Nouriel Roubini's Global EconoMonitor

Archive for September, 2008

  • The US and global financial crisis is becoming much more severe in spite of the Treasury rescue plan. The risk of a total systemic meltdown is now as high as ever

    It is obvious that the current financial crisis is becoming more severe in spite of the Treasury rescue plan (or maybe because of it as this plan it totally flawed). The severe strains in financial markets (money markets, credit markets, stock markets, CDS and derivative markets) are becoming more severe rather than less severe in spite of the nuclear option (after the Fannie and Freddie $200 billion bazooka bailout failed to restore confidence) of a $700 billion package: interbank spreads are widening (TED spread, swap spreads, Libo-OIS spread) and are at level never seen before; credit spreads (such as junk bond yield spreads relative to Treasuries are widening to new peaks; short-term Treasury yields are going back to near zero levels as there is flight to safety; CDS spread for financial institutions are rising to extreme levels (Morgan Stanley ones at 1200 last week) as the ban on shorting of financial stock has moved the pressures on financial firms to the CDS market; and stock markets around the world have reacted very negatively to this rescue package (US market are down about 3% this morning at their opening).

    Let me explain now in more detail why we are now back to the risk of a total systemic financial meltdown…

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  • Is Purchasing $700 billion of Toxic Assets the Best Way to Recapitalize the Financial System? No! It is Rather a Disgrace and Rip-Off Benefitting only the Shareholders and Unsecured Creditors of Banks

    Whenever there is a systemic banking crisis there is a need to recapitalize the banking/financial system to avoid an excessive and destructive credit contraction. But purchasing toxic/illiquid assets of the financial system is not the most effective and efficient way to recapitalize the banking system. Such recapitalization – via the use of public resources – […]

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  • RGE Conference Call on the Economic and Financial Outlook..and why the Treasury TARP bailout is flawed

    On Wednesday this week I had a 90 minutes conference call with users of the RGE Monitor service where I presented my views on the current financial crisis and the US and global economic outlook; my presentation was followed by a Q&A session with the over 500 participants in this call. The audio replay of […]

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  • HOME (Home Owners’ Mortgage Enterprise): A 10 Step Plan to Resolve the Financial Crisis

    Even if the Treasury TARP plan is implemented fairly and efficiently the US will not avoid a severe U-shaped18-month recession and a severe financial and banking crisis: the recession train has already left the station in Q1 and the financial/banking crisis will be severe regardless of what the Treasury and the Fed do from now on. What a proper rescue plan can do is to avoid having the US experience a multi-year L-shaped recession and extreme financial crisis like the one that led to a decade long stagnation in Japan in the 1990s after the bursting of their real estate and equity bubbles.

    I have also argued that, in order to resolve this financial crisis it is not enough to take the bad/toxic assets off the balance sheet of the financial institutions (a new RTC); it is also necessary and fundamental to reduce the debt overhang of millions of insolvent households via a significant debt reduction on their mortgages (an HOLC program like the one that was implement during the Great Depression); and also recapitalize undercapitalized banks with public capital in the form of preferred shares (as the RFC did with 4000 banks during the Great Depression). An RTC scheme without an HOLC and RFC component would not resolve two fundamental problems: millions of households are insolvent and unable to service their mortgages; the financial system is vastly undercapitalized and needs capital to avoid an ugly credit crunch and to foster new credit creation that is needed for future growth.

    That is why I proposed the creation of a HOME (Home Owners’ Mortgage Enterprise) that would be a combination of an RTC, a HOLC and a RFC. Let me flesh out this proposal and its key elements and compare it to the Treasury TARP proposal that in its current form has many flaws.

    There are 10 steps in this HOME proposal to resolve this most severe financial crisis. Here they are:

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  • The unraveling of the Shadow Banking System moves to hedge funds as Schmalpha replaces Alpha

    In my column in the FT yesterday I described the unraveling and demise of the shadow banking system that started with non-bank mortgage lenders, SIVs and conduits, major independent monoline broker dealers and money market funds.

    I then argued that the next leg of this unraveling would be hedge funds and private equity firms and their reckless LBOs:

    “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.”

    And indeed, faster than I can type it, this run on part of the hedge fund industry has already started. As reported by the Independent under the headline “Hedge Funds Suffer Mass Redemptions”:

    Hedge funds could have an unprecedented level of cash pulled out by investors this quarter, according to insiders, just as they faced millions of pounds of losses from last week’s shock regulation of short selling. It has been a tough year for the industry with high-profile funds blowing up, clients increasing redemptions, as well as public fury over short selling and increased threats of regulation.

