 By Patrick J. McKenna There is a rather tasteless joke that claims that a recession is when your neighbor loses his job, but a depression is when you lose yours. The curious irony is that economists have no specific point of reference to distinguish when an economy moves from one state of malaise to the other. That said, I think most people would agree that this economy is definitely in a recession. The question then becomes: How long will this last? Conventional wisdom, publicly espoused by a number of market watchers and legal consultants, is that: “The recession will be intense, but short. Everyone wants to get back to normal. Short term, the backlog of real estate will be sold as owners accept losses; banks will end the credit crunch; layoffs will make companies more efficient.” I only wish! Unlike past experiences, this downturn isn’t being caused by a downward spiral in a few isolated industries. It started with the burst of a protracted housing bubble and then metastasized into a full-blown credit crunch, eventually destabilizing the entire financial system. Back on August 8th, I predicted in my blog that “for the next five years, every time you think it's safe to get up and dust yourself off from this downturn, every time you feel like you've endured the worst of it, another piece of news is going to come along to freshly bludgeon you. This time the economic slowdown is going to be a lot different and, in many ways, a hell of a lot tougher.” While usually the unrelenting optimist, I must admit that I am witnessing a confluence of a dozen factors that, when combined, cause me to be extremely concerned for our economic well-being. Here is a summary of some of the danger signs that I’ve been tracking, together with an exercise worth conducting within your firm. What Is Likely to Happen Next? 1. The Continuation of the Mortgage Fiasco Everyone has heard more than enough about the dangers of subprime mortgages; but there is even further danger from the least-known mortgages, called pay option mortgages, which are adjustable rate mortgages that allow a borrower to pay a minimum monthly payment. There are an estimated $500 billion of these loans, 60% in California. Many are now about to come due. The mandatory trigger points for increasing monthly payments will start the default process rolling in the second half of 2008. The first re-sets are beginning and will escalate, month by month, until August, 2011. In 2008, 1.69 million homeowners will lose their houses. A wave of unstoppable foreclosures is expected to hit the housing market for three to four more years, accelerating month by month. Rod Dubitsky, managing director for asset-backed securities at Credit Suisse thinks that 3.6 million more foreclosures could pile up through 2012. Unless the government artificially props up home prices, they will continue to fall to their natural level of equilibrium. 2. A Decrease in Consumer Spending The fear of what massive foreclosures have done to the economy has led Americans to cut back on all spending. For the first time in a decade, Americans have actually reduced borrowing. The problem is that with every American cutting back simultaneously, an economy that is totally dependent on Americans spending more than they earn will implode. Consumer spending drives 70% of the U.S. economy. Without it, we are in deep trouble. That's exactly where we are heading. 3. The Next Real Estate Disaster There is yet another potential real estate crisis on the horizon in commercial property. The enormous cutback in spending by consumers will reverberate throughout the economy. Thousands of retailers and restaurants that expanded based on debt-aided demand will be going out of business. Those generous banks that gave loans to unqualified homeowners also provided the funding to support the grocery marts, fast-food restaurants, gas stations, theatres and strip malls that sprung up all around those new subprime boomtowns. But with foreclosures hitting 37-year highs and the glut of unsold property having now left millions of U.S. houses completely empty, few are left shopping at the strip malls. Many of these businesses are closing shop. In the interim, real estate investment trusts (REITs) that deal in commercial property have gotten slammed and are expected to fall even further. The cost of commercial mortgages has soared in lock step with the rise in subprime defaults. Bloomberg says we could see the worst drop in commercial property since the 2001 recession. Morgan Stanley is calling for a 15% drop over the next two years. 4. Additional Bank Failures The shoe that hasn’t fallen yet involves small regional banks that were the major lenders to developers. The bankruptcies of developers will lead to the bankruptcies of hundreds of small banks. 5. Higher Unemployment Highly leveraged mall developers and commercial developers will go bankrupt as their tenants stop paying rent. These bankruptcies will lead to a dramatic jump in unemployment. The negative feedback loop nature of this crisis will lead to unemployment rates of 8% to 10% or greater before bottoming out. 6. Escalating Credit Card Debt Since 2003, household debt is up 24%. Nearly half of all American households have made it a habit to spend more than they make each year. If you examine the subprime scenario and all its ramifications, you find that when house mortgages went bust, millions of Americans could no longer draw off home equity to pay for the newest flat-screen TV model, the vacation trip to Florida or other “essentials.” So they turned to the convenience of their credit cards. Millions of house-broke or unemployed Americans have stopped paying off their credit card balances. Just like defaults on mortgages, defaults on other consumer credit are expected to soar. Credit card debt has now hit a record $915 billion. And that's just the start. Total consumer debt stands at a mind-blowing $2.48 trillion, more than the entire United Kingdom's gross domestic product. Card issuers like American Express, Citigroup, Capital One and Bank of America are already bracing for a 20% explosion in credit card defaults over the months ahead. But here's the really scary part: Just as they did with mortgage debt, banks and other credit card issuers have "sliced" up all those credit loans and sold them back to Wall Street. Then Wall Street sliced them all up again, packaging them as "safe" debt, and sold them to the people who run our retirement funds. 