I’d love to believe that the global financial crisis is over.
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 https://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 (https://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 https://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 https://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 https://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 https://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” https://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 https://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.
Jim thanks for the great insights. You really show the macro picture an are able to make easily understood.
I think you’re right the status quo will hold in MBS land. They’re very deep in the world structure, and changing anything would “shake the foundation”, as they say. I think a lot of people don’t realize what it would do to the money market if we defaulted and started a cascade, starting with MREIT’s, going to broker-dealers, breaking the buck, and Rep. Paul Kanjorski talking to CNN about a nother run on the dollar. You don’t just get rid of the GSE model overnight.
The problem is I don’t think it will be politically acceptable to bail them out indefinitely. So, like you pointed at, we hope growth does it for us. Growth is the Savior the US prays to.
Regardless, I’ll buy NLY if the price is right, and hold on for the ride. Inflation is leverage’s best friend as long as it doesn’t become irritated.
Though I voted for Obama, I agree with your statement that it’s hard to fight corruption when it begins with you (him). That’s actually a structural problem for the whole US political system, unfortunately. Thanks for your interesting thoughts on the partial MBS default. My guess is that Bernanke and the political powers that be have seen “extend and pretend” work as a solution on debt for too long to change tracks now, and that their view will hold sway politically: that it’s a better choice to devalue the dollar and use the old “latin debt crisis” solution from the ’80’s and hope the US debt problem repairs itself in the long run rather than default – regardless what noises the tea partiers may make. Don’t forget that, as I understand it, a lot of foreign sovereign funds hold US GSE debt and MBS and it creates huge international political and economic problems to suddenly stiff those folks. That’s one big reason they didn’t let the GSE’s do restructuring and partial defaults in the first place, according to some articles I read in 2008.
Ultimately, it’s probably all minor deck chair adjustment on the Titantic whether they default or not, in any case – but even on the Titantic, timing and positioning (and luck) made a big difference whether you made it into the lifeboats. Looks like the equity stern of the ship launching skyward today – time to climb up there 😉 as Meredith Whitney says “definitely double dip in US housing” this AM. She’s a bank analyst who’s been right as rain on much that has transpired. Sorry, have to have a little dark humor about it all…
Thanks for the input. There are some who think a mixed congress actually decreases gridlock because the parties are forced to work together, compromise, and find middle of the road solutions.
I also think you are underestimating the resolve of tea party types and the emphasis on principles. Besides, most fully believe clamping the spigot will bring immediate gains rather than very long and deep pain, and don’t (or won’t) understand deflation. But they’re not going to have a large enough influence any time soon.
Good luck with Obama. It’s hard to fight corruption when it starts with you.
I can’t rule out a partial default on MBS. Govt. can do crazy things. I think the most likely policy choice would be a short term coupon suspension to recapitalize the GSE’s, but that has some serious rule of law issues (that congress should be able to overcome). Figuring 5% of $5 trillion, you’re looking at about $250 billion in annual interest. 6 months or so may be enough to recapitalize them. The important part is it has to be very well defined, and probably a partial suspension linked to repo (meaning pay the buyers repo and no more), so the market doesn’t go haywire and bankrupt the purchasers.
Actually, it’s more accurate to say that I think that if a true increase in Tea Party influence happened in Congress, it would just increase right/left gridlock and the inability of government to respond to the current and upcoming crises. The unfolding of the financial crisis, which I think is likely to re-emerge and become more difficult in any case, might speed up a bit but the trend remains the same.
For a possible silver lining, I could only imagine that Obama, (or someone new), would finally become a strong leader, level with the American public about the rampant corruption and denial we face, the various fiscal and resource crises coming down the pike and take radical action that upsets some of his big donors from Wall Street and elsewhere. I’ve written Obama quite a few emails about how he’s falling down on the job, but so far he doesn’t seem to be paying attention to me.
sigli – In my opinion, the right moving republican gains in congress in the fall that are virtually certain to occur, will mostly be “full of sound and fury, signifying nothing”. The victories will be all about political posturing and power, and another chapter in the endless story of American lack of political sophistication, but won’t have much impact on real policy affecting the liabilities of the GSE’s. Even if the Repubs gain full control of Congress, which I doubt, they still won’t let the gov’t default on GSE debt – that would just cause a more rapid deflationary blowout than is already under way.
