LQD: Roubini predicts the worst financial crisis

RGE Monitor MEDIA ALERT: Nouriel Roubini predicts the worst financial crisis since the Great Depression and the worst U.S. Recession in the last few decades.

New York, July 15, 2008- In a series of recent writings on the RGE Monitor Nouriel Roubini - Chairman of RGE Monitor and Professor of Economics at the NYU Stern School of Business - has argued that the U.S. is experiencing its worst financial crisis since the Great Depression and will undergo its worst recession in the last few decades. His analysis leads to the following conclusions:

* Hundreds of small banks with massive exposure to real estate (the average small bank has 67% of its assets in real estate) will go bust

* Dozens of large regional/national banks (a' la IndyMac) are also bankrupt given their extreme exposure to real estate and will also go bust

* Some major money center banks are also semi-insolvent and while they are deemed too big to fail their rescue with FDIC money will be extremely costly.

* In a few years time there will be no major independent broker dealers as their business model (securitization, slice & dice and transfer of toxic credit risk and piling fees upon fees rather than earning income from holding credit risk) is bust and the risk of a bank-like run on their very short term liquid liabilities is a fundamental flaw in their structure (i.e. the four remaining U.S. big brokers dealers will either go bust or will have to be merged with traditional commercial banks). Firms that borrow liquid and short, highly leverage themselves and lend in longer term and illiquid ways (i.e. most of the shadow banking system) cannot survive without formal deposit insurance and formal permanent lender of last resort support from the central bank.

* The FDIC that has already depleted 10% of its funds in the rescue of IndyMac alone will run out of funds and will have to be recapitalized by Congress as its insurance premia were woefully insufficient to cover the hole from the biggest banking crisis since the Great Depression

* Fannie and Freddie are insolvent and the Treasury bailout plan (the mother of all moral hazard bailout) is socialism for the rich, the well connected and Wall Street; it is the continuation of a corrupt system where profits are privatized and losses are socialized. Instead of wiping out shareholders of the two GSEs, replacing corrupt and incompetent managers and forcing a haircut on the claims of the creditors/bondholders such a plan bails out shareholders, managers and creditors at a massive cost to U.S. taxpayers.

* This financial crisis will imply credit losses of at least $1 trillion and more likely $2 trillion.

* This is not just a subprime mortgage crisis; this is the crisis of an entire subprime financial system: losses are spreading from subprime to near prime and prime mortgages; to commercial real estate; to unsecured consumer credit (credit cards, student loans, auto loans); to leveraged loans that financed reckless debt-laden LBOs; to muni bonds that will go bust as hundred of municipalities will go bust; to industrial and commercial loans; to corporate bonds whose default rate will jump from close to 0% to over 10%; to CDSs where $62 trillion of nominal protection sits on top an outstanding stock of only $6 trillion of bonds and where counterparty risk - and the collapse of many counterparties - will lead to a systemic collapse of this market.

* This will be the most severe U.S. recession in decades with the U.S. consumer being on the ropes and faltering big time as soon as the temporary effect of the tax rebates will fade out by mid-summer (July). This U.S. consumer is shopped out, saving less, debt burdened and being hammered by falling home prices, falling equity prices, falling jobs and incomes, rising inflation and rising oil and energy prices. This will be a long, ugly and nasty U-shaped recession lasting 12 to 18 months, not the mild 6 month V-shaped recession that the delusional consensus expects.

* Equity prices in the US and abroad will go much deeper in bear territory. In a typical US recession equity prices fall by an average of 28% relative to the peak. But this is not a typical US recession; it is rather a severe one associated with a severe financial crisis. Thus, equity prices will fall by about 40% relative to their peak. So, we are only barely mid-way in the meltdown of stock markets.

* The rest of the world will not decouple from the US recession and from the US financial meltdown; it will re-couple big time. Already 12 major economies are on the way to a recessionary hard landing; while the rest of the world will experience a severe growth slowdown only one step removed from a global recession. Given this sharp global economic slowdown oil, energy and commodity prices will fall 20 to 30% from their recent bubbly peaks.

