Financial stress on the system

I posted this last week on Google+ at https://plus.google.com/u/0/114613808538621741268/posts/13tBzre1nRa. Given market drops since then, I'm reposting it in a more public forum.

How could our next financial crisis start? I was in an interesting discussion about this last night. I'd give better than even odds that it will be ugly before Christmas. Here are some of the possibilities to watch.

- General economic slowdown. The economy seems to be slowing. Plus there are all of the other stresses I'll discuss, all of which are likely to make it slow more. But it seems implausible that a general slowdown will happen suddenly enough to precipitate a full-blown crisis. Though it sure provides stress that could cause something else to happen.

- European sovereign debt issues. We all have heard about Greece. Italy is in the news. But the really scary quantities of debt are in Spain. And Europe has proven to have no political appetite for having meaningful bailouts of one country by another. Either the prospect of the EMU (European Monetary Union) dissolving, or a liquidity crisis caused by a large default (even if it doesn't get called a default) is a likely bet.

- US sovereign debt issue. We dodged the debt ceiling debate. 2 of the 3 rating agencies have left the USA at AAA, but on a negative watch. (Meaning better than even odds of a downgrade within a year.) The third, S&P, based on past guidance is likely to downgrade the USA this month. Though they could do what the other two did. The next test is what the super committee comes up with for the second half of the cuts that are in the debt ceiling deal. That's expected around Thanksgiving. Whether that triggers a crisis depends on what is cut. But a crisis is unlikely. The bigger problem is that people have been backed into a political corner where the US government will be unable to intervene if something else goes south.

- Residential mortgages. The current expectation in the industry is a 3-6% drop next year, with 15% as a worst case scenario. However if the mortgage tax deduction were to be yanked (for instance as part of deficit reduction), much worse changes are possible. (And, of course, another financial crisis would take all bets off of the table.)

- Commercial mortgages. Everyone is aware that commercial mortgages are in a world of pain. However servicers have been very forgiving. They really don't want to force bankruptcies which are in nobody's best interest, so they restructure deals, collect as much blood as they can, then limp along. (A clear case of, "If you owe $100,000, you have a problem. If you owe $100,000,000 the bank has a problem.") However the sector is still under stress. And last month the delinquency rate spiked to the highest rate on record. There could still be trouble there. Particularly if a slowing economy reduces how much money is available to pay back debt.

- Private equity. There is a world of pain coming here as deals struck in 2006 and 2007 (2007 had a lot more) see principal payments come due this year and next. Based on the experience with commercial mortgages, I would expect the banks to be unusually forgiving. But the question is whether they have sufficient liquidity to be forgiving enough. (As much as the banks may want to make deals, they have a real problem if nobody pays them back.) Borders just went bankrupt, how many more companies will follow in the next year?

- Municipal debt. Meredith Whitney has been crying wolf on this for some time, but she has a real point. There are trillions of dollars of debt issued by municipal governments who are under stress. In the first half of this year they got unexpected revenue increases. However a slowing economy could cause them to get back in trouble. And their budget cuts to deal with financial pain could slow the economy. To add salt to the wound, most have large investments in pension plans that is budgeted to get 8% annual growth. Those rates are hard to reach in today's economy, so a lot of that money is in risky asset classes like investments in private equity. It is very likely that those assets will under perform, adding to budget holes. Central Falls, Rhode Island just filed for bankruptcy. How many more will follow in the next year?

- Chinese asset bubble pops. I know little about what is going on there. They do have a big asset bubble. History says that it will pop eventually. Nobody knows when, or what the fallout will be. However my impression is that when it happens, the pain will be mostly felt in China.

- External shocks. You name it. Successful terrorist attack. (The 10'th anniversary of 9/11 is coming up...) Unrest in the Middle East triggers oil spike. An unexpected major earthquake. (For instance the Cascadia fault slips, leaving over 100K dead in Seattle, Vancouver and Victoria.) These are all unlikely, but possible.