jueves, 9 de octubre de 2008

Nouriel Roubini: 12 pasos para el desastre financiero (escrito en febrero, 2008)

Nouriel Roubini es Profesor of Economía en Stern School of Business, NYU además de Chairman de RGE Monitor. Acaba de escribir un artículo en su blog http://www.rgemonitor.com/blog/roubini, haciendo referencia a un artículo previo del mes de febrero 2008 (The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial Disaster)
en donde más menos describió con cierta precisión lo que estaba por ocurrir. Tiene sus méritos, aunque febrero 2008 no está tan lejos de ahora. Aquí está el artículo, y también el email del profesor Roubini por si quieren contactarlo directamente:


Nouriel Roubini | Oct 8, 2008

Last February – well before the collapse of Bear Stearns - I wrote a paper "The Risk of a Systemic Financial Meltdown: The 12 Steps to Financial Disaster" where I outlined how the U.S financial crisis would become more severe and virulent and eventually lead to a systemic financial meltdown and a severe recession.

It is now worthwhile revisiting these 12 steps of the financial meltdown as the events of the last few weeks and months have confirmed – literally step by step - the 12 steps that I then argued would lead us to the current economic and financial near-meltdown. I thus provide below a summary version of this paper where each of the 12 steps of this financial meltdown is reported in summary as written in the original paper.

Steps 9 through 12 are presented in their full – not summary – original version as they are the crucial final steps of this financial disaster scenario and they closely match the rapid escalation of the severe strains experienced by financial markets in the last two months. You can compare for yourself how the 12 steps outlined in that February paper match with the actual evolution of financial markets and the real economy in the eight months since that paper was written.

After reviewing my 12 steps scenario I will present below some policy recommendation that are urgently necessary now to prevent this systemic meltdown from occurring.

Here is first the February paper in a summary – but literal – version of the original (bold added):

Here are the twelve steps or stages of a scenario of systemic financial meltdown associated with this severe economic recession…

First, this is the worst housing recession in US history and there is no sign it will bottom out any time soon…

Second, losses for the financial system from the subprime disaster are now estimated to be as high as $250 to $300 billion. But the financial losses will not be only in subprime mortgages and the related RMBS and CDOs. They are now spreading to near prime and prime mortgages as the same reckless lending practices in subprime …were occurring across the entire spectrum of mortgages;…Also add to the woes and losses of the financial institutions the meltdown of hundreds of billions of off balance SIVs and conduits;..And because of securitization the securitized toxic waste has been spread from banks to capital markets and their investors in the US and abroad, thus increasing – rather than reducing systemic risk – and making the credit crunch global.

Third, the recession will lead – as it is already doing – to a sharp increase in defaults on other forms of unsecured consumer debt: credit cards, auto loans, student loans…

Fourth, while there is serious uncertainty about the losses that monolines will undertake on their insurance of RMBS, CDO and other toxic ABS products, it is now clear that such losses are much higher than the $10-15 billion rescue package that regulators are trying to patch up. Some monolines are actually borderline insolvent and none of them deserves at this point a AAA rating regardless of how much realistic recapitalization is provided…The downgrade of the monolines will also lead to large losses – and potential runs – on the money market funds that invested in some of these toxic products. The money market funds that are backed by banks or that bought liquidity protection from banks against the risk of a fall in the NAV may avoid a run but such a rescue will exacerbate the capital and liquidity problems of their underwriters…

Fifth, the commercial real estate loan market will soon enter into a meltdown similar to the subprime one…And new origination of commercial real estate mortgages is already semi-frozen today; the commercial real estate mortgage market is already seizing up today.

Sixth, it is possible that some large regional or even national bank that is very exposed to mortgages, residential and commercial, will go bankrupt. Thus some big banks may join the 200 plus subprime lenders that have gone bankrupt. This, like in the case of Northern Rock, will lead to depositors' panic and concerns about deposit insurance. The Fed will have to reaffirm the implicit doctrine that some banks are too big to be allowed to fail. But these bank bankruptcies will lead to severe fiscal losses of bank bailout and effective nationalization of the affected institutions…

Seventh, the banks losses on their portfolio of leveraged loans are already large and growing. The ability of financial institutions to syndicate and securitize their leveraged loans – a good chunk of which were issued to finance very risky and reckless LBOs – is now at serious risk. And hundreds of billions of dollars of leveraged loans are now stuck on the balance sheet of financial institutions at values well below par (currently about 90 cents on the dollar but soon much lower). Add to this that many reckless LBOs (as senseless LBOs with debt to earnings ratio of seven or eight had become the norm during the go-go days of the credit bubble) have now been postponed, restructured or cancelled. And add to this problem the fact that some actual large LBOs will end up into bankruptcy as some of these corporations taken private are effectively bankrupt in a recession and given the repricing of risk; convenant-lite and PIK toggles may only postpone – not avoid – such bankruptcies and make them uglier when they do eventually occur…

Eighth, once a severe recession is underway a massive wave of corporate defaults will take place. In a typical year US corporate default rates are about 3.8% (average for 1971-2007); in 2006 and 2007 this figure was a puny 0.6%. And in a typical US recession such default rates surge above 10%....Corporate default rates will surge during the 2008 recession and peak well above 10% based on recent studies. And once defaults are higher and credit spreads higher massive losses will occur among the credit default swaps (CDS) that provided protection against corporate defaults. ..If losses are large some of the counterparties who sold protection – possibly large institutions such as monolines, some hedge funds or a large broker dealer – may go bankrupt leading to even greater systemic risk as those who bought protection may face counterparties who cannot pay.

