Here’s a transcript of an interview with Nouriel Roubini, Courtesy of Nouriel Roubini’s Global EconoMonitor.
Transcript of Talk at AEI seminar on the "The Deflating Mortgage and Housing Bubble, Part IV: Where Is the Bottom?"
Here is below the annotated transcript of my talk at the American Enterprise Institute’s September 30, 2008 seminar "The Deflating Mortgage and Housing Bubble, Part IV: Where Is the Bottom?" The transcript is courtesy of The Housing Doom. For those who are interested there is also a video version of my talk.
Nouriel Roubini: [23:34] Well, Desmond Lachman described very well in his remarks why things are getting worse rather than better in the housing market, and I share his outlook and pessimism. I would like to elaborate on the broader picture about what’s happening in the economy and the financial markets.
I’ve been saying for a while this will be the worst financial crisis the US has experienced since the Great Depression and it looks like the worst one. I mean I don’t think there’s anything that’s happened since the Great Depression looks so severe. Of course the real economic consequences in terms of output contraction are not going to be as bad as the Great Depression because there is a massive amount of policy action, but in terms of financial shock, I mean what does happen in the last few months is really quite unbelievable, every other week another major financial institution going belly up.
The other observation is that while we’re talking about subprime mortgages and housing, I think there’s a growing recognition that this was not just a subprime mortgage problem, where there much more generalized asset bubble and credit bubble in the economy. It was subprime, it was near-prime it was prime mortgages, there were massive excesses also of underwriting in commercial real estate, the boom in the indebtedness of the household sector included also unsecured consumer credit like credit cards, auto loans, student loans with all this other excesses in the corporate sector [25:00] coming from LBOs that should never have never occurred, financed by these leveraged loans, a trillion-plus LBO with a debt to equity ratio that didn’t make any sense. Excesses of borrowing also by municipalities — in the last real estate recession muni bonds were trading like junk bonds because there were many municipalities going belly up, the same thing is going to happen right now.
And even in the corporate sector that was on average in better shape than the housing sector there was a fat tail of corporates that were highly indebted with little profits. They issued a huge amount of junk bonds and corporate default rates that had been very very low, for the last couple of years, are going to be surging in a major way, and once this major surge of corporate defaults is going to occur this is other huge time bomb of the CDS market where about $55 trillion of nominal protection has been sold against an outstanding stock of only $6 trillion of corporate bonds.
So when you add it all up as you remember I’d estimated that the losses would be at least $1 trillion, and more likely close to $2 trillion, and at that time people thought I was exaggerating but of course a few weeks later IMF came with an estimate of $945 billion, then Goldman Sachs $1.1 trillion then John Paulson said $1.3 trillion, then IMF revised their estimate to $1.4 trillion. Most recently Bridgewater Associates said that the losses are going to be $1.6 trillion, so we don’t know how large they are going to be. What we do know is that the $1 trillion number at this point is not the ceiling, it’s just barely a floor, and the losses are going to be much more.
And there is also implication for, of course, for the TARP program and the recapitalization of the banks, because if all these losses are going to occur, the idea of injecting only $250 billion into the banking system, the financial system is going to do the job, I think is very far-fetched. I think the eventual number is going to be more like $600 or $700 billion, especially now that it is not just the banks, but also broker-dealers, insurance companies — soon enough the financing arms of GMs and GEs and … you name it, and whatever.
So the size of the problem is huge. And of course there is this vicious circle that’s been discussed between the financial shock leading among other reasons to the economic contraction, and now the economic contraction occurring, then the financial losses, the credit losses, delinquencies for households and corporates rising making the financial strains even more severe.
That leads me to the second point that is — we are in a very severe recession in the United States. I’m not going to go into the detail of it, but I do believe that it is going to be the worst economic contraction that the US has experienced for the last few decades. The typical US recession lasts about 10 months, the last two lasted only 8 months each. The 2001 recession actually — contraction of output from the peak was only 0.4 percent, for the average recession it’s been less than 2 percent. I feel this is going to be equivalent to fall of output of the order of 4 to 5 percent, the worst we’ve had in the last 50 years. We’ve 8 quarters of contracting output and input the beginning of this economic contraction at the 1st quarter of this year.
And as pointed out essentially by Desmond, this housing recession is not bottoming out. The production of new homes starting is falling sharply, but demand until recently had fallen even more, therefore this excess supply of inventory of the new and existing homes kept on becoming larger, and that put downward pressure on home prices.
Based on Case-Shiller, home prices have already fallen by about 20 percent from the peak, given the excess supply number and other factors I would expect home prices are going to fall another 20 percent for a cumulative fall of 40 percent from the peak. Now in 1991, the cumulative fall based on Case-Shiller was only 5 percent, now we’re going to have 20, another 20, 40 — something we haven’t seen since the Great Depression.
