Prediction #9 — Municipalities will see a surge of bankruptcy filings

Once the sleepy backwater of the financial world, municipal debt is turning into one of the most exciting areas of finance and debt trading — for all the wrong reasons.  Bombarded by what many are calling a perfect financial storm, municipal governments have seen their overly optimistic budget projections shotgun blasted to bits.  

The gunslingers on the most wanted posters include lower income tax revenue, lower property tax revenue, souring investments, and skyrocketing health and benefit costs.  These culprits have been aided and abetted by the unwillingness of government officials to cut services and/or raise taxes out of fear of angering their electorate.

Perhaps the next major government to go toes up will be Jefferson County, Alabama (Vallejo, California defaulted on its debt earlier this year), home of the city of Birmingham, population 600,000+.  It’s been on life support for several years as its construction of a city sewer system has gone wildly over budget and the county has borrowed to make up its cash shortfall.  But now the chickens have come home to roost and there simply isn’t enough money to service the county’s growing debt burden.

Not to be outdone:  the City of Detroit, home to ousted Mayor Kwame Kilpatrick.  According to Fox News.com:

“Kwame Kilpatrick stepped down as the mayor of Detroit [September 4th] after pleading guilty to two counts of obstruction of justice stemming from a sex-and-misconduct scandal that has plagued the Motor City for months.  Kilpatrick also pleaded no contest to assaulting or obstructing a public officer as part of the plea agreement, which ends his role as mayor of the nation’s 11th-largest city.”

Maybe the good mayor got out just in time — Motown is going through fiscal trauma of its own, aided in no small part by the near-collapse of the city’s auto industry.  From the Associated Press:

The mayor of Detroit says the city’s deficit is approaching $300 million and he has ordered all departments to reduce their budgets by 10 percent.  Mayor Ken Cockrel Jr. said in a statement [recently] that new problems are being discovered daily regarding the finances and financial reporting practices of the administration of his predecessor, Kwame Kilpatrick.  He says the discoveries confirm that Kilpatrick “misled Detroiters and misled City Council.”

Perhaps the biggest Damoclean sword hanging over muni finance world is the Golden State of California and its $42 billion budget shortfall for 2009.  With $54 billion in general obligation bonds already outstanding, Standard & Poor’s threatening to cut the state’s debt rating, and a general uneasiness on the part of investors to lend the state any more money, the Barbarian Governor’s choices are limited.

These are but a few of the more publicized examples of fiscally troubled municipalites.  However, the list of state and local governments and their severely exigent fiscal situations will only grow longer as budgeted tax receipts come in woefully short of projections.  With a credit market already leery of lending to stable and solvent borrowers, fiscally strapped municipalities’ chances of reaching 2010 in one financial piece are as bleak as the Motown winter.

Prediction #8 — Credit card debt will soar as delinquincies and defaults rise

Barely a half century ago, in 1958, the first widely accepted charge card was issued by American Express.  But the big innovation came the following year when BankAmericard (which changed its name to Visa in 1977) introduced “the first general-use credit card that allowed balances to be paid over time.”  This sea-change of events is reminiscent of what happened to poker over a century ago — the guy who invented poker was bright, but the guy who invented chips was a genius.

According to Comscore (September 2008), 55 percent of credit card users keep a balance on their credit card.  Via Bloomberg.com:

“Cardholders had $962 billion in unpaid balances on general purpose and proprietary cards at the end of 2007, an 8.6 percent increase from the previous year, according to the Nilson Report, an industry newsletter. That figure is expected to climb to $1.2 trillion by the end of 2012, or $6,373 per cardholder.”

According to the Federal Reserve, household consumer credit debt is over $2.6 trillion (yes, trillion), a 25% spike in just the past five years.  This equates to more than $22,000 per household.  And households, under the dual strains of rising unemployment and higher rates charged by credit card companies, are beginning to default at an alarming rate.

According to msnbc.msn.com, Americans defaulted on $27 billion in credit card debt in 2007.  As scary as that figure is, MSNBC estimates that that number will skyrocket to $96 billion in 2009!  That’s a 3.5-fold increase in just 2 years!!!  The ramifications could be catastrophic as lenders refuse to provide any additional capital (fearing that they’re just throwing good money after bad), at the very time that consumers need access to capital the most.