Ninth, the "shadow banking system" (as defined by the PIMCO folks) or more precisely the "shadow financial system" (as it is composed by non-bank financial institutions) will soon get into serious trouble. This shadow financial system is composed of financial institutions that – like banks – borrow short and in liquid forms and lend or invest long in more illiquid assets
. This system includes: SIVs, conduits, money market funds, monolines, investment banks, hedge funds and other non-bank financial institutions. All these institutions are subject to market risk, credit risk (given their risky investments) and especially liquidity/rollover risk as their short term liquid liabilities can be rolled off easily while their assets are more long term and illiquid. Unlike banks these non-bank financial institutions don't have direct or indirect access to the central bank's lender of last resort support as they are not depository institutions. Thus, in the case of financial distress and/or illiquidity they may go bankrupt because of both insolvency and/or lack of liquidity and inability to roll over or refinance their short term liabilities. Deepening problems in the economy and in the financial markets and poor risk managements will lead some of these institutions to go belly up: a few large hedge funds, a few money market funds, the entire SIV system and, possibly, one or two large and systemically important broker dealers. Dealing with the distress of this shadow financial system will be very problematic as this system – stressed by credit and liquidity problems - cannot be directly rescued by the central banks in the way that banks can.

Tenth, stock markets in the US and abroad will start pricing a severe US recession – rather than a mild recession – and a sharp global economic slowdown. The fall in stock markets… will resume as investors will soon realize that the economic downturn is more severe, that the monolines will not be rescued, that financial losses will mount, and that earnings will sharply drop in a recession not just among financial firms but also non financial ones. A few long equity hedge funds will go belly up in 2008 after the massive losses of many hedge funds in August, November and, again, January 2008. Large margin calls will be triggered for long equity investors and another round of massive equity shorting will take place. Long covering and margin calls will lead to a cascading fall in equity markets in the US and a transmission to global equity markets. US and global equity markets will enter into a persistent bear market as in a typical US recession the S&P500 falls by about 28%.

Eleventh, the worsening credit crunch that is affecting most credit markets and credit derivative markets will lead to a dry-up of liquidity in a variety of financial markets, including otherwise very liquid derivatives markets. Another round of credit crunch in interbank markets will ensue triggered by counterparty risk, lack of trust, liquidity premia and credit risk. A variety of interbank rates – TED spreads, BOR-OIS spreads, BOT – Tbill spreads, interbank-policy rate spreads, swap spreads, VIX and other gauges of investors' risk aversion – will massively widen again. Even the easing of the liquidity crunch after massive central banks' actions in December and January will reverse as credit concerns keep interbank spread wide in spite of further injections of liquidity by central banks.

Twelfth, a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices will ensue leading to a cascading and mounting cycle of losses and further credit contraction. In illiquid market actual market prices are now even lower than the lower fundamental value that they now have given the credit problems in the economy. Market prices include a large illiquidity discount on top of the discount due to the credit and fundamental problems of the underlying assets that are backing the distressed financial assets. Capital losses will lead to margin calls and further reduction of risk taking by a variety of financial institutions that are now forced to mark to market their positions. Such a forced fire sale of assets in illiquid markets will lead to further losses that will further contract credit and trigger further margin calls and disintermediation of credit. The triggering event for the next round of this cascade is the downgrade of the monolines and the ensuing sharp drop in equity markets; both will trigger margin calls and further credit disintermediation.

Based on estimates by Goldman Sachs $200 billion of losses in the financial system lead to a contraction of credit of $2 trillion given that institutions hold about $10 of assets per dollar of capital. The recapitalization of banks sovereign wealth funds – about $80 billion so far – will be unable to stop this credit disintermediation – (the move from off balance sheet to on balance sheet and moves of assets and liabilities from the shadow banking system to the formal banking system) and the ensuing contraction in credit as the mounting losses will dominate by a large margin any bank recapitalization from SWFs. A contagious and cascading spiral of credit disintermediation, credit contraction, sharp fall in asset prices and sharp widening in credit spreads will then be transmitted to most parts of the financial system. This massive credit crunch will make the economic contraction more severe and lead to further financial losses. Total losses in the financial system will add up to more than $1 trillion and the economic recession will become deeper, more protracted and severe.

A near global economic recession will ensue as the financial and credit losses and the credit crunch spread around the world. Panic, fire sales, cascading fall in asset prices will exacerbate the financial and real economic distress as a number of large and systemically important financial institutions go bankrupt. A 1987 style stock market crash could occur leading to further panic and severe financial and economic distress. Monetary and fiscal easing will not be able to prevent a systemic financial meltdown as credit and insolvency problems trump illiquidity problems. The lack of trust in counterparties – driven by the opacity and lack of transparency in financial markets, and uncertainty about the size of the losses and who is holding the toxic waste securities – will add to the impotence of monetary policy and lead to massive hoarding of liquidity that will exacerbates the liquidity and credit crunch.

