[R-G] [BillTottenWeblog] Yes, That's $2 Trillion of Debt-Related Losses

[Bill Totten]

Barron's (August 04 2008)


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 twenty percent 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 US 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 eighteen 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
millions 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 US 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.

What should Bernanke have done a year ago, or even prior to that?

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 one percent 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'.

Now the regulators are attempting to make up for lost time. What do you
think of their efforts?

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 US 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.

So the government should have let Bear Stearns fail, not to mention
Fannie and Freddie?

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 & Co, 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 fifteen percent 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 nine 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 eight percent
of US banks are in big trouble. Eight percent of the roughly 8,500 that
the FDIC essentially is insuring equals about 700 banks. Another eight
to sixteen percent also are shaky, so some 700 potentially are going
bust and another 700 eventually could join them. Yet the FDIC is
watching only nine 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 estimated $1.1 trillion and 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.

How long will it take for the collapse in the banking sector to play out?

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 four percent, 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 eighteen percent. The decline could be as
much as thirty percent, because the excess supply is huge.

Nouriel, have you always been so negative about everything?

No. I'm actually a pretty mainstream economist. I was trained first in
Italy and then in the US and earned my PhD 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 US, and that's why I'm bearish
about the US. 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 US 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.

That's a relief. Thank you.

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