The next three weeks could feature some of the trickiest financial crosscurrents we seen in 40 years. As you can see by the chart above, the amount of money pouring into the oil futures market has been climbing. In a classic supply demand curve the demand for oil contacts is driving price higher, especially given the limit on supply and all the other risk premiums for War, revolution, sabotage, etc. This is especially painful to the U.S. as the dollar is falling on the same commodity trader dymanics. We get twice the pain as the Euros.

Ben Bernanke knows the trading desks are gaming these markets and so yesterday he threatened to intervene on behalf of a strong dollar, while indicating the Fed would pause in Interest cuts.  This morning some of the traders started to fold. I've been warning that oil will fall and been scorned by some of my Texas correspondents. I sure hope they don't own any three month forward oil contract at $130 bucks.

The dollar will strengthen and oil will fall to $100. But listen, this is not a long term trend. I still believe in Peak Oil. That's why I say there are crosscurrents. Because if you had a long term time horizon (4 years) you would be long oil and short the dollar. Problem is, these traders have a four week time horizon, so Ben Bernanke can f**k with their heads.

The resident Cassandra, Prof. Nouriel Roubini thinks this really could get ugly soon, contrary to the conventional wisdom that the storm has blown through town.

No wonder that now heads just started to roll at the top of Wachovia and WaMu; that Lehman - even with the protection of the Fed liquidity blanket - is in trouble again; that Countrywide is on the verge of bankruptcy once BofA pulls out of a loser acquisition of the biggest and most insolvent mortgage lender; that the troubles among mortgage lenders are now spreading to the UK where the housing bubble was as big - if not bigger - than in the US; that S&P has finally downgraded major financial institutions; and now that more financial trouble lurks ahead for major US banks and smaller US banks (small banks that will go into bankruptcy by the hundreds as the housing recession deepens, home prices collapse and the economic recession deepens and persist longer than expected by the market consensus). So after a brief period of complacency - if not delusional optimism that the worst was behind us - a painful reality check is setting in. Fed Funds easing and new liquidity facilities (TAF, TSLF, PDCF, Swap lines) of the Fed cannot resolve insolvency and credit problems that go well beyond illiquidity.

As the world's economic system continues to unravel, the economist that everyone's talking about is Hyman Minsky, who was born in Chicago on Sept. 23, 1919.

It is traditional to set a chart for noon when the birth time is not known, but I'm going to guess that Minsky was born late in the day and that he is a 0 degree Libra.

Why? Because transiting Pluto in Capricorn has been squaring Minsky's Sun (and Moon) in a chart set for 11:45 p.m.  I think that Pluto transit would prompt a deep examination of the economist's work, which focuses on financial crises. Here's the chart, courtesy of Astrodienst:

http://www.astro.com/cgi/chart.cgi?cid=41laaaa19347-s971800598;lang=e;gm=a1;btyp=2;mth=gw;sday=12;smon=4;syr=2008;hsy=-1;zod=;orbp=;rs=0;ast=;nhor=201;nho2=6

Like many accomplished people, Minsky had virtually all of his planets clustered together in what I believe legendary astrologer Mark Edmund Jones (How to Learn Astrology) called a "locomotive formation." Some might say this chart has a "bucket" pattern, with Uranus in Aquarius as the handle.

Finance types will notice the similarity between some of the patterns Jones identified in horoscopes and the terms used by chartists in the financial markets. And, indeed, chartists or technical traders don't have the knee-jerk reaction against astrology that you typically find on Wall Street because they're accustomed to looking for patterns in the price movements of a commodity or stock.

The aspect that I find most intriguing in Minsky's chart is the Jupiter/Neptune conjunction in Leo, which is almost exact to the minute. This symbolizes speculation big time and the lush life. Interesting that Minsky chose to write about living the high life on credit instead of doing it himself. (Admittedly, I don't know much about his personal life, but I'll venture to say he was not a compulsive gambler or mad speculator. But maybe someone will write in and contradict me.)

The piece that brought the former Bard College economics professor, who died in 1996 at the age of 77, into the public eye is this page one story from the Wall Street Journal:  http://online.wsj.com/public/article/SB118736585456901047.html 

The article, published Aug. 18, 2007, hailed the failure of market mechanisms as a "Minsky moment." Interesting that the transiting Sun was broadly conjunct Minsky's Mars in Leo and opposing his Uranus in Aquarius on the day the article was published. It was Minsky's "moment in the sun."

Before Minsky made his appearance on the first page of the WSJ, his name and theories were being bandied about by economists such as George Magnus of UBS, according to this post at the Financial Times:

http://ftalphaville.ft.com/blog/2007/08/20/6687/economist-idol-minskys-new-found-fame/

Nouriel Roubini, a Turkish-born economist who has a great Web site, cited Minsky on July 30, 2007 when he asked: "Are we at the peak of a Minsky credit cycle?" You can read his post here: http://www.rgemonitor.com/blog/roubini/208166

According to Roubini, Minsky identified a group of buyers who come in late in the credit cycle as "Ponzi borrowers, as they need persistently increasing prices of the assets they invested in to keep on refinancing their debt obligations."  (Ponzi is a reference to notorious swindler Charles Ponzi, who popularized schemes that offered extremely high returns in the beginning, but required more and more money, usually from new investors, to keep the scam going.)

In terms of Minsky's idea of Ponzi borrowers, I can think of no better description of the hairdresser I sat next to on Metro North a few years ago. He was making his way to JFK, where he was going to fly down to Miami and "flip some condos." Now, I'm a big fan of hairdressers (what woman isn't?), but when they start talking about a particular investment, you can be sure we're close to the peak of speculation in that market. 

Back to Minsky. Given all the publicity he was getting in late July and August of last year, it is possible that he was born early in the day and his Sun is in the last degree of Virgo. He's been described as unkempt and that's not an uncommon trait among Virgos. They sometimes let things go to hell in a handbasket because they give up in the face of the monumental task of being perfect. In that case, last August, Pluto in Sagittarius was squaring Minsky's Sun.

Forgive me for thinking out loud here, but I want to share my back-of-the-envelope rectification with you as I guesstimate the time of birth.

El problema ya no son solamente las hipotecas de alto riesgo, sino un sistema financiero “de alto riesgo”. En la recesión inmobiliaria –la peor en la historia de Estados Unidos y que empeora cada día—los precios de las casas caerán con el tiempo en más del 20% y millones de estadounidenses perderán sus hogares. Las liquidaciones y los impagos se están extendiendo de las hipotecas de alto riesgo a las de riesgo medio y bajo. De esa manera, las pérdidas totales de los instrumentos relacionados con las hipotecas –incluyendo derivados crediticios exóticos como las obligaciones de deuda avalada (CDO por sus siglas en inglés)—se elevarán a más de 400 mil millones de dólares.

Además, los bienes raíces comerciales están empezando a seguir la tendencia a la baja de las propiedades residenciales. Después de todo, ¿quién quiere construir oficinas, tiendas y centros comerciales en los pueblos fantasma del oeste estadounidense?

Además de la desaceleración en los bienes raíces, ahora se está colapsando la burbuja más amplia del crédito al consumo: a medida que la economía estadounidense se acerca a la recesión, los impagos de las tarjetas de crédito, los préstamos para comprar automóviles y los créditos estudiantiles aumentarán bruscamente. Los consumidores estadounidenses han comprado en exceso, no tienen ahorros y están abrumados por las deudas. Dado que el consumo privado representa más del 70% de la demanda agregada de Estados Unidos, la disminución en el gasto doméstico agravará la recesión.

También podemos añadir a estos riesgos financieros los enormes problemas de los aseguradores de bonos, quienes garantizaron muchos de los riesgosos productos de titulización como las CDO. Una muy probable reducción de la calificación crediticia de estos aseguradores obligará a los bancos e instituciones financieras que tienen estos activos de riesgo a cancelarlos, lo que añadirá otros 150 mil millones de dólares a las crecientes pérdidas del sistema financiero.

Además, está la exposición de los bancos y otras instituciones financieras a las pérdidas crecientes relacionadas con los préstamos utilizados para financiar adquisiciones apalancadas (LBO pos sus siglas en inglés) imprudentes. Con una recesión que empeora, muchas LBO que tenían demasiada deuda y no suficiente capital fracasarán en la medida en que las empresas con ganancias menores o pérdidas mayores no puedan cubrir sus préstamos.

Ante todo esto, la recesión conducirá a un brusco aumento de los impagos corporativos, que habían sido muy bajos en los últimos dos años, con un promedio de 0.6% anual, en comparación con el promedio histórico de 3.8%. Durante una recesión típica, la tasa de impagos entre las corporaciones puede aumentar al 10-15%, lo que constituye una amenaza de grandes pérdidas para quienes tienen bonos corporativos de riesgo.

