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America’s economy risks mother of all meltdowns February 20, 2008, Financial Times
“I would tell audiences that we were facing not a bubble but a froth – lots of small, local bubbles that never grew to a scale that could threaten the health of the overall economy.” Alan Greenspan, The Age of Turbulence. That used to be Mr Greenspan’s view of the US housing bubble. He was wrong, alas. So how bad might this downturn get? To answer this question we should ask a true bear. My favourite one is Nouriel Roubini of New York University’s Stern School of Business, founder of RGE monitor. Recently, Professor Roubini’s scenarios have been dire enough to make the flesh creep. But his thinking deserves to be taken seriously. He first predicted a US recession in July 2006*. At that time, his view was extremely controversial. It is so no longer. Now he states that there is “a rising probability of a ‘catastrophic’ financial and economic outcome”**. The characteristics of this scenario are, he argues: “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.” Prof Roubini is even fonder of lists than I am. Here are his 12 – yes, 12 – steps to financial disaster. 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.
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. 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. 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. Step five would be the meltdown of the commercial property market, while step six would be bankruptcy of a large regional or national bank. 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. 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. 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. 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. 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. Step 12 would be “a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices”. These, then, are 12 steps to meltdown. In all, argues Prof Roubini: “Total losses in the financial system will add up to more than $1,000bn and the economic recession will become deeper more protracted and severe.” This, he suggests, is the “nightmare scenario” keeping Ben Bernanke and colleagues at the US Federal Reserve awake. It explains why, having failed to appreciate the dangers for so long, the Fed has lowered rates by 200 basis points this year. This is insurance against a financial meltdown.
Is this kind of scenario at least plausible? It is. Furthermore, we can be confident that it would, if it came to pass, end all stories about “decoupling”. If it lasts six quarters, as Prof Roubini warns, offsetting policy action in the rest of the world would be too little, too late. Can the Fed head this danger off? In a subsequent piece, Prof Roubini gives eight reasons why it cannot***. (He really loves lists!) These are, in brief: US monetary easing is constrained by risks to the dollar and inflation; aggressive easing deals only with illiquidity, not insolvency; the monoline insurers will lose their credit ratings, with dire consequences; overall losses will be too large for sovereign wealth funds to deal with; public intervention is too small to stabilise housing losses; the Fed cannot address the problems of the shadow financial system; regulators cannot find a good middle way between transparency over losses and regulatory forbearance, both of which are needed; and, finally, the transactions-oriented financial system is itself in deep crisis. The risks are indeed high and the ability of the authorities to deal with them more limited than most people hope. This is not to suggest that there are no ways out. Unfortunately, they are poisonous ones. In the last resort, governments resolve financial crises. This is an iron law. Rescues can occur via overt government assumption of bad debt, inflation, or both. Japan chose the first, much to the distaste of its ministry of finance. But Japan is a creditor country whose savers have complete confidence in the solvency of their government. The US, however, is a debtor. It must keep the trust of foreigners. Should it fail to do so, the inflationary solution becomes probable. This is quite enough to explain why gold costs $920 an ounce. The connection between the bursting of the housing bubble and the fragility of the financial system has created huge dangers, for the US and the rest of the world. The US public sector is now coming to the rescue, led by the Fed. In the end, they will succeed. But the journey is likely to be wretchedly uncomfortable. *A Coming Recession in the US Economy? July 17 2006, www.rgemonitor.com; **The Rising Risk of a Systemic Financial Meltdown, February 5 2008; ***Can the Fed and Policy Makers Avoid a Systemic Financial Meltdown? Most Likely Not, February 8 2008 Can the Fed and Policy Makers Avoid a Systemic Financial Meltdown? Most Likely Not.Nouriel Roubini | Feb 08, 2008
