The Three Stages of Truth

"All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident."
-- Arthur Schopenhauer.

A year ago, most so-called experts dismissed the notion of a Financial Armageddon as the delusions of a reckless madman. Indeed, I can remember contacting a few economists and asking them if they would be interested in reviewing my book -- and getting an abrupt and supercilious brush-off in return. Now, many of these clueless wonders are acting like they knew what was going to happen all along (not all of them, mind you; some are still firmly ensconsed in ivory tower la-la land).

Anyway, as I've noted before, one individual who has been educated in the dismal science who nevertheless seems quite aware of what is going on -- and who has been ahead of the curve almost every step of the way -- is Nouriel Roubini. In "Going, Going, Gone: a Rising Auction of Scary Scenarios," the Financial Times esteemed columnist Martin Wolf delves into what the good professor has been saying lately.

What am I bid on financial sector losses from the US subprime mortgage crisis? Do I have advances on the $100bn suggested by Ben Bernanke, chairman of the Federal Reserve, only last July? Yes, I now have $500bn from the gentlemen from Goldman Sachs. Any advances on $500bn? Yes, I have $1,000bn-$2,000bn from Nouriel Roubini of New York University’s Stern School of Business. Any advances? Going, going, gone.

It is easy to be cynical about this ascending auction of scary prognoses. But we cannot ignore them.

In “Why Washington’s rescue cannot end the crisis story” (this page, February 27) I analysed the implications of aggregate financial sector losses of $1,000bn. That figure was in line with estimates by Prof Roubini and George Magnus of UBS.
I concluded that even this would be manageable, if painful, for an economy as big and a government as creditworthy as that of the US. Prof Roubini objects that I have taken the downside too lightly. He now argues that financial losses might amount to $3,000bn.

A trillion dollars here, a trillion dollars there, and pretty soon you are talking real money, even for the US. So does this new bid make sense?

Most of the losses will fall not on the financial sector but elsewhere. As Prof Roubini notes, a 10 per cent fall in house prices (relative to the peak) knocks off $2,000bn (14 per cent of gross domestic product) from household wealth. The first 10 per cent fall has already happened. What he sees as a likely 30 per cent cumulative fall would wipe out $6,000bn, 42 per cent of GDP and 10 per cent of household wealth. Already, falling prices are showing up in declining net household wealth. Prof Roubini also talks of a $5,600bn decline in the value of stocks and the possibility of additional trillions of dollars in losses on commercial property. Total losses might even equal annual GDP.

The principal direct effect of such losses will be on spending, particularly residential investment and household consumption. In the third quarter of last year, personal savings were a mere 2.4 per cent of GDP, while the financial balance of the personal sector (the difference between its income and expenditure) was minus 2.1 per cent. These patterns do not make sense when asset prices are falling. But a sharp rise in household savings would ensure a deep and durable recession.

Worse, the bigger the damage to the financial sector, the more credit-fuelled personal spending is going to dry up. So what might such overall losses mean for financial intermediaries. In Prof Roubini’s 12 steps to meltdown, discussed here on February 20, 2008, he assumed that their losses on mortgages would be $300bn-$400bn, while losses on other assets (consumer debt, commercial real estate loans and so forth) would be another $600bn-$700bn, for a total of $1,000bn. On March 7, Goldman Sachs economists published an even higher estimate of mortgage-related losses, at $500bn, along with $656bn in other losses, for a total of $1,156bn. The mainstream has caught up. But Prof Roubini has moved on.

In reaching its conclusion, Goldman estimated a peak-to-trough house price fall of 25 per cent. In his comments on the FT’s forum, Prof Roubini suggests that, after price falls of 20 per cent from the peak, losses on mortgages could be as much as $1,000bn. With a 40 per cent fall, they could be $2,000bn. He adds another $700bn for other losses, to reach total financial sector losses of close to $3,000bn, or about 20 per cent of GDP.

So how does Prof Roubini reach these much higher figures? The difference between him and Goldman is not so much in assumptions about the house price fall: 25 per cent for Goldman Sachs and 20-40 per cent for Prof Roubini. Both also estimate that lenders would lose half of the loan value after repossession. But Goldman believes that just 20 per cent of households in negative equity would default, while Prof Roubini believes 50 per cent might do so.

