Nouriel Roubini has been almost freakishly accurate in calling the progression of the credit crisis, with his only major failings being predicting its onset on the early side and his fondness for an apocalyptic writing style, which now seems fully justified.
Even by the standards of his alarming missives, his latest is truly troubling. Roubini effectively says the wheels are coming off the global financial system, and if corrective action is not taken immediately, the damage to the real economy will be extensive.
Note that Roubini’s most recent forecast was that hedge funds would start folding due to redemptions and poor performance. This can lead to cascading destruction of value. Funds who have lost value and need to sell assets to cash out investors who want to exit sell positions into this lousy market. The selling pressure leads to price declines, which affects the value of holding of other hedge funds. At a minimum, they report losses to investors, some of whom will want out, feeding into the selling pressure. And some who have used leverage will face margin calls due to the decline in asset value, again leading to liquidation of positions.
Apparently a bit of that was behind the end-of-day fall in the Dow on Thursday. A hedge fund manager told me that apparently a West Coast hedge fund had to dump major positions, a portion of which were real estate debt related (no detail here, they might have been late entrant bottom fishers) and the prices they were getting were simply dreadful. The concern was that other banks and hedge funds would be required to use these prices for valuation of their assets, leading to further markdowns and selling pressure. The objective of the Paulson plan, to allow banks and investors to mark their books at above what would be market prices due to the Treasury’s above market bids appears to have been trumped by events.
From Roubini’s RGE Monitor:
The U.S. and advanced economies’ financial systems are now headed towards a near-term systemic financial meltdown as day after day stock markets are in free fall, money markets have shut down while their spreads are skyrocketing, and credit spreads are surging through the roof. There is now the beginning of a generalized run on the banking system of these economies; a collapse of the shadow banking system, i.e. those non-banks (broker dealers, non-bank mortgage lenders, SIV and conduits, hedge funds, money market funds, private equity firms) that, like banks, borrow short and liquid, are highly leveraged and lend and invest long and illiquid, and are thus at risk of a run on their short-term liabilities; and now a roll-off of the short term liabilities of the corporate sectors that may lead to widespread bankruptcies of solvent but illiquid financial and non-financial firms.
On the real economic side, all the advanced economies representing 55% of global GDP (U.S., Eurozone, UK, other smaller European countries, Canada, Japan, Australia, New Zealand, Japan) entered a recession even before the massive financial shocks…So we have a severe recession, a severe financial crisis and a severe banking crisis in advanced economies…
Countries with large current account deficits and/or large fiscal deficits and with large short-term foreign currency liabilities and borrowings have been the most fragile. But even the better performing ones – like the BRICs club of Brazil, Russia, India and China – are now at risk of a hard landing. Trade and financial and currency and confidence channels are now leading to a massive slowdown of growth in emerging markets with many of them now at risk not only of a recession but also of a severe financial crisis….
At this point the recession train has left the station; the financial and banking crisis train has left the station. The delusion that the U.S. and advanced economies contraction would be short and shallow – a V-shaped six month recession – has been replaced by the certainty that this will be a long and protracted U-shaped recession that may last at least two years in the U.S. and close to two years in most of the rest of the world. And given the rising risk of a global systemic financial meltdown, the probability that the outcome could become a decade long L-shaped recession – like the one experienced by Japan after the bursting of its real estate and equity bubble – cannot be ruled out.
And in a world where there is a glut and excess capacity of goods while aggregate demand is falling, soon enough we will start to worry about deflation, debt deflation, liquidity traps and what monetary policy makers should do to fight deflation when policy rates get dangerously close to zero.
At this point the risk of an imminent stock market crash – like the one-day collapse of 20% plus in U.S. stock prices in 1987 – cannot be ruled out as the financial system is breaking down, panic and lack of confidence in any counterparty is sharply rising and the investors have totally lost faith in the ability of policy authorities to control this meltdown.
This disconnect between more and more aggressive policy actions and easings, and greater and greater strains in the financial market is scary. When Bear Stearns’ creditors were bailed out to the tune of $30 bn in March, the rally in equity, money and credit markets lasted eight weeks; when in July the U.S. Treasury announced legislation to bail out the mortgage giants Fannie and Freddie, the rally lasted four weeks; when the actual $200 billion rescue of these firms was undertaken and their $6 trillion liabilities taken over by the U.S. government, the rally lasted one day, and by the next day the panic had moved to Lehman’s collapse; when AIG was bailed out to the tune of $85 billion, the market did not even rally for a day and instead fell 5%. Next when the $700 billion U.S. rescue package was passed by the U.S. Senate and House, markets fell another 7% in two days as there was no confidence in this flawed plan and the authorities. Next, as authorities in the U.S. and abroad took even more radical policy actions between October 6th and October 9th (payment of interest on reserves, doubling of the liquidity support of banks, extension of credit to the seized corporate sector, guarantees of bank deposits, plans to recapitalize banks, coordinated monetary policy easing, etc.), the stock markets and the credit markets and the money markets fell further and further and at accelerated rates day after day all week, including another 7% fall in U.S. equities today.
