Bloomberg TV Interview: Worst Financial Crisis Since the Great Depression and Worst U.S. Recession in Decades
Nouriel Roubini Jul 15, 2008
I was on Bloomberg TV this morning being interviewed about financial markets, the economy and the upcoming testimony by Bernanke.
As I put it in the interview: ``This is a systemic financial crisis, there is no end to it,'' Nouriel Roubini, professor of economics and international business at New York University, told Bloomberg Television. ``It's a vicious circle between a contracting economy and greater credit and financial losses feeding on the economy.''
Regular readers of this blog are familiar with my views. But here is a summary and significant extended update of my views that this will turn out to be the worst financial crisis since the Great Depression and the worst US recession in decades…
• This is by far the worst financial crisis since the Great Depression
• Hundreds of small banks with massive exposure to real estate (the average small bank has 67% of its assets in real estate) will go bust
• Dozens of large regional/national banks (a’ la IndyMac) are also bankrupt given their extreme exposure to real estate and will also go bust
• Some major money center banks are also semi-insolvent and while they are deemed too big to fail their rescue with FDIC money will be extremely costly
• In a few years time there will be no major independent broker dealers as their business model (securitization, slice & dice and transfer of toxic credit risk and piling fees upon fees rather than earning income from holding credit risk) is bust and the risk of a bank-like run on their very short term liquid liabilities is a fundamental flaw in their structure (i.e. the four remaining U.S. big brokers dealers will either go bust or will have to be merged with traditional commercial banks). Firms that borrow liquid and short, highly leverage themselves and lend in longer term and illiquid ways (i.e. most of the shadow banking system) cannot survive without formal deposit insurance and formal permanent lender of last resort support from the central bank
• The FDIC that has already depleted 10% of its funds in the rescue of IndyMac alone will run out of funds and will have to be recapitalized by Congress as its insurance premia were woefully insufficient to cover the hole from the biggest banking crisis since the Great Depression
• Fannie and Freddie are insolvent and the Treasury bailout plan (the mother of all moral hazard bailout) is socialism for the rich, the well connected and Wall Street; it is the continuation of a corrupt system where profits are privatized and losses are socialized. Instead of wiping out shareholders of the two GSEs, replacing corrupt and incompetent managers and forcing a haircut on the claims of the creditors/bondholders such a plan bails out shareholders, managers and creditors at a massive cost to U.S. taxpayers
• This financial crisis will imply credit losses of at least $1 trillion and more likely $2 trillion
• This is not just a subprime mortgage crisis; this is the crisis of an entire subprime financial system: losses are spreading from subprime to near prime and prime mortgages; to commercial real estate; to unsecured consumer credit (credit cards, student loans, auto loans); to leveraged loans that financed reckless debt-laden LBOs; to muni bonds that will go bust as hundred of municipalities will go bust; to industrial and commercial loans; to corporate bonds whose default rate will jump from close to 0% to over 10%; to CDSs where $62 trillion of nominal protection sits on top an outstanding stock of only $6 trillion of bonds and where counterparty risk – and the collapse of many counterparties – will lead to a systemic collapse of this market
• This will be the most severe U.S. recession in decades with the U.S. consumer being on the ropes and faltering big time as soon as the temporary effect of the tax rebates will fade out by mid-summer (July). This U.S. consumer is shopped out, saving less, debt burdened and being hammered by falling home prices, falling equity prices, falling jobs and incomes, rising inflation and rising oil and energy prices. This will be a long, ugly and nasty U-shaped recession lasting 12 to 18 months, not the mild 6 month V-shaped recession that the delusional consensus expects
• Equity prices in the US and abroad will go much deeper in bear territory. In a typical US recession equity prices fall by an average of 28% relative to the peak. But this is not a typical US recession; it is rather a severe one associated with a severe financial crisis. Thus, equity prices will fall by about 40% relative to their peak. So, we are only barely mid-way in the meltdown of stock markets
• The rest of the world will not decouple from the US recession and from the US financial meltdown; it will re-couple big time. Already 12 major economies are on the way to a recessionary hard landing; while the rest of the world will experience a severe growth slowdown only one step removed from a global recession. Given this sharp global economic slowdown oil, energy and commodity prices will fall 20 to 30% from their recent bubbly peaks
• The current U.S recession and sharp global economic slowdown is combining the worst of the oil shocks of the 1970s with the worst of the asset/credit bust shocks (and ensuing credit crunch and investment busts) of 1990-91 and 2001: like in 1973 and 1979 we are facing a stagflationary shock to oil, energy and other commodity prices that by itself may tip many oil importing countries into a sharp slowdown or an outright recession. Also, like 1990-91 and 2001 we are now facing another asset bubble and credit bubble gone bust big time: the housing and overall household credit boom of the last seven years has now gone bust in the same way as the 1980s housing bubble and 1990s tech bubble went bust in 1990 and in 2000 triggering recessions. And a similar housing/asset/credit bubble is going bust in other countries – U.K., Spain, Ireland, Italy, Portugal, etc. – leading to a risk of a hard landing in these economies.
• But over time inflation will be the last problem that the Fed will have to face as a severe US recession and global slowdown will lead to a sharp reduction in inflationary pressures in the U.S.: slack in goods markets with demand falling below supply will reduce pricing power of firms; slack in labor markets with unemployment rising will reduce wage pressures and labor costs pressures; a fall in commodity prices of the order of 20-30% will further reduce inflationary pressure. The Fed will have to cut the Fed Funds rate much more – as severe downside risks to growth and to financial stability will dominate any short-term upward inflationary pressures. Leaving aside the risk of a collapse of the US dollar given this easier monetary policy the Fed Funds rate may end up being closer to 0% than 1% by the end of this financial disaster and severe recession cycle.
• The Bretton Woods 2 regime of fixed exchange rates to the US dollar and/or heavily managed exchange will unravel – as the first Bretton Woods regimes did in the early 1970s – as US twin deficits, recession, financial crisis and rising commodity and goods inflation in emerging market economies will destroy the basis for it existence.
• Thus, the scenario of 12 steps to a financial disaster that I outlined in my February 2008 paper is unfolding as predicted. If anything financial conditions are now much worse than they were at the previous peak of this financial crisis, i.e. in mid-march of 2008.
Phil Gramm, the senator-banker who until recently advised John McCain's campaign, did get it right about a "nation of whiners," but he misidentified the faint-hearted. It's not the people or even the politicians. It is Wall Street--the financial titans and big-money bankers, the most important investors and worldwide creditors who are scared witless by events. These folks are in full-flight panic and screaming for mercy from Washington, Their cries were answered by the massive federal bailout of Fannie Mae and Freddy Mac, the endangered mortgage companies.
When the monied interests whined, they made themselves heard by dumping the stocks of these two quasi-public private corporations, threatening to collapse the two financial firms like the investor "run" that wiped out Bear Stearns in March. The real distress of the banks and brokerages and major investors is that they cannot unload the rotten mortgage securities packaged by Fannie Mae and banks sold worldwide. Wall Street's preferred solution: dump the bad paper on the rest of us, the unwitting American taxpayers.
The Bush crowd, always so reluctant to support federal aid for mere people, stepped up to the challenge and did as it was told. Treasury Secretary Paulson (ex-Goldman Sachs) and his sidekick, Federal Reserve Chairman Ben Bernanke, announced their bailout plan on Sunday to prevent another disastrous selloff on Monday when markets opened. Like the first-stage rescue of Wall Street's largest investment firms in March, this bold stroke was said to benefit all of us. The whole kingdom of American high finance would tumble down if government failed to act or made the financial guys pay for their own reckless delusions. Instead, dump the losses on the people.
