Publié par : crise2007 | novembre 28, 2007

Liquidity and Credit Crunch in Financial Markets is Back to Summer Peaks, Only Much Worse and More Dangerous

Liquidity and Credit Crunch in Financial Markets is Back to Summer Peaks, Only Much Worse and More Dangerous !



Nouriel Roubini | Nov 25, 2007

There is now increasing evidence that the liquidity and credit crunch in international financial markets is back to its summer peaks of August and, in most dimensions, even worse than in the summer; financial markets are now in a “virtual panic mode” according to a market participant (as reported by the FT). This worsening of the financial markets turmoil has occurred in spite of the hundreds of billions of dollars and euros that have been injected in the financial system by the Fed, the ECB and other central banks and in spite of the 75bps cut in the Fed Funds rate by the Fed. This massive easing of liquidity – both its quantity and price – has miserably failed to stem a severe liquidity crunch that is now back to the summer peaks, as evidenced for example in the interbank markets – both in US and Europe – by the sharp widening of Libor rates – at a variety of maturities – relative to equivalent maturity government yields and/or policy rate; such sharp rise of spreads to summer levels signals a worsening of the liquidity crunch.

Indeed the ECB is now announcing another massive injection of liquidity. This injection of liquidity will miserably fail like the previous ones as the ECB is not getting it that a reduction in its policy rate is now necessary and urgent. As the Fed Funds cut by the Fed suggest, such policy rate cut may not prevent a worsening of the liquidity conditions; but the lack of a cut in the ECB policy rates makes such a liquidity crunch in Europe – and the risks of a serious contagion from the US hard landing – even worse than the alternative.

  Last August the soft-landing consensus claimed that the episode of financial turmoil would be temporary (like previous ones in 2004, 2005, 2006) and that Fed easing would restore calm to the financial markets and prevent an economic hard landing. 

This author instead argue then that the turmoil and volatility in financial market would not be a temporary phenomenon but that it would rather persist and lead to a significant repricing of risk; that the liquidity and credit crunch that started in the summer would get worse rather than better over time; that such crunch reflected credit and solvency problems in the economy, not just illiquidity; that monetary policy would be ineffective in easing these liquidity and credit problems; that we would experience a Minsky Moment and the unraveling of the Minsky Credit Cycle; that the turmoil reflected deep seated unmeasurable uncertaintly rather than priceable risk; that losses from this seizure of credit and markets would be massive; that this was the first crisis of financial globalization and securitization; and that the real consequences of this liquidity and credit crunch would increase the likelihood of a US recession that was already likely without such a financial turmoil.

These bearish forecasts have indeed proven right as financial conditions are now worse than in the summer and as the likelihood of a generalized credit crunch, a US recession and the spillover of such a hard landing to the rest of the world  are increasing by the day (see Larry Summers on the FT today for another prominent scholar now suggesting that a  US recession is very likely).

The worsening of the liquidity and credit crunch relative to the summer peaks is evident from a wide variety of signals and markets: in interbank markets spreads of Libor relative to government yields are sharply up again over a range of maturities, especially the 3 month one. In derivatives markets there has been a sharp reduction in liquidity and in trading activity as counterparty risk is rising. Money market funds are also experiencing liquidity problems partly driven by credit problems. Several of such funds were exposed to toxic radioactive RMBSs and CDOs and have experienced losses that reduced their NAV below par. Thus, those backed by backed have received a bailout by their sponsoring bank; but those without the backup of a bank are now scrambling to find lines of liquidity from banks that are becoming scarce and expensive.

 More generally the risk of liquidity runs against non-banks institutions that have short term liquid liabilities and longer term and illiquid assets is rising. These institutions include: hedge funds subject to redemptions; non-bank investment banks whose liquidity and credit problems are rising; SIVs and conduits that are now unraveling fast as the ABCP paper backing their illiquid asset is rolled off (while the Super-SIV plan is another half-baked shell game that is bound to fail); money market funds experiencing NAV losses; covered bond markets are so illiquid that European banks have decided – dramaticallyto stop trading in this large $2 trillion market Soon enough even some medium sized banks that are rotten and sharply exposed to mortgages may experience runs, even if these banks may – unlike the former non-bank financial institutions – have access to the Fed lender of last resort support.  Since financial disintermediation and securitization has brought much of financial intermediation outside of the banking system we now face the mess of possible runs against a wide range of financial institutions that do not have access to the central banks’ lender of last resort support.

