Generational Dynamics: Forecasting America's Destiny Generational
 Forecasting America's Destiny ... and the World's


Generational Dynamics Web Log for 17-Nov-07
Warning signs for imminent financial crisis are growing rapidly

Web Log - November, 2007

Warning signs for imminent financial crisis are growing rapidly

European interest rates soared on Friday, raising fears of a new credit crunch.

The interest rate of concern is the LIBOR (London Interbank Offered Rate), which is the rate at which European banks lend money to one another. It jumped to nearly 6.34% on Friday (sterling, 3-month contract), from 6.29% on Thursday. It's at its highest point since September, when the worldwide credit crunch finally began to ease.

What this means is that banks are holding on to their cash, for fear of not being able to borrow money when they need it. That's exactly what happened when the global financial crisis occurred in August.

That's only one piece of a slew of extremely gloomy financial news that's been released in the last couple of days.

Goldman Sachs report

The biggest news on Friday morning was a report by Goldman Sachs on the spreading subprime crisis.

You'll recall that this has to do with CDOs and other credit derivatives with notional values that are far higher than the market would pay for them. There are hundreds of trillions of dollars (notional) worth of these in financial portfolios around the world.

The Goldman report, written by Jan Hatzius, the company's chief economist, says that "the likely mortgage credit losses pose a significantly bigger macroeconomic risk than generally recognized. It is easy to see how such a shock could produce a substantial recession."

The issue is this: Large financial firms have been "writing down" the values of their securities backed by mortgages. There have been some $64 billion in writedowns from a number of large financial institutions, including Citigroup, Merrill Lynch, Morgan Stanley, Goldman Sachs, JPMorgan Chase and Bear Stearns.

Analysts are predicting that large financial institutions will lose as much as $400 billion in writedowns, but that's the not the end of the problem:

"But unlike stock market losses, which are typically absorbed by "long-only" investors, this mortgage-related hit is mostly borne by leveraged investors such as banks, broker-dealers, hedge funds and government-sponsored enterprises.

And leveraged investors react to losses by actively cutting back lending to keep capital ratios from falling -- A bank targeting a constant capital ratio of 10 percent, for example, would need to shrink its balance by $10 for every $1 in losses.

"The macroeconomic consequences could be quite dramatic," Hatzius said in the note to clients. "If leveraged investors see $200 billion of the $400 billion aggregate credit loss, they might need to scale back their lending by $2 trillion."

"This is a large shock," he said, adding the number equates to 7 percent of total debt owed by U.S. non-financial sectors."

The scaling back of lending by $2 trillion will take an enormous amount of money out of the economy.

What the Goldman report is talking about is the reverse of the credit bubble. Financiers were using 10 to 1 leveraging to build up the credit bubble quickly, and now leveraging is going to collapse the credit bubble quickly. Because of leveraging, $200-400 billion credit loss is leveraged into $2 trillion in scaled back lending.

I want to comment on the first paragraph above. If you're a "long-only" investor, then you buy and sell stock shares, sometimes making money, sometimes losing money. If you lose money, then someone else makes money, and the total amount of money in the financial system remains the same.

But reducing lending by $2 trillion means that there's actually $2 trillion less money in the economy. (For more information, see my September 9 article, "Understanding deflation: Why there's less money in the world today than a month ago.")

But CNBC commentator Rick Santelli said that the situation is much worse than that. The following is a transcription of his remarks:

"Many of the issues that we've been talking about for how long are finally beginning to be talked about in public. I think the biggest comments today are really what Goldman is saying. And what they're saying is that unlike equities, a dollar lost is a dollar lost.

When you look at the capital markets and you consider $200-400 billion, which is probably on the light side - real losses -- in some of these investment banks, the part of the picture that nobody's talking about, that they very well understand is that trillions, hundreds of trillions, of notional value derivatives have been marketed by that core group. But yet only the core group has moved up to the confessional.

Do you think at this poker table they're only dealing derivatives among themselves? How much have you heard from all the people on the other side of the trades?

