouses to store imported goods will be underutilized. Cuts in leisure and business travel will slash hotel occupancy. Layoffs will flood the office market with sublease space, and those still employed will occupy less space as the partitions are moved in. Investors are becoming worried about the health of commercial mortgage-backed securities.

It’s highly unlikely that policy makers would ever bail out the $2-trillion hedge fund industry. In fact, some in and out of Washington consider hedge funds at least partly responsible for financial volatility.

Many hedge funds made bad bets this year, and a number have losses that are not far behind the decline in the Standard & Poor’s 500 index. The hedge fund industry as a whole is suffering a 10% to 15% decline.

Investors, who pay high fees in expectation that hedge funds will buck the stock market decline, are decamping. A recent survey found that 97% of hedge funds were below their previous high levels in value, so they can’t collect performance fees, often 20% of profits.

Estimates are that 15% of hedge funds will fold this year. Some are cutting fees from 2% management fees and 20% of profits to 1% and 15% of earnings in return for three-year lockups.

Many may have little concern over suffering hedge funds, and some may revel in their difficulties. But their $2 trillion in assets is leveraged into huge notional holdings. Hedge fund investor withdrawals that force the liquidation of those holdings can be highly disruptive to commodities, derivatives, stocks, bonds, and the many other markets in which they invest.

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