Now this fall in home prices is important for 3 reasons. As long as it occurs, residential construction is going to keep on falling in absolute terms as a share of GDP. Secondly there is the huge wealth effect coming from a fall of $6 trillion of housing wealth. But most important factor I think is that right now ongoing is that with such a fall in home prices, by the end of next year about 40 percent of all households with a mortgage are going to be underwater, negative equity with the value of their homes below the value of their mortgages. So, about 21 million out of the 51 million houses that have a mortgage, will be under-water by the end of 2009. And there’s a huge incentive to walk away from your home, because the US mortgages are not recourse loans.
Now, not everybody is going to walk away. Let’s be even conservative. Let’s assume that only 1 out of 5 people that are underwater are going to walk away. If you do the math — I’m not going to go into the detail of it — you get additional losses for the financial system of the order of $400 billion dollars. This is on top of all the other write-downs that have already had been made through subprime-kind of a writedown. [30:00] So that’s another huge loss for the financial system. This is just assuming that only 1 out of 5 people underwater are going to walk away. If it’s more like 40 percent, then the losses is another $800 billion. So you’re in a situation in which you can wipe out a good chunk of the capital of the financial system. So that’s what we are observing.
The other important point to put things in the global context I think is that while 6 months ago it looked like the US was the only advanced economy that was going — undergoing an economic contraction, starting with the 2nd quarter of this year — so even before the major financial shock of September / October occurred, and this financial shock are now making credit conditions even more tight — but even before then, if you look at the 2nd quarter data, Eurozone growth was becoming negative, UK growth was becoming negative, Canadian growth was becoming negative. Same in New Zealand, same for Japan, same for most of the other advanced economies. About 60 percent of GDP, that is most of the GDP of the advanced economies was already contracting in the 2nd quarter of this year. This is before these other shocks are going to make these things more severe.
At this point it looks like we’re not going to have just a US recession, or an advanced economies recession, we’re also going to have a global economic recession, because there is a massive amount now of re-coupling in financial markets and also in real economies, also among emerging market economies. Of course, the re-coupling of financial markets has already occurred big-time, equity prices in Europe and in emerging markets have fallen even more than United States, but now you see significant channels of transmission to emerging markets — trade channels, credit channels, financial channels, currency channels, commodity channels, confidence channels. It’s a massive slowdown of growth, and I would estimate that already in the 3rd quarter of this year, and certainly by the 4th quarter global GDP growth, measured at market prices, would already be negative.
So we are going to have a global economic recession. And by the way, within the emerging markets, there are about a dozen economies are now on the verge of a financial crisis. Thinking emerging Europe — countries like Latvia, Estonia, Lithuania, Hungary, Bulgaria, Romania, Turkey, Belarus, Ukraine; you go into Asia, trouble in Pakistan, Indonesia and Korea. You go into Latin America — trouble in Argentina, in Ecuador, Venezuela, just to name a few. So this is a global economic recession.
Now going back to the financial market, the other thing that’s kind of a matter of concern — there is a bit of a disconnect right now, that thing is worrisome, between the more and more aggressive policy actions that the policy authorities are taking — I would say even going the right direction — and the fact that the markets have seemed to lost confidence in the ability of the policy makers to do the right thing. And I’ll give you a couple of examples.
When the bailout of the creditors of Bear Stearns occurred in March, and then we created a TSLF [2] and a PDCF [3] that essentially bailed out the broker-dealers, providing them with liquidity for the first time since the Great Depression through the Feds, there was a rally in the stock market, in the money market, and in the credit markets. That rally lasted about 8 weeks. Then when trouble started to occur in July with Fannie and Freddie and Paulson went to Congress says, "Give me the power of the bazooka, if you do I’m not going to have to use the bazooka, but give me that power, it’s going to stabilize Fannie and Freddie," there was also a rally lasted about 4 weeks. Then in early September when Paulson had to use the bazooka and actually bail out, and essentially make public $6 trillions of assets and liabilities of Fannie and Freddie, and inject a couple of $100s billions there was a rally. It lasted 1 day. On that Monday after the bailout. By the next day, remember, the panic was about Lehman.
And then the next week when the collapse of AIG and the bailout of AIG occurred, there was not even a rally, on that Wednesday remember it was utter panic — the market fell 5 percent.
Then they went for the TARP legislation, and you would expect that that would have improved the markets. On the Thursday after the Senate passed it, and on the Friday the next day when House passed it, stock prices fell sharply, both on Thursday and Friday.
And then the following week when the Fed was doing all the new actions, Doubling and tripling the TF, the TSLF, the swap lines, coordinated policy reduction, the new commercial paper facility was assault on Monday, Tuesday, Wednesday, Thursday, Friday — market fell that week by 20 percent.
