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<p class="MsoNormal"><a href="http://www.irvinehousingblog.com/wp-content/uploads/2008/02/roubini022608.pdf">The Current U.S. Recession and the Risks of a Systemic Financial Crisis</a> </p>
<p class="MsoNormal"> </p>
<p class="MsoNormal">by Nouriel Roubini </p>
<p class="MsoNormal">Professor of Economics at the Stern School of Business, New York University and Chairman of RGE Monitor (<a href="http://www.rgemonitor.com/"><strong>www.rgemonitor.com</strong></a>) </p>
<p class="MsoNormal">Written Testimony for the House of Representatives’ Financial Services Committee Hearing on February 26th, 2008 </p>
<p class="MsoNormal"> </p>
<p class="MsoNormal">A vicious circle is currently underway in the United States, and its reach could broaden to the global economy. America’s financial crisis has triggered a severe credit crunch that is making the U.S. recession worse, while the deepening recession is leading to larger losses in financial markets, thus undermining the wider economy. There is now a serious risk of a systemic meltdown in US financial markets as huge credit and asset bubbles collapse.</p>
<p class="MsoNormal"> At this point the debate in the U.S. is no longer about soft landing versus hard landing (recession); it is rather on how hard the hard landing will be. An analysis of the macro data published in recent weeks suggests that the economy has already entered into a recession in December 2007. So the question now is whether this recession is going to be relatively short and shallow (lasting two quarters in Q1 and Q2 of 2008 as several analysts suggest) or much longer, deeper and more protracted (four to six quarters). </p>
<p class="MsoNormal">The fact that the US is now in a recession is, at this point, without much doubt even if the consensus forecast – always behind the curve – now gives only even odds (49% according to the WSJ panel of forecasters, 50% according to the Bloomberg panel) to a recession outcome. The latest data point to a severe recession ahead lasting at least four quarters rather than mild recession that most forecasters are now predicting: a fall in employment in January; very high and elevated levels of initial and continued unemployment claims; a non-manufacturing ISM that literally plunged; the Philly Fed report and other forward looking indicators being in recession territory; falling – in real term – retail sales in the holiday season; mediocre results and falling sales for most retailers in January; plunging auto sales; very weak and further falling consumer confidence; a credit crunch that is becoming more severe in credit market as measured by a variety of credit spreads; the beginning of a severe recession in commercial real estate; a worsening housing recession; sharply falling home prices; evidence of a serious credit crunch in the banking system based on the Fed survey of loan officers; a correction in all major stock markets and the beginning of a bear market in the NASDAQ; serious evidence of a global economic slowdown, especially in Europe, with outright recession ahead in some European countries. All these indicators points towards a severe recession. </p>
<p class="MsoNormal">It is not very likely that - as some forecasters now do – this will be a mild two-quarter recession and that growth will recover in H2 of 2008. The last two U.S. recessions in 1990-91 and 2001 lasted 8 months each. The current recession will last much longer and will be more severe for three reasons: </p>
<p class="MsoNormal">1. We are experiencing the worst U.S. housing recession since the Great Depression and this housing recession is nowhere near bottoming out. Home prices will eventually fall – relative to their 2006 peak – by 20% to 30%. They have already fallen by almost 8% based on the Case-Shiller/S&P index. </p>
<p class="MsoNormal">2. The U.S. consumer is shopped out, saving-less and debt burdened and now buffeted by oil prices close to $100 a barrel, a weakening labor market, weak income generation, falling consumer confidence, falling home values, falling home equity withdrawals, high debt, rising debt servicing ratios, a severe credit crunch and a sharp correction in the stock market that will turn into a bear market once the recession becomes deeper. </p>
<p class="MsoNormal">3. The U.S. financial system and credit markets are experiencing their most severe crisis since the early 1980s. The problems are now not limited any longer to subprime mortgages but spreading across the whole spectrum of credit and financial markets. </p>
<p class="MsoNormal">Let us consider in more detail this third point. Currently the problems in financial markets are no longer merely sub-prime mortgages, but rather a whole “sub-prime” financial system. The housing recession – the worst in U.S. history and worsening every day – will eventually see house prices fall by more than 20 percent, with millions of Americans losing their homes and/or walking away from them as they have negative equity in them. </p>