From Bloomberg.com:  “Credit-card companies, facing an increase in defaults and a decline in consumer spending, are raising some rates, adding fees and cutting credit lines.”

In 2009, this playing of hardball with the American consumer will devolve into a dangerous game of chicken between consumers and credit card companies.  Unfortunately, neither one is likely to swerve.  The resulting crash may cripple an already fragile economy.

Tomorrow:  Prediction #9 — Municipalities

Prediction #7 — Russia will default on its sovereign debt

Perhaps more than any other nation, Russia is dependent on commodity prices to support its economy.  These commodities, whether they be oil, natural gas, or raw materials, are controlled by the country’s handful of oligarchs (who, many would say, are controlled by the Kremlin).  Russia needs oil to be above $70 per barrel in order to balance its budget, according to The New York Times.  The current price is barely half that.

As commodity prices continue to plummet, taking the country’s currency and equity markets with them, many of these oligarchs are forced by Moscow to pony up their own personal wealth to stabilize the economy and local markets.  From stratfor.com:

“To inject liquidity into the system, the Kremlin first turned to the oligarchs, forcing them to inject between 10 percent and 30 percent of their total wealth into the markets and banks to shore up the financial system immediately after the Sept. 16 stock market crash. At an all-night mandatory meeting held in the Kremlin following the crash, oligarchs were ordered to plunge cash into their own faltering stocks, buy collapsing financial institutions directly, or simply fork over the cash and/or shares. Using oligarch money has the positive effect, at least from the Kremlin’s perspective, of further consolidating control over the oligarchs’ assets and decision making.”

It hasn’t helped.  Russia’s currency, the Ruble, has continued to depreciate against the dollar at an alarming rate (chart courtesy of moneycentral.msn.com):

The Ruble Continues Its Depreciation vs. The Dollar

 Russia’s equity markets have fared even worse.  Over the past several months, the government has taken the drastic action of actually closing the country’s stock markets in the face of seemingly endless drops in market values.  This hasn’t helped, as the Russian stock market has lost two-thirds of its value in the past six months:

Via marketwatch.com:

All of this is eerily similar to the Russian Debt Crisis of 1998, and is happening at a very inopportune time for the country.  Russia has over $500 billion (yes, that’s dollars, not rubles) in foreign debt, with approximately $150 billion of that coming due in 2009.

The ratings agencies have begun to take notice.  “Standard & Poor’s lowered Russia’s foreign currency sovereign credit rating,” and said “the rating is likely to be further downgraded ‘if the banking crisis and external pressures continue to impair the government’s balance sheet and its still substantial arsenal of liquid assets.’”

This follows on the heels of Ecuador’s recent default, spurred to a large degree by the recent plunge in oil prices.  If the situation in Russia gets much worse, even the oligarchs won’t be enough to save Russia from its second sovereign default in a dozen years.

Tomorrow:  Prediction #8 — Credit Card Debt

Prediction #6 — Oil will plummet as gold soars

With global economic growth and (especially) U.S. domestic demand slowing, crude oil will continue its recent nosedive (remember, oil was $147 per barrel just over five months ago), to below $20 per barrel.  As much of a decrease as this represents, this is somewhat of a reversion to the longer-term trend.  Recall that just over a decade ago, oil was at $13 per barrel.  A move from $13 to $20 over an eleven year period is still a healthy 4% annualized move, a pace greater than that of inflation.

Not even OPEC’s recently announced drops in production will be enough to overcome the recession-led drop in consumption by the industrialized world.  According to Bloomberg.com, “The U.S. Energy Department said on Dec. 9 that global demand will decline 0.5 percent to 85.3 million barrels a day.”  It will likely drop by a significantly greater amount.

One byproduct of this continued drop in oil price will be civic unrest in Iran.  The country needs oil to trade at $95 per barrel in order to balance its national budget, according to The New York Times.  A current check at the producer pumps indicate a price of barely one-third that level. 