    One hedge fund expert pointed to The Hedge Fund Implode-O-Meter (HFI) as how he judges the state of the industry. The HFI was set up online in the wake of the credit crunch “to track as hedge funds learn the double-edged-sword nature of the often extreme leverage they use”.

    The group’s “imploded funds” list has hit 51 companies since the sub-prime mortgage crisis in the United States kicked off a widespread downturn. That compares with its historical list, stretching back more than a decade to the end of 2006, of just 14, including the collapse of Long-Term Capital Management and Amaranth.

    This year, big names including Peloton Capital Partners, Carlyle Capital Corporation and Dillon Read Capital Management are just some of the half century to collapse. “We think hedge funds have largely lost their way,” HFI said. “Notably, most have abandoned capital-preservation for the goal of aggressive accumulation of capital gains, with the benefit of lax regulation and extreme leverage available to exploit.”

    It has 34 stocks on its “ailing/watch list” of those that have suffered significant value declines or temporarily halted redemptions. According to EuroHedge, a hedge fund data provider, 272 individual funds strategies were launched during the first six months of 2008, the lowest for nine years. In the same time, 243 funds have been liquidated, the highest in a six-month period.

    Nouriel Roubini, the New York University economics professor, says worse is to come. He believes there will be an increase in client withdrawals and a shake-up of how funds are regulated.

    The redemptions seem to have started in earnest, although currently the evidence is mainly anecdotal. One UK hedge fund manager confided that last week had the highest number of investors rushing to withdraw funds that he has known. The industry will know for sure whether it is a drip or a deluge when the data providers release their statistics for the third quarter, next month. One market analyst said: “I know even the good hedge funds have been suffering withdrawals recently. Investors are very nervous.”

    Performance numbers are also under pressure. Some have done well out of the market disturbance, but on average the performance numbers are at a low ebb. Andrew Baker, the deputy head of Aima, the hedge fund trade body, said: “The performance is undoubtedly soggy. There are not many strategies that stand out.”

    EuroHedge revealed that strategies that have done particularly badly this year include several run by Naissance Capital, once bankrolled by the Habsburg families, which are down a fifth and Pico Fund, which is down 32 per cent. At Endeavour Fund, set up by former Salomon Smith Barney traders, the second fund has fallen by 40 per cent, while its third fund is down 38.79 per cent in 2008. In the emerging markets, PharmaInvest Fund’s investments in emerging markets are 38.16 per cent down.

    Other funds have sought to lock in investors by halting redemptions. The latest example was RAB, with its flagship Special Situations Fund, as it was so desperate to prevent exits after a 22 per cent drop in performance that it offered vastly reduced fees in return for a lock-in period of three years.

    One of the main problems experienced by hedge funds is the extent of leverage in the industry. The funds were able to take on huge amounts of debt, with little capital needed as security, to boost returns. One observer said some of the leveraged strategies were like “picking up pennies in front of a steamroller, and that only takes a turn in the market to cause severe problems”.

    Andrew Lodge, the managing director of fund of hedge funds Nedbank Investments, said: “Some funds have gone in for huge leverage-driven strategies, which can be a problem. The appetite for leverage is less.” He added that some could be affected by increased margin calls, and could face issues over their covenants.

    At the same time, hedge funds, like the banks, have had to write down exposures to investments in risky instruments including collateralised debt obligations and asset backed securities, and also been exposed to the huge swings in the market.

    Another issue is the regulators sniffing around. There have been wider calls for transparency and official controls of the industry, which has already been stung by the shock short-selling rules.

    Mr Lodge said: “It’s a myth to say hedge funds aren’t regulated. There is a perception that they are running wild with no oversight, which isn’t true. We would welcome some regulation, just as long as it doesn’t strangle the industry.”

    On Friday, the FSA banned short selling in financial stocks, and forced hedge funds to disclose their positions. As the underlying shares rose as a result, the industry was looking at well over £1bn in paper losses on the day.

    Stuart McLaren, financial services partner at Deloitte, said: “When the dust has settled, I expect the regulators to look at the role that hedge funds have played in the current issues. I expect there will be increased calls for regulation, but I doubt much will come from it.”

    Mr Baker said: “Some hedge funds are doing well. However, the number of professionals feeling good about life will be dwindling. The health indicators are generally negative, while costs are up and performance is down. Many are feeling battered and bruised and feeling worried about the future.”

