The debt crisis in Puerto Rico could potentially cost financial institutions in the United States tens of billions of dollars in losses. This week, Puerto Rico Governor Alejandro Garcia Padilla publicly announced that Puerto Rico’s 73 billion dollar debt is “not payable,” and a special adviser that was recently appointed to help straighten out the island’s finances said that it is “insolvent” and will totally run out of cash very shortly. At this point, Puerto Rico’s debt is approximately 15 times larger than the per capita median debt of the 50 U.S. states. Yes, the Greek debt crisis is larger, as Greece currently owes about $350 billion to the rest of the planet. But only about $14 billion of that total is owed to U.S. financial institutions. But with Puerto Rico, things are very different. Just about the entire 73 billion dollar debt is owed to U.S. financial institutions, and this could potentially cause massive problems for some extremely leveraged Wall Street firms.
There is a reason why Puerto Rico is called “America’s Greece”. In Puerto Rico today, more than 40 percent of the population is living in poverty, the unemployment rate is over 12 percent, and the economy of the small island nation has continually been in recession since 2006.
Yet all this time Puerto Rico has continued to pile up even more debt. Finally, it has gotten to the point where all of this debt is simply unpayable
Steven Rhodes, the retired U.S. bankruptcy judge who oversaw Detroit’s historic bankruptcy and has now been retained by Puerto Rico to help solve its problems, gave a blunt assessment on Monday.
Puerto Rico “urgently needs our help,” Rhodes said. “It can no longer pay its debts, it will soon run out of cash to operate, its residents and businesses will suffer,” he added.
This is why I hammer on the danger of U.S. government debt so often. As we see with the examples of Greece and Puerto Rico, eventually a day of reckoning always arrives. And when the day of reckoning arrives, power shifts into the hands of those that you owe the money too.
It would be hard to understate just how severe the debt crisis in Puerto Rico has become. Former IMF economist Anne Krueger has gone so far as to say that it is “really dire”…
“The situation is dire, and I mean really dire,” said former IMF economist Anne Krueger, co-author of the report commissioned by the U.S. territory, which recommended debt restructuring, tax hikes and spending cuts. “The needed measures may face political resistance but failure to address the issues would affect even more the people of Puerto Rico.”
So who is going to get left holding the bag?
As I mentioned at the top of this article, major U.S. financial institutions are very heavily exposed. Income from Puerto Rican bonds is exempt from state and federal taxation, and so that made them very attractive to many U.S. investors. According to USA Today, there are 180 mutual funds that have “at least 5% of their portfolios in Puerto Rican bonds”…
The inability of the U.S. territory to repay its debt, combined with the financial crisis in Greece, would have far-reaching implications for financial markets and unsuspecting American investors. Morningstar, an investment research firm based in Chicago, estimated in 2013 that 180 mutual funds in the United States and elsewhere have at least 5% of their portfolios in Puerto Rican bonds.
It is important to keep in mind that many of these financial institutions are very highly leveraged. So just a “couple of percentage points” could mean the different between life and death for some of these firms.
And unlike what is happening with Greece, the private financial institutions that hold Puerto Rican bonds are not likely to be very eager to “negotiate”. In fact, the largest holder of Puerto Rican debt has already stated that it is very much against any kind of restructuring…
U.S. fund manager OppenheimerFunds, the largest holder of Puerto Rico debt among U.S. municipal bond funds, warned the island it stands ready to defend the terms of bonds it holds, a day after the governor said he wanted to restructure debt and postpone bond payments.
What Oppenheimer is essentially saying is that it does not plan to give Puerto Rico any slack at all. Here is more from the article that I just quoted above…
OppenheimerFunds, with about $4.5 billion exposure to Puerto Rico according to Morningstar, said it believed the island could repay bondholders while providing essential services to citizens and growing the economy. It said it stood ready “to defend the previously agreed to terms in each and every bond indenture.”
“We are disheartened that Governor Padilla, in a public forum, has called for negotiations with other creditors, representing and including the millions of individual Americans that hold Puerto Rico municipal bonds,” a spokesman for Oppenheimer said in a statement.
But Puerto Rico simply does not have the money to meet all of their debt obligations.
So somebody is not going to get paid at some point.
When that happens, those that insure Puerto Rican bonds are also going to take tremendous losses. The following comes from a recent piece by Stephen Flood…
Now, bondholders are at risk as are the funds which hold Puerto Rican bonds and, more importantly, those who insure them in the derivatives market.
Dave Kranzler, from Investment Research Dynamics has warned that there are signs that the Puerto Rico situation may not remain a local crisis for much longer.
He points out that share prices of MBIA, the bond insurers, have been plummeting. MBIA are valued at $3.9 billion whereas their exposure to Puerto Rican debt is around $4.5 billion. Kranzler reckons their exposure could even be multiples of that figure. A default could wipe them out.
He also points out that the firm’s largest shareholders are Warburg Pincus, the firm to which Timothy Geithner went after his stint as Treasury Secretary, when he helped paper over the chasms opening up in the financial system.
Did you notice the word “derivatives” in that quote?
Hmmm – who has been writing endless articles warning about the danger of derivatives for years?
Who has been warning that “this gigantic time bomb is going to go off and absolutely cripple the entire global financial system“?
When Puerto Rico defaults, bond insurers are going to be expected to step up and make huge debt service payments to investors.
But this just might bankrupt some of these big bond insurers. In fact, we have already started to see the stock prices of some of these bond insurers begin to plummet. The following comes from the Wall Street Journal…
Bond insurers MBIA Inc. and Ambac Financial Group Inc. are down again Tuesday as concerns over Puerto Rico’s ability to repay its debt multiply.
Investors fear that both firms face the potential for steep losses on their promises to backstop billions of Puerto Rico’s $72 billion of debt.
MBIA’s stock closed down 23% Monday, and fell more than 10% before rebounding Tuesday. By late afternoon, the stock was down 6%. Ambac’s stock fell 12% Monday and was off 14% Tuesday.
