It's that time of year where we reflect on the year that has past and gaze upon what the next 12 months might bring. Last year at this time, I wrote 5 predictions for 2009, and I would like to review those before we get into my 5 predictions for 2010. Last year's predictions:
Commercial real estate values will decline. Honestly, as a commercial banker, that prediction was not very hard and quite correct in 2009. The lag time between commercial and residential coupled with the deteriorating fundamentals behind commercial real estate pointed to this asset class declining in 2009.
Community Banks Will See a Rise in Delinquent Loans. Again, as a commercial banker who has worked in the community bank world for the past 13 years, not a difficult prediction and quite correct as the typical client of the community bank struggled, that being the small business owner, or the borrower on commercial real estate or construction financing. We have witnessed community banks with increasingly bad loans on their balance sheets. Not only have we seen a rise in delinquent loans, but a sharp increase in loans on non accrual (Those are the special loans not make any interest or principal payments -- OUCH).
A Small Wave of Bank Merges in 2009. We got a small wave but honestly it was a little smaller than my expectations. Most would blame it on the economy and lack of transparency of bank balance sheets. However, I think there is an additional reason why more banks, especially regional and community banks have not merged. In this down turn there are very few investors willing to start a new bank. So, if you are the executive officers of a bank that should be sold, where are you going to work and retain your celebrity executive status? No where. So, the executives at many banks who should be bought out have no incentive to promote such an idea to their directors or shareholders. The very interest of the executive at many banks that need to go away is directly opposed to the interest of the directors and more importantly the shareholders, so the struggling banks continue to operate under the illusion they can turn it around, or reach profitability when organic growth is non-existent for most.
I expect the stock market to continue its bottoming process. This process includes a grindingly sideways market with an upward bias for a few weeks or few months. The market needs to work off oversold conditions, which will continue to frustrate market participants. Then, we should see at least a hard retest of the lows, or in my opinion the markets will make new lows. I was a tad late, in that the stock market stopped grinding sideways to higher the first week of January, but I was dead right in that the markets would make a new low, which occurred in early March 2009. As someone who uses technical analysis and Elliott Wave Theory not exactly a difficult prediction calling for one more low back then. It just seemed to be the natural fit to ending the move down.
I expect the bond market to begin a topping process, which will include consolidating at these higher levels and build a topping pattern. During this process, I expect to see smaller highs, which will exhaust this move up as part of the topping process. After which, I expect the bond market to begin a correction. It wouldn't surprise me at all for there to be some linkage in the expected top in the bond market with a new low or at least a firm test of the lows in the stock market in 2009. We got a top in the bond market, but it was a panic buying spike top, which is very odd. We got no topping pattern. We did get the expected correction and linkage time wise to the stock market.
I'm very comfortable with the results of my 5 predictions for 2009. The only big surprise was the bond market did not break down further, especially given the advance in stocks. So, now it's time to look at 2010 and what might be ahead of us in the coming year. Here are my 5 predictions for 2010:
Commercial Real Estate Continues to Drop: In keeping it really simple and easy, let's continue to look at commercial real estate. While we experienced a decline in commercial real estate values in 2009, the real pain has yet to be felt in this part of the real estate market. In fact, the residential market has provided a great guide. That is, prices begin to decline before banks take them back as REOs, and this is when we see some of the largest declines as the bank's balance sheet bulges with bad loans and dispenses of them through he foreclosure process. 2010 (relative to 2009) will see a sharp increase in bank owned commercial real estate buildings, which will ultimately force the price of values down. Adding to the nightmare are the declining trends in lease rates, higher vacancies, and a continued soft economy, all of which re-value this type of real estate lower.
There is another unique set of circumstances that will exacerbate the problem in commercial real estate. When the FDIC closes a bad bank they award those loans and deposits to a stronger and financially healthier bank, and in so doing so, they typically mark down the value of the bad loans to what the deemed collectable value is, which is far lower than what's owed at the time of transfer to the new bank. So, it's in the new banks best interest to push these bad real estate loans off their balance sheet as quick as possible because there's an opportunity in some cases for the new bank to make some money because the marked down value in some cases is less than the market value, even with value declines, or at least smaller losses than compared to the full note value. That's right, there's now an incentive for some banks to sell discounted commercial real estate, which could further compress the commercial market place via more supply of distress real estate.
As a commercial Banker, I have access to many people who own commercial real estate, and commercial real estate brokers who specialize in this segment. And it seems like we the end of 2009 is equal to the end of the first quarter in the commercial real estate problem. We should expect commercial real estate to be soft for a number of years based on the dynamics within the industry.
