Perhaps it’s merely the result of drafting in a bit more haste than usual, but the latest offering by Nouriel Roubini, “The delusional complacency that the “worst is behind us” is rapidly melting away…and the risk of another run against systemically important broker dealers,” is unusually heated in tone, to the point where it distracts from his good observations.
The first part of the post inveighs against the so-called delusion of the last few months that the credit crunch is on the mend. We’ve been firmly in that camp, and true to form in the credit contraction, events have proven Roubini correct. But then he oversells his case with items like this:
In February this forum argued that credit losses would be at least $1 trillion. At that time that figure was derided as excessive but by now the IMF says losses will be $945 billion, Goldman Sachs estimates them at $1.1 trillion, George Magnus of UBS estimates them at $1 trillion and the hedge fund manager John Paulson (who made a fortune last year betting against subprime) is estimating them at $1.3 trilliion. Thus, it is now clear that $1 trillion is not a ceiling but rather a floor estimate for what those financial losses will be.
I may be being a tad pedantic, $1 trillion probably is the floor for the dollar amount of total credit-related losses. But the use of the term “floor estimate” suggests that there is collective agreement on this figure. That’s inconsistent with the discussion that preceded about the Pollyannaish thinking about the health of the debt markets. While analysts and industry participants are coming around to the view that things are worse than they had hoped, optimism dies hard.
Let us turn to the forward-looking sections of Roubini’s latest piece. The most interesting part is where he disputes the notion that the new Fed facilities will prevent another run on a broker-dealer:
The deleveraging process for the financial system has barely started as most of the writedowns have been for subprime mortgages; the writedowns and/or provisioning for the additional losses have barely started. Thus, hundreds of banks in the U.S. are at risk of collapse. The typical small U.S. Bank (with assets less of $4 billion has 67% of its assets related to real estate; for large banks the figure is 48%. Thus, hundreds of small banks will go belly up as the typical local bank financed the housing, the commercial real estate, the retail boom, the office building of communities where housing is now going bust. Even large regional banks massively exposed to real estate in California, Arizona, Nevada, Florida and other states with a housing boom and now bust will go belly up.
And even large banks and broker dealers are now at risk. After the bailout of Bear Stearns’ creditors and the extension of lender of last resort liquidity support, the tail risk of an immediate financial meltdown was reduced … Indeed in March we were an epsilon away from such meltdown as – without the Fed actions – you would have had a run not only on Bear but also on Lehman, JP Morgan, Merrill and most of the shadow banking system. This system of non-banks looked in most ways like banks (borrow short/liquid, leverage a lot and lend longer term and illiquid). So the risk of a bank-like run on non-bank (whose base of uninsured wholesale short term creditors/lenders is much more fickle and run trigger-happy – as the Bear episode showed – than the stable base of insured depositors of banks) became massive. Thus, the Fed made its most radical change of monetary policy since the Great Depression extending both lender of last resort support to non-bank systemically important broker dealers (via the PDCF) and becoming a market maker of last resort to banks and non-banks (via the TAF and the TSLF) to avoid a full scale sudden run on the shadow banking system and a sure meltdown of the financial system.
While the tail risk of such a meltdown has now been reduced the view that systemically important broker dealers – that have now access to the TSLF and the PDCF – now don’t risk a panic-triggered run on their liabilities is false; several of them can still collapse and not be rescued. The reasons are as follows: liquidity support by the Fed is warranted for illiquid but solvent institutions but not for insolvent ones; and the risks that some of the major broker dealers may face is not just of illiquidity but also insolvency (Lehman had as much exposure to toxic MBS, CDOs and other risky assets as Bear did). The Fed already tested the limits of legality (as argued by Volcker) in its bailout of Bear’s creditors.
Suppose that a run – triggered by concerns about illiquidity and solvency – occurs against a major broker dealer (say Lehman) would the Fed come to the rescue again? The answer is not sure: such broker dealer has access to the PDCF but sharply borrowing from this facility would signal that the institution may be bleeding liquidity and be in trouble; thus large access to the Fed facility may cause the run on the liabilities of such financial institutions to accelerate rather than ebb. The reason is as follows: if creditors of the broker dealers knew with certainty that the Fed liquidity tab is open and unlimited the existence of the facility would stop the run. But if there is any meaningful probability that the amount that the Fed would be willing to lend to an institutions using that facility is not unlimited and is not unconditional then use of the facility may accelerate the run – as those first in line would have access to the liquidity provided by the Fed lending to the broker dealer in trouble while those waiting may be stuck once the lending stops. This is akin to a currency crisis in a pegged exchange rate regime triggered by a run on the forex reserves of a central bank. Once the reserves are running down and investors expect that the central bank will run out of reserves the run accelerated and the collapse of the peg occurs faster.
So why the Fed would not provide unconditional and unlimited liquidity to a broker dealer in trouble and thus allow the run to occur? Several reasons: the Bear Stearns actions were borderline illegal; the Fed cannot keep on bailing out any major broker dealer in trouble; the Fed may be running out of Treasuries to swap for illiquid/toxic securities; the Fed is starting to face credit risks from swapping and holding toxic assets (the $29 billion given to Bear, the hundreds of billions swapped via the TAF and TSLF); the authorization for the PDCF expires in the fall; the Fed should not bail out – with risks to its own balance sheet institutions that may be insolvent on top of being illiquid.
Thus, the delusion that TSLF and PDCF implies that the risk of a run against systemically important broker dealers is now close to zero is just a delusion. If a run against Lehman or another broker dealer starts again and this broker dealer borrows $5 billion from the Fed and then $10 billion investors and creditors of this institutions – who need to decide whether to pull out or keep their credit lines – will ask themselves whether the Fed would allow this broker dealer to borrow $10 and then $15 and then $20 and then $25 and then $30 billion and then even more. Unless the Fed credibly commits to unconditional and unlimited lending the use of the facility by a broker dealer in trouble may accelerate rather than stop the run on its short term liabilities. Thus, the argument that – in a world where the Fed has extended its lender of last resort support to non-bank financial institutions – the risk of a run against these institutions is now close to zero is flawed.
Certainly the rising financial tsunami ahead as the economic contraction gets worse, the financial/credit losses mount, the credit and liquidity crunch gets worse will test both the ability and the political willingness of the Fed to further bail out major financial institutions that are in serious trouble. So the worst is well ahead of us – not behind us – for the real economy and financial markets.