The YELLOW BRICK ROAD TO ARMAGEDDON
Aubie Baltin CFP. CTA, CFA, Phd. (retired)
Both the Economy and Stock Markets are unfolding, almost as if on cue to the play I have been writing during the last year or so. I am not sure whether to be happy or sad as more and more analysts begin to see the dangers that lie beneath the surface and recognize the far reaching effects of the problems You may recall that I was always kind of hoping that this time I would be completely wrong. While it’s nice to get a little company after standing alone; I am sure we would all rather be wrong than have to bear witness to what’s coming.
Why did Bernanke cut the Fed Funds rate by an unprecedented inter-meeting 75bps, followed two weeks later by another 50bps? The flow of bad news in December to mid-January did not, by itself, justify such radical action. In order to understand these moves, one has to read between the lines and ignore the Pollyannish babbling of our Media, Politicians and Financial pundits and look instead at the rising probability of a
"Catastrophic" financial and economic collapse (1930’s type depression). It now looks like the Fed is seriously worried about the risks, the likes of which have not been seen since the 1930’s. After a year in which the FED and the Treasury were underplaying the economic and financial risks – The FED has been pressured into taking a very aggressive, wrong headed, Keynesian(Socialist) approach to risk management. To understand the risks that the financial system is facing, let us examine the "nightmare" scenario that financial officials around the world have suddenly become aware of and which can no longer be swept under the rug. To begin with let us assume that the recession, which we will soon discover, started in the last quarter of 2007, will be much worse than those that occurred in 1990-91 and 2001-02 for several reasons. First, we have the biggest housing bubble/bust in US history with some home prices likely to eventually fall 30% to 50% or more. Second, because of deregulation and the elimination of Glass Steagall and a host of other protections put in place (after the last financial debacle) by the Securities Act of 1933-34, a massive credit bubble/crunch was created that has now gone far beyond just sub-prime mortgages. Third, deregulation has caused reckless financial innovation and securitization, causing the FED to lose complete control of the money supply, leading to the worst credit crunches in American history. Fourth, US household consumption which now accounts for more than 70% of GDP have spent well beyond their means for 15 years, piling up massive amounts of debt. Now that home prices are falling and a severe credit crunch is emerging, the retrenchment of private consumption will be serious, longer lasting and far reaching.
The Ten Steps to Financial Armageddon
1. The worst housing recession in US history and there is no sign that it will bottom out any time soon. US home prices will fall between 30% and 50% from their blow-off peaks which would wipe out between $5 and $10 trillion of equity, making the 1987 and 2001-2002 equity destruction look like chump change. While a 20% home price drop will translate into a sub-prime meltdown of about 2.2 million foreclosures, a 50% fall in home values will result in over 13 to 18 million households ending up with negative equity in their homes. What will that do to consumer spending? It won’t be long before a few large home builders go bankrupt, leading to another free fall in home builders' banks and related stock prices. The perennial Bulls, looking at last years earnings began bottom fishing and rallied these stocks in spite of the worsening housing recession, thus giving us a perfect opportunity to
short the Home Builders and Banks.
2. The financial system losses from the sub-prime disaster are now estimated to be as high as $250 to $300 billion. But the financial losses will
not be restricted to sub-prime mortgages and their related CMOs and CDOs. They are now spreading to near prime and prime mortgages as the same reckless lending practices, i.e. LIAR loans (no down-payment, no income verification interest rate only, negative amortization, teaser rates), were occurring across the entire spectrum of mortgages. All of which were being pushed by Greenspan and the Government promoting the American Dream. Instead, what they have created will be the
Great American Nightmare. 60% of all mortgage origination between 2005-2007 had these suicidal features. What happened to risk underwriting? Goldman Sachs now estimates total mortgage credit losses of about $400 billion, but that is based on home prices falling only 20%. The markets for securitization of mortgages - already dead for sub-prime and practically frozen for other mortgages – further reduces the ability of banks to originate mortgages and as their risk tolerance is ever increasing, so are the minimum down-payments and credit score requirements. The huge losses have forced banks to bring back on to their balance sheet all types of toxic off-balance sheet investments and loans turning them into financial Time Bombs. Because of securitization, the toxic waste has spread from the major banks and brokers to their Investors, Pension Funds, Insurance Companies and Money Market Funds in both the US and abroad; increasing rather than reducing systemic risk as well as globalizing the credit crunch. The rest of the world will not be growing fast enough to pull the US out of recession.
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