ORIGINAL ARTICLE

To understand the Federal Reserve's recent actions, one has to realize that there is now a rising probability of a catastrophic financial and economic outcome—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.

Such a meltdown is likely to unfold in this 12-step scenario:

1. At this point it is clear that U.S. 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. Moreover, soon enough a few very large home builders will go bankrupt, leading to another free fall in home builders' stock prices.

2. Losses to the financial system from the subprime disaster, estimated to be as high as $300 billion, are now spreading to near-prime and prime mortgages as the same reckless lending practices as in subprime were occurring across the entire spectrum of mortgages; about 60% of all mortgage origination from 2005 through 2007 had these reckless and toxic features. So this is a generalized mortgage crisis and meltdown, not just a subprime one. And losses among all sorts of mortgages will sharply increase as home prices fall sharply and the economy spins into a serious recession.

Add to these losses the meltdown of hundreds of billions in off-balance-sheet structured investment vehicles and conduits, as roll-off of the asset-backed commercial paper market has forced banks to bring back on balance sheet these toxic off-balance-sheet vehicles. And because of securitization, the toxic waste has been spread from banks to capital markets and their investors in the United States and abroad, thus increasing—rather than reducing—systemic risk and making the credit crunch global.

3. The recession will lead—as it is already doing—to a sharp increase in defaults on other forms of unsecured consumer debt: credit cards, auto loans, student loans. There are tens of millions in subprime credit cards and subprime auto loans in the United States. And again, defaults in these consumer debt categories will not be limited to subprime borrowers. So add these losses to the financial losses of banks and of other financial institutions, which will lead to a more severe credit crunch.

4. While there is serious uncertainty about the losses that monoline insurance companies will take on their insurance of residential mortgage-backed securities, collateralized debt obligations and other toxic asset-backed securities products, it is now clear that such losses are much higher than the $10 billion-to-$15 billion rescue package that regulators are trying to patch together. The resulting downgrade of the monolines will lead to another $150 billion in write-downs on asset-backed securities portfolios for financial institutions that already have massive losses. It will also lead to additional losses on their portfolios of muni bonds, and to losses and potential runs on the money-market funds that invested in some of these toxic products.

5. The commercial real estate loan market will soon enter into a meltdown similar to the subprime one, as lending practices in commercial real estate were as reckless as those in residential real estate. The housing crisis will lead—with a short lag—to a bust in non-residential construction, as no one will want to build offices, stores or shopping malls/centers in ghost towns.

6. It is possible that some large regional or even national banks that are very exposed to mortgages, residential and commercial, will go bankrupt. Thus some big banks may join the 200-plus subprime lenders that have gone bankrupt, adding to an already severe credit crunch.

7. Banks' losses will grow as a result of hundreds of billions of dollars of leveraged loans stuck on their balance sheets at values well below par (currently about 90 cents on the dollar, but soon to be much lower).

8. Once a severe recession is under way, a massive wave of corporate defaults will take place. In a typical year, U.S. corporate default rates are about 3.8% (average for 1971-2007); in 2006 and 2007 this figure was a puny 0.6%. And in a typical U.S. recession such default rates surge above 10%. Also during such distressed periods, recovery rates are much lower, thus adding to the total losses from a default. Default rates were very low in the last two years because of sloshing liquidity, easy credit conditions and very low spreads. But the repricing of risk since then has been massive.

While U.S. and European corporations are in better shape, on average, in terms of profitability and debt burden than in 2001, a large number of corporations with very low profitability have piled up junk bond debt that will soon have to be refinanced at much higher spreads. Corporate default rates will surge during the 2008 recession and peak well above 10%. And once defaults and credit spreads are higher, massive losses will occur among the credit default swaps (CDS) that provided protection against corporate defaults. Estimates of the losses on a notional value of $50 trillion CDS against a bond base of $5 trillion are varied (from $20 billion to $250 billion, with a number closer to the latter figure more likely).

