Barron’s magazine has published this week an interview with me available both in the print and online edition. Barron’s online has also an additional video interview with me where I elaborate on some of the points in the print interview.
Here is below the text of the interview in the print edition of Barron’s (followed by some additional commentary by me on the U.S. and global economy and the financial crisis):
Yes, That’s $2 Trillion of Debt-Related Losses
Nouriel Roubini, Economist and Professor, New York University
By ROBIN GOLDWYN BLUMENTHAL
LIKE THE EXHORTATIONS OF JEREMIAH TO THE NATION OF Israel before the first temple’s destruction, the warnings of economist Nouriel Roubini fell on deaf ears. For the past two years Roubini, a professor at New York University, has cautioned about a huge housing bubble whose bursting would lead to a 20% drop in home prices; a collapse in subprime mortgages; a severe banking crisis and credit crunch; the near-failure of Fannie Mae and Freddie Mac , and a U.S. recession of a magnitude not seen since the Great Depression. So far, this latter-day prophet of doom has been on the mark, though time will tell about the recession part.
A Turkish native who grew up in Italy, Roubini trained at Harvard and later advised the Clinton White House, after his blog on the Asian financial crisis attracted the attention of Washington’s economic and political elite. Roubini still publishes the blog — the RGE Monitor — and teaches economics at NYU’s Stern School of Business. We caught up with him recently at his offices in lower Manhattan, and continued the conversation at Barron’s. For his latest predictions, please read on.
Barron’s: Unfortunately for the rest of us, you have a pretty good track record. How much more misery lies ahead?
Roubini: We are in the second inning of a severe, protracted recession, which started in the first quarter of this year and is going to last at least 18 months, through the middle of next year. A systemic banking crisis will go on for awhile, with hundreds of banks going belly up.
Which banks, specifically, will fail?
I don’t want to name names, but many, given the housing bust, will become insolvent. Their losses are mounting because they have written down only their subprime loans so far. They haven’t started writing down most of their consumer-credit losses, and reserves for losses are much less than they should have been. The banks are playing all sorts of accounting gimmicks not to recognize them. There are hundreds of [billions] of dollars outstanding in home-equity loans that eventually could be worth zero, too.
So far, we have seen no recession in the technical sense: two consecutive quarters of negative growth in real GDP. Why not?
The definition of a recession isn’t only two consecutive quarters of negative growth. The NBER (National Bureau of Economic Research) puts a lot of emphasis on things like employment, and employment has already fallen for seven months in a row. It also emphasizes income and retail and wholesale sales. Many of these things are declining.
Maybe the recession started in January; if you look at the data on gross domestic product on a monthly basis between February and April, GDP was falling. Saying this is not a recession is just a joke. Maybe instead of a ‘U’ recession and recovery, it will be a ‘W,’ with a rebound in the second quarter. But by the third quarter, the effect of the government’s tax rebates is totally gone, because other forces on the consumer are more persistent and negative.
Which forces, for instance?
The U.S. consumer is shopped out and saving less. Debt to disposable income has risen to 140% from 100% in 2000. Hit by falling home prices, the consumer no longer can use his house as an ATM machine. The stock market is falling and (issuance of) home-equity loans (has) collapsed. We have a credit crunch in mortgages, and gas is around $4 a gallon. Everyone says, ‘yeah, that’s true, but as long as there is job generation there is going to be income generation and people are going to spend.’ But for seven months in a row, employment in the private sector has fallen.
The most worrisome thing is that in spite of the rebates, retail sales in June were up only 0.1%. In real terms, they were down. If people were not spending their rebate checks in June, what will happen when there are no more checks?
Good question. How do you think Federal Reserve Chairman Ben Bernanke has handled the crisis so far?
The Fed’s performance has been poor. More than a year ago the Fed said the housing slump would end, but it hasn’t. They kept repeating this was a subprime-debt problem only, whereas the problems of excessive credit involve subprime, near-prime, prime, commercial real estate, credit cards, auto loans, student loans, home-equity loans, leveraged loans, muni bonds, corporate loans — you name it.