Como resultado, el mercado de swaps de impago de crédito (CDS por sus siglas en inglés) –en el que se compra y vende protección contra los impagos corporativos—también puede experimentar pérdidas importantes. En ese caso, también habrá un grave riesgo de que quiebren algunas de las empresas que vendieron protección, lo que desencadenará pérdidas adicionales para los compradores de protección cuando sus contrapartes no puedan pagar.

Encima de todo esto, existe un sistema secundario de instituciones financieras no bancarias que, al igual que los bancos, piden préstamos líquidos a corto plazo y prestan o invierten a plazo más largo en activos no líquidos. Este sistema secundario incluye los vehículos de inversión estructurada, los conductos, los fondos del mercado monetario, los fondos de cobertura y los bancos de inversión.

Al igual que los bancos, todas estas instituciones financieras están sujetas al riesgo de liquidez o de refinanciamiento –el riesgo de quebrar si los prestamistas no refinancian sus líneas de crédito a corto plazo. Pero, a diferencia de los bancos, no tienen la red de seguridad que implica el papel del banco central como prestamista de última instancia.

Ahora que la recesión está en marcha, los mercados de valores de Estados Unidos y del mundo están empezando a caer: en una recesión típica estadounidense, el índice S&P 500 cae un promedio de 28% a medida que los ingresos corporativos y las ganancias se hunden. Las pérdidas en los mercados de valores tienen un efecto doble: reducen la riqueza de los hogares y los conducen a gastar menos; y provocan enormes pérdidas a los inversionistas que pidieron préstamos para invertir en acciones y desencadenan así llamadas de margen y ventas forzadas de activos.

Hay por lo tanto un riesgo mayor de que muchos inversionistas apalancados tanto en los mercados de capital como en los de crédito se vean obligados a vender activos no líquidos en mercados no líquidos, lo que conducirá a una caída en cascada de los precios de los activos por debajo de sus valores fundamentales. Las pérdidas que de ahí se derivarán agravarán el desorden financiero y la contracción económica.

En efecto, al sumar todas estas pérdidas en los mercados financieros, se llega a una abrumadora cifra de un billón de dólares. Un racionamiento más estricto del crédito afectará aún más la capacidad de los hogares y las empresas para pedir préstamos, gastar, invertir y apoyar el crecimiento económico. El riesgo de que una crisis financiera sistémica impulse una recesión más pronunciada en Estados Unidos y a nivel mundial rápidamente ha pasado de ser una posibilidad teórica a un escenario cada vez más posible.

Nouriel Roubini es profesor de economía en la Stern School of Business de la Universidad de Nueva York y presidente de RGE Monitor (www.rgemonitor.com).

Copyright: Project Syndicate, 2008.

www.project-syndicate.org

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O professor da New York University, economista-chefe do site RGE Monitor e colunista de CartaCapital Nouriel Roubini calcula os custos de um processo de saneamento do sistema financeiro dos Estados Unidos. Analisa ainda a incoerência entre o discurso de laissez-faire do mercado, quando os ventos estão a favor, e os pedidos recorrentes dos bancos para que o governo alivie as perdas originadas no estouro da bolha imobiliária americana. "Definitivamente, estamos diante do paradoxo de privatizar os ganhos e socializar as perdas", afirma o colunista.

CartaCapital: O senhor tem discutido teses de uma intervenção maior do Estado no mercado, para sanar a crise financeira americana.

Nouriel Roubini: Os problemas do crédito subprime se espalharam por toda a cadeia econômica. Chegaram aos financiamentos de boa qualidade, há um efeito forte sobre o segmento de cartões de crédito, de bônus emitidos pelas corporações e uma retração de consumo dos cidadãos. Milhões de mutuários vêem os preços de suas casas caírem, mas a dívida permanece alta. Eles simplesmente estão abandonando os imóveis, o que potencialmente pode causar um prejuízo de 1 trilhão de dólares. E não há soluções fáceis para o problema. O governo poderia comprar as hipotecas por valor superior ao de mercado, para evitar a quebra de muitos bancos. Outra opção seria simplesmente estatizar os bancos por um tempo. Mas isso terá um custo alto, em torno de 2,7 trilhões de dólares para o país. Em ambos os casos, seria uma situação muito delicada para o sistema financeiro.

Leia mais em: Entrevista CartaCapital.

Commodities continued their bull market run with oil shooting up $5 to over $104 a barrel on supply shortages and flat Saudi production. The spike in crude also sent gold and silver up to new highs. Gold actually hit the illusive $1000 an ounce milestone on the June futures contract today. The sinking dollar hit all-time lows again.

Solar, steel, metals, gold/silver, and oil/gas stocks were strong while banks, financial, and insurance stocks were weak.

JA Solar vaulted 9%. Sunpower, First Solar, So. Peru Copper, Suntech, and Yamana Gold gained 5%. Research In Motion lost 3%.

Here are the top 10 leading groups: Fertilizers, Gold/Silver, Oil/Gas Producers, Farm Machinery, Ores, Steel, Solar Energy, Agricultural Ops, Oil/Gas Drillers, and Mining Machinery. We have to ask ourselves if this is really a stock market rally or a commodities rally? Is inflation really taking off globally evidenced by soaring food, energy, gold, and raw materials prices. I think so.

The stock market indexes have tested their down trending 50-day moving averages from an 'overbought' position and failed. IBD has now switched from 'Market in a Confirmed Rally' to 'Rally Under Pressure.' Gold, silver, grains, and oil are all moving higher in very definite up trends. We may be witnessing a 'disconnect' between commodities and stocks.

It's best to stay on the sidelines in stock markets like this and not get sucked into 'leaderless' bear markets. Patience, Grasshopper! More at www.goldenticker.com

CNN: The Next Great Depression Is On It's Way!

Nouriel Roubini

O economista da New York University e chefe do site de análises econômicas RGE Monitor, Nouriel Roubini, compara as diferenças entre as propostas para a economia norte-americana dos três principais candidatos a assumir a Casa Branca: Hillary Clinton, Barack Obama e John McCain. Comenta ainda os reflexos da eleição sobre a economia global. A conclusão é inequívoca. Seja quem for o novo morador da Casa Branca, haverá menor ênfase na guerra antiterror e maior aproximação com a América Latina.

CartaCapital: A começar pelos democratas, o que diferencia Hillary de Obama?

Nouriel Roubini: Não há diferenças fundamentais entre eles. Mas é possível se detectar algumas ênfases, principalmente no que se refere ao sistema de saúde. De maneira geral, os democratas vêm engrossando o discurso da universalização dos cuidados médicos. Hillary promete que todos terão planos de assistência médica, com subsídios do governo. Já Obama vai focar a política de saúde na assistência às crianças, e não necessariamente aos seus pais. Cálculos de alguns estudos mostram que essas iniciativas elevariam os gastos com saúde de 120 bilhões de dólares para cerca 140 bilhões de dólares ao ano. Em contrapartida, com 20 bilhões de dólares a mais por ano, o dobro de americanos teria acesso, de alguma forma, à assistência médica.

CC: Estamos falando sobre mais gastos, enquanto o déficit fiscal dos Estados Unidos é enorme.

NR: Isso não está muito claro nos programas dos candidatos. Nos Estados Unidos, muitas empresas já oferecem planos de saúde. Uma das saídas seria taxar as que não o fazem para financiar os desprotegidos.

CC: Qual dos dois é mais bem preparado para enfrentar a atual crise econômica americana?

NR: Em princípio, Hillary parece mais bem preparada para dar respostas técnicas, como a sugestão de congelar por cinco anos as hipotecas mais problemáticas, em comparação ao plano de Bush, que beneficiará apenas 10% dos mutuários em dificuldades. O discurso de Obama é mais amplo e não foca especificamente a questão dos desdobramentos do crédito subprime.

CC: McCain parece mais progressista do que a maioria de seus pares republicanos. Como ele enfrentaria os problemas econômicos?

NR: No Partido Republicano, McCain é considerado um dissidente. Ele não necessariamente segue as tradições políticas do partido. No passado, manifestou-se contra o corte de impostos (dos mais ricos) e tem posições divergentes sobre a indústria de armamentos e de tabaco. Num espectro mais amplo, ele se mostra muito mais preocupado com o enorme déficit fiscal (causado por Bush). McCain parece menos ideológico em suas posições, mais pragmático, mas ainda não deixou claras as propostas econômicas.

CC: Como a crise e a eventual recessão americana afetarão os resultados das eleições?