High-End Homes Decline: Let's stick with the real estate theme. During the majority of the first half of 2009 there was a moratorium on filing foreclosures. And when that moratorium was lifted we experienced a sharp rise in foreclosure notices. A recent report on CNBC stated that 1/3 of those notices were on high-end homes. That's a sharp rise on high-end homes from a level of 6% of foreclosure notices just a few years ago. So, why the change?
It's really quite simply and includes a couple factors. First, the high-end homes are owned by the affluent who typically have higher levels of net wroth outside of their homes, and therefore can carry mortgage payments longer should they experience financial difficulty, so the lack of affordability problem is beginning to hit them now that they have burned through capital to maintain a lifestyle no longer warranted, especially if they have seen a hit to their income levels from peak years.
Secondly, the Alt A. and Option Arm programs began to reset in earnest in late 2009, and will continue through 2011-14 in size. If California is any representation, the majority of these loans were underwritten on high-end homes, and as they re-price they are blowing people out of real estate affordability because the payment adjustment is an increase of 40-80%. In addition, by now many of these high-end homes are still vastly over priced and now upside down.
As the re-pricing continues into 2010, we should see a real issue with the percentage of homes in the foreclosure process being high end homes. Again, if California is any representation, currently the high-end market isn't moving on the sales front, it's mostly the starter market supported by government tax incentives.
If the problem persists like I expect the residential market in its entirety could eventually gets compressed from the top down. As the market sees more inventory in the high-end those prices will decline, and why would any buy a smaller house for the same price as a larger house? In fact, if the high-end homes decline it should force smaller homes or lower valued homes down with it.
The problem could be felt most persistently in California where over 50% of Alt A. and Option Arm programs are underwritten. The bubble state nightmare continues, and it's not even close to finished.
A Lot More Bank Closures: The FDIC was pretty busy in 2009, but we haven't seen anything yet. In 2009 they systematically closed 135 banks at a regular pace every Friday. What was fascinating about those bank closures is that I would have guessed California (17) and Florida (14) to be the leading state for bank closures. And I would have been dead wrong; the top two states were Illinois (21) and Georgia (26).
At the end of quarter 3 of 2009, the FDIC report the number of bad banks at slightly more than 500, which was up from the slightly more than 400 at the end of the 2nd quarter of 2009. These numbers of bad banks is a highly flawed number being report by the FDIC for 2 big reasons.
Since the inception of the banking crises many bank executives have not been divulging bad loans in their entirety. Yes, even in banking their there is a lack of transparity just like Wall Street, even at smaller banks. I know of one bank president at another institution that was let go for essentially hiding bad loans from directors and shareholders. I've also talked to chief credit officer's at other banks, who have told me that the FDIC is being a lot more aggressive in forcing banks to down grade loan and back date the down grade to when it should have occurred. Even grown ups running financial institutions don't want to admit they've failed.
The other reason is the financial statements the FDIC is looking are to rate banks as bad banks are essentially past information, and do not take into consideration the currently declining commercial estate market, the substantially weakened personal balance sheet of business owners, and the lack of true net worth within a business to weather a storm within their industry. None of those future factors are really factored into the current count of bad banks. There are over 8,000 thousand bank, and by my estimates just from reviewing banks in California, you multiple the FDIC's number by 4-5 for a national number of bad banks of 2,000-2,500. That may seem like a lot, but by the time we are done with this deflationary environment, we could actually shut down more than that.........hard to imaging.
We Will See Some Cities, Counties, or Municipalities File for Bankruptcy: I think I might be a tad early in this call, maybe by 1-2 years, but the time is very ripe for some municipalities to file bankruptcy. The City of Vallejo in California was the first, and opened the door for more to follow, but so far that has not happened, YET!
The City of Oakland has flirted with the idea and for all intended purposes the number of municipalities in California that are broke with budget deficits is staggering. Ditto in Florida, and probably the same for Arizona. The rumors are Houston is essentially broke with no way out but bankruptcy, and New York and NY City have their own issues. We could go on and on, but the message is municipalities across this country are broke.
The fiscal year will end 6/30/2010, and there are thousands of local municipalities across America, and many will realize for the 2nd or 3rd year in row they are facing large budget deficits heading into the new fiscal year starting 7/1/2010 and they have little control over their financial issues.
The sad reality is most cities and municipalities are not making big enough structural (real) changes financially, and creating more of a band approach to their problems in hopes that better times coming along to bail them out. Add into that, peak spending levels were set off revenue levels that included taxes from capital gains and developer fees, which are for the most part non existent revenue sources today, and they have a real problem that's simply not going away. Compounding that is the declining revenues from real estate taxes and retail sales taxes, and well you get the point.
Next year, we might just see some municipalities realize the only way to cure their financial issues and reset compensation levels driven by unions is to file bankruptcy! Honestly, what are they waiting for? Let's get it over with like ripping a band off in one fast motion..........right off!!!
