Nouriel Roubini and the US dollar

Nouriel Roubini, on point as always highlighting the inadequcies of the G7 attempts to talk up the US as the ECB faces growing concerns that intervention may be the only hope the Forex market has to return to some sense of normalcy.

What that is in today's markets is anybody's guess.

J




G7 Stance on the US Dollar: Talk is Cheap

Nouriel Roubini Apr 14, 2008


The French Finance Minister Lagarde compared the G7 statement on the US dollar to the 1985 Plaza Accord to weaken the US dollar; but the forex market pretty much ignored the statement pushing the dollar further down. The statement certainly signals that the G7 are getting closer to the point where the dollar weakness bothers both the US and Europe and where coordinated forex intervention may be considered; but as the saying goes “talk is cheap”. Verbal intervention – of the sort used even by Trichet in the last few weeks and used by the G7 in their weekend statement – almost never works (as the Japanese learned a few years ago). Also sterilized fx intervention usually does not work – unless such intervention goes with the wind rather than against the wind, is seriously coordinated and aggressive and signals future changes in actual monetary policies (i.e. unsterilized intervention).

What works in affecting exchange rates is unsterilized intervention – or equivalently – changes in relative monetary policies, i.e. changes in policy rates.

Currency movements are driven – apart from market noise and momentum – by economic fundamentals. Several fundamentals are driving the dollar south relative to euro and other floating currencies.

Lets discuss these fundamentals and their implications…

First, the still large and structural US current account deficits that – however shrinking – is still huge is bearish for the dollar.

Second, relative interest rate differentials; and with the Fed still expected to cut rates while ECB and BoJ are so far on hold this is dollar bearish.

Third, relative growth differentials; and with the US entering a recession while Europe and Japan slowing but at a more moderate rate this is also bearish for the US dollar.

Fourth, the relative riskiness of US assets relative to European and Japanese assets; and with the US financial crisis still in full swing, toxic assets still partly hidden (who is holding them and how much?) and the risks of further writedowns still large this is another bearish factor for the dollar.

Fifth, with China and other effective members of BW2 still effectively heavily managing their currencies relative to the US dollar (or still into outright pegs as in the Gulf states) downward fundamental pressures on the dollar are reflected in the dollar rate relative to the floaters rather than against the Asian and BW2 currencies.

So, all these five fundamental factors imply a weaker dollar ahead relative to the euro and most of the other floaters. So would verbal intervention work to stem the fall of the dollar? Of course not. So, would coordinated sterilized intervention work? Maybe for a few days but not much more.

Would unsterilized intervention or reduction in policy rates in Europe work to stop the ascent of the euro? Yes but an ECB worried about inflation has not yet reached the point of easing Eurozone rates to stem the rise of the euro. So Trichet may express his concerns about a strong Euro – and a euro close to 1.60 relative to the dollar implies pain not only for exports of the PIGS (Portugal, Italy, Greece, Spain) but increasingly also for those of France and of the Germany (the export superpower); but unless he is willing to ease rates the fall of the dollar relative to the Euro may continue for a while.

So, what could stop a disorderly fall of the dollar and a disorderly rise of the euro and the yen? At some point the rise of euro and yen is going to weaken enough economic growth in the Eurozone and in Japan that two things will happen: the growth slowdown in Europe (with outright recession in some European economies) and Japan (with the risk of Japan tipping into another recession) will tip growth rate differentials that are now bearish for the dollar into being bearish for euro and yen. Second, such a growth slowdown in Europe and Japan will lead to expectation if policy rate easing by ECB and BoJ that will also tip interest rate differentials against euro and yen.

Certainly with the euro now closer to 1.60 than 1.50 the euro is overvalued in real terms: European traded goods are much more expensive than American goods (or as European observers put it to me: “for European tourists goods are now cheaper in New York than in Bangkok!”). I.e. on a PPP basis the euro has already overshot upward its fundamental value. But market dynamics, herding and momentum can drive the euro above 1.60 (and possibly the yen back towards 90). But the more this short-run overshooting occurs the weaker the Eurozone and Japanese economies will get and the more likely the probability of ECB and even BoJ cutting rates. Thus, if euro and yen were to overshoot in the short run market forces (relative expected growth and interest rate differentials) will put a floor to how weak the dollar can get and how strong the euro and yen can get.

So, with BW2 central banks still aggressively managing their currencies values relative to the US dollar and the currencies of the floaters being controlled by endogenous changes in relative economic fundamentals a total disorderly crash of the US dollar is unlikely. And given a severe US recession and a global recoupling of growth these limits to further sharp weakness of the US dollar may imply that global imbalances may remain large for the foreseeable future even if the dollar weakness does – at the margin – help the narrowing of the US current account deficit.

