Nourel Roubine Thinks This Downturn is More than Temporary
Lisa Lisa
beginning of a systemic risk episode?
Nouriel Roubini | Aug 02, 2007 Any time there is an episode of turmoil
in US and global financial markets the question in the mind of
investors is whether this is a period of temporary turmoil or the
beginning of a more severe and protracted period of financial market
volatility and downturn that could end up into a systemic risk
episode.
In the last decade only the LTCM episode in 1998 at the peak of the
Asian and emerging markets financial crisis and the bust of the tech
bubble in 2000-2001 - that triggered the US recession of 2001 - had
systemic implications. Since then we have experienced a variety of
other episodes of financial turmoil that have ended up being only
temporary shocks. In these episodes of temporary turmoil investors
risk aversion sharply rose for a while, volatility indices and gouges
of investors risk aversion (such as the Vix, the 10 year swap spread
and credit spread) sharply increased; and the financial pressures
spilled over from credit/debt markets to equity markets. But in each
of the most recent episodes the turmoil was transitory (a few weeks
or, at most, a couple of months); once the transitory sources of the
financial disturbances disappeared, calm returned to markets and
investors risk aversion returned to lower levels.
One of such episode of temporary turmoil followed 9/11 in 2001 and the
collapse of Enron in late 2001. Another episode of transitory turmoil
occurred in early 2003 before the US invasion of Iraq when market
started to worry about the risks and consequences of the war on the
economy. A more recent episode was the one that - in the spring of
2005 - followed the downgrade of GM and Ford by credit rating
agencies; that downgrade caused serious but temporary pressures in the
credit derivatives markets and in equity markets. Another episode
occurred in the spring of 2006 when a sudden "inflation scare" in the
US (worries that inflation was rising and that, therefore, the Fed was
not done yet with rising the Fed Funds rate) led to a sharp downturn
in US and global equity markets and serious pressures on some emerging
markets currencies, equity markets and bond markets. And the final
episode - before the most recent turmoil this summer - was in late
February 2007 when the combination of a mini-crash in the Chinese
stock market, rising worries about the fallout of the subprime crisis
and a US "growth scare" affected mostly equity markets in the US.
Since most previous episodes of financial turmoil since 2001 have been
temporary, the optimistic and consensus view in the markets is that
the current financial turmoil will be again transitory and that risky
assets - starting with equities - will recover their upward price path
once investors' nervousness abates. That is certainly possible as
previous episodes of turmoil since 2001 were mostly contained. But I
will flesh out a number of reasons why the current episode of market
turmoil may be more serious and protracted than previous ones and why
we should worry now about systemic risk.
First, most of previous transitory episodes occurred at the time when
US and other G7 monetary policy conditions were much looser than
today. Starting in January 2001 the Fed aggressively cut the Fed Funds
rate that fell from 6.5% to a bottom of 1% by 2004. Next, the
normalization of US monetary policy brought back the Fed Funds rate to
5.25%; while at the same time monetary policy has been tightened in
all G7 countries and several other emerging markets. And with
inflationary pressures being still on the upper limits of many central
banks' comfort zone further tightening is expected (say in the
Eurozone, UK, China and many other economies). Thus, in past episodes,
easy monetary conditions helped; today instead policy is tighter and
on the way to further tightening.
Second, following the brief US recession between March and November
2001, economic growth - first in the US, then in other G7 economies
and emerging markets - recovered rapidly and has remained high for a
number of years. But starting with the fall of 2006 the US has
experienced a serious economic growth deceleration that may turn out
into a hard landing (either a growth recession or an outright
recession). The rest of the world is growing robustly but the clouds
over US economic growth are rising. In previous episodes - like the
spring of 2006 or early 2007 - we had an inflation "scare" or a
"growth" scare and markets reacted sharply downward. Now, if instead
of having a growth "scare" the US were to experience an actual sharp
growth hard landing (say a growth recession) the financial
consequences would be serious as hosuing, capex spending and private
consumption would sharply slow down.
