Risk of Financial Disaster Increasing
In the next few posts, I am going to summarize The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial Disasterby Professor Nouriel Roubini
of the Stern School of Business at New York University.
Professor Roubini writes primarily for sophisticated institutional investors, so much of what he says is difficult to understand if you are not familiar with the acronyms and lingo of this world. He has a very important warning that I will simplify so that it is more understandable to the average person. (Comments that are strictly my own will be enclosed in parenthesis.)
His thesis is that the U.S. Federal Reserve Bank is taking actions now that clearly indicate they believe we are at risk for a catastrophic financial outcome to our current situation and that he believes we are indeed at risk for such an outcome. Professor Roubini outlines twelve steps that could unfold (or are already unfolding) to bring about this catastrophe.
The first step is a deep housing recession. The U.S. is likely already in an economic recession and this recession is likely to be much worse than either of the last two recessions which lasted about eight months each. (1990-91 and 2001) This recession will be longer and will be made much worse by the need of households to very significantly reduce spending and to pay down their overextended debt. Housing prices will fall 20-30 percent and wipe out from $4 to $6 Trillion Dollars of household wealth. (Most of this fall will occur in areas that had the greatest appreciation.) The drop in value will cause more than ten million home owners to owe more on their mortgages than their houses are worth. This will lead many of them to walk away from their houses. The glut of houses on the market will bankrupt large homebuilders just as it has already bankrupt many small homebuilders.
Second, the subprime loan disaster will spread to near-prime and prime mortgages as housing prices fall. Goldman Sachs has estimated mortgage losses will be around $400 Billion Dollars, but this could prove to be too optimistic. As the losses mount, the entire business of mortgage origination will lock up so that very few new mortgages will be written and existing mortgages will not be able to be refinanced. Falling prices and unavailability of mortgage loans will feed on each other to make the situation worse.
Third, the recession will cause rising defaults on other types of debt such as credit cards, auto loans, and student loans. This will put more pressure on financial institutions and cause greater limits on the availability of all types of credit.
(I will pick up with the fourth step in my next post. The three steps outlined above are already underway. The Fed lowered interest rates a full one-and-a-quarter percent in only eight days. Yes, they know something you don't; the risk of a catastrophic financial disaster is rising!)