Tuesday, November 20, 2007

Fear and Greed - The Risk of a U.S. Hard Landing and Implications for the Global Economy and Financial Markets

 This speech from NOURIEL ROUBINI, Stern School of Business, New York University on September 13th is the best summary of the current capital market mess and its implications for the world that I have seen.  If you're an optimist or realist, I would suggest not reading this as it could get you down.  If you're a pessimist don't read it either - it will just make you worse.

So we have created essentially in part a little bit of a monster. Of course we all know the benefits of financial globalization and securitization and all those things, I am not saying that I am against them. But you've created a financial system in which if you take out mortgages, the mortgage originator does not care: he or she maximizes volume and [gets higher] income. Then the bank originates the stuff and packages it in MBSs and then they get the fee and they shove it to the investment banks. And the investment banks tranch it in all the different tranches of CDO and then shove it to their final investors and the rating agencies give their blessings. You would think that the final investor is the one who has to provide the market discipline but after four stages you do not even know what it is, and after CDOs you have CDOs of CDOs, and CDOs of CDOs of CDOs

and then how you price this stuff. Of course there is an element of greed. At some point people were searching for yields or they should have known better, so I cannot just blame the rating agencies. But you have a whole system in which essentially people were making income not from bearing the credit risk but essentially transferring it somewhere else and getting the fees, and in most of the financial system that is how it gets its profit these days, so there is a fundamental kind of problem. On top of that the regulators [were] asleep at the wheel and let this stuff occur without any kind of constraint.

Source: Transcript of IMF Seminar -- The Risk of a U.S. Hard Landing and Implications for the Global Economy and Financial Markets

And then he goes into speaking about a possible hard landing in the US Economy, and whether the world will be affected.

The final thing I want to just briefly just speak about is this question of will the world decouple from the U.S. or not.

A little bit less than briefly, this is the longest paragraph in the speech.

The first victim of a hard-landing in the US economy?  China? Who would benefit the most from a hard landing in the US economy?  Russia?  Other parties affected?  Emerging markets due to risk aversion.  Commodity-rich countries.  Anyone and everyone, though not on the scale of the US.  The bigger they are....

The question and answer session has even more tidbits of information.

MS. SANTOS: That was quite a disturbing lecture. I am Barbara Santos, retired from the World Bank. Let me ask you, professor, if you were in Mr. Greenspan's shoes a year ago or 18 months ago, what measures would you have taken to avoid this terrible scenario?

Mr. Roubini speaks about the last few years of "laissez-faire" regulation, and summarizes the current financial woes in the simplest manner possible.

So essentially you have the element that private markets want to make money, they are greedy, and you have to have good, sound public policy and there were failures of the credit ratings of the financial institutions and the regulators. So that was an element of the problem.

The other element of the problem is right now: I think there is going to be a renewed debate about this issue of how you deal with asset bubbles.

He suggests that the Fed should have popped the bubble long ago, but that it is the belief of Greenspan, Kohn, and Bernake that you should let the market do it's thing in good times, and only be there to provide a cushion in bad times.  (The cushion being the US taxpayer eventually.)

The Canadian finance minister's view on bubbles seems to contradict our neighbours to the south.  BCE, one of Canada's largest taxpayers, decided to go the Income Trust route and save $800 million a year.  Last October, the minister promptly and efficiently put a pin into the Income Trust bubble, calling it "a growing trend towards corporate tax avoidance" that would hurt Canada.  However, he left REITs alone, and the housing bubble has kept growing since, with the best year ever for Toronto markets.  The average house price is almost $400k. By contrast, homes in the US are expected to decline in price by 10%-20% between the peak of 2007 to the low of 2009. 

His comments on 'Chindia'—China giving us all the cheap goods and India all the cheap services really make sense when it comes to inflation control on goods and services, while increasing the prices of assets and commodities.  By outsourcing inflation to China & India, it causes the CPI number to go down.

What happens when the Fed intervenes in a bubble?  It breaks, but when a bubble breaks it can sometimes form many smaller bubbles.

MR. ROUBINI: It could be the next housing crisis or maybe the next bubble. Some people say the Fed created first the tech bubble and then the housing bubble, and if they now ease they are going to create another bubble, even if we are running out of asset markets in to create bubbles.


For a while people thought it was private equity; now that has reached its peak and so on. But we can find other things.

There is already a post-mortem being done by the Financial Stability Forum (FSF) on the financial situation that came to a head in August, and the patient isn't even dead yet.  They recommend a quick adoption of the Basel II capital guidelines, a set of requirements for managing risk to a portfolio of instruments.  This report won't come out until next Spring at the earliest, so don't expect any fast solutions to the problem, and don't expect the US to spend more CAPEX on adopting Basel II.

According to Mr. Roubini, "(t)here will be changes. After LTCM I remember—in 1998 I was in the U.S. Treasury and the White House—there were lots of proposals and then when calm came back and nothing was done, and 10 years later we are still discussing whether we should regulate hedge funds or not, directly or indirectly, and I am not saying that we should. But changes in financial regulation, even when there are big crises, occur only slowly, incrementally at the margin."

The largest bubble mentioned in Mr. Roubini's speech?  "Credit derivatives 10 years ago were zero, today they are a notional value of $26 trillion".  That's $26,000,000,000,000.00 in US dollars. 

Even with a systemic breakdown in these instruments, he doesn't see a Great Depression or anything of that sort.

More on Nouriel Roubini on his home page at NYU, his Wikipedia entry, his blog on Global EconoMonitor.

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