[29 February 2008]
Ultra-pessimist Nouriel Roubini, an economist known for predicting catastrophe, spared nothing in his recent presentation to the House Financial Services Committee. Often scoffed at before the subprime meltdown, he’s been scarily proven right about a lot of things in the past few months. In his words:
For over a year the Fed assessment of the risks to the economy and to the financial markets was flatly wrong. The Fed argued that the housing “slump” would bottom out over a year ago; instead the housing recession got deeper and is nowhere near bottoming out; Bernanke argued repeatedly that the subprime problem would be a niche and contained problem; instead we have observed a severe liquidity and credit crunch that has spread to the entire financial system; the Fed argued that the housing recession would have no significant spillovers to the other sectors of the economy in spite of the importance of housing and in spite of the fact that housing is the main assets of most households; instead we are now observing an economy wide-recession. So to put it simply the Fed – as well as most macro analysts and forecasters - got it totally wrong in its assessment of the risks to the economy and to financial markets.
He’s nothing good to say about what economic trouble we still have left to face:
Currently the problems in financial markets are no longer merely sub-prime mortgages, but rather a whole “sub-prime” financial system. The housing recession – the worst in U.S. history and worsening every day – will eventually see house prices fall by more than 20 percent, with millions of Americans losing their homes and/or walking away from them as they have negative equity in them.
Delinquencies, defaults, and foreclosures are now spreading from sub-prime to near-prime and prime mortgages. Thus, total losses on mortgage-related instruments – include exotic credit derivatives such as collateralized debt obligations (CDOs) – will add up to more than $400 billion. Moreover, commercial real estate is beginning to follow the downward trend in residential real estate. After all, who wants to build offices, stores, and shopping centers in the empty ghost towns that litter the American West? In addition to the downturn in real estate, a broader bubble in consumer credit is now collapsing: as the US economy slips into recession, defaults on credit cards, auto loans,
and student loans will increase sharply. US consumers are shopped-out, savings-less, and debt-burdened. With private consumption representing more than 70 percent of aggregate US demand, cutbacks in household spending will deepen the recession.
In a grim twist on AA rhetoric, Roubini then gives his “12 steps to financial disaster”
1. The Housing recession takes 30 percent off of home prices. As a renter, I might be cheered by this if it weren’t going to potentially destroy the economy as we know it. As house prices were running up and friends were sheepishly admitting to how they doubled their net worth, I had the vague sense of panic that I was missing out, but I also felt like this was a phantom wealth. My friends with houses seemed to like the security of it, but fortunately for them, they didn’t try to convert it into real-world wealth through home-equity lines of credit. People who got greedy or jumped into the house-buying game late after getting caught up in the hoopla are the ones who are going to find themselves with negative equity.
2. Which is Roubini’s second point. Mortgages across the house buying spectrum were suspect, in part because they were all affected and inflated by the unmoored house prices. Credit problems
are now spreading to near prime and prime mortgages as the same reckless lending practices in subprime (no down-payment, no verification of income, jobs and assets (i.e. NINJA or LIAR loans), interest rate only, negative amortization, teaser rates, etc.) were occurring across the entire spectrum of mortgages; about 60% of all mortgage origination since 2005 through 2007 had these reckless and toxic features.
With falling prices, a huge percentage of the homes sold in those years could go underwater, and those are precisely the borrowers who are ill-equipped to cope with the setback. This is true of virtually all financial panics. The last in are usually hurt first, and hurt the worst. It’s easily justified by painting such investors as greedy, as overwhelmed by envy of the profits others were making. But really, for home buyers drawn into the market by their life circumstances (and ideology about the sanctity of homeownership—how it makes you an adult and somehow legitimizes your family) and not their investment whims, it was just unfortunate timing. An unhappy consequence of treating renters like second-class citizens.
3. Credit problems begin to afflict credit-card loans. This will create a feedback loop, with bank losses tightening credit, tight credit causing consumers to pull back, balking consumers worsening the recession, and the recession compounding credit problems.