NR: Estudos acadêmicos mostram que a inflação e o nível de atividade econômica sempre foram cruciais para as eleições. Por exemplo, se o ano é de recessão, o partido no poder na Casa Branca historicamente perde para a oposição. Como 2008 será recessivo, os democratas tendem a vencer os republicanos por uma larga margem de 10 pontos porcentuais. Algo como 55% versus 45%. Claro que, como McCain é uma espécie de dissidente, ele lutará com todas as forças para mostrar que fará um governo diferente de Bush. Acredito que, a partir de agora, mais do que há seis meses, os três candidatos vão se esforçar para mostrar saídas da recessão, porque é a principal preocupação da sociedade americana hoje.

CC: Percebemos uma mudança quase semiótica nesta eleição. Há uma candidata mulher, um negro filho de imigrantes e um republicano menos conservador. É engano ou qualquer um que vença será melhor para o mundo?

NR: Do ponto de vista geopolítico global, todos os candidatos sabem que os EUA, de alguma maneira, perderam muito de sua reputação. No entanto, do lado dos democratas, não devemos esperar iniciativas muito à esquerda. Pertencem ao centro, basicamente. Claro que há diferenças pontuais, sobre o timing da questão da retirada das tropas do Iraque, por exemplo. Já McCain terá uma visão mais global sobre as desavenças internacionais, muito mais ampla do que Bush. Ao menos, ele tende a não ser tão moralista e unilateral.

CC: E para os mercados emergentes, como o Brasil, o resultado da eleição fará alguma diferença?

NR: Sim. Porque a administração Bush concentrou-se basicamente na guerra contra o terrorismo e deixou de lado, por exemplo, a América Latina. Acredito que, na questão da política externa, haverá uma reaproximação diplomática grande com os vizinhos do Sul.

"I would tell audiences that we were facing not a bubble but a froth - lots of small, local bubbles that never grew to a scale that could threaten the health of the overall economy." Alan Greenspan, The Age of Turbulence.

That used to be Mr Greenspan's view of the US housing bubble. He was wrong, alas. 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....

Read the rest:
http://news.yahoo.com/s/ft/20080219/bs_ft/fto021920081334359078;_
ylt=Au_NhPTKsmXl7duQ4a6vyJ.s0NUE

As I have been suggesting for two months, the possibility of Stagflation is real. This morning Wall Street woke up to a 4.3% year over year price inflation number. Many of you know I have great respect for Prof. Nouriel Roubini, who called the Sub Prime meltdown months before any one else. However, we part ways on the Stagflation debate. Roubini believes the coming recession will be so strong that it will lead to a "recoupling" of the U.S. and world (especially Asian) economies. This will lead to a global slowing that will reduce demand for oil and thus reduce inflation. But the figures coming out of the oil markets say that Asian demand for oil keeps growing even as the U.S. demand has slipped by 50,000 barrels a day because of our slowdown. This is only natural. Chinese car dealers sold 639,000 cars in the month of January.That was up 32% from that month last year. Indian car sales were almost as robust. Let's not kid ourselves, Asian demand for oil has already de-coupled from the U.S. economy.

Deşi, prin natura postului, urmăresc atent problemele economice, mărturisesc că nu mi-au creat deloc preocupări aceste ‘fonduri suverane de investiţii’, tot  aşa cum ele  nu mă îngrijorează nici măcar acum, chiar şi după ce sinapsele neuronilor din capul meu au fost biciuite de mulţimea avertismentelor severe pronunţate de Nouriel Roubini în amintitul articol. În vreme ce criza împrumutului ipotecar riscat (‘subprimes’ în limba engleză), care se poate transforma într –o  criză a creditelor, mă face să gândesc la o problemă economică veche de 100 de ani, a cărei natură  perversă reapare.

Astfel, o criză a creditelor a fost la 1907, alta s-a întâmplat la 1929 (pe care nu a înţeles-o încă nimeni !), în fine cea mai recentă se produce acum. De ce  articolul acesta al lui Nouriel Roubini care încearcă să abată atenţia de la gravitatea crizei  care sifonează banii din România ? Numai într -o singură zi din anul 2007 a fost sifonat 1 (un) miliard de euro peste graniţele României, şi din bogăţia naţională a României! Care este suma totală pierdută  în anul 2007  de România,  şi cine a luat miliardele de euroi ? Titus Filipas

But this *long run* is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. By John Maynard Keynes, "A Tract on Monetary Reform" (1923)

To know how to move forward we must first learn how we got here. This takes on even greater urgency in this election year.

The US economy was wracked by a series of booms and busts in the decades after the Civil War. In 1913 Congress broke with this policy of laissez faire to create the Federal Reserve, charged with stabilizing the banking system. Despite this (or perhaps because of this), these busts culminated in the Great Depression of the 1930's.

A solution was at hand. During the years 1919-1936 John Maynard Keynes developed a new paradigm for economics, both quantitatively clear and operationally simple. Its goal was to stabilize the economy at a low level of unemployment, an optimum equilibrium (this is a gross over-simplification). It ignored the inimical effect of rising debt levels. But then, in the long run we are all debt (Keynes had no children).

The US adopted his policy of aggressive economic management, stabilizing the economy though federal spending, plus manipulation of the money supply and value of the dollar. This worked well for many decades.

Average length of expansions:

• 1854-1929: 25 months (laissez faire)
• 1945-1980: 44 months (Keynesian management)

A side effect was erosion of traditional concepts of financial prudence. During the 1960's and 1970's the US economy accumulated more debt and the trade deficit deteriorated. The stress impelled President Nixon to take us off the gold standard in 1971, which led to the great inflation of the 1970's. Only after inducing a recession, the worst since the 1930's, was the Fed under Chairman Volcker able to restore stability to our economy. Widely hated for this strong medicine, he served only one term.

The Fed was an evasion of responsibility by our elected officials. In the words of Chairman William McChesney Martin Jr.,*the Fed is like "the chaperone who has ordered the punch bowl removed just when the party was really warming up." Its Chairman was to take the burden of making unpopular decisions off our elected officials. Then in 1987 Alan Greenspan became Chairman, and discovered that Chairman too could be famous and popular. Casting aside all considerations of prudence, he oversaw a massive increase in the debt of government, household, and corporate debt. every crisis or slowdown was met with more debt. This worked well for a long time. There were those warning that this would end badly, but they were discredited by the lack of immediate ill effects (heroin works in a similar fashion).

Average length of expansions:

• 1854-1929: 25 months (laissez faire)
• 1945-1980: 44 months (Keynesian management)
• 1982-now: 95 months (Greenspan management).

Sometime in the mid-1980's Maria Fiorini Ramirez, then with Drexel (now one of Wall Street's top economists) noticed that since WWII that the government's economic management resulted in debt growing over time. More interesting, the effectiveness of new debt was decreasing. That is, new debt provided less stimulus. She speculated that when the economy hit its maximum sustainable debt load, new debt would no longer spark economic growth. Technically this means the debt elasticity of GDP goes to zero. At that point the economy would have to deleverage, marking the end of the post-WWII economic regime in America.

Growth of Credit market debt growth per dollar of GDP growth.

• 1950's $1.77
• 1960's $1.53
• 1970's $1.69
• 1980's $2.92
• 1990's $3.15
• 2000 - now $4.95

Excerpts from the 3 January issue of Contrary Investor (as is the data in this article) **

BEA revisions to the real GDP calculation essentially wiped the 2001 recession off of the map in an academic sense, despite the fact that the NBER still considered the totality of events as a recession. ... In that light, can we say that the current economic expansion is really, academically, 193 months long? ... 193 months of expansion is absolutely a massive anomaly in terms of length of historical economic expansions. Absolutely nothing comes even remotely close.

... If we start the economic retrospective clock at the end of the recession in 3Q of 1982, since that time exactly 100 quarters have elapsed. Again, over that period, the US has officially experienced only 5 quarters of negative quarter to quarter real GDP. That's only 5% of the entire period!

... Since late 1982 one of the most incredible periods of academically defined US economic growth of the last quarter century exactly coincides with what has been record US credit expansion as a % GDP over the same period. ... two incredibly powerful forces up until now have act to reinforce and support each other.

All parties must eventually end

The 2001 slowdown, from bursting of the debt bubble and 9/11, were met by an unprecedented rise of debt by US governments and households. Eventually the economy responded, although quite sluggishly.

Now comes the hangover to our fifty-year long party. the "subprime crisis" is just the canary in the coal mine, defaults by the worst loans of the most vulnerable debtors. We face a slowdown, perhaps a recession. Worse, we have burned out our economic "stabilizers" through overuse (see update for more on this).

• As Comptroller-General Walker has warned, the looming retirement of the baby boomers limits the government's ability to borrow - so fiscal policy is hamstrung.
• The trade-weighted US dollar has declined to near its record lows, making holders of US bonds nervous. Monetary stimulus - printing money, lowering interest rates - risks sparking a currency crisis, perhaps ending the US dollar's reign as the world's reserve currency. The consequences of this could be calamitous, as the trillions of dollars held aboard as a store of value get sent home if the dollar becomes just another fiat currency.
• Currency management, debasing the currency in order to stimulate exports, has the same problem.

