By Nouriel Roubini | 6 February 2008
- Roubini: there is now a rising probability of 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 => 125bp rate cut by Fed within days needs to be read in this context.
- Ubide: Problem in the US today is not only illiquidity as it was in the near collapse of LTCM in 1998; it is rather a problem of solvency; and cannot be solved with liquidity injections.
- Munchau, Rajan: Financial innovation and securitization may spread credit risk at cost of higher systemic risk. Risk shared is not always risk halved if it leads to contagion instead of diversification => watch higher asset class correlation/implied correlation in structured products.
- Partnoy/Skeel (U-Penn): Perils of structured finance: credit + market = systemic risk; "garbage in, garbage out" limitations still apply to complex structures [[possibly with a vengance! : normxxx]]
- Weithers (U-Chicago): "Whether credit risk is best allocated outside of the traditional financial intermediaries remains an open question."
- Borio (BIS): The primary cause of financial instability has always been, and will continue to be, overextension in risk-taking and balance-sheets
The Rising Risk Of A Systemic Financial Meltdown:
The Twelve Steps To Financial Disaster
By Nouriel Roubini | 5 February 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, by itself, justify 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 [[aka a 'Minsky Moment' [see paragraphs in yellow on red at extreme bottom], for the scholarly inclined: normxxx]]. 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 any attempted in the Greenspan era 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 increasingly significant probability of occurring. Thus, it does not describe a very low probability event but rather an outcome that is quite conceivable and 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— and 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?
Here are the twelve steps or stages of a scenario of systemic financial meltdown associated with an economic recession this severe:
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 $6 trillion 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, putting the home keys in an envelope and mailing 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 alone 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 as in subprime (no down-payment, no verification of income, jobs or 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 increase dramatically 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 [[best case: normxxx]]; 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 dollars of off balance sheet securities held in bank sponsored SIVs and 'conduits'. This meltdown and the shutdown of the ABCP market has forced banks to bring back onto their balance sheet these 'toxic' securities, adding still further to the capital and liquidity crunch of these 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 throughout 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 tens 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 merely known and suspected financial losses of banks and of other financial institutions (as also these debts were securitized in ABS products), thus leading to a still more severe credit crunch. As the Fed loan officers survey suggests, the credit crunch is spreading throughout the mortgage market and from mortgages to consumer credit, and from large banks to smaller banks [[and from thence to nearly everyone: normxxx]].
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 already clear that such losses are much higher than the $10-15 billion rescue package that regulators are trying to patch together. Some monolines are actually borderline insolvent and none of them deserves a AAA rating at this point regardless of how much 'possible' recapitalization is provided. And, any business that needed 'to borrow' an AAA rating (from the monoline) 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.
The downgrade of the monolines will lead to another $150bn or so of writedowns on ABS portfolios for those financial institutions that have already such massive losses. It will also lead to additional losses on their portfolios 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 would still further exacerbate the capital and liquidity problems of their underwriters. The monolines’ downgrade will thus 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 housing related assets and the financial system, in general.
Fifth, the commercial real estate loan market will soon enter into a meltdown similar to that of the subprime. 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 non-residential construction as no one will want any longer 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'.
Sixth, it is possible that some large regional or even national bank that is very exposed to mortgages, residential and commercial, will [[be allowed to: normxxx]] go bankrupt. Thus some big banks may join the 200 plus subprime lenders that have already gone bankrupt. This, as in the case of Northern Rock in the UK, 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 still lead to severe losses (at least to the government/taxpayer) and will result in 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 simply 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 (which can no longer sell them) 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 further add to this problem the fact that many actual large LBOs will end up in bankruptcy as some of these corporations taken private are so encumbered by debt as to be effectively bankrupt in a recession and given the repricing of risk. Convenant-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 are close to 700bps; iTraxx and CDX indices are pricing in 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 that have piled up a mass of junk bond debt that will soon come to need refinancing at much higher spreads. 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 also go higher, massive losses will occur among the credit default swaps (CDS) that provided protection against corporate defaults [[in 'fair' weather; not in 'foul': normxxx]].
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 the 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 [[leading to a further cascade of failing creditor institutions: normxxx]].
