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Courtesy of David Rosenberg of Gluskin-Sheff

It’s that time of the year when ‘sell-side’ research departments publish their Year-Ahead Reports (as I once did in the not-too-distant past); as do all the financial magazines.

I realized after countless emails and phone conversations (in that order) that there is a very high expectation that I publish one too. I honestly have no intention of publishing a specific set of forecasts in my current role as the Chief Economist and Strategist for Gluskin Sheff for public consumption — the granularity of my recommendations is reserved for our Investment team and our client base. Be that as it may, I am more than happy to comment on what I see as an emerging consensus and my general view on the direction of the economy and the markets in the coming year without getting into too much detail or numerical forecasts, which are the domain of the ‘sell-side’ macro teams globally.

At the outset, let it be known that when I read everyone else’s year-ahead prognostications, all I can think of is, “where do I store this stuff for a year so I can look back and say ‘That was so wrong!’.” It’s not that the reports are always bullish every year; it is that they seem so contrived. And, as I mentioned in the December 10th edition of Breakfast with Dave, this year, probably like most years, there seems to be a remarkable level of agreement. Based on my reading, here is what I conclude the consensus views are as we head into 2010:

• Muted recovery, but positive growth, for sure! No risk of a ‘double dip’.
• Equity markets up!
• A barbell strategy of domestic multinational blue chips and emerging market equities.
  The U.S. dollar is…neutral, but we did locate more bulls than bears (so much for the ‘carry trade’ thesis).
• Positive on commodities for the most part.
• Concerned about government balance sheets, and therefore…
• …Bearish on long term government bonds because they are the ‘competition’ and, after all, who would tie their money up for 10 years at 3.5% when you can lose 22% in stocks? And, therefore…
• …Bullish on spread product (as long as it’s not long-term). And, therefore…
• …Really comfortable with high yield (just for the coupon and the view that default rates will come down).
• Certain that volatility will not be an impediment.
• The Fed will begin to raise rates in the second half of the year, but that this will have no impact since they will still be low.

So here we are with a glorious opportunity to reintroduce Bob Farrell’s Rule 8: “When all forecasts and experts agree, something else is going to happen.”

That being said, these economists and strategists, many of whom I know, are smart guys (and gals) and they are human. To ‘talk your book’ is human; to have the courage to ‘buck the consensus’ is divine. I too am human; I also like to feel that I have courage of my convictions; and I too have a “book” (of sorts — it’s called reputation). But I have decided to take the opportunity of the “Year-Ahead Moment” to transition from sell-side to buy-side and more importantly, to reflect on the past year and really try to prognosticate from the gut. You would be surprised how a blend of intuition and experience can make a difference in a cycle like the one we are in that has absolutely nothing in common with the other recessions of the post-WWII era.

Forecasting is a humbling profession even in the best of times and I have learned a lot in the past year, especially from my partners here at Gluskin Sheff who realizes all too well that:

1. It is what is embedded in asset prices benchmarked against the forecast that is of utmost importance for investors;
2. The focus of any forecast must take into account the reality that minimizing portfolio risks is at least as critical as maximizing the returns, and;
3. Every forecast has an error term and the range around any projection in a post-bubble credit collapse can be extremely wide.

I do not view the economic events of the last two years as a classic recession/recovery phase. They only exist in the context of a secular credit expansions and contractions. We are in a post-credit bubble credit collapse that is ongoing, à la Bob Farrell’s Rule 4: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.”

Mainstream economists called this downturn “The Great Recession”. This is truly a gentle way of saying “Depression”. When we can have the courage to come to grips with the fact that we did in fact experience a depression of sorts, which is by definition a credit event, then and only then can we draw a conclusion that a sustainable recovery will not get underway until the ratio of household credit to personal disposable income reverts to the mean (and goes to an excess in the opposite direction). I know it sounds harsh, but we shall endure — believe it. Transition is rarely without pain.

The ratio of household debt to disposable income is up from a 30% ratio back in the 1950s to 125% today (though down from 139% at the peak in 2007). Mean reverting to a ratio closer to 60% means that the deleveraging process will be a multi-year event and by the time it is over, more than $7 trillion in additional household credit will have to be extinguished. For more on this see the unbelievably grotesque article on the front page of last Thursday’s (December 10) Wall Street Journal — The New American Dream.