What happens next?

We cannot see beyond the end of the post-war economic regime. At that point we must make decisions, and we cannot see how we will choose. We have borrowed fecklessly incredible sums over many years. Will we repay these debts or default?

It is a decision we will make at all levels. Businesses will decide. Local governments will decide. Citizens will decide. The last will be a microcosm of the others.

For example: your home is worth far less than your mortgage. The loan is non-recourse to you, so if you default the bank cannot chase you for the loss. Do you pay or mail the keys to the bank ("jingle mail")?

We cannot do the same thing for America, mailing the keys to our foreign creditors - making it their problem. But we can default, or inflate the debts away to oblivion. Our creditors trusted enough in America to lend to us without collateral and in our own currency. Were they wise to do so?

Repudiating these debts will mark the end of America as a leader of the world community, and probably as a great power. It will be interesting to see how we choose.

Of course our ruling elites insure that none of this gets mentioned in the Presidential campaign, least it disturb the proles. We can assist them by not telling anyone.

* In this same speech, Chairman Martin told of the economics professor who "always posed the same questions {on the final exam}. When he was asked how his students could possibly fail the test, he replied simply "Well it is true that the questions do not change, but the answers do.""

** The always interesting Contrary Investor is a subscription service, but the provide a free monthly letter here.

Update

For a brief explanation of why government efforts — esp. fiscal policy — can do little to mitigate the coming recession, see this excerpt from today’s article by Prof Nouriel Roubini of NYU, published at the excellent RGE Monitor:

While the Summers proposal is the most sensible in terms of the appropriate fiscal stimulus it will not prevent the coming unavoidable recesssion: it will only help to make it milder. The reason is that, with large structural fiscal deficits, a much larger fiscal stimulus is now not possible.

In 2000 the US was running a large fiscal surplus – about $300 billion or 2.5% of GDP; by 2004 – after two large and unsustainable tax cuts and massive defense and national security spending increase - that surplus had evaporated into a 3.5% of GDP deficit. And while the overall deficit shrank after 2004, on a cyclically adjusted basis the structural deficit is very large now. So, unlike 2001 the US cannot afford now a massive - 6% of GDP - fiscal stimulus like the 2001-2004 one. Even the Summers proposal adds up to less than 1% of GDP. That unsustainable and reckless fiscal and monetary (Fed Funds down from 6.5% to 1%) policy stimulus in 2001-2004 was sarcastically referred to as “best recovery that money can buy” by the sensible and brilliant Ken Rogoff (a “Republican” economist who was at the time the chief economist of the IMF).

So, by using all the monetary bullets (and leading to a housing bubble) and fiscal bullets (and causing a large structural fiscal deficit) in 2001-2004, we are now in a situation where the macro policy stimulus available to address the current 2008 recession (as the economy is effectively into a recession now) is much more limited than in 2001: monetary policy easing will occur but the Fed needs to worry about lingering inflation pressures, high oil/energy/commodity prices, the risks of a disorderly fall of the dollar and the risk that foreign investors will pull the plug on the financing of the huge current account deficit and lead to a disorderly adjustment of the US external deficit.

And fiscal policy is now constrained by a large structural fiscal deficit, looming long-run entitlement spending deficits, and the lack of a large fiscal surplus buffer like the one available in 2001. Worse, with home value plunging, at the state/local level revenues are plunging and fiscal deficits rising as property tax revenues are sharply shrinking. So the overall fiscal deficit for the public sector (including both the federal government and state/local governments) is sharply rising, further constraining the room for active fiscal stimulus.

Please share your comments by posting below (brief and relevant, please), or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

For more information about this subject

1. A brief note on the US Dollar. Is this like August 1914?  (8 November 2007) — How the current situation is as unstable financially as was Europe geopolitically in early 1914.
2. The post-WWII geopolitical regime is dying. Chapter One   (21 November 2007) — Why the current geopolitical order is unstable, describing the policy choices that brought us here.
3. We have been warned. Death of the post-WWII geopolitical regime, Chapter II  (28 November 2007) — A long list of the warnings we have ignored, from individual experts and major financial institutions (links included).
4. Death of the post-WWII geopolitical regime, III - death by debt  (8 January 2008) – Origins of the long economic expansion from 1982 to 2006; why the down cycle will be so severe.
5. Geopolitical implications of the current economic downturn  (24 January 2008) – How will this recession end?  With re-balancing of the global economy, so that the US goods and services are again competitive.  No more trade deficit, and we can pay out debts.
6. A happy ending to the current economic recession (12 February 2008) – The political actions which might end this downturn, and their long-term implications.
7. What will America look like after this recession?  (18 March 208)  — More forecasts.  The recession might change so many things, from the distribution of wealth within the US to the ranking of global powers.
8. The most important story in this week’s newspapers   (22 May 2008) — How solvent is the US government? They report the facts to us every year.

To see the all posts on this subject, go to the archive for The End of the Post-WWII Geopolitical Regime.

The fiscal stimulus is of greater importance at this juncture. Firstly, it is an acknowledged fact that any monetary policy stimulus will deliver results with a lag. Considering that monetary policy easing started off approximately 4 months back, the earliest results may be expected in 5 to 6 months. Even this may not happen in considering the argument below.

Monetary policy advocacy postulates that lower interest rates will lead to lower real returns from non-productive hoarding of money by the financial institutions there by encouraging them to lend it to the consumers which in turn will stimulate economic activity. The implicit assumption in this logic is that US economy is treated as a unit not related to, nor influenced by the global economy. The quest for indirect stimulation will not produce results if the financial institutes start investing in, lets say, emerging markets like the BRIC economies instead of the US markets.

Given the impact of low interest rates on dollar, which lead to lower consumer purchasing power resulting in lower domestic economy growth leading to a clamor for still lower interest rates, the only reason a monetary policy ease should be considered would be to ensure that the housing crisis does not deepen. A lower interest rate, will make sense only if, it means lower ARM resets for the average mortgage payment.

However, a fiscal stimulus would directly kick off economic activity domestically which is important for overcoming a recession.

Nouriel Roubini

This author spent a few years of policy wonkdom working on financial crises in emerging market economies and how to resolve them; and eventually he wrote – with Brad Setser – a book about it. The crisis resolution issues faced by emerging markets (Mexico, East Asia, Russia, Brazil, Argentina, Turkey, Uruguay, etc.) were similar to those presented today by the need to resolve the sub-prime crisis and the risk that millions of households will default on their mortgages.  In any debt crisis there are two main issues:

1. Should you take a “case-by-case” approach to debt restructuring (where each individual debtor’s liabilities are restructured in court or out-of-court on a one to one basis) or should you take an “across-the-board” approach where some a priori rules are used to restructure the debts of all debtors in particular group? 

2. Is the borrower illiquid or insolvent? I.e. if you re-stretch the maturity and/or debt payments path of an illiquid borrower would such borrower be eventually able to pay its debt?

The answer to the first question, coming from the experiences with a dozen financial crises in emerging market economies, is that when millions of small agents (households with foreign currency denominated mortgages whose real value has sharply increased following a currency devaluation, small and medium sized enterprises with foreign currency debts, and even larger corporate firms when you have a systemic corporate crisis) are financially distressed it is altogether impossible to follow a case-by-case approach as neither the bankruptcy court system nor the creditors are able to expeditiously restructure on an individual basis millions of separate debt contracts.

Thus, while an across the board approach is not totally fair – as some debtors who could pay and don’t deserve debt relief do receive it – this approach is the only feasible way to deal with the need to rapidly restructure millions of separate debt contracts. Thus, while some market fundamentalists were always pushing for a case-by-case approach and wanted to avoid the IMF supporting an across-the-board approach to debt restructuring it became clear to all that, with the exception of very large corporations or financial institutions, the across-the-board approach was the only feasible one to deal with such debt crises.  

This simple lesson, that has been known for ages now, has been finally learned - after a long year of subprime meltdown - by the US Treasury and major mortgage lenders as they are now planning an across-the-board approach to the restructuring of the mortgages of some categories of sub-prime borrowers. As reported by the WSJ:

 The Bush administration and major financial institutions are close to agreeing on a plan that would temporarily freeze interest rates on certain troubled subprime home loans, according to people familiar with the negotiations.

 An accord could reassure investors and strapped homeowners, both of whom are anxious as interest rates on more than two million adjustable mortgages are scheduled to jump over the next two years. It could also give a boost to the Bush administration, which is facing criticism for inaction amid the recent housing turmoil.

 The plan is being negotiated between regulators including the Treasury Department and a coalition of mortgage-related companies including Citigroup Inc., Wells Fargo & Co., Washington Mutual Inc. and Countrywide Financial Corp. People familiar with the talks say the individual members have agreed to follow any agreement reached by the coalition, which is called the Hope Now Alliance.

