This week we
look at a recent analysis from Professor Nouriel Roubini of the Stern School
of Business at New York University. Nouriel has become known for his rather
clear clarion calls that the housing bubble would lead to a credit crisis
and possibly much worse. He has been one who has been on CNBC and was in the
clear minority early last year, but now no one is laughing (I was once on
the show with him, and we were not the majority view).
In this week's
Outside the Box, Nouriel details for us how a worse case scenario
would develop. We both hope this does not develop. It can be avoided, but
realistic investors need to know what to look for to make sure we are not
going there. I like Nouriel's work, as it pull's no punches. You can go to
RGE Monitor at www.rgemonitor.com
to see his regular work, which is geared to institutions. Like this letter,
he offers Outside the Box analysis, which I think you will find useful.
John Mauldin,
Editor
Outside the Box
The Rising
Risk of a Systemic Financial Meltdown:
The Twelve Steps to Financial Disaster
by Nouriel Roubini
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 $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, 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 billion 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 non-residential 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; 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 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 2008 recession and peak well above 10%
based on recent studies. And once defaults are higher and credit spreads higher,
massive losses will occur among the credit default swaps (CDS) that provided
protection against corporate defaults. Estimates of the losses on a notional
value of $50 trillion CDS against a bond base of $5 trillion are varied
(from $20 billion to $250 billion with a number closer to the
latter figure more likely). Losses on CDS do not represent only a transfer
of wealth from those who sold protection to those who bought it. If losses
are large some of the counterparties who sold protection -- possibly large
institutions such as monolines, some hedge funds or a large broker dealer
-- may go bankrupt leading to even greater systemic risk as those who bought
protection may face counterparties who cannot pay.
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
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 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.
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