Step one is the worst housing recession in US history. House prices will, he says, fall by 20 to 30 per cent from their peak, which would wipe out between $4,000bn and $6,000bn in household wealth. Ten million households will end up with negative equity and so with a huge incentive to put the house keys in the post and depart for greener fields. Many more home-builders will be bankrupted.Check. Median price of a home in Orange County, California in May 2005: $639,000. Median price this week? $375,000.
Step two would be further losses, beyond the $250bn-$300bn now estimated, for subprime mortgages. About 60 per cent of all mortgage origination between 2005 and 2007 had “reckless or toxic features”, argues Prof Roubini. Goldman Sachs estimates mortgage losses at $400bn. But if home prices fell by more than 20 per cent, losses would be bigger. That would further impair the banks’ ability to offer credit.Again, check. $250-$300 billion? We spent more than twice that just this week.
Step three would be big losses on unsecured consumer debt: credit cards, auto loans, student loans and so forth. The “credit crunch” would then spread from mortgages to a wide range of consumer credit.Check. The credit crunch has been around for over a year now.
Step four would be the downgrading of the monoline insurers, which do not deserve the AAA rating on which their business depends. A further $150bn writedown of asset-backed securities would then ensue.Check. That monoline insurer was Ambac, downgraded in January.
Step five would be the meltdown of the commercial property market, while step six would be bankruptcy of a large regional or national bank.Check and check, Step 5 continues through 2008 and Step 6 was of course Bear Stearns in March.
Step seven would be big losses on reckless leveraged buy-outs. Hundreds of billions of dollars of such loans are now stuck on the balance sheets of financial institutions.Check. Those losses continue and have since April: Bank of America's losses on Countrywide, Wachovia's losses on Golden State, etc.
Step eight would be a wave of corporate defaults. On average, US companies are in decent shape, but a “fat tail” of companies has low profitability and heavy debt. Such defaults would spread losses in “credit default swaps”, which insure such debt. The losses could be $250bn. Some insurers might go bankrupt.Check. 3 letters for you here: AIG.
Step nine would be a meltdown in the “shadow financial system”. Dealing with the distress of hedge funds, special investment vehicles and so forth will be made more difficult by the fact that they have no direct access to lending from central banks.Check: see the last two weeks.
Step 10 would be a further collapse in stock prices. Failures of hedge funds, margin calls and shorting could lead to cascading falls in prices.Check. US stock markets have lost 11.8% in just the last 5 weeks. Hedge funds are on the brink right now.
Step 11 would be a drying-up of liquidity in a range of financial markets, including interbank and money markets. Behind this would be a jump in concerns about solvency.Check. We've seen record LIBOR and TED spread numbers in the last two weeks. And finally...
Step 12 would be “a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices”.Freefall. Endgame. And yes, Roubini now says that after this week, we have reached step twelve.
So we are now facing:This is some deadly serious stuff, folks. Next week may determine whether or not we make it through this in 2-3 years or 10-12. How does Roubini posit we get out of this mess? Nothing short of radical, radical action:
- a silent run on the huge mass of uninsured deposits of the banking system and even a run on some insured deposits are small depositors are scared;
- a run on most of the shadow banking system: over 300 non bank mortgage lenders are now bust; the SIVs and conduits are now all bust; the five major brokers dealers are now bust (Bear and Lehman) or still under severe stress even after they have been converted into banks (Merrill, Morgan, Goldman); a run on money market funds; a serious run on hedge funds; a looming refinancing crisis for private equity firms and LBOs);
- a run on the short term liabilities of the corporate sector as the commercial paper market has totally frozen (and experiencing a roll-off) while access to medium terms and long term financings for corporations is frozen at a time when hundreds of billions of dollars of maturing debts need to be rolled over;
- a total seizure of the interbank and money markets.This is indeed a cardiac arrest for the shadow and non-shadow banking system and for the system of financing of the corporate sector. The shutdown of financing for the corporate system is particularly scary: solvent but illiquid corporations that cannot roll over their maturing debt may now face massive defaults due to this illiquidity. And if the financing of the corporate sectors shuts down and remains shut down the risk of an economic collapse similar to the Great Depression becomes highly likely.
The actions Roubini proposes are radical. They would result in the nationalization of the good banks, and the end of the bad ones. It would be temporary, but the consequences are stark:
- A temporary six-month blanket guarantee on all US deposits (not just those below $250k) combined with a rapid triage between insolvent banks that should be quickly closed and distressed but solvent – conditional on liquidity and capital injections – banks that should be rescued.
- Extension of the emergency liquidity support of the Fed (both TSLF and PDCF) to a broader range of institutions in the shadow banking system, especially those directly providing credit to the corporate sector.
- Some members of the shadow banking system will not receive such liquidity support of the Fed (hedge funds and private equity funds) as – fairly or unfairly - there is no political sympathy for such institutions. (-Z says this means let the hedge funds hit the flo')
- Direct lending to the business sector from the Fed via extension of the PDCF and TSLF to the non financial corporate sector.
- Have a coordinated 100bps reduction in policy rates by all major advanced economies central bank and, possibly, even some emerging market economies central bank
- Radically redesign the Treasury TARP rescue plan – possibly after its necessary approval today - to make it effective, efficient and fair.
Thus, to avoid another Great Depression radical and unorthodox policy action needs to be taken now both in the US and in other advanced economies as the credit crisis and liquidity crisis is now becoming virulent even in Europe and other advanced economies. This credit crisis is both a crisis of confidence and illiquidity and a crisis of credit and solvency. But while the insolvent institutions should go bust we have now reached a point where many financial institutions and now non financial firms may become insolvent because of pure illiquidity; and this would lead to an extremely severe economic contraction similar to an economic depression rather than a mild recession. At this point the US, the advanced economies (and now likely even some emerging market economies) will experience an ugly recession and an ugly financial and banking crisis regardless of what we do from now on. What radical policy action can only do is preventing what will now be an ugly and nasty two-year recession and financial crisis from turning into a systemic meltdown and a decade long economic depression. The financial and economic conditions are extreme; thus extreme policy action is needed now to save the global economy from an ugly depression.Roubini has been right at every step of the way, folks. Every. Step.
Today's bailout is meaningless. Much more vigorous action is needed to stave off a Second Great Depression, and it is needed now. Will it happen? I don't honestly know. What do I think? I think we'll be facing a sharp recession well into 2009. Roubini's worst case scenario is a massive cascade default picture: even solvent megacorporations will have to default on their obligations because there will be no capital. If that happens, the US economy will plummet. We're already looking at a situation where there will be 8-9% unemployment through 2010 or 2011.
If the next couple of weeks don't pan out, if something doesn't dissolve this clot in the circulatory system of liquidity, the heart attack it will cause could be fatal for our economy. Honestly the fate of our economy may be decided in a matter of weeks. If the cascade default scenario happens, it's game over.
How bad could it get? If there's 15% unemployment, that would be an extra ten million people out of work. 25%, the peak of the Great Depression, would mean that we would have roughly four times as many people out of work as now, bringing the total to 50 million.
Will it get that bad? Who knows? Could it get that bad? Yes.
And remember...Bush is still in charge.
Have a nice weekend.