HS Dent Publishing

Special Report March 26, 2010

Harry S. Dent, Jr.
Author of The Great Depression Ahead The Next Great Bubble Boom The Roaring 2000s The Great Boom Ahead

www.hsdent.com

The Debt Crisis Ahead: Late 2010 Late 2012 . . .

How You Can Prepare Now to Survive and Prosper
The government is racking up debt at a record pace. The goal is to stave off an economic crisis brought on by the greatest spending, real estate and debt bubble in modern history. Unfortunately, the government is doing exactly the wrong thing! Instead of trying to prop up inflated real estate values and company and consumer debt, the government should be embracing a painful but necessary period of debt restructuring. It is the ONLY SOLUTION to our current economic problems. The Federal debt mushroomed from $5 to $12 trillion in the past decade, and is forecasted, even under the best scenario, to reach $20 trillion in this decade. But are you aware that private debt has swelled to $42 trillion? If you include government debt our total is $56 trillion and growing (Chart 1). Add in unfunded liabilities for social security and health care of $46 trillion (Chart 2), our total debt balloons to $102 trillion, or seven times the value of everything we make in the US in a year (715% of GDP)! This is truly unprecedented. Before the Great Depression, total U.S. debt was 170% of GDP, the 40% fall in GDP caused that ratio to rise to 270% in 1932. If you had debts totaling $500,000 while you earned $70,000 a year, would you feel good about your future?

Compiled and Edited By: Rodney Johnson

President HS Dent Publishing www.hsdent.com

Ta b l e o f C o n t e n t s
Clear Demographic Trends Make 2 Our Debt Issues Even More Pressing The Process: Reduced Spending and Debt The Deleveraging of Debt in the 1930s The Ticking Time Bomb Despite the Recovery, Rising Mortgages Underwater

Deflation, not Inflation Despite 6 the Massive Stimulus

Total U.S. Debt, 2008

60,000,000,000,000 50,000,000,000,000 40,000,000,000,000 30,000,000,000,000 20,000,000,000,000 10,000,000,000,000 0

Unfunded Entitlement Obligations In $Trillions

Government $14Trn

Federal Govt Trust Funds Federal Govt State and Local Govt Financial Sector Foreign Corporate Household Other Consumer Credit Home Mortgage

50
Includes Social Security and Medicare

$46 $46 trillion Trillion!

Financial $17Trn

40

30
Corporate $11Trn Consumer $14Trn
Addition of Medicare Part D

20

1977 1982 1987 1992 1997 2002 2007 $56 Trn !

Total:

10 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: Federal Reserve Flow of Funds Report

Chart 1

Source: The White House, US Treasury

Chart 2

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Does adding debt to an economy that is plagued by excessive debt really sound like a solution? A 10year-old could figure that out! We must recognize the full magnitude of DEBT in the U.S. and that these levels are not healthy nor sustainable. Rather than having the government try to stimulate us out of this crisis, the only real solution is to have financial institutions, households, and businesses restructure debt back to pre-bubble levels.

Clear Demographic Trends Make Our Debt Issues Even More Pressing
Imagine that you earn $70,000 and have debts of $500,000, you are 50 years old and your income will actually decline substantially as you move toward and into retirement. Or if you got laid off and now only earn $50,000 in your new job? It makes the $500,000 burden even more insurmountable. This is the situation the U.S. is facing today. Our GDP is going to decline substantially in the next few years making our unprecedented debt burden even higher 800% to 900% of GDP! Are you aware that the Baby Boomers have peaked in their spending cycle and will be spending less, earning less and saving more in the years ahead? As Boomers move on to becoming empty nesters and retirees, they will no longer need those big houses, big cars or all the clothes, food and daily spending that went along with raising children. The Boomers will match their consumption pattern to their new stage of life. This massive economic slowdown will have a dramatic effect on our economy because there simply are not enough consumers coming in behind them in the next decade to fill that void. Exactly how is massive government stimulus going to work when our biggest group no longer needs larger houses, cars, etc.? What is it, specifically, that the government believes it is going to stimulate? Just ask the Japanese after the peak of their baby boom and housing bubble they tried unsuccessfully to stimulate in the last two decades. We must acknowledge the predictive power of DEMOGRAPHICS. The power to forecast economic change is at our fingertips! As a society we know exactly when consumers will spend, save and borrow as they go through stages of life. HS Dent has been forecasting for 20 years using the Spending Wave (Chart 3) that the U.S. economic engine, driven by the consumption spending of Baby Boomers, would peak around late 2007 (also see The Great Boom Ahead, 1994, p.35).