Since the summer both liquidity and credit problems have worsened. We now know that the losses related to mortgage and their securitized products (RMBSs, CDOs) will be in the hundreds of billion dollars range ($300 to 500 billion) and that such losses are spreading from subprime to near prime and prime mortgages. These losses do not include those deriving from the coming meltdown of the commercial real estate lending where the issuance of new CMBSs has altogether dried up and where the CMBX indices signal extreme levels of expected defaults. Such losses don’t either include the mounting default rates from credit cards and auto loans that will surge further once the US fully enters into a recession.  They do not include the losses that the GSEs – Fannie and Freddie – are starting to experience and that will mushroom in the near future; we have the paradox of the GSEs that were supposed to guarantee or repackages half of US mortgages now being in significant financial trouble; thus, their ability to reliquify the RMBS and mortgage markets is severely impaired. They do not include the coming train wreck of a downgrade of the monoliners that insured many of these toxic mortgage products. And such likely downgrade of monoliners would lead to losses expected to be in the $200 billion range, including the shock that such a downgrade will produce for the muni bond markets. And such losses now go as far as even the CPDOs market – that were supposed to be default-free – and where instead we are now observing the first defaults with 90% losses for investors Now losses and defaults of highly leveraged institutions are popping out all over the world (Australia, Asia, France, Germany, UK, even in remote Norvegian villages) and across a spectrum of financial institutions, the latest being insurance and reinsurance (Swiss Re) companies.

There are now signals of extreme illiquidity, risk aversion, credit worries and flight to safety in the US and Europe based on a wide ranges of indicators: swap spreads at all maturities (2, 5, 10 years), VIX and other measures of volatility and investors’ risk  aversion, Libor spreads versus government bonds, Libor spreads relative to Fed Funds and other policy rates, TED spreads,  Dollar and Euro Libor versus OIS spread, 3month Euribor versus ECB rate, Itraxx and CDX spreads, ABX and CMBX spreads,  US 10yr Treasury yields below 4% and sharp fall of equivalent yields in Europe; sharp fall in short dated Treasury yields in the US, Europe and now even in Asia (Korea, China). Many or most of these indicators are now back to their extreme summer levels and some even worse.

The seizure of liquidity and credit has spread to the most remote corners of the financial system: subprime, nearprime and prime mortgages, commercial real estate, consumer loans, securitized products, derivatives markets, leveraged loans, LBO market (where increasing numbers of deals are postponed, restructured or cancelled), SIVs and conduits, interbank markets, derivative markets, covered bonds markets, CDOs and CLOs; CPDOs; even the IPO market; and the list goes on and on and becomes longer by the day.

The reasons why the massive liquidity injections and policy rate cuts by central banks have miserably failed are clear and were discussed at length in August by this author in previous note: we are facing a credit/insolvency problem in addition to a liquidity crunch and central banks’ monetary policy is impotent in dealing to credit problems: Fed easing will not prevent millions of US households from defaulting on their mortgages and will not prevent home prices falling 20% or more given the biggest housing recession in US history; it did not and will not prevent dozens of mortgage lenders and home builders from going bankrupt; it will not prevent a surge in corporate defaults once the economy experiences a hard landing. Monetary policy can lead with pure liquidity runs; but when such liquidity runs are related to the risk of insolvency monetary policy is mostly impotent.  And most of the current problems in the real economy and in the financial markets have to do with insolvency, not just illiquidity.

Monetary policy is also impotent with dealing with a financial system that has become opaque and less transparent and where investors are panicking because of the lack of information. The distinction made here last summer between priceable risk and unmeasurable uncertainty is fundamental: investors don’t know and cannot price the size of the likely losses as these losses are increasing by the day; and they do not know who is holding the toxic waste (the Where is Waldo? problem). Thus, lack of confidence and trust and rising counterparty risk breeds risk aversion that liquidity easing cannot solve: those – only banks – who are lucky enough to get access to the central banks’ liquidity have their own liquidity and credit problems; and they thus hoard such liquidity rather than relending it to the parts of the financial markets – SIVs, investment banks, money market funds, hedge funds, etc. – that do not have access to the central bank lender of last resort support.

Monetary policy is impotent in dealing with the problems that a mostly unsupervised and unregulated financial system – as regulators were asleep at the wheel blinded by free market voodoo religious fundamentalism – have created Specifically, the massive disintermediation of financial activity from the banking system to the capital markets has reduced the willingness and ability of sleepy supervisors to control a credit bubble that is now going bust. And this disintermediation, largely via a securitization food chain, has sharply reduced market discipline as everyone in this chain – mortgage brokers, mortgage originators, investment banks, credit rating agencies – was making money out of fees and transferring the credit risk to someone else in a game of musical chairs.

Equity markets, for a while, decoupled from credit markets after the Fed eased policy rates twice. Such temporary decoupling was driven by a Bernanke Put or the equity investors’ belief that the Fed would and could rescue them. But not that the onslaught of worse and worse financial, credit and economic news is surging the equity markets look toppy and most of the market gains of 2007 have already been lost. This onslaught of bad news is sure to continue and – at some point – dominate the Bernanke Put. Thus, once the evidence of an economic hard landing is clear even to stock markets investors – it is certainly clear to bond markets and to credit markets by now – you can expect a sharp fall in stock prices, a process that has already started in financials’s  stocks, discretionary consumer stocks, retail stocks and housing related stocks. As I have  analyzed in previou work a typical US recession the S&P 500 falls by an average of 28%;; also today equity valuations are high based on cyclically adjusted P/E ratios that correct for the fact that the sharp growth of earnings – and share of profits in GDP – is unsustainable on both a cyclical and structural basis.

