Decidedly Speculative

Decidedly Speculative
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By John P. Hussman, Ph.D. | 14 December 2009
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"Second Wave" Concerns Begin To Appear

As part of our ongoing attention to what I've called "second wave" credit risks, we're just beginning to hear concerns about fresh credit problems: foreclosures and loan losses from other corners. A few of these concerns are from particularly credible voices, which makes us feel, well, slightly less alone in our analysis.

Last week, RealtyTrac reported that November foreclosure filings declined modestly from their peak in July. RealtyTrac SVP Richard Sharga appeared on Bloomberg and CNBC to discuss the numbers, saying:

"I'm afraid we might be looking at a false-positive trend right now. We haven't seen any improvement in underlying conditions. We're still looking at high levels of unemployment, we're still looking at a high percentage of mortgages being underwater, and we're still looking at limited credit availability which makes getting a loan difficult. So there's no organic reason for these numbers to be going down and what we think what's going on are some process delays and government intervention that is artificially delaying things. "I think that first quarter of next year we'll see a new wave of foreclosure activity. Delinquencies have been going up— we have five and a half million homeowners who are late on their mortgage payments right now, and many of those, under normal circumstances, would have already been in foreclosure. But the Treasury is asking lenders to make doubly sure that anybody who qualifies for the HAMP program or other modification program gets in those programs. We think we'll probably hit the historic peak next year, in 2010, as a lot of the Option-ARM loans reset, as unemployment related foreclosures peak, before numbers finally start to settle down a little bit in 2011. We're expecting the first quarter to be pretty ugly."

Striking a similar chord, on Tuesday, Meredith Whitney appeared as the guest host on CNBC's Squawk Box. Whitney was one of the few Wall Street analysts who foresaw the recent credit crisis, and also anticipated what I've called the "March-November 2009 lull" in credit difficulties. Having been generally positive on the financials since the first quarter, she recently became quite negative. At the end of the broadcast, when asked to end on just one short, positive note, she replied, "The Blind Side was an amazing movie."

Whitney noted,

"In the second quarter, you had banks recapitalizing themselves with huge equity volumes, you had a lot of write-ups throughout the year, but the core loan books have been declining dramatically, so what's left? The toxic assets have all been written up. There's a very limited cash market for them. You would never know about the degradation in asset quality (of loans backed by Fannie Mae) because the government has been buying the paper. [[…so the banks and speculators made out like the bandits they are…: normxxx]] The paper has never traded higher. There's still time (for toxic assets to become a major problem again). They have to because there are not cash flows to support the payments on those bonds, and the bonds will break covenants. What's happening is that the banks are going to have to start selling stuff, and so you'll start seeing a yard sale to raise capital."

One of the main concerns Whitney expressed was the collapse in credit availability.

"In the last cycle in the early 1990's, the economy slowed and banks stopped lending but the securitization market was really getting started, so consumers actually had more liquidity. Now, consumers and businesses are being stuck by— banks aren't lending and there's no securitization. So you haven't had this amount of credit contraction. There has been a trillion and a half of credit taken away from credit card lines, and that is accelerating with all the regulatory changes. So the numbers just aren't big enough from a government standpoint to mitigate the decline in credit, which is ultimately going to influence behavior. The component parts do not add up. You cannot get to a robust economic recovery with so many states under duress."

Looking forward to next year, Whitney warned of a 2010 outlook

"…which is so disturbing on so many levels to have so many Americans be kicked out of the financial system, and the consequence both political and economic of that is a real issue— you can't get around. It's never happened before in this country or in the modern economy. The biggest trend in 2010 will be seeing who gets kicked out of the banking system."

Meanwhile, in January, new accounting rules will kick in which will force banks to move off-balance-sheet "structured investment vehicles," "trust preferred assets" and other beasts onto their balance sheet, which is expected to result in some sharp hits to bank capital. In response, regulators such as the FDIC will most probably be called upon 'to look the other way' for a while. Floyd Norris of the New York Times refers to these off-balance-sheet assets as

"…a black hole that regulatory rules had ignored in assessing how much capital the banks needed to hold. The beauty of those securities was that they were really debt that the holding companies could call capital. Having that "capital" meant the bank could take on more debt. A system that lets a bank borrow more money because it has already borrowed money— rather than because it has sold stock— is hardly a wise one."