Remember this was written in February 2008, before Bear Stearns, Lehman and all the rest. Though the subprime crisis had started, and strains had spread overseas (Northern Rock’s bank run was in September 2007, but it was nationalized after the paper was published; Germany’s IKB went down in August 2008), early 2008 had an air of improvement about it. The S&P 500 was at 1337, and would be back above 1400 in May before halving its value; HY spreads were at 680 bps, and would be at nearly 2000 bps by end-2008. Fannie Mae stock was in the 30s; Lehman’s equity price was in the 60s. Look closely at his closing words: “One should be pessimistic about the ability of policy and financial authorities to manage and contain a crisis of this magnitude; thus, one should be prepared for the worst, i.e. a systemic financial crisis.”
Here’s the full count of Nouriel’s prognostications, by my read:
1. The worst housing crisis is not bottoming and will…
- wipe out $4-6 trillion in wealth
- cause 10 million households to have negative equity
- see lots of homebuilders go bust despite their stock prices irrationally surging
2. Losses for financial system will spread far beyond subprime or GS’s estimates of $400bn
- RMBS and CDO markets will remain in a severe credit crunch
- hundreds of billions of off-balance sheet SIVs and conduits will be brought back to balance sheets, making the credit crunch global
3. Recession will lead defaults (credit cards, auto), spreading the credit crunch from mortgages to consumer credit…
- Monolines are borderline insolvent and don’t deserve triple-A [It took Moody’s and S&P until June to downgrade MBIA Assurance from AAA/Aaa!]
4. Moneymarket funds will then have runs, requiring a bank rescue to avoid the risk of a fall in NAV
5. CRE meltdown
6. “Some large regional or even national bank that is very exposed to mortgages, residential and commercial, will go bankrupt. Thus some big banks may join the 200-plus subprime lenders that have gone bankrupt.”
- The Fed will have to reaffirm the implicit doctrine that some banks are too big to be allowed to fail.
- Bank bankruptcies à severe fiscal losses … and effective nationalization of affected institutions
7. Leveraged Loan mess, LBO bankruptcies
8. Recession will induce a massive wave of corporate defaults, with lower-than-typical recoveries
- Large losses on CDS
- Not just a transfer from seller to buyers, but “If losses are large some of the counterparties who sold protection—possibly large institutions such as monolines, some hedge funds or a large broker dealer—may go bankrupt leading to even greater systemic risk as those who bought protection may face counterparties who cannot pay.” [The effect is exactly what happened after Lehman, but from different causes; it is what nearly happened to AIG though it was losses on CDS written on CDOs, not corporates, but that systemic bust was averted with a bailout.]
9. Shadow banking system in serious trouble; “some of these institutions [will] go belly up.”
10. U.S. and global equity markets will enter into a persistent bear market as in a typical U.S. recession the S&P 500 falls by about 28%. [As noted above, at this point the S&P was down only 15%, it fell another 15% after Lehman, and ultimately lost 56%…so Nouriel was too cautious/optimistic, for a change!]
11. Liquidity will dry up, interbank markets will widen, in spite of further liquidity injections by central banks
12. Fire sale of assets in illiquid markets…vicious circle of losses, forced liquidation.
- Total losses more than $1 trillion.
- 1987-style crash
- Lack of trust of counterparties will add to impotence of monetary policy
- Massive hoarding of liquidity
While the worst of the crisis, which followed the above checklist to a tee, is now past, its scars are still with us. Recalling the events is a reminder that the fallout of financial crises typically lasts many years and sometimes decades: economies and market functioning has not returned to normal (setting aside the EZ Crisis, which threatens the global economy). Policy makers and investors who think a quick recovery is around the corner are as deluded as they were in 2008, and continue to ignore the consequences of Nouriel’s Twelve Steps – even long after they’ve transpired.
Even if we don’t always bat a thousand, I’m 100% certain RGE’s clients will continue to benefit from our analysis and insight .