Why did
the Fed ease the Fed Funds rate by a whopping 125bps
in eight days this past January?
It is true that most macro
indicators are heading south and suggesting a deep and severe recession
that has already started. But the flow of bad macro news in mid-January
did not justify, by itself, such a radical inter-meeting emergency Fed
action followed by another cut at the formal FOMC meeting.
To understand the Fed actions one has to realize that there is now a
rising probability of a “catastrophic” financial and economic outcome,
i.e. a vicious circle where a deep recession makes the financial losses
more severe and where, in turn, large and growing financial losses and a
financial meltdown make the recession even more severe. The Fed is
seriously worried about this vicious circle and about the risks of a
systemic financial meltdown.
That is the reason the Fed had thrown all caution to the wind – after a
year in which it was behind the curve and underplaying the economic and
financial risks – and has taken a very aggressive approach to risk
management; this is a much more aggressive approach than the
Greenspan one in spite of the initial views that the Bernanke
Fed would be more cautious than Greenspan in reacting to economic and
financial vulnerabilities.
To understand the risks that the financial system is facing today I
present the “nightmare” or “catastrophic” scenario that the Fed and
financial officials around the world are now worried about. Such a
scenario – however extreme – has a rising and significant probability of
occurring. Thus, it does not describe a very low probability event but
rather an outcome that is quite possible.
Start first with the recession that is now enveloping the US economy.
Let us assume – as likely -
that this recession – that already started in December 2007 - will be
worse than the mild ones – that lasted 8 months – that occurred in
1990-91 and 2001.
The recession of 2008 will
be more severe for several reasons:
first, we have the
biggest housing bust in US history with home prices likely to
eventually fall 20 to 30%
second, because of a
credit bubble that went beyond mortgages and because of reckless
financial innovation and securitization the ongoing credit bust will
lead to a severe credit crunch
third, US households –
whose consumption is over 70% of GDP - have spent well beyond their
means for years now piling up a massive amount of debt, both
mortgage and otherwise
now that home prices are
falling and a severe credit crunch is emerging the retrenchment of
private consumption will be serious and protracted
So let us suppose that the
recession of 2008 will last at least four quarters and, possibly, up to
six quarters.
What will be the
consequences of it?
Here are the twelve steps
or stages of a scenario of systemic financial meltdown associated with
this severe economic recession…
First, this is the worst
housing recession in US history and there is no sign it will bottom
out any time soon. At this point it is clear that US home prices
will fall between 20% and 30% from their bubbly peak; that would
wipe out between $4 trillion and $6 trillion of household wealth.
While the subprime meltdown is likely to cause about 2.2 million
foreclosures, a 30% fall in home values would imply that over 10
million households would have negative equity in their homes and
would have a big incentive to use “jingle mail” (i.e. default, put
the home keys in an envelope and send it to their mortgage bank).
Moreover, soon enough a
few very large home builders will go bankrupt and join the dozens of
other small ones that have already gone bankrupt thus leading to
another free fall in home builders’ stock prices that have
irrationally rallied in the last few weeks in spite of a worsening
housing recession.
Second, losses for the
financial system from the subprime disaster are now estimated to be
as high as $250 to $300 billion. But the financial losses will not
be only in subprime mortgages and the related RMBS and CDOs. They
are now spreading to near prime and prime mortgages as the same
reckless lending practices in subprime (no down-payment, no
verification of income, jobs and assets (i.e. NINJA or LIAR loans),
interest rate only, negative amortization, teaser rates, etc.) were
occurring across the entire spectrum of mortgages; about 60% of all
mortgage origination since 2005 through 2007 had these reckless and
toxic features.
So this is a generalized
mortgage crisis and meltdown, not just a subprime one. And losses
among all sorts of mortgages will sharply increase as home prices
fall sharply and the economy spins into a serious recession. Goldman
Sachs now estimates total mortgage credit losses of about $400
billion; but the eventual figures could be much larger if home
prices fall more than 20%. Also, the RMBS and CDO markets for
securitization of mortgages – already dead for subprime and frozen
for other mortgages - remain in a severe credit crunch, thus
reducing further the ability of banks to originate mortgages. The
mortgage credit crunch will become even more severe.