The fact that the US is now in a recession is, at this point, without much doubt even if the consensus forecast – always behind the curve – now gives only even odds (49% according to the WSJ panel of forecasters, 50% according to the Bloomberg panel) to a recession outcome. The issue right now is not anymore whether the US will experience a soft landing or a hard landing but rather how hard the hard landing will be. The latest data point to a severe recession ahead lasting at least four quarters rather than mild recession that most forecasters are now predicting: a fall in employment in January; very high and elevated levels of initial and continued unemployment claims; a non-manufacturing ISM that literally plunged; falling – in real term – retail sales in the holiday season; mediocre results and falling sales for most retailers in January; plunging auto sales; very weak and further falling consumer confidence; a credit crunch that is becoming more severe in credit market as measured by a variety of credit spreads; the beginning of a severe recession in commercial real estate; a worsening housing recession; sharply falling home prices; evidence of a serious credit crunch in the banking system based on the Fed survey of loan officers; a correction in all major stock markets and the beginning of a bear market in the NASDAQ; serious evidence of a global economic slowdown, especially in Europe, with outright recession ahead in some European countries. All these indicators points towards a severe recession. Believing – as the consensus now does – that this will be a mild two-quarter recession and that growth will recover in H2 of 2008 is wishful thinking. The last two recessions – in 1990-91 and 2001 – lasted almost three quarters (precisely 8 months) while the current recession looks fundamentally more severe than the latter two for three reasons: we are experiencing the worst housing recession ever in US history, a shopped-out, saving-less and debt-burdened consumer is now in financial trouble and retrenching; and we have a severe systemic financial crisis. Thus this recession will be longer, deeper and uglier than the previous two. Since in the previous article I described a 12 steps scenarios towards a financial meltdown and a deep recession the crucial policy question is whether the Fed and other policy officials can prevent such a scenario of a systemic financial crisis. I will present in this article the eight reasons why I am skeptical that such a systemic risk scenario can be avoided… The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial DisasterNouriel Roubini | Feb 05, 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… Commodities Pumped upFeb 21st 2008 Why the price of oil and other raw materials continues to rise despite the economic gloomAFP
 BANKERS and policymakers may be wringing their hands about the prospects for the world economy, but commodities traders, it seems, see no cause for concern. On Wednesday February 20th the oil price hit a new record of $101.32 a barrel. Soyabeans and platinum, among others, have also reached record prices in the past week. Vale, a Brazilian mining firm, has persuaded some steelmakers to pay as much as 71% more this year for its iron ore. Across the world the inflationary impact is tangible. In America consumer prices in January were up 4.3% on a year-over-year basis. Excluding food and energy, they were up 2.5%, well above the Federal Reserve’s comfort level. Despite a few years of rising raw-materials prices, many traders remain bullish in part because of further bad news about supply. A shortage of electricity in South Africa, which has forced several big smelters to shut down, has helped cause platinum’s giddy ascent. The political upheaval in Kenya has pushed tea prices higher. A leaking pipeline in Nigeria and a row between Exxon Mobil and Hugo Chávez, the president of Venezuela, have contributed to oil’s recent gains. Mining and oil firms are struggling to increase output, partly because it takes years to develop new mines or oilfields, partly because shortages of equipment and labour are hampering expansion, and partly because governments in resource-rich countries are becoming ever more prone to jacking up royalties or expropriating resources. Citigroup, for example, expects global copper production to rise by just 2% this year, even though the price is now five times higher than it was five years ago and stocks amount to less than three days’ demand. In theory, farmers should be quicker to respond to price signals, since they can easily substitute one crop for another. But the prices of wheat, corn and soyabean are all high, so any big shift towards one crop will come at the expense of the others. There is huge potential to bring more land under cultivation in Ukraine and Kazakhstan—but that would need improvements to infrastructure that could take years. Meanwhile, most analysts expect demand for raw materials to remain firm despite the gloomy economic news. Although Goldman Sachs, for one, expects oil consumption to fall in America, it also predicts that continued growth in booming spots such as China and India will underpin global demand. The International Energy Agency, a watchdog group for consuming countries, still expects the world’s consumption of oil to rise 1.9% this year. Worse, rising prices and tightening credit give the firms that process raw materials an incentive to run down their stocks, argues Jeffrey Currie of Goldman Sachs, making prices all the more vulnerable to supply shocks. America’s Department of Agriculture believes global demand for wheat will continue to exceed supply this year. That will push America’s wheat stocks to their lowest level since 1948 (see chart).  