Of course Puerto Rico is just the tip of the iceberg of the coming debt crisis in the western hemisphere, just like Greece is just the tip of the iceberg of the coming debt crisis in Europe.
So stay tuned, because the second half of 2015 has now begun, and the remainder of this calendar year promises to be extremely “interesting”.
Well, the Nasdaq finally did it. It has climbed all the way back to where it was at the peak of the dotcom bubble. Back in March 2000, the Nasdaq set an all-time record high of 5,048.62. On Thursday, after all these years, that all-time record was finally eclipsed. The Nasdaq closed at 5056.06, and Wall Street greatly rejoiced. So if you invested in the Nasdaq at the peak of the dotcom bubble, you are just finally breaking even 15 years later. Unfortunately, the truth is that stocks have not been soaring because the U.S. economy is fundamentally strong. Just like the last two times, what we are witnessing is an irrational financial bubble. Sometimes these irrational bubbles can last for a surprisingly long time, but in the end they always burst. And even now there are signs of economic trouble bubbling to the surface all around us. The following are 11 signs that we are entering the next phase of the global economic crisis…
#1 It is being projected that half of all fracking companies in the United States will be “dead or sold” by the end of this year.
#2 The rig count just continues to fall as the U.S. oil industry implodes. Incredibly, the number of rigs in operation in the United States has fallen for 19 weeks in a row.
#3 McDonald’s has announced that it will be closing 700 “poor performing” restaurants in 2015. Why would McDonald’s be doing this if the economy was actually getting better?
#4 As I wrote about the other day, we could be right on the verge of a Greek debt default. In fact, we learned on Thursday that the Greek government has been “running on empty” for months…
Greece warned it will go bankrupt next week after failing to stump up enough cash to pay millions of public sector workers and its international debts.
Deputy finance minister Dimitras Mardas set alarm bells ringing yesterday when he declared the country had been ‘running on empty’ since February.
With a debt repayment deadline looming on May 1, Greece faces the deeply damaging prospect of having to snub its own employees to make a €200m payment to the International Monetary Fund.
#5 Coal accounts for approximately 40 percent of all electrical generation on the entire planet. When the price of coal starts to drop, that is a sign that economic activity is slowing down. Just prior to the last financial crisis in 2008, the price of coal shot up dramatically and then crashed really hard. Well, guess what? The price of coal has been crashing again, and it is already lower than it was at any point during the last recession.
#6 The price of iron ore has been crashing as well. It is down 35 percent in the last nine months, and David Stockman believes that this is because of a major deflationary crisis that is brewing in China…
There is no better measure of the true contraction underway in China than the price of iron ore. The Wall Street stock peddlers will tell you not to be troubled by the 70% plunge from the 2012 highs and the 35% drop just in the last nine months. According to them, its all the fault of the big global miners who went overboard opening up massive new iron ore pits and mining infrastructure.
#7 At this point, China accounts for more total global trade than anyone else in the world. That is why it is so alarming that Chinese imports and exports are both absolutely collapsing…
China’s monthly trade data shows exports fell in March from a year ago by 14.6% in yuan terms, compared to expectations for a rise of more than 8%.
Imports meanwhile fell 12.3% in yuan terms compared to forecasts for a fall of more than 11%.
#8 The number of publicly traded companies in the United States that filed for bankruptcy during the first quarter of 2015 was more than double the number that filed for bankruptcy during the first quarter of 2014.
#9 New home sales in the United States just declined at their fastest pace in almost two years.
#10 U.S. manufacturing data has been shockingly weak lately…
On the heels of weak PMIs from Europe and Asia, Markit’s US Manufacturing PMI plunged to 54.2 in April (from 55.7). Against expectations of a rise to 55.6, this is the biggest miss on record. Of course, this is ‘post-weather’ so talking-heads will need to find another excuse as New Orders declined for the first time since Nov 2014.
#11 When priced according to “the average blue-collar hourly wage“, U.S. stocks are the most expensive that they have ever been in history right now. To say that this financial bubble is overdue to burst is a massive understatement.
For a long time, I have been pointing to 2015 as a major “turning point” for the global financial system, and I still feel that way.
But for the first four months of this year, things have been surprisingly quiet – at least on the surface.
So what is going on?
Well, I believe that what we are experiencing right now is the proverbial “calm before the storm”. There is all sorts of turmoil brewing just beneath the surface, but for the moment things seem like they are running along just fine to most people. Unfortunately, this period of quiet is not going to last much longer.
And those that are “in the know” are already moving their money in anticipation of what is coming. For example, consider the words of Snapchat founder and CEO Evan Spiegel…
Fed has created abnormal market conditions by printing money and keeping interest rates low. Investors are looking for growth anywhere they can find it and tech companies are good targets – at these values, however, all tech stocks are expensive – even looking at 5+ years of revenue growth down the road. This means that most value-driven investors have left the market and the remaining 5-10%+ increase in market value will be driven by momentum investors. At some point there won’t be any momentum investors left buying at higher prices, and the market begins to tumble. May be 10-20% correction or something more significant, especially in tech stocks.
It may not happen next week, or even next month, but big financial trouble is coming.
And when it finally arrives, it is going to shock the world, even though anyone with any sense can see the coming crisis approaching from a mile away.
According to the Wall Street Journal, Greece staying in the eurozone is no longer “the base case” for European officials, and one even told the Journal that “literally nothing has been achieved” in negotiations with the new Greek government since the Greek election almost three months ago. In other words, you can take all of that stuff you heard about how the Greek crisis was fixed and throw it out the window. Over the next few months, a big chunk of Greek government bonds held by the IMF and the European Central Bank will mature. Unless negotiations produce a load of new cash for Greece, there will be a default, and right now there is very little optimism that we will see an agreement any time soon. In fact, as I wrote about the other day, behind the scenes banks all over Europe are quietly preparing for a Grexit. European news sources are reporting that the Greek banking system is on the verge of collapse, and over the past couple of weeks Greek bond yields have shot through the roof. Most of the things that we would expect to see in the lead up to a Greek exit from the eurozone are happening, and now we will wait and see if the Greeks actually have the guts to pull the trigger when push comes to shove.
