Global Economic Issues
Econ 1000
Fall 2008
J Shogren



Lecture 6b.   12 steps to a financial meltdown

Professor Nouriel Roubini


Predicted in February 2008



1.        Housing bubble:   this is the worst housing recession in US history and there is no sign it will bottom out any time soon


2.      Subprime loans taking others down with them:    losses for the financial system from the subprime disaster are now spreading to near prime and prime mortgages as the same reckless lending practices in subprime were occurring across the entire spectrum of mortgages.


3.        Debt defaults increase: the recession will lead to a sharp increase in defaults on other forms of unsecured consumer debt: credit cards, auto loans, student loans.


4.      Huge losses to insurance companies:  while there is serious uncertainty about the losses that insurance companies will undertake, it is now clear that such losses are much higher than expected. Some insurance companies are actually borderline insolvent and none of them deserves at this point a AAA rating regardless of how much realistic recapitalization is provided.


5.        Commercial real estate loan market meltdown:   will soon enter into a meltdown similar to the subprime one. 


6.        Big banks go bankrupt:  it is possible that some large regional or even national bank that is very exposed to mortgages, residential and commercial, will go bankrupt.


7.        Bank portfolios will be worth less than they paid the banks losses on their portfolio of leveraged loans are already large and growing. Hundreds of billions of dollars of leveraged loans are now stuck on the balance sheet of financial institutions at values well below par (currently about 90 cents on the dollar but soon much lower).


8.        Corporate defaults will increase once a severe recession is underway a massive wave of corporate defaults will take place, i.e., 10% of comnpanies.


9.       Shadow financial system will soon get into serious trouble. This non-bank financial institutions system includes: Structured Investment Vehicle (SIVs, conduits, money market funds, insurance companies, investment banks, hedge funds and other non-bank financial institutions. All these institutions are subject to market risk, credit risk (given their risky investments) and especially liquidity/rollover risk as their short term liquid liabilities can be rolled off easily while their assets are more long term and illiquid. Unlike banks these non-bank financial institutions don't have direct or indirect access to the central bank's lender of last resort support as they are not depository institutions.


10.   Stock markets will start pricing a severe US recession:   rather than a mild recession and a sharp global economic slowdown. US and global equity markets will enter into a persistent bear market as in a typical US recession the S&P500 falls by about 28%.


11.    Liquidity funds will dry up:    the worsening credit crunch that is affecting most credit markets and credit derivative markets will lead to a dry-up of liquidity in a variety of financial markets, including otherwise very liquid derivatives markets.


12.    A vicious circle ensues:   downward spiral of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices will ensue leading to a cascading and mounting cycle of losses and further credit contraction.


A near global economic recession will ensue as the financial and credit losses and the credit crunch spread around the world. Panic, fire sales, cascading fall in asset prices will exacerbate the financial and real economic distress as a number of large and systemically important financial institutions go bankrupt.


A 1987 style stock market crash could occur leading to further panic and severe financial and economic distress. Monetary and fiscal easing will not be able to prevent a systemic financial meltdown as credit and insolvency problems trump illiquidity problems. The lack of trust in counterparties driven by the opacity and lack of transparency in financial markets, and uncertainty about the size of the losses and who is holding the toxic waste securities will add to the impotence of monetary policy and lead to massive hoarding of liquidity that will exacerbates the liquidity and credit crunch.


In this meltdown scenario US and global financial markets will experience their most severe crisis in the last quarter of a century.