Already isolated politically from many of its Middle East neighbors, the sharp drop in its main revenue source will make it more and more difficult for Iran’s rulers to keep its increasingly disaffected citizenry in line.  Sharp pressure from more secular sectors of society will threaten the country’s stability and could hasten a change in government.

As pointed out earlier this week in Prediction #1, the dollar will suffer a sharp decline on the back of near non-stop printing of dollar bills by the Fed.  As inflation fears grow, investors (and many central banks) will turn to gold as a safe-haven.  Gold, a.ka. “the barbarous relic” (a phrase coined by John Maynard Keynes in discussing the gold standard) will soar past $1,000 much the same way that crude oil took out the $100 per barrel level in 2008.  The only difference will be that gold will remain at a lofty level unless/until the Fed pulls the plug on its printing press — don’t hold your breath.

Tomorrow:  Prediction #7 — Russia defaults

Prediction #5 — Global trade tariffs will increase

As countries around the world suffer through recessionand anemic growth rates, they will be under enormous pressure to protect their domestic industries.  Historically, tariffs have been the easiest sale to a nation’s citizenry, but also the most deleterious on a long-term basis.

What will essentially amount to protectionism will have little effect but to decrease demand and increase deadweight loss, further damaging an already fragile global economy.  Special interest groups both here and abroad will put inordinate pressure on their governments for protection from cheap (more efficient) imports, what these groups deem to be “dumping.”

As new and greater tariffs are erected, existing trade agreements will be torn down.  The U.S. will even be under pressure from labor organizations to repeal or alter the historic North American Free Trade Agreement (NAFTA).

The resulting decrease in overseas demand will further damage already weak exports for U.S. multinational corporations and severely crimp their earnings.  The lack of trading will risk putting a cap on equity prices for the next several years.

Tomorrow:  Prediction #6 — Oil and Gold

Prediction #4 — Toyota Motor Company will buy General Motors

OK, “buy” might not be the most accurate term here.  Perhaps “obtain” will be more apropos.  As GM burns through what will likely amount to tens of billions of dollars of federal government cash/loans/preferred stock proceeds, it will eventually become apparent that GM’s debt load and cost structure are unmanageable. 

Reality will rear its ugly head and all parties (well, maybe not Ron Gettlefinger and the United Auto Workers) will throw up their hands and declare, “enough is enough.”  While plans for a pre-packaged bankruptcy will be tossed around, the Obama Administration will push for a plan that safeguards as many blue collar jobs as possible and helps to maintain a semblance of a U.S. presence in the global auto industry.

The compromise solution will have four major components.  First, Uncle Sam will extend the payback period for what will have become over $50 billion in loans to GM alone, thereby decreasing the present value of GM’s liability.  Similarly, GM debtholders will reluctantly agree to a major haircut on their bonds, receiving just ten to twenty cents on the dollar.  Third, common equity holders will be virtually wiped out as GM issues new shares to Toyota for less than $1 per share.  Finally, the UAW will (be forced to) accept cuts in its wage structure and, more importantly, a permanent cut in benefits for both retirees and current workers.

Undoubtedly, this will be a bitter pill to swallow for many.  But, it will be seen as the best long-term solution to safeguard both jobs and (what the Administration will call) a cornerstone of the American economy.

Tomorrow:  Prediction #5 — Trade

Prediction #3:  U.S. equity prices will fall more than 20%.

2008 will be remembered as one of the most brutal years for stocks since the 1970s.  While 2009 will unlikely match 2008’s dubious performance, the year to come does not look bright for domestic equity prices.

The major indices are up roughly 15% since their November 21st lows on the back of Citibank’s rescue, lower short-term (the fed funds rate is effectively 0.00%) and long-term (the 10YR U.S. Treasury note barely yields 2.00%) rates, a respite for the automobile industry’s travails, and forward price/earnings ratios that are historically cheap.

However, all of this masks one huge problem — consumer expenditures will continue to be anemic well into 2009.  Housing is one of the largest drivers of consumer spending.  With housing activity stagnating, there will be a dearth of larger durable goods purchases made by consumers.  Along with a steadily rising unemployment rate, consumers’ ability to make large scale purchases will dissipate.

