From New York to Nicosia

Here we go…Time to review the 2008 predictions.

My overall assessment is that:

a) All major directions were right in this prediction

b) Where I was wrong, I was either too early and (amazingly) too optimistic.

It has hard to realize how long ago in financial terms Jan 2008 was. As you read these predictions, they look almost mild, yet in January 2008, they would have been placed on on the far side of pessimistic.

The average Wall Street economist was predictiing S&P 1400-1500, credit losses were still going to be contained and consensus opinion was still in the 200B range, many if not most were predicting positive GDP growth and “decoupling” was still the consensus belief.

As last year, I failed to make any market moves that would actually monetize any of these predictions, but so it goes; this is economic forecasting, not investment advice…

As I have mentioned, the accuracy of last year’s predictions will be basically impossible to beat as we head into more uncertain times, but here’s my shot for 2008.

Sure. Blah. Blah.

The summary answer is 2008 will be a down year.

Well, that was an understatement.

Economy

The 15 year party for the US economy is now over. Given the technology excesses of 1999-2001, the 2001 recession should have been more severe.

As is now well-known, the severity of that recession was mitigated through very loose monetary policy which sparked a housing bubble that directly stimulated the economy and indirectly stimulated consumer spending through the wealth effect and home equity extraction.

This game is now over and with: a tapped out consumer, a tapped out federal budget and a weak dollar preventing massive rate cuts, it is hard to see what can possible drive growth in 2008

One of many underestimates in hindsight…

1. The US is mostly likely already in recession. Regardless, in 2008, the US will enter a recession of moderate-high severity. Let’s call Q1 2008 as the most likely official market of recession.

Got this one. Official start of recession was Dec 2007 it turns out.

2. A best case scenario is 3 recessionary quarters. A worst case would be 5 or 6 quarters if housing and recession intertwine in a very negative manner

Definitely will have at least 5-6 quarters of recession. This prediction will have turned out to be too optimistic I suspect.

3. The European Union will slow down as well. Certain parts of Europe, such as the United Kingdom and Spain had housing bubbles larger than that of the United States.

EU is slowing rapidly. Spain and UK housing bubbles deflating at horrifying speeds.

EU growth in 2008 will be lower than 2007. If I had to guess a growth recession for the EU overall with UK and Spain in actual recessions by the 2nd half of 2008.

Not sure if the figures have been released but I think this will turn out to be technically correct.

4. China will not decouple from the US. In a recession, growth will slow there as well by at least 3%.

Again, not sure if the full-year figures have been released but I think we will see a slow-down in China for 2008 of about this magnitude for FY2008 or maybe the 4 quarters ending Q1 2009.

5. Equity markets and risky assets overall are not going to have a good year

ha ha ha. I guess that would be a correct statement!

6. US interest rates, needless to say, are headed down. There is a 100% chance of a 100bps drop by year-end and a 65% chance of 200bps.

Yes, this was true since interest rates have gone to 0

Mortgage / Housing Market

We are, at most, in the 3rd inning of the housing market collapse

1. Last year, I predicted housing prices could fall 20% peak to trough. I stand by that prediction and revise it to be 20 to 25% in real terms with an outside shot at 30%.

Again, this was severely negative at the time; it is accepted wisdom now. The “housing prices will never fall because we like to make numerical predictions without using math” lunatics have gone to hide in shame. Again, this will likely turn out to be too optimistic by a little.

2. This is going to be the worst housing crisis in modern financial history and substantially exceed the damage caused by the S&L crisis in terms of total losses. I will come back and quantify later what S&L did.

This is clearly the case. s&L was several hundred billion. This will easily be measured in the trillions.

3. Defaults are still below their peak in subprime and will spread to alt-a, near prime, prime, credit card and other consumer debt. Particularly with the escape hatch of a subprime loan out of the picture for most people, the alternative is going to be defaults.

Prediction: Mortgage default rates peak and plateau in last 2008, early 2009. Credit card will track closely or a little later.

Data not clear yet. Default rates and credit card delinquencies are still rising. I think this will have ended up being too optimistic and that default rates will rise through 2009

4. Housing prices will trail foreclosures, will fall through 2008 and not bottom out until 2009. I am not comfortable making quarterly predictions but if I had to guess on a bottom, I would say Q3 2009 in real terms.

Too soon to tell but headed in about this direction.

5. Commercial real estate is about to enter a similar downturn with defaults starting to show up right about now: Q1 and Q2 2008

Correct but too early. Commercial is about to go down the drain NOW – Q1 and Q2 2009

Financial Markets

By 2006, we were seeing the biggest credit bubble possibly since the 1920s across every asset class, including residential real estate, commercial real estate, corporate bonds, high yield.

This was driven to a large degree by a fragmentation of the financial system that exceeded the pace of appropriate risk management, control and incentive structures.

To take the example of a mortgage, every party in the chain: mortgage broker, mortgage appraiser, mortgage originator, mortgage securitizer (and re-securitizer into CDOs, etc), credit rating agencies and even ultimate hedge fund investor either have completely non-aligned (fee-based) or asymmetrical (performance fee based) incentives.

Sparked by low nominal rates and the classic early phases of a bubble, this system spiraled out of control.