Democrats who imagine they may find some partisan advantage in these events are deeply mistaken. The Democratic party was co-author of the disaster we are experiencing and its leaders fell in line swiftly. House banking chair, Rep. Barney Frank, announced he could have the bailout bill on President Bush's desk next week. No need to confuse citizens by dwelling on the details. Save Wall Street first. Maybe lowbrow citizens won't notice it's their money.
We are witnessing a momentous event--the great deflation of Wall Street--and it is far from over. The crash of IndyMac is just the beginning. More banks will fail, so will many more debtors. The crisis has the potential to transform American politics because, first it destroys a generation of ideological bromides about free markets, and, second, because it makes visible the ugly power realities of our deformed democracy. Democrats and Republicans are bipartisan in this crisis because they have colluded all along over thirty years in creating the unregulated financial system and mammoth mega-banks that produced the phony valuations and deceitful assurances. The federal government protects the most powerful interests from the consequences of their plundering. It prescribes "market justice" for everyone else.
Of course, the federal government has to step up to the crisis, but the crucial question is how government can respond in the broad public interest. Bernanke knows the history of the last great deflation in the 1930s--better known as the Great Depression--and so he is determined to intervene swiftly, as the Federal Reserve failed to do in that earlier crisis. By pumping generous loans and liquidity into the system, the Fed chairman hopes to calm the market fears and reverse the panic. So far, he has failed. I think he will continue to fail because he has not gone far enough.
If Washington wants real results, it has to abandon the wishful posture that is simply helping the private firms get over their fright. The government must instead act decisively to take charge in more convincing ways. That means acknowledging to the general public the depth of the national crisis and the need for more dramatic interventions.
Instead of propping up Fannie Mae or others, the threatened firm should be formally nationalized as a nonprofit federal agency performing valuable services for the housing market. That is the real consequence anyway if the taxpayers have to buy up $300 billion in stock.
The private shareholders "are walking dead men, muerto," Institutional Risk Analytics, a private banking monitor, observed. Make them eat their losses, the sooner the better. The real national concern should be focused on the major creditors who lend to Fannie Mae and other US agencies as well as private financial firms. They include China, Japan and other foreign central banks. Foreign investors hold about 21 percent of the long-term debt paper issued by US government agencies--$376 billion in China, $229 billion in Japan.
It is not in our national interest to burn these nations with heavy losses. On the contrary, we need to sustain their good regard because they can help us recover by bailing out the US economy with more lending. If these foreign creditors turn away and stop their lending now, the US economy is toast and won't soon recover.
Americans should forget about whining; it's too late for that. People need to get angry--really, really angry--and take it out on both parties. What the country needs right now is a few more politicians in Washington with the guts to stand up and tell us the hard truth about out situation. It will be painful to hear. They will be denounced as "whiners." But truth might be our only way out.
The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial Disaster
by Nouriel Roubini February 5, 2008
Why did the Fed ease the Fed Funds rate by a whopping 125bps in eight days this past January? It is true that most macro indicators are heading south and suggesting a deep and severe recession that has already started. But the flow of bad macro news in mid-January did not justify, by itself, such a radical inter-meeting emergency Fed action followed by another cut at the formal FOMC meeting.
To understand the Fed actions one has to realize that there is now a rising probability of a “catastrophic” financial and economic outcome, i.e. a vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe. The Fed is seriously worried about this vicious circle and about the risks of a systemic financial meltdown.
That is the reason the Fed had thrown all caution to the wind – after a year in which it was behind the curve and underplaying the economic and financial risks – and has taken a very aggressive approach to risk management; this is a much more aggressive approach than the Greenspan one in spite of the initial views that the Bernanke Fed would be more cautious than Greenspan in reacting to economic and financial vulnerabilities.
To understand the risks that the financial system is facing today I present the “nightmare” or “catastrophic” scenario that the Fed and financial officials around the world are now worried about. Such a scenario – however extreme – has a rising and significant probability of occurring. Thus, it does not describe a very low probability event but rather an outcome that is quite possible.
Start first with the recession that is now enveloping the US economy. Let us assume – as likely - that this recession – that already started in December 2007 - will be worse than the mild ones – that lasted 8 months – that occurred in 1990-91 and 2001. The recession of 2008 will be more severe for several reasons: first, we have the biggest housing bust in US history with home prices likely to eventually fall 20 to 30%; second, because of a credit bubble that went beyond mortgages and because of reckless financial innovation and securitization the ongoing credit bust will lead to a severe credit crunch; third, US households – whose consumption is over 70% of GDP - have spent well beyond their means for years now piling up a massive amount of debt, both mortgage and otherwise; now that home prices are falling and a severe credit crunch is emerging the retrenchment of private consumption will be serious and protracted. So let us suppose that the recession of 2008 will last at least four quarters and, possibly, up to six quarters. What will be the consequences of it?
Here are the twelve steps or stages of a scenario of systemic financial meltdown associated with this severe economic recession…
First, this is the worst housing recession in US history and there is no sign it will bottom out any time soon. At this point it is clear that US home prices will fall between 20% and 30% from their bubbly peak; that would wipe out between $4 trillion and $6trillion of household wealth. While the subprime meltdown is likely to cause about 2.2 million foreclosures, a 30% fall in home values would imply that over 10 million households would have negative equity in their homes and would have a big incentive to use “jingle mail” (i.e. default, put the home keys in an envelope and send it to their mortgage bank). Moreover, soon enough a few very large home builders will go bankrupt and join the dozens of other small ones that have already gone bankrupt thus leading to another free fall in home builders’ stock prices that have irrationally rallied in the last few weeks in spite of a worsening housing recession.
Second, losses for the financial system from the subprime disaster are now estimated to be as high as $250 to $300 billion. But the financial losses will not be only in subprime mortgages and the related RMBS and CDOs. They 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. So this is a generalized mortgage crisis and meltdown, not just a subprime one. And losses among all sorts of mortgages will sharply increase as home prices fall sharply and the economy spins into a serious recession. Goldman Sachs now estimates total mortgage credit losses of about $400 billion; but the eventual figures could be much larger if home prices fall more than 20%. Also, the RMBS and CDO markets for securitization of mortgages – already dead for subprime and frozen for other mortgages - remain in a severe credit crunch, thus reducing further the ability of banks to originate mortgages. The mortgage credit crunch will become even more severe.
Also add to the woes and losses of the financial institutions the meltdown of hundreds of billions of off balance SIVs and conduits; this meltdown and the roll-off of the ABCP market has forced banks to bring back on balance sheet these toxic off balance sheet vehicles adding to the capital and liquidity crunch of the financial institutions and adding to their on balance sheet losses. And because of securitization the securitized toxic waste has been spread from banks to capital markets and their investors in the US and abroad, thus increasing – rather than reducing systemic risk – and making the credit crunch global.
Third, the recession will lead – as it is already doing – to a sharp increase in defaults on other forms of unsecured consumer debt: credit cards, auto loans, student loans. There are dozens of millions of subprime credit cards and subprime auto loans in the US. And again defaults in these consumer debt categories will not be limited to subprime borrowers. So add these losses to the financial losses of banks and of other financial institutions (as also these debts were securitized in ABS products), thus leading to a more severe credit crunch. As the Fed loan officers survey suggest the credit crunch is spreading throughout the mortgage market and from mortgages to consumer credit, and from large banks to smaller banks.
Fourth, while there is serious uncertainty about the losses that monolines will undertake on their insurance of RMBS, CDO and other toxic ABS products, it is now clear that such losses are much higher than the $10-15 billion rescue package that regulators are trying to patch up. Some monolines are actually borderline insolvent and none of them deserves at this point a AAA rating regardless of how much realistic recapitalization is provided. Any business that required an AAA rating to stay in business is a business that does not deserve such a rating in the first place. The monolines should be downgraded as no private rescue package – short of an unlikely public bailout – is realistic or feasible given the deep losses of the monolines on their insurance of toxic ABS products.
