Nouriel Roubini: It could be very bad

The Global Credit Crisis: How Bad Will it Get? April 14, 2008

Nouriel Roubini - Professor of Economics, Stern School of Business NYU

...the debate is not anymore on whether the U.S. is going to have a soft landing or a hard landing, but rather on how hard the hard landing is going to be. We've entered a recession, now the consensus of Wall Street says, it's going to be a short and shallow recession, Q1, Q2, and by the middle of the year we're going to have a recovery. And compared to this new consensus, my view of it is this is going to be much more severe, long and protracted, at least 12 months and possibly as long as 18 months, and the financial consequences are going to be severe. And I'll try to argue why that should be the case and try to [track?] the real economy with the financial side. If you look at the last two recessions if you want to compare the past with the present—1991 and 2001—those two recessions each last eight months, so the consensus today is it's going to be shorter and more shallow than the relatively shallow and mild recession the last two times around. But if I compare both macro and financial conditions today with the last two recessions, I think there are three crucial dimensions where things are much worse today, and therefore that leads me to come to the conclusion that it's going to be much more severe both on the real side and the financial side. The first way in which things are much worse than they've been in the last two cases, is we're still in the middle of the worst U.S. housing slump or recession since the Great Depression. It's truly the worst. And things are not bottoming out. The Fed was saying a year ago that it's going to bottom out. It's true the housing starts have fallen by about 50% but new home sales have fallen much more, around 60%. So the excessive inventory of unsold homes, both new and existing ones, is growing and is becoming larger in absolute terms, and is a share of sales. That means that home prices already have fallen 10% based on [Unintelligible] index [Unintelligible] peak. In my estimate they're going to fall by another 10% this year alone, and cumulatively, the fall by 2010 is going to be 30%. Now 10% fall in home prices of course, is $2 trillion of housing wealth that is wiped out. We [Unintelligible] some consumption; 20% is $4 trillion, 30% is $6 trillion. But even more importantly, I think that one new phenomenon that we have to think about when we think about falling home prices, is the financial effect. And the falling is an important point. With 10% fall in home prices, today there are about 8 million houses in the United States that are underwater with negative [Unintelligible] provided their homes have been [Unintelligible] the value of their mortgages. If home prices fall 20% the number's going to 16 million. If home prices fall by 30%, the number's going to be 21 million out of 51 million households with a mortgage. So up to 40% of houses could be underwater.

Now one thing about the U.S. mortgage is that in most states, effectively, a mortgage is non-[Unintelligible]. So if you want to walk away from your mortgage, you can do it. That's what people refer as [Unintelligible] put the kids [Unintelligible phrase] send it to your bank and say goodbye. And that phenomenon of voluntary default is rising, not just for subprime but for [Unintelligible] prime and prime. Now we don't know how many people are going to walk away. I've made estimates. And my estimates have been that if only prices fall 20% rather than 30%, if only 50% of those [Unintelligible] walk away, and if losses are going to be 50 cents on the dollar, including the foreclosure cost, that's an estimate Goldman Sachs agrees with me, then the total losses for the financial system from these walking away could be a trillion dollars. So about three-quarters of an entire capital of the U.S. banking system will be wiped out, so a systemic banking crisis. So this is a real crisis and the housing is a financial crisis.

Second way which things are worse. [Unintelligible phrase] in 2001 the sector that was in trouble was the corporate sector, boom and bust of the tax sector, that was about 10% of GDP of real capital spending. Today we know that the sector of the [Unintelligible] is under stress financially and otherwise is the housing sector. And as you know, private consumption is about 70% of the GDP and we have to back almost 20 years to have even a quarter of drop in consumption. We have to go back to 1990 [Unintelligible phrase]. So you have a U.S. consumer that's shopped-out, is saving less, is debt-burdened with the debt-to-income ratio going from 100 to 136, and is hit by all these head [Unintelligible]. First of all, you have the falling value of your homes so you cannot use your home as an ATM machine. There's been a collapse of home equity withdrawal. There's a credit crunch in the mortgage markets that's going to spread soon to consumer credit. Not only debt ratios are high, but debt servicing ratio is going higher. You have now oil crisis around $110 per bottle and gasoline towards 4. You have now a falling stock market with additional [Unintelligible] effect. And then people say, "Yeah, all these head [Unintelligible] are there, but as long as there is job and income generation, then people are capable of consuming. Guess what? For the last four months in a row, private employment has fallen for the last three months in a row. Total employment including government employment has fallen. So the last leg that was supporting income and job generation and therefore consumption, is also dropping. And if there be a significant fall in consumption, then we're going to have a significant recession, much less worse than 200(1?).

