The next, worse financial crisis

Commentary: Ten reasons we are doomed to repeat 2008

BOSTON (MarketWatch) — The last financial crisis isn’t over, but we might as well start getting ready for the next one.

Sorry to be gloomy, but there it is.

Why? Here are 10 reasons.

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1. We are learning the wrong lessons from the last one. Was the housing bubble really caused by Fannie Mae, Freddie Mac, the Community Reinvestment Act, Barney Frank, Bill Clinton, “liberals” and so on? That’s what a growing army of people now claim.There’s just one problem. If so, then how come there was a gigantic housing bubble in Spain as well? Did Barney Frank cause that, too (and while in the minority in Congress, no less!)? If so, how? And what about the giant housing bubbles in Ireland, the U.K. and Australia? All Barney Frank? And the ones across Eastern Europe, and elsewhere? I’d laugh, but tens of millions are being suckered into this piece of spin, which is being pushed in order to provide cover so the real culprits can get away. And it’s working.

2. No one has been punished. Executives like Dick Fuld at Lehman Brothers andAngelo Mozilo at Countrywide , along with many others, cashed out hundreds of millions of dollars before the ship crashed into the rocks. Predatory lenders and crooked mortgage lenders walked away with millions in ill-gotten gains. But they aren’t in jail. They aren’t even under criminal prosecution. They got away scot-free. As a general rule, the worse you behaved from 2000 to 2008, the better you’ve been treated. And so the next crowd will do it again. Guaranteed.

3. The incentives remain crooked. People outside finance — from respected political pundits like George Will to normal people on Main Street — still don’t fully get this. Wall Street rules aren’t like Main Street rules. The guy running a Wall Street bank isn’t in the same “risk/reward” situation as a guy running, say, a dry-cleaning shop. Take all our mental images of traditional American free-market enterprise and put them to one side. This is totally different. For the people on Wall Street, it’s a case of heads they win, tails they get to flip again. Thanks to restricted stock, options, the bonus game, securitization, 2-and-20 fee structures, insider stock sales, “too big to fail” and limited liability, they are paid to behave recklessly, and they lose little — or nothing — if things go wrong.

4. The referees are corrupt. We’re supposed to have a system of free enterprise under the law. The only problem: The players get to bribe the refs. Imagine if that happened in the NFL. The banks and other industries lavish huge amounts of money on Congress, presidents and the entire Washington establishment of aides, advisers and hangers-on. They do it through campaign contributions. They do it with $500,000 speaker fees and boardroom sinecures upon retirement. And they do it by spending a fortune on lobbyists — so you know that if you play nice when you’re in government, you too can get a $500,000-a-year lobbying job when you retire. How big are the bribes? The finance industry spent $474 million on lobbying last year alone, according to the Center for Responsive Politics.

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5. Stocks are skyrocketing again. The Standard & Poor’s 500 Index SPX +1.05% has now doubled from the March 2009 lows. Isn’t that good news? Well, yes, up to a point. Admittedly, a lot of it is just from debasement of the dollar (when the greenback goes down, Wall Street goes up, and vice versa). And we forget there were huge rallies on Wall Street during the bear markets of the 1930s and the 1970s, as there were in Japan in the 1990s. But the market boom, targeted especially toward the riskiest and junkiest stocks, raises risks. It leaves investors less room for positive surprises and much more room for disappointment. And stocks are not cheap. The dividend yield on the S&P is just 2%. According to one long-term measure — “Tobin’s q,” which compares share prices with the replacement cost of company assets — shares are now about 70% above average valuations. Furthermore, we have an aging population of Baby Boomers who still own a lot of stocks, and who are going to be selling as they near retirement.

TRADING STRATEGIES: JULY

Playing the debt crisis — make that 'crises'
With Greece's fate still uncertain and the U.S. struggling to raise its debt ceiling, investors have lots to worry about, and lots to profit from in July.
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6. The derivatives time bomb is bigger than ever — and ticking away. Just before Lehman collapsed, at what we now call the height of the last bubble, Wall Street firms were carrying risky financial derivatives on their books with a value of an astonishing $183 trillion. That was 13 times the size of the U.S. economy. If it sounds insane, it was. Since then we’ve had four years of panic, alleged reform and a return to financial sobriety. So what’s the figure now? Try $248 trillion. No kidding. Ah, good times.