Third, between 2001 and 2006 the debt, credit and financial excesses
of important sectors of the economy were contained; today they are
not. At the time of the 2001 recession the balance sheets of the
corporate sector were weak but those of the household were relatively
sound. Today, instead, after six years of excessive borrowing and two
years of negative savings the balance sheets of the household sector
are weak and fragile. At the same time the process of releveraging of
the financial and corporate system (hedge funds, private equity, prop
desks, LBO and share buyback activity) has led to significant increase
in the amount of debt and leverage in the private sector. As suggested
by Ed Altman - the leading academic expert of corporate distress -
corporate defaults have been kept at a much lower levels (0.6%) than
justified by current corporate financial fundamentals (2.5%) only
because of the slosh of liquidity that allowed potentially distressed
corporations to refinance their debts or do out-of-court restructuring
plans. In the last few years a credit boom - if not a bubble -
stimulated asset prices in a typical Minsky-style credit-driven asset
bubble. The easy monetary conditions after 2001 and the continued wall
of liquidity coming from highly saving and forex-accumulating emerging
markets fed a US and partly global asset bubble and a credit/debt
bubble. Thus, the excessive leveraging of households, some parts of
the corporate sector and many financial investors is a new source of
financial fragility and systemic risk.
Fourth, the housing bubble has already popped in the US and is at risk
of popping in other bubbly housing markets (UK, Spain, Ireland,
Australia, New Zealand, and Iceland to name a few cases). The fallout
of the US housing recession has been twofold. First, spillover to
other sectors of the economy (auto recession, weakness in durable
goods and housing related sectors, weak capex investment of the
corporate sectors, slowdown of private consumption among overstretched
US households). Second, spillover to other financial markets as: a)
this is not just a subprime problem but increasing a near prime and
prime mortgage problem; b) there is now a liquidity and credit seizure
in a variety of credit markets (LBOs, CDOs, CLOs, etc).
Fifth, we are now reaching a point where the distress of many and
different economic agents may lead to a systemic effect. Some have
argued that the growth of credit derivatives has diffused financial
risks among many different agents and in a variety of countries
reducing systemic risk. That is why - it is argued - the risk of one
huge LTCM blowing up and causing systemic risk are limited. But the
experience with previous episodes of systemic risk (the S&L crisis
where hundreds of smaller financial institutions went belly up causing
a credit crunch and the 1990 recession; the tech bust of 2000-2001
where hundreds of smaller tech and internet companies went belly up
and triggered the 2001 recession) suggest that the LTCM type of
systemic crisis (one large institution getting in trouble and taking
with it most of the financial system) is the exception rather than the
rule: many and different agents and institutions getting in trouble
can lead to systemic effects especially after a period of asset
bubbles driven by a credit/debt bubble.
And today there is a variety of economic and financial agents that are
under financial pressure if not outright distress. Specifically,
hundreds of thousands of subprime and near prime households will
default on their mortgage and their homes will end up in foreclosure;
the ability of the financial and legal system to manage such a surge
in bankruptcies is severely limited. Also, over fifty subprime lenders
have now gone out of business and now some of the larger lenders - see
AHM and Accredited Home Lenders Holdings Co. - are also in trouble
and near bankrupt; the mortgage rot is spreading from subprime to near
prime and Alt-A (see Countrywide, IndyMac, etc.). Now, there are news
of massive losses among major US home builders and rumors that some
may be near bankruptcies. There are already half a dozen mid-sized
hedge funds - between US, Australia and Europe - that have gone belly
up; and every day financial institutions across the world are
reporting large subprime-related losses as a lot of the RMBS and CDO
were bought by foreign investors. And in a world where most investors
in these illiquid instruments (RMBS, CDOs, CLOs, etc.) are marking to
model rather than marking to market the extent of the eventual losses
is unknown and the number of financial institutions that will go belly
up is also unknown and likely to surprise on the upside. Systemic risk
episodes often occur with a death through 1000 cuts rather than one
single major - a' la LTCM - blow.
{ Friday Update:
Vid...@tcq.net
yep, in the interconnect, deregulated, free market, wild west, one
domino can fall, and set off a chain reaction.