Predictions for 2010: The Best is Yet to Come

December 21, 2009

"Mr. Wilson says 'the trusts are our masters now, but I for one do not care to live in a country called free even under kind masters.' Good! The Progressives are opposed to having masters, kind or unkind., and they do not believe that a 'new freedom' which in practice would mean leaving four Fuel and Iron Companies free to do what they like in every industry would be much of a benefit to the country. The Progressives have a clear and definite programme by which the people would be the masters of the trusts instead of the trusts being their masters, as Mr. Wilson says they are. With practical unanimity the trusts supported the opponents of this programme, Mr. Taft and Mr. Wilson, and they evidently dreaded our programme infinitely more than anything that Mr. Wilson threatened." President Theodore Roosevelt Theodore Roosevelt: An Autobiography Macmillan, New York (1913)

As is our custom at the end of a year, we below provide our thoughts on the coming year and reflect on the year that was. We wish all of the readers of The IRA a very happy holiday and a safe and prosperous New Year.

And remember that the special rate for subscriptions to the past articles from The Institutional Risk Analyst expires 12/31/09 when we transition to a paid model for past commentaries. Makes a perfect stocking stuffer for that aspiring young student of American political economy.

The first issue we see in 2010 is "completing the transition into a new reality that the country has moved into a post real estate boom phase," as IRA CEO Dennis Santiago wrote in his "Picking Nits" blog on December 8th ("Industry and Bankers: Chasing Quality"). He continued to describe the situation in the banking industry revealed in the Q3 2009 Bank Stress Index and supporting metrics:

"Shedding exposure is a tactical necessity. This means banks need to tend to their own health particularly with respect to the lingering cancer of losses from distressed real estate still in their bloodstreams. Projected real estate loan losses still to come are massive. The bulk of Option-ARM reset dates are in the still to come in 2010 and 2011 bucket. The reality is that these loans were never meant to survive the reset. Unless an alternative is created, the human pain and loss will be massive."

The second issue related to the first point will be the peak of loss experience for some US banks as the credit cycle plays out during 2010. Some of the most trouble-looking institutions will actually start to improve, while other banks that during the past year or more have seemed to be paragons of virtue will finally, grudgingly be force to take their lumps. In a very real sense, some banks will be changing places in 2010 even as the worst of the credit crunch plays out in the real economy.

In any event, we expect to see the US banking industry continue to shrink in terms of assets and the number of FDIC-insured institutions as losses are taken and banks are resolved and sold. Dennis describes the position of the US banking industry as of Q3 2009 in Pickin Nits.

We'll be describing the winners and losers in the battle for survival in the US banking industry in the IRA Advisory Service in 2010. Of note, also in 2010 the IRA Advisory Service will be available via our partners at FactSet Research Systems (FDS).

The third trend we see emerging in 2010 is the unwinding of the welfare state. That's right, back to the future carried by the negative cash flow of a flat real estate market and shrinking credit.

You might wonder how we can sound retreat on middle class entitlement as the Democratic Congress is preparing to pass a national health care scheme funded with borrowed money. We invite you to consider the example of New York.

New York began to default on its financial obligations last week, but so far only to internal creditors like cities and counties in that state. Only a few members of the Big Media bothered to notice. We hear that IL is right behind New York when it comes to fiscal problems. True to its Central European roots, says one well-known Chicago native, IL is starting to resemble Latvia. We hear similar reports of fiscal constraint in CA and other states.

The Democratic governor said New York's financial crisis required him to delay $750 million in payments to public schools and local governments. New York state would run out of cash this month if it paid all its bills, according to Patterson, who refused to raise taxes this year to close the $1 billion revenue shortfall. Few of America's politicians, you'll notice, are able to say the word "tax" in public at present.

Meanwhile in New York City, the Metropolitan Transit Authority, the nation's largest mass transit system, just announced service cutbacks and the end of free fare's for NYC school children. By no coincidence, the MTA union just won itself an 11% wage increase from a compliant arbitrator. But rather than raise fares to pay for the wage hike, the MTA board and New York's cowardly political leadership decided to delay a fare increase until next year but stick it to the city's school children today.

Like many mass transit systems, the MTA is largely subsidized by general tax revenues to the tune of $3 for every $2 fare paid by riders. Yes, the actual cost is $5 per rider. The system looses more money the more riders it attracts. With the revenues of NYC falling and New York State likewise facing a sharp decline in revenue, the MTA union and the working parents of NYC school children are about to collide.

