I do not toss around the idea of a market crash lightly. If you've been
following me long enough, you know that only in very rare instances do I issue a
cautionary Alert (I've only issued four since my website launched in 2008), and
I am generally not given to hyperbole.
Let's be clear: I'm not issuing an Alert at this time. But I am concerned
that a materially adverse disruption to the financial markets is increasingly
likely in the near future.
Perhaps a definition will be helpful as we begin. A 'market crash' is an
event where there are no bids to meet a wall of selling. The actual amount of
the percentage decline is less important to note than the amount of chaos, or
loss of control, that a given market experiences. Some like to say that a market
downdraft requires a decline of 10%, or maybe even 15% or 20% (or more), in
order to qualify as a 'crash.' For me, the key factor is not so much the amount
of the decline, but the
pace of the decline.
With perhaps a quadrillion US dollars of hyper-interconnected derivatives
outstanding -- that's the notional value, but who really knows what the real
number is? -- an orderly market is essential for knowing whether or not the
counterparty to one's trade is solvent. During periods of intense price swings
in the market, such things are simply not knowable, and spawn the fear and
paralysis that really define a market crash.
The Next Market Crash
Like everybody, I have no idea
when the next market crash will
occur, but I do happen to hold the view that a market crash is on the way. In
fact, my view is that the entire future from here onward will be marked by sharp
plunges (both crashes and regular market declines), followed by periods of
stability, if not apparent recovery.
What I track instead are imbalances and risks. Sort of like being a fire
marshal who takes note of an outlet with fifteen things plugged into it, some
with frayed cords, located near a pile of old cleaning rags. I can't tell you
for sure that a fire will result, only that the odds are elevated. A prudent
person will take steps to remedy the situation or at least prepare for the
possibility of a fire.
Here's one view of the possible trigger for the next meltdown from Dr. Robert
Shapiro, advisor to Presidents Clinton and Obama, and now the IMF, as offered on
BBC Newsnight on October 5, 2011:
"If they cannot address this [the sovereign debt crisis in Europe] in
a credible way, I believe within perhaps two to three weeks, we will have a
meltdown in sovereign debt which will produce a meltdown across the European
banking system.
We're not just talking about a relatively small Belgian bank, we're talking
about the largest banks in the world. The largest banks in Germany, the largest
banks in France that will spread to the UK in part through the sovereign
debt problems in Ireland.
It will spread everywhere because the global financial system is so
interconnected, all those banks are counterparties to every significant bank
in the US and in Britain, and in Japan and around the world. This would be a
crisis, in my view, more serious than the crisis in 2008."
(Source)
What he's warning about here are two main things. The first is the risk of
contagion, where problems in one area spread to another because everything is so
intertwined. The second is that you can count on the rot spreading from the
weaker periphery to the stronger core. Crisis always progresses from the outside
in.
That dynamic has been playing out for months, and it should be obvious to the
most casual of observers that the Greece situation has not been improved one
iota by any of the steps yet taken.
The stakes could not be higher. Normally staid politicians are letting their
guard down and saying previously unthinkable things. For example, this shocker
recently came from the Polish finance minister:
Poland warns of war 'in 10 years' as EU leaders scramble to contain
panic
Oct 14, 2011
Speaking to MEPs in Strasbourg on Wednesday morning (14 Sept) [the Polish
finance minister] warned of the need to act rapidly to prevent grave danger for
the EU. Making reference to a recent report entitled 'Euro Break Up - The
Consequences' by Swiss financial giant UBS, he declared: "There is no doubt
we are in danger. Europe is in danger".
The paper by UBS, normally known for its highly sober analysis, warned that
historically, monetary unions do not break up without civil war or
some other form of authoritarian reaction. "The risk of civil disorder
questions the rule of law, and as such basic issues such as property rights.
Even those countries that avoid internal strife and divisions will likely have
to use administrative controls to avoid extreme positions in their markets", it
said.