7. The ancient regime is in the saddle. I have to laugh whenever I hear Republicans ranting that Barack Obama is a “liberal” or a “socialist” or a communist. Are you kidding me? Obama is Bush 44. He’s a bit more like the old man than the younger one. But look at who’s still running the economy: Bernanke. Geithner. Summers. Goldman Sachs. J.P. Morgan Chase. We’ve had the same establishment in charge since at least 1987, when Paul Volcker stood down as Fed chairman. Change? What “change”? (And even the little we had was too much for Wall Street, which bought itself a new, more compliant Congress in 2010.)

8. Ben Bernanke doesn’t understand his job. The Fed chairman made an absolutely astonishing admission at his first press conference. He cited the boom in the Russell 2000 Index RUT +1.52%  of risky small-cap stocks as one sign “quantitative easing” had worked. The Fed has a dual mandate by law: low inflation and low unemployment. Now, apparently, it has a third: boosting Wall Street share prices. This is crazy. If it ends well, I will be surprised.

9. We are levering up like crazy. Looking for a “credit bubble”? We’re in it. Everyone knows about the skyrocketing federal debt, and the risk that Congress won’t raise the debt ceiling next month. But that’s just part of the story. U.S. corporations borrowed $513 billion in the first quarter. They’re borrowing at twice the rate that they were last fall, when corporate debt was already soaring. Savers, desperate for income, will buy almost any bonds at all. No wonder the yields on high-yield bonds have collapsed. So much for all that talk about “cash on the balance sheets.” U.S. nonfinancial corporations overall are now deeply in debt, to the tune of $7.3 trillion. That’s a record level, and up 24% in the past five years. And when you throw in household debts, government debt and the debts of the financial sector, the debt level reaches at least as high as $50 trillion. More leverage means more risk. It’s Econ 101.

10. The real economy remains in the tank. The second round of quantitative easing hasn’t done anything noticeable except lower the exchange rate. Unemployment is far, far higher than the official numbers will tell you (for example, even the Labor Department’s fine print admits that one middle-aged man in four lacks a full-time job — astonishing). Our current-account deficit is running at $120 billion a year (and hasn’t been in surplus since 1990). House prices are falling, not recovering. Real wages are stagnant. Yes, productivity is rising. But that, ironically, also helps keep down jobs.

You know what George Santayana said about people who forget the past. But we’re even dumber than that. We are doomed to repeat the past not because we have forgotten it but because we never learned the lessons to begin with. 

'Perfect Storm' Coming for Global Economy in 2013: Roubini

Weakening economic conditions will come together in 2013 and create a "perfect storm" of global weakness, economist Nouriel Roubini told CNBC.

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Known for his generally dour outlook that helped him see the financial crisis before it hit in 2008, Roubini said the US, European nations and others have become adept enough at forestalling their problems that a true crisis won't hit until 2013.

But when it does, the effects are likely to be painful.

"My prediction for the perfect storm is not this year or next year but 2013, because everybody is kicking the can down the road," he said in a live interview. "We now have a problem in the US after the election if we don't resolve our fiscal problems. China is overheating...eventually it's going to have a hard landing."

In the nearer term, Roubini sees slow but steady growth in the US, with gross domestic product likely to be a bit above 2 percent, with unemployment and housing continuing to hold back the economy.

From there, recovery will be difficult as the government cuts spending and raises taxes to ease pressure from the bulging debt and deficit issues.

At the same time, euro zone periphery nations like Greece, Portugal and Spain will continue to wrestle with their own debt problems, and China will act to prevent inflation from getting out of control.

Then the storm hits, he said.

"I see every economy in the world trying to push their problems to the future," he said. "We start with private debt, public debt, supra-national debt—we're kicking the can down the road and eventually this is going to come to a head in 2013."

China's efforts to pull inflation back to the 5 or 6 percent range also will constrain growth and hit its trading partners, said Roubini, head of Roubini Global Economics.

"That implies lower commodities, lower exports from Europe to China, weaker global economic growth and a situation in which all advanced economies have weak economic growth," he said.

Roubini refrained from any specific predictions about GDP or stock market levels, but said the damage will be widespread.

"If we don't have enough job creation there's not enough labor income. Therefore, there's not enough consumption and consumer companies are going to be depressed. Therefore, the recovery is going to remain weak," he said. "The markets are expecting now a robust recovery in the second half of the year. I think the recovery is going to disappoint on the downside."

China Headed for Recession in 2-3 Years: Fund Manager

Regardless whether China succeeds in taming inflation, the economy is headed for a recession, says Bill Smead, Chief Investment Officer at Smead Capital Management.

Sam Diephuis | Getty Images Bill Smead, Chief Investment Officer at Smead Capital Management thinks the Chinese economy will contract 3 percent quarter on quarter in the next 2-3 years.

