Long-term yields for U.S. Treasuries should indeed firm but be tempered by a slowing as this phase o...
Three bombs that could still wreck the recovery from the global financial crisis
06/18/2010 8:30 am EST
But I can’t.
I just see too many unexploded bombs in the road ahead for me to believe the danger is past.
And I’m not talking about the big bombs ticking away and set to explode in decades. You know the ones I’m talking about: the demographic ones built out of all the promises governments and companies have made to an aging workforce that no one will be able to keep.
No, the bombs that I’m talking about now have much shorter fuses than that. If they go off—and I don’t know which ones or how many will—it will be a matter of quarters not decades, until explosion.
Knowing that they’re out there creates quite a quandary for an investor.
There’s no guarantee that these bombs will go off. If they don’t, you can be on the sidelines when the big gains arrive as many investors were in 2009. And as I was to a degree that left Jubak’s Picks trailing the index by almost half. For the 12 months that ended on March 31, 2010 my portfolio was up 26.6% while the Standard & Poor’s 500 Stock Index was up 49.8%.
But if they do go off, any of them, we could get the kind of downturn that will make the 12.5% drop from the April 23 closing high of 1217 to the June 4 close at 1065 feel like the good old days.
I don’t think any one of these time bombs is big enough to blow a hole in the global economy comparable to that of 2007. I don’t think these bombs are leveraged into the global financial system in a way that would inflict that kind of It’s-the-end-of-the-world’s-financial-system possibility again.
I’m not talking Great Depression here. Or even a replay of the 1929 stock market crash.
But these bombs are big enough to lead to a give-back of a major portion of the huge stock market gains from the March 2009 bottom. Investors and traders really haven’t put fear behind them and it wouldn’t take much to let fear run wild again. What worries me most about that possibility is that I don’t see the kind of growth in the world’s developed economies that would power a stock market rally big enough to make up for those losses.
My take on the market in the 12 to 18 month time period I follow in the Jubak’s Picks portfolio and that I call the middle term—that’s not the short term of a four week summer rally (see my post http://jubakpicks.com/2010/06/15/did-the-summer-rally-begin-today-and-will-it-be-more-than-just-the-return-of-son-of-bounce-ii/) or the long-term of five to ten years (http://jubakpicks.com/2010/05/25/get-used-to-it-the-global-debt-crisis-will-play-out-over-and-over-again-in-the-next-decades/ ) –is to avoid risk when the payoff isn’t sufficient, to play the big relief rallies after massive sell offs with caution when you can, and to try to make your bread and butter, steady money in the stocks of the world’s developing economies. (For some suggestions on picks in those markets when the time is right see my posts http://jubakpicks.com/2010/06/11/the-next-rally-wont-be-like-the-last-one-heres-how-to-make-sure-you-find-the-next-leaders/ and http://jubakpicks.com/2010/06/15/faster-growth-and-cheaper-too-whats-not-to-like-in-emerging-market-stocks/ )
You don’t have to follow that strategy. Maybe you’ve got a better one.
And you don’t have to buy into my talk of time bombs and major stock market routs.
But you should at least make sure you’re familiar with the downside case before you decide on your strategy for the next 12 to 18 months.
Here are the three bombs I’m most worried about in that time period.
The Fannie Mae (FNM) and Freddie Mac (FRE) money pit.
You know those signs you see in antique stores? You break it, you’ve bought it? Well, I wish that Fannie Mae and Freddie Mac followed those rules. The banking and mortgage banking industries broke these two mortgage financing machines. But tax payers have bought them. Now all that remains is figuring out how big the bill might be. (Fannie Mae and Freddie Mac will be delisted from the New York Stock Exchange in July. For more on why and what that means see my post http://jubakpicks.com/2010/06/17/goodbye-fannie-mae-and-freddie-mac-as-feds-decide-to-delist-stocks-on-nyse/ )
Estimates are all over the block from the merely frightening to the downright terrifying.