Perhaps inflation is a consensus forecast but deflation is the present day reality and often lingers for years following a busted asset and credit bubble of the magnitude we have endured over the past two years. The fact that China’s voracious appetite for basic materials will continue to exert upward pressure on commodity prices does not detract from this view, especially given the widespread excess capacity in the manufacturing sector and the new frugality that has gripped, and in many cases, been embraced by the retail sector. Higher raw material prices, owing to developments in Asia as opposed to demand pressures here at home, will prove to be a sustained source of profit margin compression for many sectors and companies linked to finished consumer goods and services.

So, much of what I have read in various Year-Ahead Reports predict corporate earnings, GDP growth here and abroad, interest rates and relative values of currencies. As I mentioned earlier, the error term is bound to be very wide in this new paradigm (since WWII) of a secular credit collapse. GDP growth in 1934 was 10%, but the Depression wasn’t over until 1940.

Since 1989, the Japanese stock market has had no fewer than four 50%-plus rallies and there still has been no period of growth that can be called a sustained expansion. Today, we have our own special set of conditions and it is bound to be tricky as is typical during a post-bubble credit collapse, no matter how intense the government reaction. Prematurely committing to the ‘risk’ trade is probably going to be the most lamentable action over the next few years.

Suffice it to say, we believe that the dominant focus will be on capital preservation and income orientation, whether that be in bonds, hybrids, hedge fund strategies, and a consistent focus on reliable dividend growth and dividend yield would seem to be in order. To reiterate, I see the range of outcomes in the financial markets and the economy to be extremely wide at the current time. But one conclusion I think we can agree on is the need to maintain defensive strategies and minimize volatility and downside risks as well as to focus on where the secular fundamentals are positive such, as in fixed-income and in equity sectors that lever off the commodity sector.

This, in turn, underscores my primary focus of favouring Canadian dollar based investments over the U.S. because at no time in my professional life have the downside risks — economic, fiscal, financial and political — been so low on a relative basis and the upside potential so high as is the case today. The near-2,000 basis point gap this year between the TSX and the S&P 500 — the former leading — should be taken in the context of being just past the halfway point of a secular (ie, 16-18 year) period of outperformance. Northern exposure never felt this hot.

I spoke with some friends who are Greek and also in the shipping
business. They hate the problems that Greece is facing. The 12.7%
budget deficit is the highest in the EU and is not sustainable. Efforts
to cut government expenses have caused a political backlash against PM
Papandreou. The only available solution is to raise taxes and crack
down on tax evaders.

The Shippers are largely untaxed on their global operations. Their
status is ‘protected’ under the constitution. Taxing the shippers would
go a long way toward closing the budget gap. The changes in tax laws
will not come easy. There is no certainty of the outcome. The sense
that I got from these discussions was that there is a short window open
for Greece to come up with a plan to cut its deficit to approximately
9%. I asked for both a ”good” and a “bad” news scenario. Although the
responses to the question I asked are speculation, they have
interesting implications.

“If Greece is able to restructure its tax code and install a
plan to reduce its deficits to 8% of GDP, then China will invest Euro
25 billion in Greek bonds.”

The issue of the Chinese investing in Greece was first raised on November 29 by the WSJ.
I think it was one of those well placed rumors. If this were to happen,
it would be of significance. It would establish that China is assuming
a role as some form of ‘lender of last resort’. The bilateral trade
conditions that would be attached to a deal of this magnitude would
re-raise the issue of China’s trade hegemony and economic muscle. For
me, the most significant aspect of this is that it would represent yet
another significant diversion of China’s investable funds away from the
US.

If this were to happen, the $40 billion under discussion would not
impact the supply demand equation for US debt. But the direction of
this would be significant. The US desperately needs China to
significantly increase their holdings of US IOU’s in the coming years.
They are under no obligation to do so. What if they were to take a
stance with the US similar to Greece? We would get a headline that
looked like:

Of course we are not going to see a headline like that anytime soon,
but the developments in Greece are a possible first step in that
direction. If China bails out Greece in 2010 it is a game changer from
a number of perspectives.