9. The “shadow banking system” (as defined by Pimco), or more precisely the “shadow financial system” (as it is composed by non-bank financial institutions), will soon get into serious trouble. This shadow financial system is composed of financial institutions that—like banks—borrow short and in liquid forms and lend or invest long in more illiquid assets. This system includes: SIVs, conduits, money-market funds, monolines, investment banks, hedge funds and other non-bank financial institutions. All these institutions are subject to market risk, credit risk (given their risky investments) and especially liquidity/rollover risk as their short-term liabilities can be rolled off easily while their assets are more long term and illiquid. Unlike banks, these entities don't have direct or indirect access to the central bank's lender of last resort support as they are not depositary institutions. Thus, in the case of financial distress and/or illiquidity, they may go bankrupt because of the inability to roll over or refinance their short-term liabilities. Deepening problems in the economy and in the financial markets and poor risk management will lead some of these institutions to go belly-up: a few large hedge funds, a few money-market funds, the entire SIV system and, possibly, one or two large and systemically important broker-dealers.

10. Stock markets in the U.S. and abroad will start pricing in a severe U.S. recession—rather than a mild one—and a sharp global economic slowdown. The late-January rally appears to have fizzled out, as investors have begun to realize that the economic downturn is more severe than anticipated, that the monolines will not be rescued, that financial losses will mount and that earnings will drop sharply in a recession, not just among financial firms but also non-financial ones. A few long equity hedge funds will go belly-up in 2008 after the massive losses of many hedge funds in August, November and, again, last month. Large margin calls will be triggered for long equity investors, and another round of massive equity shorting will take place, leading to a cascading fall in equity markets in the United States and a transmission to global equity markets. U.S. and global equity markets will enter into a persistent bear market, as in a typical U.S. recession the S&P 500 falls by about 28%.

11. The credit crunch that is affecting most credit markets and credit derivative markets will lead to a drying up of liquidity in a variety of financial markets, including otherwise very liquid derivatives markets. Another round of credit crunch in interbank markets will ensue—triggered by counterparty risk, lack of trust, liquidity premiums and credit risk. A variety of interbank rates will massively widen again. Even the easing of the liquidity crunch after massive central bank action in December and January will reverse as credit concerns keep interbank spreads wide in spite of further injections of liquidity by central banks.

12. A vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices will ensue, leading to a mounting cycle of losses and further credit contraction. Capital losses will lead to more margin calls and further reduction of risk taking by a variety of financial institutions that will then be forced to mark to market their positions. Such a forced fire sale of assets in illiquid markets will lead to further losses that will further contract credit and trigger further margin calls and disintermediation of credit. The triggering event for the next round of this cascade is the downgrading of the monolines and the ensuing sharp drop in equity markets; both will trigger margin calls and further credit disintermediation.

Based on estimates by Goldman Sachs, $200 billion in losses in the financial system would lead to a contraction of credit of $2 trillion, given that institutions hold about $10 of assets per dollar of capital. The recapitalization of banks by sovereign wealth funds, about $80 billion so far, will be unable to stop this credit disintermediation. With the movement of off-balance-sheet items back on balance sheets and of assets and liabilities from the shadow banking system back to the formal banking system, there will be an ensuing credit contraction because the mounting losses will outweigh by a large margin any bank recapitalization from sovereign funds. A contagious and cascading spiral of credit disintermediation, credit contraction, sharp falls in asset prices and widening in credit spreads will then be transmitted to most parts of the financial system. This massive credit crunch will make the economic contraction more severe and lead to further financial losses. Total losses in the financial system will add up to more than $1 trillion and the economic recession will become deeper, more protracted and more severe.

A near-global economic recession will ensue as the credit losses and the credit crunch spread around the world. U.S. and global financial markets will experience their most severe crisis in the last quarter-century.



Nouriel Roubini, a professor of economics at New York University's Stern School of Business, is chairman of the online publication RGE Monitor, where this article initially appeared.