Thursday, March 13, 2008

Scary Stat of the Day: Roubini Calling for $1 Trillion-$3 Trillion in Losses

According to Yahoo Finance/ the market is rallying from the lows of the day on a call by S&P that subprime losses will reach about $285 Billion.
  • Subprime mortgage write-downs could reach $285 billion but an end to the write-downs is now in sight for large financial institutions, Standard & Poor's said in a report on Thursday.
  • "We believe that the largest players, such as Merrill Lynch & Co Inc (MER) and Citigroup Inc (C), have rigorously and conservatively valued their exposures to subprime asset-backed securities such that most of the damage should be behind them," S&P said in a statement.
Judging from how accurate the rating agencies have been in their "work" the past few years, I wonder how anyone gives anything they say any credibility but hey, Kool Aid is there so we can rally. That is a huge increase from here, but it puts a "target out there". The one thing Wall Street hates more than bad news is uncertainty. And this is the crux of our problem - no one knows how bad the credit situation will be and how much more pain is coming. Even if it were an enormous number like $600 Billion, the market would drop, price it in, and then we'd move on from there. But we don't have a figure and really won't know until it's over. Also keep in mind subprime is just the leading edge of the issue - back last year all we heard was "it's contained to subprime" - what a pack of lies (or errors) that was. THis mortgage issue is hitting people all across the credit spectrum from subprime to Alt A to prime mortgages. It only hit the weakest (subprime) first. So $285 B from subprime but how much from the larger markets of Alt A and prime? And what about auto loans? credit cards? Student loans? personal loans? That's the pickle.

Now we hear Nouriel Roubini is calling for $1 Trillion in writedowns. Last time we visited Nouriel [FT.Com: America's Economy Risks Mother of all Meltdowns] he laid out a 12 point plan for very bad things coming down the pike (also lightly reported in the USA) So do we trust a rating agency which is conflicted and hands out AAA ratings as if they are going out of style? Or one of the economists who nailed this credit contraction 10x from Sunday? You know the answer folks - when the market sees a fork in the road it will choose the path with most Kool Aid on it. Or at least a path along a river called "Denial" that flows with Kool Aid. So we get a rally, however fleeting. Grasp at any straw. Unfortunately, this sort of stock action clearly demonstrates to me once again we are still in denial which is bearish in my book. Again, the power to kick the can down the road and avoid reality in the equity market is amazing; until true realization hits I just cannot get bullish other than for a few hours at a time. I still contend we are getting to S&P 1270 and now it looks like we have a great chance to break below it. Let's hear some analysis on why Roubini has put out such a scary number...(of course its all over the UK papers because in the US our strategy is to ignore it, and it will go away) And as usual, forecasters like Roubini are early, and then the "herd" falls in line later after smirking for a few months/quarters about "outlandish" figures by "doomsday" economists.
  • In "Why Washington's rescue cannot end the crisis story" (this page, February 27) I analysed the implications of aggregate financial sector losses of $1,000bn. That figure was in line with estimates by Prof Roubini and George Magnus of UBS. I concluded that even this would be manageable, if painful, for an economy as big and a government as creditworthy as that of the US. Prof Roubini objects that I have taken the downside too lightly. He now argues that financial losses might amount to $3,000bn
  • Most of the losses will fall not on the financial sector but elsewhere. As Prof Roubini notes, a 10 per cent fall in house prices (relative to the peak) knocks off $2,000bn (14 per cent of gross domestic product) from household wealth. The first 10 per cent fall has already happened. What he sees as a likely 30 per cent cumulative fall would wipe out $6,000bn, 42 per cent of GDP and 10 per cent of household wealth.
  • Prof Roubini also talks of a $5,600bn decline in the value of stocks and the possibility of additional trillions of dollars in losses on commercial property. Total losses might even equal annual GDP.
  • Worse, the bigger the damage to the financial sector, the more credit-fuelled personal spending is going to dry up. So what might such overall losses mean for financial intermediaries. In Prof Roubini's 12 steps to meltdown, discussed here on February 20, 2008, he assumed that their losses on mortgages would be $300bn-$400bn, while losses on other assets (consumer debt, commercial real estate loans and so forth) would be another $600bn-$700bn, for a total of $1,000bn. On March 7, Goldman Sachs economists published an even higher estimate of mortgage-related losses, at $500bn, along with $656bn in other losses, for a total of $1,156bn. The mainstream has caught up. But Prof Roubini has moved on.
  • In reaching its conclusion, Goldman estimated a peak-to-trough house price fall of 25 per cent. In his comments on the FT's forum, Prof Roubini suggests that, after price falls of 20 per cent from the peak, losses on mortgages could be as much as $1,000bn. With a 40 per cent fall, they could be $2,000bn. He adds another $700bn for other losses, to reach total financial sector losses of close to $3,000bn, or about 20 per cent of GDP.
  • So how does Prof Roubini reach these much higher figures? The difference between him and Goldman is not so much in assumptions about the house price fall: 25 per cent for Goldman Sachs and 20-40 per cent for Prof Roubini. Both also estimate that lenders would lose half of the loan value after repossession. But Goldman believes that just 20 per cent of households in negative equity would default, while Prof Roubini believes 50 per cent might do so.
  • For people with poor credit ratings and few assets, apart from their house, walking away does seem to make disturbingly good sense ("Jingle-mail rings alarm bells for lenders", Financial Times, March 7). Buyers with no equity had an option to walk. Now they are exercising it. This was demented finance. [Remember, this coincides with my view that 2008 will be the year of the "walkaway"]
  • Suppose, then, that Prof Roubini were right. Losses of $2,000bn-$3,000bn would decapitalise the financial system. The government would have to mount a rescue. The most plausible means of doing so would be via nationalisation of all losses. While the US government could afford to raise its debt by up to 20 per cent of GDP, in order to do this, that decision would have huge ramifications. We would have more than the biggest US financial crisis since the 1930s. It would be an epochal political event. [Not to sound alarmist but this is the path we seem to be headed - as I've said, if things continue to degrade down this path the Federal Reserve will literally be buying mortgages and effectively nationalizing the banking system - Tuesday's actions are 1 step away by providing "rolling 28 day loans" indefinitely]
  • Yet, Goldman argues that, after allowing for loan-loss provisions, the proportion of loss-making loans advanced by the non-leveraged sector and the ability to write off losses against tax, its $1,156bn comes down to $298bn. If a similar magic could be worked on the Roubini numbers, the effective losses to the leverage sector would fall to less than $750bn - huge, but more manageable. (nothing like financial accounting magic, eh?)
  • Alas, worries are understandable. There are two ways of adjusting the prices of housing to incomes: allow nominal prices to fall or raise nominal incomes. The former means mass bankruptcy and a huge fiscal bail out; the latter imposes the inflation tax. In extreme circumstances inflation must be attractive. Even if it is not the Fed's choice, it is what a reasonable outsider might fear, with obvious consequences for all asset prices.
  • I suspect Prof Roubini's latest estimates are excessively pessimistic. But I am not certain this is so, given his record: just look at the vicious interaction between falling asset prices, financial stress and spending. We must pray that the Fed can clean it all up, without excessive collateral damage. Unfortunately, such prayers often go unanswered.

So it's come down to prayer. Thankfully the "2nd half recovery" is only months away. So as we in the US (including media) keep our heads in the sand for another 3 months, we just have to keep from suffocating down there until the magical nirvana begins on July 1, 2008. And remember S&P says losses are finite and heck we're over half way there! So rejoice!

Position: Can't wait for unicorns, butterflies, and singing mermaids to appear on July 1, 2008 as part of the "2nd half recovery"

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