4. Monoline insurers—the firms that back debt issuance and allow municipal and corporate creditors to represent themselves as less risky—start to fail, casting doubt on all those improved bond ratings they helped facilitate. This roils all the different institutional investors that hold the bonds, and makes them impossible to value because no one wants to buy them and thereby put a price to them. Panic begins to afflict the managers of these funds, as they can no longer tell what their asset holdings are actually worth, or how well they themselves are performing.
5. Commercial real estate begins to meltdown the same way that the residential market has. The associated securities and the banks and investors involved with them all suffer.
6. The combined weight of all these problems causes a regional bank to fail, prompting the specter of bank runs and forcing the Fed to commit to bailouts.
7. Banks’ balance sheets take a hit from ill-conceived leveraged buyouts from the credit bubble era—these loans were often overleveraged and undercollateralized, leaving banks more exposed to potential losses if the business involved fail—and we are in a recession after all.
8. Corporate defaults will begin to mount. Fear of counterparty risk will loom large, deepening the credit freeze.
Corporate default rates will surge during the 2008 recession and peak well above 10% based on recent studies. And once defaults are higher and credit spreads higher massive losses will occur among the credit default swaps (CDS) that provided protection against corporate defaults. Estimates of the losses on a notional value of $50 trillion CDS against a bond base of $5 trillion are varied (from $20 billion to $250 billion with a number closer to the latter figure more likely). Losses on CDS do not represent only a transfer of wealth from those who sold protection to those who bought it. If losses are large some of the counterparties who sold protection – possibly large institutions such as monolines, some hedge funds or a large broker dealer – may go bankrupt leading to even greater systemic risk as those who bought protection may face counterparties who cannot pay.
9. Then the “shadow banking system” will collapse.
the “shadow banking system” (as defined by the PIMCO folks) or more precisely the “shadow financial system” (as it is composed by non-bank financial institutions) will soon get into serious trouble. This shadow financial system is composed of financial institutions that – like banks – borrow short and in liquid forms and lend or invest long in more illiquid assets. This system includes: SIVs, conduits, money market funds, monolines, investment banks, hedge funds and other non-bank financial institutions. All these institutions are subject to market risk, credit risk (given their risky investments) and especially liquidity/rollover risk as their short term liquid liabilities can be rolled off easily while their assets are more long term and illiquid. Unlike banks these non-bank financial institutions don’t have direct or indirect access to the central bank’s lender of last resort support as they are not depository institutions. Thus, in the case of financial distress and/or illiquidity they may go bankrupt because of both insolvency and/or lack of liquidity and inability to roll over or refinance their short term liabilities.
10. The stock market tanks; the S&P 500 loses a quarter of its value.
11. Credit spreads—a measure of risk—widen, which not only makes the Fed’s policy tool of cutting rates ineffective but also spurs a widespread liquidity crisis—in other words, people can’t get their money.
12. The liquidity problems force assets to sell at an unwarranted discount, given the assets’ underlying value. This becomes a downward spiral for all sorts of investments.
A near global economic recession will ensue as the financial and credit losses and the credit crunch spread around the world. Panic, fire sales, cascading fall in asset prices will exacerbate the financial and real economic distress as a number of large and systemically important financial institutions go bankrupt. A 1987 style stock market crash could occur leading to further panic and severe financial and economic distress. Monetary and fiscal easing will not be able to prevent a systemic financial meltdown as credit and insolvency problems trump illiquidity problems. The lack of trust in counterparties – driven by the opacity and lack of transparency in financial markets, and uncertainty about the size of the losses and who is holding the toxic waste securities – will add to the impotence of monetary policy and lead to massive hoarding of liquidity that will exacerbates the liquidity and credit crunch.
This is what Roubini calls the meltdown scenario. But can anyone stop it? Roubini: “most likely not.”