By Nouriel Roubini, Chairman, RGE Monitor
This author spent last weekend in New Orleans at the Annual Meetings of the American Economic Association (AEA). At a session on the subprime mess, moderated by David Wessel of the Wall Street Journal, I was a panelist together with Paul Krugman, Bob Shiller and Larry White, a housing expert at NYU/Stern. A crowd of over 400 listeners followed the two hour debate and asked probing questions.
The mood at the panel was gloomy. Bob Shiller spoke of the subprime meltdown, of how households are still deluding themselves — in polls — that home prices will keep on rising for the next decade while they have already fallen by 10% in real terms and need to fall by a cumulative 30% before they bottom out (a loss of home values of about $6 trillion); he also argued that the probability of an economy wide recession is now about 75%.
Larry White discussed how housing has been subsidized for a long time in the US via a plethora of subsidies and tax incentives; we thus invest way too much into the housing capital stock and not enough into more productive real capital; thus, the subprime mess is in part a reflection of this subsidization of housing. He also discussed the conflicts of interest of rating agencies and the lack of competition in the rating business. He also referred to the problems in the securitization food chain as due to information asymmetries, adverse selection and moral hazard.
I discussed in plainer terms these distortions in the securitization food chain: lender know less than borrowers about their ability to pay and lenders who do not hold the credit risk as they originate and distribute it know more about the quality of the mortgages than the final investors holding RMBs and CDOs (info asymmetries); those who are willing to take risky mortgages that may balloon and reset at higher rates may want to strategically default (adverse selection); and those in the securitization food chain (mortgage brokers, mortgage originators, mortgage appraisers, managers of CDOs, credit rating agencies) who are now not holding the credit risk but only earning a fee are subject to conflicts of interest when shoving such products to the final investors (moral hazard). This is the worst housing recession in US history and an economy-wide recession is now unavoidable and it will be a severe recession rather than a mild recession; and there is now a risk of a systemic financial crisis. This is a crisis of insolvency, not just illiquidity; it is a problem of unmeasurable uncertainty (on the size of the losses and who is holding the toxic waste) rather than priceable risk; and liquidity risk is now severe and not manageable as we have a shadow financial system where non-bank institutions (SIVs, conduits, money market funds, hedge funds, investment banks, etc.) borrow short/liquid and invest in long/illiquid assets; so they are subject to a severe liquidity/rollover risk but they don’t have access to the lender of last resort support of the central bank in the case of a liquidity run.
Paul Krugman also summarized the subprime debacle – an “unmitigated disaster” in his words – but he was more cautious and sanguine on whether this housing meltdown and the large financial losses will lead to a recession. In his view the fall in residential investment – as a share of GDP – has been compensated by a comparable increase in the share of exports in GDP (thanks to a weaker dollar); also so far consumption has held up rather than faltering. So maybe a recession will be avoided event if the ugly December employment figures made him a little more cautious about whether a recession can be avoided. So paradoxically Krugman was the most cautious in his assessment of an economy wide recession
A lot of interesting points and nuances were added in the question and answer session after the initial presentation by the panelist. But there was an overall consensus – subject to the above caveats - that home prices may have to fall 20 to 30% before they bottom out and that the risks of an economy wide recession are high and rising.
So, as argued before in this forum, at this point the debate is not anymore about whether we will have a soft landing or a hard landing recession; it is rather on how hard the hard landing will be, i.e. whether the upcoming recession will be mild – and lasting only a couple of quarters – or more severe and lasting several quarters. I have argued that this will be a severe recession rather than a mild one like the mild ones in 1990-91 and 2001; and that the risks of a severe systemic financial crisis are now very serious.
There is now a consensus – certainly at the AEA panel – that home price will have to fall 20% to 30% before they bottom out, most likely 30%. This is a whopping loss of home values of about $6 trillion that will have significant macro effects and financial effects. With losses this large the wealth effects on consumption – and the related collapse in home equity withdrawal – will be serious; and with losses this large over 10 million households will end up in negative home equity territory and would thus have a strong incentive to default on their mortgages as most US states treat mortgages as non-recourse loans (i.e. once you default and get foreclosed you are not liable for the difference between the amount of your mortgage and the lower value of your home). The macro and financial consequences of losses and defaults of this size are massive. The part of these $6 trillion losses that will be incurred by households having their home equity wiped out will show up in lower private consumption; while the part of these $6 trillion losses born by banks, other financial institutions and investors in the US and across the world will lead to a severe credit crunch.
And research by Goldman Sachs suggests that even a modest $200 billion of losses for banks – and related reduction in their capital – would lead to a reduction of $2 trillion in credit – a severe credit crunch – as banks create about 10 dollars of assets for each dollar of capital that they hold. This credit crunch will be much more severe if mortgage losses incurred by bank and other financial institutions are – as likely - much more than $200 billion. And certainly while SWFs have partly recapped bank capital through their equity injections this increase in capital – at about $20 billion – is a fraction of the capital losses that are being incurred by financial institutions. Thus, the credit crunch could be extremely serious. So the process of capital losses and bank reintermediation – as SIVs, conduits and other off-balance sheet vehicles are brought bank on-balance sheet – is likely to exacerbate the liquidity crunch of banks and the credit crunch of banks and other financial institutions.
So while 2007 was mediocre for the US stock market – with the S&P500 down in real terms and returning less than safe US Treasuries – 2008 will be a much worse year as the economy spins into a recession (See: 2007: Cash Outperformed The Stock Market). The first three trading days of 2008 were already ominous with all the major indices sharply down Wednesday and Friday last week. But this is only the beginning of a real bearish stock market as a bear market is always associated with economic recessions.
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