“If Greece is unable to address its budget deficit the Chinese
will not invest and financial conditions for the country will
deteriorate quickly. One consequence would be that Greece would be
forced to separate from the Euro.”

This is not a high probability outcome. However, talk of  it would have
a very significant impact on the FX markets. The people who I spoke
with made an interesting observation, “Switzerland
is very much integrated with the EU and the Euro, but they have
maintained their own currency. If Greece had its own currency it could
adjust it to achieve a trade advantage that would address the
fundamental imbalances.” (Same argument as “the weak dollar is good
for the USA”). These same people point to the fact that the Swiss
National Bank has been intervening in the currency market to weaken the
Swiss Franc in order to achieve a trade advantage. The thinking is, “If it works for the Swiss, then Greece should do it too!”

Consider where this could go. If there is talk of this happening, it
would raise the same issue for Spain and Italy who are suffering from
their association with they Euro. This could lead in the direction of a
two-tiered Euro. One would be strong. The other weak. The implications
for the dollar would be significant in both the short and long term. It
could be the source of instability as the process unfolds.

The Greece story has already gotten the money moving. It is a story
that could take us in some surprising directions. I got the sense that
there was a short fuse on this. The next three months may put some
powerful forces into play.

Is there anything behind the Chinese/Greece connection? I think so. I
always assume there is something to it when you get statements like the
following. Asked whether Greece is negotiating with China to sell
bonds, a government spokesman said:

“It may be true, and if it is true, we do not want to comment. But even if it isn’t true we wouldn’t want to comment.”

US Dollar Very Long Term Chart

 

By Tyler Durden and Geoffrey Batt

These days catching the Fed chairman telling the truth as opposed to a b(a)ld faced lie is in itself a six sigma event. Sadly this post will continue with hugging the median. Some observations on the most recent fabrications by the chief money printer himself, which go to show just how willing Bernanke is willing to bend reality and/or his perception of it as the occasion suits.

A week ago Zimbabwe Ben wrote an op-ed in Washington Post last week in which he said:

“Now more than ever, America needs a strong, nonpolitical and independent central bank with the tools to promote financial stability and to help steer our economy to recovery without inflation.”

Recovery without inflation is another way of articulating the Fed’s quixotic dual mandate.  Of course, everyone knows the Fed does not care about inflation, or, it seems, the economy, unless of course Goldman Sachs recently changed its name to Inflation Economy, Inc. But what’s striking about this sentence (the last sentence, no less, of a decidedly political op-ed), is that it directly contradicts what he says about QE in two papers in 2004.
 
In the May 2004 edition of The American Economic Review, Bernanke and Reinhart published “Conducting Monetary Policy at Very Low Short-Term Interest Rates.”  ZH cited this paper before as evidence that Bernanke considered monetizing equities viable in a debt deflation.  This time, however, it’s useful because he claims aggressive QE may “have expansionary fiscal effects.” 

Furthermore:

“So long as market participants expect a positive short-term interest rate at some date in the future, the existence of government debt implies a current or future tax liability for the public. In expanding its balance sheet by open-market purchases, the central bank replaces public holdings of interest-bearing government debt with non-interest-bearing currency or reserves. If the increase in the monetary base is expected to persist, then the expected interest costs of the government and, hence, the public’s expected tax burden decline. (Effectively, this process replaces a direct tax, say on labor, with the inflation tax.)”

Then in the Fed Minutes from Nov 4th we get:

“Participants noted that the recent fall in the foreign exchange value of the dollar had been orderly and appeared to reflect an unwinding of safe-haven demand in light of the recovery in financial market conditions this year, but that any tendency for dollar depreciation to intensify or to put significant upward pressure on inflation would bear close watching.”

