Time to remind ourselves that while we’ve all been cooing over Obama and fretting over NATO cohesion, the small matter of the security of the world’s financial system has continued to smoulder. At dinner with a group of hedge fund analysts last week, it was abundantly clear that just because the issue has disappeared from the front pages for a time doesn’t mean it’s gone away: au contraire, one analyst was bluntly stating that all we’ve seen so far has been no more than the trailer.
Nouriel Roubini, bearish as ever (though let’s remember that he’s been consistently right so far), asks the big question:
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.
So to cheer you on your way on a foggy London morning in February, here’s Roubini’s 12-step “‘nightmare’ or ‘catastrophic’ scenario that the Fed and financial officials around the world are now worried about” – which “has a rising and significant probability of occurring”. Here’s the executive summary for those of you too lazy to set up a free subscription to read the whole thing:
1. This is already the worst housing recession in US history; prices will fall 20-30% from their peak. That would imply about 10 million homes in negative equity.
2. Financial system subprime losses are now estimated at $250 to $300 billion; and now spreading to near-prime and prime, through the same lax lending criteria: “this is a generalized mortgage crisis and meltdown, not just a subprime one”. And don’t forget all the off-balance sheet Structured Investment Vehicles etc., and the fact that “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”.
3. “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.” All of which makes the credit crunch even more severe – and takes it from large banks through to smaller banks. [Loan companies are already scrambling to tighten up lending criteria in the UK, as the FT set out over the weekend.]
4. “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.” As a result, their debt rating will probably get downgraded; which will lead to large losses for funds that invested in them, and another sharp drop in US equity markets. [For more background, here’s a story about monolines from last week that made the front page of the FT.]
5. Next, “the commercial real estate loan market will soon enter into a meltdown similar to the subprime one”, thanks to – guess what? – similarly reckless lending criteria. So, “the housing crisis will lead – with a short lag – to a bust in non-residential construction as no one will want to build offices, stores, shopping malls/centers in ghost towns”. [FT last week: outflows from UK commercial property up 76 per cent from third quarter.]
6. It’s entirely possible that a large regional or even national bank will go bust. “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.” [Sound familiar?]
7. Bank losses on leveraged loans are already large, and rising – “leading to a freezing up of the CDO market and to growing losses for financial institutions”.
8. “Once a severe recession is underway a massive wave of corporate defaults will take place.” Roubini adds, “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%.”
9. The “shadow financial system” – non-bank financial institutions – will shortly get into serious trouble. And unlike proper 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”.
10. Stock markets in the US and abroad will start pricing in a severe recession rather than just a slowdown. Roubini notes that “in a typical US recession the S&P 500 falls by about 28%”.
11. Liquidity in financial markets will dry up all over again; the easing pf the liquidity crunch after central banks’ massive interventions in December and January will reverse.
12. “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”.
All in all:
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…
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 [here] – 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.