Companies will find both retail and wholesale orders lagging overly optimistic projections.  Earnings will slide as the oft-rumored 2009 recovery fails to materialize.  While we are unlikely to see another 40% plunge in equity prices like we witnessed in 2008, losses of half that amount are likely.  Remember, one-year bear markets are rare, as shown most acutely in the 1930s, 1970s, and earlier this decade.

Tomorrow:  Prediction #4 — The Automobile Industry

Prediction #2:  Long-term interest rates will tumble lower; housing will struggle.

With the federal funds target already essentially at zero percent and the Fed looking for additional ways to stimulate the economy, Bernanke and Co. will use a bigger gun from its arsenal.  Though this has been hinted at for nearly a month, and expounded upon at the last Federal Open Market Committee (FOMC) meeting, the idea will morph from concept to practice.

The Fed will turn its eye from purchasing GSE (Fannie Mae, Freddie Mac, Federal Home Loan Banks, etc.) and mortgage debt toward directly purchasing longer-dated Treasury securities with the goal of lowering all long-term rates in a desperate attempt to kick-start the economy.  The yield on 10YR Treasury obligations will plummet to 1.00% or lower with few market participants willing to “fight the Fed.”

While the primary goal of this policy action will be to bolster the housing market, results will be mixed at best.  30-year fixed-rate mortgage rates will migrate toward 4.00%, though this will do little to stop the descent of housing prices.  With the country still fighting through the effects of years of double-digit real estate appreciation and unemployment continuing to rise, housing prices will fall another 15% before they return to the long-term equilibrium of less than 2.5 times median household income:

 Tomorrow:  Prediction #3 — Equity prices

In December 2007, who would have predicted that the coming year would witness not only the demise of Bear Stearns, Lehman Brothers and Merrill Lynch, but also a zero percent federal funds target and a $110 drop in the price of oil?  Oh, and how about the quasi-nationalization of Fannie Mae, Freddie Mac, AIG, General Motors, Chrysler, Citibank, and dozens of other multi-billion dollar financial institutions?

That’s the thing about predictions – as far-fetched as they sound in foresight, reality is often even more implausible and fantastic.  With 2008 as a backdrop, The Lamb presents nine predictions for 2009, one to be released each of the next nine days: 

Prediction #1:  The dollar will suffer a large drop in value. 

Currently trading at 1.39 to the Euro and buying 89 Japanese Yen, the greenback’s purchasing power will decline by over 20% to 1.70 and 70, respectively — both post-war lows.  There will be two major causes for this.  The first is the Federal Reserve’s non-stop printing of dollar bills in its attempt to stave off deflation, using that money to purchase questionable assets for its balance sheet, thereby (it hopes) pulling the country out of recession.  As James Grant pointed out in his December 20, 2008, Wall Street Journal editorial:

“The Fed pays for its assets with freshly made dollars. It conjures them into existence on a computer; ‘printing’ is a figure of speech.”  He continues, “there are risks to ‘creating’ a trillion or so of new currency every few months, but that is tomorrow’s worry. On today’s agenda is a deflationary abyss. Frostbite victims tend not to dwell on the summertime perils of heatstroke.”

The second cause of the dollar’s demise is a little scarier — China will begin to shed much of its dollar-denominated holdings.  While China will likely continue to hold its fair share of U.S. Treasury securities for foreign-exchange (FX) reserve purposes, its holding of mortgage-backed securities and Agency securities (Fannie Mae, Freddie Mac, etc.), will continue to decline.

Already, many foreign central banks have been selling these assets.  Net selling by these entities has taken place for four consecutive months, according to U.S. Treasury data, for the first time since at least the 1970s.  Ongoing concerns about the soundness of the U.S. economy will cause a reallocation into non-U.S. dollar assets.

China’s actions will be most pronounced as it grapples with its own domestic economic slowdown and fears of political unrest.  Selling non-core dollar-denominated assets will serve the dual purpose of loosening its reliance on the United States and having an adequate arsenal of FX with which to defend its currency if it needs to continue to drop its own managed short-term interest rates (now at 5.31%, down over 2 percentage points in just four months).

Tomorrow:  Prediction #2 — Interest Rates and Housing