Also add to the woes and losses of the financial institutions the
meltdown of hundreds of billions of off balance SIVs and conduits;
this meltdown and the roll-off of the ABCP market has forced banks
to bring back on balance sheet these toxic off balance sheet
vehicles adding to the capital and liquidity crunch of the financial
institutions and adding to their on balance sheet losses.
And because of
securitization the securitized toxic waste has been spread from
banks to capital markets and their investors in the US and abroad,
thus increasing – rather than reducing systemic risk – and making
the credit crunch global.
Third, the recession
will lead – as it is already doing – to a sharp increase in defaults
on other forms of unsecured consumer debt: credit cards, auto loans,
student loans. There are dozens of millions of subprime credit cards
and subprime auto loans in the US. And again defaults in these
consumer debt categories will not be limited to subprime borrowers.
So add these losses to the financial losses of banks and of other
financial institutions (as also these debts were securitized in ABS
products), thus leading to a more severe credit crunch. As the Fed
loan officers survey suggest the credit crunch is spreading
throughout the mortgage market and from mortgages to consumer
credit, and from large banks to smaller banks.
Fourth, while there is
serious uncertainty about the losses that monolines will undertake
on their insurance of RMBS, CDO and other toxic ABS products, it is
now clear that such losses are much higher than the $10-15 billion
rescue package that regulators are trying to patch up.
Some monolines are
actually borderline insolvent and none of them deserves at this
point a AAA rating regardless of how much realistic recapitalization
is provided. Any business that required an AAA rating to stay in
business is a business that does not deserve such a rating in the
first place. The monolines should be downgraded as no private rescue
package – short of an unlikely public bailout – is realistic or
feasible given the deep losses of the monolines on their insurance
of toxic ABS products.
Next, the downgrade of the monolines will lead to another $150 of
writedowns on ABS portfolios for financial institutions that have
already massive losses. It will also lead to additional losses on
their portfolio of muni bonds. The downgrade of the monolines will
also lead to large losses – and potential runs – on the money market
funds that invested in some of these toxic products.
The money market funds
that are backed by banks or that bought liquidity protection from
banks against the risk of a fall in the NAV may avoid a run but such
a rescue will exacerbate the capital and liquidity problems of their
underwriters. The monolines’ downgrade will then also lead to
another sharp drop in US equity markets that are already shaken by
the risk of a severe recession and large losses in the financial
system.
Fifth, the commercial
real estate loan market will soon enter into a meltdown similar to
the subprime one. Lending practices in commercial real estate were
as reckless as those in residential real estate. The housing crisis
will lead – with a short lag – to a bust in non-residential
construction as no one will want to build offices, stores, shopping
malls/centers in ghost towns. The CMBX index is already pricing a
massive increase in credit spreads for non-residential
mortgages/loans. And new origination of commercial real estate
mortgages is already semi-frozen today; the commercial real estate
mortgage market is already seizing up today.
Sixth, it is possible
that 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. This, like in the case of Northern Rock, will lead to
depositors’ panic and concerns about deposit insurance. The Fed will
have to reaffirm the implicit doctrine that some banks are too big
to be allowed to fail.
But these bank
bankruptcies will lead to severe fiscal losses of bank bailout and
effective nationalization of the affected institutions. Already
Countrywide – an institution that was more likely insolvent than
illiquid – has been bailed out with public money via a $55 billion
loan from the FHLB system, a semi-public system of funding of
mortgage lenders. Banks’ bankruptcies will add to an already severe
credit crunch.
Seventh, the banks
losses on their portfolio of leveraged loans are already large and
growing. The ability of financial institutions to syndicate and
securitize their leveraged loans – a good chunk of which were issued
to finance very risky and reckless LBOs – is now at serious risk.
And hundreds of billions of dollars of leveraged loans are now stuck
on the balance sheet of financial institutions at values well below
par (currently about 90 cents on the dollar but soon much lower).
