Tuesday, March 11, 2008

Nouriel Roubini and the Systemic Meltdown

This piece from Nouriel Roubini's blog http://www.rgemonitor.com/blog/roubini provides an indepth analysis of the current risks facing investors and a great overview of other analysts opinions regarding the growing dramatics in capital markets.

Its long but well worth the read, Mr. Roubini, author of
Bailouts or Bail-Ins: Responding to Financial Crises in Emerging Markets made many of his most bearish calls years ago when euphoria was high and such opinions were unpopular:

The Rising Risk of a Financial Meltdown and the Escalating Losses in the Financial

Nouriel Roubini Mar 10, 2008

Given the growing turmoil in financial, credit and equity markets my 12 steps scenario to a systemic financial meltdown is becoming more likely by the day; and my estimate that financial losses could end up being at least $1 trillion dollars – considered as an extreme worst case scenario a few weeks ago – is now being endorsed by an increasing number of serious analysts.

Let us consider the details of these seriously worsening financial conditions…

Serious concerns about a systemic financial crisis or a meltdown have been recently expressed by a number of very distinguished observers and analysts. Larry Summers recently warned that “we are facing the most serious combination of macroeconomic and financial stresses that the U.S. has faced in a generation--and possibly, much longer than that"; he then added the country has "never been in more need of serious economic thinking than we are now"; he warned that "the current estimates of mortgage losses are $400 billion…Those estimates are substantially optimistic."; and then argued that "It's a grave mistake to believe in the self-equilibrating properties of economies in the face of large shocks…Markets balance fear and greed. And when fear takes over, the capacity for self-stabilization is not one that can be relied upon."

Similar concerns about a systemic financial crisis/meltdown have also been echoed today – in a series of op-eds – by Clive Crook in the FT (“In the grip of implacable subprime forces”), Paul Krugman in the NYT (“Mr. Geithner came as close as a Fed official can to saying that we’re in the midst of a financial meltdown”), and Wolfgang Munchau in the FT (“Central banks cannot stop this contagion”).

As for the losses from this financial crisis – that I estimated to be at least $1 trillion and possibly much higher – George Magnus of UBS (the wise analyst who coined the “Minsky Moment” term) agrees with the view that they will end up being about $1 trillion. Mortgage losses alone are now estimated – in the excellent paper by Greenlaw, Hatzius, Kayshap and Shin – to be $400 billion rather than original estimates of $100 to $200 billion. And the $400 billion estimate for mortgage losses does not include the losses from commercial real estate loans, from consumer credit (credit cards, auto loans, student loans), losses on muni bonds and ABS instruments from monoline downgrades, losses on leveraged loans, losses on corporate loans and defaulting corporate bonds, losses on credit default swaps, and losses on agency debt. Also, a recent analysis by UBS estimates the losses in the financial system to be at least $600 billion; but it is not clear how much this study includes the potential losses in a variety of non-mortgage credit markets. Also Clive Crook argued in the FT today that “as house prices continue to fall – leaving as many as 20m in negative equity, on some estimates – the lenders’ losses could exceed even Mr Roubini’s estimates”.

The very thoughtful Martin Wolf – who masterly summarized my systemic crisis scenario in a recent column of his in the FT – then went on in his next column to argue that this may be a worse case scenario. But he then acknowledged that a $1 trillion dollar loss – and related potential fiscal bailout cost of rescuing the financial system - is possible but would be manageable as it would represent only a 7% of GDP fiscal bailout cost. Following my extensive reply that losses may be much larger than 7% of GDP and that a financial system that privatizes gains but socializes losses is seriously flawed Martin Wolf replied that “I think Nouriel’s post is so important that I plan to devote a column to it in the not too distant future”. One can thus look forward to another thoughtful and insightful contribution by Martin Wolf to this debate.

In the meanwhile conditions in financial markets have significantly worsened in all dimensions compared to the time I wrote my 12 step scenario a month ago: stock markets are falling day after day; margin calls are hitting hedge funds and highly leveraged institutions; highly leveraged private equity firms are in serious trouble; more large mortgage lenders are going belly up; credit derivatives spreads for corporate bonds are widening even for high grade bonds; even the super safe agency debt spreads are now widening; the muni bonds, TOB and ARS markets are in a seizure; the liquidity crunch is back with a vengeance forcing the Fed to sharply increase the size of its liquidity operations; but since such widening spreads in interbank rates are now representing more credit premia rather than liquidity premia monetary injections are likely to become increasingly impotent in addressing such widening spreads. Market observers are now using terms such as the markets are becoming “utterly unhinged”, the financial system is “broken” and “everybody's in de-levering mode'' to describe the rising panic in financial markets.