* The current U.S recession and sharp global economic slowdown is combining the worst of the oil shocks of the 1970s with the worst of the asset/credit bust shocks (and ensuing credit crunch and investment busts) of 1990-91 and 2001: like in 1973 and 1979 we are facing a stagflationary shock to oil, energy and other commodity prices that by itself may tip many oil importing countries into a sharp slowdown or an outright recession. Also, like 1990-91 and 2001 we are now facing another asset bubble and credit bubble gone bust big time: the housing and overall household credit boom of the last seven years has now gone bust in the same way as the 1980s housing bubble and 1990s tech bubble went bust in 1990 and in 2000 triggering recessions. And a similar housing/asset/credit bubble is going bust in other countries - U.K., Spain, Ireland, Italy, Portugal, etc. - leading to a risk of a hard landing in these economies.

* But over time inflation will be the last problem that the Fed will have to face as a severe US recession and global slowdown will lead to a sharp reduction in inflationary pressures in the U.S.: slack in goods markets with demand falling below supply will reduce pricing power of firms; slack in labor markets with unemployment rising will reduce wage pressures and labor costs pressures; a fall in commodity prices of the order of 20-30% will further reduce inflationary pressure. The Fed will have to cut the Fed Funds rate much more - as severe downside risks to growth and to financial stability will dominate any short-term upward inflationary pressures. Leaving aside the risk of a collapse of the US dollar given this easier monetary policy the Fed Funds rate may end up being closer to 0% than 1% by the end of this financial disaster and severe recession cycle.

* The Bretton Woods 2 regime of fixed exchange rates to the US dollar and/or heavily managed exchange will unravel - as the first Bretton Woods regimes did in the early 1970s - as US twin deficits, recession, financial crisis and rising commodity and goods inflation in emerging market economies will destroy the basis for it existence.

Thus, the scenario of 12 steps to a financial disaster that I outlined in my February 2008 paper is unfolding as predicted. If anything financial conditions are now much worse than they were at the previous peak of this financial crisis, i.e. in mid-march of 200

are you sayind that we just can’t possibly know since we have nothing like this to compare to....

You are perceptive. I disagree with his conclusions. We are in uncharted territory. I don't like it. I am glad you are sounding an alarm. More people should pay attention to finances. I am not as pessimistic as most anonymous agitators on these economic threads.

The United States of America hasn't done too bad for herself these last 232 years.

yitbos

The FED is not trying to inflate. It is inflating very industriously. Reagan commenced a mild deflation that lasted until Bush II and corresponded with boomtimes.One sign of that was the near disappearance of industrial strikes. Wages did not rise much in nominal terms but there was a perception that things were a tad easier from year to year. Bush deliberately commenced to inflate and announced it, calling it "devaluation." Moderate inflation and deflation are both not incompatible with prosperity and expansion but neither helps. The deflation of the Depression did not cause hard times, though things would have been easier with steady money. The depression was actually a series of panic and several recessions caused by massive government intervention and misdirection of resources. That is what is occurring "even as we speak" starting with Bear Stearns and being greatly enhanced with mortgage bailouts and Fannie Mae etc. These measures will be paid for with inflation. The inflation causes other problems because, besides it being used to surreptitiously raise real taxes, it makes economic calculation much more difficult because it tends to accelerate and thus causes actors in the market to misallocate resources as they try to predict future prices. Tremendous amounts of resources are inefficiently used because of all this or, more plainly speaking, are wasted. Alas If Bush is succeeded by Hussein the combination will be FDR all over again and long term hard times. The Depression didn't really end until Eisenhower and deregulation added to millions of vets going to work.All that full employment in the war was not prosperity because everything was still rationed and folks did not have it economically better than in the thirties. They just had jobs that paid very little. The slogans were the same in the 30s and the 40s- Use it up! Mend it! Wear it out!

No doubt they have crushed the dollar so some inflation has occurred but it seems to be offset at least by deflation in areas other than food and energy. "Crushing the Dollar"= devaluation which is a politically more acceptable word for INFLATION. You use the word "inflation" but you are talking about price increases. Inflation is the increase of the ratio of the stock of money- the number of dollars- to the supply of goods.

The average of prices tends to rise in an inflation but that is not, itself, inflation. It is a result of inflation and is not uniform. Some prices even fall as buying patterns change. There is high inflation in the economy and has been for 6 years.

Oil has soaked up quite a bit of it but it is not reflected in the official CPI numbers because it is not "counted" due to it having an identifiable "cause." If there were no inflation, the rising price of oil must cause the average of all other prices to fall because the ratio of dollars to available goods would not have changed. That is not what has happened.