An odd remark considering what Bernanke et al said in Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment Author(s): Ben S. Bernanke, Vincent R. Reinhart, Brian P. Sack Source: Brookings Papers on Economic Activity, Vol. 2004, No. 2 (2004), pp. 1-78. More specifically:

…quantitative easing may work through a signaling channel if its implementation marks a general willingness of the central bank to break from the cautious and conventional policies of the past. A historical episode that may illustrate this channel at work (although the policymaker in question was the executive rather than the central bank) was the period following Franklin D. Roosevelt’s inauguration as U.S. president in 1933. During 1933 and 1934 the extreme deflation seen earlier in the decade suddenly reversed, stock prices jumped, and the economy grew rapidly.Christina Romer has argued persuasively that this surprisingly sharp recovery was closely associated with the rapid growth in the money supply that arose from Roosevelt’s devaluation of the dollar, capital inflows from an increasingly unstable Europe, and other factors. Because short-term interest rates remained near zero throughout the period, the episode is reasonably characterized as a successful application of quantitative easing.

It appears despite Bernanke (and Geithner’s) repeated appearances, admonitions and Fed Minute posturings to the contrary, Bernanke is fully aware of what his actions will do to both inflation and the dollar, and that the devaluation of the greenback is critical to the success of his campaign of bailing out CREs laden bank balance sheets. Yet in the meantime on every TV and congressional appearance the Chairman will eagerly lie and prevaricate, hoping his listeners have short memories, and have not bought a Kindle yet (difficult to imagine judging by Amazon’s 1,000,000,000,000,000 (non)inflation adjusted P/E) to have read his own scribblings on the matter of impending dollar devaluation. America deserves all it gets if it allows its Senators to reconfirm this human being for the most important post in the world.

Tomorrow’s Bernanke reconfirmation hearing just got more interesting, courtesy of Vermont Senator Bernie Sanders who has stated he will put a “hold” on the Bernanke confirmation process, meaning the Senate will need to amass 60 votes in order to override and proceed with the confirmation process. Yet as the NYT notes: “though the Senate has been paralyzed by similar blocking tactics on
countless other issues, Mr. Bernanke probably has enough support in
both parties to clear the 60-vote hurdle.” It is time to call your Senators and remind them that at best only 21% of Americans favor Bernanke’s reappointment.

More from the NYT:

Senator Bernard Sanders of Vermont, said Wednesday that he would try to block the Senate from confirming Ben S. Bernanke to a second term as chairman of the Federal Reserve.

The move is unlikely to derail Mr. Bernanke’s reappointment, but it
could slow the confirmation process and give the Fed’s critics
additional opportunity to press their case. As a practical matter, it
means Senate Democratic leaders will have to line up 60 votes in favor
of Mr. Bernanke rather than a simple majority at a time when the
Federal Reserve is under increasing populist attacks from lawmakers on
both the right and the left.

Mr. Sanders, an independent, is not a member of the Senate Banking
Committee, but he has frequently accused the Federal Reserve of bailing
out Wall Street firms and the banking industry at the expense of
ordinary citizens.

“In this country, there is profound disgust
at what happened on Wall Street,” Mr. Sanders said in a telephone
interview. “People want a new direction and people are asking, where
was the Fed? How did the Fed allow this to happen, when one of their
mandates to oversee the safety and soundness of the banking system?”

Mr.
Sanders said he would place a “hold” on Mr. Bernanke’s nomination when
it reaches the Senate floor. Under Senate rules, lawmakers would need
to amass 60 votes to override Mr. Sanders and proceed with a vote on
the nomination.

As pointed out previously, Bernanke is a Bush legacy, yet is somehow supposed to represent Obama’s “change” agenda:

The Fed chairman was originally appointed by President George W. Bush
and took over the central bank in February 2006. Despite his Republican
ties, Mr. Bernanke forged a close working relationship with President Obama and his top economic advisers during the financial crisis.

And some more potential wild cards in tomorrow’s historing hearing:

Senator Christopher J. Dodd,
Democrat of Connecticut and chairman of the banking committee, has said
Mr. Bernanke was “probably” the best person to lead the Fed because he
responded valiantly to the financial crisis when it began two years ago.

But
Mr. Dodd has also proposed stripping the Federal Reserve of virtually
all its powers as a banking regulator, and consolidating all the
federal government’s bank regulatory efforts in a new agency. In an
Op-Ed article last Sunday in The Washington Post, Mr. Bernanke sharply
criticized Mr. Dodd’s proposal.