"We think economic contraction in China - actual negative real growth numbers - sometime in the next two or three years," Bill Smead, Chief Investment Officer at Smead Capital Management told CNBC on Thursday.

He expects the Chinese economy to contract 3 percent quarter-on-quarter for two straight quarters in the short to medium term. Click here for full interview.

China, Smead explained, is in a "no-win" situation because to “kill” inflation, authorities would have to tighten credit enough to invert the yield curve.

"If you do that you're going to clobber the economy," Smead said. "If you don't invert the yield curve and you do these gentle quarter point raises you allow the bad behaviors to go on and it just means your bust is going to be bigger when you finally do it."

China raised interest rates by 25 basis points on Wednesday for a third time this year, bringing the benchmark one-year lending rate to 6.56 percent, and its benchmark one-year deposit rate to 3.5 percent. The move comes ahead of key inflation data due next week where the nation’s consumer price index (CPI) in June is widely expected to surge to a 3-year high of 6.3 percent, compared to May's 5.5 percent figure.

While analysts have been warning of the disastrous effects of a hard landing for China, Smead thinks the bust is exactly what China needs.

"For China to be a successful major player, they're going to have to go through the cleansing," he said, referring to the bad loans generated from the billions of dollars lent to local governments to boost growth. This week, Moody's said that China’s local government debt may be understated by $540 billion, and warned that bad debt could reach 8-10 percent of total loans.

These loans, especially those used to fund development projects, are like a ticking bomb, Smear warned. "Most of the time, you don't acknowledge the loans get sour till the projects get finished."

"The problem is when homes in the big cities trade at 12 times the average household income, they're already over-capitalized by a factor of 2 to 1," he added. "So the problem is we're going to wake up some time in the next couple of years and people who bought a house 6 months ago or a year ago are going to be 30 percent under water."

China’s bust will trigger a collapse in commodities as will as currencies that have enjoyed the "incredible boomlet" from the mainland, Smead said.

"We're in the camp that we don't want to own Australian bonds, we don't want to own Canadian bonds."

Bank: Gold seems to be the best investment in uncertain time

KUALA LUMPUR: In an investment climate shrouded in uncertainty, gold seems poised to provide a desirable annualised return of 13% over the next three years and should peak at US$2,100 per ounce in 2014.

Standard Chartered Bank chief investment strategist Steve Brice said gold remained the group's favourite and most interesting long-term commodity.

Brice was bullish on the outlook for gold. A reason for this was attributed to stronger economic growth in China and India is expected to lift disposable incomes in the coming years, therefore providing a boost in demand for gold.

Aside from this, rising debt levels and fears of sustainable economic recovery in the West have reduced central banks sensitivity to inflation. Gold has typically done well during negative real interest rates environments, which are likely to continue for some time in the US and UK with inflation accelerating and interest rate hikes to be done in the distant future, said Brice during a media briefing yesterday on the investment outlook for the second half of this year.

“Based on history, gold has done well during periods of negative US real yields and gold falls when in positive real interest rate environments. We expected the Fed to hike interest rates from the third quarter of next year,” he added.

Another reason for his bullish take on gold was Asian central banks remaining underweight on gold and the shift from global central banks being a source of net supply of gold to a situation where they are increasing their gold reserves.

“For as long as I've been working, central banks have always been net suppliers of gold but we saw them turn into net buyers last year,” he said.

Finally, gold supply is likely to be constrained in the near term although investment activity is starting to pick up considerably.

“The lead-lag relation between increased investment and increased output suggests prices will remain high for some time,” he added.

For the second half of this year, Brice said equity markets were expected to generate “normal” returns of between 18% and 30% on an annualised basis, while traditional assets classes such as cash and bonds will generate meagre returns.

“We are neutral on the global equity market, underweight on bonds, neutral on cash and overweight on alternative assets. For the Malaysian equity market, we are also neutral as the equities are neither cheap nor expensive. We would only be overweight on the Malaysian equity market if the PE was 12 to 13 times,” he said.

The FTSE Bursa Malaysia KL Composite Index is currently trading at a price to earnings ratio of 16.8 times.

Key potential risks that could have implications on the investment climate include the European sovereign risk and prolonged slowdown in the United States. Brice said sentiment had improved as the odds of Greece avoiding a near-term default increased with the passage of austerity measures.