The issue here is that Goldman says the "back of the envelope" on this $400 billion could turn out to be trillions. Well of course it can.

You know, this credit was created off balance sheet for a reason. It's credit creation out of the realm of regulators. Unregulated means unregulated. And the notion we've had all along -- delights many on our channel -- is that the Fed's easing is going to make a difference.

Well, it probably makes a difference on the back side when the economy looks at this leverage and realizes it can get nastier.

But the reality is that it's not going to help the epicenter of this, or as it spreads out into things like hedge funds ...

You know, maybe Goldman's on the right side of this trade, but the real question is - the leverage on those receivables they think they have might be at the risk of the counterparty who owes them the money who at some point might not be willing or able to pony it up."

Santelli is referring to a figure that I've mentioned a few times -- the $750 trillion of credit derivatives that are in financial portfolios around the world.

Many of these are Credit Default Swaps (CDSs) that investors take out as "insurance" against mortgage defaults and foreclosures. The counterparties are the institutions that will have to pay off that insurance if the defaults occur. The problem is that these counterparties will "not be willing or able" to make the insurance payouts, as the number of mortgage foreclosures surges.

As Santelli points out, this is something that almost no one is talking about, except on web sites like this one. But now the Goldman report is beginning to make these concerns public. This would make the macroeconomic losses much higher than the $2 trillion, which is already astronomically high.

Fourth quarter earnings

As I wrote a couple of days ago, third quarter corporate earnings are far below expectations. As of July 1, analysts were predicting that third quarter corporate earnings would grow 6.2%; now it turns out that they didn't grow at all, but fell by 2.4%. This is a huge turnaround.

Now let's turn to fourth quarter earnings.

Another anomaly is that, up until two or three weeks ago, analysts were predicting that 4th quarter earnings growth would be double-digits -- 11.5%. Now the analysts have adjusted these predictions to a growth of only 3%.

Quarterly S&P 500 earnings growth, 2000-present, with estimates for Q4 and for 2008 (graphic from 23-Oct).
Quarterly S&P 500 earnings growth, 2000-present, with estimates for Q4 and for 2008 (graphic from 23-Oct).

In an article a month ago, I posted the adjoining WSJ graphic which shows -0.1% earnings growth in Q3 2007 (that's the figure that's now been reduced to -2.4%), but also showed over 10% earnings growth estimates in Q4 and Q1. I and several CNBC pundits pointed out that those Q4 and Q1 estimates are completely unrealistic.

Well, now is the time that those unrealistic estimates are finally coming down. Fourth quarter estimates of earnings growth are now only 3%.

CNBC anchor Bob Pisani's fourth quarter earnings growth summary. <font face=Arial size=-2>(Source: CNBC)</font>
CNBC anchor Bob Pisani's fourth quarter earnings growth summary. (Source: CNBC)

CNBC's Bob Pisani discussed these changes, highlighting the major ones with the adjoining graphic. Stocks for financial institutions had been expected to grow by 0.7%; instead, growth is negative, down 20%. Stocks for retailers for consumer discretionary spending had been expected to grow by 22%; now the estimate is only 15%.

Chances of a recession

For at least a couple of years, pundits have debated whether a recession was coming, especially in view of escalating energy prices, and the bursting of the housing bubble. The analytical view was that consumers would have less to spend because of increasing energy prices, and falling real estate prices would make it impossible for consumers to borrow money by refinancing their homes.

What's happened for several quarters now is that consumers have continued to borrow, but on their credit cards, with the result that retail spending has continued to grow.

But now the "chickens are coming home to roost," as the saying goes, and consumers finally appear to be spending less.

The stock market bubble in the last few years was based on this willingness of Americans to buy more and more on credit, using money provided through the astronomical credit bubble. But as these bubbles burst, consumers and businesses alike are becoming more risk-averse.

On CNBC on Friday afternoon, David Rosenberg, chief North American economist at Merrill Lynch, made the case why a recession is coming.