Next, the downgrade of the monolines will lead to another $150 of writedowns on ABS portfolios for financial institutions that have already massive losses. It will also lead to additional losses on their portfolio of muni bonds. The downgrade of the monolines will also lead to large losses – and potential runs – on the money market funds that invested in some of these toxic products. The money market funds that are backed by banks or that bought liquidity protection from banks against the risk of a fall in the NAV may avoid a run but such a rescue will exacerbate the capital and liquidity problems of their underwriters. The monolines’ downgrade will then also lead to another sharp drop in US equity markets that are already shaken by the risk of a severe recession and large losses in the financial system.
Fifth, the commercial real estate loan market will soon enter into a meltdown similar to the subprime one. Lending practices in commercial real estate were as reckless as those in residential real estate. The housing crisis will lead – with a short lag – to a bust in nonresidential construction as no one will want to build offices, stores, shopping malls/centers in ghost towns. The CMBX index is already pricing a massive increase in credit spreads for non-residential mortgages/loans. And new origination of commercial real estate mortgages is already semi-frozen today; the commercial real estate mortgage market is already seizing up today.
Sixth, it is possible that some large regional or even national bank that is very exposed to mortgages, residential and commercial, will go bankrupt. Thus some big banks may join the 200 plus subprime lenders that have gone bankrupt. This, like in the case of Northern Rock, will lead to depositors’ panic and concerns about deposit insurance. The Fed will have to reaffirm the implicit doctrine that some banks are too big to be allowed to fail. But these bank bankruptcies will lead to severe fiscal losses of bank bailout and effective nationalization of the affected institutions. Already Countrywide – an institution that was more likely insolvent than illiquid – has been bailed out with public money via a $55 billion loan from the FHLB system, a semi-public system of funding of mortgage lenders. Banks’ bankruptcies will add to an already severe credit crunch.
Seventh, the banks losses on their portfolio of leveraged loans are already large and growing. The ability of financial institutions to syndicate and securitize their leveraged loans – a good chunk of which were issued to finance very risky and reckless LBOs – is now at serious risk. And hundreds of billions of dollars of leveraged loans are now stuck on the balance sheet of financial institutions at values well below par (currently about 90 cents on the dollar but soon much lower). Add to this that many reckless LBOs (as senseless LBOs with debt to earnings ratio of seven or eight had become the norm during the go-go days of the credit bubble) have now been postponed, restructured or cancelled. And add to this problem the fact that some actual large LBOs will end up into bankruptcy as some of these corporations taken private are effectively bankrupt in a recession and given the repricing of risk; covenant-lite and PIK toggles may only postpone – not avoid – such bankruptcies and make them uglier when they do eventually occur. The leveraged loans mess is already leading to a freezing up of the CLO market and to growing losses for financial institutions.
Eighth, once a severe recession is underway a massive wave of corporate defaults will take place. In a typical year US corporate default rates are about 3.8% (average for 1971-2007); in 2006 and 2007 this figure was a puny 0.6%. And in a typical US recession such default rates surge above 10%. Also during such distressed periods the RGD – or recovery given default – rates are much lower, thus adding to the total losses from a default. Default rates were very low in the last two years because of a slosh of liquidity, easy credit conditions and very low spreads(with junk bond yields being only 260bps above Treasuries until mid June 2007). But now the repricing of risk has been massive: junk bond spreads close to 700bps, iTraxx and CDX indices pricing massive corporate default rates and the junk bond yield issuance market is now semi-frozen. While on average the US and European corporations are in better shape – in terms of profitability and debt burden – than in 2001 there is a large fat tail of corporations with very low profitability and that have piled up a mass of junk bond debt that will soon come to refinancing at much higher spreads. Corporate default rates will surge during the 2008recession 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.
Ninth, 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. Deepening problems in the economy and in the financial markets and poor risk managements will lead some of these institutions to go belly up: a few large hedge funds, a few money market funds, the entire SIV system and, possibly, one or two large and systemically important broker dealers. Dealing with the distress of this shadow financial system will be very problematic as this system – stressed by credit and liquidity problems - cannot be directly rescued by the central banks in the way that banks can.
Tenth, stock markets in the US and abroad will start pricing a severe US recession – rather than a mild recession – and a sharp global economic slowdown. The fall in stock markets – after the late January 2008 rally fizzles out – will resume as investors will soon realize that the economic downturn is more severe, that the monolines will not be rescued, that financial losses will mount, and that earnings will sharply drop in a recession not just among financial firms but also non financial ones. A few long equity hedge funds will go belly up in 2008 after the massive losses of many hedge funds in August, November and, again, January 2008. Large margin calls will be triggered for long equity investors and another round of massive equity shorting will take place. Long covering and margin calls will lead to a cascading fall in equity markets in the US and a transmission to global equity markets. US and global equity markets will enter into a persistent bear market as in a typical US recession the S&P500 falls by about 28%.
Eleventh, the worsening credit crunch that is affecting most credit markets and credit derivative markets will lead to a dry-up of liquidity in a variety of financial markets, including otherwise very liquid derivatives markets. Another round of credit crunch in interbank markets will ensue triggered by counterparty risk, lack of trust, liquidity premia and credit risk. A variety of interbank rates – TED spreads, BOR-OIS spreads, BOT – Tbill spreads, interbank-policy rate spreads, swap spreads, VIX and other gauges of investors’ risk aversion – will massively widen again. Even the easing of the liquidity crunch after massive central banks’ actions in December and January will reverse as credit concerns keep interbank spread wide in spite of further injections of liquidity by central banks.
Twelfth, a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices will ensue leading to a cascading and mounting cycle of losses and further credit contraction. In illiquid market actual market prices are now even lower than the lower fundamental value that they now have given the credit problems in the economy. Market prices include a large illiquidity discount on top of the discount due to the credit and fundamental problems of the underlying assets that are backing the distressed financial assets. Capital losses will lead to margin calls and further reduction of risk taking by a variety of financial institutions that are now forced to mark to market their positions. Such a forced fire sale of assets in illiquid markets will lead to further losses that will further contract credit and trigger further margin calls and disintermediation of credit. The triggering event for the next round of this cascade is the downgrade of the monolines and the ensuing sharp drop in equity markets; both will trigger margin calls and further credit disintermediation.
Based on estimates by Goldman Sachs $200 billion of losses in the financial system lead to a contraction of credit of $2 trillion given that institutions hold about $10 of assets per dollar of capital. The recapitalization of banks sovereign wealth funds – about $80 billion so far – will be unable to stop this credit is intermediation – (the move from off balance sheet to on balance sheet and moves of assets and liabilities from the shadow banking system to the formal banking system) and the ensuing contraction in credit as the mounting losses will dominate by a large margin any bank recapitalization from SWFs. A contagious and cascading spiral of credit disintermediation, credit contraction, sharp fall in asset prices and sharp widening in credit spreads will then be transmitted to most parts of the financial system. This massive credit crunch will make the economic contraction more severe and lead to further financial losses. Total losses in the financial system will add up to more than $1 trillion and the economic recession will become deeper, more protracted and severe.
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.
In this meltdown scenario US and global financial markets will experience their most severe crisis in the last quarter of a century.
Can the Fed and other financial officials avoid this nightmare scenario that keeps them awake at night? The answer to this question – to be detailed in a follow-up article – is twofold: first, it is not easy to manage and control such a contagious financial crisis that is more severe and dangerous than any faced by the US in a quarter of a century; second, the extent and severity of this financial crisis will depend on whether the policy response – monetary, fiscal, regulatory, financial and otherwise – is coherent, timely and credible. I will argue – in my next article - that one should be pessimistic about the ability of policy and financial authorities to manage and contain a crisis of this magnitude; thus, one should be prepared for the worst, i.e. a systemic financial crisis.