Births Lagged for Peak in Family Spending

5,200,000

The Spending Wave

4,700,000

4,200,000

After that, this previously free-spending group would be more focused on saving and paying down debt as they prepare for retirement. Our readers were warned many years in advance of a seismic shift in how our economy operates! We also forecasted a 12- to 14-year downturn in Japan in the late 1980s when most economists thought Japan was the country of the future.

3,700,000

3,200,000

Immigrationadjusted Births Lagged for Peak Spending

The Process: Reduced Spending and Debt

We have already entered what we call the winter season in our economy marked by lower consumer spending and falling prices with the following turn of events: Consumers spend less and borrow less.

2,700,000

2,200,000 1956 1966 1976 1986 1996 2006 2016 2026 2036 2046 2056

Source: HS Dent

Chart 3

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Businesses sell less, so they borrow less, employ fewer people and pay less in wages. Falling spending, falling wages, rising unemployment and declining debt levels lead to deflation in prices and reinforce the lower spending cycle. This cycle cannot be fully broken by stimulus spending as Japan has proven. The government did not create this boom the Baby Boomers did as they raised their families. Hence, the government cannot stop the natural decline in spending and the restructuring of unsustainable debts. We must work to make the decline and restructuring as quick and painless as possible, not try to stop it. This movie attacking a slowdown in consumer spending with stimulus spending by a government has been made before. After a major real estate and debt bubble in the 1980s that was fueled by the growth of their own Baby Boom generation, the Japanese tried to endlessly stimulate their economy. They are still trying today. Its been 20 long, miserable years, and they are still in the tank! Their government debt (not including retirement issues like Social Security and Medicare) is now 210% of GDP and climbing fast versus the U.S. at 87% of GDP (not including Social Security and Medicare). Is that where we want to be a decade from now? The notion that stimulus spending is the key ingredient to jumpstart an economy is not just flawed, but is based on a myth that this approach worked in the U.S. in the 1930s.

The Deleveraging of Debt in the 1930s

Many economists and market pundits point to stimulus spending as the way the U.S. pulled out of the Great Depression. ITS NOT TRUE. Stimulus spending in the 1930s eased the pain of the day, but it did not cause a recovery. It was the rising spending wave of the Bob Hope generation from 1942 1968 along with lower costs and lower debt levels that ultimately led to a sustainable long term boom. During the 1930s the U.S. went through a painful process that eliminated a massive amount of private debt. Because private debt was brought down to manageable levels, once we emerged from World War II the U.S. was in a fabulous position to grow. Chart 4 shows how extensive the restructuring of business debt was in the 1930s. Despite the rise in government debt, overall debt ratios fell dramatically and that was a good thing. This time, however, much more of the debt is consumer debt, and even more is debt for leveraging investments in our financial institutions. That is why you see massive defaults on mortgages and the sudden meltdown of so many major banks and financial institutions in addition to U.S. Debt Since 1929 credit card charge-offs and other reductions in consumer as a percentage of GDP by category debt. There will be a much greater financial meltdown to come between late 2010 and late 2012 thats why you need to protect yourself now!

The Ticking Time Bomb Despite the Recovery, Rising Defaults from Mortgages Underwater
The economy has been recovering since the summer of 2009 due to the direct and indirect government stimulus programs. But unemployment remains near 10%, and worse, more homes continue to fall below their mortgage

Source: SG Global Strategy, Bloomberg, US Federal Reserve

Chart 4

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value leading to continued rises in defaults. Deutsche Bank estimates that the number of mortgage holders who were underwater in the first quarter of 2009 was approximately 26%. By the first quarter of 2011, it estimates that number will grow to 48%! By 2011 28% of mortgage holders will be severely underwater, 20% will be mildly underwater and another 20% will be borderline (Chart 5). Given that we predict the economy worsens we expect these numbers to be substantially higher. The trigger for this ticking time bomb will be rising adjustments or resets to risky mortgages later this year. Chart 6 shows the estimated number of mortgages in different categories that are due for an interest rate adjustment, or reset, from 2006 through 2012. Just as sub-prime mortgages caused so much havoc in 2008 and early 2009 when they were resetting, it will be option adjustable rate mortgages (option ARMs) and Alt-A mortgages (no documentation loans) that cause problems in late 2010 and 2011. These resets, with their higher interest rates, along with the devastating level of unemployment and the continued drag of foreclosures, will combine to push values further down and leading to an even greater avalanche of defaults. The next big surge hits between July and October of 2010, with an even larger surge into September of 2011.

