By Nouriel Roubini
Dec 03, 2007
SourceThis author writes a monthly column for "La Repubblica", the leading italian newspaper. The last column was published in Italian today. An english translation of it is provided here below:Events in the last few weeks have clearly shown that the liquidity and credit crunch that started last August in financial markets in the US and Europe not only has not improved; it has rather worsened in many dimensions. In the US this crunch and other serious weaknesses in the economy imply that the US is now headed towards an inevitable recession with the growth in this quarter already likely to be close to 0%. It is also still the case that when the US sneezes the rest of the world catches the cold; and in this case the US will not suffer just of a common cold but rather experience a protracted and severe pneumonia; thus, the rest of the world should be ready for a severe viral contagion.
Let us start with the financial markets turmoil. In spite of hundred of billions of dollars and euros of injections of liquidity in financial markets since August, and in spite of a 75bps cut of the policy interest rate by the Fed, the liquidity crunch is now as severe if not worse than last summer. For example, the difference between the interest rate at which US and European banks lend to each other relative to safe government yields of similar maturity is a proxy for the fear and risk aversion and counterparty risk. This difference is now again at extreme highs that signals near panic conditions in financial markets. The reason why such a massive liquidity injection and monetary easing have miserably failed is that the financial system is not experience only illiquidity; it is also experiencing serious and severe credit and insolvency problems. And monetary policy cannot resolve insolvency issues. Indeed, you have two million plus US households that will likely default on their mortgages; dozens of mortgage lenders who have already gone bankrupt; plenty of homebuilders suffering losses and closing shop; highly leveraged financial institutions all over the world (US, UK, France, Germany, Australia, etc.) that made reckless investment and have gone belly up; and even corporate firms defaults will now start to sharply increase as the economy falls into a recession.
Also, the size of the financial losses are staggering and growing by the day: financial institutions have so far recognized about $50 billion of losses but a variety of analysts estimate that total losses in sub-prime alone could add up to $300 to $400 billion; add to those the losses in near prime and prime mortgages; the losses on credit cards and auto loans whose default rates are rising; the losses on commercial real estate that experienced a boom and bubble similar to residential real estate; the losses that will be suffered by banks on lending to corporate firms and in LBO deals. It will all add up to a staggering figure closer to $1,000 billion of losses. And given such losses, the necessary contraction of credit by financial institutions that have lower capital could reduce the stock of credit – and thus cause a massive credit crunch – of the order of several trillions US dollars. In turn, such credit crunch will make the quantity of credit lower and its cost higher for households, firms and borrowers in general, thus reducing aggregate demand. Moreover, given securitization and financial globalization these losses are spread not just among banks but also investment banks, hedge funds, mutual funds, money market funds, SIV and conduits, insurance companies in the US and across the world. Thus the financial contagion is spreading from banks to the rest of the financial system and from the USEurope and the rest of the world increasing the risk of a systemic financial crisis. This is indeed the first crisis of financial globalization and securitization.
Thus, no wonder that major financial markets are now in a seizure of credit and liquidity: interbank markets, SIVs financed by ABCP, securitization markets, derivatives markets, LBO markets, leveraged loans and CLO markets. Given uncertainty on the size of the losses and on who is holding the toxic waste assets everyone is afraid of their counterparty and is hoarding liquidity. This is the effect of having created a financial system with less transparency, more opacity and lack of information and financial disclosure.
In the US this liquidity and credit crunch, the massive losses experienced by financial institutions on their reckless mortgage and other lending, the worst housing recession in US history with now free falling home prices, oil prices at historic highs, and a fragile consumer imply that the US will experience – starting early 2008 - a severe and painful recession. The saving-less and debt burdened US consumer is now at a tipping point. It cannot use any more its home as an ATM machine by borrowing against it and spending more than its income as home wealth is now falling. This consumer is buffeted by many negative shocks: falling home values, falling home equity withdrawal, rising debt servicing ratios, a credit crunch in housing and consumer credit, rising oil and gasoline prices, a weakened labor markets and, soon enough, a falling stock market. Easing by the Fed will not prevent the coming recession as it will be too little too late and as monetary policy becomes less effective once you have a massive glut of homes, of consumer durables, of autos and motor-vehicles. It will take years to work out this glut.
The rest of the world – including Europe – has so far deluded itself that it can decouple from a US slowdown. But decoupling would occur only if the US experienced a soft landing; if the US experiences a recessionary hard landing there will be no decoupling and global growth will sharply slowdown. And Europe could be one of the first victims of the US hard landing. Already the European financial system not only has not decoupled from the US one; it has been rather subject to a massive contagion since August. And since European firms depend on bank lending more than US ones the coming credit crunch will hit the European corporate sector and its ability to produce, hire and invest. Also boom and bubbles in housing were not limited to the US; similar bubbles were experienced by Spain, the UK, Ireland and, in smaller scale, by France, Portugal, Italy and Greece. Now such housing bubbles are starting to deflate in Europe adding to the downside growth risks.
