The least useful investment books are those that describe either extremely bright or very dark outcomes for the markets. The quality of predictions in both types tends to be so awful that they generally provide reliable contrarian indicators. If the author says buy, you should sell, and vice versa.
Michael Panzners Financial Armageddon, which was published in early 2007, is an exception to this rule. The books deeply gloomy predictions have proved so accurate that, if the text were changed from the future to the past tense, it would read like a financial history of the past year and a half. Theres more bad news to come, says Panzner. Given his extraordinary track record, investors are bound to pay attention.
One seldom profits from following the advice of a doom-monger. In September 1981, The Coming Currency Collapse by Jerome Smith was published. Over the next year the dollar appreciated by roughly one third against the yen. Richard Zambells Hyperinflation or Depression appeared in 1984. This book ushered in more than two decades of stable consumer prices. James Dale Davidsons The Plague of the Black Debt: How to Survive the Coming Depression went to press in 1993, just as the U.S. economy was about to embark on a decade and a half of credit-fueled expansion. The optimists havent much to crow about, either. Far from tripling in value, as the authors of Dow 36,000 predicted back in the summer of 1999, U.S. stocks are currently worth one third less than a decade ago.
The style of Panzners Financial Armageddon is typical of the genre. The forecasts are grim, they are presented with deep conviction, and the crisis deepens melodramatically with each successive chapter. What distinguishes Panzner is that his predictions have come true.
More than two years ago, Panzner warned that the collapse in the housing market would drag the United States and ultimately, the rest of the world into a deep and dark abyss, the likes of which we havent seen for decades. He anticipated that the hardest-hit countries would be those emerging markets that depended most on the bloated American consumer and that had accumulated massive reserves of dollars and holdings of U.S. assets in an expensive yet ultimately failed strategy to maintain an export market for their rapidly expanding output.
Panzners analysis of the credit system has been vindicated. Banks no longer knew their customers. Instead, they depended on credit scores and risk modeling. But the risk models were flawed: They understated risk during the good times but would force financial players to make fire-sale disposals after a crisis appeared. Panzner pointed out the dangers of subprime and negative-amortization mortgage loans long before this credit detritus became common knowledge.
He described banks originating loans for a fee and parking them in off-balance-sheet funds, which in turn issued commercial paper to investors. In time it would become clear that allegedly sophisticated investors had struck something of a Faustian bargain during the good times, by exchanging immense quantities of borrowed money for unsalable assets. Panzner excoriated the securitization of loans, which had created an overflowing mess that will contaminate the financial groundwater for years.
This analysis wasnt wholly original. However, by synthesizing a knowledge of eco-nomic history with a deep understanding of recent financial developments, Panzner boldly imagined how events would unfold. His description of how the credit system would unravel was specific and, as things turned out, accurate. The trigger for a fully fledged systemic crisis will likely be the abrupt and unexpected failure of an aggressive operator. Banks and prime brokers would scramble to call in loans.
By that time there will almost certainly have been a dominolike collapse of more than a few large intermediaries and allegedly sophisticated global financial firms, including hedge funds, insurers and brokers. Concerns about counterparty risk, Panzner predicted, would reach a fever pitch. In the early stages of the panic, the dollar would climb in value as leveraged financial players required the U.S. currency to unwind dollar-denominated positions.
A number of financial institutions would fail, including Fannie Mae and Freddie Mac, Panzner forecast. As commercial paper soured, several money market funds would be set to break the buck. The collapse of the bond insurers would lead municipal bond spreads to blow out. By then many near-bankrupt states and municipalities would be forced to raise taxes, cut costs and turn to Washington for a handout. Highly rated securitized bonds would likely suffer steep and instantaneous downgrades. Big banks would be no safe haven: A long overdue economic slowdown or turn in the credit cycle will almost certainly decimate the financial position of Americas largest banks.