While there were concerns over how effective the implementation of these measures would be, Brice said another concern among investors would be how the European Central Bank (ECB) would react should the rating agencies downgrade the country's sovereign debt rating to default, as the ECB has previously said that it would not allow defaulted debt to be used as collateral in money market operations. Thus, a default would likely bankrupt the country and increase the contagion risk

Analysis: Worries on debt ceiling bubble beneath surface

(Reuters) - As the standoff over raising the government's borrowing limit enters its final month, it's becoming harder for investors to avoid thinking the unthinkable: the world's most trusted borrower could soon renege on its debt.

The U.S. Treasury says it will be forced to default on its obligations if Congress does not raise the $14.3 trillion debt ceiling, which caps how much it can borrow, by August 2.

The Treasury has not specified which bills it wouldn't pay, but the prospect of its missing interest or principal payments on any outstanding debt is a terrifying one for Wall Street.

Even a temporary default would erode the United States' status as the world's most powerful economy and the dollar's role as the dominant global currency.

"It would be catastrophically bad to tell the world that the United States is willing to default on its obligations," said Gregory Whiteley, who helps manage $12 billion in assets at DoubleLine Capital in Los Angeles. "Even if the default only lasted a few days, the precedent would be set."

A default would undermine confidence in Treasuries, the world's safest asset and the benchmark for the global bond market, particularly if ratings agencies were to cut the United States' prized AAA credit rating.

If investors start demanding higher returns for holding riskier U.S. debt, the rise in bond yields would crank up borrowing costs for consumers and businesses. This in turn could tip a still fragile economy back into recession.

QUANTIFYING THE UNTHINKABLE

Republicans in Congress want the White House to commit to deep spending cuts before lifting the ceiling while Democrats favor adding tax increases on the wealthy. Talks collapsed two weeks ago, and compromise seems far off.

Even so, investors are not panicking. The benchmark 10-year Treasury yielded 3.09 percent on Wednesday. While above its 2011 low of 2.84 percent hit last week, that was still far below where it would be if markets felt default was imminent.

"I don't think the majority of Congress is so stupid as to visit an actual default on the United States," said David Kelly, chief market strategist at JPMorgan Asset Management. "Their constituents would never forgive them for playing fast and loose with the credit-worthiness that it took 230 years to build up."

But as the deadline nears, markets may grow more restive.

Standard and Poor's told Reuters last week it would waste no time cutting the top-notch U.S. credit rating if Treasury missed a $30 billion debt payment on August 4.

Robert Tipp, chief investment strategist at Prudential Fixed Income, with $240 billion in assets, said long-term interest rates could swiftly rise by up to 50 basis points.

Based on the projected budget deficit, that amounts to an extra $70 billion in interest costs -- a fairly hefty price to pay for a country already facing a large debt burden.

Robert Brusca, chief economist at Fact and Opinion Economics, reckons a default could be a lot more costly, knocking Treasury prices down 5 to 10 points in a day -- a violent and unusual move. "This could be a horror show."

DOLLAR AT RISK?

The turmoil would likely spread far beyond the bond market as Treasuries are the one asset invariably accepted worldwide as collateral. A downgrade could result in margin calls, unleashing a wave of selling in stock and other markets.

In a note to clients this week, Priya Misra, head of U.S. rates research at BofA-Merrill Lynch, suggested owning some S&P 500 "puts" in case the debt ceiling is not raised by August 2.

The dollar would be vulnerable, too. As the global reserve currency, it dominates world trade and is the one in which central banks store most of their savings.

But if the "full faith and credit" of the U.S. government comes under question, that would plant "a seed of doubt" for global investors, said Barclays chief currency strategist Jeffrey Young, and could erode the dollar's unique status.

Foreigners hold more than half of outstanding dollar-denominated U.S. government debt. Chinaalone holds more than $1 trillion, according to Treasury data.

Even if Treasury were to make good eventually on missed payments, "there's no way to guarantee to foreign investors that the dollar, having sold off on a debt ceiling breach, will go back to where it was once things are resolved," said Steven Englander, who heads G10 FX strategy at Citigroup.

The short-term impact would likely boost the yen and Swiss franc, already up 10 percent against the dollar this year, short-circuiting a typical safe-haven bid for the greenback.

In the longer run, it could boost the euro.

"There have been plenty of warnings from around the world, notably China, that the United States is playing with fire," said Douglas Borthwick, managing director of Faros Trading.

"They wouldn't be able to dump $1 trillion in Treasuries overnight, but over time, they will probably prefer to hold European debt, given the Europeans look like they're willing to deal with deficit issues, while the United States does not."

PAINFUL BUT NOT A CATASTROPHE

Some contend failure to lift the debt ceiling need not end in catastrophe. Whiteley said Treasury tax revenues are sufficient to cover immediate interest and principal payments.