Add to the problems of Europe the strength of the Euro that is sharply reducing the external competitiveness of the Eurozone; as well the forthcoming weakening demand for European goods from the US hard landing. Add to the mix high and rising oil prices. Then this combination of shocks implies serious risks of a sharp growth deceleration in Europe and even the possibility of a Eurozone hard landing. In the meanwhile while the Fed has already started to aggressively cut interest rates the ECB is deluding itself that it could raise its policy rate further once the perceived temporary financial crunch is past. What the ECB should instead to is to start cutting its policy rate now. Temporizing, like the ECB did in the 2001-2002 episode, will ensure that the negative growth contagion from the US to Europe will be more severe and protracted.
So the conditions are now setting for a perfect storm - financial and real economic one - in the US that will spread to Europe and across the world. So, as Bette Davis said in All About Eve: “Fasten your seatbelts as it’s gonna be a bumpy ride!”.
Nouriel Roubini is Professor at New York University and Chairman of RGE Monitor, an economic consultancy.In other news Paul Krugman provided today - in his NYT column - his excellent summary interpretation of how the current financial crisis has been due to "financial innovation". His points are all valid and well taken; this blogger agrees on them as they have been fleshed out in quite detail in this blog over the last few months. Here is Paul's column:Innovating Our Way to Financial CrisisBy
PAUL KRUGMANDecember 3, 2007 Op-Ed Columnist
SourceThe financial crisis that began late last summer, then took a brief vacation in September and October, is back with a vengeance.
How bad is it? Well, I’ve never seen financial insiders this spooked — not even during the Asian crisis of 1997-98, when economic dominoes seemed to be falling all around the world.
This time, market players seem truly horrified — because they’ve suddenly realized that they don’t understand the complex financial system they created.
Before I get to that, however, let’s talk about what’s happening right now.
Credit — lending between market players — is to the financial markets what motor oil is to car engines. The ability to raise cash on short notice, which is what people mean when they talk about “liquidity,” is an essential lubricant for the markets, and for the economy as a whole.
But liquidity has been drying up. Some credit markets have effectively closed up shop. Interest rates in other markets — like the London market, in which banks lend to each other — have risen even as interest rates on U.S. government debt, which is still considered safe, have plunged.
“What we are witnessing,” says Bill Gross of the bond manager Pimco, “is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August.”
The freezing up of the financial markets will, if it goes on much longer, lead to a severe reduction in overall lending, causing business investment to go the way of home construction — and that will mean a recession, possibly a nasty one.
Behind the disappearance of liquidity lies a collapse of trust: market players don’t want to lend to each other, because they’re not sure they’ll be repaid.
In a direct sense, this collapse of trust has been caused by the bursting of the housing bubble. The run-up of home prices made even less sense than the dot-com bubble — I mean, there wasn’t even a glamorous new technology to justify claims that old rules no longer applied — but somehow financial markets accepted crazy home prices as the new normal. And when the bubble burst, a lot of investments that were labeled AAA turned out to be junk.
Thus, “super-senior” claims against subprime mortgages — that is, investments that have first dibs on whatever mortgage payments borrowers make, and were therefore supposed to pay off in full even if a sizable fraction of these borrowers defaulted on their debts — have lost a third of their market value since July.
But what has really undermined trust is the fact that nobody knows where the financial toxic waste is buried. Citigroup wasn’t supposed to have tens of billions of dollars in subprime exposure; it did. Florida’s Local Government Investment Pool, which acts as a bank for the state’s school districts, was supposed to be risk-free; it wasn’t (and now schools don’t have the money to pay teachers).
How did things get so opaque? The answer is “financial innovation” — two words that should, from now on, strike fear into investors’ hearts.
O.K., to be fair, some kinds of financial innovation are good. I don’t want to go back to the days when checking accounts didn’t pay interest and you couldn’t withdraw cash on weekends.
But the innovations of recent years — the alphabet soup of C.D.O.’s and S.I.V.’s, R.M.B.S. and A.B.C.P. — were sold on false pretenses. They were promoted as ways to spread risk, making investment safer. What they did instead — aside from making their creators a lot of money, which they didn’t have to repay when it all went bust — was to spread confusion, luring investors into taking on more risk than they realized.
Why was this allowed to happen? At a deep level, I believe that the problem was ideological: policy makers, committed to the view that the market is always right, simply ignored the warning signs. We know, in particular, that Alan Greenspan brushed aside warnings from Edward Gramlich, who was a member of the Federal Reserve Board, about a potential subprime crisis.
And free-market orthodoxy dies hard. Just a few weeks ago Henry Paulson, the Treasury secretary, admitted to Fortune magazine that financial innovation got ahead of regulation — but added, “I don’t think we’d want it the other way around.” Is that your final answer, Mr. Secretary?
Now, Mr. Paulson’s new proposal to help borrowers renegotiate their mortgage payments and avoid foreclosure sounds in principle like a good idea (although we have yet to hear any details). Realistically, however, it won’t make more than a small dent in the subprime problem.
The bottom line is that policy makers left the financial industry free to innovate — and what it did was to innovate itself, and the rest of us, into a big, nasty mess.