In my most recent post, I gave a fairly comprehensive retrospective of the year that was. Near the end of that post, I listed a number of posts I wrote in October and November which point to how I see 2009 shaping up. Let me give you a more direct assessment here. I will finish it off with my top ten predictions for 2009.
2008 was a disaster. The subprime meltdown actually started in February 2007, giving policy makers plenty of time to act. However, inaction proved fatal as the subprime crisis metastasized into a global credit crisis that did not take full form until this past year. In so doing, it revealed a number of inherent weaknesses in the global financial system which I believe will play out in 2009.
The first problem to note is global banking fragility. It bears noting that after the Japanese banking crisis, many prognosticators pointed to the weak capital structures at Japanese banks as a cause for the crisis. I felt then and still do today that they had it backwards. Poor lending practices made institutions in Japan that previously seemed well-capitalized into capital weaklings. This will be very much the case globally in 2009.
In the U.S., Ireland and the U.K. in particular, there are significant loan losses that have yet to be taken. This is partly due to the fact that loans are carried at book value until the borrower cannot pay. On the other hand, freely traded securities like Mortgage-backed securities must be written down immediately to reflect market values. That has meant that institutions which have credit risk held in the form of marketable securities have taken the lion's share of the pain. I expect that to change in 2009.
Going forward, real economy problems i.e. default and bankruptcy will become an issue. That means that those hidden loan losses will have to be taken. You should note that I am definitely suggesting the following: had loans been traded in the same way that mortgage-backed securities were, we would have seen a tidal wave of losses here already.
Which countries and which asset classes are vulnerable? From a country perspective, one could look first to the first bubble economies to pop as canaries in the coalmine: Ireland, Spain, the U.K. and the U.S. I will not make any predictions about Spain, but I will say that I do expect to see horrific loan losses in the other three countries.
Asset Class Weakness
From an asset class perspective, here is my thinking:
- Residential Property - In the U.S., Alt-A payment resets approach and recession will start to hit through unemployment. Therefore, expect to see Alt-A loans go sour as their subprime brethren did before. This class includes those exotic mortgage types like no-payment, option ARM, and negative amortization loans to prime borrowers. As there are many Mortgage-backed securities of the Alt-A variety, these loan losses will lead to writedowns at those same banks that have had massive writedowns already, further impairing their capital base. The subprime crisis is less of an issue at this point. In the U.K. and Ireland, property prices will decline in 2009 and unemployment will rise. This double whammy will mean mortgage defaults will rise and loan losses will increase at those institutions most levered to the residential property markets.
- Commercial Property (CRE) - I was way too early on this asset class, expecting to see major losses in 2008. But, CRE will be front and center in 2009. Why? It stands to reason that in recession, businesses are hit as consumption growth slows or goes negative. This will depress demand for commercial property, driving down lease prices. Simultaneously, retailers will struggle and this will increase defaults. That means much less income and huge loan losses for CRE REITs and commercial property-oriented financial institutions. This will be true in the U.S., Ireland and the U.K. at a minimum. However, although I am not making a forecast here, I am also hearing much the same across the Eurozone.
- Leveraged Loans and High Yield - These asset classes are sporting record yields because credit quality has deteriorated significantly across the board. For instance, at the tail end of the boom, there were many more low quality single B rated bonds. Leveraged loans are those loans given to finance higher risk, leveraged buyouts. "High yield" is simply a moniker used for lower quality bonds. It stands to reason that poorer asset quality loans and bonds will be hit first during a downturn. That means leveraged loans and high yield will suffer before any other corporate bond and loan class. This is going to be true in the U.S. and in Europe across the board. (See Wikipedia's entry for high yield debt).
- Credit Card and Auto Loans - Here is another class that will implode the balance sheets of major banks because of tradeable asset-backed securities (ABS). We have already seen credit card chargeoffs increase significantly. Even American Express, generally considered the highest card quality provider, has been experiencing increased loan losses. Now, remember, there are boatloads of auto and credit card ABS bonds trading in the open market. These securities will be severely impaired and writedowns will be enormous. I predict some institutions will fail as a direct result of these writedowns.
