Archive for February, 2008
In the new column Wolf makes a series of interesting points. First he argues that my “analysis suggested a highly plausible worst case scenario, not the single most likely outcome”. Second, he argues that, even in this worst case scenarios, the expected losses for the financial system (that I estimated to be about $1 trillion) and thus the potential fiscal costs of a bailout of the financial system would be only 7% of GDP, an amount that a large economy such as the US can easily afford: as he argues the US public debt would increase in that scenario only to 70% of GDP. And the yearly costs of servicing such increased debt would be – in his view – “a mere 0.2% of GDP in perpetuity. This is a fiscal bagatelle”.
What should we make of his argument? For now I will not debate whether my scenario is plausible or not; let us leave aside this debate for now and let us concentrate on the fiscal costs of a bailout of the financial system in this “worst case scenario”. Will it be only 7% of GDP or more? I will argue in this article that such fiscal costs of a financial crisis could be much higher than 7% of GDP, as high as 19%, even leaving aside the even bigger losses in the net worth of the private sector that a severe financial crisis would imply.
Here are a number of reasons why the overall financial losses and the fiscal costs of a bailout of the financial system could be much higher than 7% of GDP…
Testimony on the Economy, Fed Policy and Financial Markets at a Hearing in the House Committee on Financial Services
Today I was one of the five speakers at a Congressional Hearing in the House of Representatives’ Committee on Financial Services. The hearing was on Monetary Policy and the State of the Economy. Fed Chairman Bernanke will appear tomorrow Wednesday in front of this committee to present the Fed’s semi-annual Humphrey-Hawkins testimony on the state of the economy.
In addition to myself the other speakers at today’s hearing were Alice Rivlin, John Taylor, Mark Zandi and Carmen Reinhart (a video webcast of the full hearing is available here). Here is a brief summary of the views expressed during the hearing…
Regular readers of this Global EconoMonitor are already aware of most of my views about the risks ahead: a severe US recession, recoupling of the rest of the world with the US hard landing, severe credit crunch and the risks of a systemic financial crisis.
Here are a below few online publications/media appearances where I have recently summarized and fleshed out these views…
For the last few years owners of private equity firms had been the new “Masters of the Universe”. At the 2007 World Economic Forum in Davos last year it was almost impossible to get into the panel on private equity as they were fully booked from the very first day. And I remember the head of one of the leading private equity firms cockily arguing in a session that all was fine in that industry and any attempt to regulate it or tax it otherwise was inappropriate interference.
But what a difference a year makes! Yesterday’s Masters of the Universe are now in the dust as the private equity and LBO bubble has now gone bust. By now dozens of LBOs announced in 2007 have been either restructured, postponed or cancelled altogether; also seven actual medium sized LBOs have gone into bankruptcy this year alone and many more of the bigger ones may also go bust.
Let us next flesh out in more detail this bust of the private equity and LBO bubble…
Needless to say the latest macro news (the Philly Fed report) and financial news (increase in corporate bankruptcies and LBOs going belly up, monoline deeper mess, trouble in the muni bonds markets, credit spreads widening, etc.) confirm my analysis that the risk of a systemic financial crisis is rising.
The text of my Project Syndicate column is available here below:
Today Martin Wolf of the Financial Times devotes his column to present my “12 Steps to Financial Disaster” scenario and my follow-up piece on why the Fed and financial policy makers may not be able to prevent this systemic financial risk episode. I feel certainly honored that the most thoughtful and well respected commentator on [...]
The Forthcoming “Jingle Mail” Tsunami: 10 to 15 Million Households Likely to Walk Away from their Homes/Mortgages Leading to a Systemic Banking Crisis
The current housing recession, subprime meltdown and severe credit crunch in financial markets has many worrisome aspects. And while there is always a “crisis de jeur” – one day SIVs, the next day monolines, the next day TOBs or auction-rate securities – one needs to keep some perspective and consider which risks are first-order sources of stress for financial markets and which ones are of second or third-order concern.
I will argue that the most important first-order risk for financial markets derives from the likelihood that 10 million to 15 million households may walk away from their homes if – as likely – home prices fall another 10% in 2008 and further in 2009. When – in the summer of 2006 – this author argued that this would be the worst housing US recession in the last 50 years and that home prices would fall – from their peak value – by 20% such predictions were taken as being nearly lunatic. Too bad that this author ended up being too optimistic, not too pessimistic, about the severity of this housing recession. Indeed, this will end up to likely to be the worst housing recession in US history – not just in the last 50 years – and home prices may likely eventually fall by 30%, not this author’s “optimistic” 20%. By now prices declines of the order of 20% are predicted by Goldman Sachs, Robert Shiller, MarketWatch chief economist Irwin Kellner and others; while Paul Krugman has suggested even a figure of 30%; and, according to Bob Shiller, in some markets home prices may fall by 40 to 50%.
So let us consider the implications for the household sector of price declines of the order of 20 to 30%. The math is simple as I will flesh out in this note: 10 to 15 million households will end up in negative equity territory and will be likely to default on their homes and walk away from them. Then, the losses for the financial system from this massive defaults will be of the order of $1 trillion to $2 trillion, a multiple of the $200 to $400 billion of losses currently estimated for mortgage related securities.
Let us consider next some of the details of this scenario and its consequences for the financial system…
The latest saga in the credit market relates to the nexus between monolines, borrowing by state and local governments (the muni bonds market) and the related troubles in the tender option bonds (TOB) and auction-rate securities (ARS) markets.
A few issues are clear now: the monolines don’t deserve their AAA and are unable to raise enough capital to maintain such a rating. Moreover, an unavoidable downgrade of these monolines would lead to several side effects: loss of AAA status for the muni bonds insured by the monolines; inability of monolines to generate new business in the muni space as such borrowers expect AAA rating and could not get it from firms that don’t have an AAA rating themselves; a massive writedown – about $150 billion – of the mortgage related securities (RMBS, CDOs, etc.) that had been “insured” by the monolines.
Let us then analyze in more detail the consequences of the above observations for: the future of the monolines; the losses that a downgrade of the monolines would imply for financial firms and investors; and the market for state and local (muni) financing.
The conventional wisdom is that state and local government rarely default; thus, there is a viable business for monolines that insure only state and local government. We will argue in this article that such conventional wisdom – behind the current plans to split the monolines’ business in a “good” muni insurance component and a “bad” structured finance insurance component – may be wrong…
Here is the link to the video of my debate last nite with Larry Kudlow on his CNBC show on whether we will have a recession.
As readers of this Global EconoMonitor are already aware it is my view that we are already in a recession and this recession will be uglier and more protracted than the previous two with significant risks of a financial meltdown.
Indeed, the financial market problems have now spread from subprime mortgages to most other credit markets and financial markets. We have a subprime financial system, not just a subprime mortgage problem.
Let me flesh out next the details of this massive financial contagion that is leading to a serious risk of a systemic financial crisis…
Free registered users of the RGE Monitor get access to most – but not all – of my Global EconoMonitor postings as well as being able to read and post comments on this venue. They also receive twice a week the overview or Monitor of global economic and financial trends that is produced by the RGE analysts team. The topic of today’s Monitor is the worsening credit crunch.
Here is below the text of this report in a slightly extended form that covers a wider range of credit issues. You will get to know about new structured finance acronyms such as TOBs, VRDOs, ARS, Market-Value CLOs, LevX, LCDX and the serious trouble in the markets for these instruments…