The Fed’s other mistake was to believe the collapse of the housing market would have no effect on the rest of the economy, when housing accounted for a third of all job creation in the past few years. When the proverbial stuff started to hit the fan last summer, the Fed went into aggressive-easing mode. But it has always been kind of catching up.
The damage was done earlier, beginning when the Greenspan Fed lowered interest rates in 2001 after the bust of the technology bubble, and kept them too low for too long. They kept cutting the federal funds rate all the way to 1% through 2004, and then raised it gradually instead of quickly. This fed the credit and housing bubble.
Also, the Fed and other regulators took a reckless approach to regulating the financial sector. It was the laissez-faire approach of the Bush administration, and (tantamount to) self-regulation, which really means no regulation and a lack of market discipline. The banks’ and brokers’ risk-management models didn’t make sense because no one listens to the risk managers in good times. As Chuck Prince (the deposed CEO of Citigroup) said, ‘when the music plays you have to dance.’
The paradox is they’re going to the opposite pole. They are overregulating, bailing out troubled participants and intervening in every market. The Securities and Exchange Commission has accused others of trying to manipulate stocks, but the government itself is now the manipulator. The regulators should investigate themselves for bailing out Fannie Mae (FNM) and Freddie Mac (FRE), the creditors of Bear Stearns and the financial system with new lending facilities. They have swapped U.S. Treasury bonds for toxic securities. It is privatizing the gains and profits, and socializing the losses, as usual. This is socialism for Wall Street and the rich.
If you let Bear Stearns fail you can have a run on the entire banking system. But there are ways to manage Bear or Fannie and Freddie in a fairer way. If public money is to be put at stake, first all the shareholders of these companies have to be wiped out. Management has to be wiped out, and the creditors of Bear should have taken a hit. Why did the Fed buy $29 billion of the most toxic securities, and essentially bail out JPMorgan Chase (JPM), which bought Bear Stearns?
Because JPMorgan was a counter-party?
Exactly. The government bailed out everyone. Even the unsecured creditors of Fannie and Freddie should have taken a hit. Sometimes it is necessary to use public money to rescue institutions, but you do it in a way in which you’re not bailing out those who made the mistakes. In each one of these episodes the government bailed out the shareholders, the bondholders and to some degree, management.
At what point does the government run out of money to lend to troubled banks?
Many public institutions are themselves going bankrupt. The FDIC (Federal Deposit Insurance Corporation) has only $53 billion of funds, and has already committed almost 15% of it to bail out depositors of IndyMac. The FDIC’s deposit-insurance premiums weren’t high enough, and now it is asking Congress to raise them. Plus, the agency claims only [ninety] institutions are on its watch list. IndyMac wasn’t on the watch list until June, the month before it collapsed. Studies done by experts in banking suggest that at least 8% of U.S. banks are in big trouble. Eight percent of the roughly 8,500 that the FDIC essentially is insuring equals about 700 banks. Another 8% to 16% also are shaky, so some 700 potentially are going bust and another 700 eventually could join them. Yet the FDIC is watching only [ninety] institutions. It’s a joke.
What recourse will the taxpayer have?
The taxpayer’s bill is going to be huge. I estimate this financial crisis will lead to credit losses of at least $1 trillion and most likely closer to $2 trillion. When I made this analysis in February everybody thought I was a lunatic. But a few weeks later the International Monetary Fund came out with an estimate of $945 billion, Goldman Sachs (GS) estimated $1.1 trillion and UBS (UBS) $1 trillion. Hedge-fund manager John Paulson recently estimated the losses would be $1.3 trillion, and late last month Bridgewater Associates came up with an estimate of $1.6 trillion. So, at this point $1 trillion isn’t a ceiling, it’s a floor. And the banks, as I’ve said, have written down only about $300 billion of subprime debt.
It is happening in real time. Many smaller banks are going bust already. More than 200 subprime-mortgage lenders have gone bust in the past year alone. And many community banks will go bankrupt. Community banks usually finance everything: the homes, the stores, the downtown, the commercial real estate, the shopping center. If you are in a town or a municipality where there is a housing bust, the bank is gone. Of three dozen or so medium-sized regional banks, a good third are in distress. That includes the Wachovias and Washington Mutuals of the world. Half of this group might go bankrupt. Even some of the majors could end up technically insolvent, though they might be deemed too big to fail.
