Ten Things You Can Worry About

by: David Merkel, CFA

I've been picking up on some comments from my previous post, such as: Why am I not concerned about counterparty exposure? Because Wall Street has always been very good at cutting off overleveraged clients in the past, that's why. LTCM was an exception there, and only because Wall Street gave in to their request for secrecy. Wall Street grabs collateral first, and then lets the client argue to get it back. The investment banks require a significant margin, and when there is significant concern about getting paid, the lines get pulled.

1) The real worry here is that the investment banks don’t have good enough risk controls for each other. Note that Bear’s crisis started when other banks stopped extending credit to Bear, and the fear fed on itself.

I liken the investment banks to long-tail commercial casualty insurers. No one knows whether the reserves are right. No one can. Confidence is a necessary part of the game, which is made easier at lower levels of leverage. But high leverage and opaqueness are a recipe for disaster when volatility rises.

2) Should you worry about Fed policy? Yes. The Fed is steering away from the Scylla of a compromised financial sector, and into the Charybdis of inflation. As I will point out later, that is already having impacts on the rest of the world. As for now, there are a few ill-informed writers who say that a negative TIPS yield on the short end is a reason not to buy TIPS. That might be correct if inflation mean-reverts. Given the short-term resource scarcity building in our world, I don’t think that is likely.

3) Should you worry about the US Government budget deficit? A little — oh, and worry about the real deficit, one that puts the wars and other emergency appropriations on-budget, and takes out the excess cash flow from Social Security. In a macro sense, for the nation as a whole, the impact isn’t that great… but it sends a message to foreign creditors who wonder what the value of the dollars will be when they get paid back. When they see the Fed running an aggressive monetary policy in the face of rising inflation and a weak dollar, it makes their heads spin, as they contemplate the hard choices the weak dollar forces on them.

4) Could the falling dollar cause a crisis in China? Maybe. China is levered to US growth, which is slowing, and their export competitiveness versus the US declines as the dollar declines. And what will they do with all of those dollar reserves? Beats me. After a certain point, additional reserves are useless — it is akin to lending more to an entity that you know is insolvent. My guess is that the yuan will get revalued after the Olympics, and then the real slowdown will hit China.

5) What of foreign food riots; are they a worry? (More, and more.) A little. They are a canary in the coal mine. They point to the short-term scarcity of total resources in our world, which only becomes obvious as a large part of the world tries to develop. But, one practical thing that it implies is that energy and food prices will remain high for some time. We are one global market at present, and energy and food prices are interlinked through the energy and fertilizer costs of farmers, and through stupid ideas like corn-based ethanol.

6) What of flat crude oil production? Yes, worry. As I have said before, the government oil companies of OPEC countries control most of the supply, but they don’t always manage their resources as well as a capitalistic oil company. Mexico, Venezuela, and Russia have declining production, to name a few. The Saudis may not want to produce more, because they don’t know what to do with all the US dollar reserves that they have today. Or maybe they can’t …

7) Worry about falling housing prices? Yes. The problems in the housing market stem from overbuilding. There are too many houses chasing too few solvent borrowers. This will eventually affect prime mortgages, because declines of 15-20% in housing prices mean that many prime loans would be underwater in a sale. Remember, an underwater loan becomes a default after a negative life event — unemployment, death, disability, divorce, and uninsured disaster.

Before all of this is done, one of the major mortgage insurers should fail. We aren’t there yet.

8 ) What of falling residential real estate prices in foreign countries? Yes, worry. For Europe, it could lead to the end of the Euro, as countries needing looser monetary policies get tempted to abandon the Euro. If the Euro’s existence becomes questioned, it will be a systemic risk to the world.

9) What of credit card delinquencies? Yes, worry. It shows that total financial stress on the consumer is high, particularly when added to the problems in mortgage and home equity loans.

10) Should you worry about bank solvency? A little. All of these previously described stresses have some bearing on the ability of the banking system to make good on their obligations. Be aware that the FDIC was designed to handle sporadic losses, not systemic crises. The odds of these problems affecting the depositary financials is still low, but the protective measures will not be capable of dealing with the worst case scenario, should it arise.

Perhaps I have more to worry about. As I close up here, I haven’t mentioned the PBGC, Medicare, and a variety of other problems. But, I have to stop somewhere, and symmetry with my other piece is worth a little to me.