<p class="MsoNormal">Delinquencies, defaults, and foreclosures are now spreading from sub-prime to near-prime and prime mortgages. Thus, total losses on mortgage-related instruments – include exotic credit derivatives such as collateralized debt obligations (CDOs) – will add up to more than $400 billion. </p>
<p class="MsoNormal">Moreover, commercial real estate is beginning to follow the downward trend in residential real estate. After all, who wants to build offices, stores, and shopping centers in the empty ghost towns that litter the American West? </p>
<p class="MsoNormal">In addition to the downturn in real estate, a broader bubble in consumer credit is now collapsing: as the US economy slips into recession, defaults on credit cards, auto loans,and student loans will increase sharply. US consumers are shopped-out, savings-less, and debt-burdened. With private consumption representing more than 70 percent of aggregate US demand, cutbacks in household spending will deepen the recession. </p>
<p class="MsoNormal">We can also add to these financial risks the massive problems of bond insurers that guaranteed many of the risky securitization products such as CDOs. A very likely downgrade of these insurers’ credit ratings will force banks and financial institutions that hold these risky assets to write them down, adding another $150 billion to the financial system’s mounting losses. </p>
<p class="MsoNormal">Then there is the exposure of banks and other financial institutions to rising losses on loans that financed reckless leveraged buy-outs (LBOs). With a worsening recession, many LBOs that were loaded with too much debt and not enough equity will fail as firms with lower profits or higher losses become unable to service their loans. </p>
<p class="MsoNormal">Given all this, the recession will lead to a sharp increase in corporate defaults, which had been very low over the last two years, averaging 0.6 percent per year, compared to an historic average of 3.8 percent. During a typical recession, the default rate among corporations may rise to 10-15 percent, threatening massive losses for those holding risky corporate bonds. </p>
<p class="MsoNormal">As a result, the market for credit default swaps (CDS) – where protection against corporate defaults is bought and sold – may also experience massive losses. In that case, there will also be a serious risk that some firms that sold protection will go bankrupt, triggering further losses for buyers of protection when their counterparties cannot pay.</p>
<p class="MsoNormal"> </p>
<p class="MsoNormal">by Nouriel Roubini </p>
<p class="MsoNormal">Professor of Economics at the Stern School of Business, New York University and Chairman of RGE Monitor (<a href="http://www.rgemonitor.com/"><strong>www.rgemonitor.com</strong></a>) </p>
<p class="MsoNormal">Written Testimony for the House of Representatives’ Financial Services Committee Hearing on February 26th, 2008 </p>
<p class="MsoNormal"> </p>
<p class="MsoNormal">A vicious circle is currently underway in the United States, and its reach could broaden to the global economy. America’s financial crisis has triggered a severe credit crunch that is making the U.S. recession worse, while the deepening recession is leading to larger losses in financial markets, thus undermining the wider economy. There is now a serious risk of a systemic meltdown in US financial markets as huge credit and asset bubbles collapse.</p>
<p class="MsoNormal"> At this point the debate in the U.S. is no longer about soft landing versus hard landing (recession); it is rather on how hard the hard landing will be. An analysis of the macro data published in recent weeks suggests that the economy has already entered into a recession in December 2007. So the question now is whether this recession is going to be relatively short and shallow (lasting two quarters in Q1 and Q2 of 2008 as several analysts suggest) or much longer, deeper and more protracted (four to six quarters). </p>
<p class="MsoNormal">The fact that the US is now in a recession is, at this point, without much doubt even if the consensus forecast – always behind the curve – now gives only even odds (49% according to the WSJ panel of forecasters, 50% according to the Bloomberg panel) to a recession outcome. The latest data point to a severe recession ahead lasting at least four quarters rather than mild recession that most forecasters are now predicting: a fall in employment in January; very high and elevated levels of initial and continued unemployment claims; a non-manufacturing ISM that literally plunged; the Philly Fed report and other forward looking indicators being in recession territory; falling – in real term – retail sales in the holiday season; mediocre results and falling sales for most retailers in January; plunging auto sales; very weak and further falling consumer confidence; a credit crunch that is becoming more severe in credit market as measured by a variety of credit spreads; the beginning of a severe recession in commercial real estate; a worsening housing recession; sharply falling home prices; evidence of a serious credit crunch in the banking system based on the Fed survey of loan officers; a correction in all major stock markets and the beginning of a bear market in the NASDAQ; serious evidence of a global economic slowdown, especially in Europe, with outright recession ahead in some European countries. All these indicators points towards a severe recession. </p>
