A new message of economic doom
As the global credit crisis has unfolded, few forecasters have been closer to the mark than New York University economics professor Nouriel Roubini.
In July last year, when United States Treasury Secretary Henry Paulson was still insisting the subprime fallout had been contained, Professor Roubini, who also heads his own research firm RGE Monitor, warned the bursting of the US housing bubble would lead to a severe credit contraction. Within weeks the crunch had begun to bite, leading to the collapse of British mortgage lender Northern Rock in September.
Then in February this year, Professor Roubini published a paper in which he warned of a 'financial meltdown' in which 'one or two large and systemically important broker dealers' could go bust. One month later, Bear Stearns imploded.
So the audience was all ears yesterday when a select group of Hong Kong's investment community gathered in the Mandarin Hotel to listen to the professor's predictions for the US economy.
They weren't pleasant. Although the immediate risk of a financial system meltdown may have been averted by the rescue of Bear Stearns, Professor Roubini warned that anyone now heaving a sigh of relief is dangerously complacent.
For a start, he argued that the US economy is already in recession. The 0.6 per cent growth recorded in first-quarter gross domestic product is misleading, he said. Final demand is already falling and the only thing keeping the GDP figure in positive territory is a heavy build-up of inventories of unsold goods. That will be paid for in the coming months as companies scale back production while they try to shift accumulated stock.
Nor will this recession be as short and shallow as the downturns of either 1991 or 2001. With home prices down 15 per cent from their July 2006 peak, the US is already in the middle of its worst housing slump since the Depression of the 1930s.
And with the stock of unsold new houses still rising, Professor Roubini argued that prices may not bottom out until they have fallen 30 per cent from their high. A fall of such magnitude would wipe US$6.6 trillion off household wealth, plunging 40 per cent of all mortgage borrowers into negative equity.
Even if home prices only fall 20 per cent, with half the underwater households defaulting and lenders recovering 50 cents on the US dollar, the losses inflicted on the financial system will be an enormous US$1 trillion, equivalent to 75 per cent of US banks' capital. 'The potential risk for the financial system would be huge,' warned Professor Roubini. 'A significant number of institutions could go belly up.'
That's not all. The 2001 recession was centred on company investment, which makes up only 10 per cent of the economy. This time around, it is individual spenders who are in trouble, and they make up a whopping 70 per cent of GDP.
With consumers already up to their eyeballs in debt and unable to raise any more cash by remortgaging their homes, private sector employment stalling, and credit card and car loan defaults rising, consumer spending looks sure to contract nastily.
That, in turn, will hit the commercial real estate market hard, especially in the retail sector. And although US corporations are by and large in good shape, Professor Roubini points out that following the private equity buyout boom, there is a significant 'fat tail' of highly leveraged companies which will soon begin to look very exposed.
Over the past two years, the default rate on corporate bonds has been just 0.6 per cent. That now looks set to rise towards the historical average of 3.8 per cent, and possibly towards the 10 per cent rate seen in typical recessions. At the same time, recovery rates will drop from 70 cents on the dollar now to a typical recession rate of about 35 cents.
That threatens to punch a gaping hole in the US$62 trillion market for credit derivatives. A number of protection-sellers - investment banks and hedge funds - will go to the wall, leaving buyers who thought they were hedged bearing losses of another US$200 billion to US$250 billion.
Meanwhile, municipal governments will see their revenues from property and sales taxes evaporate and they too will start to default, inflicting yet more losses on hapless lenders.
Of course, faced with such a grim scenario, the US government would be forced to act, possibly by buying up mortgages or simply by printing money.
Even so, says Professor Roubini, the resulting recession will last a painful 12 to 18 months, twice as long as either of the two previous downturns.
Inevitably, such a long and deep slump would have a grievous effect on economies in Asia, but more of that another day...