At this point, many top European officials are quietly admitting that it is more likely than not that Greece will leave the euro by the end of this year. The following is an excerpt from the Wall Street Journal article that I mentioned above…
It’s still possible that Greece can remain in the eurozone—though that is no longer the base case for many policy makers. At the very least, most fear the situation is going to get much, worse before it gets any better. No one now expects a deal to unlock Greek bailout funding at this week’s meeting of eurozone finance ministers in Riga—originally set as the final deadline for a deal. The new final, final deadline is now said to be a summit on May 11.
But among European politicians and officials gathered in Washington DC last week for the International Monetary Fund’s Spring Meetings, there was little optimism that a deal will be agreed by then.
The two sides are no closer to an agreement than when the Greek government took office almost three months ago. “Nothing, literally nothing has been achieved,” says an official.
Literally nothing has been achieved?
That is not what the mainstream media has been telling us over the past few months.
They kept telling us that agreements were in place and that everything had been fixed.
I guess not.
The Germans believe that the risks of a “Grexit” have already been priced in by the financial markets and that a Greek exit from the euro can be “managed” without any serious risk of contagion.
So they are playing hardball with the Greeks.
On the other hand, the Greeks believe that the risk of contagion will eventually force the Germans to back down…
Greece’s Finance Minister Yanis Varoufakis said in an interview broadcast on Sunday that if Greece were to leave the euro zone, there would be an inevitable contagion effect.
“Anyone who toys with the idea of cutting off bits of the euro zone hoping the rest will survive is playing with fire,” he told La Sexta, a Spanish TV channel, in an interview recorded 10 days ago.
“Some claim that the rest of Europe has been ring-fenced from Greece and that the ECB has tools at its disposal to amputate Greece, if need be, cauterize the wound and allow the rest of euro zone to carry on.”
In this case, I believe that the Greeks are right about what a Grexit would mean for the rest of Europe and the Germans are wrong.
Once one country leaves the euro, that tells the entire world that membership in the euro is only temporary. Immediately everyone would be looking for the “next Greece”, and there are lots of candidates – Italy, Spain, Portugal, etc.
There is a very good chance that a Grexit would set off a full-blown European financial panic. And once a financial panic starts, it is very hard to stop. The danger that a Grexit poses is so obvious that even the Obama administration can see it…
A Greek exit from the euro zone would carry significant risks for the global economy and no one should be under the impression that financial markets have fully priced in such an event, the chairman of the White House Council of Economic Advisers said.
The comments by Jason Furman in an interview with Reuters in Berlin are among the strongest by a senior U.S. official and are at odds with those of German Finance Minister Wolfgang Schaeuble, who told an audience in New York last week that contagion risks from a so-called “Grexit” were limited.
“A Greek exit would not just be bad for the Greek economy, it would be taking a very large and unnecessary risk with the global economy just when a lot of things are starting to go right,” Furman said.
Meanwhile things continue to get even worse inside Greece. If you have any money in Greek banks, you need to move it immediately. The following comes from Zero Hedge…
Things for insolvent, cashless Greece are – not unexpectedly – getting worse by the day.
Following yesterday’s shocking decree that the government will confiscate local government reserves and “sweep” them into the central bank to provide the country more funds as it approaches another month of heavy IMF repayments, earlier today Bloomberg reported that the ECB would add insult to injury and may increase haircuts for Greek banks accessing Emergency Liquidity Assistance, thus “reining in” the very critical emergency liquidity which has kept Greek banks operating in recent weeks as the bank run sweeping the domestic banking sector has gotten worse by the day.
And many Greeks don’t even have any money to put in the banks because they haven’t been paid in months…
Meanwhile, the reality is that for a majority of the Greek population, none of this really matters because as Greek Ta Nea reports, citing Labor Ministry data, about one million Greek workers see delays of up to 5 months in salaries payment by their employers. The Greek media adds that about 45% of salaried workers in Greece make no more than €751 per month, the country’s old minimum wage; which also includes part-time workers.
No matter what European officials try, things just continue to unravel in Greece and in much of the rest of Europe.
We stand on the verge of the next great global economic crisis. The lessons that we should have learned from the last crisis were never learned, and instead global debt levels have exploded much higher since then. In fact, according to Doug Casey, the total amount of global debt is 57 trillion dollars higher than it was just prior to the last crisis…
In 2008, excess debt pushed the global financial system to the brink. It was a golden opportunity for governments and banks to reform the system. But rather than deal with the problem, they papered over it by issuing more debt. Worldwide debt levels are now $57 trillion higher than in 2008.
The eurozone as it is constituted today is doomed.
That doesn’t mean that the Europeans are going to give up on social, economic and political integration. It just means that we are entering a time of transition that is going to be extremely messy.
And once the European financial system begins to fall apart, the rest of the world will quickly follow.
Are we on the verge of a major worldwide economic downturn? Well, if recent warnings from prominent bankers all over the world are to be believed, that may be precisely what we are facing in the months ahead. As you will read about below, the big banks are warning that the price of oil could soon drop as low as 20 dollars a barrel, that a Greek exit from the eurozone could push the EUR/USD down to 0.90, and that the global economy could shrink by more than 2 trillion dollars in 2015. Most of the time, very few people ever actually read the things that the big banks write for their clients. But in recent months, a lot of these bankers are issuing such ominous warnings that you would think that they have started to write for The Economic Collapse Blog. Of course we have seen this happen before. Just before the financial crisis of 2008, a lot of people at the big banks started to get spooked, and now we are beginning to see an atmosphere of fear spread on Wall Street once again. Nobody is quite sure what is going to happen next, but an increasing number of experts are starting to agree that it won’t be good.
Let’s start with oil. Over the past couple of weeks, we have seen a nice rally for the price of oil. It has bounced back into the low 50s, which is still a catastrophically low level, but it has many hoping for a rebound to a range that will be healthy for the global economy.