The recklessness of a highly leveraged financial system is epitomized by the Carlyle Group bond fund (Carlyle Capital Corp.) that failed this week to meet its margin calls and is now on the verge of bankruptcy. Think of the chutzpah of such a private equity firm that – well into the current financial turmoil – raised about a paltry $600 million of investors’ equity and leveraged it about 32 times to make over $21 billion of investments in agency (GSE) AAA mortgage debt. Of course the only way to make a high and risky return on AAA debt that had originally very low spreads relative to US Treasury was to lever the initial investment by a reckless 32 times. Too bad that the massive losses that even GSEs are experiencing on their portfolios have recently led to a significant widening of such spreads and massive default on this highly risky scheme (or scam?). Only fools would be shocked that such agency debt spreads have widened: in August of 2006 this column warned that the coming housing bust would not spare even Fannie and Freddie as they would experience massive losses on their portfolios of mortgage related assets. At that time – August of 2006 – when the housing and subprime bust had barely started this column warned:

the coming housing bust may lead to a more severe financial and banking crisis than the S&L crisis of the 1980s. The recent increased financial problems of H&R Block and other sub-prime lending institutions may thus be the proverbial canary in the mine – or tip of the iceberg - and signal the more severe financial distress that many housing lenders will face when the current housing slump turns into a broader and uglier housing bust that will be associated with a broader economic recession. You can then have millions of households with falling wealth, reduced real incomes and lost jobs being unable to service their mortgages and defaulting on them; mortgage delinquencies and foreclosures sharply rising; the beginning of a credit crunch as lending standards are suddenly and sharply tightened with the increased probability of defaults; and finally mortgage lending institutions - with increased losses and saddled with foreclosed properties whose value is falling and that are worth much less than the initial mortgages – that increasingly experience financial distress and risk going bust.

One cannot even exclude systemic risk consequences if the housing bust combined with a recession leads to a bust of the mortgage backed securities (MBS) market and triggers severe losses for the two huge GSEs, Fannie Mae and Freddie Mac. Then, the ugly scenario that Greenspan worried about may come true: the implicit moral hazard coming from the activities of GSEs - that are formally private but that act as if they were large too-big-to-fail public institutions given the market perception that the US Treasury would bail them out in case of a systemic housing and financial distress – becomes explicit. Then, the implicit liabilities from implicit GSEs bailout-expectations lead to a financial and fiscal crisis. If this systemic risk scenario were to occur, the $200 billion fiscal cost to the US tax-payer of bailing-out and cleaning-up the S&Ls may look like spare change compared to the trillions of dollars of implicit liabilities that a more severe home lending industry financial crisis and a GSEs crisis would lead to.

The main, still unexplored issue, is where the risk from mortgages is concentrated: among the sub-prime lenders)…or among commercial banks or among hedge funds and other financial intermediaries that purchased mortgage backed securities(MBSs) or among the GSEs (Fannie and Freddie)? Commercial banks claims that they have transferred a lot of their mortgage risk to other financial intermediaries – such as asset managers, hedge funds or insurance companies – who purchased large amounts of MBSs. But banks have still lots of mortgages on their books and, on top of it they have tons of consumer debt exposure (credit cards, auto loans, consumer credit) that may go really bad in a recession. If part of the housing risk has been off-loaded to hedge funds, the risk is not just of some of these hedge funds going bust but also their prime brokers (i.e. large investment banks) getting into trouble; counterparty risk will become serious once the hot potato of mortgage risk is pushed from one counterparty to the other. And finally, a large part of the housing risk is also in the hands of Fannie and Freddie. How much are the GSEs at risk is a complex issue… Either way, a serious housing bust followed by an economy-wide recession implies serious financial risks for the entire financial system, not just risks for the real side of the economy. A systemic risk episode triggered by a housing bust cannot be ruled out”

To repeat: those are words that were written here in August of 2006. And now that the systemic financial crisis that some of us warned about in the summer of 2006 is in full swing the Fed cannot does not seem to be able to do any better than effectively bailing out those reckless investors and private equity firms that levered a paltry equity position 32 times (!) to make the most risky investments in agency debt. This is a bailout as the recent decision by the Fed to increase size of its liquidity injections (via TAF and other operations) to $200 billion will imply that financial institutions will be able to sell to the Fed agency debt (as well as other much more toxic ABS instruments) and get Fed liquidity in exchange for it.

So now the Fed has effectively entered into the business of propping up a market – and reckless investors – whose spreads are widening for good fundamental reasons (as such GSE are now experiencing mounting multi-billion dollar losses on their portfolios). No wonder that some observers are starting to talk about a covert partial nationalization of the US banking system. Then the explicit partial nationalization of this financial system may only become the next step of this financial meltdown.

Tuesday morning update: The just announced new Fed facility - the the Term Securities Lending Facility that will to lend up to $200 billion of Treasury securities in exchange for debt including agency and private mortgage-backed securities - confirms that the Fed has now entered into the business of artificially propping up the agency debt market and the residential MBS market. With credit risk for GSEs recently rising for fundamental reasons the manipulation of this market just increases moral hazard and saddles the Fed with meaningful credit risk.

No comments: