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This is not a crisis of “crony capitalism” in emerging economies, but of sophisticated, rules-governed capitalisms in the world’s most advanced economy. The instinct of those responsible will be to mount a rescue and pretend nothing happened… Worse, the institutions that prospered on the upside expect rescue on the downside. They are right to expect this. But this can hardly be a tolerable bargain between financial insiders and wider society. Is such mayhem the best we can expect? Is so, how does one sustain broad support for what appears so one-sided game?”
-- Martin Wolf
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This is indeed a one-sided game where financial insiders privatize profits while the massive losses of their reckless behavior – searching dangerously for yield, gambling for redemption, being subject to distorted incentive not to monitor their lending and risky investments - are systematically socialized during a crisis. This is actually “crony capitalism” of the worst kind, as bad as the one that plagued emerging market economies and led to their severe financial crises in the last decade."
-- Nouriel Roubini
(No Title)
By Nouriel Roubini
February 29th, 2008
SourceIn his February 27th column in the Financial Times Martin Wolf considers further my “
12 steps scenario to a systemic financial crisis” that he had very thoughtfully presented in his previous column.
In the new column Wolf makes a series of interesting points. First he argues that my “analysis suggested a highly plausible worst case scenario, not the single most likely outcome”. Second, he argues that, even in this worst case scenarios, the expected losses for the financial system (that I estimated to be about $1 trillion) and thus the potential fiscal costs of a bailout of the financial system would be only 7% of GDP, an amount that a large economy such as the US can easily afford: as he argues the US public debt would increase in that scenario only to 70% of GDP. And the yearly costs of servicing such increased debt would be – in his view – “a mere 0.2% of GDP in perpetuity. This is a fiscal bagatelle”.
What should we make of his argument? For now I will not debate whether my scenario is plausible or not; let us leave aside this debate for now and let us concentrate on the fiscal costs of a bailout of the financial system in this “worst case scenario”. Will it be only 7% of GDP or more? I will argue in this article that such fiscal costs of a financial crisis could be much higher than 7% of GDP, as high as 19%, even leaving aside the even bigger losses in the net worth of the private sector that a severe financial crisis would imply.
Here are a number of reasons why the overall financial losses and the fiscal costs of a bailout of the financial system could be much higher than 7% of GDP.
First of all 7% of GDP still represents $1 trillion of greater stock of public debt. And $1 trillion is not spare change, even for a large country like the US. The S&L crisis cost the US budget about $120 billion (closer to $250 billion in today’s dollars). A cost of $1 trillion is at least four times as high. Also consider the political consequences of asking the US tax payer to allow the increase of the explicit debt of the US government by $1 trillion in order to bail out the financial system. Currently even much more modest proposals to use a few billions of public money to deal with the foreclosure crisis are met with political resistance; let alone thinking of adding another $1 trillion to the US public debt.
Second, in past episodes of fiscal bailouts of a financial system in crisis, such as those described by Wolf in a chart in his column, such bailouts have been usually associated with a formal or effective nationalization of most or all of the banking system. In a financial crisis the entire capital of the banking system is often wiped out and, ever after shareholders have lost all of their equity, the value of the assets of the banks is below the value of their liabilities (deposits and other insured debts). Thus, a fiscal bailout and recapitalization of the banking system requires an effective nationalization – until banks are cleaned up, recapped and sold back to the private sector – of the banking system. So in this $1 trillion (7% of GDP) fiscal bailout scenario, you would get an effective nationalization of a good part of the US banking and financial system. Is this nationalization a consequence that the US – the beacon of free market capitalism – is comfortable with? As it is, already now the partial recapitalization of the US financial system is occurring via foreign government-owned entities – the sovereign wealth funds – providing the new capital. So, regardless of whether it would be the US government or some foreign governments to take control of US financial institutions we would be on the way to an effective domestic or foreign nationalization of the US financial system.
Third, in this financial crisis scenario the real losses for the net worth of the US private sector are much higher than $1 trillion. With home prices having already fallen by 10% relative to their peak, $2 trillion of the value of equity in US homes (housing wealth) has already been wiped out (14% of GDP). Since home price are almost certain to fall by another 10% in 2008 and beyond a 20% cumulative fall in home prices is equivalent to $4 trillion of losses (or $28% of GDP). And an eventual cumulative fall in home prices of the order of 30% is highly likely at this point; that would wipe out $6 trillion of housing wealth (or 48% of GDP). 48% of GDP is a much bigger loss than 7% of GDP.
Fourth, in an average US recession – even in a mild one such as those in 1990-91 and 2001 - the S&P500 falls by an average of 28% and often it takes five to ten years for the index to recover its pre-recession level. Given that the US stock market capitalization was about $20 trillion at its peak in 2007 that 28% loss would wipe out another $5.6 trillion (or 39% of GDP) from the net worth of the private sector.
Fifth, commercial real estate was – like residential real estate – in a bubble that is now starting to go bust as reckless lending and underwriting practices similar to those in residential mortgages were experienced in commercial real estate mortgages. Prices of commercial real estate are expected to fall by 10% to 20% that would wipe out a few additional trillion dollars from the value of such assets.
Sixth, and most important, my estimate of $1 trillion of losses for the financial system was based on the view that total credit losses on mortgages would be around $300 to $400 billion while the other losses of the financial system (on consumer debt, commercial real estate loans, leveraged loans, downgrade of the assets insured by monolines, loans to non financial corporations and holdings of corporate bonds, credit default swaps) would add up to another $600 to $700 billion. But the total credit losses on mortgages may end up being much higher than $300 billion and as high as $1 trillion to $2 trillion.
The reason is as follows: today there are already over 8 million households with negative equity in their homes (i.e. the value of their homes being lower than the value of their mortgage debt); if home prices fall by another 10% (20% cumulative) the number of households with negative equity would be over 16 million; and if home prices fall by a cumulative 30% about 21 million households would have negative equity. As discussed in a previous column of mine in this scenario of negative equity households have a strong incentive to walk away from their homes and saddle the banks or holders of the mortgage with the loss deriving from the difference between the mortgage value and the home value.
Based on work done by Calculated Risk, I have argued that in this scenario of massive “jingle mail” the losses for the financial system would be at least $1 trillion and as high as $2 trillion. To get $1 trillion of losses one does not have to make heroic assumption: even assuming only a 20% (rather than 30% fall in home prices) and even assuming that only half of the 16 million households with negative equity “walk away” you easily get losses of the order of $1 trillion (assuming that the average mortgage is $250k and that the loss to the creditor is about 50% with the latter assumption based on the fall in the price of the home, the legal and other costs of foreclosure and the additional costs of selling a home in a very illiquid market). With larger home price depreciation and thus larger numbers of households walking away the losses can be as high as $2 trillion.
These are staggering amounts that would totally wipe out all of the capital of the US banking system and lead to a systemic banking crisis. So, in the worst case scenario if the losses on mortgages are $1 trillion (or in an extreme case $2 trillion) rather than the current estimate of $300 billion and, if on top of these losses the additional credit losses from consumer credit, commercial real estate, leveraged loans, etc. are another $700 billion the total losses for the financial system would add up to at least $1.7 trillion ($1 trillion plus $700 billion) and as high as $2.7 trillion ($2 trillion plus $700 billion). $1.7 trillion adds up to a maximum fiscal bailout cost of about 12% of GDP (not 7%) while $2.7 trillion adds up to a maximum fiscal bail-out cost of about 19% of GDP.
Now 12% of GDP is not spare change and, certainly, 19% of GDP is a staggering amount (ten times higher than the fiscal bailout cost of the S&L crisis). Of course some of the losses would be taken by the shareholders of the banks and financial institutions; but a clean and fair fiscal bail out of the financial system – that reduces the fiscal costs – would imply first wiping out all of the shareholders of these institutions (as their capital/equity is fully destroyed by such losses) and a formal nationalization of a good part of the banking and financial system. And thus in such a scenario one has to ask again the question: what are the implications of a potential nationalization of a good part of the financial system of the most advanced capitalist country in the world?
Some final and additional considerations.
First, if millions of households exercise their legal option of walking away from homes with negative equity, even before any government intervention the losses for the financial system would be larger than the equity in the system. So banks and other financial institutions would be insolvent and forced to be taken over by the government leading to the need for a fiscal bailout (as most bank liabilities are effectively safe given deposit insurance).