<p class="MsoNormal">It is not very likely that - as some forecasters now do – this will be a mild two-quarter recession and that growth will recover in H2 of 2008. The last two U.S. recessions in 1990-91 and 2001 lasted 8 months each. The current recession will last much longer and will be more severe for three reasons: </p>
<p class="MsoNormal">1. We are experiencing the worst U.S. housing recession since the Great Depression and this housing recession is nowhere near bottoming out. Home prices will eventually fall – relative to their 2006 peak – by 20% to 30%. They have already fallen by almost 8% based on the Case-Shiller/S&P index. </p>
<p class="MsoNormal">2. The U.S. consumer is shopped out, saving-less and debt burdened and now buffeted by oil prices close to $100 a barrel, a weakening labor market, weak income generation, falling consumer confidence, falling home values, falling home equity withdrawals, high debt, rising debt servicing ratios, a severe credit crunch and a sharp correction in the stock market that will turn into a bear market once the recession becomes deeper. </p>
<p class="MsoNormal">3. The U.S. financial system and credit markets are experiencing their most severe crisis since the early 1980s. The problems are now not limited any longer to subprime mortgages but spreading across the whole spectrum of credit and financial markets. </p>
<p class="MsoNormal">Let us consider in more detail this third point. Currently the problems in financial markets are no longer merely sub-prime mortgages, but rather a whole “sub-prime” financial system. The housing recession – the worst in U.S. history and worsening every day – will eventually see house prices fall by more than 20 percent, with millions of Americans losing their homes and/or walking away from them as they have negative equity in them. </p>
<p class="MsoNormal">Delinquencies, defaults, and foreclosures are now spreading from sub-prime to near-prime and prime mortgages. Thus, total losses on mortgage-related instruments – include exotic credit derivatives such as collateralized debt obligations (CDOs) – will add up to more than $400 billion. </p>
<p class="MsoNormal">Moreover, commercial real estate is beginning to follow the downward trend in residential real estate. After all, who wants to build offices, stores, and shopping centers in the empty ghost towns that litter the American West? </p>
<p class="MsoNormal">In addition to the downturn in real estate, a broader bubble in consumer credit is now collapsing: as the US economy slips into recession, defaults on credit cards, auto loans,and student loans will increase sharply. US consumers are shopped-out, savings-less, and debt-burdened. With private consumption representing more than 70 percent of aggregate US demand, cutbacks in household spending will deepen the recession. </p>
<p class="MsoNormal">We can also add to these financial risks the massive problems of bond insurers that guaranteed many of the risky securitization products such as CDOs. A very likely downgrade of these insurers’ credit ratings will force banks and financial institutions that hold these risky assets to write them down, adding another $150 billion to the financial system’s mounting losses. </p>
<p class="MsoNormal">Then there is the exposure of banks and other financial institutions to rising losses on loans that financed reckless leveraged buy-outs (LBOs). With a worsening recession, many LBOs that were loaded with too much debt and not enough equity will fail as firms with lower profits or higher losses become unable to service their loans. </p>
<p class="MsoNormal">Given all this, the recession will lead to a sharp increase in corporate defaults, which had been very low over the last two years, averaging 0.6 percent per year, compared to an historic average of 3.8 percent. During a typical recession, the default rate among corporations may rise to 10-15 percent, threatening massive losses for those holding risky corporate bonds. </p>
<p class="MsoNormal">As a result, the market for credit default swaps (CDS) – where protection against corporate defaults is bought and sold – may also experience massive losses. In that case, there will also be a serious risk that some firms that sold protection will go bankrupt, triggering further losses for buyers of protection when their counterparties cannot pay.</p>