What's interesting about this interview was the behavior of the interviewer, well-known CNBC anchor Maria Bartiromo. This chick is an enormous cheerleader for the bubbleheads. I mentioned a couple of months ago one day when the market went up that Bartiromo "was so giddy that she jumped up and down like a schoolgirl."

In this interview, she was openly hostile to Rosenberg's discussion of the factors leading to a recession. Here's Rosenberg's first response to why a recession is coming:

"We had a number today [indicating] that the recession may already be starting. The industrial production number. The production of consumer goods was down .3% - it's now down 3 months in a row.

Another sign: We have the worst credit crunch since 1991; we have the worst energy price information since 1991; we have a situation where employment growth has been cut in half; and you can see already in the consumer confidence numbers we're going into the most important season of the year for retailers, and consumer confidence is actually weaker today than it was in the onset of the past two recessions.

David Rosenberg, Merrill Lynch, on CNBC.  On the bottom, Maria Bartiromo glares at Rosenberg to convey disbelief. <font face=Arial size=-2>(Source: CNBC)</font>
David Rosenberg, Merrill Lynch, on CNBC. On the bottom, Maria Bartiromo glares at Rosenberg to convey disbelief. (Source: CNBC)

And what people are telling you in these surveys is that people are pulling back in their selling intentions, and it's primarily what we've seen in the housing market, the credit crunch, reduced employment prospects, and of course these punishingly high gasoline prices now as well."

Bartiromo asked where there were weaknesses in the economy besides housing.

"Out of the retail numbers, you're seeing a slowdown in practically every consumer discretionary, consumer cyclical outside of restaurants. Restaurants and travel and tourism -- because of the weak dollar I would say that part is absolutely booming - but you're seeing it across apparel, you're seeing it in department stores, you're seeing it in furniture, applicances, electronics. You're even starting to see it now out of the data in "etailing" [[electronic retailing]] - so online shopping's also slowing down. So it's actually -- even outside housing it's becoming very broadly based. This is no longer a "contained" story, just the latest in the housing market.

Bartiromo: But what about the other side, that the global story remains intact, we're seeing economies around the world doing very well, American businesses are benefiting from that.

Rosenberg: That's an overbought story, and frankly I don't even think it's true any more."

Now, here's where Bartiromo became super-indignant. "How is it not true any more? You've got India growing 9%, China growing 12%, and Europe up 3%. What do you MEAN it's not true any more?"

As she said that, she raised her eyebrows, opened her mouth, and effected a glare that a woman might use to convey doubt that the lipstick on her boyfriend's collar had an innocent explanation.

Rosenberg stuttered a little under this hostile glare, but pushed on:

"OK, well look, the UK - is it speeding up or slowing down? It's slowing down. Is continental Europe speeding up or slowing down? It's slowing down. Japan's probably going to be negative this quarter. When you take a look at the part of the global economy that's actually slowing down right now, it's 60% of our exports. So yeah, it's nice to talk about India, Russia and China -- but when you take a look at these bricks, the emerging markets, they represent 10% of our exports. 60% of our export pie in terms of where it goes globally, is actually slowing down right now, so the export story -- I'm not going to stay it's not a positive story. It's been completely overblown."

It doesn't appear that Bartiromo understood the point Rosenberg was making, as she asked, "How much can China slow down so it's going to be a problem? It's growing 12%, so it slows down to 10% -- I'm supposed to be worried at that?"

Rosenberg concluded,

"No, but if China slows down, how does that affect the United States? Maybe if China slows down, it's gonna affect emerging markets. China's the one that exports to the US. We don't really export to China. That's my major point, Maria. Who are our primary export destinations? It's not China. It's Canada, it's Mexico, it's the UK, it's Euroland, it's Japan. They're all slowing down. I would say take the last 12 months, and transcend it on the next 12 months is a very dangerous game right now. The global economy is slowing. It doesn't mean that there's not pockets of strength. Unfortunately the pockets of strength are not where the US exports to."

When Rosenberg referred to "pockets of strength," Bartiromo could be heard to exclaim, "Aha!"