For people with poor credit ratings and few assets, apart from their house, walking away does seem to make disturbingly good sense (“Jingle-mail rings alarm bells for lenders”, Financial Times, March 7). Buyers with no equity had an option to walk. Now they are exercising it. This was demented finance. Yet, so long as the economy remains reasonably robust, highly indebted people with good career prospects would surely not wish to wreck their credit rating. Nevertheless, markets are pessimistic: the prices of even AAA tranches of securitised loans are collapsing.

Suppose, then, that Prof Roubini were right. Losses of $2,000bn-$3,000bn would decapitalise the financial system. The government would have to mount a rescue. The most plausible means of doing so would be via nationalisation of all losses. While the US government could afford to raise its debt by up to 20 per cent of GDP, in order to do this, that decision would have huge ramifications. We would have more than the biggest US financial crisis since the 1930s. It would be an epochal political event.

Yet, Goldman argues that, after allowing for loan-loss provisions, the proportion of loss-making loans advanced by the non-leveraged sector and the ability to write off losses against tax, its $1,156bn comes down to $298bn. If a similar magic could be worked on the Roubini numbers, the effective losses to the leverage sector would fall to less than $750bn – huge, but more manageable.

Much will depend on what happens to the economy. Unfortunately, the effectiveness of monetary policy is constrained when the worries are more about insolvency than illiquidity. Concern about credit quality is rampant, not least in the resurgent spreads on interbank lending. Monetary policy is further constrained when lower short-term interest rates fail to translate into long-term rates, partly because of worries about inflation.

Alas, worries are understandable. There are two ways of adjusting the prices of housing to incomes: allow nominal prices to fall or raise nominal incomes. The former means mass bankruptcy and a huge fiscal bail out; the latter imposes the inflation tax. In extreme circumstances inflation must be attractive. Even if it is not the Fed’s choice, it is what a reasonable outsider might fear, with obvious consequences for all asset prices.

I suspect Prof Roubini’s latest estimates are excessively pessimistic. But I am not certain this is so, given his record: just look at the vicious interaction between falling asset prices, financial stress and spending. We must pray that the Fed can clean it all up, without excessive collateral damage. Unfortunately, such prayers often go unanswered.

Comments

[Jes]

"Yet, so long as the economy remains reasonably robust, highly indebted people with good career prospects would surely not wish to wreck their credit rating."

This can be interpreted two ways. One meaning is that people (who feel they can always get jobs) won't wish to wreck their credit rating. The other meaning, and I think this is closer to what the author intended, is that people who feel they are emplyable won't wish to do smething (wreck their credit rating) that could damage their employability.

If the second interpretation is correct, then this is another instance of the delusion suffered by the lenders that left them unable to imagine jingle mail as a real possibility when their toxic mortgages reset. We've already established that pride of ownership won't keep a person in a house. Likewise, concern about one's employability won't keep a debtor in a house. If many people are walking out of their houses, and thus many job applicants have mortgage-related bad credit, HR staff aren't going to toss out those applicants. Companies will adjust their policies, instead.

[Ordog]

Pride of Ownership, indeed. Have any of you ever worked with the bank's ideas of pride of ownership? A pretty house outside, a hell hole inside is "pride of ownership". Buying a house as an investment, replacing the costly old heat, putting in insulation, circuit breakers installed to replace deadly fuses, that is not displaying pride of ownership. Pride of ownership is when you overlook those things, and plant flowers, put in a picket fence - put lipstick on a pig. And no property that is worth less than a certain threshold, no matter the neighborhood or condition, is EVER eligible for pride of ownership. My example for my area (very low cost of living here):

Working class buyer finds a solid fixer-upper. Working class buyer can't buy the house b/c it isn't worth enough - so the bank lends more to re-side, landscape, etc, and working class buyer does this or has no choice to get a loan, yet the issues that make the house costly - high utility bills, poor wiring - are not addressed, so the buyer has to face high payments and high expenses. Of course, the bank's sub-prime 2nd mortgage unit is there to help with that....

The bottom line is that people don't have a choice - if you can't pay you can't pay.

[USFSucks]

Prof Roubini is certainly entertaining. He *has* to be the alpha bear. LOL!