My apologies for the second consecutive article of the new year continuing to sound sombre and heaping still more bad news. Today’s ill tidings have to do entirely with the USA. Most of the facts given here are culled out from an outstanding presentation that Thomas A. Russo will have made at the January 2008 Annual Meeting of the World Economic Forum at Davos.

It has been my privilege to have interacted with Tom for several years. He is a deep thinker of the economy and capital markets; has been in the business for long; and as Vice Chairman and Chief Legal Officer of Lehman Brothers, knows his onions. Tom shared a late November version of his findings with some of us in Washington DC in early December 2007. The data has been updated right up to early January 2008. Everything looks nastier.

Let’s start with the real estate sector. As I wrote last fortnight, for the first time since November 2005, the US unemployment rate has touched 5 per cent. The Conference Board’s Consumer Confidence Index in December 2007 was 21 per cent lower than in July 2007. Debt-service payments and financial obligations of US households have been creeping up over the years. By Q3 2007, these together stood at over 19 per cent of household disposable income. In addition, higher energy prices have reduced the budget for discretionary consumption spends by as much as 1 percentage point. Its not surprising, therefore, that with the solitary exception of November 2007, US retail sales growth rates have been lower for every month of 2007 than they were in either 2006 or 2005. Both July and December 2007 — the traditional big-spend months — have shown the worst growth in the last four years.

Now, on to the financial sector. By the end of 2007, outstanding sub-prime mortgages were estimated at over $1.2 trillion. To put it in perspective, that’s about 20 per cent more than India’s GDP at current prices. Over two-thirds of these mortgages are called ‘2-28’ — the first two years with a teaser fixed rate, then 28 years of higher calibrated floating rates. Something like $550 billion, or 2.8 million sub-prime loans will be reset to floating rates by the end of 2008, which will increase monthly mortgage payments by at least 20 per cent, or by an average of $300 per month.

With shell-shocked banks employing much tighter lending standards and falling home prices, the sure-shot outcome will be a further rise in home loan delinquencies. Analysts at Lehman Brothers have forecast cumulative defaults of sub-prime loans taken in 2006 and the first half of 2007 to be as much as 40 per cent in the course of this year. Consequently, home loan foreclosures have been estimated to rise to a total of around 2 million single-family home units over 2008 and 2009 — which would be over three times the normal US foreclosure rate.

Given the massive inventory of unsold home units in the US, the huge growth in home loan foreclosures will further depress home prices. In Q1, 2005, US average home price inflation was at 15.7 per cent — which allowed home owners to extract large equity values and increase consumer spending as well as GDP. Today, the inflation rate is (-)4.5 per cent. Analysts believe that the index will fall by 20 per cent from peak to trough, with an extra 5 percentage point downside risk. That, according to Russo, would make it the most dramatic fall in home loan prices since the Great Depression of 1929-34.

There’s more bad news. Credit card delinquencies have started picking up for all issuers, with Capital One being the worst hit. Economics tells us that these delinquencies ought to rise as consumer budgets get stretched and mortgage defaults increase. To make matters worse, sub-prime auto loan defaults have also started, especially for loans from 2007.

Tom Russo doesn’t overstate facts. He studies numbers and treads very carefully before coming to a view. The fact that Tom has written what he has and is going to share this presentation at Davos, convinces me that things are going to get quite a bit worse. Be prepared, then, for streams of bad news coming from the US over the first six months of 2008, if not longer. And for global financial markets being on a perpetual edge as everyone skates on US thin ice. (The US Federal Reserve cut interest rates by 75 basis points as this article went to press).

No doubt, what goes down will bounce up. The question is: Down for how long? How fast? And till where? That is the stuff that is giving everyone sleepless nights.

The author is chairman of CERG Advisory. This email address is being protected from spam bots, you need Javascript enabled to view it
(Businessworld Issue 25 Dec-31 Dec 2007)