Unfortunately, many of the experts at the big banks are now anticipating that the exact opposite will happen instead. For example, Citibank says that we could see the price of oil go as low as 20 dollars this year…
The recent rally in crude prices looks more like a head-fake than a sustainable turning point — The drop in US rig count, continuing cuts in upstream capex, the reading of technical charts, and investor short position-covering sustained the end-January 8.1% jump in Brent and 5.8% jump in WTI into the first week of February.
Short-term market factors are more bearish, pointing to more price pressure for the next couple of months and beyond — Not only is the market oversupplied, but the consequent inventory build looks likely to continue toward storage tank tops. As on-land storage fills and covers the carry of the monthly spreads at ~$0.75/bbl, the forward curve has to steepen to accommodate a monthly carry closer to $1.20, putting downward pressure on prompt prices. As floating storage reaches its limits, there should be downward price pressure to shut in production.
The oil market should bottom sometime between the end of Q1 and beginning of Q2 at a significantly lower price level in the $40 range — after which markets should start to balance, first with an end to inventory builds and later on with a period of sustained inventory draws. It’s impossible to call a bottom point, which could, as a result of oversupply and the economics of storage, fall well below $40 a barrel for WTI, perhaps as low as the $20 range for a while.
Even though rigs are shutting down at a pace that we have not seen since the last recession, overall global supply still significantly exceeds overall global demand. Barclays analyst Michael Cohen recently told CNBC that at this point the total amount of excess supply is still in the neighborhood of a million barrels per day…
“What we saw in the last couple weeks is rig count falling pretty precipitously by about 80 or 90 rigs per week, but we think there are more important things to be focused on and that rig count doesn’t tell the whole story.”
He expects to see some weakness going into the shoulder season for demand. In addition, there is an excess supply of about a million barrels of oil a day, he said.
And the truth is that many firms simply cannot afford to shut down their rigs. Many are leveraged to the hilt and are really struggling just to service their debt payments. They have to keep pumping so that they can have revenue to meet their financial obligations. The following comes directly from the Bank for International Settlements…
“Against this background of high debt, a fall in the price of oil weakens the balance sheets of producers and tightens credit conditions, potentially exacerbating the price drop as a result of sales of oil assets, for example, more production is sold forward,” BIS said.
“Second, in flow terms, a lower price of oil reduces cash flows and increases the risk of liquidity shortfalls in which firms are unable to meet interest payments. Debt service requirements may induce continued physical production of oil to maintain cash flows, delaying the reduction in supply in the market.”
In the end, a lot of these energy companies are going to go belly up if the price of oil does not rise significantly this year. And any financial institutions that are exposed to the debt of these companies or to energy derivatives will likely be in a great deal of distress as well.
Meanwhile, the overall global economy continues to slow down.
On Monday, we learned that the Baltic Dry Index has dropped to the lowest level ever. Not even during the darkest depths of the last recession did it drop this low.
And there are some at the big banks that are warning that this might just be the beginning. For instance, David Kostin of Goldman Sachs is projecting that sales growth for S&P 500 companies will be zero percent for all of 2015…
“Consensus now forecasts 0% S&P 500 sales growth in 2015 following a 5% cut in revenue forecasts since October. Low oil prices along with FX headwinds and pension charges have weighed on 4Q EPS results and expectations for 2015.”
Others are even more pessimistic than that. According to Bank of America, the global economy will actually shrink by 2.3 trillion dollars in 2015.
One thing that could greatly accelerate our economic problems is the crisis in Greece. If there is no compromise and a new Greek debt deal is not reached, there is a very real possibility that Greece could leave the eurozone.
If Greece does leave the eurozone, the continued existence of the monetary union will be thrown into doubt and the euro will utterly collapse.
Of course I am not the only one saying these things. Analysts at Morgan Stanley are even projecting that the EUR/USD could plummet to 0.90 if there is a “Grexit”…
The Greek Prime Minister has reaffirmed his government’s rejection of the country’s international bailout programme two days before an emergency meeting with the euro area’s finance ministers on Wednesday. His declaration suggested increasing minimum wages, restoring the income tax-free threshold and halting infrastructure privatisations. Should Greece stay firm on its current anti-bailout course and with the ECB not accepting Greek T-bills as collateral, the position of ex-Fed Chairman Greenspan will gain increasing credibility. He forecast the eurozone to break as private investors will withdraw from providing short-term funding to Greece. Greece leaving the currency union would convert the union into a club of fixed exchange rates, a type of ERM III, leading to further fragmentation. Greek Fin Min Varoufakis said the euro will collapse if Greece exits, calling Italian debt unsustainable. Markets may gain the impression that Greece may not opt for a compromise, instead opting for an all or nothing approach when negotiating on Wednesday. It seems the risk premium of Greece leaving EMU is rising. Our scenario analysis suggests a Greek exit taking EURUSD down to 0.90.
If that happens, we could see a massive implosion of the 26 trillion dollars in derivatives that are directly tied to the value of the euro.
We are moving into a time of great peril for global financial markets, and there are a whole host of signs that we are slowly heading into another major global economic crisis.
So don’t be fooled by all of the happy talk in the mainstream media. They did not see the last crisis coming either.
When the stock market starts to behave like a roller coaster, that is a sign that a major move to the downside is right around the corner. As I have stated repeatedly, when the market is very calm it tends to go up. But when the waters start getting really choppy, that is a clear indication that stocks are about to plummet. In early 2015, volatility has returned to Wall Street in a big way. At one point on Tuesday, the Dow was up more than 300 points. But then the bottom dropped out. From the peak on Tuesday, the Dow plunged nearly 700 points in less than 30 hours before recovering more than 100 points at the end of the day. The Dow has now experienced the longest losing streak that we have seen in 3 months, but that is not that big of a deal. Of much greater concern is the huge price swings that we have been seeing. Remember, the three largest single day stock market increases in history were right in the middle of the financial crisis of 2008. So if stocks go up 400 points tomorrow that is NOT a good sign. What we really need is a string of days when stocks move less than 100 points in either direction. If stocks keep making dramatic moves up and dramatic moves down, history tells us that it is only a matter of time before they collapse. Any student of stock market history knows that what we are witnessing right now is exactly how markets behave right before they crash.
