Economic nightmare scenario

POSTED BY: SignyM
UPDATED: Tuesday, August 18, 2026 19:56
VIEWED: 4053
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SIGNYM

Wednesday, February 6, 2008 8:45 PM

I hope I don't get in trouble with the internet police. I found this on the RGE Monitor which is an economic review website with a macro bent. I'm going to edit this for brevity, so if you want to see the rest you'll have to register on the wesbite

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The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial Disaster

Nouriel Roubini | Feb 05, 2008

Why did the Fed ease the Fed Funds rate by a whopping 125bps in eight days this past January? It is true that most macro indicators are heading south and suggesting a deep and severe recession that has already started. But the flow of bad macro news in mid-January did not justify, by itself, such a radical inter-meeting emergency Fed action followed by another cut at the formal FOMC meeting.

To understand the Fed actions one has to realize that there is now a rising probability of a “catastrophic” financial and economic outcome, i.e. a vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe. ... That is the reason the Fed had thrown all caution to the wind – after a year in which it was behind the curve and underplaying the economic and financial risks – and has taken a very aggressive approach to risk management.

To understand the risks that the financial system is facing today I present the “nightmare” or “catastrophic” scenario that the Fed and financial officials around the world are now worried about. Such a scenario – however extreme – has a rising and significant probability of occurring. Thus, it does not describe a very low probability event but rather an outcome that is quite possible.

Start first with the recession that is now enveloping the US economy. Let us assume – as likely - that this recession – that already started in December 2007 - will be worse than the mild ones – that lasted 8 months – that occurred in 1990-91 and 2001. The recession of 2008 will be more severe for several reasons:

First, we have the biggest housing bust in US history with home prices likely to eventually fall 20 to 30%;

Second, because of a credit bubble that went beyond mortgages and because of reckless financial innovation and securitization the ongoing credit bust will lead to a severe credit crunch;

Third, US households – whose consumption is over 70% of GDP - have spent well beyond their means for years now piling up a massive amount of debt, both mortgage and otherwise; now that home prices are falling and a severe credit crunch is emerging the retrenchment of private consumption will be serious and protracted. So let us suppose that the recession of 2008 will last at least four quarters and, possibly, up to six quarters. What will be the consequences of it?

Here are the twelve steps or stages of a scenario of systemic financial meltdown associated with this severe economic recession…

First, this is the worst housing recession in US history and there is no sign it will bottom out any time soon. At this point it is clear that US home prices will fall between 20% and 30% from their bubbly peak; that would wipe out between $4 trillion and $6 trillion of household wealth. While the subprime meltdown is likely to cause about 2.2 million foreclosures, a 30% fall in home values would imply that over 10 million households would have negative equity in their homes and would have a big incentive to use “jingle mail” (i.e. default, put the home keys in an envelope and send it to their mortgage bank). Moreover, soon enough a few very large home builders will go bankrupt and join the dozens of other small ones that have already gone bankrupt thus leading to another free fall in home builders’ stock prices that have irrationally rallied in the last few weeks in spite of a worsening housing recession.

Second, losses for the financial system from the subprime disaster are now estimated to be as high as $250 to $300 billion. But the financia

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SIGNYM

Wednesday, February 6, 2008 8:53 PM

ABS, MBS, CMBS, CMO, CDO, CBO, and CLO are subset of what are generally characterized as structured products. Below is what the acronyms stand for.

MBS = Mortgage-Backed Securities, and the universe of MBS is vast, it is however reserved by market participants to denote the pass-through mortgage bonds (agency pass-through and nonagency pass-through).

CMBS = Commercial Mortgage-Backed Securities, which are trust certificates (bonds) backed by a pool of commercial mortgage loans. The certificates are tranched on the basis of prepayment and credit.

CMO = Collateralized Mortgage-backed Obligations, which are pool of pass-through mortgage bonds tranched to reflect the degree of sensitivity to prepayment (particularly, agency CMO).

ABS = Asset Backed Securities, for example home equity loans (HEL), credit cards, etc. These are securities backed by receivables [payments] that are either secured (HEL) or unsecured (credit card), tranched on the basis of prepayment and default risks.

CDO = Collateralized Debt Obligation, for example, ABS CDO which consist of a portfolio of different ABS bonds, and the payments to the holders of these trust certificates are derived from the cash flows of the ABS bonds.

CBO = Collateralized Bond Obligation, for example high yield [emerging market] CBO which consist of a portfolio of different high yield [emerging market] bonds.

CLO = Collateralized [leveraged] Loan Obligation which consist of a portfolio of different leveraged loans

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Always look upstream.

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CHRISISALL

Wednesday, February 6, 2008 8:59 PM

Signy, if it happens as written, it won't be literally overnight, so expect the conservative element here to spend a lot of time poo-pooing it- until they lose their jobs or homes, that is.

The sky needs supports Chrisisall

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FLETCH2

Wednesday, February 6, 2008 9:16 PM

And then there is the wonderfull world of financial derivatives. To quote Warren Buffet.

Quote:

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I view derivatives as time bombs, both for the parties that deal in them and the economic system.

Basically these instruments call for money to change hands at some future date, with the amount to be
determined by one or more reference items, such as interest rates, stock prices, or currency values. For
example, if you are either long or short an S&P 500 futures contract, you are a party to a very simple
derivatives transaction, with your gain or loss derived from movements in the index. Derivatives contracts
are of varying duration, running sometimes to 20 or more years, and their value is often tied to several
variables.

Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the
creditworthiness of the counter-parties to them. But before a contract is settled, the counter-parties record
profits and losses – often huge in amount – in their current earnings statements without so much as a
penny changing hands. Reported earnings on derivatives are often wildly overstated. That’s because
today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for
many years.

The errors usually reflect the human tendency to take an optimistic view of one’s commitments. But the
parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade
derivatives are usually paid, in whole or part, on “earnings” calculated by mark-to-market accounting. But
often there is no real market, and “mark-to-model” is utilized. This substitution can bring on large-scale
mischief. As a general rule, contracts involving multiple reference items and distant settlement dates
increase the opportunities for counter-parties to use fanciful assumptions. The two parties to the contract
might well use differing models allowing both to show substantial profits for many years. In extreme
cases, mark-to-model degenerates into what I would call mark-to-myth.

I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost
invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO
who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from
his options. Only much later did shareholders learn that the reported earnings were a sham.

Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for
completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that
a company suffering a credit downgrade immediately supply collateral to counter-parties. Imagine then
that a company is downgraded because of general adversity and that its derivatives instantly kick in with
their requirement, imposing an unexpected and enormous demand for cash collateral on the company.

The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases,
trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.
Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off
much of their business with others. In both cases, huge receivables from many counter-parties tend to
build up over time. A participant may see himself as prudent, believing his large credit exposures to be
diversified and therefore not dangerous. However under certain circumstances, an exogenous event that
causes the receivable from Company A to go bad will also affect those from Companies B through Z.

In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the Federal
Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden
and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now
insulates the strong f

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