Nonetheless, the prospects for demand must have diminished at least somewhat as the world economy has slowed, and the outlook for supply has not worsened dramatically in the past few months. Hence some other factor must be at play. Many analysts blame speculation. As falling interest rates, tumbling stockmarkets and contracting house prices drive investors out of bonds, equities and property, the argument runs, there is lots of money looking for a new home. And since commodities have produced such lavish returns in recent years, and have weathered the recent turmoil relatively unscathed, they are an alluring option. Citigroup believes that the recent rise in the oil price “is driven principally by a sharp uptick in fund flows.” Lombard Street Research sees an “iron bubble”. Others worry that America’s fiscal stimulus may cause trouble by inflating demand for commodities. In Citigroup’s cheery phrase, “the collapse of one bubble often sows the seeds of the next.” Wall Street Abandons Neediest Clients, Cuts Credit (Update2)
By Pierre Paulden, Caroline Salas and Jody Shenn 
Feb. 20 (Bloomberg) -- A year ago $20 million would have gotten Luminent Mortgage Capital Inc. access to $640 million in loans to buy top-rated mortgage-backed securities. Now that much cash gets the firm no more than $80 million. ``There's nobody out there trying to lend money on securities,'' said Luminent Chief Executive Officer Trezevant Moore. Six lenders are offering five times leverage on what the San Francisco-based company has contributed, while a year ago, 20 banks extended 33 times, he said. Wall Street firms, reeling from $146 billion in losses on their debt holdings, are fueling a credit crisis by clamping down on lending to investors and hedge funds that use borrowed money to buy securities. By pulling back, Barclays Plc, Bank of America Corp., and Merrill Lynch & Co. are contributing to reduced demand and lower prices throughout the fixed-income world. ``The banks themselves, because they owned so much of this different kind of affected paper ranging from leveraged loans to mortgage-backed bonds, have simply got their snoot full,'' said Roy Smith, a former Goldman Sachs Group Inc. partner who teaches finance at New York University's Stern School of Business. They ``don't have their usual amount of room to step up.'' Mortgage-backed bonds and high-yield, high-risk loans are trading at or near record lows as the banks' retreat compounds the fallout from the collapse of the subprime mortgage market. Widespread Writedowns A surge in delinquencies on loans to homeowners in the riskiest subprime category triggered widespread writedowns on mortgage-backed securities and sapped investor demand for high- yield, or junk, loans and bonds. Banks are saddled with about $190 billion in loans they promised to underwrite for the record buyout deals announced last year, Morgan Stanley said in a report Feb. 15. Junk debt is rated below Baa3 by Moody's Investors Service and less than BBB- by Standard & Poor's. Investors who borrow to boost returns aren't the only ones feeling squeezed. On Jan. 22, Citigroup Inc., Goldman Sachs, and Deutsche Bank AG scrapped a $2 billion loan to Solutia Inc., a St. Louis-based nylon and plastics maker that was relying on the funds to emerge from bankruptcy protection. UBS AG, the second- largest underwriter of auction-rate securities, notified brokers last week that it won't buy the debt when there aren't bidders. The average actively traded junk loan dropped as much as 8.54 cents on the dollar this year, reaching 86.28 cents on Feb. 8, according to S&P data. Bonds rated AA and backed by prime ``jumbo'' mortgages typically traded at 72 cents in early February, down from 80 cents in mid-December, according to Bear Stearns Cos. Junk Bonds The extra yield investors demand to own junk bonds instead of Treasuries widened to 7.48 percentage points on Jan. 23, the most in about five years, from a record low of 2.41 percentage points in June, Merrill Lynch index data show. The spread narrowed to 7.25 percentage points yesterday. The cost of protecting corporate bonds from default soared to a record today as investors bought insurance against losses stemming from the $2 trillion market for collateralized debt obligations. Credit-default swaps on the Markit CDX North America Investment-Grade Index of 125 companies with investment-grade ratings jumped 9 basis points to 163 at 7:44 a.m. in New York, according to Deutsche Bank. Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent if a borrower fails to adhere to its debt agreements. A rise indicates deterioration in the perception of credit quality; a decline, the opposite. Subprime Fallout Collateralized loan obligations, a type of CDO that pools leveraged loans, show how the subprime fallout is spreading. Aladdin Capital Management LLC used $70 million to obtain $360 million of financing from Barclays Capital, a unit of London-based Barclays, to create a CLO in July. Barclays this month forced the Stamford, Connecticut-based firm to unwind the CLO because the portfolio's value had dropped more than the $29.7 million allowed in the terms of their deal, according to LaSalle Bank, the CLO's trustee, and the fund's prospectus. Mike Carroll, a director at Aladdin, declined to comment. Market value CLOs contain $35 billion of loans at risk of being liquidated, Victor Consoli, a credit strategist at Bear Stearns in New York, said on Feb. 7. Liquidations Threatened Ten CLOs have broken thresholds that may force liquidations since Jan. 18, Fitch Ratings said today, citing ``unprecedented decline in loan values.'' Hartford Investment Management Co. unwound the Hartford Leveraged Loan Fund on Feb. 8, according to Fitch. Hartford spokesman Tim Benedict didn't immediately return a phone message. CLOs accounted for 63 percent of loan buyers in the first half of 2007. ``Some of the most astute players with the best pedigree and goodwill with the Street cannot get a required amount of leverage,'' said Michael Hennessey, who helps manage $10 billion in hedge funds as managing director at Morgan Creek Capital Management in Chapel Hill, North Carolina. The company's investors include Julian Robertson, founder of Tiger Management LLC. Declining prices are good news for investors with the funds to buy, said Brett Jefferson, a former managing director at Marathon Asset Management LLC. Jefferson is starting a hedge fund called Hildene Capital Management LLC to buy distressed collateralized debt obligations, including CLOs. He aims to raise $1 billion from investors, he said. `Getting Out' ``The dealers aren't in a position to be taking on more risk, they're in the position of getting out of risk, and it's a great opportunity to buy,'' said Jefferson, president and chief investment officer of Hildene in New York. Citigroup, Goldman, and Deutsche Bank are already facing a backlash. Solutia filed suit on Feb. 6 to compel the banks to fund its loan. ``We feel the banks have pulled the rug from beneath our feet,'' said Paul Berra, a spokesman for Solutia. Citigroup said the suit is without merit and the company has complied with all its ``contractual obligations.'' Deutsche Bank's John Gallagher and Goldman's Michael DuVally declined to comment. The retreat in the $300 billion market for auction-rate securities is affecting borrowers including the Port Authority of New York, student loan provider SLM Corp. and closed-end funds run by Nuveen Investments Inc. Rate Reduction Banks haven't been encouraged by the Federal Reserve's 2.25 percentage point reduction in benchmark interest rates since September. About one-third of U.S. banks increased their standards on commercial and industrial loans, according to the Fed's survey of senior loan officers on Feb. 4. The ability of mortgage bond buyers such as Luminent to use leverage with their investments has diminished. Investors in the most senior commercial-mortgage securities could typically borrow 33 times the amount of their investment at a cost of 0.03 percentage points above the one-month London interbank offered rate in January 2007, according to a JPMorgan Chase & Co. report last month. At the start of this year, an investor might only be granted 10-to-1 leverage, and pay 20 basis points above Libor. To earn the same 12.5 percent returns generated when spreads were at about 0.25 percentage point a year ago, a leveraged portfolio manager would need spreads of about 0.93 percentage point, according to JPMorgan. ``We've got to stop being so afraid,'' New York University's Smith said, invoking the words of U.S. President Franklin D. Roosevelt at his 1933 inaugural address during the Great Depression. ``When Roosevelt said, `We have nothing to fear but fear itself,' he said it in the context of the banking crisis.'' To contact the reporters on this story: Pierre Paulden in New York at ppaulden@bloomberg.net ; Caroline Salas in New York at csalas1@bloomberg.net ; Jody Shenn in New York at jshenn@bloomberg.net Last Updated: February 20, 2008 12:15 ESTHigh-yield Debt Defaults Year-to-Date Exceed All of 2007 Volume Already: How Much More to Come?
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