Bartiromo thanked Rosenberg for coming on the show. Later in the hour, when the Dow Industrials index increased, Bartiromo once again squealed with delight like a schoolgirl.

Mervyn King predicts severe fall

Mervyn King, Governor of the Bank of England. <font face=Arial size=-2>(Source: Bloomberg)</font>
Mervyn King, Governor of the Bank of England. (Source: Bloomberg)

Mervyn King is the Governor of the Bank of England, and plays the same central banker role for Britain that Ben Bernanke does for the US as Chairman of the Federal Reserve Bank.

It was just three weeks ago that the Bank of England issued a report saying that the global financial system is at risk of further instability because of "ongoing uncertainties" about credit-market losses, and that both the stock market and commercial real estate values are particularly vulnerable to "further shocks, either in credit markets or from new sources."

Now Mervyn King is adding an "extremely unusual warning" about the world stock markets. His point was that the August credit crunch was so severe that it should have driven stock prices down.

(I just love this. King is totally confused because investors drove the stock market up, even though the financial news was very bad. Poor Mervyn King just doesn't understand the bubblehead investor logic that "bad news is good news" that's prevailed for several years: If the news is bad, then the Fed will lower interest rates, and so the news is really good.)

"It is very striking that despite the developments we've seen in the last three months , despite the stresses and strains in the banking sector , equity prices are higher now than they were in August. ... This is true around the world, and in emerging markets they're 20% higher. There must be some downside risks there. ... That's the bigger risk to the global economy than the narrower one focused on the banking sector. ...

The repricing of risk hasn't really fed through to equity markets, and if there were to be an adjustment of risk premia in equity markets with a fall in asset prices then that could have a bigger impact on the world economy. ...

The difficulty in the world economic system at present is that a number of major economies have flexible exchange rates... Others, like China, have linked theirs to the dollar and that is causing great currency tensions.

I came away from the [International Monetary Fund] meeting more concerned about the implications of these tensions, because the unwinding of [global economic] imbalances is not just a hypothetical prospect, but is happening now. And I think this is a major concern."

The last paragraph is important, because it describes the current situation in a way that few people seem capable of understanding: The financial crisis has already begun.

I'll repeat an analogy that I've used before. Think of the world economy as a huge, enormous bloated mansion made of wood, with all kinds of additions tacked on all over the place. Think of the CDOs as millions of termites that are eating away at the insides, so that another piece of the mansion falls off into the ravine almost every day.

The Fed and other central banks have been running around the mansion with hammers and glue and nails, patching things up as fast as they can, trying to keep ahead of termites. They've been pretty successful with their hammers and glue and nails in postponing the inevitable, even bloating the mansion up a little more, but they can't keep up with the termites.

What Mervyn King is saying is that the hammers and glue and nails aren't working, and that it won't be long now before the entire mansion collapses into the ravine.

Nouriel Roubini: Systemic Financial Meltdown

I've mocked Nouriel Roubini before, and recently criticized him further, because he repeatedly presents a great deal of data in his blog showing that the economy is headed for a major crisis, but he remains completely unwilling to draw that as a conclusion. Instead, he equivocates over whether the economy will have a "soft landing" or "hard landing."

On Friday, Roubini turned around. The data is too great for even him to ignore. In his Friday blog entry he wrote the following:

"Those of us who warned for the last 12 months about a combination of a worsening housing recession, a severe credit crunch and financial meltdown, high oil prices and a saving-less and debt-burdened consumers being on the ropes causing an economy-wide recession were repeatedly rebuffed the consensus view about a soft landing given the presumed resilience of the US consumer.

But the evidence is now building that an ugly recession is inevitable. Thus, the repeated statements by Fed officials that they may be done with cutting the Fed Funds rate are both hollow and utterly disingenuous. The Fed Funds rate will be down to 4% by January and below 3% by the end of 2008.

More revealing of the change in mood the financial press and some of the most prominent market analysts are coming to the realization that a recession is highly likely. The Economist has a cover story and long piece arguing that a US recession highly likely (and citing this author's work with Menegatti and our views on the inevitability of such a recession)."

