On the Risk of "Genearalized Meltdown of the Financial System"

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.

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  1. Anonymous

    Difficult to read so much rhetoric on the world economies and so much fainted naivety or real ignorance when we start with debt and indebt ness few figures may provide the required sobering view
    In 1954 the ratio of US total credit debt to GDP is 128.5 Pct in 2006 at 330 Pct without going further the problem is solvency and not credit.
    Leverages and debts are no longer a business model as capital gains are no longer rewarding, Goldman Sacks does not seem to realise it unable to liquify its assets at levels 2 3, pushing loans and credits are merely trying to reintroduce a losing business pattern (The Minsky cycle is merely a recognition through credit that the Tobin Q is prevalent).
    Sorry yes this crisis yet to come has been provoked by the Central banks and the Banks and none have many resources to remedy (The Central Banks are behind the inflation head lines and the Banks are behind their losses)
    The interest rate plea is quiet puerile.

  2. Anonymous

    Dear anon above.

    I’ll be more inclined to read your prattlings when:

    1. You learn the difference between “quiet” and “quite”

    2. You learn to spell “feigned” correctly.

    3. You stop “sack”ing Goldman.

    4. Learn that commas and periods are different punctuation marks.

    And DO occasionally try to assemble a sentence with all its body parts intact.

    When you have accomplished these relatively modest tasks we’ll go into more substantive issues such as the quality of your thinking.

  3. Anonymous

    May I apologise for my poor locution in English as it was at school my fourth language after German and Russian and of course my native French .
    I understand that style is of essence and that substance may be addressed after, I looked forward to read your thoughts should you have any.

  4. Anonymous

    As regards staffing up to service loans — the people who are doing that now will need jobs somewhere. I see third party servicing companies arising that will contract with banks to take over the function now and contract with investment banks to do so when Wall street moves back into the securitization business.

  5. minka

    Anon of November 17, 2007 8:23 AM I appreciate your comment, and please disregard the repressed English teacher who, as we say here, ‘dissed’ you.

    Yves thanks for your discussion of the latest Roubini. I have been trying since the start to get a layman’s feel of the dimensions of this crisis and I haven’t yet. I read Roubini and felt disturbed. I hope more folks comment on his take so I can better evaluate it.

  6. Anonymous

    Good point on outsourcing of processes to the dealers. Same phenomenon is going on in reverse.

    Banks who until August were able to originate-to-sell now have to portfolio a lot of product, and do not have the processes in place yet to make timely writedowns, to monitor & to mitigate.

  7. Anonymous

    Seems to me that the textile industry took it on the chin without trying to drag everyone else into their vortex and with more excuses for poor performance than this lot.

    Why does the financial industry not simply eat their losses, cut expenses and shut up! Just like they tell everyone and everyone else has to do when they run themselves into trouble. How much is 500bn over a couple of years against their pretax and salaries and other bills anyway? Don’t these guys save?

    Masters of the Universe one quarter… tin cup the next.

    I say welcome back to the earth.

  8. Independent Accountant

    Banks like Citibank issue “money”. hence are of interest to the Fed, unlike textile companies. I agree, we will not get bank runs by retail depositors, instead we will get a continuing dollar run.

  9. Anonymous


    1) There were several bank runs in the 1980s, all involving, IIRC, state chartered (& insured) institutions in Maryland, Texas and Ohio.

    2) shotgun marriages, not gunshot marriages (though the latter is an interesting idea – probably an accurate description of many, if we take gunshot metaphorically!)

  10. Anonymous

    The point is they can continue issuing “money”, just not as much as they have been to existing shareholders and employees (and accountants?) without getting it from the Fed, read..(non- shareholders/employees and accountants).

    The special-whinging is also quite unbecoming.

  11. pjfny

    Here is one more disturbing fact:

    The CDS (credit default swap market), a multi trillion dollar mkt, which many many financial services companies are relying on to hedge their credit risk…..only works if the credit default seller can perform!!!! That’s systemic risk if there ever was one!

  12. Michael

    Yves, I think you underestimated the potential for panic and bank runs. In the post-911 and post-Katrina world, the trust in government has deteriorated. We have already had a preview in Countrywide and Northern Rock in terms of bank runs. Just wait when people start losing jobs. Ask yourself this question: would YOU saunter down to your local bank and withdraw some cash if you just lost your job and the local newspaper screams xxx Bank is teetering, all the while the Roubini’s doom and gloom are openly trumpeted, not only on CNBC, but also on Oprah?

  13. Yves Smith


    We may unfortunately have the opportunity to see soon enough. However, the news was pretty bad in 1988 and 1989, particularly if you were in Texas, where it seemed as if virtually every other bank was in trouble, yet there were very very few (I earlier said no, but a reader corrected me) bank runs.

    I actually think people are more trusting in the government than before, perversely. While they may tell pollsters they hate Washington, their actions say otherwise. Why is there so much complacency about torture, unauthorized wiretaps, police brutality (aka use of Tasers) and invasion of privacy? If we were as concerned as we ought to be, there would be mass protests. Instead, most members of the electorate prefer safety to political liberties, and they look to the government to provide safety.

    And you saw all those creepy photo ops during the southern California fires of people in that football stadium (I only saw one clip, and don’t recall the name of the facility, but it looked like a total PR plant) showing lots of smiling people saying how well they were taken care of.

    People are also more interested in finance and a bit better informed than they were a 20 years ago due to the rise of 401 (k)s, a larger proportion of the population owning stocks, and financial TV. Even in the S&L crisis, most people apparently understood that bank deposits are insured up to a certain level, and I can’t believe proportionately fewer know now than then.

  14. Perceptions

    Population Growth & Aging –
    This current crisis is not just the usual end of another business cycle.
    Demographic levels are now being re-shaped Globally, as nearly two Billion Baby Boomers have commenced a 20 year transition from being big spenders, to big Retirement savers, to thrifty Retirees, before leaving us forever, in increasing numbers.
    This will completely change the dynamics of the world economy, as the generations following behind the Baby Boomers, are substantially less in numbers and wealth.
    The costs of an aging population divide, between Boomers and the following X & Y generations are also becoming evident, as real estate values start to fall, in the US & elsewhere.
    Whilst sub-prime has its own distinct origins, it has highlighted falling Real Estate values and New Housing starts, which have separate Demographic origins, pre-dating the sub-prime debacle.
    The sub-prime issue, still has at least 18 months to run and many skeletons are yet to be let out of their darkened closets.
    However, the Real Estate and New Housing markets will not subsequently recover. As the Boomers shift, into Retirement and then leave us altogether, a great vacuum is being created and it will not be filled by the following smaller natural generations, nor by less wealthy immigrants.
    As if that were not enough, this aging process will also produce vast increases in the medical costs associated with an aging population, it will also vastly increase taxes on those in following generations and you can guess what happens to government Budget deficits.

    The scene has been set and I think it is very likely that decisions have been made.
    We are 10 minutes into the first quarter, of the highest stakes game, ever played!
    I recommend that information not be taken at face value. Do our own research, but without pre-conceived ideas, see where it leads you and come to our own conclusions.
    That said, all information needs to be read in context with the providers self interest, a great deal of information is tainted by the “smoke & mirrors” effect.

    We are now, at the top of a once in history Population Growth Mega Cycle and some have caught a glimpse of the downside.

    In contemplating the future, there are three absolute basics going forward –
    1. Population/Growth/Aging.
    2. Population/Climate
    3. Population/Peak Oil.

    Unfortunately, when the herd turns, Scary will not be the right word.
    Good luck and watch the debt!

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