The average of all prices is rising inexorably. Those prices that had been falling steadily due to advances in materials and production are holding steady in nominal dollars or even going up. Of major components only housing is falling and in an inflation some prices do fall but the average rises. The FED is complicating it and making it worse and much more difficult to cope by keeping interest rates artificially low- below the rate of inflation so that the real interest is often negative.

I’m not talking Great Depression II, but more 1990s like Japanese deflation

Why so optimistic? Japan had a fairly healthy economy, with only a few decades of excess built into it, with a hard working, frugal saving, well educated, populace and much local industry.

It has been sometime since the 1930's since the United States has had a serious economic house cleaning. Since then, we have had wave upon wave, bubble upon bubble, where the worst we saw caused five or ten years of muddling through with any collapses confined to one or a few sectors of the economy. We are coming off one of the most stunning asset bubbles in human history.

We have no savings, we have little of our previous manufacturing capability left, we are deeper in debt than any nation in human history by a factor of a hundred, deeper in debt and toxic paper than we were even a decade ago by a factor of ten, we have a populace that majority of which is ruined by public education and leftist media, we have a government (legislature, courts, bureaucracy and if Obama wins, the White House) that is corrupt beyond recall with leftist lies and greed, the money center banks own us (and they're in deep yogurt), we have a media that will soon be working overtime to take down Rush, Mark Levin and the Free Republic, ...

That Great Depression is starting to look pretty good to me.

And don’t pay attention to the government and MSM “economists.” Kudlow and Williams and Sowel know what they are talking about. Krugman and Bernanke and Paulson may but they are in the business of politics, not economics and what they may know is irrelevant to their prescriptions. Samuelson, like Bush, himself, is a “conservative” Keynesian. That means he desires more or less conservative ends but believes that government oversight and action are necessary to achieve economic ends. The methods are incompatible with the ends.

It (the FED) is inflating very industriously.

And failing massively. They have about as much chance as the Captain of the Hindenburgh would have had keeping that derigible up by huffing and puffing. The Fed's assets are a tiny fraction of all the toxic paper going up in smoke.

The dislocation of assets from high risk investments and non-essential goods to basic essentials like food and energy is putting up a nice little smoke screen (though it looks like the oil price bubble just broke this week.) But the total value of assets in this country (ask each person and corporation "what are you worth" and add it up) is collapsing massively.

Prices even for essential commodities are now beginning to fall, reflecting this. Wages for many jobs have gone world wide; I compete with equally capable computer programmers from other countries who are paid a fifth or a tenth of what I'm paid. That inequality will not last much longer. I expect soon to be living on a fifth or a tenth of what I had been living on.

Only later in this crash, much later, when the total economy is a small fraction of what it is now, will the Fed have the ability to seriously inflate our monetary supply.

I expect the falling prices of real estate and stocks to ripple through the rest of the economy, with low interest rates on Treasuries, for the next year or two. Perhaps then we will see seriously rising prices and interest rates.

I wish I was not so pessimistic on the economy. I just don’t know how this will come out.

Sometimes I fear the worst. I thought Y2K was going to be bad and it turned out I completely over reacted. No, I didn’t go find a bomb shelter to occupy, but I pulled out lots of cash, stocked up on food and water and sat tight on New Years Eve. Turned out it was nothing. I was badly fooled and I over reacted.

Maybe I’m badly fooled with the economy. Maybe I’m over reacting. I just don’t know. No, I don’t expect a depression but at age 49, I expect to see a deeper and longer recession with more personal suffering from economic tightening than anything I’ve seen in my lifetime. I guess the 70s were the worst I’ve seen so far, although I graduated college in 1982 and I remember how hard it was to find a job. A grad from the University of California at Davis, in an industry with a shortage of workers, and it still took me 2 years to find a job. Two years. Over one hundred job applications. Over 30 job interviews. I expect this downturn to be worse.

I wish I wasn’t so pessimistic, but I’ve never seen a situation in my lifetime where debt was at such an all time high in every sector and where there was such distrust and outright fear among bankers.

I’ll be glad when this is over and it’s just a mild recession and I can get out and play again. I just want all this over with.

It remains to be seen if we can inflate. It is very obvious we are under inflation pressures from huge debt and a weak dollar. I’m not blind. But can it continue?

