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.
i find this discussion fascinating, many reading this blog are not Americans or live in America, but all have an opinion about US policy and housing values ,, etc.
Since all these effect everyone’s life (investor or not) the more we read the more we get involved and debate the founding fathers intentions. And how the high court ruling on opening the tap for contribution coming from private companies, can and will effect the financials system in the world actually.
CallOfDutyFan–Annaly’s (NLY) last quarterly release has an interesting view that you may appreciate. I don’t think I agree with them, but it gives a very good answer to your question.
http://annaly.com/Admin/AttachmentFiles/136Q12010ItsaWonderfulWrap4May2010FINAL.pdf
Over time, our love of freedom helps us forget why earlier generations did things. I laugh reading late 1800’s ideas regarding banking. The conspiracy then was deflation (as Annaly talks about), so we set up a central bank. But the people were so paranoid of government doing anything that they required the famous public-private partnership, with a very specific power hindering structure. Most don’t seem to care why we set up our central bank, and the conspiracies are mainly regarding inflation and private ownership. So we set up a system the best we could, to eliminate public stupidity and private control, but time washed the reasoning away.
Banking and money creation is linked to government. I don’t see why the right wouldn’t want it as highly regulated as possible.
No one seems to be asking IF the government should have any interest in people owning homes. IF people have the means and the will to buy, they will. Owning is not for everyone. I am a conscious renter, and probably will be one for a long time. I don’t see why the government needs to guarantee mortgages for citizens. I just don’t get it.
On a side note, have you heard about the “Golden Rule”? He who has the Gold makes the rules. That’s what democracy in modern America has come to.
Hi Jim,
What about commercial real estate? Isn’t that a bomb? Commercial property “owners” are underwater, there’s little credit available because community banks are failing, and malls are losing their tenants.
Jim,
I think you are very correct in your statement. Many of the governments programs are setup with very great intentions. Thats why lobbying is such a lucrative and integral part of major companies, business associations, and large industries that deal with direct government involvement. Just slowly chip away at the stones that cost you money and polish them into a fine gem worth billions.
Hello everyone, I never participate in comments section but read it every day. Jim your last entry sums up the problem perfectly. Left or right the problem gets down to the politician’s 3 vice’s POWER SEX or MONEY. The right thing to do has nothing to do with their ultimate decision!!
Case in point: Obama’s forcing of BP to cut the dividend and set aside 20B for Gulf clean-up.
Those who are anti-government got crazy enough to apologize to big business for government’s attempts to defend people’s properties!
http://robertreich.org/post/711904473/joe-barton-and-the-big-big-debate
I find it interesting that at a time the government’s are trying to stop the so called “too big to fail” problem, they are solving the banking crisis in the US and Spain by encouraging the large banks to take over the smaller banks that are under capitalized.
Too big to fail will continue to be an issue.
I think the pro and anti government arguments above need to get a bit more nuanced. Government agencies and programs with often laudible initial goals–prevent monopolies or prevent rate gouging by railroads or let more people own homes–tend to get captured over time by the industries they’ve been set up to regulate or those industries take the programs over because they se the government as the most reliable source of profits if they can just get the government to organize the market in the right way (why are there only 3 significant credit rating companies, for example). Fannie and Freddie were long ago captured by the mortgage industry and went from government programs designed to increase home ownership (whatever you think of that goal) to private companies with some kind of governmetn guarantee that were in the business of increasing profits (and decreasing risk) for mortgage lenders. This history, repeated over and over again and not just in the U.S., is why such strange ideological partners as Thomas Jeffeson and Mao have both advocated a statge of permanent revolution. (Well, in Jefferson’s case only every 20 years, actually.) You could achieve much of the same thing by sunsetting every govenrment agency or program after 20 years but Congress isn’t likely to do that since the 20 year point in the life of any agency or program is just when industries have figured out how to extract maximum advantage from the government’s “good”intentions.
Barney Frank pushing legislation that was intended to increase minority home ownership at the expense of documentation of income surely didn’t have anything to do with this. At least he didn’t receive a bunch of money from Fannie and Freddie.
Right/Left, whatever, keep throwing barbs back at each other. Greenspan is the main culprit in all of this. Greenspan Jr dropping money from his helicopter is why I’ve been in PM since the crash.
Why the government keeps home prices artificially high? The home appreciation tax break, home buyer tax credit, bla bla bla …. They are taxing me to subsidize the homeowners.
If there was no tax incentives, home prices would have been lower making homes affordable to many like me.
Fannie and Freddie bashers must really HATE this guy who directed Fannie and Freddie to lend money to minorities to close the “home ownership gap.”
