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The professor's 12-step lesson to global meltdown

Last summer, when the first subprime tremors began to shake the financial world, most experts promised the crisis would soon pass and that the after-effects would be limited.

One notable exception was Nouriel Roubini. In July, when US Treasury Secretary Henry Paulson was still insisting the subprime meltdown had been contained and that the underlying economy was in robust health, Professor Roubini was warning that things were going to get worse; much worse.

The bursting of the credit-driven bubble in the US housing market would lead to a painful economic downturn and probably recession, warned the New York University economics professor.

Considering that what was very much a minority view seven months ago has since become mainstream opinion, it is worth paying close attention to what Professor Roubini is saying now. Unfortunately, his outlook is not good.

In a paper released last week, he outlined 12 steps by which he believes the subprime crisis is likely to tip over into a nightmare scenario involving 'systemic financial meltdown' and prolonged 'near-global economic recession'.

1) The worst housing downturn in US history gets even worse as the credit crunch squeezes new mortgage origination. Home prices fall by 20 to 30 per cent from their peak, wiping up to US$6 trillion off household wealth and plunging 10 million households into negative equity. Default rates soar as home owners turn in their keys.

2) Financial losses spread as it becomes clear the same sort of reckless lending prevailed in the prime mortgage market as in the subprime sector. Mortgage credit losses exceed US$400 billion, forcing banks to take a whole new suite of structured products onto their balance sheets. The global credit squeeze tightens.

3) As the situation worsens and the US economy slows, consumers begin defaulting on their other debts, including car loans, credit cards, and student loans. These losses spread throughout the global financial system as these loans, too, have been repackaged and sold on as asset-backed securities.

4) As the losses mount, the credit ratings of the specialist 'monoline' insurance companies which guaranteed these securities and their related financial products get downgraded. This forces another US$150 billion or so of write-downs on banks and other financial institutions, hammering their stock prices.

5) With consumer spending drying up and business credit hard to come by, the retail and office property markets also roll-over, inflicting new losses on the financial system. Construction grinds to a halt.

6) At this point, Professor Roubini warns that a large regional or even a national US bank with heavy exposure to residential and commercial mortgages could go bankrupt. The Federal Reserve would have to prop it up, but the uncertainty would only exacerbate the credit squeeze.

7) Rising risk aversion would make it impossible for banks to securitise loans made to fund leveraged buyouts. Companies bought out in the good times begin to go bankrupt as business slows and they find they cannot service their debts. The banks take yet more losses.

8) With the US now in severe recession, corporate default rates surge above 10 per cent from 0.6 per cent in 2007. Financial companies, which earlier made piles of money selling protection through the new-fangled market in credit derivatives, sustain losses of US$200 billion or more.

9) This bankrupts a few hedge funds and possibly a broker-dealer or two. Assessments of counterparty risk surge and liquidity dries up. Denied access to funding, more hedge funds go belly up and perhaps even a big investment bank.

10) Stock markets plummet, with US equity prices down by 25 per cent or more.

11) As investors' and counterparties' risk aversion reaches new heights, liquidity evaporates across a range of financial markets. Even highly-rated companies find credit too expensive.

12) By this time the world's financial markets are locked in a death spiral in which losses trigger widespread margin calls, forcing the liquidation of assets at fire sale prices in illiquid markets. This pushes prices still lower, imposing yet more losses when assets are marked to market, leading to further forced sales as institutions shrink their balance sheets, driving prices even lower in a vicious cascade.

Total losses in the financial system will exceed US$1 trillion, warns the professor, as systemically important financial institutions go to the wall. As credit dries up almost completely 'a near global recession will ensue'.

This is a horribly gloomy scenario, but the professor argues that it has a 'rising and significant probability of occurring'. Even worse, he doubts the ability of central banks and finance ministries to manage and contain such a severe crisis, and warns that we should be prepared for the worst.

He has been proved right before, let us hope he has got it all wrong this time.

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