"But if you tell retirees we're not sending social security checks this month but we will be paying our Chinese debt holders, that makes for an uncomfortable situation," he said.

A few Republicans have even said a "technical" default that involves missing a few payments is manageable.

There's room for debate there. In 1979, Treasury was late in redeeming more than $100 billion of Treasury bills but that episode did not have a lasting effect on U.S. credibility.

However, that incident was the result of a freak printing problem, according to Richard Marcus, afinance professor at the University of Wisconsin-Milwaukee who later co-wrote a paper on the episode. Marcus' research did find it resulted in a 60-basis point interest rate premium on T-bills.

"People knew it was temporary, and I think that does make a difference," he said. "So it depends on how protracted it is. But I think it is a bad idea to miss payments, whether you are a homeowner, a company or a government."

Which Way Does Risk Sentiment Blow This Week? Look at US and EUR Factors

After a week in which we had very strong performance in global and US equities, the big question this week will be how equities fare in the week after. Much of the positive sentiment came on the back of relief that Greece will not default in the short term, and that European leaders would release the next tranche of aid for the country.

With that huge risk factor out of the immediate path of traders – though some worries remain about the credit rating agencies still judging the ”voluntary” debt roll over as a selective default – the attention may now turn more to the fundamental picture.

The risk appetite trade will be front and center this week as we see if last week’s gains in equities are sustainable or if we experience a correction or pullback. Weaker fundamental data will give incentive to traders to take profit.

Will US Data Show Economy Exiting Soft Patch? How Does Market Respond to Another Month of Soft Job Growth?

In the US, the focus will be on whether we start to see some of the data showing improvement as the economy moves past some of the strongest headwinds that were aligned against it in the 2nd quarter. Traders will be looking for data to show better times ahead, that the soft patch was temporary.

Last Friday’s ISM manufacturing report gave us the first indication that that may be afoot as the index came in stronger than expected at 55.3, helping to lift expectations that the supply disruptions as a result of closed Japanese plants may have worked through the system.

Data this week will feature factory orders, the ISM non-manufacturing index, and our batch of employment reports including the ADP employment change on Thursday and Friday’s non-farm payroll data. The expectation is that the ISM services index eased slightly in June, falling to 54.0 from 54.6. A surprise reading here to the topside would undoubtedly help the theme of risk appetite, while a disappointing result can cast doubt on how quick the US can escape the 2Q malaise. The non-farm payroll report is expected to show the economy adding 87K jobs, a second straight month of soft job growth, which may have the effect of undercutting expectations around the economy – especially if we have a figure that disappoints to the downside.

Therefore we return to a more fundamental release driven trading this week compared to the more headline news driven trading we have had over the past few weeks.

EUR Should Be Supported by ECB Hike, But Greece Worries Still Loom in Background

If risk sentiment improves, that can help bolster the case of the EUR, which should be supported by the ECB hiking rates this week. We also have European ministers working on a second Greek bailout, which would guarantee funding for the country through 2014. While positive movement on this front can help the EUR, we started the week with jitters as S&P said that it would label the current bond-holder participation plan as a selective default.

Also on tap will be Germany’s factory orders and industrial production for May, two key readings on how the German manufacturing sector has coped with the Japan shortages. Factory orders are expected to show a 0.5% decline compared to a 2.8% increase in April, while industrial production is forecast to make up the 0.6% drop in April with a climb of 0.7% in May. Again, we are looking for positive data to help boost the risk appetite trade, while weaker data would benefit the risk-off trade and would argue for a correction of the recent equity gains.

Keeping an Eye on US Treasury Yields

For the US, another important factor is how US Treasury bond yields continue to react to the end of QE2. We have seen the 10-year yield reach 3.2% after a strong surge last week.

That creates some concern that bond markets have not responded well to the end of the easing program. For the USD one major worry is the continuing debate around the government federal debt ceiling. While some resolution is expected, tensions over the next few weeks can limit USD gains. Usually higher yields can attract foreign investment, but that is when yields are climbing on the back of expectations of economic growth and higher inflation, not as a result of yields climbing on a heightened risk premium. It will be important to monitor which way yields head this week just as it will be to monitor equities.

So it’s not a clear which way sentiment takes us this week, and it will be important to watch the various factors laid out above. If we do see a continuation of risk sentiment from last week, the EUR/USD would be poised to rally to the 1.47 area, however risk aversion can see the EUR/USD top off near its current levels and retrace some of the 450 pip rally we saw last week.