By Nouriel Roubini
Published: September 21 2008 17:57 | Last updated: September 21 2008 17:57
Last week saw the demise of the shadow banking system that has been created over the past 20 years. Because of a greater regulation of banks, most in the past two decades has grown within this shadow system whose members are broker-dealers, hedge funds, , structured investment vehicles and conduits, money market funds and non-bank mortgage lenders.
Like banks, most members of this system borrow very short-term and in liquid ways, are more highly leveraged than banks (the exception being money market funds) and lend and invest into more illiquid and long-term instruments. Like banks, they carry the risk that an otherwise solvent but liquid institution may be subject to a selffulfilling and destructive run on its liquid liabilities. (The known business model is that brokers-dealers run with a 25 to 1 leverage on capital to do their business. Following this debacle, we can expect a tightening on capital leverage, maybe down to 5-6 times. This will make it more difficult to generate fees on limited capital, and will limit the ability to fund deals. I expect the financial industry will be looking to rely more on SWF, private equity and hedge funds to fund any kind of substantial deals. No one can really hope to go it alone.)
But unlike banks, which are sheltered from the risk of a run – via deposit insurance and central banks’ lender-of-last-resort liquidity – most members of the shadow system did not have access to these firewalls that prevent runs.
A generalised run on these shadow banks started when the deleveraging after the asset bubble bust led to uncertainty about which institutions were solvent. The first stage was the collapse of the entire SIVs/conduits system once investors realised the toxicity of its investments and its very short-term funding seized up.
The next step was the run on the big US broker-dealers: first Bear Stearns lost its liquidity in days. The Federal Reserve then extended its lender-of-last-resort support to systemically important broker-dealers. But even this did not prevent a run on the other broker-dealers given concerns about solvency: it was the turn of Lehman Brothers to collapse. Merrill Lynch would have faced the same fate had it not been sold. The pressure moved to Morgan Stanley and Goldman Sachs: both would be well advised to merge – like Merrill – with a large bank that has a stable base of insured deposits.
The third stage was the collapse of other leveraged institutions that were both illiquid and most likely insolvent given their reckless lending: Fannie Mae and Freddie Mac, AIG and more than 300 mortgage lenders.
The fourth stage was panic in the. Funds were competing aggressively for assets and, in order to provide higher returns to attract investors, some of them invested in illiquid instruments. Once these investments went bust, panic ensued among investors, leading to a massive run on such funds. This would have been disastrous; so, in another radical departure, the US extended to the funds.
The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken excessive risks with high leverage and are poorly managed may collapse. A massive shake-out of the bloated hedge fund industry is likely in the next two years. (This has not happened yet, and I suspect with the US$700bn facility, I doubt there would be a run on hedged funds' leveraged positions. We have to know that hedge funds have already seen an exodus by clients taking their money away from them for more than 6 months. The unwinding and so-called run have actually been happening in stages already.)
Even private equity firms and their reckless, highly leveraged buy-outs will not be spared. The private equity bubble led to more than $1,000bn of LBOs that should never have occurred. The run on these LBOs is slowed by the existence of “convenant-lite” clauses, which do not include traditional default triggers, and “payment-in-kind toggles”, which allow borrowers to defer cash interest payments and accrue more debt, but these only delay the eventual refinancing crisis and will make uglier the bankruptcy that will follow. Even the largest LBOs, such as GMAC and Chrysler, are now at risk. (I tend to disagree with Roubini here as I think private equity firms are actually going to come out on tops here. Yes, some of them have borrowed to the hilt to takeover companies and may be suffering now, but generally its the last few deals which look troublesome - such as GMAC and Chrysler, the majority are still OK and they won't be coming back to the markets till conditions have improved. PE firms will play an important role going ahead because they still have large pots of uninvested monies. As mentioned above, this type of capital is going to be seen in a more important light for funding purposes.)
We are observing an accelerated run on the shadow banking system that is leading to its unravelling. If lender-of-last-resort support and deposit insurance are extended to more of its members, these institutions will have to be regulated like banks, to avoid moral hazard. Of course this severe financial crisis is also taking its toll on traditional banks: hundreds are insolvent and will have to close.
The real economic side of this financial crisis will be a severe US recession. , the strong euro, falling US imports, the bursting of European housing bubbles, high oil prices and a hawkish European Central Bank will lead to a recession in the eurozone, the UK and most advanced economies. (I also doubt if a severe recession is in store if you note the billions they central banks are throwing at the problem. While I agree that its something the Fed/Treasury should do, I also think that it will actually maintain an excessive amount of liquidity in the world, which will rear its head in high commodity, high food prices, and reignite inflationary concerns... lesser of two evils?)
Europeanare at risk of sharp losses because of the toxic US securitised products sold to them; the massive increase in leverage following aggressive risk-taking and domestic securitisation; a severe liquidity crunch exacerbated by a dollar shortage and a ; the bursting of domestic housing bubbles; household and corporate defaults in the recession; losses hidden by regulatory forbearance; the exposure of Swedish, Austrian and Italian banks to the Baltic states, Iceland and southern Europe where housing and credit bubbles financed in foreign currency are leading to hard landings.
Thus the financial crisis of the century will also envelop European financial institutions. (Its bad, but not as bad as King Roubini makes it out to be. Global treasuries and central banks have never worked closer before. We should not underestimate the power of collusion. I also think Roubini still believe the economic engine and power of the world reside solely in the US and Europe, well not really anymore. If the last 5 years have shown us anything, its that the balance of economic power and engine for growth have shifted substantially to China and India, together with Latam, parts of Africa and most of emerging Asia. While the shift is not a tectonic shift, it is a substantive one. One which is altering the equation of global markets continually. The doom and gloom over USA and Europe painted by Roubini is correct, but don't miss the nice landscape and background of the other "bigger" emerging economies.)
The writer, chairman of Roubini Global Economics, is professor of economics at the Stern School of Business, New York University (The blogger is not a professor, not a graduate of economics, and although he enroled for a Masters course in business, he rarely attended classes ... and the closest he got to NYU is wearing the fake t-shirt he bought from Petaling Street)
p/s photos: Janice Man