If we don't see bankruptcy happen it will be for one of two reasons. First, Uncle Sam might step in and bail out some states: California is too big to fail mentality, something like that. Secondly, the unions are fighting it tooth and nail, and they carry sizeable political clout, and local leaders have been for the most part imputent to tackle the union issue, at least so far.
The U.S. Treasury Bond Market Finally Breaks Down Below It's Channel!!!
Below is a 30 year chart of the U.S. Treasury Bond Market. Notice I've drawn two channel lines. The one in green is off absolute tops and bottoms. The pink is off the majority of tops and bottoms. You'll notice that bond price have spent very little time between the pink and green lines and in the past has signaled a top or bottom.
In an article in the Wall Street journal several years ago, I read that 50% of all deposits are maintained at the 10 largest banks in the country. So, now you understand one of the reasons why the federal government is willing to back the largest financial institutions, they are protecting the majority of deposit holders or are they really buying voter approval of more government intervention. It's one in the same.
In addition, if they back the largest institutions, they also back the very components in the Dow Jones and SP500, which has help create the stock market bounce of 2009. Had they back the smaller banks, we'd get a lot less bounce in the stock market because those smaller banks are not components of major stock indexes, so the side benefit for the government is stock market manipulation, again in an attempt for voter approval of government intervention and continued insanity.
In the game of too big to fail, the government is back stopping the large institutions while they are slowly letting the smaller regional and community banks fail and systematically dismantling a few every Friday, and thereby picking winners and losers. In addition, the smaller banks they close down are being awarded to larger banks, and thus the FDIC is creating bigger banks in the long run, and we just can't get away from the too big to fail mentality in government.
I wouldn't expect this game to change, and as the commercial real estate market continues to decline, and the small business owner struggles, those corresponding loans will impair a great many smaller banks, especially those who already have problems. I expect to see closures in California lead the way in 2010.
Next year, the FDIC will close more banks in 2010 than it did in 2009. The only two things that might inhibit that: 1) Does the FDIC have the man power to do it? 2) Some sort of government invention, with the big banks paying back TARP, the government will probably seek a way to redistribute that money. Once it's taken from the tax payer, its never really returned, now is it!.
There are a few things very interesting about the technical set up for a correction in long bonds.
We had a panic buying spike that corresponded with the stock market bottom of 2009 on a lower highs in both the MACD and RSI. Bearish Divergence.
We've made continual new price highs while making lower highs in both the RSI and MACD over time. Bearish Divergence.
The blue arrows reflect market bottoms in price corresponding with price touching the channel lines while the MACD bottomed below the zero line and turned higher. Look at the current set up and we are about to test the bottom channel lines again, and yet the MACD has a lot more room to go on the down side. Ditto the RSI. This could be a very telling difference that the market is finally ready to break its channel.
Point and figure charts reflect a target on shorter term charts of 95.
Below is a weekly chart of the Long Bond:
On a weekly basis, we see a potential head and shoulder's topping pattern. If so, the price target is 82. Hard to fathom, but that is what the target is based on the pattern. The MACD is rolling over. The right should looks like a sideways consolidation so the trend lower should still be intact. And, the RSI has not reached oversold levels.
Below is the weekly chart of the yield on the Ten Year Treasury Note:
If we look at the yield on the 10 year note, we see a corresponding head and shoulder's bottoming pattern and it's testing its neckline right now. If the pattern holds the target yield is 5.75-6.0%. Very hard to fathom again, but I imagine that the 10 year yield at those rates would correspond very well with the long bond trading down to 82-95!
I don't think the world is ready for higher rates and lower bond values.
Lower bond values would trap so many nervous investors, who rushed into that market as the safe haven move when stocks were crashing, and they could easily get trapped into a bear market and more wealth destruction is on the way.
Higher rates would further compress the problem in commercial real estate values, as higher rates would raise the cost of financing, bearish. And, raise the cap rate to value commercial real estate thereby lowering its value, bearish.
Greater downside pressure on commercial real estate would also impact the balance sheets of regional and community banks and potentially exacerbate the number of failing banks that need to be closed.
Higher rates would also put relatively more down side pressure on high end residential real estates, as a cost of financing, bearish.
And those risks would be the easy one's to deal with. A large correction in the long bond would probably be the first significant red flag of a loss in confidence in the United States from global trading partners, as they would probably be part of the selling. It would also probably the first significant sign that the US is losing its grip as the dominant power of the globe.
I also believe when it happens it will be the precursor for a more protectionist environment, global tensions, and most of all a long term leading indictor for the next great bubble: SOCIAL UNREST.
Happy New Year.