Roubini gives several more examples to show that the mood has changed in the financial press.

As I've said many times, the important things from the point of view of Generational Dynamics are the attitudes and behaviors of the large masses of people, entire generations of people. Although Roubini (probably) knows nothing about generational theory, his remarks are exactly to the point that the mood is changing, and that this widespread change in mood is significant.

What is most breathtaking about Roubini's Friday essay is his conclusion:

"I now see the risk of a severe and worsening liquidity and credit crunch leading to a generalized meltdown of the financial system of a severity and magnitude like we have never observed before. In this extreme scenario whose likelihood is increasing we could see a generalized run on some banks; and runs on a couple of weaker (non-bank) broker dealers that may go bankrupt with severe and systemic ripple effects on a mass of highly leveraged derivative instruments that will lead to a seizure of the derivatives markets (think of LTCM to the power of three); a collapse of the ABCP market and a disorderly collapse of the SIVs and conduits; massive losses on money market funds with a run on both those sponsored by banks and those not sponsored by banks (with the latter at even more severe risk as the recent effective bailout of the formersí losses by theirs sponsoring banks is not available to those not being backed by banks); ever growing defaults and losses ($500 billion plus) in subprime, near prime and prime mortgages with severe known-on effect on the RMBS and CDOs market; massive losses in consumer credit (auto loans, credit cards); severe problems and losses in commercial real estate and related CMBS; the drying up of liquidity and credit in a variety of asset backed securities putting the entire model of securitization at risk; runs on hedge funds and other financial institutions that do not have access to the Fedís lender of last resort support; a sharp increase in corporate defaults and credit spreads; and a massive process of re-intermediation into the banking system of activities that were until now altogether securitized.

When a year ago this author warned of the risk of a systemic banking and financial crisis Ė a combination of global liquidity and solvency/credit problems - like we had not seen in decades, these views were considered as far fetched. They are not that extreme any more today as Goldman Sachs is writing today on the risk of a contraction of credit of the staggering order of $2 trillion dollars in the next few years causing a severe credit crunch and a serious recession. As I will flesh out in a forthcoming note the risks of such a generalized systemic financial meltdown are now rising. Hopefully by now some folks at the New York Fed and at the Fed Board are starting to think about this most dangerous systemic financial crisis that could emerge in the next year and what to do to prepare for it."

Roubini is very late to the game in saying these things, but that fact alone gives his remarks greater significance. What's interesting is that he provides a step by step scenario about how he expects the system to break down.

Even now, he's hedging. His final sentence says that the crisis "could emerge in the next year." He's still covering his ass, apparently for fear that God, in a massive deus ex machina intervention in human affairs, will smite the financial engineers and restore the global economy to normalcy. I don't think that's in the cards.

Some Observations

On August 17, I posted an article entitled "The nightmare is finally beginning." I indicated that we were now on the road to a stock market crash in the near future. The exact timing couldn't be predicted, but the speculation was that it would happen by the end of September.

It didn't happen at that time, but the trends have only been getting worse. Today the trend lines are MUCH WORSE than they were on August 17.

Perhaps most significant of all is that the mood of gloom and doom is saturating the investment community, including investors and pundits, except for Maria Bartiromo.

From the point of view of Generational Dynamics, there have been a series of generational financial panics and crashes, of international significance, every 70-80 years or so. Since the 1600s, these have been: the 1637 Tulipomania bubble, the South Sea bubble of the 1710s-20s, the bankruptcy of the French monarchy in the 1789, the Panic of 1857, and the 1929 Wall Street crash. Each new bubble begins precisely when the people in the generations that survived the preceding crash all disappear (retire or die), all at once, leaving behind younger generations with no wisdom and no fear of the horrors of a generational panic.

We're now overdue for the next generational panic. It might happen next week, next month or next year, but it MUST happen soon because the stock market is overpriced by a factor of 250%, same as in 1929. The worsening trend lines indicate that it's getting close. (17-Nov-07) Permanent Link
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