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Is the worst over?

August 19th, 2008 · 1 Comment

Well, if you ask a couple of famous economist, not really…

First, the former chief economist of the IMF, Kenneth Rogoff:

  • Rogoff told a conference in Singapore today that the credit crisis is likely to worsen and a large bank may fail, Reuters reported earlier. He was the IMF’s chief economist from August 2001 to September 2003.
  • Credit market turmoil has driven the U.S. into a recession and may topple some of the nation’s biggest banks, said Kenneth Rogoff, former chief economist at the International Monetary Fund.
  • The worst is yet to come in the U.S.,” Rogoff, a Harvard University professor of economics, said in an interview in Singapore today. “The financial sector needs to shrink; I don’t think simply having a couple of medium-sized banks and a couple of small banks going under is going to do the job.”
  • Freddie Mac and Fannie Mae “should have been closed down 10 years ago,” he said. “They need to be nationalized, the equity holders should lose all their money. Probably we need to guarantee the bonds, simply because the U.S. has led everyone into believing they would guarantee the bonds.”
  • “The only way to put discipline into the system is to allow some companies to go bust,” Rogoff said. “You can’t just have an industry where they make giant profits or they get bailed out.”
  • The world’s largest economy is already in a recession, and the housing market will continue to deteriorate, Rogoff said. The U.S. slowdown will last into the second half of next year, he said, predicting a faster recovery in Europe and Asia.

And he’s not even the most gloomy economist. There is Nouriel Roubini, or Dr. Doom, as a recent beautiful NYT article had him. One has to give it to him though, he did predict unfolding events with amazing accuracy:

  • On Sept. 7, 2006, Nouriel Roubini, an economics professor at New York University, stood before an audience of economists at the International Monetary Fund and announced that a crisis was brewing. In the coming months and years, he warned, the United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession.
  • He laid out a bleak sequence of events: homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unraveling worldwide and the global financial system shuddering to a halt. These developments, he went on, could cripple or destroy hedge funds, investment banks and other major financial institutions like Fannie Mae and Freddie Mac.
  • The audience seemed skeptical, even dismissive. As Roubini stepped down from the lectern after his talk, the moderator of the event quipped, “I think perhaps we will need a stiff drink after that.” People laughed — and not without reason. At the time, unemployment and inflation remained low, and the economy, while weak, was still growing, despite rising oil prices and a softening housing market.
  • And then there was the espouser of doom himself: Roubini was known to be a perpetual pessimist, what economists call a “permabear.” When the economist Anirvan Banerji delivered his response to Roubini’s talk, he noted that Roubini’s predictions did not make use of mathematical models and dismissed his hunches as those of a career naysayer.

And that was not even the first time he argued this case:

  • The ’90s were an eventful time for an international economist like Roubini. Throughout the decade, one emerging economy after another was beset by crisis, beginning with Mexico’s in 1994. Panics swept Asia, including Thailand, Indonesia and Korea, in 1997 and 1998.
  • The economies of Brazil and Russia imploded in 1998. Argentina’s followed in 2000. Roubini began studying these countries and soon identified what he saw as their common weaknesses. On the eve of the crises that befell them, he noticed, most had huge current-account deficits (meaning, basically, that they spent far more than they made), and they typically financed these deficits by borrowing from abroad in ways that exposed them to the national equivalent of bank runs. Most of these countries also had poorly regulated banking systems plagued by excessive borrowing and reckless lending. Corporate governance was often weak, with cronyism in abundance.
  • After analyzing the markets that collapsed in the ’90s, Roubini set out to determine which country’s economy would be the next to succumb to the same pressures. His surprising answer: the United States’. “The United States,” Roubini remembers thinking, “looked like the biggest emerging market of all.” Of course, the United States wasn’t an emerging market; it was (and still is) the largest economy in the world. But Roubini was unnerved by what he saw in the U.S. economy, in particular its 2004 current-account deficit of $600 billion.
  • He began writing extensively about the dangers of that deficit and then branched out, researching the various effects of the credit boom — including the biggest housing bubble in the nation’s history — that began after the Federal Reserve cut rates to close to zero in 2003. Roubini became convinced that the housing bubble was going to pop. By late 2004 he had started to write about a “nightmare hard landing scenario for the United States.”