- Eastern European Loans - Countries like Ukraine, Hungary, Latvia, Estonia and Poland are going to see major downturns. Unfortunately, this will mean currency weakness. That has a major impact on debtors in those countries as they have borrowed in Euros (much like Icelanders had). Combine the currency impact with recession and you have the makings of a debt crisis. The banks loaning Eastern European corporates and homeowners these funds are situated in countries like Austria, Germany, Denmark, and Sweden. Therefore, expect significant writedowns at major European institutions as these loans sour. Will this be Europe's equivalent of the Latin American debt crisis of the 1980s? Yes.
- Other Asset Classes - We are talking about prime mortgages, ordinary bank loans, and corporate loans. These will suffer impairment because of the recession, but the problems here should be much less than in the asset classes I identified above.
It is extremely difficult to call currencies. In 2009, it will be especially difficult because there are potential trouble spots everywhere.
However, on the whole, one should expect the British Pound and the U.S. Dollar to be weak currencies as their central banks are going to resort to quantitative easing in order to forestall depression. The ECB is less likely to do so despite the problems in Ireland, Spain or Greece. At its core, the ECB is an institution controlled by the Germans, French, and Belgo-Dutch. These hard money types will be reluctant to resort to ZIRP (a zero interest rate policy) or quantitative easing. So, I expect the Euro to be strong.
Why the Yen remains strong is beyond me because the Japanese are about to engage in quantitative easing and ZIRP. They have experienced a very hard landing. But, the carry trade is no longer as appealing because foreign interest rates are falling as other central banks cut rates. So the desire to unwind carry trades is supportive of the Yen. I expect a strong Yen.
I'll leave it at that for currencies, except to say that Latvia will be a test case for Eastern Europe as the IMF did not require a competitive currency devaluation there as part of a bailout package. It remains to be seen how that will play out. I reckon we will see economic pain followed by capitulation and devaluation. Russia is doing the right thing in devaluing, although that reduces the standard of living (through high import prices) and invites civil unrest. Let's wait and see.
Ten Predictions for 2009
So, now it is time for me to lay it on the line and make my ten predictions. Here they are:
- The Obama Administration will not be a significant change from the status quo economically. As a result, they will drag their feet on offering a comprehensive banking solution, leading to another (fatal) banking crisis in 2009 from ABS losses.
- The Obama Administration will satisfy cultural liberals by re-regulating the banking industry heavily and by massive spending on public works. Liberals will be ecstatic about American jurisprudence: Obama will appoint at least two liberal Supreme Court justices to the bench as Ruth Bader Ginsburg and John Paul Stevens step down.
- The Obama Administration will be faced with a state government bankruptcy. They will bail out the state and promise to do the same again, much to the liking of liberals and municipal bond holders.
- Eastern Europe will face depression, much as Asia did in 1997. The result will be civil unrest and a near collapse of the European banking system.
- The Irish banking system will suffer a crisis of confidence as the Irish will come to be seen as the next Iceland: oversized banking sector, huge loan losses. The European Union will bail out the entire Irish banking system.
- Oil prices will sink to $25 a barrel before rising back to $55 by the end of the year.
- China, damaged by a huge decline in export demand, will undergo a massive stimulus campaign. It will not be enough. GDP growth will drop to 2% and civil unrest will ensue.
- Tariffs, export subsidies and currency devaluations will roil the desire for free trade. Initially, countries will seek relief at the WTO (World Trade Organization) but later they will begin to act unilaterally. The U.S. will be the first to unilaterally retaliate.
- U.S. house price declines and subprime defaults will slow. Prime and Alt-A defaults will increase. Meanwhile, Irish and U.K. mortgage defaults will increase dramatically.
- The U.S. will begin to initiate detente with Venezuela, Cuba or Iran. The moves will be heralded as a foreign policy coup on the lines of the Sino-American detente under Nixon. Obama's status abroad will be boosted.
So, there it is. My ten predictions. I think this set of ten is pretty bold, actually. So I expect to be very wrong on many of them. Hopefully, it gives you food for thought. Please feel free to call me out on an especially good/bad prediction or opine on your own predictions in the comment section.