When in markets that are clearly way oversold, even the most radical policy actions don’t provide rallies or relief to market participants. You know that you are one step away from a market crash and a systemic financial sector and corporate sector collapse. A vicious circle of deleveraging, asset collapses, margin calls, and cascading falls in asset prices well below falling fundamentals, and panic is now underway.
At this point severe damage is done and one cannot rule out a systemic collapse and a global depression. It will take a significant change in leadership of economic policy and very radical, coordinated policy actions among all advanced and emerging market economies to avoid this economic and financial disaster. Urgent and immediate necessary actions that need to be done globally (with some variants across countries depending on the severity of the problem and the overall resources available to the sovereigns) include:
another rapid round of policy rate cuts of the order of at least 150 basis points on average globally.
a temporary blanket guarantee of all deposits while a triage between insolvent financial institutions that need to be shut down and distressed but solvent institutions that need to be partially nationalized with injections of public capital is made;
a rapid reduction of the debt burden of insolvent households preceded by a temporary freeze on all foreclosures;
massive and unlimited provision of liquidity to solvent financial institutions;public provision of credit to the solvent parts of the corporate sector to avoid a short-term debt refinancing crisis for solvent but illiquid corporations and small businesses;
a massive direct government fiscal stimulus packages that includes public works, infrastructure spending, unemployment benefits, tax rebates to lower income households and provision of grants to strapped and crunched state and local government;
a rapid resolution of the banking problems via triage, public recapitalization of financial institutions and reduction of the debt burden of distressed households and borrowers;
an agreement between lender and creditor countries running current account surpluses and borrowing, and debtor countries running current account deficits to maintain an orderly financing of deficits and a recycling of the surpluses of creditors to avoid a disorderly adjustment of such imbalances.
At this point anything short of these radical and coordinated actions may lead to a market crash, a global systemic financial meltdown and to a global depression. The time to act is now as all the policy officials of the world are meeting this weekend in Washington at the IMF and World Bank annual meetings.
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I find the contrast between the indubitably terrible condition of the markets, particularly in the credit markets and the shadow banking system, and the seemingly blase reaction of people in the street and ordinary businesses, to be really striking. I’ve read anecdotes of small businesses failing to get loans, but so far I haven’t seen a single picture of an ashen-faced ordinary person that can match the despair of floor traders or the gloomy faces of Paulson and Bush.
All in all, the memorable images of this crisis so far are of foreclosure signs and of people who inhabit that science-fiction like world that we call Wall Street.
o.k. What to do then?
It's hard for me to get too excited about this. I'm a lawyer, and in the late 1990's, I helped tech IPO's and M&A in silly valley. I saw the most of the newbie deal lawyers and engineers get laid off. And have to find work in other industries, or worse jobs paying less money. Nevertheless, everyone managed to get by.
This crash reminds me of the tech crash, except in finance, rather than tech. People seem to be overreacting as much now as then. Every industry has been through a severe recession since 1940. Aerospace in LA. Oil in Houston. Tech after the 60's and 90's booms. I could go on. Having to retool and move on isn't easy, but it isn't the end of the world.
I feel for the kids with a year or 2 of experience, lots of student loans, and no savings, who will need to switch industries, geography, etc. As for buy side and sell side folks with 10+ years experience, I've got no sympathy. They've had time to prepare for a rainy day.
Having followed the string of correct predictions of Mr. Roubini (and Yves Schmidt, it should be said) for more than a year now, I’m left troubled only by the suggestion that part of the answer is a massive global interest rate cut. I still fail to see that it is the cost of money via policy rates that changes this, as the price of money is way, way, way too cheap already, as disregarding various inflation disapperance tools, policy rates are below the real rate of inflation. For me that is nigh on criminal from a moral point of view.
The problem is that no one is channeling that cheap money through to the real economy anymore which brings about potential failures of even very solid businesses.
Perhaps such rate cuts are part of the solution in an acute crisis, but I still think that the more important and acute part of Roubini’s message has to do with the triage aspect, as it is simply crucial that it is understood which banks are viable, and that those banks receive explicit guarantees while the others are left to scramble for survival on their own. In that sense I likd the UK plan.