Senator Richard C. Shelby
of Alabama, the top Republican on the Senate Banking Committee, has
also been sharply critical of the Federal Reserve but has not yet said
how he would vote on Mr. Bernanke’s nomination.

Even with Zero Hedge polling indicates a mere 11% of our readers would support Bernanke’s reconfirmation, a different poll by Rasmussen finds a comparable result: only 21% favor Bernanke as Chairman.

And here is a reminder of the confirmation whip count in the Senate Banking Committee:

Definite no: 2
Lean no: 3
No indication: 6
Lean yes: 7
Definite yes: 5
Definite no: 2

Bernie Sanders (I-VT):

Senator Bernard Sanders, a Vermont independent who isn’t on the banking committee, said Nov. 29 on ABC television’s “This Week” that he will “absolutely not vote for Mr. Bernanke” and that the Fed chief is “part of the problem.”

Jim Bunning (R-KY):

Jim Bunning, the Kentucky Republican who was the only senator to oppose Bernanke’s first nomination in 2005, hasn’t changed his views.

‘His job rating would be zero minus F,’ Bunning said in an interview yesterday. ‘He has catered to the big banks, to the Wall Street elitists, to every major money concern in the country and in the world.’

It is possible that one or both of these Senators will place a “hold” on the nomination.  Such a procedural move would at least delay a vote on Bernake, which would provide opponents of his reconfirmation time to organize.  For more details on what a “hold” is, check Tom Coburn’s website (no one places more holds than Coburn).

Lean no: 3
Jim DeMint (R-SC):

“He’s [Bernanke's] going to face some tough questions because he’s got a lot to answer for,” leading Fed critic Sen. Jim DeMint said through a spokesman. “The Fed’s mission is to guard the value of the dollar and to focus on employment, and right now their track record is looking very poor.”

Richard Shelby (R-AL):

Sen. Richard Shelby (R-Ala.), the top Republican on the Banking committee, would not say how he would vote on Bernanke’s nomination, only encouraging reporters to stay tuned for the chairman’s hearing this week.

“I used to be a big defender of the Fed,” he said, adding he believes the institution has “utterly failed” in its role for regulating financial institutions.”

David Vitter (R-LA): As a support of auditing the Fed, everything I have heard is that Vitter is a no–and is even possibly willing to put a hold on Bernake.  Still, lacking a public statement to that effect, I won’t put him in the “definite no” category.

No indication:  6
Michael Bennet (D-CO):  No word for Bennet one way or the other.  His primary challenger, Andrew Romanoff, might be an interesting way to move Bennet on this one.

Mike Crapo (R-ID): Praised Bernanke’s nomination in 2005, but no word on where he stands now.

Herb Kohl (D-WI)

Three said they’re undecided, including Wisconsin’s Herb Kohl, Jon Tester of Montana and Jeff Merkley of Oregon.

Kay Baily Hutchinson (R-TX): I can’t find any indication on Hutchison, one way or the other.

Jeff Merkley:

Three said they’re undecided, including Wisconsin’s Herb Kohl, Jon Tester of Montana and Jeff Merkley of Oregon.

Jon Tester:

Three said they’re undecided, including Wisconsin’s Herb Kohl, Jon Tester of Montana and Jeff Merkley of Oregon.

Lean Yes:  7
Robert Bennett (R-UT)

Utah’s Robert Bennett said he’ll probably vote in favor

Sherrod Brown (D-OH):

“He’s been far from perfect,” Senator Sherrod Brown, an Ohio Democrat, said in an interview yesterday. “He was not quick enough responding last year to many of these issues that we care about, particularly in housing. I want him to focus on jobs. But I think he’s generally done a decent job.”

Tom Carper (D-DE):

“Sens. Charles Schumer (D-N.Y.), Tom Carper (D-Del.) and Mark Warner (D-Va.) all said they’d wait until hearing from Bernanke.”

Bob Corker (R-TN)

Corker noted that he leans toward supporting a second term for the Fed chairman, who was nominated in August to a second term by President Barack Obama, but acknowledged gripes toward the Fed chairman on the left and the right.”

Chris Dodd (D-CT, chair):

I’m inclined to be supportive. I think he’s done a far better job in the last couple of years than he did initially.

