Thoughts on a Possible Economic Crash

Includes: AMBC, MBI
by: Andy So

There are a number of startling factors for investors to consider when evaluating the possibility of a larger looming economic crisis. A few authors have guessed that the majority of writedowns are now done and that the worst may be past us. From the most recent news, I believe we may extend losses past the most recent credit crises fueled by collateralized debt. We may soon face a banking crisis larger than the Savings and Loan crises of the late 1980’s.

Here are a few factors to consider:

1) The Fed may increase interest rates in the near future. An increase in rates is bullish for the dollar and necessary to fight inflation. An increase would add tremendous pressure to an already fragile housing market by making payments on adjustable rate mortgages more expensive. Increases would also make borrowing more expensive and would restrict access to already tight credit. The potential impact of rate increases is unknown.

2) Any failure in the derivatives market would signal the beginning of an imminent crash. Estimates vary wildly over the total value of the derivatives market. The Financial Times recently estimated that the size of the derivatives markets stood at roughly $450 trillion dollars. As of December 2007, The Bank of International Settlements estimated that the amount of listed credit derivatives, i.e. tradable in some form through an exchange, stood at roughly $548 trillion. The amount of OTC derivatives was estimated at $596 trillion notional value. This brings the total derivatives estimate by The Bank of International Settlements to 1,140 trillion.

Taken from Investopedia:

[A]…derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.

Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Because derivatives are just contracts, just about anything can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.

Due to the complex structure of derivatives, it becomes very difficult to evaluate the underlying assets of many derivatives. Problems in the industry could lead to massive derivative writedowns by banks. Derivatives could form an extension of the collateralized debt obligation [CDO] and mortagage backed security [MBS] problems that fueled most of the recent writedowns by financial institutions. If there are too many sellers and not enough buyers in the derivatives market, investments become stagnant and pose the possibility of devaluation if anxious sellers seek to cash out.

My guess is that the derivatives estimate from The Bank for International Settlements is the most accurate. Taken from The Bank of International Settlements website: The Bank for International Settlements [BIS] is an international organization which fosters international monetary and financial cooperation and serves as a bank for central banks. The bank was established on May 17th, 1930 and is headquartered in Switzerland. BIS is the world’s oldest international financial organization and currently includes 55 member central banks.

3) Leverage is out of control. As we learned from the Bear Stearns Crash, leverage can turn against you very quickly. Bear Stearns leveraged 11.8 billion to control a balance sheet of 395 billion. Carlyle Capital leveraged its balance sheet 32 times to own $21.7 billion in mortgage backed securities, primarily AAA-rated bonds guaranteed by Fannie Mae (FNM) and Freddie Mac (FRE). Carlye Capital’s portfolio was backed by just $670 million in equity. The problem of leverage is prominent by all major big balance sheet banks such as Goldman Sachs (NYSE:GS) and JPMorgan Chase (NYSE:JPM) is very real as they provide access to credit and frequently loan money between each other. Any devaluation of assets or calls for more collateral on loans could lead to forced margin calls and major additional writedowns for banks.

4) Credit ratings on bond insurers Ambac (ABK) and MBIA (MBIA) fall. Ockham Research wrote on February 28th, 2008:

“Citigroup (NYSE:C), Wachovia (NASDAQ:WB), and UBS (NYSE:UBS) among others need to keep Ambac healthy as the ripple effect from an Ambac bankruptcy would be massive. Oppenheimer estimates that the major banks have $70 billion of exposure to Ambac and the bonds they insure.

Clearly, Ambac losing its credit rating of AAA or declaring bankruptcy would be catastrophic. If the worst were to occur it would make the housing crisis pale in comparison. The banks act as underwriters for billions of dollars in corporate bonds of which Ambac and MBIA are the two main insurers.”

Banks like UBS (UBS), Citigroup (C) and Merrill Lynch (MER) buy bond insurance as a hedge from Ambac and MBIA. If the insurer were to go out of business, 100% of the default risk is exposed to the bank. Banks have taken insurance on trillions of dollars of collateralized debt obligations and other mortgage backed securities. The potential impact of bond insurers going out of business for banks is tremendous. Market Watch is reporting that Ambac’s drop from AAA to AA is going to cost UBS, Citigroup and Merrill Lynch an estimated additional $10 Billion in new writedowns. This is money that the banks can’t afford to continue losing.

5) The Fed is printing money at an ever quicker pace. I’ve covered most of this in my previous article on How to Predict the Price of Goods. An increase in the money supply helps to alleviate access to credit and offers additional available cash to banks in the form of Fed loans. Increases also lead to an inflationary economy and possible drop in the dollar.

6) Inflation is out of Control. Basic necessities like food and energy prices have skyrocketed 300% or more in recent years.

7) Eli Hoffman reported that financial performance of mutual funds in 2008 may be worse than the year of the .com crash. Eli writes that “As of January, 2007, nearly 1,400 mutual funds were earning 15% or more. This January, just 270 funds hit that number — an 80% decline. From December 2000 to December 2001 — the bursting of the tech bubble — the 12-month drop was only 57%.”

There are many situations that may play out. The extreme economic collapse would be a failure of the banking system that would mean massive bank runs and a large devaluation of the dollar. Since the risk of an economic crash is very real, and may be the worst since the great depression, I am continuing to recommend cycling into physical assets and a diversified portfolio of non-cash assets.

Food for thought: Stocks and bonds are held in a clearing account by your bank or brokerage. If a bank run causes you to lose your money, eventually your stocks and bonds will be returned to you since technically they can be delivered in the form of stock certificates and paper contracts. Picking the correct recession resistant investments will be key to preserving capital in the event of an economic crash.

The good news is that if we are able to quickly emerge from a recession, every post economic recovery has lead to higher wages and asset appreciation. This has been true all the way from the Great Depression to the .com lead recession.

*Disclaimer: The author does not own a position in any of the stocks above.