Ninth, the "shadow banking system" (as defined by the PIMCO folks) or more precisely the "shadow financial system" (as it comprises all non-bank financial institutions) will soon get into far more serious trouble. These shadow financial institutions— like banks— borrow short and in liquid forms and lend or invest long in more illiquid assets. They include: SIVs, 'conduits', money market funds, monolines, investment 'banks', hedge funds and similar institutions. All of 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.
However, unlike banks, these non-bank financial institutions don’t have direct or easy 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 simply go bankrupt because of both insolvency and/or lack of liquidity and the 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 (and many small ones), a few money market funds, many of the SIVs not sponsored by banks and, possibly, one or two large and systemically important broker dealers. Dealing with the distress of this shadow financial system will be difficult and 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 for a severe US recession— rather than a mild recession— and a sharp global economic slowdown. The fall in world 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 may not be rescued, that financial losses will mount, and that earnings will sharply drop in a recession not just for financial firms but for all. A few long equity hedge funds will go belly up in 2008 after the massive losses of many hedge funds in August and November, 2007 and, again, in January 2008. 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 the US equity markets— which will be transmitted to the global equity markets. US and global equity markets will enter into a persistent bear market— 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 unknown (and unknowable, but growing) counterparty risk, lack of trust, and generally rising 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 again massively widen. Even the easing of the liquidity crunch after the massive central banks’ actions in December and January will reverse as credit concerns keep the interbank spreads 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 realistic prices will ensue, leading to a cascading and mounting cycle of losses and further credit contraction. In an illiquid market, actual market prices of assets will be substantially lower than the lowest intrinsic value that they should have even allowing for a worst case scenerio and the general credit problems in the economy [[in effect, the market will be charging a large premia for uncalculable risk: normxxx]]. Market prices will include a large illiquidity and market risk discount on top of the discount due to any credit and fundamental problems of the underlying assets that are backing the distressed financial assets. Such capital losses will lead to further margin calls and reduction of risk taking by a variety of financial institutions that will now be forced to mark their positions to market. Such a forced fire sale of assets in illiquid markets will lead to still further losses that will still further contract credit and trigger yet 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 disintermediation— (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 losses mount will dominate by a large margin any bank recapitalization from SWFs or CBs. A contagious and cascading spiral of credit disintermediation, credit contraction, sharp falls in asset prices and sharp widening in credit spreads will then be transmitted to most parts of the failing financial system. This massive credit crunch will make the economic contraction more severe and lead to yet further financial losses. Total losses in the financial system will easily 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 rapidly around the world. Panic, fire sales, cascading falls 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 (but this time with the economy and financial crises in the credit markets leading the way down) resulting in 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 central authorities and monetary policy, resulting in massive hoarding of liquidity that will simply exacerbate 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 at least 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 on an international scale.
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Risk Of A Global Recession Following The U.S. Hard Landing?
By Nouriel Roubini | 30 January 2008
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The economies most at risk of an outright recession are the following ones:
The United Kingdom that looks— in many dimensions— like the US, a housing bubble now going bust, excessive consumer credit creation, unsustainable boom in consumption, large current account deficit, overvalued currency. A recession in the UK is now highly likely.
Spain is an even worse example of an unsustainable housing bubble than the US or the UK: in the US, residential investment peaked at 6% of GDP; in Spain at a whopping 19% of GDP. For many years, the housing bubble masked— via high GDP growth— the fact that Spain had experienced a real appreciation of its currency and a loss of competitiveness as large as that of the other Club Med countries (Portugal, Italy, Greece). Now that the Spanish housing bubble is busting, it is clear that the emperor has no clothes, i.e. Spanish growth was driven by the housing bubble.
Ireland— like the UK and Spain— had a massive housing bubble that is now deflating. The medium term fundamentals of the Irish economy are sounder than those of Spain or the Club Med, but in the short run the Irish economic slowdown will be severe and an outright recession cannot be ruled out.
Among the other Eurozone countries Italy and Portugal are at risk. In Italy even official forecasts put 2008 growth below 1% and an outright recession cannot be ruled out; and the political instability (61 governments since World War II with the latest one falling this past week) will not help the economic outlook. Portugal— like the other Club Med economies— has structural problems of competitiveness given the large increase in unit labor costs, the real appreciation of the currency and the loss of market share in international trade given the rise of China and Asia.