Details of the plan, which could be announced as early as next week, are still being worked out. In general, the government and the coalition have largely agreed to extend the lower introductory rate on home loans for certain borrowers who will have trouble making payments once their mortgages increase.

Many subprime loans carry a low "teaser" interest rate for the first two or three years, then reset to a higher rate for the remainder of the term, which is typically 30 years in total. In a typical case, the rate would rise to around 9.5% to 11% from 7% or 8%. That would boost an average borrower's payment by several hundred dollars a month….

Mr. Paulson, who is philosophically opposed to federal meddling in markets, at first rejected a sweeping approach to loan modifications when the idea was floated by Federal Deposit Insurance Corp. Chairwoman Sheila Bair. But he shifted his position recently. He told The Wall Street Journal last week that it would be impossible to "process the number of workouts and modifications that are going to be necessary doing it just sort of one-off."

So after wasting almost a year in supporting  a case-by-case approach to loan modification and realizing that only a paltry 1% of such mortgages had been modified as lenders and servicers did not have either the skills or the human resources or the physical resources to modify one by one millions of loans after a dragged out negotiating process with the debtor, both the mortgage lenders and the US Treasury have now gotten religion and accepted an approach that they had vehemently opposed before: i.e. move from a case-by-case to an across-the-board approach to loan modification.  Even Paulson finally got it that – as reported by the WSJ - it would be impossible to "process the number of workouts and modifications that are going to be necessary doing it just sort of one-off."

The answer to the first question is also pretty obvious from the experience with emerging markets financial crises: if the borrower is illiquid re-stretching maturities (if the principal on the debt was coming due soon) with no reduction in the face value of the debt and at the same time freezing the interest rate on the debt at below market rates can allow an illiquid but solvent debtor to eventually repay the face value of the debt. But if the debtor is insolvent and a maturity re-stretching will not affect its eventual ability to repay its debts it is better to allow default and debt write-downs.  Note that even in the case of maturity re-stretching with no face value reduction the lender suffer of a NPV loss as the interest on the re-stretched debt is set a below market rates. So while no face value reduction occurs there is still an NPV loss for the creditor and a form of debt relief for the borrowers (under the assumption that the lower interest rate is not capitalized).

And indeed last March when this author suggested abandoning a case-by-case approach and moving to an across-the-board approach to the looming sub-prime crisis this distinction between illiquid and insolvent debtors was at the center of the proposed approach to loan modifications. As I put it then:

[Here are] some principles for the coming financial support that will be given with public funds to clean up the unfolding mortgage disaster. First, distinguish between true victims of predatory lending and deadbeat borrowers who were into early strategic default. Early payments default is a clear way to distinguish between inability to pay and unwillingness to pay. Also, means testing for financial support is crucial: low income and low asset households who were pursuing the American Dream and were deceived by lenders may deserve support. But subprime borrowers with higher incomes and/or assets do not deserve support and should be pushed into foreclosure if they are unable or unwilling to service their mortgages. Also, condo-flippers and other individuals who bought homes for speculative purposes such as speculating on price increases (i.e. folks who were not first time homeowners who lived in their homes) would get no financial relief at all and will be forced to foreclose if they are unable or unwilling to service their mortgage.  Second, financial support to households who were victims of predatory lending (and owners of overvalued homes whose value was incorrectly assessed as much higher than equilibrium) should take the form of reduced debt servicing (as in some recent proposals) rather than subsidies to borrowers; this to prevent the support of the borrowing victims from indirectly bailing out the culprits of reckless or predatory lending.

For example, suppose that the value of a home (with zero down-payment) has fallen 10% (following the current housing bust) and that the borrower cannot now pay the full value of the mortgage debt servicing payments that are now being reset at much higher interest rates. Then, if the borrower can afford a lower string of service payments  that, in NPV terms, is 10% lower than the initial terms of the mortgage (and equal to the true value of the home), the solution will be to allow a reduction of 10% (in NPV terms) of the debt-servicing payments for the borrower. Instead, a public subsidy to the borrower in the same amount would have the same effect on the borrower while bailing out a reckless or predatory lender. 

Suppose instead that the home value has fallen 10% but the household cannot afford even a 10% NPV reduction of the stream of debt payments associated with the initial mortgage (say at zero initial down-payment). Then, the household – duped or not – was buying a home with a bundle of housing services that was too large relative to its ability to afford it even after the value of the mortgage has been adjusted to the lower market value of the home. In this case if it takes more than a 10% reduction in the NPV of the debt payments to allow the household to be able (or equivalently willing) to afford the home. Thus, it make sense to foreclose the home and not provide financial support to the household: duped or not the household had bought a home whose real housing services were too large relative to even its ability to afford it at a reduced market value. Thus, financial support of the household is not warranted and foreclosure is a socially efficient solution. The bank should take the loss of a mortgage with a home value lower than the mortgage. And such household should rent a lower amount of housing services by renting a smaller home/apartment rather than own a home with a bundle of housing services that it cannot afford.

In that analysis of mine the first type of  borrower is illiquid but solvent; the latter is both illiquid and insolvent.  And those who could afford or were strategic defaulters would not receive debt relief. 

The proposal for mortgage modification now supported by Treasury and the coalition of lenders takes a similar approach with three groups of borrowers. First, interest rate resets will be frozen for a while (possibly up to seven years) while face value of the loan will be maintained for selected group of sub-prime borrowers who are illiquid but otherwise solvent.  Second, those who can afford to keep on paying their mortgages would not receive the interest rate relief. Third, those who cannot afford to service their mortgages even at frozen reset rates should not receive the relief but should be allowed to default.  As the WSJ put it:

Treasury officials say financial institutions are likely to set criteria that divide subprime borrowers into three groups: those who can continue to make their payments even if rates rise, those who can't afford their mortgages even if rates stay steady, and those who could keep their homes if the maturity date of their mortgages were extended or the interest rates remained at the teaser rates. Only the third group would be eligible for help.

Notice that, even in the case of illiquid borrowers, it is essential the maintaining the face value of the debt with frozen – rather than reset – interest rate works as long as the difference between the implied reset rate and the frozen teaser rate is not capitalized. Otherwise the face value of the debt increases over time and eventually the loan modification is bound to trigger a likely default. I.e. freezing the teaser rates works only if you provide true NPV reduction of the debt claim. So, even with no face value reduction the debtor gets some debt relief in net present value terms. Also note that a variety of combinations of debt payment streams can be equivalent in NPV terms: you can keep face value and freeze interest rate payment; you can reduce face value and allow resets at higher rates; or you can taka a combination of face value reduction and some partial resetting of rates. All those can be equivalent on a NPV basis and all of them imply some reduction in the NPV of the claim and some effective debt reduction for the borrower. So while the Treasury proposal does not touch – for now – the face value of the mortgage claim it still represents a form of debt reduction – on a NPV basis  - for the borrower (unless the banks push for capitalizing the difference between the reset rate and the frozen initial rate).

As a final observation one can say: better late than never. After wasting a year on a mission impossible quest to deal with the sub-prime problem on a case-by-case basis and avoiding debt relief to the borrowers the Treasury and the banks saw the light and realized that only an across-the-board approach would work even if this approach implies an indirect government interference – via moral suasion – with the “free market” process and an effective debt relief to the borrowers rather than a bailout of reckless lenders. And this type of government interference with the market mechanism is – based on initial information – sounder than the other half-baked proposal pushed by Treasury to deal with the SIVs mess, i.e. the super-shell game “Super-Conduit”. Having botched the latter mess, Paulson legacy may – hopefully – remain with a sounder proposal to deal with a systematic and across-the-board partial resolution of the sub-prime mess.

 Nouriel Roubini

How sharply will the US stock market fall if the US experiences a  recession? Given the recent flow of very negative macro news, the likelihood of a US hard landing has sharply increased; thus, it is important to assess the implication of such growth slowdown, hard landing or outright recession on the stock market.

It is true that in the last two days the US stock market has recovered sharply after a significant 10% downward correction in the period from early October until Monday. But the most sensible interpretation of the upward move on Tuesday and Wednesday this week (in spite of an onslaught of lousy macro news: consumer confidence, existing home sales, Beige Book, fall in durable goods orders, regional Fed manufacturing reports, initial claims for unemployment benefits, expectations that Q4 growth will be closer to 0% after the revised 4.9% in Q3, sharply rising credit losses, falling home prices and a worsening housing recession, etc.) is that this is the last leg of a sucker's rally (or dead cat's bounce) driven by wishful hopes that the Fed easing will prevent a recession.