Real Estate bubble was caused by the Fed. (Greenspan) Pres. Bush and the Congress wanting everyone to buy a home which allowed for easy money.
How the US got it’s start;
It was the revolutionary war that provided the first impetus for unity. Coordination of the war effort required something more than 13 independant nations fighting separately toward a common goal…..They were wresting power from one sovereign and were in no hurry to turn it over to another. Consequently, they gave the Continental Congress only powers strictly necessary for carrying out war.
Brevity was a salient feature of our constitution. The Framer did not clutter the constitution with unnecessary details that might have made it obsolete in a generation or two. Instead they laid out a broad framework, having faith that courts would interpret the language of the constitution wisely and in accordance with the emergent needs of society.
(Info. From Book; Constitutional Law, Klotter, Kanovitz, Kanovitz)
Housing is in much better shape than commercial real estate. When discussing real estate one should distinguish between the two.
To rolfer1:
I agree with you 100%. All I would like to add is:
If Fannie and Freddie model were so bad, why didn’t it fail during prior 70 years of existence?
Fannie and Freddie were founded with the objective of HELPING ordinary Americans realize the American dream. They were not intended to originate/guarantee unaffordable mortagages and that was what they did prior to the Crisis. We all know who fueled the housing boom and bust from the White House to Wall Street. Where were the Fannie and Freddie bashers when W. Bush gave this speech?:
http://www.youtube.com/watch?v=kNqQx7sjoS8
I believe the founding fathers would short the hell out of CMI right now, check it out
Speaking of bombs, way to show-up US soccer team!
Rolfer, you are correct in your analysis of the greedy and immoral role the private sector banks played in the crisis. However, the goverment ALSO played a part in pushing loans to unqualified borrowers (democrats) while at the same time failing to regulate derivatives and rating agencies (republicans). So the solution is not to punish people for trying to make a profit but to regulate in a manner that protects the interests of all players in the market and allows the free market mechanisms to set equilibrium prices. Chances that the people in office are going to do that? Zero.
Ed,
Agreed! The one thing I’ve noticed “more” about this economic “spat” than others is it’s not confined and is amplified by the severity of the numbers (although an argument can be made that numbers in any era are just as terrible). Bubbles (RE, banking) Euro, China, unemployment, bailouts (GE AIG, etc) runaway spending, yada, yada…the list goes on and on to describe a few of my favorite things when you want an example of how not to do something.
bsdgv,
Careful, careful…our founders are turning over in their graves over the extent of government’s involvement now. Guranteed…they weren’t “progressive” in their intent…change is a booger-bear…how much we’ve changed from the intent of the original authors of our governance. Hell’s bells! Scholars and lawyers have been arguing forever, it seems, about what “they” really meant. Forgive the aside…governance and “investing” are attached at the hip. You can’t escape its profound influence! Investors today who keep their money on the table…cast iron stomachs & tums are their lot!
To all you fans of STD, here is some good news:
http://www.cnbc.com/id/37777834
rolfer1,
You completely miss the flaw in the entire system: Exactly where in that system is there an incentive for the private sector banks to make sure that the mortgages will be honored by the borrowers? All the banks do is make the mortgage, then sell it to the government, and collect the fees. It’s a sweet deal for the banks, but lousy for the taxpayers.
By the way, it wasn’t the derivatives that caused the system to collapse. That was just a side effect.
If you want to blame the “greedy bankers”, go ahead. But it’s your elected politicians who set up this system, and they allow it to continue even AFTER it has already collapsed once. For some reason, the phrase “stuck on stupid” comes to mind…
To all of you egotists and complainers about governmental “intervention” – i.e., ignorant dogmatic d*bags – please take note of Jim’s comments: “Fannie Mae and Freddie Mac are in the business of buying and guaranteeing mortgages ***originated*** by banks and mortgage companies” and “[to] 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”. That is, loans originated by private-sector banks — so go complain to Citi about those “other people” getting loans on homes they couldn’t afford, and NOT Fannie or Freddie. While you’re at it, keep in mind that the private sector geniuses, NOT the government, sliced and diced those loans into derivative tranches and that the private sector rating agencies blessed those tranches facilitating their sales to investors.
bsdgv,
READ the Constitution! READ the Bill of Rights! READ the Federalist Papers! These were not documents written by people who had an unending love of government! Even those who were in favor of a strong central government also recognized how it could be abused, hence the separation of powers.
I personally don’t claim they were homogeneous. But if they saw what we have today, ALL of them would be apalled! The taxes alone would be offensive to them. Ask yourself why they never included an income tax in the Constitution? If they all loved government so much, wouldn’t they find a way to fund it to the fullest extent possible?