Charles Schumer (D-NY):

Sens. Charles Schumer (D-N.Y.), Tom Carper (D-Del.) and Mark Warner (D-Va.) all said they’d wait until hearing from Bernanke.

Mark Warner (D-VA): Over email, a spokesman for Mark Warner told me “Senator Warner is inclined to be supportive of Bernanke’s reappointment, but he’s certainly not a fan of expanding the role or the power of the Fed as part of financial re-reg.”

Definite Yes: 5
Daniel Akaka (D-HI):  Bloomberg reports Akaka is a yes.

Evan Bayh (D-IN):  Bayh was the first prominent Democrat to support Bernanke in 2005.  According to Bloomberg, also support him in 2009.

Judd Gregg (R-NH):

Judd Gregg, a New Hampshire Republican, said Nov. 20 he will “absolutely” vote for Bernanke.

Mike Johanns (R-NE):

Among Republicans, Nebraska’s Mike Johanns said Bernanke “will have my support.

Tim Johnson (D-SD):

Sen. Tim Johnson (D-S.D.) — a favorite of Wall Street — told HuffPost that he has decided to vote to confirm Bernanke.

By Economic Forecasts & Opinions

Stock markets around the world cracked on Friday with the Dow Jones industrial average down more than 150 points (Fig. 1), and commodities plunging as Dubai debt woes unnerved investors, and sent tremors of uncertainty throughout all markets.

The crisis flared after Dubai, a part of the United Arab Emirates (UAE) federation, asked to delay interest payment for six months on $60 billion of debt issued by the state-run conglomerate Dubai World and its main property unit Nakheel.

Concerns that a government-backed investment company risked default ripped through world markets. Investors read it as a sign of yet another sovereign implosion after Iceland and Ireland, and recoiled from risk and piled into dollars.

Las Vegas on Steroids

Dubai World has served as Dubai’s main driver of growth, operating ports, transportation groups, spearheading real-estate & infrastructure projects both at home and abroad. Its real-estate subsidiary Nakheel built Dubai’s iconic palm-tree-shaped island, packed with luxury villas and hotels, many still under construction. Real estate and construction accounts for about 23% of Dubai’s GDP.

With little oil, Dubai financed much of this rapid real estate development with debt. After incurring its estimated $80-$90 billion of debt in a four-year construction boom to transform its economy into a regional financial and tourism hub, Dubai suffered the world’s steepest property slump in the first global recession since World War II.

Deutsche Bank estimates that Dubai’s property prices, both commercial and residential, have halved since August last year, and could fall a further 15-20% this year.

U.S. Banks Less Exposed

Most analysts believe U.S. banks are probably less exposed than European rivals to a potential debt default by Dubai World, but a lack of transparency and the interconnection of the modern financial system make it difficult to know which institutions are ultimately exposed.

Dubai World’s largest creditors are reportedly domestic banks in Dubai and Abu Dhabi. MarketWatch noted data from the Bank for International Settlements which put cross-border banking exposure for the UAE as a whole at $123 billion at the end of June. Of that total, European banks hold 72%, with the United States and Japan only holding 9% and 7% of the exposure, respectively. The United Kingdom is by far the biggest creditor with a share of 41%.

Reminder of Other Risks

On a global scale, Dubai World’s debt problem seems relatively minor, but it illustrates the impact from one tiny country in an increasingly interconnected world. The Dubai news also cast doubt over the strength of the U.S. economic recovery, and the prospects for a bottoming of property prices.

Commercial Real Estate

As pointed out in my previous article that the commercial real estate sector posed a much greater threat than the over-hyped “mother of all carry trades.”  The Dubai debt crisis further reinforces this viewpoint.

The potential for contagion from Dubai’s debt woes could further unhinge an already fragile U.S. commercial real estate sector, whose values have already fallen 42.9% from their 2007 peak, close to the lowest since 2002, according to Moody’s. (Fig. 2) The latest Moody’s projection is for prices to bottom at 45-55% below their peak, but could drop as much as 65% from their peak in a “stress case”.