Can US inflation continue without wage inflation? I see no signs of wage inflation. Wages are stagnant. What I see is a leap of short term inflation that could be strangled without wage inflation. People aren’t going to have more dollars to chase these same goods, they are just going to redirect discretionary dollars to necessary goods. We may have inflation in staples offset by deflation in luxuries.

I am rapidly coming around to the deflation camp, and thinking inflation is going to be short term, snuffed out by a suddenly weakened economy.

I keep hearing people claim that inflation is the obvious end game but I’m far from convinced. I don’t see where it will come from without wage inflation and with deflation coming on so quickly from collapsed housing prices and deflated corporate earnings.

I readily acknowledge GDII as a possibility but I can’t bring myself to accept it. I also tend to over react and don’t want to find myself over reacting and saying a depression is likely and having to back from that prediction. About all I can handle mentally is to acknowledge that the economic slowdown is going to be deep and long. It is going to hit hard and hold fast. Housing is going to take so long to go back up, a LOT of people are going to be singing the old tune that “we will never see another housing boom in our lifetimes”. Well, of course we will. It always cycles.

I can’t bring myself to accept the possibility of a depression, sorry. I just don’t want to believe it.

Now, in my heart of hearts do I think we have a pretty good chance of one? Well, a complete collapse of the US banking system would be a great start along those lines and so far the FED has had to bail out 3 major banks, the failure of any one of which could have collapsed the banking system. So yes, I can’t say a depression is a complete stretch given all the deflationary factors we are seeing at play in the market and economy today. But I figure the government will find some way to make this a long, dragged out stagnation ala Japan, rather than a short, sharp depression.

Now, if we lose the dollar as a reserve currency, then yes, we are in a depression. If foreign interests dump our Treasuries, that’s a depression. If the bond market collapses, maybe depression. If the US dollar collapses for real, then depression. But this deflation could be survivable as a long, stagnant, endless recession. A slow bleed. I don’t think it has to end in depression — but it could.

It terrifies me to even think that it could and I just don’t want to face up to that fact. I’m in denial.

Who knows? All I can do is go by history. In the late 1920s, you were having 2,000 banks a year fail. We haven't seen anything even remotely resembling that. If you go to the 1980s, I distinctly remember the warnings that the "Latin American debt bomb" was going to cause the collapse of Bank of America (now called Bank of Amigo), Chase, and many others. Of course it did no such thing. The S&L disaster was first put at $800 billion. It came in at less than half that, and if the banks and others had just held onto their real estate a little longer, many of them wouldn't have been hurt at all.

Without seeing their balance sheets, you can't know---but history tells us that real estate values always come back, and that if a bank is in trouble because of bad real estate loans, those prop. values will rise again.

Now, as to transparency: I think it's ironically hilarious that people are concerned about what is essentially "outsider lending," i.e., lending based on stuff they don't understand to people they don't know---when historically (until the last 30 or 40 years), banks have traditionally made "insider loans." In fact, that was the whole point of starting a bank in the 1800s----to make loans to your business and the businesses of your friends, i.e., the people you had information about. So here we are complaining that we don't know who is getting the loans, or who holds them. I thought that's what our great regulatory system was designed to do!!?

Finally, surely you know that all value comes down to faith: what will someone else give you for what you have? In good times, people "trust" that things will get better and take more risks. In bad times, they trust that things will be worse and won't loan or take risks.

I still think most of this hinges on energy: that lower energy prices cause rising productivity, rising incomes, which restores confidence, which brings back (some) mortgage values. No, everyone cannot live in CA, and you cannot drive 2 hours each way to work, so that bubble had to burst. It still isn't done flushing, and I think the CA economy pimple still hasn't been effectively squeezed.

I readily acknowledge GDII as a possibility but I can’t bring myself to accept it.

We're in unchartered waters ... deep and stormy waters.

Our fate depends in good part on the integrity, competence, and skill of our leaders, and of the integrity, resilience and flexibility of the various financial, political, bureaucratic, and media organizations that have the most influence on our economic health and political freedom.

... oops

Yes, we've been through worse, and come out ok.

We've seen worse predictions, and things were not as as bad as some predicted.

That doesn't tell us much one way or the other how this time will turn out. It just tells us that there is a wide range of possible outcomes, and an even wider variety of predictions.

One key ingredient to catastrophic, systemic failure is the belief that such can't happen, so we can take increasingly large and increasingly new risks, confident that we can always recover, somehow.

Pride goeth before destruction, and an haughty spirit before a fall.

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