When others got optimistic in April and May this year, he didn’t:

  • In February, when the conventional wisdom held that the venerable investment firms of Wall Street would weather the crisis, Roubini warned that one or more of them would go “belly up” — and six weeks later, Bear Stearns collapsed. Following the Fed’s further extraordinary actions in the spring — including making lines of credit available to selected investment banks and brokerage houses — many economists made note of the ensuing economic rally and proclaimed the credit crisis over and a recession averted.
  • Roubini, who dismissed the rally as nothing more than a “delusional complacency” encouraged by a “bunch of self-serving spinmasters,” stuck to his script of “nightmare” events: waves of corporate bankrupticies, collapses in markets like commercial real estate and municipal bonds and, most alarming, the possible bankruptcy of a large regional or national bank that would trigger a panic by depositors.
  • Not all of these developments have come to pass (and perhaps never will), but the demise last month of the California bank IndyMac — one of the largest such failures in U.S. history — drew only more attention to Roubini’s seeming prescience.

And, for economist, another remarkable thing is that he does this all without the aid of any mathematical model of the economy, or, one might say, because he doesn’t use such models:

  • Recessions are signal events in any modern economy. And yet remarkably, the profession of economics is quite bad at predicting them. A recent study looked at “consensus forecasts” (the predictions of large groups of economists) that were made in advance of 60 different national recessions that hit around the world in the ’90s: in 97 percent of the cases, the study found, the economists failed to predict the coming contraction a year in advance. On those rare occasions when economists did successfully predict recessions, they significantly underestimated the severity of the downturns. Worse, many of the economists failed to anticipate recessions that occurred as soon as two months later.
  • The dismal science, it seems, is an optimistic profession. Many economists, Roubini among them, argue that some of the optimism is built into the very machinery, the mathematics, of modern economic theory. Econometric models typically rely on the assumption that the near future is likely to be similar to the recent past, and thus it is rare that the models anticipate breaks in the economy. And if the models can’t foresee a relatively minor break like a recession, they have even more trouble modeling and predicting a major rupture like a full-blown financial crisis.

We’re not close to the end of the crisis either:

  • For months Roubini has been arguing that the true cost of the housing crisis will not be a mere $300 billion — the amount allowed for by the housing legislation sponsored by Representative Barney Frank and Senator Christopher Dodd — but something between a trillion and a trillion and a half dollars.

Here, the most succinct, sharpest, shortest analysis of what’s wrong we have seen to date:

  • But most important, in Roubini’s opinion, is to realize that the problem is deeper than the housing crisis. “Reckless people have deluded themselves that this was a subprime crisis,” he told me. “But we have problems with credit-card debt, student-loan debt, auto loans, commercial real estate loans, home-equity loans, corporate debt and loans that financed leveraged buyouts.” All of these forms of debt, he argues, suffer from some or all of the same traits that first surfaced in the housing market: shoddy underwriting, securitization, negligence on the part of the credit-rating agencies and lax government oversight. “We have a subprime financial system,” he said, “not a subprime mortgage market.”

Where could this lead?

  • Roubini argues that most of the losses from this bad debt have yet to be written off, and the toll from bad commercial real estate loans alone may help send hundreds of local banks into the arms of the Federal Deposit Insurance Corporation. “A good third of the regional banks won’t make it,” he predicted. In turn, these bailouts will add hundreds of billions of dollars to an already gargantuan federal debt, and someone, somewhere, is going to have to finance that debt, along with all the other debt accumulated by consumers and corporations. “Our biggest financiers are China, Russia and the gulf states,” Roubini noted. “These are rivals, not allies.”
  • The United States, Roubini went on, will likely muddle through the crisis but will emerge from it a different nation, with a different place in the world. “Once you run current-account deficits, you depend on the kindness of strangers,” he said, pausing to let out a resigned sigh. “This might be the beginning of the end of the American empire.”

That’s strong stuff. Can something still be done?

  • Accordingly, he sees the choice facing the United States as stark but simple: either the government backs up a trillion-plus dollars’ worth of high-risk mortgages (in exchange for the lenders’ agreement to reduce monthly mortgage payments), or the banks and other institutions holding those mortgages — or the complex securities derived from them — go under. “You either nationalize the banks or you nationalize the mortgages,” he said. “Otherwise, they’re all toast.”

It’s the same solution as that of Rogoff. Very, very good stuff this.

Tags: The Markets

1 response so far ↓

  • 1 The US is losing economic power // Sep 11, 2008 at 5:28 pm

    […] that the US, in the words of Nouriel Roubini, turns out to have a ’sub-prime financial system’, the distrust against American assets […]