Unless something like this happens in most Western countries, you will inevitably have a situation where no government, be it the US one or single European governments (or EU if we assumed that we could get together on something significant for once) can actually guarantee anything. The numbers are just too high.
NB: I am a journalist, and if anyone here has any information on the level of the Danish banking sectors exposure to smelly CDS or CDO’s, I would love to hear from you. The Danish banking authorities are very hessitant in sharing, and from a risk analysis point of view its an interesting case with Denmark not being part of the Euro, and having to actually increase interest rates this week to guard the currency.
Fantastic blog, Yves.
glenmikkelsen@gmail.com
@anon, who compares this to the tech crash, but for finance.
After the tech crash there were a lot less online services. After a financial meltdown there will be a lot less money.
“When in markets that are clearly way oversold . . . .” No. This market is not oversold: the prices of equities were illusory, tied to faux earnings on vapor assets. The clock is chiming, Cleverfella’s ball duds are changing back into rags, and the midden stink is inescapable. What we have is a sudden return to reality. Equities have been in a twenty year bubble; now, that gurgling you hear is the pseudo-wealth draining out of the bathtub.
I have to say that Roubini’s cures sound worse than the disease. It would be extremely helpful if the govt would just get the hell out of the way and let private parties work this out. Merge, declare BK, downsize, cancel or default CDS, whatever it takes. Nor do I think “fiscal stimulus” will fix anything faster than tax cuts.
Allowing the market place to take care of itself is not a bad idea, unfortunately the market place would dissolve the banking industry into nothingness. Banks issuing their own notes (again, historically) might work locally but internationally you need a central bank or at the very least a central clearing house (well funded).
If the Treasury would just take their 750b and start a new bank and issue new currency with no interest service fees only loans it would isolate the bad debt and attract money like you wouldn’t believe. I can hear the whining to that idea but you get a depression no matter what, international banks will continue throwing money down the drain and calls for a new world bank system is already being touted.
Why wouldn’t the Treasury do it? Because 1. The bankers will not be able to make obscene profits on a fee only bank. 2. The loss of central banking power would not be acceptable.
How about cutting taxes?
The current high marginal rates seem like a quaint relic from the era of “bubble”.
They just don’t make sense anymore.
“Fiscal stimulus” is central to the tenets of Keynesian Economics. Econ 101 courses will even throw in a chapter about it. At least, the concept has been exposed to rigorous analysis by the Economics profession.
Instead, we have Congressinal leaders calling for another round of “tax rebate”. That is a political approach. They need to be told “no more business as usual”.
Seeing a higher net from each paycheck – that would be a big morale boost for the folks.
Hi Yves, i would like to thank you for this blog. It certanly paints a very scary picture. I dont want to use word anarchy, but i am a reader of apoclyptic books. And this sure is looks like start of one.
I personally buying silver and camping equipment. Plus food supplies and a bike. I wish i got fire arms training, but alas.
“When in markets that are clearly way oversold . . . .”
oversold does not mean undervalued. I have done extensive analysis of price movements over the last decade, and 6 consecutive days of dramatic falling prices does not fit any historical pattern (even 1929 and 1987). This market is oversold by any technical measure. That does not mean that it won’t (and shouldn’t) fall some more. There are obviously some mechanical factors at play (as there were in 1987) where falling prices are triggering more sales.
Nobody wants to hear people talk about true value. It sounds like whining. And with trust disappearing as quickly as the market, even solid earnings and growth history will be viewed as suspect.
Technical bounces will occur when the mechanical selling stops. But do not mistake that for the bottom, or this for capitulation. The event is just too rare to draw meaningful conclusions.
I may cover my shorts soon, but I do not see myself long for a while. I am seeing too many people actually abandon the stock market as a place for savings.
Capitalism is failing. Now the oligarchy is feeling it , hence the desperation. But working folks have been feeling like this for a generation and none of their masters gave a damn. Let the system fail, and replace it with something better for people and the planet.
As much as I think Roubini is right with his predictions, IMHO his solutions are not necessarily going to stop anything.
“a temporary blanket guarantee of all deposits while a triage between insolvent financial institutions that need to be shut down and distressed but solvent institutions that need to be partially nationalized with injections of public capital is made;”
Any “triage” of financial institutions will necessarily result in less lending, and so a “triage” in companies and businesses, with a depression-like impact on the real economy.
I’m afraid Prof. Roubini do not realize how incredibly difficult it would be for the politicians to even UNDERSTAND, let alone accept that his suggestions must be implemented in one form or another.
