Nouriel Roubini Warns of Another Broker-Dealer Run

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.

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  1. Kevin

    For those who were wondering, as I was, about Roubini’s reference to “in March we were an epsilon away from such meltdown”:

    The strain (deformation as a fraction of total sample length) at which the sample fails or breaks.

    Hacker Slang: epsilon
    [see delta]

    1. n. A small quantity of anything. “The cost is epsilon.”

    2. adj. Very small, negligible; less than marginal. “We can get this feature for epsilon cost.”

    3. within epsilon of: close enough to be indistinguishable for all practical purposes, even closer than being within delta of. “That’s not what I asked for, but it’s within epsilon of what I wanted.”

    Alternatively, it may mean not close enough, but very little is required to get it there: “My program is within epsilon of working.”

  2. Independent Accountant

    My spin is that this is an advocacy piece. Roubini is a smart guy. I’ve read him for over a year. What he is doing here is signalling the Fed he wants more forceful action to protect the banks and brokers. Larry Summers is another smart guy who writes advocacy pieces from time-to-time.

  3. a

    Sure, there are a lot of insolvent banks out there, being held up by the Fed’s life support. The Fed’s strategy is to hold them up long enough until they get recapitalized and/or earn profits by lending long and borrowing short from the Fed. I’d agree that this strategy is not sure to work, indeed is more likely than not to misfire, as banks begin to collapse too soon. But heck, stranger things have happened.

  4. sinic

    I agree with Independent Accountant above. Roubini has been delivering these doom and gloom pieces regularly, I believe, with the goal of encouraging a response by the Fed and Treasury to prevent the scenarios that he’s outlining.

  5. Bob_in_MA

    If another broker-dealer, or large bank, does get in trouble, it’s hard to see another JPMorgan (or BoA in the case of Countrywide) rushing in to pick up the pieces. Who’s left to do it? Maybe a Chinese bank? ;-)

  6. Anonymous

    With the Supreme Court ruling, you could say the government is staring down the barrel (so to speak). Not much else can be done but injections of capital, another rate cute, rollover windows loans into the next millennium and let populace eat cake.

  7. Anonymous

    Not sure what the point of previous comments to the effect that Roubini’s doomsday forecasts are designed to encourge action that would prevent the doomsday result.

    Are you saying that Roubini doesn’t believe the doomsday forecasts but wants to encourage Fed bailout actions anyway?

    Or that he does believe his doomsday forecasts but shouldn’t tell anyone because he might influence others to take action to prevent the doomsday event?

  8. sinic

    anonymous, Roubini sees a train wreck coming and is warning people about it. He can “see” into the future better than some of his colleagues. He publishes what he comes up with using his analytic skills; if the powers that be heed his warnings and take timely action, who knows, the wreck might be averted.

  9. Anonymous

    fine, the likelihood of a big instituion going under is not zero – so what? that doesn’t mean the system is about to collapse there is too much speculation in this piece

  10. Anonymous

    You think Roubini is saying all this to get the fed to act??? You totally missed the point! He’s saying the fed CAUSED this in the first place with easy money policies. You can not “fix” this. Roubini in no way tried to offer suggestions for a way to avoid the turbulence other than to strap in.

    When are you folks going to wake up from LA LA pollyanna land?

  11. cent21

    I suspect Roubini isn’t a whole lot smarter than many other people but had the conviction to go with a scenario that was pretty far from the main-stream starting a few years ago. But now he’s riding his success.

    I can certainly see the possibility that much worse things are to come, but unlike a few years ago, when I thought a bubble was building because of federal policy, at this point, the bubble is well enough burst that it is no longer a primary concern; I have some concern about the huge volumes of countering financial flows and their secondary effects; and I’d just as soon see some stability emerge, hopefully with current equity prices for homes and stocks more or less supported by current employment levels and wages.

    Though I’m far from the front lines I have a suspicion that the central players are risking going too far rather than not far enough, in introducing large new policies. On the one hand, I think some flexibility has to be kept in reserve; and on the other, I think the private sector really has to find its own equilibrium somewhere, and the public sector has to get feedback from the current policies and fine tune them and do whatever it can to take a few steps back from the fire pit wherever possible. People aren’t going to be confident in the future until they have some sene that the present is stabilized. And I don’t want to be in an uber-centralized world, I’m I guess what you’d call a “mixed economy” guy, of the 1960s variety, not a fascist or a crony capitalist.

    Though I must say, it certainly seems that the markets have been pretty far from straight and true the past bunch of years. My goodness, gasoline down to $2.31 this week. I think we’d have all been better off if it had just stuck a shade under $3 on the upside and the downside rather than whipping its way up to a froth and now falling like a dead cat waiting to bounce.

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