IT'S WEARISOME, TO SAY THE LEAST, TO CHRONICLE the bad news on the financial front, week after week after bloody week. And we long for the chance to switch from dirge to lullaby as we compose our weekly litany of what's happening and what's likely to happen, in both the stock market and the economy.
Being the messenger who delivers the bad news is just part of the job, the dark and dirty part, you might say. But after all these years, it still hurts to see grown men cry (women, being the stronger sex, tend to make do with a grimace).
So when, as they finally did last week, the clouds that have enshrouded the investment landscape for months suddenly seem to be lifting, we'd normally seize the opportunity to start chirping instead of carping. But no sooner had we begun to sound the first joyous note than we found ourselves confronted by a devil of a dilemma. To wit:
Is the recovery for real? Or is it merely the result of one of those fabricated rumors that the SEC sternly has warned will be prosecuted to the full extent of the law? And, if it should prove the latter, do we risk jail time for perpetuating a false rumor by giving it currency in this sacred space?
What a conundrum! We were somewhat reassured after inferring from a scan of the dictum that only false rumors that cause stocks to go down -- not false rumors that cause stocks to go up -- are verboten by the powers that be. Which makes sense, we guess, since everybody loves a winner.
Still, what gives us pause and, more than that, makes us fidgety, is that several short sellers phoned us to report the upswing in the market (and we plumb forgot to ask whether any of them were guilty of naked short selling, although in their case the literal image that phrase conjures up is itself more than a little unsettling).
Rather weird, too, it strikes us, is that naked short selling -- that is, selling shares short before you've arranged to borrow them, as the SEC has mandated on the stocks of 19 key lenders including such impoverished beauties as Fannie Mae and Freddie Mac -- is already illegal. An incorrigible cynic might be prompted to conjecture that Chairman Cox and his team of ferocious Chihuahuas are engaged in making a very public hullabaloo to cover up their shameful laxity in enforcing the securities laws.
In like vein, that same unreconstructed cynic might wonder if the agency, by promiscuously issuing subpoenas to virtually everyone on Wall Street who ever uttered the name Bear Stearns is not so much intent on pursuing a forensic autopsy as helping the staggering economy by throwing money around like an investment banker after his first bottle of wine, and enriching legions of lawyers.
Our timidity, not to mention our confusion, has been greatly furthered by the fingering by Washington of speculators for hiking the price of oil sky-high. Are the short sellers who drive stocks down the same knaves who drive oil prices up? Are they ambidextrous investors or two distinct species? Wouldn't it prevent innocents like ourselves from being ensnared by these bad people if they were compelled to have identifying tattoos imprinted on their foreheads that marked them as naked short sellers, speculators or, heaven forbid, both?
But, forgive us this confessional digression. We're a journalist first and foremost. And journalists are fearless (within reason) and dedicated to speaking truth to power (especially when it doesn't cost them anything). So here goes: The stock market is rallying and the spirited rally has legs that could carry it onward and upward for at least another day. Toot the horns and bang the drum and shout hallelujah!
THOSE MIGHTY BURSTS OF AGITATION and hot air in Washington, even if most of what passed for action was really motion, did provide the excuse the market needed to show a little spunk. All the sound and fury about short sellers, besides confounding the trading desks of most Street houses, inevitably spooked the bearishly inclined, who rushed to cover their short positions, particularly in the financial sector, where pickings had been lush and easy, and seek the safety of the sidelines.
And it certainly didn't hurt that crude, which had touched $147 a barrel a couple of weeks ago, a cool 90% higher than a year earlier and up some 40% since the start of this year, took a spill. Before attracting support, it broke below $130. Here, too, we suspect, Congress' huffing and puffing about commodity-index speculation sent a bit of a shiver through futures traders.
Indeed, a reverse similarity was at play in the stock market's rally and petro's skid. Both were "entitled" to at least a brief change of course. Crude, as noted, has been on a tear, and not only this past year: It's up roughly six-fold since 2001 and has comfortably more than doubled since the final quarter of 2006. A 10% or 11% decline, although inarguably compressed, would seem to merit that much-abused description of "correction," and not an especially severe one, at that.
For its part, our good old stock market, before it found some footing, was off 22.6% (the Dow), 22.5% (Nasdaq) and 22.4% (the S&P 500), from the peaks reached in October of '07. This year's performance hasn't been anything to write home about, either, with the Dow industrials down 13% and the S&P 500 and Nasdaq off about 14%. As to the financials -- we trust you're sitting down -- the poor things have been positively pulverized, losing upward of 54% between their high in February 2007 and their low last week.
Even in the grisliest bear markets, sellers suffer an occasional spot of fatigue, draw a breath and take a time out. We strongly suspect that's pretty much the story here for equities. As to oil, mindful of the potential erosion of demand that recession and obscene prices are likely to cause, we nonetheless have every confidence that Ben, with his helicopter, and Hank, with his bazooka, will continue to wreak havoc on the badly wounded dollar, one of the unintended consequences of which will be to bolster crude prices.
And not the least of the reasons we remain skeptical of the prospects for stocks is that it's a "it coulda been worse" market. Especially among the walking dead of the financials, the release of operating results awash in red ink were greeted by the cry "it coulda been worse," and their stocks momentarily came to life.
This tendency was also very much in evidence among banks and their kin that have weathered the credit storms and mortgage mess in comparatively decent shape -- like JPM, which reported a 50% drop in profits and whose shares promptly enjoyed a sharp gain.
The bank's top man, James Dimon, in releasing its lower earnings report, termed the economy weak and likely to get weaker and ventured that capital markets will remain under stress. He also warned that losses on prime mortgages (the cream of the crop that is turning sour, big-time) could triple. Mr. Dimon, rather a class act in a field not abounding in them, gets high marks for his candor. As for the eager beavers who shrugged off his cautions and rushed to buy the stock, we give them an investment grade of "F," for frivolous.
And for all those hopeful souls who have been champing at the bit to buy because things could have been worse, we say stick around awhile; they will be.
WHY WE'RE STILL BEARISH WAS SPELLED out starkly in a dispatch we received last week from Nouriel Roubini. Nouriel is a professor of economics at NYU Stern School of Business (but don't hold that against him) and runs an economic advisory firm called RGE Monitor that casts a knowing and clear eye on the global financial and economic scene. We think he's top-notch (which means we agree with him, a lot of the time).
The nub of his argument is that we're suffering the worst financial crisis since the Great Depression, and he proceeds to give chilling chapter and verse. He predicts that hundreds of small banks loaded with real estate will go bust and dozens of large regional and national banks will also find themselves in deep do-do.
He reckons that, in a few years, there'll be no major independent broker-dealers left: They'll either pack it in or merge, victims of excessive leverage and a badly flawed and discredited business model.
The Federal Deposit Insurance Corp., after it gets through picking up the pieces of IndyMac, will sooner or later have to get a capital transfusion, Nouriel asserts, because its insurance premiums won't cover the tab of rescuing all the troubled banks. He foresees credit losses ultimately reaching at least $1 trillion and anticipates a heap of woe for credit purveyors across the board.
The poor consumer, he contends, is shopped out and being hammered by falling home prices, falling equity prices, falling jobs and incomes, rising inflation. The recession he anticipates will last 12 to 18 months. And the rest of the world won't escape: He looks for hard landings for 12 major economies. As for the stock market, he hazards that there's plenty of room left on the downside. In fact, he feels the bear market won't end until equities are down a full 40% from their peaks.
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Bloomberg TV Interview: Worst Financial Crisis Since the Great Depression and Worst U.S. Recession in Decades
Nouriel Roubini
Jul 15, 2008
I was on Bloomberg TV this morning being interviewed about financial markets, the economy and the upcoming testimony by Bernanke.