They do not have the capacity, nor the inclination to move so radically so fast.
The pain is not severe enough,(yet) the mob hasn’t chase them with pitches and forks to make them more mentally malleable to reality.
So, we will have to go through a meltdown and depression.
I have found Rs comments on commercial construction to be fairly clueless. The hedge funds seem to have been collapsing for a while: almost the whole way through.
I like him because he has had to the play the role of a Casandra arguing for the obvious and being vilified in the process for some time before the obvious came to pass. His specific prognostications are interesting, but not much more.
Roubini is right about most things – but WRONG about suspending foreclosures. This will be a big disincentive to all the struggling homeowners now cutting back on daily spending to cover their monthly mortgage payments. The unintended consequences of this action could be to kill off all non-government backed mortgage lending for years.
A better option would be to forcibly convert distressed mortgages to the Fed funds rate plus say 1% and extend the term of the mortgage to 50, 70 or 100 years to cover the original loan. This will make many distressed mortgages affordable – and provide an incentive to householders to stay in their homes. The alternatives: renting or eviction – will be financially worse options.
Super-long-term mortgages will help put a floor under the housing-market – but only as a temporary measure. When normal conditions resume these should fall out of favour with market pressures or regulation (to avoid this being a contributing factor to the next housing boom).
For a Palin-esque and Panglossian antidote to Roubini, one of the University of Chicago acolytes offers this in today’s NY Times:
http://www.nytimes.com/2008/10/10/opinion/10mulligan.html
Hedge Funds! Compared to minor problems of Fanny Mae that’s what’s concerning me.
Help! Why have we’ve been hearing that the assessed values in ‘Hedge Funds’ are at the 500 Trillion level? I am trying to grasp that number and wikipediaed it and then get the BIS banking system instead then realize that all of the values of Everything couldn’t come close to that 500 Trillion level.
So thus, it’s the Mother and Father of all Bubbles.
Obviously since the Electric Koolaid writer announces on NPR that the end of Sept maybe is the doom’s day (not in those words….), one wonders about the chill in Greenwich, Conn (maybe minus a n)…and we have until next year to assess that hell that we’ve entered due to the redemption period of three monthes. Does anyone think there hasn’t been a huge calling of the chips in the biggest of all casinos? Does anyone think there is money to cover those ‘chips’?
Tell me again where those 500 Trillions are, someone?
Alan van Altendorf:
We Houstonians, earth men, must stick together. I agree with you. It’s more than time to let the finance sector collapse. When Wall Street has a 60% unemployment rate, like we had in the oil patch in 1986-87, we’ll know the “crisis” is about to end. Roubini is all wet here. Let his students at NYU’s Stern get real jobs. In mining, manufacturing, the oil patch, agriculture, etc. Wait, the time may come we will see thousands of people protest the bailout in front of the Treasury building as recently happened in Taiwan. Whaaat? There was a protest in Taiwan over Lehman Brothers having sold fraudulent securities there. Or so the Taiwanese say. Our crisis is becoming a foreign policy disaster too! Talk about “Ugly Americans”!
@ Independent Accountant … The decision by the majors to defend their stock prices by laying off so many people in the 80s and hiring no one in the 90s is still causing problems in the oil patch today, lest you forget.
There’s a reason no one decided to go to school to become an engineer during that time and that, of course, is part of the reason why the cost of new oil is so high just now.
I’m not entirely sure that the oil patch–and, by extension, the world–would welcome a similar tax on the cost of money going forward. But, of course, we do have the mantra of maximizing returns to shareholders without regard to anything else to blame for the situation in both.
The odd schadenfreude of people who are apparently so independently wealthy that they frankly don’t give a damn about the rest of the people of the world aside, is this language from Roubini useful or even actionable?
– Politically what he calls for is almost certainly impossible.
– Economically my limited sense is that certain of his provisions, like suspending all foreclosures, will worsen the situation.
If not, why distribute it further?
Why would there be redemptions at hedge funds? Don’t most of their investor contracts stipulate that the investor would have to wait X days from the request for redemption until the investor’s investment (minus losses) is paid back?
Roubini is an unusually astute mainstream economist in that he holds an essentially Austrian view of capital and correctly identifies causes with an almost Misesian historical perspective.
However, his policy recommendations are a polar opposite to the Austrian School; he still retains an innately Keynesian faith in governments’ abilities to solve the messes they’ve created, despite rather stark prior evidence to the contrary.
HP
Isn’t it time to revert back to some form of gold standard even though it is far from being perfect?