Everyone I know says Fannie/Freddie need to be re-orged. So what? The die is already cast on US Federal and State debt, bailouts and guarantees – it’s not going to be a happy circumstance going forward. IMO, all the Tea Party yap about cutting the deficit, getting the gov’t out of this and out of that, etc. is just not going to happen in any meaningful way because, in practice, any meaningful steps would, at this point, be political suicide for the GOP and right wing. The US economy and a large chunk of its citizens are being kept alive by money printing and gov’t programs. The fiscal conservatives should have done their work decades ago. In fact, the Right Wing in the next year or two may have to vote to bail out the state of California in an attempt to save the US from a full blown deflationary spiral – and *that* would at least provide a little entertainment.
How about starting by recouping some of the bonuses paid out to the management of Fannie and Freddie. In this era of idiotic CEO pay, “performance” bonuses need to reside in an escrow account for three years before they are accessible in order to eliminate short term thinking and short term accounting manipulation.
kelvinator–How do you discount a right moving republican November victory into what you said? I don’t think the MBS paper will be defaulted on, but I’ve no way to factor a Tea Party type congress. I think they’ll go after the GSE’s. That’s why I ask what’s next??? Defaulting GSE guaranteed MBS’s would throw a serious monkey wrench into the money market. But leaving GSEs as they are will be politically unacceptable to the right. So, pray for democrats or stay away? Or is there a silver lining?
Some quick explanation on why I said several times that US real estate is at least 20% overpriced on average.
Though not an expert, I pay great deal of attention to real estate with very detailed, specific and hands on experience and analysis. (BTW, I am not in the real estate business, though I have very close-up view of it.) Although there are many well-known real estate tracking data out there, all they do is to tell you that real estate went up or down so and so % in the past quarter or year…..That’s not really interesting or useful to me. (Of course I care even less about the so-called income comparison as some people indicated on this blog). Because none of these would tell you the real estate is under-priced or over price or just about right. That’s what I want to know.
You do PE or PEG or whatever analysis on stocks, right? If yes, did you do the same on your home or you just simply trusted the appraised value? If yes, did you ask the appraiser if he/she had actually saw the comparison properties which is the key method of real estate appraisers? Chances are “no”. If so, why would you assume the appraiser is correct? A home with a $1K stove can not compare with a home with a $10K stove even on the same street. And of course, you can not just compare the stoves. That’s why it’s crucial to compare the actual properties, not just the data on paper.
I analyzed quite quantity of real estate data of four states in the last several years including several times alone last year and I saw many, many properties first hand. (I prefer not to give the names of the states, but I can tell you that it included both costal and in land states.) Although my purpose was not to draw a national conclusion, it just came out during the process. My conclusion was that they are over-priced by at least 20% on average. The census’s data (150 million units v. 300 million people) just made me even more skeptical about it.
I don’t know what caused this over-price. Besides supply and demand, couple of things may worth consider.
(1) Despite we have a saying of “house is the biggest investment for most Americans”, I highly doubt that most Americans treated their biggest investment as such. You won’t buy any stock without due diligent, why would you make an even bigger investment without it. They seem often caught up in what they want in the kitchen or bathrooms or whatever. The only money matter they think about is if they can afford the monthly payment or the closing costs, not if the property worth the price they pay. They relied on “experts” about the value. As results, I saw people paying the kind of price that I would never pay.
(2) Unlike many other products, every time when a real estate changes hands, it adds 6% to its price or value and it stays there foreever. Over the years, it really adds up.
Jim:
Your above comment is well said. I wish there are some kind of sunset provision for government agencies, etc. But the reality is that once set up, it’s forever and they usually expand very fast. I heard that’s what really brought down the Soviet. At one point, 50% of its population was doing some kind of government works and the country finally could not carry the weight anymore and it just collapsed to the ground!