In this meltdown scenario US and global financial markets will experience their most severe crisis in the last quarter of a century.

Can the Fed and other financial officials avoid this nightmare scenario that keeps them awake at night? The answer to this question – to be detailed in a follow-up article – is twofold: first, it is not easy to manage and control such a contagious financial crisis that is more severe and dangerous than any faced by the US in a quarter of a century; second, the extent and severity of this financial crisis will depend on whether the policy response – monetary, fiscal, regulatory, financial and otherwise – is coherent, timely and credible. I will argue – in my next article - that one should be pessimistic about the ability of policy and financial authorities to manage and contain a crisis of this magnitude; thus, one should be prepared for the worst, i.e. a systemic financial crisis.

This is what I wrote in February and indeed, step by step, we have gotten very close now to this systemic financial meltdown, first in the US and now also in Europe. Last week I suggested, among many other policy options, the need for a coordinated monetary policy rate cut. That cut arrived this morning with Fed, ECB and other central banks cutting their policy rates by 50bps. This action is necessary but only cosmetic and it is too little too late. European central banks should have cut rates – as I suggested – many months ago before the recession and financial crisis became so virulent; and now 50bps for the Eurozone is peanuts at the time when a minimum of 150bps is necessary to restart the economy and unclog frozen financial markets. 50bps is also too little in the US given the damage to the real economy of the financial shocks of the last month; during the last recession the Fed cut the Fed Funds down to 1%; we are still 50bps away from that level. But at the end of this cycle – as I argued before – the Fed Funds will be closer to 0% than to 1%.

Policy rate cuts will have limited effects as they don't resolve the fundamental problem in markets that is keeping money market spreads relative to safe rates so high, i.e massive counterparty risk. To resolve that triage of insolvent banks and recapitalization of solvent banks, together with massive injections of liquidity in non banks and the corporate sector are necessary; yesterday plan to support the commercial paper market – something I recommended last week - is a step in the right direction.

Other more radical additional policy actions are also needed now; here are four suggestions for such additional policy action:

- To reduce the counterparty risk in the money markets a triage between insolvent banks that need to be shut down and a recapitalization of solvent banks is necessary together with massive injections of liquidity in non-banks and the corporate sector. Yesterday's plan to support the commercial paper market – something I recommended last week - is a step in the right direction. Direct lending by the government to small businesses – via the Small Business Administration – is also necessary to avoid the implosion of smaller businesses.

- a generalized temporary blanket guarantee of all deposits is now necessary both in the US and in Europe followed by a triage between insolvent banks to be closed rapidly and illiquid but solvent banks that deserve to be rescued to avoid the moral hazard of such blanket guarantee;

- the flawed $700 bn TARP legislation will have to be modified in three ways to: a) allow for direct government injection of public capital in banks in the form of preferred shared matched by private capital contributions by current shareholders (via suspension of all dividend payments and matching Tier 1 capital provided by private shareholders); b) implement a clear plan to reduce the face value of mortgages for distressed home owners and avoid a tsunami of foreclosures; c) do a rapid and radical triage between solvent banks and insolvent banks that need to be rapidly closed.

- given the collapse of private aggregate demand (consumption is falling, residential investment is falling, non-residential investment in structures is falling, capex spending by the corporate sector was falling already before the latest financial and confidence shock and will now be plunging at an even faster rate) you need to give a boost to aggregate demand to ensure that an unavoidable two-year recession does not become a decade long stagnation. Since the private sector is not spending and since the first fiscal stimulus plan (tax rebates for households and tax incentives to firms) miserably failed as households and firms are saving rather than spending and investing it is necessary now to boost directly public consumption of goods and services via a massive spending program (a $300 bn fiscal stimulus): the federal government should have a plan to immediately spend in infrastructures and in new green technologies; also unemployment benefits should be sharply increased together with a targeted tax rebates only for lower income households at risk; and federal block grants should be given to state and local government to boost their infrastructure spending (roads, sewer systems, etc.). If the private sector does not spend and/or cannot spend old fashioned traditional Keynesian spending by the government is necessary. It is true that we are already having large and growing budget deficits; but $300 bn of public works is more effective and productive than spending $700 bn to buy toxic assets.

So we are now very close to the systemic financial meltdown that I outlined in my February paper. But radical action can be taken and should be taken to control the damage and prevent this meltdown from occurring. At this point the US, the advanced economies (and now most likely even some emerging market economies) will experience an ugly recession and an ugly financial and banking crisis regardless of what we do from now on. We are already now in a global recession that is getting worse by the day. What radical policy action can only do is preventing what will now be an ugly and nasty two-year recession and financial crisis from turning into a systemic meltdown and a decade long economic depression. The financial and economic conditions are extreme; thus extreme policy action is needed now to save the global economy from an ugly depression.