… in a more dramatic fashion than …
Along with your mid-term concerns about housing prices, Freddy and Fanny and what yx is talking about – I think housing in this country is going nowhere for the next 10 -20 years.
Look on any good retirement website, and you will find just how ill-prepared the boomers are for retirement. The average 401k WAS pathetic BEFORE all this went down. Aside fro social security, their homes are the only asset worth talking about. I believe this will cause them to be sold as people downsize is a more dramatic fashion thatn has been expected. This will drive down or at least stagnate house prices for the forseeable future I believe.
Disclose: I am a boomer; also own a home.
> The Founding Fathers weren’t too fond of government either.
Puhleeze! I beg to disagree with that…
I know my Founding Fathers: 1) Yes, Jefferson (although I admire him very much for his radical views such as rewriting the laws every once in a while:) was anti-fed. 2) Madison, although from Virginia like Jefferson, is the writer of our Constitution for God’s sake. 3) Washington, although from Virginia like Jefferson, listened mostly to Hamilton who was the arch-enemy of Jefferson when it came Federal monatery affairs. 4) The rest of the bunch who were from New York and Boston (Adams for example) were very much for strong federal government.
The ones who foresaw the economic future of America (industrialization, Britain’s superpowership in the 19th century, etc) were for STRONG central govenment. The ones who were from backward states like anything to the south of Pennsylvania believed in absurd things like agricultural model of development, alliance with France, etc.
The founding fathers were NOT a homogeneous bunch as right-wingers tend to claim. They disagreed so much some of them stopped talking to each other for years and even killed each other in duels with pistols (Burr and Hamilton).
yx,
Lighten up hoss! We aren’t out to get you. In fact, I agree with everything you said. In truth, there is nothing wrong with being “anti-government”. The Founding Fathers weren’t too fond of government either.
Jim,
I like how you’ve narrowed down the macro forces driving the market right now.
About the real estate market, that is probably my biggest worry at the moment. We did absolutely zilch to fix the problems that caused the last crash. Anyone who thinks it won’t happen again is, well, blowing bubbles.
As for Europe, I don’t expect any firm resolution to the problems there until at least 2011, at the earliest. More likely, they will drag their heels on it until either Germany leaves or some of the PIIGS leave. BTW, watch for the PIIGS to add an “F” (for France).
Finally, China. I am not sure we will ever find out if their debt problem actually causes a problem. They might slap a coat of paint on it and sell it at Walmart next week.
I hate to say this, but I took my first step in capitulating to Ed’s side yesterday — I bought some SPXU as a hedge to my few long positions like ETP and AAPL. (OK, it was the second step after buying the bear claws.)
Cramer’s post can be found at http://articles.moneycentral.msn.com/Investing/top-stocks/blog.aspx?post=1771158&_blg=1,1771228
Sorry one typo above. I meant to say “accusation” not “accession”. I may be thinking too much of recession, bot the two words mixed up.
Cramer has a post on MSN titled “Why not to trust this rally”. Pretty interesting. (Sorry I don’t have a link.)
(1) How dare Jim called government INTERVENTION “bomb”! Fanny and Freddie are nothing but the government’s INTERVENTION in the mortgage business.
(2) Was Barclays Capital saying the US real estate may drop 20%? That’s what I posted here before!
On several occasions in the last several months, I posted that US is overbuilt (150 million housing units v. 300 million people per US Census. Four people occupy my unit! You do the math.) and the government’s propping ups (or let’s just call it INTERVENTION!) are keeping the real estate price artificially high. The moment the INTERVENTION withdrawn, it will fall. I even posted one time that I think US real estate is at least 20% overpriced on average, though it may be different area by area. So far it has been the case that whenever the government ‘s INTERVENTION ran out, real estate drops! I think this only prolongs the pain! And it’s not helping your beloved GOVERNMENT. Because an artificially high real estate price keeps Fannie & Freddie lending or guaranteeing more money on a property than they should. So, two days ago, I posted that we or the government “needs to face the music!”, because I’d rather take the pain and get over with it! Don’t you all know that stock market doesn’t like uncertainty? Why do we want this “bomb” hanging over our heads for so long? That’s when a manure-filled personal attach was launched against me. All kind of malicious name callings and accessions were made against me who was just trying to express some opinions like every other person on this blog! I guess certain people just can not stand the truth and they just can not help to pull out a Hugo stand on free speeches.
BTW, for those who want to round up the “anti-government” cooks, go to ABC’s website. Under ABC’s latest report on the spill, hundreds reader comments were posted. I read several pages of them, did not find even one government supporter.
Jim has turned very bearish lately…