In the new EU accession countries and the other economies in south Europe there are also serious vulnerabilities and outright risk of financial crisis. These 18 economies— from the Baltics all the way to Turkey— all share a large current account deficit; some also have a large fiscal deficit, an overvalued currency and fixed exchange rates; also, currency and maturity mismatches prevail throughout the region; and housing booms if not bubbles financed with excessive credit growth in foreign currency are also common. The Baltic nations— especially Latvia— are at risk of currency and financial crisis; Hungary, Romania and Bulgaria look fragile (especially the former); and even Turkey, which has better fundamentals, has an unsustainable external deficit.
The risk is that a sudden stop of foreign capital and a global credit crunch in these countries could lead to a currency crisis that will, in turn, lead to a private sector (household) crisis. Differently from Western Europe where mortgages are financed in local currency, in these countries most of the mortgages are in foreign currency (Swiss francs and Euros). Thus, a currency crisis would have a devastating balance sheet effect on the household sector and lead to a household mortgage debt crisis and a banking crisis, as happened in Mexico in 1995 and in Argentina in 2001— 2002 when their currency pegs collapsed. And given the exposure of Italian, Austrian and Swedish banks to these East European economies, a financial crisis in these economies will lead to a credit crunch in these 'other' European financial systems, in the same way as the East Asian crisis of 1997— 98 worsened the condition of Japanese banks exposed to East Asia.
Japan also looks like a candidate for a likely recession in 2008. The economy is anemic— always on the borderline between growth and recession, between inflation and deflation. Most of the growth of Japan in the last few years has been driven by external demand, net exports with a weak yen. Domestic demand has been weak, especially private consumption, as real income and real wage growth has been anemic. But now a US recession and a strengthening of the Yen are likely to tip Japan back into a recession.
The biggest victim of a severe US hard landing will be China. For China, having growth falling from 11% to 6 - 7% is the equivalent of a hard landing, as every year China needs growth above 10% to transfer about 20 million rural workers to the modern, manufacturing and urban sectors. Officially Chinese economists expect Chinese growth to slow down only to 9% following a US recession; but this is conditional on such a US recession being mild— i.e. lasting two quarters. If the US recession is severe— lasting over four quarters— and centered on a faltering US consumer that cuts back sharply on his imports of cheap Chinese goods, then the consequent Chinese growth slowdown will be severe and at least close to a 'hard' landing (e.g., of growth less than 7%). Of course China could use fiscal policy to counter the effects of this slowdown, but there is a question on how fast the Chinese fiscal lever can be put into action.
In Australia the housing boom has already started to go bust. But until recently high commodity prices kept the growth rate sustained, especially in the commodity producing regions of the countries. But a US recession and global slowdown will lead to a sharp fall in commodity prices; thus a recession in Australia cannot be ruled out.
Most emerging market economies have much better fundamentals than they did a few years ago: current account surpluses, flexible exchange rates, large stock of forex reserves, lower fiscal deficits and actual primary surpluses, lower stocks of foreign and public debt, lower balance sheet vulnerabilities. They have done well because of reforms and better polices. But they have also done well because of good luck and the best external global conditions in a generation: the high global growth; high and rising commodity prices; low risk aversion and a search for yield among investors, especially international investors. In a world with a US recession and global slowdown, commodity prices and global growth will be significantly lower, and investors' risk aversion will rise.
No wonder that stock markets in emerging markets have already started to correct sharply in the last few weeks. One cannot lump all emerging market economies together; there are those with better macro, policy and financial fundamentals; and those with weaker ones. Countries with large current account deficits or large external financing needs (rollover of foreign currency liabilities), with fiscal deficits, overvalued and semi-fixed currencies, credit booms, asset bubbles in real estate and equity markets are most at risk of financial pressures— sudden stop of capital inflows and credit crunch— if not outright financial crisis. Current account deficit countries include— on top of the 18 in East/Central/South Europe— India, South Africa, Mexico and a few other emerging market economies.
In conclusion, while a global recession will likely be avoided as global growth is unlikely to fall below 2.5%, the global economy will sharply slow down in 2008 and it will feel like a global recession even if one is formally avoided, with several countries being in an outright recession.
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Normxxx
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