Thursday, February 21, 2008

FT.com: America's Economy Risks Mother of all Meltdowns

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Below is an article from the Financial Times. However, the majority of the article is based off the work of Nouriel Robini, who along with Peter Schiff, Mike Shedlock, the whole group at Minyanville.com, and TraderMark have been warning of a potential financial abyss. I remember watching Roubini on CNBC a few years ago and he was basically looked upon as the crazy guy with the scowl (he always seems to have a scowl with a deep Eastern European accent - very scary!) :). Now, a few years later, at this year's Davos where all the financial braniacs gather, he is a rock star. Amazing what being correct can do for you.

Now, I don't know myself how bad things will get, but there is certainly a very valid case that things can go very bad. I however, do expect if things unravel, some (more) historical type of government interventions, of much bigger size and scale than we've seen so far, as the onion of credit stink is unwrapped. And I think a lot more damage will be done on Main Street (and the bond market), then perhaps the equity market. But it's worth seeing some of the worst case scenarios so you can at least be aware of what potentially is out there, from people who have nailed this thing when it was not a popular position. I have not been reading all these guys for 5 years, but I do think it is also very important to separate these folks from those who have been calling for a bear market every year since 1982. That sort of advice is useless. Some of these thoughts have been "early" but Kool Aid is a long lasting drug, so being early does not mean being wrong (as long as it was not 7 years early for example)

Again, we have an epic bubble based on overinflated home prices, allowed by Fed Bubble in Chief, combined with the mantra that all regulation was evil and those generous folks in NYC will self police themselves. As each week passes more and more people are going to be living in houses "underwater". Much of our credit system is based on either home values or massive leverage (or some combination thereof). If prices don't stabilize soon this will creep into more and more people's lives. (but not in every state! Agriculture and natural resource states will be living charmed lives, oblivious to the pain) And into more and more loans. That's why I think "walk aways" will be a huge theme if things continue to degrade. And we haven't even overlayed any sort of recession or inflation on top of all those issues. Because the Fed tells us there is no inflation and there will be no recession so who doesn't trust these folks? ;) ("Subprime will be contained". - Spring 2007) Or an overbuilt retail and restaurant system especially in Midwest and Northeast, full of outlets expanding on the thought people really had the amount of money they were flashing in 2002-2006, when much of it was house ATM money.
  • 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.
Please note if you believe in the "2nd half recovery boom" thesis, with malls teaming with content consumers, combined with a "housing shortage by year end 2008" (per Cramer) as people flood the housing market, everything below will sound like pure drivel and scare tactics.
  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. Step five would be the meltdown of the commercial property market, while step six would be bankruptcy of a large regional or national bank.
  6. 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.
  7. 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.
  8. 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.
  9. 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.
  10. 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.
  11. Step 12 would be “a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices”.
Ed. note: But other than that, things should turn out fine ;)

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. (I think this is a key point; there is so much inherent trust that the Fed can fix anything; if/when this is shown to fail that is when a true panic would happen.... if) 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.

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.

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My own take is at some point... if things do degrade in the first few steps above... the government will literally be taking debt from the banks themselves and holding it on their (already hugely in debt) books. So we'll see how it works out. Either way this "shadow system" is something we're all going to learn far more about in the coming 1-2 years. And my belief is as taxpayers we are going to be bailing out someone when all is said and done, to keep the "system sound". And pass the cost on to great great great great grandkids. I think the next interesting stage will be after the next cut (or two?) to 2.50 or 2.0%. What then? If credit systems are still clogged up, what's the next step? We should know by May. And will this unshakeable faith in the Fed as our white knight in shining armor fail? It's all about confidence. Equity markets appear to have all the confidence in the world in the white knight in his helicopter to fix all the bad boo boos. Debt markets.... not so much.

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