From the Financial Times:
Step 1 is the worst housing recession in US history. House prices will, he says, fall by 20 to 30 per cent from their peak, which would wipe out between $4,000 billion and $6,000 billion in household wealth. Ten million households will end up with negative equity and so with a huge incentive to put the house keys in the post and depart for greener fields. Many more home-builders will be bankrupted.
Step 2 would be further losses, beyond the $250 billion-$300 billion now estimated, for sub-prime mortgages. About 60 per cent of all mortgage origination between 2005 and 2007 had “reckless or toxic features”, argues Roubini. Goldman Sachs estimates mortgage losses at $400 billion. But if home prices fell by more than 20 per cent, losses would be bigger. That would further impair the banks’ ability to offer credit.
Step 3 would be big losses on unsecured consumer debt: credit cards, auto loans, student loans and so forth. The “credit crunch” would then spread from mortgages to a wide range of consumer credit.
Step 4 would be the downgrading of the monoline insurers, which do not deserve the AAA rating on which their business depends. A further $150 billion writedown of asset-backed securities would then ensue.
Step 5 would be the meltdown of the commercial property market, while Step 6 would be bankruptcy of a large regional or national bank.
Step 7 would be big losses on reckless leveraged buy-outs. Hundreds of billions of dollars of such loans are now stuck on the balance sheets of financial institutions.
Step 8 would be a wave of corporate defaults. On average, US companies are in decent shape, but a “fat tail” of companies has low profitability and heavy debt. Such defaults would spread losses in “credit default swaps”, which insure such debt. The losses could be $250 billion. Some insurers might go bankrupt.
Step 9 would be a meltdown in the “shadow financial system”. Dealing with the distress of hedge funds, special investment vehicles and so forth will be made more difficult by the fact that they have no direct access to lending from central banks.
Step 10 would be a further collapse in stock prices. Failures of hedge funds, margin calls and shorting could lead to cascading falls in prices.
Step 11 would be a drying-up of liquidity in a range of financial markets, including interbank and money markets. Behind this would be a jump in concerns about solvency.
Step 12 would be “a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices”.These, then, are 12 steps to meltdown. In all, argues Roubini: “Total losses in the financial system will add up to more than $1,000 billion and the economic recession will become deeper more protracted and severe.” This, he suggests, is the “nightmare scenario” keeping Ben Bernanke and colleagues at the US Federal Reserve awake. It explains why, having failed to appreciate the dangers for so long, the Fed has lowered rates by 200 basis points this year. This is insurance against a financial meltdown.