The deteriorating financial conditions of NY, CA, IL and other states raises an interesting question: Can a state file bankruptcy? The answer apparently is no. Being sovereign, the fifty states simply default like an independent country. Can you imagine a creditor's committee negotiating with governor-elect Andrew Cuomo next year? No? How about Cuomo announcing a tax increase before next November? Not on your life.

Unlike the federal government, which can call upon a compliant central bank to bridge the gap between tax revenue and spending, states like New York cannot print money. Whereas 2009 was about stabilizing the banks, 2010 may be dominated by sovereign defaults a la Dubai, Greece, Iceland and even New York - especially given the political dysfunction visible in all of these jurisdictions.

If the several states of this great union start to fail financially, the question will be begged with respect to the credit rating of the federal government. Recall the comment about the threat to the ad valorem tax base the TX banker made in this space last year?

Conventional wisdom has it that there is no default risk on Treasury debt, only the risk of inflation, since the Fed can always print more fiat dollars. But of course this assumes that foreign creditors are willing to hold dollar assets in the face of massive monetary expansion by the Fed.

This brings us to the fourth issue we see in 2010, namely the growing understanding of the fiscal, that is, political, nature of the Fed's intervention in the US financial markets. The vast amount of asset purchases conducted by the Fed during 2009 amounts to an act of social engineering by the central bank that has yet to be recognized as such. See the comment in this regard last week on Yahoo Tech | Ticker by IRA co-founder Chris Whalen.

Simply stated, the Fed's intervention in AIG and the subsequent purchase of $2 trillion in MBS and Treasury obligations is a massive fiscal operation and thus a political action. To talk about "central bank independence," we need to discuss how to make our political class independent of the monetary excesses of the Bernanke Fed. One of our fishing buddies who works in Abu Dhabi gave us the following comment regarding our coverage of Chairman Bernanke and Fed policy:

"The issue really is not Bernanke and AIG. He made choices during a crisis that can surely be second-guessed. The broader governance issue is that much of what the Fed does with its balance sheet is fiscal policy, not monetary policy. Fiscal policy is about redistribution and should not be delegated to an independent agency. AIG is water under the bridge now; there are much bigger macro policy issues facing Washington that should be under discussion."

The same source notes that sniping at Bernanke and fussing about Fed audits is missing the point. The Congress was delighted last year that the Fed could throw a few trillion dollars at the economy without having those dollars get on budget. And the Congress is quite happy to let the Fed decide what to do next year with its big MBS portfolio, while maintaining the free option to criticize later if things go badly. We agree.

And this brings us full circle to the quotation at the top of this issue of The IRA from the 26th President of the United States, Theodore Roosevelt. TR was the youngest president in the nation's history and the first commander in chief of the 20th Century, a war hero who led troops in battle but also was a great conservationist.

TR did not particularly hate large companies or trusts, but he did feel compelled to use the power of government to strike them down when he perceived them to be malevolent, using their size and influence to restrain free trade. The quotation illustrates a point that readers of The IRA will appreciate, namely that from TR's progressive perspective, both the Democrats and Republicans were bought and sold by the money trusts which controlled much of the US economy at the turn of the last century. Sound familiar?

The history books describe President Woodrow Wilson as a great reformer, but to TR he was just another tool of the large corporate interests that have always controlled Washington policy. So while it may seem that in the politics of today, the large banks and other corporate interests wield undue influence, it is important to recall than compared with the situation in 1909 when TR left office, not a great deal has changed with respect to money politics in Washington.

The new factor in the equation is the willingness of the Fed to finance the wants and needs of the political class and the Wall Street banks with monetary emissions, a policy choice that we believe has a finite and likely unhappy terminus. As one reader wrote last week:

"Bernanke should be arrested, but a good back-up in long rates is the next best thing to stop his madness. No Fed scheme to remove duration will work forever if the global markets say no. ZIRP has always led to unintended consequences and the recent rise in long rates globally is beginning to look serious. US households could literally get killed as they have bought and continue to buy longer and longer paper in a desperate search for yield. They are even selling tax-exempt money market funds to buy longer term muni funds."

In 2010, keep you powder dry and your maturities short. The most challenging part of the global economic crisis still lies ahead.

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