2010: Fingers of Instability

The first few fingers relate to the possibility of Banks suffering from “rolling waves of defaults” (Our Man thinks Mike Mayo, of Calyon Securities and formerly Deutsche Bank coined the term a couple of years ago).  Our Man suspects that most of the cases below bear conceptual similarities to sub-prime in that the risks are well understood by the market but that the consequences (especially the secondary and tertiary impacts; as a result of parceling out of risk from the banks to other investors) are not fully appreciated.

- Commercial Real Estate
The weakness of CRE is well-known, with the Moods/REAL Commercial Property Price Index down 44% from its October 2007 peak and reaching levels last seen in August 2002.  Given how well-known the decline is, the general assumption is that defaults will have limited impact on the markets.  With only a limited number of defaults so far, an estimated $1.4trn of CRE debt scheduled to mature over the next 5-years and 50%+ of it underwater (per Foresight Analytics), Our Man thinks we’ve yet to see how this one plays out.

- Residential Real Estate:
While Our Man thinks it is fair to say that most believe that the residential estate issues are behind us, his opinion is that we’re sitting in the midst of a lull period between the first wave of issues and a second wave.  Unfortunately, while the FED/Treasury has done a fine job in delaying (or ‘extending and pretending’, if you’re feeling less generously inclined) defaults and trying to maintain home prices (think HAMP, first-time tax buyer’s credit and it’s extension and expansion, FED buying mortgages, Treasury backstopping Fannie & Freddie, etc), Our Man is of the opinion that this is all it is…delaying.  Things he worries about in Residential Real Estate world are:
 a). The recast schedule for Option ARMs (which is when the payment changes, to reflect full amortization as well as interest payments). 
Given the predominance of homeowners (analysis from S&P, Moodys, etc suggests they are in the 80%+ range) who’ve been paying only the minimum payment (i.e. interest-only), the jump in payment (to include amortization over the remaining term of the mortgage) is far more important than the impact of a change in rates (known as a “reset”).  The difficulty is knowing when the recast will happen, as it will happen at either at the time of the reset (generally 5-years after the mortgage was taken out) or when the negative amortization cap (normally 125% of the original principal balance) is reached.  Given the level of minimum payments being made, it is likely that recasts will happen before the reset schedule.

b) Prime Mortgages default rates well above historic norms.
Our Man can hear you snickering in the background at this one, after all Prime Mortgages are the good stuff and have been around long-before all this financial shenanigans began so we can data-mine and know how they’ve defaulted historically.  However, Our Man notes that the standard (pre-2003) DTI (Debt-To-Income) ratios were 28% (for housing, 33% for Jumbo loans) and 36% (for total debt) and were based (largely) on documented income.  Post-2003, they could be anything up to 50% and in many cases (data varies from 35-50%+of Prime/Jumbo Prime loans) were based upon limited documentation (which Our Man is willing to bet is because the borrowers didn’t have their stated income).   Given these 2 changes; Our Man isn’t certain that the historical data will be an accurate guide to future problems.

 - Bank Lending (general) and Consumer Deleveraging
Our Man has already mentioned that he thinks Bank Lending & Consumer Deleveraging will prove to be the key factors in the coming months (perhaps years).  The reason is simply that they stand at the hub of the primary debate, will the FED's 'quantitative easing' cause inflation or will we see continued deleveraging from an over-levered consumer causing deflation.

- Sovereign Risk
Dubai & Greece have hit the headlines recently, there have been additional worries over Spain and Ireland during the year, Short Japanese Government Bond trades are being put back on (again!) as their Debt/GDP goes through 200% and there’s been a lot of muttering over the last couple of months about how US rates will have to rise substantially (though Our Man's L Treasury position is clearly a wager that this will not be the case), will there be more tumult (especially across Eastern Europe, Italy and Our Man's homeland) to follow.

- Monetary Tightening
While Our Man would be surprised if the FED Funds rate went up any time soon (in part since many blame the FED for raising too early during the Great Depression causing the relapse; though Our Man's view this is that it's a tad hopeful to try and solve a major solvency crisis by injecting liquidity, and then being shocked that the underlying solvency issues remain when the liquidity is removed).

- China
“The Chinese government…are executing their eleventh ‘five year plan.’ They do exactly what they say they will do. They will likely be the biggest economy in the world someday. Man, these guys are good.” - Jeffrey Immelt, CEO of GE, following a speech at WestPoint earlier this month. 
The point of the quote isn't mean to disparage Jeff Immelt (who in OM’s opinion has done a fine job, given the abysmal quality of the hand dealt to him by Jack Welch) but more to display what's the prevailing conventional wisdom China be it from business folk or finance experts (like Nomura's Richard Koo, an expert on Japan) -- China can do no wrong & will grow at 10%+ forever (ok, maybe that’s a touch of hyperbole).  Sadly, Our Man fears reality is never like that...and notes that in addition to  mass certainty in an outcome (house prices never go down & Tech is the new paradigm (and so deserves a new valuation model where profitability doesn't matter) the other 'best' indicator of an asset bubbles is loose credit conditions (and he'd certainly call China's loose). 

- Terrorism
Enough said.

- Global Trade, Protectionism & Emerging Asian Economies
For those who are historically minded, the steady decline of Global Trade and the rise of Protectionism, was one of the noticeable features of the 1930's depression in the US.  That threat is clearly present today (see this week's decision by the US ITC) and will only become more tempting for US firms/ politicians/ people to demand should the recovery prove sluggish.  With so many Asian economies relying on export driven demand (to Japan, Western Europe, and the US), and gearing their industrial production to a pick-up in this demand, the rise (or not) of protectionism home & abroad could be a vital factor.

- Valuation
 From Our Man’s perspective, the market is not cheap; currently, based on the Shiller 10yr P/E ratio, the S&P trades around 20x, which is above the historical average (c16.5x).  Furthermore, Our Man notes the persistent overvaluation of the S&P over the last 20years and despite expectation of a V-shaped recovery, his simple model (using the very generous assumption of $75+ Earnings for the S&P 500 in 2010) the S&P’s multiple looks set to climb next year (towards 22x) even without an increase from the present S&P level.