Tuesday, July 22, 2008

Thoughts On Roubini's Thesis

Below is Roubini's thesis on the current implosion. My thoughts in PURPLE.
  • This is by far the worst financial crisis since the Great Depression
  • May be pretty bad but not actually the worst. We have to remember that Roubini is speaking mainly from a US perspective. Even so, the 70s oil crunch and hyper inflation was a lot worse for the US. Interest rates went to nearly 20%, can you believe that. Roubini's version of the worst financial crisis basically rests on the huge implosion within the US and the rippling effects through the global economy. I tend to think that its VERY DIFFICULT to have the worst recession since the Great Depression because the US economy and the global economy is so so much bigger now. Yes, things are also quite inter-connected but the sheer size of pockets of world economy would ensure that the whole world would not die if USA really implodes big time. The pockets in global economy being sustainable enough in size (Asia, Australia, parts of Europe, Latam, Middle East) would be able to deflect the imminent weakness from the US. The US economy is very deep, just look at the number of biggest companies in the US, most have strong global operations as well. Despite losing much economic muscle and leadership, USA is still way in front in technology and innovation. The biggest pillar being affected is the financial companies in the US - they used to be global behemoths, now being cut down to size. Bear Stearns, Citigroup, Merrill Lynch, and now even regional banks and government agencies in financial markets. Besides being pummeled in terms of size and market cap, the financial sector is also selling large portions to overseas investors as well, thus reducing "wealth" in the US. More of every dollar earned are going to be going overseas. Its the start of a long diminishing role of American might in finance, but the trends are clear. The willingness of the recycling of petrodollars and SWFs back to help ailing US financial companies is already cushioning some of the ill effects which Roubini's describing.
  • Hundreds of small banks with massive exposure to real estate (the average small bank has 67% of its assets in real estate) will go bust
  • Dozens of large regional/national banks (a’ la IndyMac) are also bankrupt given their extreme exposure to real estate and will also go bust
  • As mentioned above, foreign investors are lining up to buy up and inject capital to own these financial companies, if the Americans do not suddenly turn nationalistic.
  • Some major money center banks are also semi-insolvent and while they are deemed too big to fail their rescue with FDIC money will be extremely costly.
  • In a few years time there will be no major independent broker dealers as their business model (securitization, slice & dice and transfer of toxic credit risk and piling fees upon fees rather than earning income from holding credit risk) is bust and the risk of a bank-like run on their very short term liquid liabilities is a fundamental flaw in their structure (i.e. the four remaining U.S. big brokers dealers will either go bust or will have to be merged with traditional commercial banks). Firms that borrow liquid and short, highly leverage themselves and lend in longer term and illiquid ways (i.e. most of the shadow banking system) cannot survive without formal deposit insurance and formal permanent lender of last resort support from the central bank.
  • The FDIC that has already depleted 10% of its funds in the rescue of IndyMac alone will run out of funds and will have to be recapitalized by Congress as its insurance premia were woefully insufficient to cover the hole from the biggest banking crisis since the Great Depression
  • Fannie and Freddie are insolvent and the Treasury bailout plan (the mother of all moral hazard bailout) is socialism for the rich, the well connected and Wall Street; it is the continuation of a corrupt system where profits are privatized and losses are socialized. Instead of wiping out shareholders of the two GSEs, replacing corrupt and incompetent managers and forcing a haircut on the claims of the creditors/bondholders such a plan bails out shareholders, managers and creditors at a massive cost to U.S. taxpayers.
  • This financial crisis will imply credit losses of at least $1 trillion and more likely $2 trillion.
  • This is not just a subprime mortgage crisis; this is the crisis of an entire subprime financial system: losses are spreading from subprime to near prime and prime mortgages; to commercial real estate; to unsecured consumer credit (credit cards, student loans, auto loans); to leveraged loans that financed reckless debt-laden LBOs; to muni bonds that will go bust as hundred of municipalities will go bust; to industrial and commercial loans; to corporate bonds whose default rate will jump from close to 0% to over 10%; to CDSs where $62 trillion of nominal protection sits on top an outstanding stock of only $6 trillion of bonds and where counterparty risk – and the collapse of many counterparties – will lead to a systemic collapse of this market.
  • This is where Roubini goes on a rippling effect argument, most of which is highly probable. Fannie and Freddie probably will be nationalise. The Fed and Treasury will more than likely print more money to sustain liquidity in many of the affected organisations. Rather than seeing pockets of these GSEs failing, the sheer size of the bailout will whack the USD down a lot more. I forsee the USD going to 90 cents to the AUD, 1.2 to 1 with the Singdollar, 2.8 with the ringgit, 6.2 to the yuan, and 1.7 to the euro by end 2009. Foreign investors will still be very willing to lend capital, buy bonds and inject funds to these affected financial companies in the US - at the same time, the forex market will exact a price on the USD to reflect the deluge of USD in the system. Last year China bought US66bn in GSEs debt and only US12bn in US Treasuries. Russia bought US34bn of GSEs debt and SOLD US22bn of US Treasuries. There is no way foreign buyers of Treasuries and GSEs debt will be sustain unless they remains attractive. They will remain attractive if the Treasury and Fed stand firmly behind these GSEs and even regional banks. Hence a bailout is a must even though its inequitable. Only by a declining USD will the Dow and S&P be able to avert a more severe sell down. Paulson and Bernanke know this is the strategy to take, but they will not be making it known publicly. For the strategy to work, it has to be a gradual and calm decline.