Homeowners Underwater
DB estimates that 26% of homeowners are currently underwater Severely Negative Equity 13% Severely Negative Equity 28% Positive Equity 21% Modest Equity 12% Negative Equity 20% Borderline Negative Equity 20% and sees the percentage rising to 48% by 2011.

Negative Equity 13%

Positive Equity 34%

Borderline Negative Equity Modest Equity 23% 18%

Source: Deutsche Bank August 5, 2009 Report

Chart 5

Mortgage Resets
We are here

The last banking crisis and meltdown seemed to come Source: T2 Partners Chart 6 from nowhere in 2008. The next such crisis is likely to emerge equally as suddenly between August and October of 2010. You need to be selling stocks and real estate ahead of this debt crisis! Understanding this combined debt and demographic storm is only part of the equation. To prepare and prosper in the years ahead, we must have an understanding of how this crisis will be resolved. The answer is deflation. Most people assume that a period of deflation is a simple opposite to inflation; therefore, deflation is a time of falling prices. While that is true, it does not convey the immense power of a deflationary period. In a period of deflation, the prices of most consumer goods as well as investment assets across the board like real estate, stocks, commodities, oil and even gold, go down. It is a time of conservation and the survival of the fittest. Consumers see their investments fall, business owners have less revenue, and companies employ fewer people and pay those they do hire less. Deflation requires very different investment and business strategies than what we would do during inflation. Most of us have never experienced deflation. Our issues have always centered on lower or higher rates of inflation, which over time meant that assets like investments and real estate tended to go up. That period is over. Deflation, with all of its complexities, is not just a forecast but is as inevitable as winter following fall.
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Why is this the case? As the U.S. went through a long-term growth season in the economy, many different forces began working together to feed our growing consumption. One of the areas that saw the biggest change was real estate. The price of real estate, which is the biggest cost of living for most consumers, on average doubled from 2000 to 2005, putting a new home out of reach for the new generation of families entering our economy. How can our kids have the American dream of owning a home if it costs $700,000 for a starter home in California or Miami? This exploding bubble in prices came from an unprecedented expansion in household borrowing power (home equity loans, no money down, cash out refinancing, very low interest rates, loose lending standards) and coincided with a demand for spending and very low interest rates. The borrowing capacity of the average household almost tripled. Lenders went nuts as they thought real estate could never go down, so there was no risk in lending against real estate. This was the mistake the Japanese banks made in the 1980s. This should not have been allowed to occur in the U.S., but it did! This process of a bubble in prices and then a crash is not new. In the late 1990s stock prices got unreasonably high, peaking in early 2000 and then crashing back down to reality from 2000 - 2002. The real estate bubble in Japan peaked in 1991 and then crashed, never to return to past levels. The same is happening now with real estate prices, energy prices and stocks, especially in emerging markets like China. Unfortunately, because the last and largest part of our bubble was fueled with massive amounts of debt, the pain of the bursting bubble will be much greater than anything we have experienced in the last 75 years! One way to illustrate the thirst for borrowing is to look at the ratio of debt to discretionary spending (Chart 7). In the 80s, this measure was about 65%. As we go through the 90s consumers took on even more debt. By the time we get to the 2000s the measure of debt to discretionary spending is more than 130%! As Baby Boomers reached the peak of their spending cycle, we borrowed at a feverish pace. Now, the reality is setting in, and its not pretty.

Deflation, not Inflation Despite the Massive Stimulus

When assets deflate in price we have three choices: the loans have to be paid as structured, canceled (foreclosure) or written down (modified). Because there is not enough income generated to pay these debts outright, we are left with cancellation and modification, which creates incredible pain for the lenders, the banks and investors who fueled the boom. On the positive side, this removes or reduces the debt from the books of companies and consumers, which brings the cost Household Debt as % Disposable Income of real estate, living and doing business back down to 1946 - 2009 affordable levels. After this deflationary process, the 140% general standard of living begins to grow again, which is a 120% good thing for your kids and grandkids!
100%

80%

60%

40%

20%

0%

a e

r 1

5 9

0 1

5 9

5 1

6 9

0 1

6 9

5 1

7 9

0 1

7 9

5 1

8 9

0 1

8 9

5 1

9 9

0 1

9 9

5 2

0 0

0 2

0 0

Source: Federal Reserve Z1

Chart 7

Deleveraging is the same as a business going through debt reorganization. This process happens when a business is viable, but is currently unable to pay its bills. Doesnt that sound like a lot of the U.S. today the leading economy in the world, but debt-laden? Businesses seek reorganization to restructure their debts and avoid an all-out liquidation. That is where we are as a nation and many other countries face a similar crisis.

