Wednesday, July 23, 2008
how do we get out of this mess?
the links to nouriel roubini's tech ticker interviews are everywhere, but i'll cite 1440 wall street.
roubini drills right to the core of the housing problem here. the economic unit we call the united states became deeply overleveraged in the credit boom which ended in 2007 and now carries more debt than it can service. what is needed for resolution is debt reduction, sometimes otherwise known as deflation.
but how can we get there without going through a process of unmitigated liquidation and cascading defaults? roubini posits that there are essentially two avenues for public policy here -- either explicitly nationalize the mortgage market and guarantee investor capital, or allow losses in mortgages to materialize and subsequently nationalize most of the banking system.
make no mistake -- as the housing delevering runs its course, these are the options. the latter would be the sweden model, effectively. the institutional risk analytics roundtable of last week gave a frightening window on what roubini is saying. when jonathan rosner suggested that house prices still have another 15-20% to correct -- something i consider to be a given, even optimistic, as i commented here -- the response was telling.
Wallison: ... Banks that hold this paper would see their capital decline in value along with the value of the GSE debt. Then we really would begin to see the failure of banks or at least the inability of banks to make new loans. My hope is that we can stabilize the GSEs and see the housing market also stabilize. But if Josh is right about the real estate market declining another 20 points, the GSEs will have to go into receivership. Then the question will be where is the US government going to get the money to ensure that the GSE debt is serviced. ...
Rosner: Yes and Treasury is worried about brokers while we are getting ready to see a couple of thousand small and medium size banks sold or closed in the next year or more.
it is worth remembering that the great depression saw about 11,000 banks fail out of a pool of 25,000. banks were then smaller and more localized -- today there are about 8,000. rosner is positing bank failures on a level not all that far from those seen in 1932-33.
O'Driscoll: If Josh's prediction about the real estate market declining further is correct, then I don't know what we'll do about the banks.[a plan to give a 10% haircut to holders of GSE debt, doubtful in the opinion of the others to be acceptable to foreign central bank holders -- ed.] given a chance to work, it is really hard to see global central banks agreeing to such a scheme.
Wallison: Well, if Josh is right about real estate prices, then the Fed is going to have to open up investments in banks to non-financial firms. We should be getting rid of the BHCA entirely to raise the capital the industry needs. ...
Wallison: If Josh is right about the direction of housing and it goes down another 20%, yes there will be a huge crisis in the banking industry and at FNM and FRE, and the US government will be heavily involved. It has to be. ...
The IRA: As much as I'd like to see Josh's pre-pack plan
Rosner: Then we are probably going to see the result nobody wants, namely the junk status of the GSEs eventually transferred to the US government itself and a potential credit ratings downgrade of the US.
in other words, wall street got drunk and now we all get to share in the hangover. and that from a man who ought to know.
a successful nationalization of a large part of the banking system would be predicated on massive foreign recapitalization assistance, either through direct ownership transfer or through foreign central bank funding of the necessary treasury debt issuance that would accompany a government recapitalization.
there is clearly -- as rosner points out in this last statement -- some queston as to whether that help would be forthcoming. china is even now accelerating the depegging of the yuan, bringing forward the end of vendor finance for the largest player in that game, fostering what will eventually end up being a terrible currency crisis for the united states dollar. the spectre of what would effectively be a sovereign default by the united states is suddenly on the table. and a run on the dollar would lead in a roundabout way to the same disorderly deleveraging and economic collapse that we are hoping to dodge in the first place.
roubini apparently does not consider this to be the end of the debt supercycle as defined by the bank credit analyst if he thinks that moving the GSEs on balance sheet will not spark a treasury debt repudiation. but if dollar recycling slows as foreign vendor currencies -- the yen and yuan particularly -- are allowed to strengthen against the dollar in an american financial crisis and economic recession, it is hard to escape the notion that market interest rates will continue to rise more than would be expected in coming months and years as the united states is weaned from foreign financing. this would exacerbate economic stagnation and deepen the recession.
but the takeaway for housing market and economy watchers is that an explicit nationalization of the GSEs with debt guarantees in the area of $1tn or more may well be considered a hallmark of a resolution of the financial sector crisis.
UPDATE: via yves smith, indeed it would seen roubini is on to something!