Certainly yesterday Wednesday equities rally was totally driven by Fed governor Kohn signaling the obvious, i.e. that given that the liquidity and credit crunch is now worse than at its August peak the Fed will cut rates in December, January and for as long as needed. In this game of chicken between the Fed and the bond market (with the latter signaling already for a while that the Fed will keep on cutting) the Fed was obviously the one to blink: this was no surprise to anyone who had noticed the meltdown in financial markets (a ugly liquidity and credit crunch) in the last few weeks. But for some reason the stock market on Wednesday discovered what analysts, the bond market and credit markets knew all along, i.e. that the Fed will have to keep on cutting rates as we are headed towards an ugly recession that is now inevitable regardless of how much the Fed cuts rates.

The behaviour of the stock market since last August can be best interpreted in terms of a Bernanke Put, i.e. the stock markets' hope that a Fed easing will prevent a hard landing of the economy. The August liquidity and credit shock severely tested the stock market downward; then you had a first sucker's rally on August 16th when the Fed announced the switch from a tightening bias towards an easing bias. A second phase of this sucker's rally occurred on September 18th when the Fed surprised the markets with a 50bps Fed Funds rate cut rather than the 25bps that the market expected.  Then equities kept on rising, in spite of worsening economic and credit news, all the way until October 9th. Then, a drumbeat of weaker and weaker economic and credit news started to take a toll again on the stock market and triggered the beginning of the stock market correction (10% fall in stock prices) that continued until last Monday November 26th.  A third phase of this sucker's rally occured after the Fed cut rates on October 31st triggering another stock market rally that turned out to be brief as a bombardment of awful credit news and weak economic data pushed down the market again. 

The current leg of the sucker's rally was on Wednesday - with stock prices sharply up - when Kohn effectively signaled to the markets that - in spite of all the Fed rhetoric to the contrary in the last few weeks - the Fed would ease rates in December and for as long as needed to deal with the liquidity and credit crunch and to avoid a recession. In each case in the last few months the stock market has rallied when the Fed has signaled a willingness to ease monetary policy to avoid a recession. 

Call it a Bernanke Put if you believe that the Fed is trying to avoid a financial meltdwon; call it a need to bail out the economy rather than bailing out the markets  if you believe - as I do - that the Fed actions are more driven by its concerns about the economy rather than an attempt to rescue investors; call it a moral hazard play if you believe that the Fed is trying to rescue investors and risks to create down the line another asset bubble. You can call it whatever you like but one thing is obvious: the Fed easing is perceived by the stock market as an action aimed to prevent a recession from occurring and stock prices rally - in spite of worsening macro news that are signaling recession ahead - because of the hope - that I will show is only wishful thinking - that the Fed will be able to avoid such a hard landing. Thus, what has been mostly driving up the stock market in the cycles since last summers is Fed policy expectations of easing.  

The same pattern of  market delusion and serial sucker's rallies occurred in 2001: the economy entered in a recession in March 2001 but the S&P 500 index rallied by  a whopping 18%  in April and May  because the market and investors expected that the aggressive Fed easing - that had started in January  - would prevent a 2001 recession (the famed and deluded hope of a second half of 2001 "growth rebound" that never occurred). It was only in June when it was obvious that the economy was sinking in spite of the Fed attempt to bail it out that the stock market started to sharply fall again; so then  and again now the onset of a recession led to a typical sucker's rally fed by expectations of a Fed bailout of the economy; and the latest rally this week is occurring while the liquidity and credit crunch in the markets are as bad now or worse than in August and while macro news are worsening by the day.

Indeed the 2008 recession will repeat the Fed cycle and stock market cycle of the 2000-2001 recession: then the Fed tightened rates all the way to 6.5% in June 2000 and kept a tightening bias in July, September, November as it was worried more about inflation than about growth (that had been as strong as 5% in Q2 of 2000 but was sharply deceleraring in H2 of 2000 as the tech boom was going bust). The Fed was totally mistaken then about its assessment of the effects of the tech bust on the economy and kept on worrying about inflation while growth was plunging after Q2 of 2000; it was only at the mid December 2000 FOMC meeting, when the signals were that the holiday sales would be awful, that the Fed suddenly switched from its November FOMC tightening bias to an easing bias. And two weeks later when, after lousy holiday sales data, the NASDAQ fell 7% in its first 2001 trading day on January 3rd the Fed stared to aggressively cutting the Fed Funds rate with a an initial 50bps inter-meeting cut that day. Then, as now you had a sucker's rally following the Fed easings that intensified in April and May 2001 as the Fed kept on cutting rates.

Indeed, not only the Fed got it wrong on the coming recession in the 2000-2001 period; also professional forecasters got it wrong as an Economist magazine poll in March 2001 (when the recession had already started) showed that 95% of such forecasters believed that a recession would be avoided as the aggressive Fed easing would lead to a H2 growth rebound. And, as discussed above, even the stock market got it wrong as the 18% final sucker's rally (or last dead cat bounce) in April and May 2001 was followed by a massive bear market starting in June 2001 as the economy spinned into a deeper recession in spite of the aggressive Fed ease.

To take a longer and more analytical perspective notice that typically a sucker's rally always occurs at the beginning of an economic slowdown that leads to recession. The first reaction of markets to a flow bad economic news is usually a stock market rally based on the belief that a Fed pause (like the rally following the August 2006 Fed pause) and then possibly easing will rescue the economy. This rally  always ends up being a sucker's rally as, over time, the perceived beneficial effects of a Fed ease meet the reality of the investors realizing that a recession is coming and that the effects of such a recession on profits and earnings are first order while the effects of the Fed easing on the economy and stock market are - in the short run of a recession - only second order. That is why we had several sucker's rallies this fall  every time the Fed eased rates or surprised markets with greater easing than expected or signaled to markets that it would ease ahead (as on Wednesday).  But, as the continued flow of poor macro news increases the probability of a recession, the equity markets do and will - in due time – sharply fall when wave of news and macro developments hits hard a weakened and vulnerable economy; then you will see a serious bearish market in equities. So, equities came under pressure in July and August when macro and credit news turned very negative; they rallied after the August 16th and September 18th Fed surprised; and turned into a negative 10% after October 9th when macro and credit news became awful again.

It is well known – from basic macro theory – that the equity market reaction to poor growth news is ambiguous. Lower than expected growth lead to a higher stock market value via the “interest rate channel” and to a lower stock market value via the “profits/earnings channel”. The former effect derives from the fact that bad economic news increase the probability that the Fed will ease monetary policy and thus stimulate the economy, demand and profits. The latter channel derives from the fact that slower growth – or even worse an outright recession – will lead to lower demand, lower revenues and lower profits. Indeed, as stock prices are forwards looking and equal to the discounted value of dividends where the discount rate is related to an appropriate measure of interest rates, bad growth news affect the numerator and denominator of the ratio of dividends to the appropriate discount rate. Usually, the first effect dominates at the beginning of an economic slowdown – when the likelihood of a slowdown is high but the likelihood of a true hard landing or recession is still low and unclear: then the interest rate channel dominates the profits channel. But once the signal of a hard landing or recession become clearer and the likelihood of such hard landing much higher the profits channel dominates the interest rate channel.

Why is this conceptual discussion important? Now that the likelihood of a recession has increased – even in the eyes of otherwise soft landing analysts – one is starting to hear and read with increasing frequency some Goldilocks statements such as “a hard landing will be good for stocks” or “the stock market will rally during a recession” or “the Fed will rescue the markets during a recessionary hard landing” or "P/E ratios are low and earnings yields are much higher than bond yields, thus the stock market is now undervalued".

To clear the air from the spin that one is increasingly hearing it is useful to ask a simple factual question: what is the relation between stock markets and recessions? So, for a moment, let us leave aside the issue of whether my recession call is correct or not. And let us assume, for the sake of the pure logical argument, that a recession is coming and then ask the question: if we will have a recession, what will happen to the stock market? So, you do not have to believe in a recessionary hard landing to consider this specific question. You just need to ask yourself the simple question of what happens to stock prices when recessions do come.

Luckily we have enough data from previous recessions and stock prices to give an answer to this simple question. Consider the charts that are shown below. They present the percentage change in that S&P500 index around the last six U.S. recessions (i.e. starting with 1970), i.e. in the months before the start of a recession, in the months during a recession and in the months after it. The vertical lines in each charts represents the peak of the business cycle (i.e. the beginning of a recession) and its trough (end of a recession). On average the stock market does not change much between the peak and the trough of the business cycle: on average the fall is only 0.4% between peak and trough; in some recessions – such as the 1974-1975 one - the peak-to-trough fall is much deeper (-13%) but in others – such as the 1980 one – stock prices actually rose 5.8% between peak and trough; so -0.4% is an average for all recessions.