Examine the chart below very carefully. It is a chart of the CBOE Volatility Index from 2006 to 2008. As you can see, volatility was very low as stocks soared during 2006. Then things started to get a bit choppy in 2007, and investors should have recognized this as a warning sign. Finally, you can see that the VIX absolutely skyrocketed during the financial crisis of 2008…
Looking back, it seems so obvious.
So why aren’t more people alarmed this time around?
As CNN is reporting, the VIX is up almost 20 percent so far in 2015…
Volatility has returned with a vengeance this January. The Dow has been moving up or down by at least 100 points nearly every day this year.
CNNMoney’s Fear & Greed Index is showing signs of Extreme Fear again. And a volatility gauge known as the VIX, which is one of the components in our index, is up nearly 20% so far this year.
Meanwhile, there are lots of other signs of trouble on the horizon as well.
For example, the price of copper got absolutely hammered on Wednesday. As I write this, it has fallen more than 5 percent and it has not been this low in more than five years.
In financial circles, it is referred to as “Dr. Copper” because it is such a valuable indicator regarding where the global economy is heading next.
For example, in 2008 the price of copper was close to $4.00 before plummeting to below $1.50 by the end of that year as the global financial system fell apart.
Now the price of copper is plunging again, and many analysts are becoming extremely concerned…
One growing global worry is the steep decline in copper, which is used in many products and is often viewed as good gauge on how China is doing. The price of copper hit its lowest price since 2009 on Wednesday at $2.46. Copper is down nearly 7% this week alone.
Meanwhile, the recession (some call it a depression) in Europe continues to get even worse, and the euro continues to plunge.
On Wednesday, the euro declined to the lowest level that we have seen in nine years, and Goldman Sachs is now saying that the euro and the U.S. dollar could be at parity by the end of next year.
That is amazing considering the fact that it took $1.60 to get one euro back in July 2008.
Personally, I am fully convinced that Goldman Sachs is right on this one. I believe that the euro is going to all-time lows that we have never seen before, and this is going to create massive problems for the eurozone.
With all of these signs of trouble out there, the smart money is rapidly pulling their money out of stocks and putting it into government bonds. This usually happens when a crisis is looming. It is called a “flight to safety”, and it pushes government bond yields down.
On Wednesday, the yield on 10 year U.S. Treasuries fell beneath the important 1.8 percent barrier. We will probably see it go even lower in the months ahead.
As the rest of the world economy crumbles, the remainder of the globe is looking to America to be the rock in the storm. For example, the following quote that I found today comes from a British news source…
‘The global economy is running on a single engine… the American one,’ the World Bank’s chief economist, Kaushik Basu, said. ‘This does not make for a rosy outlook for the world.’
Well, they may not want to rely on us too much, because there are plenty of signs that our economy is slowing down too. For example, we learned today that December retail sales were down 0.9% from a year ago, and this is being called “an unmitigated disaster“. Americans were supposed to be taking the money that they were saving on gasoline and spending it, but that apparently is not happening.
Back on October 29th, I wrote an article entitled “From This Day Forward, We Will Watch How The Stock Market Performs Without The Fed’s Monetary Heroin“. In that article, I warned that the end of quantitative easing could have dire consequences for the financial system as bubbles created by the Fed began to burst.
And that is precisely what is happening. In fact, many analysts are now pinpointing the end of QE as the exact moment when our current troubles began. For instance, check out this excerpt from a CNBC article that was published on Wednesday…
“Stuff happens when QE ends,” said Peter Boockvar, chief market analyst at The Lindsey Group. “It’s no coincidence that the market started going into a higher volatility mode, it’s no coincidence that the decline in commodity prices accelerated, it’s no coincidence that the yield curve started flattening when QE ended.”
Indeed, the increase in volatility and its effect on prices across the capital market spectrum was closely tied to the Fed ending the third round of QE in October.
We are moving into a time of great danger for Wall Street and for the global economy as a whole.
If we continue to see a tremendous amount of volatility, history tells us that it is only a matter of time before the markets implode.
Hopefully you will be ready when that happens.
Are much lower oil prices good news for the U.S. economy? Only if you like collapsing capital expenditures, rising unemployment and a potential financial implosion on Wall Street. Yes, lower gasoline prices are good news for the middle class. I certainly would rather pay two dollars for a gallon of gas than four dollars. But in order to have money to fill up your vehicle you have got to have an income first. And since the last recession, the energy sector has been the number one creator of good jobs in the U.S. economy by far. Barack Obama loves to stand up and take credit for the fact that the employment picture in this country has been improving slightly, but without the energy industry boom, unemployment would be through the roof. And now that the “energy boom” is rapidly becoming an “energy bust”, what will happen to the struggling U.S. economy as we head into 2015?
At the start of this article I mentioned that much lower oil prices would result in “collapsing capital expenditures”.
If you do not know what a “capital expenditure” is, the following is a definition that comes from Investopedia…
“Funds used by a company to acquire or upgrade physical assets such as property, industrial buildings or equipment. This type of outlay is made by companies to maintain or increase the scope of their operations. These expenditures can include everything from repairing a roof to building a brand new factory.”
Needless to say, this kind of spending is very good for an economy. It builds infrastructure, it creates jobs and it is an investment in the future.
In recent years, energy companies have been pouring massive amounts of money into capital expenditures. In fact, the energy sector currently accounts for about a third of all capital expenditures in the United States according to Deutsche Bank…
US private investment spending is usually ~15% of US GDP or $2.8trn now. This investment consists of $1.6trn spent annually on equipment and software, $700bn on non-residential construction and a bit over $500bn on residential. Equipment and software is 35% technology and communications, 25-30% is industrial equipment for energy, utilities and agriculture, 15% is transportation equipment, with remaining 20-25% related to other industries or intangibles. Non-residential construction is 20% oil and gas producing structures and 30% is energy related in total. We estimate global investment spending is 20% of S&P EPS or 12% from US. The Energy sector is responsible for a third of S&P 500 capex.
These companies make these investments because they believe that there are big profits to be made.
Unfortunately, when the price of oil crashes those investments become unprofitable and capital expenditures start getting slashed almost immediately.
For example, the budget for 2015 at ConocoPhillips has already been reduced by 20 percent…
ConocoPhillips is one of the bigger shale players. And its decision to slash its budget for next year by 20% is raising eyebrows. The company said the new target reflects lower spending on major projects as well as “unconventional plays.” Despite the expectation that others will follow, it doesn’t mean U.S. shale oil production is dead. Just don’t expect a surge in spending like in recent years.
And Reuters is reporting that the number of new well permits for the industry as a whole plunged by an astounding 40 percent during the month of November…
Plunging oil prices sparked a drop of almost 40 percent in new well permits issued across the United States in November, in a sudden pause in the growth of the U.S. shale oil and gas boom that started around 2007.
Data provided exclusively to Reuters on Tuesday by industry data firm Drilling Info Inc showed 4,520 new well permits were approved last month, down from 7,227 in October.
If the price of oil stays this low or continues dropping, this is just the beginning.
Meanwhile, the flow of good jobs that this industry has been producing is also likely to start drying up.
According to the Perryman Group, the energy sector currently supports 9.3 million permanent jobs in this country…
According to a new study, investments in oil and gas exploration and production generate substantial economic gains, as well as other benefits such as increased energy independence. The Perryman Group estimates that the industry as a whole generates an economic stimulus of almost $1.2 trillion in gross product each year, as well as more than 9.3 million permanent jobs across the nation.
The ripple effects are everywhere. If you think about the role of oil in your life, it is not only the primary source of many of our fuels, but is also critical to our lubricants, chemicals, synthetic fibers, pharmaceuticals, plastics, and many other items we come into contact with every day. The industry supports almost 1.3 million jobs in manufacturing alone and is responsible for almost $1.2 trillion in annual gross domestic product. If you think about the law, accounting, and engineering firms that serve the industry, the pipe, drilling equipment, and other manufactured goods that it requires, and the large payrolls and their effects on consumer spending, you will begin to get a picture of the enormity of the industry.
And these are good paying jobs. They aren’t eight dollar part-time jobs down at your local big box retailer. These are jobs that comfortably support middle class families. These are precisely the kinds of jobs that we cannot afford to lose.
In recent years, there has been a noticeable economic difference between areas of the country where energy is being produced and where energy is not being produced.
Since December 2007, a total of 1.36 million jobs have been gained in shale oil states.
Meanwhile, a total of 424,000 jobs have been lost in non-shale oil states.
So what happens now that the shale oil boom is turning into a bust?
That is a very good question.
Even more ominous is what an oil price collapse could mean for our financial system.
The last time the price of oil declined by more than 40 dollars in less than six months, there was a financial meltdown on Wall Street and we experienced the deepest recession that we have seen since the days of the Great Depression.
And now many fear that this collapse in the price of oil could trigger another financial panic.
According to Citigroup, the energy sector now accounts for 17 percent of the high yield bond market.
J.P. Morgan says that it is actually 18 percent.
In any event, the reality of the matter is that the health of these “junk bonds” is absolutely critical to our financial system. And according to Deutsche Bank, if these bonds start defaulting it could “trigger a broader high-yield market default cycle”…
Based on recent stress tests of subprime borrowers in the energy sector in the US produced by Deutsche Bank, should the price of US crude fall by a further 20pc to $60 per barrel, it could result in up to a 30pc default rate among B and CCC rated high-yield US borrowers in the industry. West Texas Intermediate crude is currently trading at multi-year lows of around $75 per barrel, down from $107 per barrel in June.
“A shock of that magnitude could be sufficient to trigger a broader high-yield market default cycle, if materialized,” warn Deutsche strategists Oleg Melentyev and Daniel Sorid in their report.
If the price of oil stays at this level or continues to go down, it is inevitable that we will start to see some of these junk bonds go bad.
In fact, one Motley Fool article recently stated that one industry analyst believes that up to 40 percent of all energy junk bonds could eventually go into default…
The junk bonds, or noninvestment-rated bonds, of energy companies are also beginning to see heavy selling as investors start to worry that drillers could one day default on these bonds. Those defaults could get so bad, according to one analyst, that up to 40% of all energy junk bonds go into default over the next few years if oil prices don’t recover.
That would be a total nightmare for Wall Street.
And of course bond defaults would only be part of the equation. As I wrote about the other day, a crash in junk bonds is almost always followed by a significant stock market correction.
In addition, plunging oil prices could end up absolutely destroying the banks that are holding enormous amounts of energy derivatives. This is something that I recently covered in this article and this article.
As you read this, there are five “too big to fail” banks that each have more than 40 trillion dollars in exposure to derivatives. Of course only a small fraction of that total exposure is made up of energy derivatives, but a small fraction of 40 trillion dollars is still a massive amount of money.
These derivatives trades are largely unregulated, and even Forbes admits that they are likely to be at the heart of the coming financial collapse…
No one understands the derivative risk positions of the Too Big To Fail Banks, JP Morgan Chase, Citigroup, Bank of America, Goldman Sachs or Morgan Stanley. There is presently no way to measure the risks involved in the leverage, quantity of collateral, or stability of counter-parties for these major institutions. To me personally they are big black holes capable of potential wrack and ruin. Without access to confidential internal data about these risky derivative positions the regulators cannot react in a timely and measured fashion to block the threat to financial stability, according to a National Bureau of Economic Research study.
So do we have any hope?
Yes, if oil prices start going back up, much of what you just read about can be averted.
