A lot of people are pondering the next shoe to drop in the global economy. Most that I read are concerned primarily with the US economy, but that’s simple selection bias. There are many contenders, of course: residential real estate, commercial real estate, consumer spending, pensions, state governments, (US or European) banks, oil, private equity, a currency crisis, or some sort of problems with China. Let’s take an updated look at some of these.

Residential Real Estate

Residential Real Estate, aside from being one of the last shoes to drop, has two interesting votes for being the next shoe to drop. The first comes from an interesting post by Mark Hanson about the Mid to High (MTH) End Mortgage & Housing Market — A Slower Moving Train Wreck

One market segment that will not catch fire from anything being done is the mid-to-high end (MTH). This is where the next crisis is building right now. Only significant house price depreciation and sustained low rates can spur sustained sales in this market segment.

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[T]he MTH is a slower moving train wreck, which in the macro may be worse than the way Subprime imploded. Subprime borrowers who got wiped out a couple of years after getting their 2/28 are way down the de-levering road — renting a property and living within their means, which is when spending can begin again if they chose. At the end of the day, defaults and foreclosures across the MTH will be in the double digits with a respectable number in front, but stretched out over a longer period of time pressuring this housing and borrower segment for the duration.

Meridith Whitney also chimed in on this today. Watch the video. She predicts increased mortgage costs and another leg down in housing. She also hits on consumer credit, banks, state governments, and even the overvaluation of equities.

I haven’t been this bearish in a year… I look at the board and every single stock from Tiffany to Bank of America to Caterpillar is up, but there’s no fundamental rooting behind why these names are up, particularly in the consumer space… You haven’t seen this much consumer credit contraction ever… You didn’t see this amount of consumer credit contraction even in the Great Depression… All this said, I don’t know what’s going on in the market right now because it makes no sense to me… There’s no root in fundamentals.

On the plus side, she doesn’t think that commercial real estate is as big a problem as residential real estate.

Commercial Real Estate

Bernanke gave a speech at the Economic Club of New York On the Outlook for the Economy and Policy

While I am on the topic of bank lending, I would like to add a few words about commercial real estate (CRE). Demand for commercial property has dropped as the economy has weakened, leading to significant declines in property values, increased vacancy rates, and falling rents. These poor fundamentals have caused a sharp deterioration in the credit quality of CRE loans on banks’ books and of the loans that back commercial mortgage-backed securities (CMBS). Pressures may be particularly acute at smaller regional and community banks that entered the crisis with high concentrations of CRE loans. In response, banks have been reducing their exposure to these loans quite rapidly in recent months. Meanwhile, the market for securitizations backed by these loans remains all but closed. With nearly $500 billion of CRE loans scheduled to mature annually over the next few years, the performance of this sector depends critically on the ability of borrowers to refinance many of those loans. Especially if CMBS financing remains unavailable, banks will face the tough decision of whether to roll over maturing debt or to foreclose.

His speech also hit on the unemployment outlook (not very good, and hope rests upon productivity improvements reversing).

Pensions

The problems with pensions are just starting to be addressed. Some have noted that the pension problem may end up costing another $1 trillion. The post office just declared a $3.8 billion loss. Last year’s loss of $2.8 billion was largely attributed to their attempts to make up for their pension shortfalls ($5.6 billion). This year, it only amounted to $1.4 billion. The fact that the post office is probably the most fiscally responsible government establishment should give some idea how bad problems are elsewhere. Social Security still has rather optimistic forecasts built into its projections. For those keeping track, France is way ahead of the US on this. See France Shows Us Our Future: Longer Work, Shorter Retirement.

Private Equity

I actually haven’t heard a lot of people talking about this as the next shoe to drop, but a short article was linked to by Naked Capitalism today. The Coming Private Equity Default Crisis. The problem is roughly the same size as the sub-prime meltdown. About $1 trillion in debt must be rolled over by the companies owned by private equity. How long the refinancing window will stay open is anybody’s guess.

China

Ambrose Evans-Pritchard jumps on the Blame China bandwagon in China has now become the biggest risk to the world economy. For a slightly different take, see William L. Anderson’s post.

US Banks

FAS 166/167 both passed their activation date without another delay. I thought there would be more headlines about them, but I forgot the fact that the earliest they would have an impact would be January. That’s when banks will report their Q4 status. The accounting rules will force banks to bring previously off-balance sheet assets onto their balance sheets. This will involve roughly $450 billion in assets. That could force some banks (Citi) to recognize some big losses.

Conclusion

It’s not news that the economic recovery is rather fragile. Q3 GDP numbers will likely be revised down due to poor estimates on business inventories and the trade deficit. It’s unrealistic to assume that there won’t be stumbles on the path to recovery. Some of these stumbles will prevent a worse fall, but others may involve more than scraped knees. Further bailouts are guaranteed. A second large stimulus package is starting to be discussed in earnest. Unemployment will not fall back to 5% until after 2020 (though there’s a good chance a large fraction of the unemployed will no longer be counted in the official U-3 headlining rate by then).

If I had to guess at a precipitating event, I would look at either the junk bond yields or the dollar carry trade. Either the financing window will close and cause stocks to follow, causing credit to tighten and a time warp back to last year to occur, or something will reverse the dollar carry trade, and all other asset classes will collapse at the same time, ending with a similar feedback cycle. If I am right—and both the magic 8 ball and the Ouija board indicate I am—I will likely change my opinions toward inflation being the biggest threat to economic health. This would be fortunate, as inflation is a solvable problem.