We are thus now observing a severe worsening of conditions in financial markets with a generalized liquidity and credit crunch that will have serious effects on real economies. With a US economy already headed towards an inevitable recession this crunch makes financial conditions much tighter for consumers, home borrowers, financial institutions and the corporate sector, thus shrinking the real demand for homes, consumer durables, investment goods for firms, and overall capital spending. A beginning of a credit crunch is also evident in an already weakened European economy; and given the greater reliance of European firms – relative to the US ones – on bank financing the growing credit crunch in Europe is hurting the corporate sector. 

The credit boom and easy liquidity of the 2001-2006 period led to a massive releveraging of households, financial institutions and parts of the corporate sector in a credit boom that became a credit bubble and where we observed a Minsky credit cycle where asset prices went into bubble territory given the credit leverage. Now, capital losses, credit crunch and reintermediation is leading to the unraveling of this credit house of cards. Using analytical models developed by research scholars – such as Adrian and Shin  – Goldman Sachs estimated that losses in the $400 billion range ($200 b among financial institutions) will lead to a deleveraging of credit of the order of $2 trillion. The overall deleveraging could be higher than that as a variety of institutions (financial and others including households and corporate firms) that will experience a hit to their balance sheet and net worth will have to start deleveraging their balance sheets. Indeed, the latest data suggest that corporate earnings have already fallen 8.5% in Q3 207 relative to the third quarter of 2006.

Such academic and analytical research also suggests that illiquidity that forces fire sales of assets – of the sort we are starting to see in financial markets – has contagious effects from one financial institution to the other causing a chain of losses that can become systemic and exacerbate liquidity and capital losses (while implementation of FASB 157 will not prevent the past fudge of marking to model rather than marking to market such illiquid and impaired assets). So a contagious unraveling of the Minsky Credit Cycle is now underway. 

And now a perverse cycle of financial conditions and credit crunch worsening leading to a worsening of the real economy and, in turn, a worsening of the real economy increasing the financial losses and worsening the liquidity and credit crunch is creating a vicious circle that has significantly increased the likelihood of a now effectively inevitable US recession and of a global economic slowdown.  Bernanke and Mishkin know a lot about the “credit channel” and “financial accelerator” effects as they have extensively written about these in their former academic life. This vicious circle is leading to fall in asset prices, fall in net worth, deleveraging, tightening of the quantity and price of credit and fall in durable and non durable spending by households and financial and corporate firms that, in turn, will worsen the financial conditions.

And indeed a saving-less and debt-burdened consumer is now on the ropes and at a tipping point as it is buffeted by a variety of headwindsthe beginning of the holiday season was weak as U.S. consumers spent on average 3.5 percent less during the post-Thanksgiving Day holiday weekend than a year earlier; add to this the most recent gloom in the auto sales, in consumption of durables and the worst housing recession ever . The combination of a severe and worsening liquidity and credit crunch, oil prices close to $100, a worsening housing recession and its wealth effects on consumption, a weakening labor market and a consumer that is buffeted by severe negative shocks means that a US recession is by now inevitable and that the rest of the world will not decouple from the US hard landing.

As the New York Times reported my views today in a lead article on the risks of a US recession:

The most bearish indulge frighteningly gloomy tones. “The evidence is now building that an ugly recession is inevitable,” declared Nouriel Roubini, an economist who was among the first to warn of the dangers of a real estate downturn, writing last week on his blog, the Global EconoMonitor. “When the United States sneezes the rest of the world gets the cold. And since the United States will not just sneeze, but is risking a serious case of protracted and severe pneumonia, the rest of the world should start to worry about a serious viral contagion.”

And indeed Larry Summers made similar warnings in his FT column today:

“Three months ago it was reasonable to expect that the subprime credit crisis would be a financially significant event but not one that would threaten the overall pattern of economic growth. This is still a possible outcome but no longer the preponderant probability.

Even if necessary changes in policy are implemented, the odds now favour a US recession that slows growth significantly on a global basis. Without stronger policy responses than have been observed to date, moreover, there is the risk that the adverse impacts will be felt for the rest of this decade and beyond.

Several streams of data indicate how much more serious the situation is than was clear a few months ago.”

As the title of his column is appropriately warning investors, the Fed and other policy makers: “Wake Up to the Dangers of a Deepening Crisis”

  Finally,  for the ahead-of-the-curve, continued and up-to-date RGE Monitor coverage of the liquidity and credit crunch see the RGE Monitor pages on the financial markets turmoil and on the risks of a systemic financial crisis

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