Pondering the next “shoe to drop”

If there’s one good thing about how drastic the market declines have been, it’s that there are unlikely to be many more unpleasant surprises, a panel of experts assembled by the CFA Institute argued. But there are still a few problem areas they have their eyes on.

Gillian Tett, assistant editor of the Financial Times, was the featured speaker at the Institute’s Global Financial Crisis Roundtable. Tett is largely recognized as the first member of the global news media to have sounded the alarm on an impending financial meltdown — and spent most of the early part of 2007 being maligned by the banking establishment for her views.

Vindicated, although not necessarily happy about what has occurred, Tett, who holds a PhD in social anthropology, told the audience she believes that the market psyche has entered the depression phase — and the list of potential financial time-bombs is getting quite short.

“We are in a situation of depression, and it could get worse. Some people would say we’re at the nadir and are in the greatest buying opportunity of our lives. Some people say there is more pain to come,” she said. “About a year ago, I sat down with the rest of my team and said, let’s draw up a hit list of all the weakness of the financial system, all the cracks that exist.”

She adds, “We sat down and made a list, and said, monolines look a bit dodgy, AIG looked dodgy — we were already very worried about Iceland and Eastern Europe. The list went on. The good news — if you can call it that — is that much of what was on that list has already toppled over.”

Tett says only two identified problem areas remain, but she’s unsure what sort of impact they will have. The first — and most likely next — landmine in the markets is the implosion of large leveraged buyouts that took place at the height of the credit lending spree in late 2006 and early 2007.

“I understand from talking to corporate finance people that most of the nuttier private finance takeover deals in the first half of 2007 were refinanced at a pretty late stage in the game,” she says. “Those loans probably won’t start really blowing up until the second half of 2009, possibly as late as 2010.”

The more troublesome — but less likely — crisis could occur with U.S. Treasuries. The influx of capital into Treasuries has been almost unprecedented, to the extent that some in the industry are warning that the market is on the verge of another asset bubble. Tett isn’t sure how sustainable that market is, given the amount of debt the U.S. intends to carry.

“Thus far, investors have reacted to government shock by choosing to buy more government bonds, not less. It’s perfectly understandable because there really are not many places to put your money right now,” she says. “However, there is a risk. People might start saying there is a limit to how long the U.S. government can keep bailing out its banks — creating another TARP, $700 billion here and $700 billion there — these are really big numbers even for the U.S. economy.”

During the Japanese crisis, the government was able to maintain a stable bond market. Tett, who has written extensively about the Japanese banking crisis, says most of those bonds were domestically held. U.S. and British Treasuries are widely held by foreign governments and investors.

“You need to remember that when Japan had its crisis, it had more than 95% of the Japanese Treasury bond market in the hands of domestic investors. They were a pretty patriotic, loyal bunch. That is obviously not the case with the U.S. and the U.K.,” she says. “I don’t think we’re [near a crisis] yet. I don’t think we may ever be there — at least I hope not.”

The outsized balance sheet of the U.S. government has Jason Trennert, managing partner and chief investment strategist of Strategas Research Partners, wondering when inflation may return, even though right now deflation is a huge concern as deleveraging occurs in the market.

“I’m worried about deflation at the moment. The trade for investors over the next couple of years from an equity market point of view will be when to stop playing deflation and when to start playing inflation; that is to say, when to get back to buying things like energy and basic materials,” he says. “I find it hard to believe that, despite best intentions, the Fed and the administration will be able to ‘stick the landing’ on price stability when the Fed has quadrupled its balance sheet and the administration will be running trillion-dollar deficits.”

Abby Joseph Cohen, CFA, president of the Global Markets Institute and senior investment strategist at Goldman Sachs, says European banks may still be hiding many dodgy assets on their balance sheets due to their lackadaisical adherence to mark-to-market accounting. This means their leverage still remains quite high. She suggested European banks may offer a few more surprises. In the U.S., most of the bad news has been felt.

“[Europe’s] local banking sectors have not been quite as robust as had the Federal Reserve and others. It may very well be that some of these institutions are more levered than you think they are,” she says. “Leverage is the function of debt, but also the denominator. If those assets are overstated and the asset value is not appropriately marked lower, then the leverage in some of those institutions may be higher than what is being currently reported.”