As I put it in the interview: ``This is a systemic financial crisis, there is no end to it,'' Nouriel Roubini, professor of economics and international business at New York University, told Bloomberg Television. ``It's a vicious circle between a contracting economy and greater credit and financial losses feeding on the economy.''
Regular readers of this blog are familiar with my views. But here is a summary and significant extended update of my views that this will turn out to be the worst financial crisis since the Great Depression and the worst US recession in decades…
• This is by far the worst financial crisis since the Great Depression
• Hundreds of small banks with massive exposure to real estate (the average small bank has 67% of its assets in real estate) will go bust
• Dozens of large regional/national banks (a’ la IndyMac) are also bankrupt given their extreme exposure to real estate and will also go bust
• Some major money center banks are also semi-insolvent and while they are deemed too big to fail their rescue with FDIC money will be extremely costly
• In a few years time there will be no major independent broker dealers as their business model (securitization, slice & dice and transfer of toxic credit risk and piling fees upon fees rather than earning income from holding credit risk) is bust and the risk of a bank-like run on their very short term liquid liabilities is a fundamental flaw in their structure (i.e. the four remaining U.S. big brokers dealers will either go bust or will have to be merged with traditional commercial banks). Firms that borrow liquid and short, highly leverage themselves and lend in longer term and illiquid ways (i.e. most of the shadow banking system) cannot survive without formal deposit insurance and formal permanent lender of last resort support from the central bank
• The FDIC that has already depleted 10% of its funds in the rescue of IndyMac alone will run out of funds and will have to be recapitalized by Congress as its insurance premia were woefully insufficient to cover the hole from the biggest banking crisis since the Great Depression
• Fannie and Freddie are insolvent and the Treasury bailout plan (the mother of all moral hazard bailout) is socialism for the rich, the well connected and Wall Street; it is the continuation of a corrupt system where profits are privatized and losses are socialized. Instead of wiping out shareholders of the two GSEs, replacing corrupt and incompetent managers and forcing a haircut on the claims of the creditors/bondholders such a plan bails out shareholders, managers and creditors at a massive cost to U.S. taxpayers
• This financial crisis will imply credit losses of at least $1 trillion and more likely $2 trillion
• This is not just a subprime mortgage crisis; this is the crisis of an entire subprime financial system: losses are spreading from subprime to near prime and prime mortgages; to commercial real estate; to unsecured consumer credit (credit cards, student loans, auto loans); to leveraged loans that financed reckless debt-laden LBOs; to muni bonds that will go bust as hundred of municipalities will go bust; to industrial and commercial loans; to corporate bonds whose default rate will jump from close to 0% to over 10%; to CDSs where $62 trillion of nominal protection sits on top an outstanding stock of only $6 trillion of bonds and where counterparty risk – and the collapse of many counterparties – will lead to a systemic collapse of this market
• This will be the most severe U.S. recession in decades with the U.S. consumer being on the ropes and faltering big time as soon as the temporary effect of the tax rebates will fade out by mid-summer (July). This U.S. consumer is shopped out, saving less, debt burdened and being hammered by falling home prices, falling equity prices, falling jobs and incomes, rising inflation and rising oil and energy prices. This will be a long, ugly and nasty U-shaped recession lasting 12 to 18 months, not the mild 6 month V-shaped recession that the delusional consensus expects
• Equity prices in the US and abroad will go much deeper in bear territory. In a typical US recession equity prices fall by an average of 28% relative to the peak. But this is not a typical US recession; it is rather a severe one associated with a severe financial crisis. Thus, equity prices will fall by about 40% relative to their peak. So, we are only barely mid-way in the meltdown of stock markets
• The rest of the world will not decouple from the US recession and from the US financial meltdown; it will re-couple big time. Already 12 major economies are on the way to a recessionary hard landing; while the rest of the world will experience a severe growth slowdown only one step removed from a global recession. Given this sharp global economic slowdown oil, energy and commodity prices will fall 20 to 30% from their recent bubbly peaks
• The current U.S recession and sharp global economic slowdown is combining the worst of the oil shocks of the 1970s with the worst of the asset/credit bust shocks (and ensuing credit crunch and investment busts) of 1990-91 and 2001: like in 1973 and 1979 we are facing a stagflationary shock to oil, energy and other commodity prices that by itself may tip many oil importing countries into a sharp slowdown or an outright recession. Also, like 1990-91 and 2001 we are now facing another asset bubble and credit bubble gone bust big time: the housing and overall household credit boom of the last seven years has now gone bust in the same way as the 1980s housing bubble and 1990s tech bubble went bust in 1990 and in 2000 triggering recessions. And a similar housing/asset/credit bubble is going bust in other countries – U.K., Spain, Ireland, Italy, Portugal, etc. – leading to a risk of a hard landing in these economies.
• But over time inflation will be the last problem that the Fed will have to face as a severe US recession and global slowdown will lead to a sharp reduction in inflationary pressures in the U.S.: slack in goods markets with demand falling below supply will reduce pricing power of firms; slack in labor markets with unemployment rising will reduce wage pressures and labor costs pressures; a fall in commodity prices of the order of 20-30% will further reduce inflationary pressure. The Fed will have to cut the Fed Funds rate much more – as severe downside risks to growth and to financial stability will dominate any short-term upward inflationary pressures. Leaving aside the risk of a collapse of the US dollar given this easier monetary policy the Fed Funds rate may end up being closer to 0% than 1% by the end of this financial disaster and severe recession cycle.
• The Bretton Woods 2 regime of fixed exchange rates to the US dollar and/or heavily managed exchange will unravel – as the first Bretton Woods regimes did in the early 1970s – as US twin deficits, recession, financial crisis and rising commodity and goods inflation in emerging market economies will destroy the basis for it existence.
• Thus, the scenario of 12 steps to a financial disaster that I outlined in my February 2008 paper is unfolding as predicted. If anything financial conditions are now much worse than they were at the previous peak of this financial crisis, i.e. in mid-march of 2008.
Wall Street's Great Deflation
by William Greider
07/14/2008
Phil Gramm, the senator-banker who until recently advised John McCain's campaign, did get it right about a "nation of whiners," but he misidentified the faint-hearted. It's not the people or even the politicians. It is Wall Street--the financial titans and big-money bankers, the most important investors and worldwide creditors who are scared witless by events. These folks are in full-flight panic and screaming for mercy from Washington, Their cries were answered by the massive federal bailout of Fannie Mae and Freddy Mac, the endangered mortgage companies.
When the monied interests whined, they made themselves heard by dumping the stocks of these two quasi-public private corporations, threatening to collapse the two financial firms like the investor "run" that wiped out Bear Stearns in March. The real distress of the banks and brokerages and major investors is that they cannot unload the rotten mortgage securities packaged by Fannie Mae and banks sold worldwide. Wall Street's preferred solution: dump the bad paper on the rest of us, the unwitting American taxpayers.
The Bush crowd, always so reluctant to support federal aid for mere people, stepped up to the challenge and did as it was told. Treasury Secretary Paulson (ex-Goldman Sachs) and his sidekick, Federal Reserve Chairman Ben Bernanke, announced their bailout plan on Sunday to prevent another disastrous selloff on Monday when markets opened. Like the first-stage rescue of Wall Street's largest investment firms in March, this bold stroke was said to benefit all of us. The whole kingdom of American high finance would tumble down if government failed to act or made the financial guys pay for their own reckless delusions. Instead, dump the losses on the people.
Democrats who imagine they may find some partisan advantage in these events are deeply mistaken. The Democratic party was co-author of the disaster we are experiencing and its leaders fell in line swiftly. House banking chair, Rep. Barney Frank, announced he could have the bailout bill on President Bush's desk next week. No need to confuse citizens by dwelling on the details. Save Wall Street first. Maybe lowbrow citizens won't notice it's their money.