Add to this that many
reckless LBOs (as senseless LBOs with debt to earnings ratio of
seven or eight had become the norm during the go-go days of the
credit bubble) have now been postponed, restructured or cancelled.
And add to this problem the fact that some actual large LBOs will
end up into bankruptcy as some of these corporations taken private
are effectively bankrupt in a recession and given the repricing of
risk; convenant-lite and PIK toggles may only postpone – not avoid –
such bankruptcies and make them uglier when they do eventually
occur.
The leveraged loans mess
is already leading to a freezing up of the CLO market and to growing
losses for financial institutions.
Eighth, once a severe
recession is underway a massive wave of corporate defaults will take
place. In a typical year US corporate default rates are about 3.8%
(average for 1971-2007); in 2006 and 2007 this figure was a puny
0.6%. And in a typical US recession such default rates surge above
10%. Also during such distressed periods the RGD – or recovery given
default – rates are much lower, thus adding to the total losses from
a default. Default rates were very low in the last two years because
of a slosh of liquidity, easy credit conditions and very low spreads
(with junk bond yields being only 260bps above Treasuries until mid
June 2007).
But now the repricing of
risk has been massive: junk bond spreads close to 700bps, iTraxx and
CDX indices pricing massive corporate default rates and the junk
bond yield issuance market is now semi-frozen. While on average the
US and European corporations are in better shape – in terms of
profitability and debt burden – than in 2001 there is a large fat
tail of corporations with very low profitability and that have piled
up a mass of junk bond debt that will soon come to refinancing at
much higher spreads.
Corporate default rates
will surge during the 2008 recession and peak well above 10% based
on recent studies. And once defaults are higher and credit spreads
higher massive losses will occur among the credit default swaps
(CDS) that provided protection against corporate defaults. Estimates
of the losses on a notional value of $50 trillion CDS against a bond
base of $5 trillion are varied (from $20 billion to $250 billion
with a number closer to the latter figure more likely).
Losses on CDS do not
represent only a transfer of wealth from those who sold protection
to those who bought it. 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.
Ninth, the “shadow
banking system” (as defined by the PIMCO folks) or more precisely
the “shadow financial system” (as it is composed by non-bank
financial institutions) will soon get into serious trouble. This
shadow financial system is composed of financial institutions that –
like banks – borrow short and in liquid forms and lend or invest
long in more illiquid assets. This system includes: SIVs, conduits,
money market funds, monolines, investment banks, hedge funds and
other non-bank financial institutions.
All these institutions
are subject to market risk, credit risk (given their risky
investments) and especially liquidity/rollover risk as their short
term liquid liabilities can be rolled off easily while their assets
are more long term and illiquid. Unlike banks these non-bank
financial institutions don’t have direct or indirect access to the
central bank’s lender of last resort support as they are not
depository institutions. Thus, in the case of financial distress
and/or illiquidity they may go bankrupt because of both insolvency
and/or lack of liquidity and inability to roll over or refinance
their short term liabilities.
Deepening problems in
the economy and in the financial markets and poor risk managements
will lead some of these institutions to go belly up: a few large
hedge funds, a few money market funds, the entire SIV system and,
possibly, one or two large and systemically important broker
dealers. Dealing with the distress of this shadow financial system
will be very problematic as this system – stressed by credit and
liquidity problems - cannot be directly rescued by the central banks
in the way that banks can.
Tenth, stock markets in
the US and abroad will start pricing a severe US recession – rather
than a mild recession – and a sharp global economic slowdown. The
fall in stock markets – after the late January 2008 rally fizzles
out – will resume as investors will soon realize that the economic
downturn is more severe, that the monolines will not be rescued,
that financial losses will mount, and that earnings will sharply
drop in a recession not just among financial firms but also non
financial ones.