7. The Impact of U.S. General Accounting Rule “FAS 157” Rule FAS 157 says that banks can no longer hide what are called "level three" assets. Stocks, bonds and all the investments you've already heard of are what are called "level one" investments. "Level two" includes some of the less-traded mortgage-backed investments that started blowing up late last year. But here's the biggest risk. At the top tier—"level three"—you've got the hidden investments that almost never trade. These are the huge derivative positions, the private equity investments and enormous slices of the mortgage market. Banks don't talk about them. The market doesn't put a price on them. So the only way for accountants to figure out what they're worth is to guess. It's called “mark to model” pricing. It means each firm can basically set the value of its own assets, using its own formula. It is kind of like “deciding” your net worth, or the value of your car or house, without anybody checking your math. And that's exactly the problem. Until recently, financial firms could pretend those hidden assets were worth plenty. But with the “FAS 157” crackdown, that's getting harder, especially since many of these hidden “level three” assets are based on failing subprimes, collapsing lenders and defaulting consumer debt. When the public finds out just how many hidden “level three” investments are worth nothing close to what the banks have said they're worth, brace yourself. Because the bank losses that have rattled Wall Street already will feel like a day in the park. 8. The Escalating Costs of the Financial Rescue In addition to capital infusions in U.S. banks, the government announced that it would temporarily guarantee $1.5 trillion worth of new debt issues by banks as well as insure another $500 billion in deposits. All in, the potential cost of the total bailout package is coming closer to exceeding $2.25 trillion—triple the size of the original rescue package, which centered on buying distressed assets. The government will continue to pump hundreds of billions (it does not have) into an insolvent banking system. These actions will have a dramatic unintended consequence (known as hyper-inflation). And all of this does not include a parallel bailout of the financial sector and other industries through a series of obscure tax breaks that are expected to add billions of dollars to the federal government’s deficit. Meanwhile, the domestic automobile companies (employing 600,000 line workers and another 3.6 million people indirectly) are currently looking to Washington for their own bailout. It has been estimated that if an automaker declared Chapter 11, taxpayers will be on the hook for billions in retiree benefits from that company. 9. The Obscure World of Credit Default Swaps (CDSs) The October 13th issue of Fortune warns: “the financial crisis has put a spotlight on credit default swaps – which trade in a vast, unregulated market that most people haven’t heard of and even fewer understand.” CDSs are the fastest-growing major type of financial derivatives. They are complex financial instruments originally designed to protect lenders if a borrower should fail to make its debt payments. They have since played a central role in our unfolding financial crisis by providing “insurance” on risky mortgage bonds, which ostensibly allowed companies to feel safe by passing the risk down the line. Unfortunately the federal government shied away from any oversight of CDSs, allowing giant financial institutions to be insured by and expect to collect money from unregulated “institutions only slightly more solvent than your average minimart.” Since the mid-90s these privately traded derivative contracts have grown into a $54.6 trillion market (the European banks wrote a staggering $426 billion worth of CDSs with AIG in 2007 alone). After emphasizing that CDSs enabled reckless behavior, that the risk exposure here is in the trillions with a capital “T,” and that as recently as a year ago, there was $1 trillion worth of swaps that were unsettled among counterparties, Fortune asked: “Will this be the next disaster?” With approximately $55 trillion of derivatives outstanding in the world, no one knows how much is at risk. There is no formal system for handling these instruments. If these derivatives continue to implode, no country in the world has enough money to prop up the system. Very smart people are extremely worried about this possibility. 10. The Coming Wave of Corporate Bond Defaults A number of prominent investment firms are also now warning that high-yield, high-risk U.S. corporate bonds are likely to deteriorate in the coming months, as the market braces for more corporate defaults. Now that the corporate junk bond market has grown to $1.3 trillion, the likelihood of significant defaults cannot be ignored. The cost of protecting high-yield, high-risk corporate debt from default becomes more acute amid concern that hedge funds are being forced to liquidate as the financial crisis depresses asset prices and investors withdraw. One of the effects of any wave of defaults is that it makes a recession last longer by heaping more bad news on a market whose faith in credit ratings is already impaired. 11. Massive Increases in Government Debt at All Levels Federal, state, county and local governments did what they always do. They extrapolated the tax revenue they were receiving during the housing boom years. Their current spending far outreaches the revenue that is coming from taxes. Thirty-two states will have a combined budget deficit of $50 billion this year. It will get worse in 2010. California is already begging for $7 billion from the Treasury. New York State and City have been dependent on Wall Street tax revenues. They will get $0 from these firms going forward. Citizens will not be happy with tax increases during a recession. Concurrently, over $6 trillion of stock market value has been lost in the market during the last year. For those who are retired or close to retirement, their future has been devastated. Seventy-six million baby boomers all plan to retire over the next 10-15 years. The time is quickly approaching when the baby boomers will start adding big time to government spending (Medicare and social security). But, the U.S. has $53 trillion of unfunded liabilities and a national debt of $10.1 trillion. How is it going to cope? 12. And the Expanding U.S. Trade Deficit With the trade deficit now running at $750 billion per year, and much of that money coming back into U.S. Treasuries, the U.S. government has grown dependent on foreigners to sustain the continuing deficits. That level of debt would normally cause extreme weakness in a currency—just as it would in the value of debt owed by a deeply indebted individual. However, the sheer magnitude of the foreign holdings provides something of a bastion against a total collapse in the dollar. Even so, some foreign holders are easing toward the exits through the purchase of an operating company or resource deposit here, or a landmark New York building there. They might make a billion-dollar equity investment in a brand name company, or exchange some dollars for a basket of currencies or a ton or two of gold. It’s a delicate balancing act, because if they get too aggressive, they risk triggering a mad dash for the exits, a nightmare scenario where the value of their trillions of dollars in holdings would be devastated almost overnight. The Washington Post is now talking openly about something that would have seemed impossibly scary and absurd a few years ago—a $1 trillion deficit for 2009. Read more for tips on how to handle the crisis Page: 1 of 2 pages for this article 1 2 >
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