We are witnessing a momentous event--the great deflation of Wall Street--and it is far from over. The crash of IndyMac is just the beginning. More banks will fail, so will many more debtors. The crisis has the potential to transform American politics because, first it destroys a generation of ideological bromides about free markets, and, second, because it makes visible the ugly power realities of our deformed democracy. Democrats and Republicans are bipartisan in this crisis because they have colluded all along over thirty years in creating the unregulated financial system and mammoth mega-banks that produced the phony valuations and deceitful assurances. The federal government protects the most powerful interests from the consequences of their plundering. It prescribes "market justice" for everyone else.
Of course, the federal government has to step up to the crisis, but the crucial question is how government can respond in the broad public interest. Bernanke knows the history of the last great deflation in the 1930s--better known as the Great Depression--and so he is determined to intervene swiftly, as the Federal Reserve failed to do in that earlier crisis. By pumping generous loans and liquidity into the system, the Fed chairman hopes to calm the market fears and reverse the panic. So far, he has failed. I think he will continue to fail because he has not gone far enough.
If Washington wants real results, it has to abandon the wishful posture that is simply helping the private firms get over their fright. The government must instead act decisively to take charge in more convincing ways. That means acknowledging to the general public the depth of the national crisis and the need for more dramatic interventions.
Instead of propping up Fannie Mae or others, the threatened firm should be formally nationalized as a nonprofit federal agency performing valuable services for the housing market. That is the real consequence anyway if the taxpayers have to buy up $300 billion in stock.
The private shareholders "are walking dead men, muerto," Institutional Risk Analytics, a private banking monitor, observed. Make them eat their losses, the sooner the better. The real national concern should be focused on the major creditors who lend to Fannie Mae and other US agencies as well as private financial firms. They include China, Japan and other foreign central banks. Foreign investors hold about 21 percent of the long-term debt paper issued by US government agencies--$376 billion in China, $229 billion in Japan.
It is not in our national interest to burn these nations with heavy losses. On the contrary, we need to sustain their good regard because they can help us recover by bailing out the US economy with more lending. If these foreign creditors turn away and stop their lending now, the US economy is toast and won't soon recover.
Americans should forget about whining; it's too late for that. People need to get angry--really, really angry--and take it out on both parties. What the country needs right now is a few more politicians in Washington with the guts to stand up and tell us the hard truth about out situation. It will be painful to hear. They will be denounced as "whiners." But truth might be our only way out.
The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial Disaster
by Nouriel Roubini
February 5, 2008
Why did the Fed ease the Fed Funds rate by a whopping 125bps in eight days this past January? It is true that most macro indicators are heading south and suggesting a deep
and severe recession that has already started. But the flow of bad macro news in mid-January did not justify, by itself, such a radical inter-meeting emergency Fed action followed by another cut at the formal FOMC meeting.
To understand the Fed actions one has to realize that there is now a rising probability of a “catastrophic” financial and economic outcome, i.e. a vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe. The Fed is seriously worried about this vicious circle and about the risks of a systemic financial meltdown.
That is the reason the Fed had thrown all caution to the wind – after a year in which it was behind the curve and underplaying the economic and financial risks – and has taken a very aggressive approach to risk management; this is a much more aggressive approach
than the Greenspan one in spite of the initial views that the Bernanke Fed would be more cautious than Greenspan in reacting to economic and financial vulnerabilities.
To understand the risks that the financial system is facing today I present the “nightmare” or “catastrophic” scenario that the Fed and financial officials around the world are now worried about. Such a scenario – however extreme – has a rising and significant probability of occurring. Thus, it does not describe a very low probability event but rather an outcome that is quite possible.
Start first with the recession that is now enveloping the US economy. Let us assume – as likely - that this recession – that already started in December 2007 - will be worse than the mild ones – that lasted 8 months – that occurred in 1990-91 and 2001. The recession of 2008 will be more severe for several reasons: first, we have the biggest housing bust in
US history with home prices likely to eventually fall 20 to 30%; second, because of a credit bubble that went beyond mortgages and because of reckless financial innovation and securitization the ongoing credit bust will lead to a severe credit crunch; third, US households – whose consumption is over 70% of GDP - have spent well beyond their means for years now piling up a massive amount of debt, both mortgage and otherwise; now that home prices are falling and a severe credit crunch is emerging the retrenchment of private consumption will be serious and protracted. So let us suppose that the recession of 2008 will last at least four quarters and, possibly, up to six quarters. What will be the consequences of it?
Here are the twelve steps or stages of a scenario of systemic financial meltdown associated with this severe economic recession…
First, this is the worst housing recession in US history and there is no sign it will bottom out any time soon. At this point it is clear that US home prices will fall between 20% and 30% from their bubbly peak; that would wipe out between $4 trillion and $6trillion of household wealth. While the subprime meltdown is likely to cause about 2.2 million foreclosures, a 30% fall in home values would imply that over 10 million households would have negative equity in their homes and would have a big incentive to use “jingle mail” (i.e. default, put the home keys in an envelope and send it to their mortgage bank). Moreover, soon enough a few very large home builders will go bankrupt and join the dozens of other small ones that have already gone bankrupt thus leading to another free fall in home builders’ stock prices that have irrationally rallied in the last few weeks in spite of a worsening housing recession.
Second, losses for the financial system from the subprime disaster are now estimated to be as high as $250 to $300 billion. But the financial losses will not be only in subprime mortgages and the related RMBS and CDOs. They 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. So this is a generalized mortgage crisis and meltdown, not just a subprime one. And losses among all sorts of mortgages will sharply increase as home prices fall sharply and the economy spins into a serious recession. Goldman Sachs
now estimates total mortgage credit losses of about $400 billion; but the eventual figures could be much larger if home prices fall more than 20%. Also, the RMBS and CDO markets for securitization of mortgages – already dead for subprime and frozen for other mortgages - remain in a severe credit crunch, thus reducing further the ability of banks to originate mortgages. The mortgage credit crunch will become even more severe.
Also add to the woes and losses of the financial institutions the meltdown of hundreds of billions of off balance SIVs and conduits; this meltdown and the roll-off of the ABCP market has forced banks to bring back on balance sheet these toxic off balance sheet vehicles adding to the capital and liquidity crunch of the financial institutions and adding to their on balance sheet losses. And because of securitization the securitized toxic waste has been spread from banks to capital markets and their investors in the US and abroad, thus increasing – rather than reducing systemic risk – and making the credit crunch
global.
Third, the recession will lead – as it is already doing – to a sharp increase in defaults on other forms of unsecured consumer debt: credit cards, auto loans, student loans. There are dozens of millions of subprime credit cards and subprime auto loans in the US. And again defaults in these consumer debt categories will not be limited to subprime borrowers. So add these losses to the financial losses of banks and of other financial institutions (as also these debts were securitized in ABS products), thus leading to a more severe credit crunch. As the Fed loan officers survey suggest the credit crunch is spreading throughout the mortgage market and from mortgages to consumer credit, and from large banks to smaller banks.
Fourth, while there is serious uncertainty about the losses that monolines will undertake on their insurance of RMBS, CDO and other toxic ABS products, it is now clear that such losses are much higher than the $10-15 billion rescue package that regulators are trying to patch up. Some monolines are actually borderline insolvent and none of them deserves at this point a AAA rating regardless of how much realistic recapitalization is provided. Any business that required an AAA rating to stay in business is a business that does not deserve such a rating in the first place. The monolines should be downgraded as no private rescue package – short of an unlikely public bailout – is realistic or feasible given the deep losses of the monolines on their insurance of toxic ABS products.
