naked capitalism

Nouriel Roubini, in his latest post, “With the Recession Becoming Inevitable the Consensus Shifts Towards the Hard Landing View. And the Rising Risk of a Systemic Financial Meltdown,” takes his somber views one step further and discusses the possibility of a crisis in some detail. Even by Roubini standards this is grim reading.

I have been worried about the potential for a nasty financial implosion for some time, but have chosen to let my selection of material do the talking. One reason is that I am neither in the markets nor have I delved into the data deeply enough to have enough to warrant taking a public stand. And since fear, whether well founded or not, can turn a problem into a panic, it’s best not to yell “fire” in crowded theaters casually. The other reason is that human society has lurched from crisis to crisis and often manages to save itself from falling into the abyss.

But the situation that have developed in the last few years looks nasty and unprecedented. We’ve had truly awe-inspiring creation of leverage, to the point that virtually no asset class was untouched (Marc Faber remarked, “two asset classes stand out as major losers: the Zimbabwe dollar and the US dollar”).

And the tools that the powers that be have for ameliorating the damage look woefully inadequate. Lowering interest rates has neither revived the commercial paper market, salvaged overextended mortgage borrowers, nor made banks more generous with credit. The ideas for salvaging the housing market (assuming that that is the correct action; I’m not convinced that there aren’t better courses to take) basically amount to having the government assume more risk by having Fannie, Freddie, and the FHA take a bigger role. Yet the federal budget is already is a serious deficit that Congress and presidential candidates want to shrink, or at least not make worse. But no one seems to acknowledge that there are practical limits on what the federal government can do (witness that Fannie Mae, which either acquires or guarantees 20% of the US residential mortgage market, saw its stock price fall 17% last week due to fears of undisclosed credit losses).

Japan at least entered its post-bubble-era hangover with a high savings rate. Lacking that, the US has even fewer options if things turn out badly. Policy makers need to think more in terms of triage than broad-based rescue operations.

Roubini starts with a detailed discussion (including lengthy quotes from various economists) of how the tone of forecasts among Wall Street professionals has taken a decided turn for the negative. That is particularly revealing since their franchise almost demands that they be upbeat. He then gives his latest reading:

So at this point the debate is less and less on whether we are going to have a recession that looks inevitable; but it is rather moving towards a debate on how deep, protracted and severe such a recession will be. But the financial and real risks are much more severe than those of a mild recession.

I now see the risk of a severe and worsening liquidity and credit crunch leading to a generalized meltdown of the financial system of a severity and magnitude like we have never observed before. In this extreme scenario whose likelihood is increasing we could see a generalized run on some banks; and runs on a couple of weaker (non-bank) broker dealers that may go bankrupt with severe and systemic ripple effects on a mass of highly leveraged derivative instruments that will lead to a seizure of the derivatives markets (think of LTCM to the power of three); a collapse of the ABCP market and a disorderly collapse of the SIVs and conduits; massive losses on money market funds with a run on both those sponsored by banks and those not sponsored by banks (with the latter at even more severe risk as the recent effective bailout of the formers’ losses by theirs sponsoring banks is not available to those not being backed by banks); ever growing defaults and losses ($500 billion plus) in subprime, near prime and prime mortgages with severe known-on effect on the RMBS and CDOs market; massive losses in consumer credit (auto loans, credit cards); severe problems and losses in commercial real estate and related CMBS; the drying up of liquidity and credit in a variety of asset backed securities putting the entire model of securitization at risk; runs on hedge funds and other financial institutions that do not have access to the Fed’s lender of last resort support; a sharp increase in corporate defaults and credit spreads; and a massive process of re-intermediation into the banking system of activities that were until now altogether securitized.

When a year ago this author warned of the risk of a systemic banking and financial crisis – a combination of global liquidity and solvency/credit problems – like we had not seen in decades, these views were considered as far fetched. They are not that extreme any more today as Goldman Sachs is writing today on the risk o a contraction of credit of the staggering order of $2 trillion dollars in the next few years causing a severe credit crunch and a serious recession.

I agree with Roubini that there is the very real possibility of a financial horrorshow, However, I differ with him on some of the particulars. We are not going to see bank runs. We didn’t have them in the late 1980s where S&Ls were actually failing and Citi nearly went under. However, we are already seeing institutional money getting very costly for Citi, and their tsuris have only begun. And we are seeing more examples of Citi-type behavior, where banks have what effectively were contingent liabilities (think, for example, of the guarantees and/or cash injections to keep affiliated money market funds from breaking the buck). These funding or liability demands are coming at precisely the time when bank equity is under strain, due to the need to increase loss reserves and writedowns. Look, for example, at asset backed commercial paper. The Financial Times reported today that banks have shown substantial balance sheet growth of late. But it isn’t net new lending; it’s credit commitments or actual drawdown related to ABCP.

I expect Citi to be in serious trouble in 6 to 12 months, and that specter will increase risk premia for many banks, and could push others towards the edge. So I anticipate a lot of near-failures, some gunshot marriages, and possibly even real bank collapses, but the mechanism will not be a run by retail depositors.

But I expect to see more serious damage among the “large complex financial institutions” of which Citi is one. There are 16 behemoths that have been deemed by the Bank of England as especially important to global credit intermediation. One is already in the process of taking a body blow. If we see damage to any others, it will lead to a contraction in the credit markets, both directly (shrinkage of their balance sheets) and indirectly (shrinkage of everyone else’s balance sheets due to new found conservatism and sharply higher borrowing costs). The securitization market, absent government agency paper, is not functioning very well right now. It will really start laboring if conditions on Wall Street continue to deteriorate.

And if securitization looks less attractive because investors are far more stringent (and maybe no longer believe ratings) and Wall Street looks to have lost a couple of cylinders, then the banks need to step into the breech. Ah, but will they? Banks for the most part are no longer in the habit of keeping a lot of their own loans on their balance sheet.

But isn’t trouble on Wall Street a business opportunity for banks? Not really. First, it will come at precisely the time when they aren’t too eager to take on risk. Second, it isn’t simply a matter of taking on more loans. Holding loans, as opposed to securitizing them, requires different processes, and different ongoing requirements (the bank has to perform the operational tasks of billing, collections, monitoring credit quality). It isn’t that they don’t lack those skills, but they’d have to staff up to resume performing functions that were largely outsourced via securitization.

And who is going to take the risk of staffing up when Wall Street will eat your lunch once it recovers in a few years? It’s tantamount to trying to reopen textile mills in the US just because the dollar has fallen. Most people believe that the loss of the textile industry is an irreversible development. Many banks feel that way about securitization, and therefore will be reluctant to make any institutional changes to step into gaps left by investment banks.