Fannie Mae and Freddie Mac are in the business of buying and guaranteeing mortgages originated by banks and mortgage companies. The idea is that these two companies, once government agencies and then, in theory, private companies with publicly traded stock (You know like General Motors (GM) or Citigroup (C)), would by buying mortgages from the original mortgage lenders (and then reselling them to income investors) give those mortgage lenders new money to lend or by guaranteeing them allow the original mortgage lenders to bundle those mortgages into securities and then resell them.
See where the trouble lies? If the original, underlying mortgages turn out to be bad, bad enough so that borrowers default on their payments, Fannie and Freddie are stuck paying a lot of interest to the buyers of mortgages they sold and they’re on the line for a lot of guarantees.
Fannie and Freddie own or guarantee about 53% of the country’s $10.7 trillion in mortgages. And after bailing out these two once private companies in 2008, tax payers own about 80% of them.
Now if you think taxpayers got a bad deal when they bailed out Citigroup or American International Group, wait until you hear what kind of deal the Bush administration struck with your money in the case of Fannie Mae and Freddie Mac. In exchange for giving up 80% of their companies to taxpayers, the companies got an unlimited credit line from taxpayer. So far they’ve drawn down $145 billion, but that isn’t the end of the story. Borrowers continue to default on their mortgages and the companies’ obligations continue to grow.
So how much are taxpayers on the hook for?
In February 2010 the Obama Office of Management and Budget estimated that the two companies could need as little as $160 billion—that’s only $15 billion more—if the economy strengthened.
In their dreams, I’m afraid.
Back in August the Congressional Budget Office estimated that the two companies would need $389 billion in government money through 2019.
Barclays Capital said in December that the price tag could run as high as $500 billion if housing prices fall another 20%. (Housing prices as measured by the Case-Shiller index fell in the first quarter of 2010.)
Sean Egan, president of Egan-Jones Ratings, recently told Bloomberg that a 20% loss on mortgages and guarantees—which is in line with the losses at a mortgage lender such as Countrywide Financial (now owned by Bank of America (BAC))—could take a worst-case scenario to $1 trillion.
No one knows. But add whatever estimate you like to the potential loss on the $1 trillion in mortgages that the Federal Reserve has bought and that now sit on its balance sheet and there’s an awful lot of taxpayer money riding on housing prices.
All this is off-balance sheet, of course. The obligations are real but none of it is in the federal budget.
How long will the foreign money financing the U.S. deficit buy that one, do you think?
The debt in Spain mainly snowballs. (And in Portugal too.)
Okay, the ink isn’t even dry on the signatures on the plan designed to prop up the finances of Spain, Portugal, Ireland, and other budgetary basket cases in the Euro Zone and already economists at the European Commission are saying the $900 billion in the plan isn’t enough.
Those ingrates. How dare they say the emperor has no clothes? Don’t they know the emperor pays their salaries?
Those pesky economists calculate that Spain’s pledge to cut its budget deficit to 9.3% of GDP in 2010 can actually be achieved with only minor tweaks to the government’s budget plan, but that the goal of reducing the deficit to 6% of GDP in 2011 will require additional budget cuts of at least 1.75% of GDP or an additional $25 billion. In May the Spanish government announced $18 billion in budget cuts over two years. That set off loud protests in Spain. (Just for context, a Spanish budget cut of $25 billion would be equal to a budget cut of $250 billion in the United States.)
In Portugal, the economists warned, the government will have to come up with additional budget cuts of 0.3% of GDP this year to meet its goal of reducing its budget deficit to 7.3% of GDP in 2010 and cuts of 1.5% of GDP next year to bring the deficit down to a promised 4.6% of GDP.
Just so we remember, the agreement that set up the European Monetary Union requires members to run deficits of no more than 3% of GDP.
And if Spain and Portugal don’t meet their targets?
