Some thoughts on Prof. Roubini’s important piece on the Need for Radical Policy Solutions to the Crisis published yesterday. (His site now requires subscription, so I’ll quote liberally with bold added.)
It is now clear that the US and global financial markets are experiencing their worst financial crisis since the Great Depression. And in spite of desperate and radical actions by the Fed this crisis is getting worse.
The Fed took extreme action by now lending not only to Fed-regulated banks, but also to unregulated financial institutions and by taking assets (mortgage backed securities – MBS) of dubious value as collateral.
We saw a bailout of Bear Stearns and a gift for JP Morgan as the Fed accepted to carry the risk for $30 billion of Bear Stearns bad assets. This move was similar to actions taken in Japan in the 1990s that led to 10+ years of economic problems.
But despite the Fed’s action, says Roubini, all numbers show that the credit-market situation is getting worse and will have severe consequences:
[W]ith [interest] spreads [between treasuries and] even “safe” AAA agency and private label debt and MBS being so wide expect another round of massive writedowns that will lead to the bankruptcies of a wide range of leveraged institutions (hedge funds, broker dealers and other members of the shadow financial system).
Today we are facing a massive margin call on highly leveraged US capital markets and a massive de-leveraging of the financial system following fire sales of marked to market assets in vastly illiquid money markets, credit markets and derivatives markets.
Two weeks ago
I explained the De-leveraging Spiral phenomenon in some detail.
There is a run on the ‘shadow’ financial system, i.e. the unregulated brokers, hedge funds, etc., that will wipe out most of these and some of the regulated institutions too. This run has only barely started.
The lack of trust of financial institutions in their counterparties is surging in spite of all the Fed actions as panic is setting in money markets and credit markets.
Now what to do? The reaction to the Fed’s provisions has proven beyond doubt that the Fed is incapibale of stopping this. What is urgently needed is political/policy action. Without it, the meltdown will overshoot. Prices of all financial assets and houses would sink far below their real value and the financial destruction would have even more very severe social consequences then those that are already in the making.
[T]he piecemeal approach to crisis management taken by the Fed, the Treasury and other financial authorities is going to fail miserably. A severe recession and a severe financial crisis cannot be avoided at this point. Only much more radical government action will limit the financial meltdown and start to put a floor on the financial markets collapse. This government intervention would not be aimed to prevent the necessary adjustment of asset prices; it would be aimed at ensuring that the necessary adjustment is not disorderly.
So Roubini calls for the inevitable takeover by the taxpayer, while urging to avoid moral hazard and punishing the guilty. There are three parts to this (underline in the original).
Such radical policy action includes a government plan to purchase – at a significant discount to minimize its fiscal cost – hundreds of billions of dollars – possibly trillions – of mortgages, effectively a nationalization of mortgages. Once purchased by the governments at a significantly discounted price these mortgages could be restructured to reduce their face value, reduce the interest rate on the mortgage and allow distressed but solvent borrowers to avoid foreclosure.
…
This plan also include a formal nationalization Fannie and Freddie as the ongoing farce of pretending that these insolvent institutions are private sector firms is being revealed: […] if these bankrupt institutions need to be used for public policy purposes – as they may need to – let us formally nationalize Fannie and Freddie – and put transparently on the public sector balance sheet the costs of bailing out the mortgage market.This plan would also include the closing and/or nationalization of banks and other systemically important financial institutions that will fail in droves during the current financial crisis (they can then be privatized again after proper restructuring as many countries did after their banking crises). Again moral hazard distortions can be minimized by wiping out 100% the shareholders in these institutions and firing – with no sweet severance packages – all the reckless senior management that created this mess.
A agree with Roubini. The government takeover is unavoidable and if it doesn’t happen now, it will happen later with much more severe consequences.
It should be pointed out that such a move would increase the federal debt of the U.S., currently at some $9+ trillion, by several trillion dollars. I still have to think through the international financial and political consequences of this. They will likely be very severe.
Roubini closes:
A market solution to this crisis does not exist; those who believe in such markets solutions are deluding themselves as markets left alone will melt down and enter into the mother of all meltdowns, margin calls, cascading collapse of asset prices, massive credit crunch and liquidity seizure and severe economic recession.
Of course the price adjustment in overpriced asset prices should not and cannot be avoided: home prices will have to fall at least 30%; equities will need to sharply correct in a bear market; risk spreads will have to widen sharply; many institutions will go bankrupt as they should. But what we risk today is a systemic financial meltdown where negative feedback loops lead asset prices to collapse much more than justified even by the much lower fundamental value of such assets.
We are facing now the risk of the mother of all financial crises and meltdowns. Moral hazard can be realistically address by wiping out reckless investors and lenders, having the government buying assets that need to be restructured at low prices closer to their fundamental value and limiting the mortgage debt reduction to truly deserving borrowers who were victims of predatory lending practices. But radical and coherent policy action needs to be taken urgently and without further delay as there is now the risk that the US will experience its most severe recession in decades and that the US and global financial system may melt down.
I completely agree. The nationalization, which must include significant ‘haircuts’ for everyone involved, should happen immediately.
But it will likely not happen anytime soon.
The political constellation does not allow for such a huge nationalization project. Bush and most Republicans in congress will not agree to it. It will take another year until a new president settles in. Then the government takeover of the system will come. But by then the crisis will be so deep, that even nationalization will not help much.
Therefore the "worst financial crisis since the Great Depression" may well become worse than the Great Depression.
Let’s all hope that I am too pessimistic here.