A few long equity hedge
funds will go belly up in 2008 after the massive losses of many
hedge funds in August, November and, again, January 2008. Large
margin calls will be triggered for long equity investors and another
round of massive equity shorting will take place. Long covering and
margin calls will lead to a cascading fall in equity markets in the
US and a transmission to global equity markets. US and global equity
markets will enter into a persistent bear market as in a typical US
recession the S&P500 falls by about 28%.
Eleventh, the worsening
credit crunch that is affecting most credit markets and credit
derivative markets will lead to a dry-up of liquidity in a variety
of financial markets, including otherwise very liquid derivatives
markets. Another round of credit crunch in interbank markets will
ensue triggered by counterparty risk, lack of trust, liquidity
premia and credit risk. A variety of interbank rates – TED spreads,
BOR-OIS spreads, BOT – Tbill spreads, interbank-policy rate spreads,
swap spreads, VIX and other gauges of investors’ risk aversion –
will massively widen again. Even the easing of the liquidity crunch
after massive central banks’ actions in December and January will
reverse as credit concerns keep interbank spread wide in spite of
further injections of liquidity by central banks.
Twelfth, a vicious
circle of losses, capital reduction, credit contraction, forced
liquidation and fire sales of assets at below fundamental prices
will ensue leading to a cascading and mounting cycle of losses and
further credit contraction. In illiquid market actual market prices
are now even lower than the lower fundamental value that they now
have given the credit problems in the economy. Market prices include
a large illiquidity discount on top of the discount due to the
credit and fundamental problems of the underlying assets that are
backing the distressed financial assets.
Capital losses will lead
to margin calls and further reduction of risk taking by a variety of
financial institutions that are now forced to mark to market their
positions. Such a forced fire sale of assets in illiquid markets
will lead to further losses that will further contract credit and
trigger further margin calls and disintermediation of credit. The
triggering event for the next round of this cascade is the downgrade
of the monolines and the ensuing sharp drop in equity markets; both
will trigger margin calls and further credit disintermediation.
Based on estimates by
Goldman Sachs $200 billion of losses in the financial system lead to
a contraction of credit of $2 trillion given that institutions hold
about $10 of assets per dollar of capital.
The recapitalization of
banks sovereign wealth funds – about $80 billion so far – will be unable
to stop this credit disintermediation – (the move from off balance sheet
to on balance sheet and moves of assets and liabilities from the shadow
banking system to the formal banking system) and the ensuing contraction
in credit as the mounting losses will dominate by a large margin any
bank recapitalization from SWFs.
A contagious and cascading
spiral of credit disintermediation, credit contraction, sharp fall in
asset prices and sharp widening in credit spreads will then be
transmitted to most parts of the financial system. This massive credit
crunch will make the economic contraction more severe and lead to
further financial losses. Total losses in the financial system will add
up to more than $1 trillion and the economic recession will become
deeper, more protracted and severe.
A near global economic recession will ensue as the financial and
credit losses and the credit crunch spread around the world. Panic, fire
sales, cascading fall in asset prices will exacerbate the financial and
real economic distress as a number of large and systemically important
financial institutions go bankrupt. A 1987 style stock market crash
could occur leading to further panic and severe financial and economic
distress.
Monetary and fiscal easing
will not be able to prevent a systemic financial meltdown as credit and
insolvency problems trump illiquidity problems. The lack of trust in
counterparties – driven by the opacity and lack of transparency in
financial markets, and uncertainty about the size of the losses and who
is holding the toxic waste securities – will add to the impotence of
monetary policy and lead to massive hoarding of liquidity that will
exacerbates the liquidity and credit crunch.
In this meltdown scenario US and global financial markets will
experience their most severe crisis in the last quarter of a century.
Can the Fed and other financial officials avoid this nightmare scenario
that keeps them awake at night?
The answer to this question
– to be detailed in a follow-up article – is twofold:
first, it is not easy to
manage and control such a contagious financial crisis that is more
severe and dangerous than any faced by the US in a quarter of a
century
second, the extent and
severity of this financial crisis will depend on whether the policy
response – monetary, fiscal, regulatory, financial and otherwise –
is coherent, timely and credible
I will argue – in my next
article - that 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.