Well, the economists’ draft paper said that their budget deficits would snowball—the final version of the report took out that word. The longer the countries put off the necessary cuts, the larger future budget cuts will have to be to make up the short fall. And at some point the needed cuts become so large that there is simply no way for the countries to catch up to the problem. In a worst case scenario Spain and Portugal would each wind up with a government debt equal to more than 130% of GDP by 2020. (Currently Spain’s debt stands at 70.5% of GDP and Portugal’s at 80.5 %.)
The rest of the monetary union—which means for all intents and purposes the voters of Germany—would not backstop that level of debt. No way. (For more on the political problems that even the current plan has created for the German government see my post http://jubakpicks.com/2010/06/15/looming-political-crisis-in-germany-threatens-the-euro/ )
China’s bad debt crisis can’t be papered over
Everybody knows that China’s banks have a huge bad debt problem. But almost everybody right now is committed to pretending that it doesn’t exist. The common faith is that the government will bury the problem just as it buried the banks’ bad debt problem after the Asian currency crisis in 1997.
But a few bank regulators are worried that burying the debt might not be so easy this time. On June 15 the China Banking Regulatory Commission warned in its annual report that bad home mortgage loans could set off a chain reaction that could spread to loans to real estate development companies. That would be serious since real estate development companies are some of the biggest companies listed on the Hong Kong and Shanghai stock exchanges. A retreat in those stocks has been a primary cause of the bear market on the Shanghai stock exchange that began in November 2009.
The timing of a further fall in China’s stock markets couldn’t be much worse since China’s already publicly traded banks are looking to raise more than $40 billion in new capital this year on these very financial markets. A retreat in share prices would make raising this capital much more expensive if not impossible. Already it looks like a $30 billion IPO (initial public offering) by the Agricultural Bank of China, the only one of China’s biggest banks that hasn’t yet gone public, will have to be scaled back to $20 billion. (The Agricultural Bank of China IPO isn’t included in the $40 billion estimate of how much capital China’s publicly traded banks need to raise.)
Difficulty in raising new capital would have wide ranging consequences. Regulators are forcing banks to raise new capital because they are raising reserve requirements at the banks to offset what are feared to be huge numbers of bad loans to financial companies affiliated with local governments. Conservative estimates put bad loans to these politically connected entities at $200 billion.
If banks can’t raise the capital regulators require, regulators will be forced either to rescind the new higher reserve requirements or to force banks to reduce lending. The first would bring worries about China’s banks and its entire financial system to the top of investors’ worry list. The second would send economic growth in China into a tailspin.
Neither is exactly a recipe for climbing share prices in China—or in any of the other markets that take their cue from China. (For more on China’s bank loan problem and the scheme to escape the consequences see my post “Move over Charles Ponzi and Bernie Madoff—China is running history’s largest financial scam” http://jubakpicks.com/page/4/?s=China
I’ve got a kind of rough calendar for these three bombs.
By the end of July we’ll know if the Agricultural Bank of China IPO went and for how much. And that will let us judge whether this bomb is likely to go off or not. (For more on that indicator see my post http://jubakpicks.com/2010/06/03/think-chinas-bear-market-is-a-buying-opportunity-heres-one-way-to-tell-when-to-get-in/ )
We’ll know more about the direction of housing prices—and the projected size of the Fannie Mae/Freddie Mac bill—by late summer or early fall (say, to be safe when third quarter GDP numbers come out in October), I’d guess. By that time we’ll have a pretty good idea of how home sales are holding up in the absence of government incentives and of how fast the economy is growing.
Creating a time table for the euro debt crisis is harder. So much depends on whether or not the budget cuts send Spain and other high deficit nations into a recession. And how many other countries impose their own cuts and what size they are. (The United Kingdom is a key case.) I don’t think we’ll know much on this front until late in 2010 or early in 2011.
And that’s what I worry about in the middle term anyway. I try not to think about the really big problems coming in the long run.
Full disclosure: I don’t own shares of any company mentioned in this post.
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