February 20, 2008

Tick, Tick, Tick, Tick ...

MARTIN WOLF, A COLUMNIST for the Financial Times, recently devoted space in his column to a rather interesting list. The developer of this list is Prof Nouriel Roubini, of the Stern School of Business at New York University, and its topic is nothing less than what one might call a financial doomsday scenario.

There are many very good reasons why one must take Prof Roubini seriously, but here are two of them. First, he called our present state of affairs way back in 2006. Back then, the people laughed, but they are not laughing now. Second, his list is cold, calculated, and the events described therein are eminently possible. Prof Roubini's list, according to Mr Wolf, is as follows:

Step one is the worst housing recession in US history. House prices will, he says, fall by 20 to 30 per cent from their peak, which would wipe out between $4,000bn and $6,000bn in household wealth. Ten million households will end up with negative equity and so with a huge incentive to put the house keys in the post and depart for greener fields. Many more home-builders will be bankrupted.

Step two would be further losses, beyond the $250bn-$300bn now estimated, for subprime mortgages. About 60 per cent of all mortgage origination between 2005 and 2007 had "reckless or toxic features", argues Prof Roubini. Goldman Sachs estimates mortgage losses at $400bn. But if home prices fell by more than 20 per cent, losses would be bigger. That would further impair the banks' ability to offer credit.

Step three would be big losses on unsecured consumer debt: credit cards, auto loans, student loans and so forth. The "credit crunch" would then spread from mortgages to a wide range of consumer credit.

Step four would be the downgrading of the monoline insurers, which do not deserve the AAA rating on which their business depends. A further $150bn writedown of asset-backed securities would then ensue.

Step five would be the meltdown of the commercial property market, while step six would be bankruptcy of a large regional or national bank.

Step seven would be big losses on reckless leveraged buy-outs. Hundreds of billions of dollars of such loans are now stuck on the balance sheets of financial institutions.

Step eight would be a wave of corporate defaults. On average, US companies are in decent shape, but a "fat tail" of companies has low profitability and heavy debt. Such defaults would spread losses in "credit default swaps", which insure such debt. The losses could be $250bn. Some insurers might go bankrupt.

Step nine would be a meltdown in the "shadow financial system". Dealing with the distress of hedge funds, special investment vehicles and so forth will be made more difficult by the fact that they have no direct access to lending from central banks.

Step 10 would be a further collapse in stock prices. Failures of hedge funds, margin calls and shorting could lead to cascading falls in prices.

Step 11 would be a drying-up of liquidity in a range of financial markets, including interbank and money markets. Behind this would be a jump in concerns about solvency.

Step 12 would be "a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices".

These, then, are 12 steps to meltdown. In all, argues Prof Roubini: "Total losses in the financial system will add up to more than $1,000bn and the economic recession will become deeper more protracted and severe." This, he suggests, is the "nightmare scenario" keeping Ben Bernanke and colleagues at the US Federal Reserve awake. It explains why, having failed to appreciate the dangers for so long, the Fed has lowered rates by 200 basis points this year. This is insurance against a financial meltdown.

Is this kind of scenario at least plausible? It is.

YES, IT IS PLAUSIBLE. At this point, though, I do not think it all that probable -- although that could certainly change if the economic situation turns for the worse. The trouble with economic cycles, of course, is that they have a cascading effect. That's great on the upside, not so great on the downside. Right now, we're pretty clearly on the downside.

After all, just because the numbers look good on paper does not mean we can avoid getting into a pickle. Unemployment now stands at 4.9 pc, real inflation stands over 7 pc, and nationally, home prices are now back to where they were in 2005. (They may be worse in your neighborhood). All in all, that's not too bad, considering where we have been, and those who argue a recession is not in the cards would say there's little to worry about. After all, they say, what's five percent unemployment and seven percent inflation? Do you not remember the late Seventies and early Eighties? How about the early Nineties?

Fair enough. However, such an analysis leaves out one minor point, which is that the late Seventies, early Eighties, and early Nineties sucked like New Coke sucked. You can't compare today's numbers to the bad old days without noting the good old days were better. As I see it, the trouble is that things may -- could -- perhaps -- get worse. Where will we be then, if unemployment jumps to seven or eight percent, and that causes real inflation to spike, and home prices slowly swirl down the drain?

Were that to happen, I think we'd find ourselves somewhere about Step Four on the list. As for the points after it, I'm not entirely sure they're in the proper order, but that's just how I see things. For instance, I see Steps Five and Six as being too early on the list, while Steps Seven, Eight and Nine are a bit too late.

If you look closely into these things, you can already see instances where private-equity investments are failing: they may be isolated at this point, and indicative of poor management rather than an economic disaster, but they are happening. If we work from Prof Roubini's argument that at least some LBOs are on the brink now, it stands to reason that a worsening in economic conditions would cause that to happen sooner, not later. The same goes for Step Eight -- the corporate defaults. And as for Step Nine -- well, it only takes a few bad bets for hedge funds to implode. Already 49 hedge funds have either gone bust or suffered badly, according to no less a source than the Hedge Fund Implode-O-Meter. When you consider that many hedge funds are heavily, heavily leveraged -- it may not take much more to push them over the edge. Nor, as Prof Roubini notes, can these funds turn to the central bankers -- instead, their competitors will carve them up and eat them. One of the reasons why Long-Term Capital Management failed back in the day was because their competition figured out what was happening to LTCM, and turned on the wounded fund like a pack of jackals.

Conversely, though, I don't see Steps Five and Six happening until we see a bit of Steps Seven, Eight and Nine. The commercial real-estate market has already gotten its ass kicked and so I would argue that it would take real trouble, with a Capital T, to make things get markedly worse there. (As I, to my sorrow, know). As for Step Six, I find it hard to believe any large regional or national bank would seriously go under and wipe out their shareholders. Politically, it could not happen; the Government would step in and act.

If we get to Step Ten, though, I'm moving to California. I have some friends there, and they have a lemon tree in their backyard. I could sell the lemons on commission and survive that way.

But let's step back a bit. I don't think we'll get to Step Ten. Nor do I think we'll get to my Step Nine -- the massive bank failure. For that matter, I don't think we'll get too far down the list before the world's major Governments take action. They can, you know. And they will -- if only to save their own necks from angry voters.

Already we have heard rumblings about the so-called "Plunge Protection Team" -- the shadowy Government panel with extraordinary powers to intervene in the markets -- from Ambrose Evans-Pritchard at The Telegraph, and most recently John Crudele at the New York Post. No one knows what this panel can do and how they would do it, but they're definitely out there. Given the press coverage, it seems clear they want it known they're out there, even if at this point, they only want to be remembered in the dim reaches of the back of one's mind. If they do take action, well -- we might not all be reduced to selling apples just yet.

Posted by Benjamin Kepple at February 20, 2008 12:01 AM | TrackBack
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