How bad could things get, prompting a flight to gold?
*Financial Times, by Martin Wolf, February 19, 2008:
"So how bad might this downturn get? To answer this question we
should ask a true bear. My favourite one is Nouriel Roubini of New York
University’s Stern School of Business, founder of RGE monitor.
Recently, Professor Roubini’s scenarios have been dire enough to make
the flesh creep. But his thinking deserves to be taken seriously. He
first predicted a US recession in July 2006*. At that time, his view
was extremely controversial. It is so no longer. Now he states that
there is 'a rising probability of a ‘catastrophic’ financial and
economic outcome'**. The characteristics of this scenario are, he
argues: '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.'
Prof Roubini is even fonder of lists than I am. Here are his 12 – yes,
12 – steps to financial disaster.
Step one is the worst housing recession in US history. House prices
will, he says, fall by 20 to 30 per cent from their peak, which would
wipe out between $4,000bn and $6,000bn in household wealth. Ten million
households will end up with negative equity and so with a huge
incentive to put the house keys in the post and depart for greener
fields. Many more home-builders will be bankrupted.
Step two would be further losses, beyond the $250bn-$300bn now
estimated, for subprime mortgages. About 60 per cent of all mortgage
origination between 2005 and 2007 had 'reckless or toxic features',
argues Prof Roubini. Goldman Sachs estimates mortgage losses at $400bn.
But if home prices fell by more than 20 per cent, losses would be
bigger. That would further impair the banks’ ability to offer credit.
Step three would be big losses on unsecured consumer debt: credit
cards, auto loans, student loans and so forth. The 'credit crunch'
would then spread from mortgages to a wide range of consumer credit.
Step four would be the downgrading of the monoline insurers, which do
not deserve the AAA rating on which their business depends. A further
$150bn writedown of asset-backed securities would then ensue.
Step five would be the meltdown of the commercial property market,
while step six would be bankruptcy of a large regional or national bank.
Step seven would be big losses on reckless leveraged buy-outs. Hundreds
of billions of dollars of such loans are now stuck on the balance
sheets of financial institutions.
Step eight would be a wave of corporate defaults. On average, US
companies are in decent shape, but a 'fat tail' of companies has low
profitability and heavy debt. Such defaults would spread losses in
'credit default swaps', which insure such debt. The losses could be
$250bn. Some insurers might go bankrupt.
Step nine would be a meltdown in the 'shadow financial system'. Dealing
with the distress of hedge funds, special investment vehicles and so
forth will be made more difficult by the fact that they have no direct
access to lending from central banks.
Step 10 would be a further collapse in stock prices. Failures of hedge
funds, margin calls and shorting could lead to cascading falls in
prices.
Step 11 would be a drying-up of liquidity in a range of financial
markets, including interbank and money markets. Behind this would be a
jump in concerns about solvency.
Step 12 would be 'a vicious circle of losses, capital reduction, credit
contraction, forced liquidation and fire sales of assets at below
fundamental prices'.
These, then, are 12 steps to meltdown. In all, argues Prof Roubini:
'Total losses in the financial system will add up to more than $1,000bn
and the economic recession will become deeper more protracted and
severe.' This, he suggests, is the 'nightmare scenario' keeping Ben
Bernanke and colleagues at the US Federal Reserve awake. It explains
why, having failed to appreciate the dangers for so long, the Fed has
lowered rates by 200 basis points this year. This is insurance against
a financial meltdown.
Is this kind of scenario at least plausible? It is. Furthermore, we can
be confident that it would, if it came to pass, end all stories about
'decoupling'. If it lasts six quarters, as Prof Roubini warns,
offsetting policy action in the rest of the world would be too little,
too late.
Can the Fed head this danger off? In a subsequent piece, Prof Roubini
gives eight reasons why it cannot***. (He really loves lists!) These
are, in brief: US monetary easing is constrained by risks to the dollar
and inflation; aggressive easing deals only with illiquidity, not
insolvency; the monoline insurers will lose their credit ratings, with
dire consequences; overall losses will be too large for sovereign
wealth funds to deal with; public intervention is too small to
stabilise housing losses; the Fed cannot address the problems of the
shadow financial system; regulators cannot find a good middle way
between transparency over losses and regulatory forbearance, both of
which are needed; and, finally, the transactions-oriented financial
system is itself in deep crisis.
The risks are indeed high and the ability of the authorities to deal
with them more limited than most people hope. This is not to suggest
that there are no ways out. Unfortunately, they are poisonous ones. In
the last resort, governments resolve financial crises. This is an iron
law. Rescues can occur via overt government assumption of bad debt,
inflation, or both. Japan chose the first, much to the distaste of its
ministry of finance. But Japan is a creditor country whose savers have
complete confidence in the solvency of their government. The US,
however, is a debtor. It must keep the trust of foreigners. Should it
fail to do so, the inflationary solution becomes probable. This is
quite enough to explain why gold costs $920 an ounce."
*This information is solely a highlight of the opinion of a third-party publication and is incomplete. Please subscribe to this publication for the full and timely opinion of the author and call a Monex Account Representative for any additional up-to-date information. This is not an offer to buy or sell precious metals. Investors should obtain advice based on their own individual circumstances and understand the risk before making any investment decision.
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