This may seem like a relatively small adjustment but the peak-to-trough comparison is deceptive. It is deceptive because, usually, the stock market starts to fall before a recession starts (i.e. before the business cycle peak), then it falls very sharply during the first stage of a recession, and then in starts to recover in the late stages of a recession before the recession has reached its bottom (i.e. before the trough of the recession). Specifically, the stock market falls from the peak in the business cycle to its lowest level during a recession averages 17.5%; and in every one of these six recessions you have the same pattern: initially stock prices sharply fall as the economy enters a recession. Then, the recovery of the stock market starts before the trough of the business cycle has occurred, i.e. before the economy has gotten out of a recession.

Notice also that, in most episodes, the stock market peaks a few months before the actual start of the recession and starts falling even before the formal start of the recession (i.e. before the peak of the business cycle). Since stock prices almost always start to fall a few months before the recession has formally started – as signals of an impending slowdown and possible recession are already mounting even before a recession is formally triggered and thus priced in the stock market – the cumulative fall in stock prices from their pre-recession peak to their bottom level in the actual recession is well above the 17.5% figure for the stock price fall from the start of a recession to the lowest level of such stock prices during a recession. This average fall in stock prices from pre-recession peak to into-recession bottom is actually close to 28%, an extremely severe and sharp bearish downfall.

In other terms, the peak-to-trough average flat behavior of the stock market hides a much sharper fall in the stock market before a recession and during the first half or so of a recession, followed by a relatively sharp recovery in the late stages of a recession. This pattern makes total sense as equity prices are forward looking and, at any point in time, they reflect all available information about the expected path of current and future dividends/earning and interest rates. The stock market starts to fall before a recession has formally started because the closer you get to the peak of the business cycle when the macro news on growth become increasingly weaker, the higher is the probability that a recession will occur and will thus drag down profits. So, a forward looking equity market peaks before the peak of the business cycle and starts falling before the actual recession has started. That is why stock prices tend to be a good – if imperfect - leading indicator of the business cycle.

The fall in the stock market from the peak of the business cycle to the market lowest level in the recession was 21.0% in the 1970 recession, 33.88% in the 1974-75 recession, 10.6% in the 1980 recession, 18.2% in the 1981-82 recession, 14.6% in the 1990 recession, 10.3% in the 2001 recession. In most recession, as discussed above, the stock market peaks before the recession and starts to fall even before the recession has formally started. In the 1970 episode the stock market peaked 9 months before the recession and fell 12% even before the recession started. In the 1974-75 episode, the stock market peaked 12 months before the start of the recession and fell 23% even before the recession formally started in December 1973 with a good half of this pre-recession drop right after the beginning of the Yom Kippur war that led to Arab oil embargo. An exception is the 1980 episode when the stock market was actually rising in the few months before the start of the recession in February 1980. In the 1981-82 case, the stock market peaked four months before the onset of the recession and then fell already about 4% before the recession actually started. In the 1990 case, the stock market peaked two month before the recession and fell about 2% before the formal start of the recession. In the 2001 episode, the S&P peaked about seven months before the start of the recession in March 2001 and then fall by 31% even before the recession started (the peak of the Nasdaq was, of course even earlier, in March 2000 a full year before the formal onset of the recession).

Of course, in the economic history of the US in the last few decades sometimes stock prices have fallen and a recession has not materialized, i.e .stock markets are not a perfect and uniquely correct leading indicator of a recession. But, and this is more important in the context of the question asked above, any time a recession did occur, the stock market actually sharply fell. So, the issue here is not whether the stock market may at times provide false alarms or incorrect signals of the business cycle; of course, as it is well known, it does at times provide false signals. The issue is whether hard landing and beginning of recessions are associated with sharply falling stock prices. And the simple and unequivocal answer is that recession lead to bearish stock markets where the peak in the economy to the trough in the stock market (as separate from the economic peak-to-trough that lags the one of asset prices) is about 17.5% and where the peak-to-trough in the stock market (i.e. the pre-recession peak to the into-recession bottom of the stock market) is about 28%, i.e a very clear, sharp and deep bear market. So, factually hard landings and recessions do lead to falling stock prices and bear stock markets. So, the recent market buzz and chatter about hard landings and recessions being good for the stock market is utter nonsense based on actual data from decades of US business cycles and repeated recession episodes.

Of course, once a recession has triggered a severe bear market, at some point – before the bottom of the recession – the stock market does start to recover. The fact that the stock market recovers before the trough of the business cycle is reach is also logical and based on the forward looking nature of stock prices: even before a recession has ended the rate of economic activity fall tends to increase: in early stage of a recession the first derivative of output is negative (negative growth) while the second derivative shows an acceleration of the rate of economic contraction. In later stages of a recession, the first derivative is still negative but the second derivative shows a slower rate at which the economy is contracting and signals that the trough of the business cycle may be close, i.e. there is incoming light at the end of the recession tunnel. Thus, for forward looking stock prices it is not necessary to wait until the recession is over for such prices to recover: once the evidence is building up that the worst stage of a recession is close to be over and that the trough – bottom of the downturn – will be reached soon (i.e. the probability that the recession will be over soon is increasing) then the stock markets starts to recover: i.e. stock prices reach their trough before the trough of the business cycle.

How about “soft landing” episodes, i.e. episode where a Fed tightening did not lead to an outright recession but rather to a significant slowdown of the economy and then an economic recovery? The only recent episode of a successful soft landing is 1994-95 when a 300bps tightening by the Fed in 1994 did not lead to a recession but rather a relatively sharp slowdown in the economy. Note that, even in that episode, the Fed risked overdoing it and it eased the Fed Funds rate in 1995 when the slowdown appeared as excessive and risking to jeopardize an economic growth that was on the cusp of the internet and information technology revolution of the mid-late 1990s. Note also that, in that episode, the economy was just coming out of a painful recession that, while it formally ended in 1991, was followed by a job-loss and then a job-less recovery in 2002 and 2003; only by early 1994 the economy was showing signs of rapid growth and employment recovery. So, in term of economic cycle, the monetary tightening of 1994-95 was at a very different stage of the business cycle, early-mid recovery and the Fed was just bringing back the Fed Funds rate to a neutral level after its sharp easing during the 1990-91 recession. In terms of the market consequences of such a “soft landing”, the S&P500 fell by 5% between January and December 1994 as the Fed tightening was under way and the economy was starting to decelerate following the monetary break imposed by the Fed. Thus, while the S&P had started to briskly recover after the 1990-91 recession and had double digit return both in 1992-93 and from 1995 on, the soft landing of the economy in 1994 led to a significant fall in the stock market: while the fall in 1994 was modest – about 5% - since the underlying trend in the market index for a sharp double digit annual recovery since 1992 and after 1995, the soft landing of 1994 implied an underperformance of the stock market relative to its underlying trend that was of the order of 17%, i.e. without the soft landing slowdown of 1994 the market could have grown – based on the underlying trend of the S&P – by at least 17%.

What are the potential caveats to the arguments above that a US recession would lead to a sharp drop in the stock market? Some argue that the sharp fall in equity prices during previous recession occurred after long periods in which the market was bullish and sharply increasing; thus, close to a recession P/E ratios were already excessively high and bound to adjust; also the monetary and credit tightening in previous recession squeezed severely profits and push equity prices lower. Instead, it is argued that today’s conditions are very different from previous growth slowdowns: equity prices zig-zagged without much of a strong trend from 2002 to 2005 and have grown modestly since then while earnings have sharply increased given increased profitability of the corporate sector; thus, the argument goes, P/E ratios are now relatively low and valuations are not inflated; if anything, given the surge in earnings valuations are relative low and bound to rise if a soft landing occurs or bound not to fall as much even if a hard landing occurs. Specifically, unless a major credit crunch  leads to a sharp fall in profits and earnings, equity valuations may not be as much at risk in a US hard landing scenario. 

The above arguments require a whole separate discussion of earnings and profits and their likely future trends that will be discussed in another note. For now, let us observe why these arguments are not convincing. First, in a recession revenues fall and both profits and earnings sharply fall; so equity valuations need to take a hit; and while recessions triggered by a credit crunch or a monetary tightening have more severe effects on corporate profits even recessions triggered by the bursting of a bubble – the tech bubble in 2000, the housing bubble today and its consequent credit crunch – can severely affect earnings and thus valuations. In a typical US recession NIPA profits fall by about 20% and corporate earnings fall by more than NIPA profits, closer to 30% plus. Such a drop in profits and earnings has devastating effect on stock prices. Second, recent data on Q3 earnings suggest already a fall in earnings in Q3 of 8.3% relative to a year ago and a fall in earnings relative to Q2. Third, on a cyclically adjusted basis P/E ratios are still very high: since both profits and earnings now look peaky and bound to sharply slow down, P/Es may be still too high once one considers the likely fall in earnings during an economic hard landing. Of course, the fact that valuations have been relative moderate for a number of years may imply that not all stocks will be hit as hard in a recession: many will gradually fall during the economic downturn but others, that have low valuations now and whose earnings would be less affected by a recession, may do relatively better or not as bad as the overall market.  It may also be the case that, on average the stock market will fall by less than the average 285 in a typical recession .Still, it is hard to avoid the conclusion that a recession would be really bad for the stock market. In every previous recession equities have done very poorly and it is hard to make a logical or empirical argument why in the next recession things would be meaningfully different.