In conclusion, Mr. Trichet if you are really worried about the rise of the euro there is something very simple you can do to stem that rise: cut European policy rates! All the rest – including coordinated sterilized intervention – may end up being cheap talk.

Nouriel Roubini claims in this latest piece "The Worst Financial Crisis Since the Great Depression is Getting Worse":

It is now clear that the US and global financial markets are experiencing their worst financial crisis since the Great Depression. And in spite of desperate and radical actions by the Fed this crisis is getting worse. A brief equity rally after the rescue of Bear Stearns, the 75bps Fed Funds and the announcement of new radical and unorthodox lending facilities (allowing non bank primary dealers access to the Fed discount window) has already completely fizzled today with US equities plunging over 2% while the severe crunch in money markets and credit market is becoming much worse.

Let me now flesh out how the crisis is becoming more severe and increasing the risk of the mother of all financial meltdowns…

First note that in spite of the most radical change in Fed policy since the Great Depression – i.e. the extension of the Fed’s lender of last resort support to non bank primary dealers and the announced swap of up to $400 bn of safe Treasuries for toxic agency and private label MBS again make available also to non bank primary dealers – the panic in money markets and interbank markets is now seriously worsening: today the yield on 3 month Treasuries plunged to 0.56, a level not seen since the 1950s; the TED spread (the difference between dollar Libor and 3 month T-bills) increased 32 basis points to 1.98 percentage points; swap spreads widened again; while the VIX spiked to a level close to 30; even off-the-run long dated Treasuries are becoming illiquid (as in the 1998 LTCM crisis). The situation in money markets is scary as there is a generalized flight to safety with investors avoiding everything but the most liquid and safe government bonds.

In the meanwhile the liquidity and credit crunch in the agency debt and MBS market is worsening in spite of all the Fed recent easing actions and in spite of the Fed decision to swap Treasuries for hundreds of billions of agency and private label MBS: the difference in yields for Fannie Mae's current-coupon, 30-year fixed-rate mortgage bonds and 10- year government notes widened again both yesterday and today. So the radical decision of the Fed to prop the agency and non-agency MBS market with $400 bn of swaps has done very little to affect the liquidity and spreads of these markets. This is no wonder as Fannie and Freddie are – on a mark to market basis – effectively insolvent and the widening in their debt and MBS spreads reflect the worsening credit outlook for their assets, not just a situation of illiquidity.

Today we are facing a massive margin call on highly leveraged US capital markets and a massive de-leveraging of the financial system following fire sales of marked to market assets in vastly illiquid money markets, credit markets and derivatives markets. We are thus close to the last steps of my 12 Steps to a Financial Disaster. Each of these 12 steps is now underway and the only question is not whether such steps will take place but rather how severe they will be and how big the losses will be. We are now observing – with the Bear Stearns episode as well as with the collapse of the SIVs, the losses on money market funds and the collapse of hedge funds and highly leveraged funds – the beginning of a generalized run on the shadow financial system.

And - as discussed in my 12 Steps to a Financial Disaster - the financial losses are now spreading from subprime to near prime and prime mortgages, to commercial real estate loans, to consumer debt (credit cards, auto loans, student loans), to leveraged loans, to muni bonds and writedowns from the impairment of the monolines' insurance, to corporate loans and bonds whose defaults will surge soon, to the massive losses in the CDS markets.

The Fed response to this run has been to provide the Bear Stearns bailout and provide both liquidity and swap of illiquid and toxic assets for safe Treasuries to the non-bank primary dealers. But these radical and risky actions of the Fed - as the collateral for this lending is now toxic – are not achieving their goals: in the short run the risk of a run on a Lehman may have been reduced; but what is happening in the money markets and in the agency markets shows that the Fed can only affect partially liquidity premia, not credit premia; and spreads are widening for a wide range of money markets and credit markets because of widening credit spreads driven by sharply rising counterparty risk.

The lack of trust of financial institutions in their counterparties is surging in spite of all the Fed actions as panic is setting in money markets and credit markets. Thus, providing access to a dozen broker dealers who are primary dealers does nothing to ease the credit risk and liquidity/rollover risk of thousands of US and global institutions that are part of the shadow financial system. In a mark to market world many of these highly leveraged institutions – including large broker dealers other than Bear Stearns – are effectively bankrupt and no Fed action can rescue them. And the run on the shadow financial system has barely started.

Claiming the Bear Stearns was not bailed out because the current shareholders got only $2 per share is disingenuous: this was a massive bailout as the Fed put $30 billion of cheap credits in the pot: without this massive financial support not only the shareholders would have been wiped out 100% as they deserved to (rather than keeping the option value that the government support will recover in due time the value of their shares); but also many of the creditors of Bear Stearns would have experienced massive losses as Bear was insolvent and unable to pay such creditors with its impaired assets. Instead the $30 bn Fed support represents a major subsidy for JPMorgan and a major bailout of Bear’s creditors.