Unfortunately, that does not seem likely any time soon. Even though U.S. energy companies are cutting back on capital expenditures, most of them are still actually projecting an increase in production for 2015. Here is one example from Bloomberg…
Continental, the biggest holder of drilling rights in the Bakken, last month said 2015 output will grow between 23 percent and 29 percent even after shelving plans to allocate more money to exploration.
Higher levels of production will just drive the price of oil even lower.
At this point, Morgan Stanley is saying that the price of oil could plummet as low as $43 a barrel next year.
If that happens, it would be absolutely catastrophic to the most important industry in the United States.
In turn, that would be absolutely catastrophic for the economy as a whole.
So don’t let anyone tell you that much lower oil prices are “good” for the economy.
That is just a bunch of nonsense.
Could rapidly falling oil prices trigger a nightmare scenario for the commodity derivatives market? The big Wall Street banks did not expect plunging home prices to cause a mortgage-backed securities implosion back in 2008, and their models did not anticipate a decline in the price of oil by more than 40 dollars in less than six months this time either. If the price of oil stays at this level or goes down even more, someone out there is going to have to absorb some absolutely massive losses. In some cases, the losses will be absorbed by oil producers, but many of the big players in the industry have already locked in high prices for their oil next year through derivatives contracts. The companies enter into these derivatives contracts for a couple of reasons. Number one, many lenders do not want to give them any money unless they can show that they have locked in a price for their oil that is higher than the cost of production. Secondly, derivatives contracts protect the profits of oil producers from dramatic swings in the marketplace. These dramatic swings rarely happen, but when they do they can be absolutely crippling. So the oil companies that have locked in high prices for their oil in 2015 and 2016 are feeling pretty good right about now. But who is on the other end of those contracts? In many cases, it is the big Wall Street banks, and if the price of oil does not rebound substantially they could be facing absolutely colossal losses.
It has been estimated that the six largest “too big to fail” banks control $3.9 trillion in commodity derivatives contracts. And a very large chunk of that amount is made up of oil derivatives.
By the middle of next year, we could be facing a situation where many of these oil producers have locked in a price of 90 or 100 dollars a barrel on their oil but the price has fallen to about 50 dollars a barrel.
In such a case, the losses for those on the wrong end of the derivatives contracts would be astronomical.
At this point, some of the biggest players in the shale oil industry have already locked in high prices for most of their oil for the coming year. The following is an excerpt from a recent article by Ambrose Evans-Pritchard…
US producers have locked in higher prices through derivatives contracts. Noble Energy and Devon Energy have both hedged over three-quarters of their output for 2015.
Pioneer Natural Resources said it has options through 2016 covering two- thirds of its likely production.
So they are protected to a very large degree. It is those that are on the losing end of those contracts that are going to get burned.
Of course not all shale oil producers protected themselves. Those that didn’t are in danger of going under.
For example, Continental Resources cashed out approximately 4 billion dollars in hedges about a month ago in a gamble that oil prices would go back up. Instead, they just kept falling, so now this company is likely headed for some rough financial times…
Continental Resources (CLR.N), the pioneering U.S. driller that bet big on North Dakota’s Bakken shale patch when its rivals were looking abroad, is once again flying in the face of convention: cashing out some $4 billion worth of hedges in a huge gamble that oil prices will rebound.
Late on Tuesday, the company run by Harold Hamm, the Oklahoma wildcatter who once sued OPEC, said it had opted to take profits on more than 31 million barrels worth of U.S. and Brent crude oil hedges for 2015 and 2016, plus as much as 8 million barrels’ worth of outstanding positions over the rest of 2014, netting a $433 million extra profit for the fourth quarter. Based on its third quarter production of about 128,000 barrels per day (bpd) of crude, its hedges for next year would have covered nearly two-thirds of its oil production.
When things are nice and stable, the derivatives marketplace works quite well most of the time.
But when there is a “black swan event” such as a dramatic swing in the price of oil, it can create really big winners and really big losers.
And no matter how complicated these derivatives become, and no matter how many times you transfer risk, you can never make these bets truly safe. The following is from a recent article by Charles Hugh Smith…
Financialization is always based on the presumption that risk can be cancelled out by hedging bets made with counterparties. This sounds appealing, but as I have noted many times, risk cannot be disappeared, it can only be masked or transferred to others.
Relying on counterparties to pay out cannot make risk vanish; it only masks the risk of default by transferring the risk to counterparties, who then transfer it to still other counterparties, and so on.
This illusory vanishing act hasn’t made risk disappear: rather, it has set up a line of dominoes waiting for one domino to topple. This one domino will proceed to take down the entire line of financial dominoes.
The 35% drop in the price of oil is the first domino. All the supposedly safe, low-risk loans and bets placed on oil, made with the supreme confidence that oil would continue to trade in a band around $100/barrel, are now revealed as high-risk.
In recent years, Wall Street has been transformed into the largest casino in the history of the world.
Most of the time the big banks are very careful to make sure that they come out on top, but this time their house of cards may come toppling down on top of them.
If you think that this is good news, you should keep in mind that if they collapse it virtually guarantees a full-blown economic meltdown. The following is an extended excerpt from one of my previous articles…
For those looking forward to the day when these mammoth banks will collapse, you need to keep in mind that when they do go down the entire system is going to utterly fall apart.
At this point our economic system is so completely dependent on these banks that there is no way that it can function without them.
It is like a patient with an extremely advanced case of cancer.
Doctors can try to kill the cancer, but it is almost inevitable that the patient will die in the process.
The same thing could be said about our relationship with the “too big to fail” banks. If they fail, so do the rest of us.
We were told that something would be done about the “too big to fail” problem after the last crisis, but it never happened.
In fact, as I have written about previously, the “too big to fail” banks have collectively gotten 37 percent larger since the last recession.
At this point, the five largest banks in the country account for 42 percent of all loans in the United States, and the six largest banks control 67 percent of all banking assets.
If those banks were to disappear tomorrow, we would not have much of an economy left.
Our entire economy is based on the flow of credit. And all of that debt comes from the banks. That is why it has been so dangerous for us to become so deeply dependent on them. Without their loans, the entire country could soon resemble White Flint Mall near Washington D.C….