It seems to me that all government agencies (not just federal) only have one thing in mind, defending its own turf. When something really happens even if it’s on their turf, they have only one goal, covering their own rear-end. You don’t need to be an “anti-government” cook to notice that. The response to oil spill showed just that.
I read there are about 12 (yes, 12) federal agencies have some kind of authority over the matter, but none is in charge. (You see, they only see “authority”, not responsibility. They all want authority=turf, but not responsibility.)
To be fare, I don’t blame the administration for the spill, though the regulator could have done better jobs. But once it happened, there are many things that federal government could do to minimize the impact. I understand fed does not have the expertise to “plug the hole”, but it can orchestra or organize a massive “rescue mission” to pick up more oil and to prevent it from reaching shore. (I am sure you all see many such wisdoms or suggestions posted on internet. I don’t need to repeat here.) It does not seem happening or the federal government seems very ineffective if not an obsticle. I guess we shouldn’t expect too much when the spill tzar works “part time” and the president got so much other priorities. Two vacations, countless golfing and in-house parties including a recent 5-hour golfing and a star-studed concert honoring S. Africa’s Tutu. The folks in the gulf area can wait.
I thought that protecting people of this country (not running a car company or a bank or giving out more mortgage) is the fed’s most important function and duty. This spill effected millions people’s lives and it’s beyond any state’s capacity and boundary. It is the fed’s responsibility to take the lead of the rescue and recover efforts. Particularly after BP repeatedly failed to plug the hole, has the government tried anyone else in the world that may be able to do it? For example, Exxon recently said it has drilled more than 250 deep walter wells in the past 10 years and had no problems. Can Exxon or even Norway or anyone else in the world do it? (Remember Norway picked up the Russia submarine that was sunken in the deep freezing north see several years ago? Normally none wants foreigners get close to their super secret submarine, but Russia had to ask Norway to do it, because it was the only country that could.) How about reports of 13 countries offered help to pick up more oil and we turned them down? Sorry, folks. No desire to be “political”, you just can not help if you care about the matter.
Jim, I am also very glad that you did not get caught in my in initial post of “how dare you…”. When I was writing that comment, I assumed everyone knew what I meant if they had been reading this blog in the last few days. Later I thought I may have offended you by saying “how dare……” but I had took off for the day and could not clarify it sooner. I thought that if someone could call disagreement with government policy or intervention as “anti-government”, calling government a “bomb” would be worse. BTW, Fannie and Freddie are no longer “enterprise”. It’s government itself. Because (a) government now owns 80%, (b) they delisted from the exchange, (c) government banking boss Frank said they are “government’s policy arms”.
Ed:
(1) I did not mean you were out there to get the “anti-governmts”. Anyone who read this blog in the last few day should know that I did not mean you.
(2) I don’t know anyone else on this blog has caused more “get out” calls than you did. I remember early this year Jim himself had to come out to calm it down. I defended you (I would do the same for anyone else under the same circumstance) that as long as it’s civil, more is better. If anyone does not like it, just skip it. None is forcing anyone reading anything. I just don’t see any reason for you to get so hot-headed. You too could just skip it like I skipped yours so many times.
CynD:
It’s only a paper moon, sailing over a cardboard sea…
The US gov’t is backing the Freddie/Fannie bonds. The guarantee is as good (or as bad) as the credit of the US. It’s tough to believe the gov’t is going to default on the bonds. I and many investors believe though that, in the end, the US and many other governments which are guaranteeing bad debts that are beyond their real productive capacity to pay off are going to ultimately (in the medium to long run) devalue the purchasing power of their currency to pay the debt nominally but not in real terms. IMO, that’s one reason why gold hit a new high yesterday. So, the effect on the US guaranteed bonds is that the payments and principal may be “safe”, but the bond or fund value containing the bonds may take a hit when ultimately US borrowing costs (interest rates) rise just like Greece’s or Spain’s, because people don’t believe that $100 lent to the US now will ever be paid back as $100 with the same purchasing power + interest in the future.
CynD–That depends on what paper are you talking about.
Ummm…this may be a bit off-topic, since this has become a political “head-bashing” site, but if you own bond funds which include Freddie/Fannie is the government takeover going to affect the payout and/or the quality of those funds?