Effectively the Fed has taken on its balance sheet the entire credit risk of $30 of toxic securities held by Bear Stearns. So, this Fed bail out is an explicit case of using the disastrous Japanese model of a “convoy system” (healthier banks taking over zombie banks with the help of lots of public money) that led to a decade of economic and financial stagnation. A market solution to this crisis does not exist; those who believe in such markets solutions are deluding themselves as markets left alone will melt down and enter into the mother of all meltdowns, margin calls, cascading collapse of asset prices, massive credit crunch and liquidity seizure and severe economic recession.

We are facing now the risk of the mother of all financial crises and meltdowns. Moral hazard can be realistically address by wiping out reckless investors and lenders, having the government buying assets that need to be restructured at low prices closer to their fundamental value and limiting the mortgage debt reduction to truly deserving borrowers who were victims of predatory lending practices. But radical and coherent policy action needs to be taken urgently and without further delay as there is now the risk that the US will experience its most severe recession in decades and that the US and global financial system may melt down.

I will flesh out in more detail in the near future the logic and specific elements of this radical plan to resolve this most severe and dangerous financial crisis.

NB

Nouriel Roubini and the Shawdow Financial System

This latest missive from Mr. Nouriel Roubini highlights the currents risks facing the banking sector. Nouriel is one of my favourite writers and the threats to the "shadow" sector of the capital markets is where the real beef lies in the current Federal Reserve bail-outs of Bear Sterns:

A Generalized Run on the Shadow Financial System

Nouriel Roubini | Mar 17, 2008

Since the onset of the liquidity and credit crunch last summer this column has been arguing that monetary policy would be impotent to address such a crunch because, in part, of the existence of a non-bank “shadow financial system”. This system is composed of conduits, SIVs, investment banks/broker dealers, money market funds, hedge funds and other non bank financial institutions.


All these institutions look similar to banks because they are highly leveraged and borrow short and in liquid ways and invest or lend long and in illiquid ways. This shadow financial system is, like banks, subject not only to credit and market risk but also to rollover or liquidity risk, i.e. the risk deriving from having a large stock of short term liabilities (relative to liquid assets) that may not roll over if creditors decide to withdraw their credits to these institutions.


Unlike banks this shadow financial system does not have access to the lender of last resort support of the central bank as these are not depository institutions regulated by the central banks. What we are now observing – with the case of Bear Stearns and the recent disaster among SIVs, conduits, run on a number of hedge funds and money market funds is a generalized liquidity run on this shadow financial system.


The response of the Fed to this run has been radical and in the form of the extension of the lender of last resort support to non bank financial institutions. Specifically, the new $200 bn term facility allows primary dealers – many of which are non banks – to swap their toxic mortgage backed securities for US Treasuries; second, the Fed provided emergency support to Bear Stearns and following the purchase of Bear Stearns by JPMorgan, is now providing a $30 bn plus support to JPMorgan to help the rescue of Bear Stearns; finally, now the Fed is allowing primary dealers to access the Fed discount window at the same terms as banks.


This is the most radical change and expansions of Fed powers and functions since the Great Depression: essentially the Fed now can lend unlimited amounts to non bank highly leveraged institutions that it does not regulate. The Fed is treating this run on the shadow financial system as a liquidity run but the Fed has no idea of whether such institutions are insolvent. As JPMorgan paid only about $200 million for Bear Stearns – and only after the Fed promised a $30 billlion loan – this was a clear case where this non bank financial institution was insolvent.


The Fed has no idea of which other primary dealers may be insolvent as it does not supervise and regulate those primary dealers that are not banks. But it is treating this crisis – the most severe financial crisis in the US since the Great Depression – as if it was purely a liquidity crisis. By lending massive amounts to potentially insolvent institutions that it does not supervise or regulate and that may be insolvent the Fed is taking serious financial risks and seriously exacerbate moral hazard distortions. Here you have highly leveraged non bank financial institutions that made reckless investments and lending, had extremely poor risk management and altogether disregarded liquidity risks; some may be insolvent but now the Fed is providing them with a blank check for unlimited amounts. This is a most radical action and a signal of how severe the crisis of the banking system and non-bank shadow financial system is. This is the worst US financial crisis since the Great Depression and the Fed is treating it as if it was only a liquidity crisis. But this is not just a liquidity crisis; it is rather a credit and insolvency crisis. And it is not the job of the Fed to bail out insolvent non bank financial institutions. If a bail out should occur this is a fiscal policy action that should be decided by Congress after the relevant equity holders have been wiped out and senior management fired without golden parachutes and huge severance packages

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
System

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.