The Polish minister went on to warn of a doubling of unemployment within
two years "even in the rich countries".
He concluded his comments by recollecting a recent conversation he had with
an old friend who is now head of a major bank: "We were talking about the crisis
in eurozone. He told me 'You know, after all these political shocks, economic
shocks, it is very rare indeed that in the next 10 years we could avoid a war'.
A war ladies and gentlemen. I am really thinking about obtaining a green card
for my kids in the United States".
(Source)
I'm not sure whether the US will be a much better place to ride out the storm
if the European banking system collapses, as it will be only a matter of time
before the US is exposed as being just as financially and fiscally ruined as the
EU.
Supporting this view is a rather famous Harvard economist (and the probable
successor for Bernanke's current position, according to some rumors):
Martin Feldstein says there's a "nontrivial" chance the U.S.
economy will turn down again and calls the recovery "about as bad an
expansion as I've ever seen."
Another downturn here will further expose the fact that there are still
towers of tottering debt that can only be serviced by an expansion, and a robust
one at that. With this next revelation of systemic weakness, expect more debt
defaults, institutional failures, and the same sort of banking weakness seen in
Europe to occur in the US.
In short, there's every chance here that an even worse repeat of 2008 could
happen at any time. And in my estimation, the chance that this will come in the
form of a market crash is too high to ignore.
Right now, with the rot creeping from the outside in, I see those chances as
not only high, but rising.
From the Outside In
It can be very difficult to envision what an 'outside in' crisis looks and
feels like. In order to get a better feel for the dynamic, we turn to Phoenix,
Arizona for an excellent case study.
Once the darling of the housing boom, with endless desert building lots
enabling the most egregious sort of bubble sprawl, Phoenix is now in the grips
of a horrific housing crash. Like all big adjustments, it appears to those
experiencing it to be in slow motion:
Phoenix-area real estate collapse echoed troubles
Oct 9, 2011
A look at metro Phoenix's foreclosure crisis over the past five years shows
an economic crash moving through time and space.
The collapse started in new-housing areas on the fringes and then swept
inward, hitting more established areas as the unemployment rate climbed.
Now, as the stock market struggles and speculation swirls about another
recession, foreclosures are flaring in the Valley's luxury-home
neighborhoods.
(Source)
That's a perfect illustration of the 'outside in' dynamic. At the beginning
of the bubble's burst, it was almost certainly unthinkable to the inhabitants of
the wealthier neighborhoods that they would get swept up in the cataclysm. But
they did -- first the weaker and more distant locales, then the middle-strength
ones, and then the core.
The article continues:
A new Arizona Republic analysis, which maps out every home in default in the
region over the past five years, is the first comprehensive look at the wave
of foreclosures that has swept the Valley since the market began its steep
decline in 2007.
The analysis, based on data from Phoenix foreclosure-information service AZ
Bidder, plots individual foreclosures and overall trends by year.
It shows how the Valley's foreclosure crisis was more than one crisis.
Foreclosures arose in waves, driven first by problematic mortgages, then by
the job woes of the recession and now by lingering economic effects being felt
in expensive neighborhoods.
(Source)
It wasn't just caused by housing weakness alone, but the way that housing
weakness led to job weakness, and how they ended up preying together on
confidence in the bubble and ultimately dragging down the local economy.
One more perfect passage from that article that illustrates our point:
As Phoenix's foreclosure crisis crept inward from the fringes
during late 2008, it was being driven not just by subprime lending but also
by the economy at large.
The state and the nation had fallen into a recession. Hundreds of thousands
of jobs, many in the construction industry, were lost in Arizona.
As metro Phoenix's unemployment rate climbed, so did foreclosures. The
number of borrowers losing Phoenix-area houses to lenders hit a record in
2009.
Foreclosures began to affect communities closer in, where less speculation
and new building had taken place. Chandler, Gilbert and Glendale, as well as
central and north Phoenix, began to see foreclosures climb and home values
fall.
(Source)
Similarly, the European debt crisis began in the weakest locales first
(Ireland and Greece), then infected the middle countries (Portugal, Italy, and
Spain) and now threatens to overrun the core (Germany and France). A wave of
sovereign defaults will sweep across the region, progressing from the outside in
with a self-sustaining and self-reinforcing dynamic, unless somehow stopped.
That's the important risk to focus on. And whether the crisis is a little one
or one that ends in everyone's worst fear -- another war on the Continent --
remains to be seen. But the probability of an approaching market calamity is
non-trivial. So that brings us to the main insight we are trying to convey here:
We need to be prepared for a major market clearing event that finally allows the
rot to be cleared from the system.
Progressive Failure
The problem in Europe is very far from resolved at this point, the recent
happy noises about Belgium nationalizing part of Dexia bank notwithstanding. As
an aside on that matter, I found this to be quite interesting:
Belgium nationalizes part of Dexia bank for $5.4B
Oct 10, 2011
The Belgian state will buy the national subsidiary of embattled bank
Dexia for euro4 billion ($5.4 billion) and provide tens of
billions of euros in new guarantees as part of a wider bailout of the lender,
the first victim of a new squeeze in European credit markets.
On top of the nationalization, the governments of Belgium, France and
Luxembourg together will provide an additional euro90 billion ($121
billion) in funding guarantees for the bank for up to 10 years.
Belgium will provide 60.5 percent of these guarantees, 36.5 percent
will come from France and the remaining 3 percent from Luxembourg.
(Source)
This means Belgium is potentially on the hook for $78.6 billion in bailout
funds for a single institution, which amounts to 17% of GDP (2010 figure). To
put this into perspective for our US readers, that would be the equivalent of
the USA guaranteeing $2.6 trillion...for a
single bank. Anybody care to
guess whether the amount that they decided to guarantee will be ultimately
sufficient to cover the actual amount of the total potential losses? My guess is
that over time the number will prove to be far, far below the final and true
cost.
Even if the Dexia situation has been temporarily stabilized, Greece has not,
and this is where the Europe story really begins. With Greek ten-year notes over
24%, two-year notes of 75%, and one-year notes over 150%, there is virtually no
chance of anything happening other than a Greek default.
A writedown of Greek debt is inevitable here; the only question is, how much?
Here's the current view:
Europe Divided on Greek Writedowns That Juncker Says May Top 60%
Oct 11, 2011
European Central Bank President Jean-Claude Trichet said Europe’s debt crisis
now threatens the region’s financial system as officials race to put
together a new plan to end the turmoil.
“The crisis has reached a systemic dimension,” Trichet told lawmakers in
Brussels today in his capacity as head of the European Systemic Risk Board.
“Sovereign stress has moved from smaller economies to some of the larger
countries. The crisis is systemic and must be tackled
decisively.”
European leaders are trying to shore up the region’s banks as they debate how
best to manage the fallout from any Greek default. Governments yesterday pushed
back a summit amid opposition to Germany’s drive for deeper-than-planned Greek bond writedowns
that Luxembourg’s Jean-Claude Juncker says may exceed 60 percent.
“Time is always of the essence when you have to be in a mode of crisis
management,” said Trichet.
(Source)
A 'writedown' is just another of many more pleasant-sounding terms that are
being used instead of 'default,' which is precisely what Greece will soon be
doing.
With the triggering of a default, the fear of contagion will spread, because,
frankly, nobody really knows where the time bombs are located in the credit
default swap (CDS derivative) markets. Sure, we can know roughly who is holding
what, but each of these holdings is then linked to the primary institutions' own
credit ratings, which themselves have vast piles of CDS paper attached to them.
In other words, everything is so interconnected that it's nearly impossible for
anyone, even the owners of these derivatives, to conduct an accurate
risk-assessment or predict how they're going to behave during a market
dislocation.