Finally, notice that the equity valuations of homebuilders, financials, and discretionary consumption firms have already followed the pattern that I described above: sharp fall in earnings followed by a sharp fall (about 20% or more in equity valuations).

The discussion above clarifies what one should expect if – as I have predicted – the US slowdown accelerates into a recession: based on historical experience the stock market is likely fall sharply by about 28% from peak to the trough of the equity market before it is starts to recover in the late stages of the recession. So beware of the large amount of spin that is being peddled today by bulls that are now starting to recognize that a recession is likely: they need to spin the bad news about the economy as suggesting that such bad news are actually very good news for the stock markets or that the Fed will be able to prevent such a recession. For these perma-bulls good economic news are very good for the stock market and bad economic news are also very good for the stock markets as the reaction (“I guess it is probably a buying opportunity”) to my recession call by the Squawk Box anchor interviewing a while ago suggests. But savvy investors will not let themselves to be fooled by such non-sequitur arguments and will cautiously adjust their portfolio to reduce the risk of being stuck in a bear market when the recession actually gets under way.

Nouriel Roubini | Nov 25, 2007

There is now increasing evidence that the liquidity and credit crunch in international financial markets is back to its summer peaks of August and, in most dimensions, even worse than in the summer; financial markets are now in a “virtual panic mode” according to a market participant (as reported by the FT). This worsening of the financial markets turmoil has occurred in spite of the hundreds of billions of dollars and euros that have been injected in the financial system by the Fed, the ECB and other central banks and in spite of the 75bps cut in the Fed Funds rate by the Fed. This massive easing of liquidity – both its quantity and price - has miserably failed to stem a severe liquidity crunch that is now back to the summer peaks, as evidenced for example in the interbank markets – both in US and Europe - by the sharp widening of Libor rates - at a variety of maturities – relative to equivalent maturity government yields and/or policy rate; such sharp rise of spreads to summer levels signals a worsening of the liquidity crunch.

Indeed the ECB is now announcing another massive injection of liquidity. This injection of liquidity will miserably fail like the previous ones as the ECB is not getting it that a reduction in its policy rate is now necessary and urgent. As the Fed Funds cut by the Fed suggest, such policy rate cut may not prevent a worsening of the liquidity conditions; but the lack of a cut in the ECB policy rates makes such a liquidity crunch in Europe – and the risks of a serious contagion from the US hard landing - even worse than the alternative.

  Last August the soft-landing consensus claimed that the episode of financial turmoil would be temporary (like previous ones in 2004, 2005, 2006) and that Fed easing would restore calm to the financial markets and prevent an economic hard landing. 

This author instead argue then that the turmoil and volatility in financial market would not be a temporary phenomenon but that it would rather persist and lead to a significant repricing of risk; that the liquidity and credit crunch that started in the summer would get worse rather than better over time; that such crunch reflected credit and solvency problems in the economy, not just illiquidity; that monetary policy would be ineffective in easing these liquidity and credit problems; that we would experience a Minsky Moment and the unraveling of the Minsky Credit Cycle; that the turmoil reflected deep seated unmeasurable uncertaintly rather than priceable risk; that losses from this seizure of credit and markets would be massive; that this was the first crisis of financial globalization and securitization; and that the real consequences of this liquidity and credit crunch would increase the likelihood of a US recession that was already likely without such a financial turmoil.

These bearish forecasts have indeed proven right as financial conditions are now worse than in the summer and as the likelihood of a generalized credit crunch, a US recession and the spillover of such a hard landing to the rest of the world  are increasing by the day (see Larry Summers on the FT today for another prominent scholar now suggesting that a  US recession is very likely).

The worsening of the liquidity and credit crunch relative to the summer peaks is evident from a wide variety of signals and markets: in interbank markets spreads of Libor relative to government yields are sharply up again over a range of maturities, especially the 3 month one. In derivatives markets there has been a sharp reduction in liquidity and in trading activity as counterparty risk is rising. Money market funds are also experiencing liquidity problems partly driven by credit problems. Several of such funds were exposed to toxic radioactive RMBSs and CDOs and have experienced losses that reduced their NAV below par. Thus, those backed by backed have received a bailout by their sponsoring bank; but those without the backup of a bank are now scrambling to find lines of liquidity from banks that are becoming scarce and expensive.

 More generally the risk of liquidity runs against non-banks institutions that have short term liquid liabilities and longer term and illiquid assets is rising. These institutions include: hedge funds subject to redemptions; non-bank investment banks whose liquidity and credit problems are rising; SIVs and conduits that are now unraveling fast as the ABCP paper backing their illiquid asset is rolled off (while the Super-SIV plan is another half-baked shell game that is bound to fail); money market funds experiencing NAV losses; covered bond markets are so illiquid that European banks have decided – dramatically – to stop trading in this large $2 trillion market.  Soon enough even some medium sized banks that are rotten and sharply exposed to mortgages may experience runs, even if these banks may – unlike the former non-bank financial institutions – have access to the Fed lender of last resort support.  Since financial disintermediation and securitization has brought much of financial intermediation outside of the banking system we now face the mess of possible runs against a wide range of financial institutions that do not have access to the central banks’ lender of last resort support.

Since the summer both liquidity and credit problems have worsened. We now know that the losses related to mortgage and their securitized products (RMBSs, CDOs) will be in the hundreds of billion dollars range ($300 to 500 billion) and that such losses are spreading from subprime to near prime and prime mortgages. These losses do not include those deriving from the coming meltdown of the commercial real estate lending where the issuance of new CMBSs has altogether dried up and where the CMBX indices signal extreme levels of expected defaults. Such losses don’t either include the mounting default rates from credit cards and auto loans that will surge further once the US fully enters into a recession.  They do not include the losses that the GSEs – Fannie and Freddie - are starting to experience and that will mushroom in the near future; we have the paradox of the GSEs that were supposed to guarantee or repackages half of US mortgages now being in significant financial trouble; thus, their ability to reliquify the RMBS and mortgage markets is severely impaired. They do not include the coming train wreck of a downgrade of the monoliners that insured many of these toxic mortgage products. And such likely downgrade of monoliners would lead to losses expected to be in the $200 billion range, including the shock that such a downgrade will produce for the muni bond markets. And such losses now go as far as even the CPDOs market - that were supposed to be default-free - and where instead we are now observing the first defaults with 90% losses for investors.  Now losses and defaults of highly leveraged institutions are popping out all over the world (Australia, Asia, France, Germany, UK, even in remote Norvegian villages) and across a spectrum of financial institutions, the latest being insurance and reinsurance (Swiss Re) companies.

There are now signals of extreme illiquidity, risk aversion, credit worries and flight to safety in the US and Europe based on a wide ranges of indicators: swap spreads at all maturities (2, 5, 10 years), VIX and other measures of volatility and investors’ risk  aversion, Libor spreads versus government bonds, Libor spreads relative to Fed Funds and other policy rates, TED spreads,  Dollar and Euro Libor versus OIS spread, 3month Euribor versus ECB rate, Itraxx and CDX spreads, ABX and CMBX spreads,  US 10yr Treasury yields below 4% and sharp fall of equivalent yields in Europe; sharp fall in short dated Treasury yields in the US, Europe and now even in Asia (Korea, China). Many or most of these indicators are now back to their extreme summer levels and some even worse.

The seizure of liquidity and credit has spread to the most remote corners of the financial system: subprime, nearprime and prime mortgages, commercial real estate, consumer loans, securitized products, derivatives markets, leveraged loans, LBO market (where increasing numbers of deals are postponed, restructured or cancelled), SIVs and conduits, interbank markets, derivative markets, covered bonds markets, CDOs and CLOs; CPDOs; even the IPO market; and the list goes on and on and becomes longer by the day.

The reasons why the massive liquidity injections and policy rate cuts by central banks have miserably failed are clear and were discussed at length in August by this author in previous note: we are facing a credit/insolvency problem in addition to a liquidity crunch and central banks’ monetary policy is impotent in dealing to credit problems: Fed easing will not prevent millions of US households from defaulting on their mortgages and will not prevent home prices falling 20% or more given the biggest housing recession in US history; it did not and will not prevent dozens of mortgage lenders and home builders from going bankrupt; it will not prevent a surge in corporate defaults once the economy experiences a hard landing. Monetary policy can lead with pure liquidity runs; but when s