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We need to restructure and write-off debts that are no longer in line with the underlying assets, such as the commercial real estate and homes that they were lent against. Trying to treat the problem of excess debt by taking on even more debt is like trying to take more heroin to kick a heroin addiction detox is the only solution you have to get the heroin out of your system first! Our government is trying to convince us to spend more, borrow more and take more of the drug that has caused us so much pain. Its reasoning? So that the country will not have to go through the painful detox process of deleveraging from too much borrowing, no matter how unrealistic or unsustainable this effort is. Our forecast is that the U.S. government and many others will be forced to stop stimulating in such an irresponsible manner. Their massive stimulus programs will fail in the second half of 2010 losing the confidence of an already skeptical public, and many foreign governments and investors like China will balk at funding continually increasing massive U.S. deficits. From studying centuries of credit and asset bubbles, we are able to arrive at a very conclusive forecast: by late 2010 we will go back into the process of deleveraging in order to deal with the massive credit bubble, and we will suffer through the ensuing deflation in prices and assets. The only question is, Do we take our medicine sooner by greatly reducing our stimulus spending, or do we drag this out for many years and make it worse by continuing to try to prop up these inflated asset prices and debt with even more borrowing? But recall that a deflationary environment requires very different investment and business strategies from an inflationary environment like the 1970s. We want to help guide you through a brief economic period that will be unlike anything you have seen in your lifetime. At HS Dent our mission is to help people understand change. We show you how you can see key economic trends that will impact your life, your business, your family and your investments over your lifetime. We specialize in providing a unique type of long term insurance against major negative economic surprises by providing you with clear research and forecasts we develop by using our unique forecasting tools. We alert you to the opportune times as well. We accurately forecasted the peaking of the housing bubble in 2005/2006 and the peaking of our economy between late 2007 and early 2010. This same approach allowed us to alert readers to major new growth areas and opportunities in The Great Boom Ahead in 1993 at a time when most economists and books were bearish. Our analysis has led us to forecast the next global boom from 2020 2035 and the ultimate rise of India over China in the decades to come. In Chart 8 we outline a rough forecast of the Ticking Time Bombs that are likely to generate a very sharp stock crash in the Summer and Fall of 2010. The Dow could go as low as 3,800.

Minefield of Ticking Time Bombs

October September August July June May April March February January

China Bubble Bursts

Accelerating Mortgage Defaults Very Disappointing 2nd Qtr GDP

Iran Tensions, Terrorist Strikes, Oil Spikes Mildly Disappointing 1st Qtr GDP Further Default Threats in Europe Austerity Programs Greece Default Threat

China / India Tighten

2010

Source: HS Dent

Chart 8

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Summary
We see a number of ticking time bombs that point towards a crisis in the 3rd quarter of 2010:
1. Mortgage defaults accelerate due to rising mortgage loan resets between July and October of 2010 2. Rising geopolitical tensions and terrorist events into the summer, especially around Iran 3. Consumers slow again as stimulus fades with disappointing GDP report for 2nd quarter GDP 4. Continued threats of government defaults in Southern and East Europe as the recovery there continues to fail 5. Continued rising long term interest and mortgage rates into late 2010 6. The unprecedented bubble in China bursts after the U.S. and Europe slow again

We see a number of big surprises just ahead:

1. Another Major Stock Crash between August and December of 2010 2. The Second Major Real Estate Crash to Follow between Late 2010 and Late 2012 3. Gold falls and the U.S. dollar rises 4. Rising Tax Rates for Years to Come 5. The Sale of a Lifetime on Stocks, Bonds and Real Estate Ahead

Cash, cash flow and good credit will be the key for prospering from this once-in-a-lifetime deflationary downturn wherein you can buy real estate, companies, stocks, boats, cars, etc., at the lowest prices you may ever see. It takes patience, research and analysis to arrive at the conclusions that can financially secure you and your familys future. Please join us by signing up for our monthly newsletter, 7 CD course, webinar, and two-day seminar. The future starts now! Learn how to protect and prosper!

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