The results are evident in the last 6 months of mind-boggling write-downs at our major financial institutions that look like they will total > $100B this first phase alone. This is a complete repudiation of the “we have to be in this business/at these terms/etc to be competitive/maintain market share/etc” or other related stupidity.

These words should strike terror in the hearts of any rational, economically driven shareholder. The net result of all of this is that existing shareholders are getting diluted out to the Gulf states, Singapore and China.

There is no doubt in mind that the writedowns at most firms will far exceed the fee income they generated during corresponding time period. Note: the bonuses for executives from the go-go days will not be clawed back of course which tells you all you need to know.

Well, yes.

1. This phase of write-downs is almost complete. There will be another series of confessionals this week (Jan 14th) and then I think we will be quiet for a whole.

2. The next large phase of write-downs will occur in second half of 2008 when mortgage holders actually start defaulting and later (late 2008 to mid 2009?) when high yield starts to feel pain and all consumer credit categories suffer

Well, we basically had write-offs all year long. I think the peak of consumer and high yield losses is still ahead of us so this remains in progress.

3. When all is said and done (2009), I am going to put the total credit market losses (mortgage, commercial real estate, credit card, high yield, CDS) at above $800B

Big number at the time. Looks like it will have been too optimistic again.

4. We will have substantial credit contraction as banks protect their balance sheet and off-balance sheet structures evaporate. I am not in a position to guess the magnitude but it will be meaningful.

yes, clearly “meaningful” was an understatement

Private Equity/High Yield

1. I am holding to last year’s predictions that we will start to see the first losses in high-yield backed CDOs in 2008, though the worst of it won’t show up until 2009-2010

2. PE Fund vintages invested too late (2006 to early 2007?) to do the fast dividend recap before the credit market closed are going to be hurt. At some point you have to sell and with credit spreads back at historical norms, buyers can’t bid the companies up the same way. Most likely response by PE firms will be to wait it all out, but that means, at best, mean longer holder periods, anemic growth and lower IRRs.

Most deals done in late 05 to early 07 did not bake in much tolerance for a recession!

Still in progress, but I think this will turn out to be right.

3. More generally, in 2008 we will start seeing the first corporate defaults. High yield has had unnaturally low defaults not through underwriting genius but due to the fact that companies could refinance out of trouble (just like homeowners).

That window is closed. Expect something closer to historical default rates in 2008 and above historical default rates in 2009

I believe this is turning out exactly as predicted. Lots of PE defaults in 2008; more on the way.

I think 2008 was back to about historical, maybe a bit higher. Any PE guys have the numbers?

4. Last year, I told a friend that we are going to have an iconic PE blow-up in this cycle and guessed it would be a deal that badly violated the traditional parameters of where PE makes sense: Sallie Mae, Chrysler or third deal that I can’t remember (maybe TXU).

Sallie Mae escaped just in time by not concluding the deal otherwise it would have been the star disaster show, though the mega-breakup fee-to-be will for the record books I think in PE.

In the meantime we can get to watch great business drama with Chrysler to see if Cerberus can find a way forward there. From some parties’ perspective this is already a mess since the investment banks are still sitting on $10B of loans they have not placed

If Cerberus manages to escape with a dollar from Chrysler they deserve a gold medal in Governmental Lobbying. Under any “free-market” conditions they would be in BK by now.

5. Go long distressed funds in 2009! (if you have access to them)

Still the case.

Currency

1. GBP will weaken. The GBP:US will drop to at least 1.8 over the course of the year

Same theme. Right direction, but too conservative. I thought 1.8 would be a big move!

GPB:US was down to 1.47 on 12/31/2008

2. Dollar-Euro will spend the year primarily in the 1.40 to 1.60 range. Yes, the dollar is weak and will weaken but the Euro-zone is not as strong as it looks.

Got the range just about right. Dollar:Euro spent 77.5% of the year in that range. At the beginning of the year, the fear was dollar weakness; i figured the euro-strength would not last and by the end of the, the euro was trading below this range.

Online

1. By Q3-Q4 2008, we will have a mini internet bust. The internet is now a permanent part of the economic structure and will continue to take disproportionate share of growth over the next 10 years.

But there are quite a few companies being funded recently at levels that don’t make much sense to me.

Still, this bust will be nothing like that bust of 2001 as the amounts at play are much smaller ($2M to $10M rounds).

Starting soon at a theater near you. Probably was 3-4 quarters early on this one.

2. Most online video startups will fail particularly badly. The economics of general, entertainment or user-generated online video are not very good. Generic advertising dollars at a $10CPM are just covering bandwidth costs and partial content generation costs, let alone SGA or profits. It is going to be almost impossible to make a destination video site, particularly with original content, successful from scratch. I will give a detailed analysis of the economics of online video in a different posting

I don’t know how to quantify this prediction since most startups fail, so I will have to take a raincheck on quantification.

Disclaimer: we are invested in online.tv which has a very large collection of .tv domains on which we hope that we or others will build online video businesses so this post might be dismissed as competitive sniping!

Again, this is going to happen. Hope we don’t get bit by this too!

That’s all for now. I think generally will be a bad year in 2008 from a financial [long] perspective, but that does not matter all that much. You need some downturns to make the upswings fun.

Have a great 2008!

Indeed…

This entry was posted on Wednesday, January 14th, 2009 at 9:48 am and is filed under 1-Alternative Investments. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.