by Nouriel Roubini
This is a continuation of the article, "Calm Like A Bomb: The Impending World Recession".
Below is the edited piece of Nouriel Roubini's recent article:
I’ve been saying for a while this will be the worst financial crisis the US has experienced since the Great Depression and it looks like the worst one.
I think there’s a growing recognition that this was not just a subprime mortgage problem, where there much more generalized asset bubble and credit bubble in the economy. There were massive excesses also of underwriting in commercial real estate, the boom in the indebtedness of the household sector included also unsecured consumer credit like credit cards, auto loans, student loans with all this other excesses in the corporate sector.
And even in the corporate sector that was on average in better shape than the housing sector there was a fat tail of corporates that were highly indebted with little profits. They issued a huge amount of junk bonds and corporate default rates that had been very very low, for the last couple of years, are going to be surging in a major way, and once this major surge of corporate defaults is going to occur this is other huge time bomb of the CDS market where about $55 trillion of nominal protection has been sold against an outstanding stock of only $6 trillion of corporate bonds. So when you add it all up as you remember I’d estimated that the losses would be at least $1 trillion, and more likely close to $2 trillion.
This housing recession is not bottoming out. The production of new homes starting is falling sharply, but demand until recently had fallen even more, therefore this excess supply of inventory of the new and existing homes kept on becoming larger, and that put downward pressure on home prices.
Based on Case-Shiller, home prices have already fallen by about 20 percent from the peak, given the excess supply number and other factors I would expect home prices are going to fall another 20 percent for a cumulative fall of 40 percent from the peak. Now in 1991, the cumulative fall based on Case-Shiller was only 5 percent, now we’re going to have 20, another 20, 40 — something we haven’t seen since the Great Depression. If it’s more like 40 percent, then the losses is another $800 billion. So you’re in a situation in which you can wipe out a good chunk of the capital of the financial system.
If you look at the 2nd quarter data, Eurozone growth was becoming negative, UK growth was becoming negative, Canadian growth was becoming negative. Same in New Zealand, same for Japan, same for most of the other advanced economies. About 60 percent of GDP, that is most of the GDP of the advanced economies was already contracting in the 2nd quarter of this year. This is before these other shocks are going to make these things more severe.
At this point it looks like we’re not going to have just a US recession, or an advanced economies recession, we’re also going to have a global economic recession, because there is a massive amount now of re-coupling in financial markets and also in real economies, also among emerging market economies.
So we are going to have a global economic recession. And by the way, within the emerging markets, there are about a dozen economies are now on the verge of a financial crisis. Thinking emerging Europe — countries like Latvia, Estonia, Lithuania, Hungary, Bulgaria, Romania, Turkey, Belarus, Ukraine; you go into Asia, trouble in Pakistan, Indonesia and Korea. You go into Latin America — trouble in Argentina, in Ecuador, Venezuela, just to name a few. So this is a global economic recession.
Now why do I think that the bottom in financial market is not been reached yet — for 3 reasons and I’ll conclude on that. The first one is that I think that the flow of market-economic news are going to surprise on the downside for the next few weeks and months. People have priced now a US recession, but if this US recession is I believe going to be more like 24 months, rather than only 8 months, and is going to be global, then there will be surprises on consumption, investment, on housing, on employment and industrial production.
Secondly, I think there will be negative surprises also for earnings. Not just earnings of financial firms, but also in a severe recession a sharp contraction of the earnings of the non-financial corporate sector.
And the third reason is that while the sources of a systemic financial meltdown has been somehow contained, I still see as a lot of potential threats to the financial system. One is this major surge of corporate defaults is going to occur in the next year or so. The second one is related to it is the blowup is going to occur in the CDS market is a major source of the systemic risk. Third of all you are going to have hundreds of hedge funds are going to go bust in the next few months.
And finally there is this other time bomb of many emerging market economies, the risk of a financial crisis. And any of them going bust could have contagious and systemic effects. And one example — take Iceland. Little small island of 300,000 folks in the middle of Atlantic. Their banks had borrowed an amount of money was 12 times the GDP of the country to buy toxic MBSs, CDOs and you name it. Now the banks are bust, the government doesn’t have resources to bail out the banks, and these banks will have to sell, in a highly distressed and illiquid market, a huge amount of distressed assets. And even a small tiny island like Iceland can have systemic effects on asset prices, let alone if you have a blowup of Hungary, or Argentina, or Korea, or other economies.
So, for the last few months people have always been calling the bottom. Every time there was a major event they said this is the cathartic event that says the markets have bottomed out. They said it after Bear Stearns, after Fannie and Freddie, after AIG, after TARP, after the G7 Communique. And each time markets have rallied for a little bit, and have gone further south. Unfortunately I don’t think we’re at the bottom of the housing crisis, we’re not at the bottom of the mortgage crisis, we’re not at the bottom of the financial and banking crisis, and certainly we’re not at the bottom of the severe economic crisis. So I’m quite still pessimistic looking ahead.