Take Citigroup. In 1991 there was a small real-estate bust, though the quarterly fall in home prices was only 4%, based on the S&P/Case-Shiller indices. Citi was effectively bankrupt and signed a memorandum of understanding with the Fed that allowed the government to give the bank regulatory forbearance. Citi was allowed to ride it out and try to recapitalize in a few years, and thereby avoid bankruptcy protection. This time around the S&P/Case-Shiller indices indicate home prices already have fallen 18%. The decline could be as much as 30%, because the excess supply is huge.
No. I’m actually a pretty mainstream economist. I was trained first in Italy and then in the U.S. and earned my Ph.D. at Harvard. My interests are in international market economics and international finance, and I’m not a ‘perma-bear’ on the stock market nor an eternal pessimist.
Leaving aside the fact that we are going to have a pretty nasty recession and international crisis, the global economy is going to grow at a sustained rate once this downturn is over. There are significant financial and economic problems in the U.S., and that’s why I’m bearish about the U.S. But the emergence of China and India and other powers is going to shift global economics and politics radically, and the world is going to be more balanced in the future, rather than relying on one engine, which has been the U.S. There are big issues ahead: How do you integrate the 2.2 billion Chinese and Indians into the global economy? There will be transitional costs and the displacement of workers, both blue-collar and white, in the advanced economies. But I’m quite bullish about the state of the global economy, and I’m positive about the medium and long term.
And here are below the comments that Alan Abelson – Barron’s columnist and one of the most senior and well respected commentators on Wall Street – made a few weeks ago (in his Barron’s column – aptly titled “Dead Stocks Rallying”) following my analysis of the extent of the economic and financial crisis that the U.S. and the world economy would experience:
WHY WE’RE STILL BEARISH WAS SPELLED out starkly in a dispatch we received last week from Nouriel Roubini. Nouriel is a professor of economics at NYU Stern School of Business (but don’t hold that against him) and runs an economic advisory firm called RGE Monitor that casts a knowing and clear eye on the global financial and economic scene. We think he’s top-notch (which means we agree with him, a lot of the time).
The nub of his argument is that we’re suffering the worst financial crisis since the Great Depression, and he proceeds to give chilling chapter and verse. He predicts that hundreds of small banks loaded with real estate will go bust and dozens of large regional and national banks will also find themselves in deep do-do.
He reckons that, in a few years, there’ll be no major independent broker-dealers left: They’ll either pack it in or merge, victims of excessive leverage and a badly flawed and discredited business model.
The Federal Deposit Insurance Corp., after it gets through picking up the pieces of IndyMac, will sooner or later have to get a capital transfusion, Nouriel asserts, because its insurance premiums won’t cover the tab of rescuing all the troubled banks. He foresees credit losses ultimately reaching at least $1 trillion and anticipates a heap of woe for credit purveyors across the board.
The poor consumer, he contends, is shopped out and being hammered by falling home prices, falling equity prices, falling jobs and incomes, rising inflation. The recession he anticipates will last 12 to 18 months. And the rest of the world won’t escape: He looks for hard landings for 12 major economies. As for the stock market, he hazards that there’s plenty of room left on the downside. In fact, he feels the bear market won’t end until equities are down a full 40% from their peaks.
We must say this vision is a mite too apocalyptic even for us. But Nouriel is not a professional fear-monger out to make a splash with end-of-the-world prognostications He’s a sound guy with a solid record and an impressive résumé. We obviously believe his views are worth pondering, even if they ruin your appetite.
Those views of mine – that Abelson was referring to – were in a blog of mine that I wrote in mid-July that summarized a number of my recent writings and analyses. Here is below the summary of those views…:
This will turn out to be the worst financial crisis since the Great Depression and the worst US recession in decades…
This is by far the worst financial crisis since the Great Depression (not as severe as the Great Depression but second only to it).
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
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 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.
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.
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.
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.
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.