Next, the downgrade of the monolines will lead to another $150 of writedowns on ABS portfolios for financial institutions that have already massive losses. It will also lead to additional losses on their portfolio of muni bonds. The downgrade of the monolines will also lead to large losses – and potential runs – on the money market funds that invested in some of these toxic products. The money market funds that are backed by banks or that bought liquidity protection from banks against the risk of a fall in the NAV may avoid a run but such a rescue will exacerbate the capital and liquidity problems of their underwriters. The monolines’ downgrade will then also lead to another sharp drop in US equity markets that are already shaken by the risk of a severe recession and large losses in the financial system.
Fifth, the commercial real estate loan market will soon enter into a meltdown similar to the subprime one. Lending practices in commercial real estate were as reckless as those in residential real estate. The housing crisis will lead – with a short lag – to a bust in nonresidential construction as no one will want to build offices, stores, shopping malls/centers in ghost towns. The CMBX index is already pricing a massive increase in credit spreads for non-residential mortgages/loans. And new origination of commercial real estate mortgages is already semi-frozen today; the commercial real estate mortgage market is already seizing up today.
Sixth, it is possible that some large regional or even national bank that is very exposed to mortgages, residential and commercial, will go bankrupt. Thus some big banks may join the 200 plus subprime lenders that have gone bankrupt. This, like in the case of Northern Rock, will lead to depositors’ panic and concerns about deposit insurance. The Fed will have to reaffirm the implicit doctrine that some banks are too big to be allowed to fail. But these bank bankruptcies will lead to severe fiscal losses of bank bailout and effective nationalization of the affected institutions. Already Countrywide – an institution that was more likely insolvent than illiquid – has been bailed out with public money via a $55 billion loan from the FHLB system, a semi-public system of funding of mortgage lenders. Banks’ bankruptcies will add to an already severe credit crunch.
Seventh, the banks losses on their portfolio of leveraged loans are already large and growing. The ability of financial institutions to syndicate and securitize their leveraged loans – a good chunk of which were issued to finance very risky and reckless LBOs – is now at serious risk. And hundreds of billions of dollars of leveraged loans are now stuck on the balance sheet of financial institutions at values well below par (currently about 90 cents on the dollar but soon much lower). Add to this that many reckless LBOs (as senseless LBOs with debt to earnings ratio of seven or eight had become the norm during the go-go days of the credit bubble) have now been postponed, restructured or cancelled. And add to this problem the fact that some actual large LBOs will end up into bankruptcy as some of these corporations taken private are effectively bankrupt in a recession and given the repricing of risk; covenant-lite and PIK toggles may only postpone – not avoid – such bankruptcies and make them uglier when they do eventually occur. The leveraged loans mess is already leading to a freezing up of the CLO market and to growing losses for financial institutions.
Eighth, once a severe recession is underway a massive wave of corporate defaults will take place. In a typical year US corporate default rates are about 3.8% (average for 1971-2007); in 2006 and 2007 this figure was a puny 0.6%. And in a typical US recession such default rates surge above 10%. Also during such distressed periods the RGD – or
recovery given default – rates are much lower, thus adding to the total losses from a default. Default rates were very low in the last two years because of a slosh of liquidity, easy credit conditions and very low spreads(with junk bond yields being only 260bps above Treasuries until mid June 2007). But now the repricing of risk has been massive: junk bond spreads close to 700bps, iTraxx and CDX indices pricing massive corporate default rates and the junk bond yield issuance market is now semi-frozen. While on
average the US and European corporations are in better shape – in terms of profitability and debt burden – than in 2001 there is a large fat tail of corporations with very low profitability and that have piled up a mass of junk bond debt that will soon come to refinancing at much higher spreads. Corporate default rates will surge during the 2008recession 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.
Ninth, 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. Deepening problems in the economy and in the financial markets and poor risk managements will lead some of these institutions to go belly up: a few large hedge funds, a few money market funds, the entire SIV system and, possibly, one or two large and systemically important broker dealers. Dealing with the distress of this shadow financial system will be very problematic as this system – stressed by credit and liquidity problems - cannot be
directly rescued by the central banks in the way that banks can.
Tenth, stock markets in the US and abroad will start pricing a severe US recession – rather than a mild recession – and a sharp global economic slowdown. The fall in stock markets – after the late January 2008 rally fizzles out – will resume as investors will soon
realize that the economic downturn is more severe, that the monolines will not be rescued, that financial losses will mount, and that earnings will sharply drop in a recession not just among financial firms but also non financial ones. A few long equity hedge funds will go belly up in 2008 after the massive losses of many hedge funds in August, November and, again, January 2008. Large margin calls will be triggered for long equity investors and another round of massive equity shorting will take place. Long covering and margin calls will lead to a cascading fall in equity markets in the US and a transmission to global equity markets. US and global equity markets will enter into a persistent bear market as in a typical US recession the S&P500 falls by about 28%.
Eleventh, the worsening credit crunch that is affecting most credit markets and credit derivative markets will lead to a dry-up of liquidity in a variety of financial markets, including otherwise very liquid derivatives markets. Another round of credit crunch in interbank markets will ensue triggered by counterparty risk, lack of trust, liquidity premia and credit risk. A variety of interbank rates – TED spreads, BOR-OIS spreads, BOT – Tbill spreads, interbank-policy rate spreads, swap spreads, VIX and other gauges of investors’ risk aversion – will massively widen again. Even the easing of the liquidity crunch after massive central banks’ actions in December and January will reverse as credit concerns keep interbank spread wide in spite of further injections of liquidity by central banks.
Twelfth, a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices will ensue leading to a cascading and mounting cycle of losses and further credit contraction. In illiquid market actual market prices are now even lower than the lower fundamental value that they now have given the credit problems in the economy. Market prices include a large illiquidity discount on top of the discount due to the credit and fundamental problems of the underlying assets that are backing the distressed financial assets. Capital losses will lead to margin calls and further reduction of risk taking by a variety of financial institutions that are now forced to
mark to market their positions. Such a forced fire sale of assets in illiquid markets will lead to further losses that will further contract credit and trigger further margin calls and disintermediation of credit. The triggering event for the next round of this cascade is the downgrade of the monolines and the ensuing sharp drop in equity markets; both will trigger margin calls and further credit disintermediation.
Based on estimates by Goldman Sachs $200 billion of losses in the financial system lead to a contraction of credit of $2 trillion given that institutions hold about $10 of assets per dollar of capital. The recapitalization of banks sovereign wealth funds – about $80 billion so far – will be unable to stop this credit is intermediation – (the move from off balance sheet to on balance sheet and moves of assets and liabilities from the shadow banking
system to the formal banking system) and the ensuing contraction in credit as the mounting losses will dominate by a large margin any bank recapitalization from SWFs. A contagious and cascading spiral of credit disintermediation, credit contraction, sharp fall in asset prices and sharp widening in credit spreads will then be transmitted to most parts of the financial system. This massive credit crunch will make the economic contraction more severe and lead to further financial losses. Total losses in the financial system will add up to more than $1 trillion and the economic recession will become deeper, more protracted and severe.
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.
In this meltdown scenario US and global financial markets will experience their most severe crisis in the last quarter of a century.
Can the Fed and other financial officials avoid this nightmare scenario that keeps them awake at night? The answer to this question – to be detailed in a follow-up article – is twofold: first, it is not easy to manage and control such a contagious financial crisis that is more severe and dangerous than any faced by the US in a quarter of a century; second, the extent and severity of this financial crisis will depend on whether the policy response – monetary, fiscal, regulatory, financial and otherwise – is coherent, timely and credible. I will argue – in my next article - that one should be pessimistic about the ability of
policy and financial authorities to manage and contain a crisis of this magnitude; thus, one should be prepared for the worst, i.e. a systemic financial crisis.