It was once a hubbub of activity, where shoppers would snap up seasonal steals and teens would hang out to ‘look cool’.
But now White Flint Mall in Bethesda, Maryland – which opened its doors in March 1977 – looks like a modern-day mausoleum with just two tenants remaining.
Photographs taken inside the 874,000-square-foot complex show spotless faux marble floors, empty escalators and stationary elevators.
Only a couple of cars can be seen in the parking lot, where well-tended shrubbery appears to be the only thing alive.
I keep on saying it, and I will keep on saying it until it happens. We are heading for a derivatives crisis unlike anything that we have ever seen. It is going to make the financial meltdown of 2008 look like a walk in the park.
Our politicians promised that they would do something about the “too big to fail” banks and the out of control gambling on Wall Street, but they didn’t.
Now a day of reckoning is rapidly approaching, and it is going to horrify the entire planet.
There has only been one other time in history when the price of oil has crashed by more than 40 dollars in less than 6 months. The last time this happened was during the second half of 2008, and the beginning of that oil price crash preceded the great financial collapse that happened later that year by several months. Well, now it is happening again, but this time the stakes are even higher. When the price of oil falls dramatically, that is a sign that economic activity is slowing down. It can also have a tremendously destabilizing affect on financial markets. As you will read about below, energy companies now account for approximately 20 percent of the junk bond market. And a junk bond implosion is usually a signal that a major stock market crash is on the way. So if you are looking for a “canary in the coal mine”, keep your eye on the performance of energy junk bonds. If they begin to collapse, that is a sign that all hell is about to break loose on Wall Street.
It would be difficult to overstate the importance of the shale oil boom to the U.S. economy. Thanks to this boom, the United States has become the largest oil producer on the entire planet.
Yes, the U.S. now actually produces more oil than either Saudi Arabia or Russia. This “revolution” has resulted in the creation of millions of jobs since the last recession, and it has been one of the key factors that has kept the percentage of Americans that are employed fairly stable.
Unfortunately, the shale oil boom is coming to an abrupt end. As a recent Vox article discussed, OPEC has essentially declared a price war on U.S. shale oil producers…
For all intents and purposes, OPEC is now engaged in a “price war” with the United States. What that means is that it’s very cheap to pump oil out of places like Saudi Arabia and Kuwait. But it’s more expensive to extract oil from shale formations in places like Texas and North Dakota. So as the price of oil keeps falling, some US producers may become unprofitable and go out of business. The result? Oil prices will stabilize and OPEC maintains its market share.
If the price of oil stays at this level or continues falling, we will see a significant number of U.S. shale oil companies go out of business and large numbers of jobs will be lost. The Saudis know how to play hardball, and they are absolutely ruthless. In fact, we have seen this kind of scenario happen before…
Robert McNally, a White House adviser to former President George W. Bush and president of the Rapidan Group energy consultancy, told Reuters that Saudi Arabia “will accept a price decline necessary to sweat whatever supply cuts are needed to balance the market out of the US shale oil sector.” Even legendary oil man T. Boone Pickens believes Saudi Arabia is in a stand-off with US drillers and frackers to “see how the shale boys are going to stand up to a cheaper price.” This has happened once before. By the mid-1980’s, as oil output from Alaska’s North Slope and the North Sea came on line (combined production of around 5-6 million barrels a day), OPEC set off a price war to compete for market share. As a result, the price of oil sank from around $40 to just under $10 a barrel by 1986.
But the energy sector has been one of the only bright spots for the U.S. economy in recent years. If this sector starts collapsing, it is going to have a dramatic negative impact on our economic outlook. For example, just consider the following numbers from a recent Business Insider article…
Specifically, if prices get too low, then energy companies won’t be able to cover the cost of production in the US. This spending by energy companies, also known as capital expenditures, is responsible for a lot of jobs.
“The Energy sector accounts for roughly one-third of S&P 500 capex and nearly 25% of combined capex and R&D spending,” Goldman Sachs’ Amanda Sneider writes.
Even more troubling is what this could mean for the financial markets.
As I mentioned above, energy companies now account for close to 20 percent of the entire junk bond market. As those companies start to fail and those bonds start to go bad, that is going to hit our major banks really hard…
Everyone could suffer if the collapse triggers a wave of defaults through the high-yield debt market, and in turn, hits stocks. The first to fall: the banks that were last hit by the housing crisis.
Why could that happen?
Well, energy companies make up anywhere from 15 to 20 percent of all U.S. junk debt, according to various sources.
It would be hard to overstate the seriousness of what the markets could potentially be facing.
One analyst summed it up to CNBC this way…
“This is the one thing I’ve seen over and over again,” said Larry McDonald, head of U.S strategy at Newedge USA’s macro group. “When high yield underperforms equity, a major credit event occurs. It’s the canary in the coal mine.“
The last time junk bonds collapsed, a major stock market crash followed fairly rapidly.
And those that were hardest hit were the big Wall Street banks…
During the last high-yield collapse, which centered around debt tied to the housing sector, Citigroup lost 63 percent of its value in the following 60 days, Kensho shows. Bank of America was cut in half.
I understand that some of this information is too technical for a lot of people, but the bottom line is this…
Watch junk bonds. When they start crashing it is a sign that a major stock market collapse is right at the door.
At this point, even the mainstream media is warning about this. Just consider the following excerpt from a recent CNN article…
That swing away from junk bonds often happens shortly before stock market downturns.
“High yield does provide useful sell signals to equity investors,” Barclays analysts concluded in a recent report.
Barclays combed through the past dozen years of data. The warning signal they found is a 30% or greater increase in the spread between Treasuries and junk bonds before a dip.
If you have been waiting for the next major financial collapse, what you have just read in this article indicates that it is now closer than it has ever been.
Over the coming weeks, keep your eye on the price of oil, keep your eye on the junk bond market and keep your eye on the big banks.
Trouble is brewing, and nobody is quite sure exactly what comes next.