Ten Things You Can Worry About

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.

Comments

[iThinkBig]

I believe you are correct. Now onto the solutions suggestions articles please.

[Moby Waller]

"1) The real worry here is that the investment banks don’t have good enough risk controls for each other. "

Pretty much agreed

-- although investment companies of all sorts have all kinds of risk controls on paper -- in reality when a division/department/trader is making big profits, they can pretty much do what they want to some degree -- which leads to Rogue Trader type situations as well as giving out idiotic Interest-Only mortgages to everyone and his brother

[proseadvocate]

As a former broker, I don't trust 'wall street' to do anything but lie, cheat and steal from anybody stupid enough to believe that trees grow to the sky. In case you hadn't noticed, hedge funds are not regulated and the managers get overpaid to bet the farm and lose nothing when they loose your (the investors") farm.

[pedro segundo]

NO DOLLARS, NO EUROS,,,THEN?

[vinchenzo]

Guns and food storage!!! ha ha ha

[vinchenzo]

What would PONZI do!

[User 130076]

What, American investors worry we have CNBC to lead the cheers and Kudlow to let us know that as long as the Wall Stret crooks are making Millions, every thing is fine.

[WAKEUP]

You worry. I'm busy.

[Phil Jacksonian]

There is no such thing as foreign reserves. You simply click online and buy 100 million at a shot on vwap until you have a global currency index. This can be done ex-US dollar. That's why the dollar has fallen so much in the first place. Everyone holding dropping currency reserves has already sold privately. How naive to think that sovereign trading pools don't manipulate currency actively and with the push of a button.

[johngonole]

Lots to worry about for sure. Keep on working pay down your debts and marry a Nurse. The food scare is what is interesting to me. This could get worse. Land prices are high making investment in farm land too costly. Ethanol taking up supply. More and more people. Land being bought up for conservation land use....

[Robert Trudeau]

No new information, but I agree with your comments. Yes, there is a Global energy, real estate, and food crisis. That is the crux of the problem, it is not isolated to any one country or region of the world. With M3 growing at an annualized rate of 17-18%, and real U.S. inflation as caculated in 1980 at 12%, sooner or later even the Saudi's will start rethinking their position on the dollar. I don't even want to think about the consequence of that to our highly leveraged economy. As for the investment banks, why should they care about risk control. They make a killing on the upside, and the Fed covers their downside. Talk about encouraging risky behavior. Buffet won't touch most of their illiquid, impossible to understand derivatives. No one knows what the equilibrium price of oil is, but if we don't find a lot more of it within the next few years, we'll sure find out, and it will finally begin to slow global growth. You are exactly right about prime mortgages if home values fall another 20%, which is what I anticipate, although that pain will be spread out over more time than the sub-prime melt down. Food is a big problem when you are talking staples like wheat and rice. This hits everyone, and unlike oil/gas you can't compensate by cutting back on consumption.

[Robert Trudeau]

Thinkbig, sorry I forgot about your question. The solution, and it is already being implemented, is to deleverage. For individuals this means to pay down their debt and start saving, or in other words to stop consuming more than they produce. For the U.S. government it means to balance the budget, and reduce the deficit. This is the only way to give support to the dollar, and to maintain our standard of living. The author is absolutely correct that ultimately, those folks overseas who lend us and our government the money we spend will stop lending to us if they don't feel we are able to pay them back, or are going to pay them back with devalued dollars. Up until now, their fates were so tied to ours that they have been willing to look the other way. Yes this means slower growth for the US economy, but slower growth sure beats the alternative.

[galewhitaker]

Robert Trudeau
I read your comment about "the price of oil reaching its equilibrium". Thats an entertaining idea. Have you read "The Long Emergency". Cheap oil is gone forever (peak oil is past) and the price of oil will always go higher in the future. Kunstler says that scientifically there is NO alternative to CHEAP oil. Our civilization can look foward to freezing, starving, chaos and war. We currently have food riots (Egypt for example) and the truckers are stopping traffic on the Parkway but everyone (including you) has their head in the sand. The only hope we have is extreme conservation but no one seems to have the wisdom or the foresight to switch out of their SUV.