Third point. People now, when they talk about sub prime, of course they say "sub prime [Unintelligible], sub prime disaster." Two years ago, I said this housing crisis is going to be the worst, the last 50 years are going to [Unintelligible] from sub prime. Now it's conventional wisdom. Guess what? It's not any more a sub prime problem. With a sub prime financial system. The same kind of restless lending practices occurred in sub prime, things like no down payment, no verification of the income assets and jobs, interest rate only, negative [amortization?], [these are rates?]. The same kind of stuff was occurring sub prime, near prime and [Unintelligible] in prime, in jumbo loans, in home equity loans, in piggyback loans. About two-thirds of all mortgage origination since 2005 [Unintelligible] 2007 include these reckless characteristics. And they thought just residential mortgages. Guess what? The same kind of risky stuff was occurring in commercial real estate. High [Unintelligible] value ratios inflate the expectation of rent increases. Guess what? Now that [CNBX?] Index is expectation major default of commercial real estate and an entire market for new commercial real estate loans has essentially gone dead. And on the real side, of course, if you have a nasty slap in housing, what do you expect? You're going to have a nasty slap in commercial real estate. Why? You go outside of Las Vegas or the American West, there are entire ghost towns. Who's going to [Unintelligible] offices, shopping centers, shopping malls in these ghost towns? Of course, falling and collapsing housing are going to fall and collapse in commercial real estate. It's not just residential and commercial real estate. In any recession, you have a massive increase in default rates for unsecured consumer loans. Credit card, auto loans, student loans. Those default rates are rising, are going to become bigger. And it's not just consumer credit. You have about $12 billion in leveraged of loans that were financing these [Unintelligible phrase] debt-to-earnings ratio of 10 [Unintelligible] as opposed to 40 historically. But now it's frozen, sitting on the balance sheet of [Unintelligible] financial institution, and they're being traded at 80 cents on the dollar, not 100 cents on the dollar.

Additional point. People say the monolines got in trouble when they started insuring the toxic stuff while the safe stuff was the Moody bonds. People forget. In '90-'91, the Moody bonds were junk bonds. Why? The [Unintelligible phrase] went belly-up. What's happening today? You have [Unintelligible phrase] across the West that have the revenue [Unintelligible] collapsing. Most likely fees from developers, was most mostly property taxes and state taxes, so your revenue basis collapsed, you have high debt, you have high deficits, and most of your spending salaries to unionized public employees. Guess what they're going to do? They're going to start to default. And they're going to have a spike in default rating for Moody bonds. Finally, people say, "The housing sector is fine, but the corporate sector is lean and mean." Highly profitable is not the problem they had in 2001. Yeh, for the average U.S. non-financial corporate, that's true, but you have [Unintelligible] of corporations that are highly indebted and borderline unprofitable. In a typical year, in the United States, the default rates on corporate bonds in a normal year since '71, [Unintelligible] the average is 3.8%. In 2006 and 2007, the default rates of corporate bonds was 0.6%. One-sixth of what's normal. Why? You have the slosh of liquidity, you have the slosh of credit. [Unintelligible] spreads bottomed-out at 250 [Unintelligible] Treasuries in June of last year, and of course, even corporates were in trouble because [the refinance out of court?]. You know, private equity money, hedge funds money and so on. [Unintelligible phrase] In a typical recession, default rates on corporate bonds spike about 10%, up to [last two recessions?] 15%. It's a double one, because not only default rates spike up, but the recovery rates, given the default, in a normal year, about 70 cents on the dollar; in a recession year, is only 30 or 40 cents on the dollar. You get the double one, higher default rates and much lower recovery rates. And once you're going to have the spike in the default rates on the corporate sector, you have about $50 trillion of a market for [CDS?] sitting on over $5 trillion on standing corporate bonds. And the systemic effects of that are going to be potentially massive. We don't know what are going to be the losses because it's not just a re-distribution between those who sought protection and those who bought protection, because what's going to happen is that those who sought protection are highly concentrated, a bunch of hedge funds, a bunch of hedge funds, a bunch of monolines, and those guys are going to go belly-up given the amount of protection they sold—look at Bear Stearns—and those who bought protection who thought [were hedge?] [Unintelligible phrase].

So the systemic effect of this black box, of credibility, is going to be something we don't understand. So when you put together the fact that we have the worst housing recession in the last 50 years, that we have now the U.S. consumers' on the ropes at a tipping point, and we have a systemic financial crisis [Unintelligible] that we have not since the Great Depression, the idea that this is going to be a mild and shallow recession, I think to me, is far-fetched, and once you get into a vicious circle of it, falling economy with greater credit losses and a greater credit losses leading to a greater credit crunch, and even more contracting, the real economy is going to be very ugly. I don't have time right now to talk about the [Unintelligible phrase] but condition of a severe U.S. recession, the idea that Europe, Asia and the rest of the world can [Unintelligible] to me, also sounds far-fetched.