As commercial property values fall, debt defaults rise. The $3.4 trillion outstanding in debt backed by commercial real estate poses a real threat to the recovery. Trepp LLC reported that last month, delinquencies on U.S. commercial real estate loans that were packaged into commercial mortgage-backed securities reached 4.8%, more than six times the year earlier level. Hotel loans, at 8.7% distressed, have begun falling into delinquency faster than any other kind of commercial real estate debt.

Write-downs and losses at banks around the world have risen to more than $1.7 trillion since 2007 as the credit crisis undermined the value of assets owned by financial institutions, according to data compiled by Bloomberg. Any further deleveraging and the resulting credit tightening from commercial real estate would impede the financial sector and probably derail the U.S. economy sending it into another recession. 

Housing Market Mortgage Crisis

So far, the appearance of recovery in the housing sector is being driven primarily by reduced prices combined with federal programs to lower mortgage rates with the goal of bringing more buyers into the market.

Based on a study released by Zillow.com, the foreclosure crisis has moved beyond subprime mortgages and into the prime mortgage market. (Fig. 3) While subprime borrowers are still a factor in the current foreclosure epidemic, it’s becoming increasingly apparent that the weak labor market is the driving force behind the mortgage crisis we face today.

According to the Mortgage Bankers Association, one in seven U.S. home loans was past due or in foreclosure as of Sept. 30, putting that quarterly delinquency measure at its highest level since t

he report’s inception, 1972, and up from one in ten at the beginning of the year.

The continued surge in delinquencies suggests that a recovery in the housing market could be hindered by the weak job market as well as by further fallout from the easy money and loose lending practices of the past. The foreclosures and delinquencies are expected to keep rising well into 2010, not leveling off until the unemployment rate starts to moderate.

In a study by First American CoreLogic found that one in four of all U.S. mortgage-borrowers owe more than the value of their properties in the 3rd quarter. And many experts didn’t expect U.S. home prices to hit bottom until early 2011, perhaps falling another 5-10%, as more foreclosures get pushed onto the market.

Negative equity is another outstanding risk hanging over the mortgage market.

Dubai Is No Lehman

The circumstances behind Dubai’s moves are murky, making it hard to gauge the exact risk to the pertaining bonds and Dubai’s own general creditworthiness. UBS cautioned that Dubai’s overall debt “might be higher than the generally assumed $80 billion to $90 billion, due to potential off-balance sheet liabilities. These could include unlimited and unquantifiable amount of credit default swaps (CDS) and other derivatives against the underlying assets, and once unraveled, could potentially erupt into a subprime-like crisis.

The current expectation; however, is that there’s a good chance that Dubai’s problems will probably prove a local issue. Most likely, Dubai, or its neighboring emirate, Abu Dhabi, won’t risk tarnishing their images and reputation further, and will come up with a reasonable resolution.

Even if Dubai goes into sovereign default, the amount is probably not enough on its own to threaten the financial system since any actual losses would be a fraction of the total. So, the problems in Dubai are unlikely to be as serious as last year’s Lehman Brothers collapse, nor is it a reflection on the ability of emerging markets to lead a global economic recovery.

Rational Expectations?

But Dubai could well spur a broader crisis of investor confidence in overly leveraged economies as market confidence world-wide is still fragile from the severity of the financial crisis.  The debts of many emerging markets have risen even further as the countries governments have fought the ravages of the global recession by issuing more stimulus debt to fill the gap voided by private investment.

The spread of credit-default swaps on developing-nation’s bonds jumped 14 basis points after the Dubai news broke, the most in a month, to 3.24 percentage points, according to JPMorgan Chase & Co.’s EMBI+ Index. There is also a clear sign of potential contagion effects of global risk aversion on basically all risky assets, with the dollar and yen being the prime beneficiaries.

Rational expectations or not, for now, the Dubai crisis is simply a reminder that the severe global recession has relegated much debt to near junk status, and there still remains a high degree of uncertainty as to the percentage recoverable on all outstanding debt which is going to be coming due over the next 5 years.

Despite some seminal signs of green shoots in the news headlines during this 9 month liquidity driven rally in many asset classes around the globe, we should be reminded that all that glitters is not gold, and that the global economic recovery is still on shaky ground.

#  “I know the odds are against me, but if there’s a win I’m gonna find it!”  ~Goku  #

Economic Forecasts & Opinions