  • This will be the most severe U.S. recession in decades with the U.S. consumer being on the ropes and faltering big time as soon as the temporary effect of the tax rebates will fade out by mid-summer (July). This U.S. consumer is shopped out, saving less, debt burdened and being hammered by falling home prices, falling equity prices, falling jobs and incomes, rising inflation and rising oil and energy prices. This will be a long, ugly and nasty U-shaped recession lasting 12 to 18 months, not the mild 6 month V-shaped recession that the delusional consensus expects.
  • As for the longevity of the downturn 12-18 months is about right, and that will be the time needed to take the USD on a gradual decline to balance out the bailout funds into the system, and to make things cheaper to foreign funds for them to keep buying and reinvesting capital into US companies.
  • Equity prices in the US and abroad will go much deeper in bear territory. In a typical US recession equity prices fall by an average of 28% relative to the peak. But this is not a typical US recession; it is rather a severe one associated with a severe financial crisis. Thus, equity prices will fall by about 40% relative to their peak. So, we are only barely mid-way in the meltdown of stock markets.
  • If the Dow is supposed to go to 10,000 or 9,000... that may be averted if the USD fall gradually, and the Fed bringing down fed funds rate to 1%. I do not see another major downside of 20% for all markets like Roubini does, but I do think most markets will be range bound for some time. If USD stays strong and they keep doing big bailouts, you can bet that the Dow will crash to 8,000 even - but things are not static, the Fed and Treasury will react. There are too many variables to predict strongly that the Dow will hit 9,000 (the Hand Seng hitting 17,000... the KLCI hitting 950..etc.) like what Roubini is implying.
  • The rest of the world will not decouple from the US recession and from the US financial meltdown; it will re-couple big time. Already 12 major economies are on the way to a recessionary hard landing; while the rest of the world will experience a severe growth slowdown only one step removed from a global recession. Given this sharp global economic slowdown oil, energy and commodity prices will fall 20 to 30% from their recent bubbly peaks.
  • This is where Roubini score high marks. He sees demand destruction as a bigger factor going forward. If global commodities and soft commodities were to weaken by 20% over the next 6 months, it cools inflationary expections even though many countries are grappling with higher inflation. To a large extent that will create a higher platform for equities as well as inflationary expectation is a big factor killing off sentiment for stocks.
  • The current U.S recession and sharp global economic slowdown is combining the worst of the oil shocks of the 1970s with the worst of the asset/credit bust shocks (and ensuing credit crunch and investment busts) of 1990-91 and 2001: like in 1973 and 1979 we are facing a stagflationary shock to oil, energy and other commodity prices that by itself may tip many oil importing countries into a sharp slowdown or an outright recession. Also, like 1990-91 and 2001 we are now facing another asset bubble and credit bubble gone bust big time: the housing and overall household credit boom of the last seven years has now gone bust in the same way as the 1980s housing bubble and 1990s tech bubble went bust in 1990 and in 2000 triggering recessions. And a similar housing/asset/credit bubble is going bust in other countries – U.K., Spain, Ireland, Italy, Portugal, etc. – leading to a risk of a hard landing in these economies.
  • There will be hard landing as the liquidity bubble is not just a US problem. In most of Europe, like the countries cited above, the ECB had been on a strong money supply growth curve for the last 6 years as well. There will be some hard lending in those economies brought on by a slump in property prices. While its bad, it will also rein in inflation and slow these economies down somewhat. That is another reason why this won't be a truly bad recession as it is brought on by a liquidity bubble only in selected parts of the world. I see this more like an earthquake with fault lines appearing as the whole economic paradigm adjust to revise global economic power bases, a reallocation of resources, and adjustment to purchasing power throughout the world.
  • But over time inflation will be the last problem that the Fed will have to face as a severe US recession and global slowdown will lead to a sharp reduction in inflationary pressures in the U.S.: slack in goods markets with demand falling below supply will reduce pricing power of firms; slack in labor markets with unemployment rising will reduce wage pressures and labor costs pressures; a fall in commodity prices of the order of 20-30% will further reduce inflationary pressure. The Fed will have to cut the Fed Funds rate much more – as severe downside risks to growth and to financial stability will dominate any short-term upward inflationary pressures. Leaving aside the risk of a collapse of the US dollar given this easier monetary policy the Fed Funds rate may end up being closer to 0% than 1% by the end of this financial disaster and severe recession cycle.
  • The Bretton Woods 2 regime of fixed exchange rates to the US dollar and/or heavily managed exchange will unravel – as the first Bretton Woods regimes did in the early 1970s – as US twin deficits, recession, financial crisis and rising commodity and goods inflation in emerging market economies will destroy the basis for it existence.
  • Thus, the scenario of 12 steps to a financial disaster that I outlined in my February 2008 paper is unfolding as predicted. If anything financial conditions are now much worse than they were at the previous peak of this financial crisis, i.e. in mid-march of 2008.
p/s photos: AF (that's all I got, and that she is Thai)


Anonymous said...

Are you suggesting that Fed will going to do another magic show by creating a new bubble call the GREATEST BAILOUT BUBBLE OF THE NEW CENTURY !!!!!!!!!!!!!!!!!!!

Saviour said...

Saint Robin Hood Fed is robbing Paul taxpayer and John The Saving for rainy day (depreciating dollar) to bail out Too BIG Too Fail Fred and Fannie .

Avatar said...

Thanks for that opinion piece. Things are certainly going to be interesting going forward.

My blog:

clk said...

Is a US currency control in the horizon as well? A friend of mine thinks this is coming, and all the US T-Bonds will be in "default" and repaid overtime with new USD bills issued post-control.

If it does materialise, the world as we know it may change forever.