Second, proposals for a fiscal resolution of the foreclosure crisis do not necessarily prevent this effective bankruptcy of the banking system. For example, if as proposed by folks such as Mark Zandi and Alan Blinder, the government were to buy via auctions distressed mortgages and RMBS, the only way to limit the fiscal cost of such government intervention would be to buy such mortgages at their true market value that is equal to the value of the property once the full downward price adjustment has occurred. In this best case the government does not lose much money on such a scheme of taking over mortgages and repackaging them in lower loan value and lower interest rate mortgages for distressed borrowers. However in this scenario: first a good part of the mortgages are effectively nationalized; and second the full losses deriving from the difference between the market value of the home and the value of the original mortgage are then absorbed by the creditor financial institutions. Thus you end up again with a situation where the equity of these financial institutions is wiped out, they become insolvent and the government is then forced to take them over and incur the fiscal costs of bailing them out and recapitalizing them.
Conversely, if the mortgages are bought – via auctions – at a price that is higher than the eventual market value of the home, the fiscal costs of this effective nationalization of the mortgages becomes potential very large (as the government takes the downside risk of the further fall in home values and eventual default of households with negative equity) while the financial sector’s equity is less than fully wiped out. Thus, in this scenario the weaker financial institutions go belly and are nationalized – in spite of this partial bailout of the shareholders of these entities – while the stronger ones do not go belly up only because the public sector provides a massive bailout (equivalent to the difference between the secondary market value of the mortgage and the true underlying value of the home). In summary, regardless of whether you nationalize mortgages (in the scenario of the government buying a whole bunch of such mortgages) or nationalize the banks you end up with massive losses (again possibly as high as $1 trillion to $2 trillion for mortgages alone) that are – in one way or the other – fiscalized.
In conclusion, it used to be said that “a million here, a million there and soon you are speaking about real money”. In this case we need to amend the saying to “a trillion here, a trillion there and soon you are speaking of staggering amounts of money and massive fiscal bailout costs”. Martin Wolf says that a fiscal bill of 7% of GDP is modest and affordable. But the analysis above suggest that the fiscal bill of bailing out a banking and financial system that suffers a systemic crisis would be at least 12% of GDP and as high as 19% of GDP. Even for a rich country like the US 19% of GDP (or $2.7 trillion of additional public debt) is not spare change nor is a “fiscal bagatelle”. And saddling every US household with an additional $30,000 of debt in perpetuity is not small burden either. And all this is true even leaving aside the other $10 trillion plus of losses in the net worth of the US private sector (fall in the value of residential real estate and commercial real estate, and in the value of the stock market) that a severe recession and financial crisis would imply.
The wise Wolf is himself – at the end – very aware of the political economy of a financial system where in good times the profits are privatized and in bad times the losses are socialized. This is not a politically sustainable regime. As he correctly puts it:
“This is not a crisis of “crony capitalism” in emerging economies, but of sophisticated, rules-governed capitalisms in the world’s most advanced economy. The instinct of those responsible will be to mount a rescue and pretend nothing happened… Worse, the institutions that prospered on the upside expect rescue on the downside. They are right to expect this. But this can hardly be a tolerable bargain between financial insiders and wider society. Is such mayhem the best we can expect? Is so, how does one sustain broad support for what appears so one-sided game?”
This is indeed a one-sided game where financial insiders privatize profits while the massive losses of their reckless behavior – searching dangerously for yield, gambling for redemption, being subject to distorted incentive not to monitor their lending and risky investments - are systematically socialized during a crisis. This is actually “crony capitalism” of the worst kind, as bad as the one that plagued emerging market economies and led to their severe financial crises in the last decade.
PS: In this article I have left aside the complex issue of what are “inside” assets versus “outside” assets (or net worth) of an economy. Financial losses are in part a redistribution of wealth from creditors to debtors and thus “inside” assets that should not affect the net worth of an economy. But they can have financial consequences on net worth for several reasons. First, a financial crisis that leads to a credit crunch can cause a recession that reduces the value of output/income that is generated by the economy; this is a real loss of income and welfare. Second, the part of loss of net worth that is driven by an asset bubble and excessive investment in assets (such as residential and commercial real estate) that eventually go into a bust is a real wealth loss as it signals that too much was invested for many years in assets with low returns. Thus, the sharp fall in the market value of such assets (residential and commercial real estate and value of equities) reflects this low return on such capital goods, another factor that reduces long-term consumption and economic welfare.