Dead Stocks Rallying
By Barrons
July 21, 2008
IT'S WEARISOME, TO SAY THE LEAST, TO CHRONICLE the bad news on the financial front, week after week after bloody week. And we long for the chance to switch from dirge to lullaby as we compose our weekly litany of what's happening and what's likely to happen, in both the stock market and the economy.
Being the messenger who delivers the bad news is just part of the job, the dark and dirty part, you might say. But after all these years, it still hurts to see grown men cry (women, being the stronger sex, tend to make do with a grimace).
So when, as they finally did last week, the clouds that have enshrouded the investment landscape for months suddenly seem to be lifting, we'd normally seize the opportunity to start chirping instead of carping. But no sooner had we begun to sound the first joyous note than we found ourselves confronted by a devil of a dilemma. To wit:
Is the recovery for real? Or is it merely the result of one of those fabricated rumors that the SEC sternly has warned will be prosecuted to the full extent of the law? And, if it should prove the latter, do we risk jail time for perpetuating a false rumor by giving it currency in this sacred space?
What a conundrum! We were somewhat reassured after inferring from a scan of the dictum that only false rumors that cause stocks to go down -- not false rumors that cause stocks to go up -- are verboten by the powers that be. Which makes sense, we guess, since everybody loves a winner.
Still, what gives us pause and, more than that, makes us fidgety, is that several short sellers phoned us to report the upswing in the market (and we plumb forgot to ask whether any of them were guilty of naked short selling, although in their case the literal image that phrase conjures up is itself more than a little unsettling).
Rather weird, too, it strikes us, is that naked short selling -- that is, selling shares short before you've arranged to borrow them, as the SEC has mandated on the stocks of 19 key lenders including such impoverished beauties as Fannie Mae and Freddie Mac -- is already illegal. An incorrigible cynic might be prompted to conjecture that Chairman Cox and his team of ferocious Chihuahuas are engaged in making a very public hullabaloo to cover up their shameful laxity in enforcing the securities laws.
In like vein, that same unreconstructed cynic might wonder if the agency, by promiscuously issuing subpoenas to virtually everyone on Wall Street who ever uttered the name Bear Stearns is not so much intent on pursuing a forensic autopsy as helping the staggering economy by throwing money around like an investment banker after his first bottle of wine, and enriching legions of lawyers.
Our timidity, not to mention our confusion, has been greatly furthered by the fingering by Washington of speculators for hiking the price of oil sky-high. Are the short sellers who drive stocks down the same knaves who drive oil prices up? Are they ambidextrous investors or two distinct species? Wouldn't it prevent innocents like ourselves from being ensnared by these bad people if they were compelled to have identifying tattoos imprinted on their foreheads that marked them as naked short sellers, speculators or, heaven forbid, both?
But, forgive us this confessional digression. We're a journalist first and foremost. And journalists are fearless (within reason) and dedicated to speaking truth to power (especially when it doesn't cost them anything). So here goes: The stock market is rallying and the spirited rally has legs that could carry it onward and upward for at least another day. Toot the horns and bang the drum and shout hallelujah!
THOSE MIGHTY BURSTS OF AGITATION and hot air in Washington, even if most of what passed for action was really motion, did provide the excuse the market needed to show a little spunk. All the sound and fury about short sellers, besides confounding the trading desks of most Street houses, inevitably spooked the bearishly inclined, who rushed to cover their short positions, particularly in the financial sector, where pickings had been lush and easy, and seek the safety of the sidelines.
And it certainly didn't hurt that crude, which had touched $147 a barrel a couple of weeks ago, a cool 90% higher than a year earlier and up some 40% since the start of this year, took a spill. Before attracting support, it broke below $130. Here, too, we suspect, Congress' huffing and puffing about commodity-index speculation sent a bit of a shiver through futures traders.
Indeed, a reverse similarity was at play in the stock market's rally and petro's skid. Both were "entitled" to at least a brief change of course. Crude, as noted, has been on a tear, and not only this past year: It's up roughly six-fold since 2001 and has comfortably more than doubled since the final quarter of 2006. A 10% or 11% decline, although inarguably compressed, would seem to merit that much-abused description of "correction," and not an especially severe one, at that.
For its part, our good old stock market, before it found some footing, was off 22.6% (the Dow), 22.5% (Nasdaq) and 22.4% (the S&P 500), from the peaks reached in October of '07. This year's performance hasn't been anything to write home about, either, with the Dow industrials down 13% and the S&P 500 and Nasdaq off about 14%. As to the financials -- we trust you're sitting down -- the poor things have been positively pulverized, losing upward of 54% between their high in February 2007 and their low last week.
Even in the grisliest bear markets, sellers suffer an occasional spot of fatigue, draw a breath and take a time out. We strongly suspect that's pretty much the story here for equities. As to oil, mindful of the potential erosion of demand that recession and obscene prices are likely to cause, we nonetheless have every confidence that Ben, with his helicopter, and Hank, with his bazooka, will continue to wreak havoc on the badly wounded dollar, one of the unintended consequences of which will be to bolster crude prices.
And not the least of the reasons we remain skeptical of the prospects for stocks is that it's a "it coulda been worse" market. Especially among the walking dead of the financials, the release of operating results awash in red ink were greeted by the cry "it coulda been worse," and their stocks momentarily came to life.
This tendency was also very much in evidence among banks and their kin that have weathered the credit storms and mortgage mess in comparatively decent shape -- like JPM, which reported a 50% drop in profits and whose shares promptly enjoyed a sharp gain.
The bank's top man, James Dimon, in releasing its lower earnings report, termed the economy weak and likely to get weaker and ventured that capital markets will remain under stress. He also warned that losses on prime mortgages (the cream of the crop that is turning sour, big-time) could triple. Mr. Dimon, rather a class act in a field not abounding in them, gets high marks for his candor. As for the eager beavers who shrugged off his cautions and rushed to buy the stock, we give them an investment grade of "F," for frivolous.
And for all those hopeful souls who have been champing at the bit to buy because things could have been worse, we say stick around awhile; they will be.
WHY WE'RE STILL BEARISH WAS SPELLED out starkly in a dispatch we received last week from Nouriel Roubini. Nouriel is a professor of economics at NYU Stern School of Business (but don't hold that against him) and runs an economic advisory firm called RGE Monitor that casts a knowing and clear eye on the global financial and economic scene. We think he's top-notch (which means we agree with him, a lot of the time).
The nub of his argument is that we're suffering the worst financial crisis since the Great Depression, and he proceeds to give chilling chapter and verse. He predicts that hundreds of small banks loaded with real estate will go bust and dozens of large regional and national banks will also find themselves in deep do-do.
He reckons that, in a few years, there'll be no major independent broker-dealers left: They'll either pack it in or merge, victims of excessive leverage and a badly flawed and discredited business model.
The Federal Deposit Insurance Corp., after it gets through picking up the pieces of IndyMac, will sooner or later have to get a capital transfusion, Nouriel asserts, because its insurance premiums won't cover the tab of rescuing all the troubled banks. He foresees credit losses ultimately reaching at least $1 trillion and anticipates a heap of woe for credit purveyors across the board.
The poor consumer, he contends, is shopped out and being hammered by falling home prices, falling equity prices, falling jobs and incomes, rising inflation. The recession he anticipates will last 12 to 18 months. And the rest of the world won't escape: He looks for hard landings for 12 major economies. As for the stock market, he hazards that there's plenty of room left on the downside. In fact, he feels the bear market won't end until equities are down a full 40% from their peaks.
We must say this vision is a mite too apocalyptic even for us. But Nouriel is not a professional fear-monger out to make a splash with end-of-the-world prognostications He's a sound guy with a solid record and an impressive résumé. We obviously believe his views are worth pondering, even if they ruin your appetite.
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