These in turn are held by other institutions and funds, which are heavily
leveraged and exposed to the very same market forces that will assure that the
exact opposite of hedging will erupt during the hairiest part of the coming
rout.
For perspective, Greece has nearly 330 billion euros ($445 billion) of debt
outstanding, on top of which CDS paper has been layered. That is, if Greek debt
gets a 60% haircut, the basement-level losses we can expect as a result are $270
billion, but the CDS paper will certainly amplify that number much higher for
some unlucky institutions.
For even more perspective, consider that Spain and Italy have nearly $3.4
trillion in debt, making their combined predicament worth about 7.5 Greek
dramas.
If you think the big banks represent the smart money, I would remind you that
when the subprime CDS disaster finally blew up, it was the big banks (and AIG)
that were holding the bag -- supposedly the smartest of the smart money. I
somehow doubt they are going to be any smarter this time.
The contagion fear here is that several mega banks (and/or funds) will fail
as a result of these cross-correlated and therefore unhedged bets. When the
European Banking Authority ran their stress tests a while back, several very
large banks in Spain and France barely passed, and that was without booking any
losses on any of their outstanding loans to Greece, Ireland, or Portugal. If one
tips over, so will the rest, because they all owe each other.
To simplify, here's a picture of the world banking system as it currently
stands:
Another form of contagion will come with the thought that if one major
Western economy can default, others can, too. A precedent will have been set,
and other over-indebted economies will suffer higher interest rates on their
borrowing as a result. The thing about higher interest rates is that once they
are past a certain level, they become self-fulfilling prophecies, virtually
assuring that default is a mathematical inevitability (see
Greece,
above). Over the long haul, interest rates over the long haul cannot be higher
than the nominal rate of GDP growth, generally speaking. In today's low-growth
environment, that is a low bar, indeed; perhaps just 2%-3%.
A final concern for European banks (in particular) concerns bank runs, in
which institutional and retail depositors decide to flee a given bank, causing
it to topple over, as the first domino in a long line.
The bottom line here is that the European situation is quite far from
resolved, and as we've been saying all along, it really can't until large losses
are taken by
someone. For now, the banks are trying desperately to
convince the world that the losses should be shared by everyone through the
miracle of inflation (with central banks printing money, a.k.a. "quantitative
easing" or QE, to buy the bad debts off the banks) while the people of various
countries are increasingly protesting this regrettable practice of socializing
banks' losses, yet allowing privatized profits.
Expect Volatility
The key point to understand about our economy is that it is anything but
straightforward and linear. It is a complex system, meaning that it has two
characteristics of which we should be aware: It requires energy to maintain
and/or increase its complexity, and it is unpredictable.
One typical feature of complex systems is that they tend to jump rather
abruptly from one state to the next. Where they can exist in some sort of
seeming equilibrium for quite a while, a sufficient exogenous shock (or a change
in conditions, such as becoming energy-starved) can often cause them to
transition rather suddenly to the next point of 'equilibrium'.
Said more simply, systems often have tipping points, where they no longer
react to insults proportionally, but chaotically and sometimes violently.
Phoenix, Arizona was coasting along just fine until experiencing a tipping point
in its housing market that involved both the job market and the broader economy,
dragging both down on the way to finding a new and much lower equilibrium
point.
Focus on Positioning Yourself Prudently
What we have here is an ideal set of conditions for a tipping point to arise
in our financial system. When such a tipping point occurs, you should expect
wild volatility in the markets and be prepared for things to be moving far too
quickly to react to with any sort of precision or grace.
That's why it's best to be pre-positioned in your financial, physical, and
emotional preparations, so that when the next bout of extreme volatility exerts
itself, little to no immediate action is needed on your part during the
tumult.
Ride out the chaos in safety and confidence. Be a support to those less
prepared within your family and community. And take advantage of the luxury few
will have to plan your next steps carefully, once the corrective forces clear
much of the current uncertainty out of the markets. Doing so will set you up
better than most to prosper in the aftermath.