    Let me now discuss in more detail this unraveling of parts of the hedge fund industry…

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  • The Shadow Banking System is Unravelling: Roubini Column in the Financial Times. Such demise confirmed by Morgan and Goldman now being converted into banks

    The Financial Times published in its Monday edition my Op-Ed column “The Shadow Banking System is Unravelling”. The column was written and posted on their web site a few hours before the sudden announcement of the end of major independent broker dealers with the Fed announcement that Morgan Stanley and Goldman Sachs will become bank holding companies and will be thus regulated as banks. This is the additional step in the demise of Wall Street as we know it and the unraveling and demise of the “shadow banking system” that I described in my Financial Times Op-Ed column.

    Here is the text of my Op-Ed column:

    The shadow banking system is unravelling

    Nouriel Roubini

    Financial Times 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 financial intermediation in the past two decades has grown within this shadow system whose members are broker-dealers, hedge funds, private equity groups, 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 self-­fulfilling and destructive run on its ­liquid liabilities.

    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 money markets. 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 deposit insurance 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.

    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.

    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. Financial contagion, 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.

    European financial institutions are 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 credit crunch; 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.

    The writer, chairman of Roubini Global Economics (, is professor of economics at the Stern School of Business, New York University

    Let me now elaborate in more details on the arguments of this column also in light of the just announced decision to convert Morgan Stanley and Goldman Sachs into banks that will be regulated like banks…

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  • We need a new HOLC – more than a new RTC or RFC- to provide massive debt relief to the household sector. We need to create the HOME (Home Owners’ Mortgage Enterprise)

    In the last two weeks financial markets reached near panic conditions with almost every day another major financial institution on the verge of collapse (first Fannie and Freddie, then Lehman, then Merrill, then AIG and now Morgan Stanley, Goldman Sachs, WaMu, Wachovia and other banks under pressure), money markets seizing up and interbank spreads spiking like never before, Treasury bills yields plummeting as investors were seeking the safety of near cash instruments, credit spreads surging and stock markets tumbling on Monday and Wednesday. Even the Washington policy makers finally realized that this is the worst financial crisis since the Great Depression and that their ad hoc step-by-step and unsystematic approach to resolving this crisis was not working and the effect of ad hoc and band-aid policies in boosting market confidence was fizzling out. Indeed , after the March bailout of Bear Stearns markets rallied for two months; after the July announcement that Fannie and Freddie may be rescued markets rallied for three weeks; after the announcement of the actual bailout of Fannie and Freddie last week markets rallied for only one day on Monday and went into a tailspin starting on Tuesday with the worries about Lehman and other broker dealers; and after the bailout of AIG stock markets did not even rally: actually they tumbled almost 5% on Wednesday while money markets and credit markets went into a total seizure.

    So by Wednesday this week as markets were in total panic (stock prices collapsing, interbank spread surging to levels never seen before, credit spreads reaching new highs and Treasury bill rates practically down to zero as investors rushed to safety) the policy authorities decided that something more radical – that many of us had advocated for a long time – needed to be done. The most important policy action is not the decision of extending the swap lines between central banks (so as to provide dollar liquidity to non-US banks abroad); it is not the re-imposition of limits to short sales (a policy action that is itself a naked attempt to manipulate upward stock prices); it is rather the realization that a generalized debt and solvency problem required a solution that leads to significant debt reduction.

    Let me explain in detail how we now need bold policy action to resolve this most severe financial and economic crisis…

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  • The transformation of the USA into the USSRA (United Socialist State Republic of America) continues at full speed with the nationalization of AIG

    Last week we argued that, with the nationalization of Fannie and Freddie, comrades Bush, Paulson and Bernanke had started transforming the USA into the USSRA (United Socialist State Republic of America). This transformation of the USA into a country where there is socialism for the rich, the well connected and Wall Street (i.e. where profits are privatized and losses are socialized) continues today with the nationalization of AIG.

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  • The Worst Financial Crisis Since the Great Depression

    Regular readers of this blog are familiar with my views. But here below is a repeat of detailed summary of the reasons for my views (as presented on this forum last month) that this will turn out to be the worst financial crisis since the Great Depression and the worst US recession in decades (hyperlinks to my relevant recent writings are provided for each argument). As I wrote in August:

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  • The Demise of the Shadow Banking System and of the Broker Dealers: Some Media Appearances

    I discussed in detail over the weekend the Lehman and Merrill crisis and explained why – as I argued months ago – the remaining broker dealers (now only Morgan Stanley and Goldman Sachs being left) will go bust unless they merge with a financial institution that has a stable base of insured deposits. The business […]

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