By that Friday before the IMF meeting, we were literally one epsilon away from a systemic financial meltdown. At that point the policymaker got religion. They realized that these step-by-step ad-hoc approach to managing the crisis did not make sense. And it started doing something more systematic. So you had the G7 Communique and then the EU Summit.
Now, what did they decide? They decided first of all that no systemically important financial institution is going to be allowed to fail. I.E. they decided that it had made a mistake letting Lehman go. Secondly they said we are going to provide unlimited liquidity to the financial system as a way to unfreeze this kind of liquidity crunch. Three, we’re going to recapitalize [35:00] financial institutions with public money, these preferred shares. Four we’re going to guarantee a wide variety of liabilities of the banking system, that policy’s new debt making inter-bank lines. And fifth, we’re going to do everything as is necessary to avoid systemic financial meltdown.
Now, given that massive aggressive policy response the market rallied on that Monday for a day, by 10 percent. And then a slew of lousy news about the economy and markets fall all of that week, and then the last week it was all the slew of bad earnings news and market became worse and worse and worse.
And just the other day when the markets went up 10 percent, what were the good news that day? The consumer confidence had collapsed like never before in 50 years, and because the Case-Shiller number was still showing a freefall of the markets.
What that tells me is that currently financial markets are dysfunctional. Fundamentals don’t matter, valuations don’t matter, it’s just the flow that matters these days. And in most days what has happened for last couple of weeks in spite of this major policy effort is been is that there is a flow of sellers — and there are not that many buyers — in most days markets are falling very far, very sharply. So it’s becoming a really dysfunctional financial market, in which even the very aggressive policy action do not seem to make a difference. And that’s something that worries me.
Now why do I think that the bottom in financial market is not been reached yet — for 3 reasons and I’ll conclude on that. The first one is that I think that the flow of market-economic news are going to surprise on the downside for the next few weeks and months. People have priced now a US recession, but if this US recession is I believe going to be more like 24 months, rather than only 8 months, and is going to be global, then there will be surprises on consumption, investment, on housing, on employment and industrial production. Those surprises are going to be negative for the market.
Secondly, I think there will be negative surprises also for earnings. Not just earnings of financial firms, but also in a severe recession a sharp contraction of the earnings of the non-financial corporate sector. That’s going to be a negative for the financial market. And the third reason is that while the sources of a systemic financial meltdown has been somehow contained, I still see as a lot of potential threats to the financial system. One is this major surge of corporate defaults is going to occur in the next year or so. The second one is related to it is the blowup is going to occur in the CDS market is a major source of the systemic risk. Third of all you are going to have hundreds of hedge funds are going to go bust in the next few months, and while none of them is as large or as leveraged as LTCM was in 1998, if you have 300 to 600 of them going bust all at the same time, and having to deleverage and sell assets in a distressed market, then the consequences are going to be negative for asset prices.
And finally there is this other time bomb of many emerging market economies, the risk of a financial crisis. And any of them going bust could have contagious and systemic effects. And one example — take Iceland. Little small island of 300,000 folks in the middle of Atlantic. Their banks had borrowed an amount of money was 12 times the GDP of the country to buy toxic MBSs, CDOs and you name it. Now the banks are bust, the government doesn’t have resources to bail out the banks, and these banks will have to sell, in a highly distressed and illiquid market, a huge amount of distressed assets. And even a small tiny island like Iceland can have systemic effects on asset prices, let alone if you have a blowup of Hungary, or Argentina, or Korea, or other economies.
So, for the last few months people have always been calling the bottom. Every time there was a major event they said this is the cathartic event that says the markets have bottomed out. They said it after Bear Stearns, after Fannie and Freddie, after AIG, after TARP, after the G7 Communique. And each time markets have rallied for a little bit, and have gone further south. Unfortunately I don’t think we’re at the bottom of the housing crisis, we’re not at the bottom of the mortgage crisis, we’re not at the bottom of the financial and banking crisis, and certainly we’re not at the bottom of the severe economic crisis. So I’m quite still pessimistic looking ahead. Thanks.
Alex Pollock: Thank you Nouriel. I hope you’re all feeling better. [laughter] Just before we go ahead to Tom I have one question, Nouriel, for you. I think it was implied in your comments that you would recommend the entirety of the TARP — the $700 billion — be used for capital additions to financial firms. Would that be a fair conclusion from your comments?
Nouriel Roubini: Yes. I think that the capital needs of the financial system are going to be much more than the $250 billion. I thought that even originally the TARP as an idea of buying at high prices toxic assets was a bad idea if you look any history of systemic banking crisis, in most cases the way you recapitalize the banks is by injection of public capital either common shares or preferred shares or sub-debt — it’s really the exception, the idea of buying toxic assets. [40:00] So I think most of it is going to be used for that and maybe we’ll have a TARP II at this point. It may be needed to buy more stuff to recapitalize more. I would not exclude that.
Alex Pollock: OK, thanks. Tom. [40:12]
