Time Bombs Put Portfolios in Peril

06/18/2010 9:12 am EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

In the next several months, any or all of these could detonate, and each has the potential to inflict serious damage on your investments.

I'd love to believe the global financial crisis is over.

But I can't.

I see too many unexploded bombs on the road ahead for me to believe the danger has passed.

And I'm not talking about the big bombs ticking away and set to explode in decades—the demographic ones built out of all the promises governments and companies have made to an aging work force that they won't be able to keep.

No, the bombs I'm talking about now have much shorter fuses than that. If they go off— and I don't know how many will—it will be a matter of quarters, not decades, until detonation.

Knowing that they're out there creates quite a quandary for an investor.

There's no guarantee that any of 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 Standard & Poor's 500 Index by nearly half. For the 12 months that ended March 31, 2010, my portfolio was up 26.6% while the S&P was up 49.8%.

But if the bombs do go off, any of them, we could get the kind of downturn that will make the 13.7% drop from the April 23 close of 1,217 to the June 7 close of 1,050 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 2008. I don't think these bombs are leveraged into the global financial system in a way that would inflict that kind of 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 giveback of a major portion of the huge stock market gains from the March 2009 bottom. Investors and traders haven't really put fear behind them, and it wouldn't take much for fear to 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 for the next 12 to 18 months: Avoid risk when the payoff isn't sufficient; when you can, with caution, play the big relief rallies after massive selloffs; and try to make steady money in the stocks of the world's developing economies your bread and butter. (For some suggestions on picks in those markets when the time is right, see my columns on the next rally's leaders and emerging markets.)

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 through the end of next year.

Here are the three bombs I'm most worried about in that time period:

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The Fannie Mae and Freddie Mac Money Pit

You know those signs you see in antique stores: "You break it, you buy it?” Well, I wish Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) had followed those rules. The banking and mortgage industries broke these two mortgage financing machines, but taxpayers have bought them. Now all that remains is figuring out how big the bill might be.

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) would buy mortgages from the original mortgage lenders, providing those mortgage lenders new money to lend. In concept, Fannie and Freddie then would be able to resell their mortgages to income investors, or, by guaranteeing the loans, allow the original mortgage lenders to bundle mortgages into securities and resell those securities themselves.

See where the trouble lies? If the original, underlying mortgages turn out to be bad enough that borrowers default on their payments, Fannie and Freddie are stuck paying a lot of interest to the investors who bought the mortgages they sold. The arrangement also puts Fannie and Freddie on the line for a lot of guarantees.

The two companies own or guarantee about 53% of the country's $10.7 trillion in mortgages. And after bailing out these entities in 2008, taxpayers own about 80% of the companies.

Now if you think taxpayers got a bad deal when they bailed out Citigroup (NYSE: C) or American International Group (NYSE: AIG), 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 pair got unlimited federal credit lines. 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, the 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.

In August, the nonpartisan Congressional Budget Office estimated 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 dropped an additional 20%. (Housing prices as measured by the S&P/Case-Shiller 20-city index fell 3.2% in the first quarter of 2010 compared with the previous quarter.)

Sean Egan, the 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 (NYSE: BAC), could take a worst-case scenario to $1 trillion.

No one knows the exact number, but there's an awful lot of taxpayer money riding on housing prices.

The obligations are real, but none of it is in the federal budget. How long will the foreign money financing the US deficit buy that one, do you think?

NEXT: More Ticking Time Bombs

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The Debt in Spain Mainly Snowballs

OK, the ink isn't even dry for 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 gross domestic product in 2010 could 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 would 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 there. (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 it faces 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 says that their budget deficits would snowball, although the final version of the report took out that word. The longer the countries put off needed cuts, the larger future budget cuts will have to be to make up the shortfall. And at some point, the 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 both wind up with 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 would not backstop that level of debt. No way. (Find more of my views on the political problems that even the current plan has created for the German government in this post.)

China's Debt Crisis Can't Be Papered Over

It's common knowledge that China's banks have a huge bad-debt problem. But almost everybody right now is committed to pretending it doesn't exist. The common faith is that the government will bury the problem, just as it buried the banks' bad-debt problems 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 loans could set off a chain reaction that spreads to loans to real estate development companies. That would be serious, because 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.

The timing of a further fall in China's stock markets couldn't be much worse. China's 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 that much capital more expensive, if not impossible. Already, it looks like a $30 billion 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 IPO isn't included in the $40 billion estimate of how much capital China's publicly traded banks need to raise.)

Difficulty in raising capital would have wide-ranging consequences. Regulators are forcing banks to raise capital by increasing 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 that the regulators require, regulators will have to rescind the new higher reserve requirements or force banks to reduce lending. The former action would bring concerns about China's banks and its entire financial system to the top of investors' worry lists. The latter 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 cues from China. (For more on China's bank loan problem and the schemes to escape the consequences, see this column.)

Tick, Tick, Tick…

I have a rough calendar for these three bombs.

By the end of July, we'll know if the Agricultural Bank of China IPO went ahead and for how much. And that will let us judge whether this bomb is likely to go off. (For more on that indicator, see this blog post on my Web site.)

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, I'd guess. By that time, we should 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 timetable for the euro debt crisis is harder. So much depends on whether the budget cuts send Spain and other high-deficit nations into a recession. And on 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 2010 or early 2011.

That's what I worry about in the middle term. I try not to think about the really big problems coming further down the road.

At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column.

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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