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The Coming
U.S. Hard Landing
By Nouriel Roubin
09/12/07 "ICH' --- -- The utterly ugly employment figures
for August (a fall in jobs for the first time in four years,
downward revisions to previous months’ data, a fall in the labor
participation rate, and an even weaker employment picture based
on the household survey compared to the establishments survey)
confirm what few of us have been predicting since the beginning
of 2007: the U.S. is headed towards a hard landing.
The probability of a US economic hard landing (either a likely
outright recession and/or an almost certain “growth recession”)
was already significant even before the severe turmoil and
volatility in financial markets during this summer. But the
recent financial turmoil - that has manifested itself as a
severe liquidity and credit crunch - now makes the likelihood of
such a hard landing even greater. There is now a vicious circle
where a weakening US economy is making the financial markets’
crunch more severe and where the worsening financial markets and
tightening of credit conditions will further weaken the economy
via further falls of residential investment and further
slowdowns of private consumption and of capital spending by the
corporate sector.
The US economic slowdown was already serious since early 2007
and will get worse in the next few quarters for a variety of
reasons. A massive housing bubble - where home prices went to
stratospheric levels because of a debt-driven asset bubble (a
massive rise in mortgage debt of households) - has now turned
into the most severe housing recession in the last 30 years and
into a house price bust: for the first time since the Great
Depression of the 1930s home prices are now falling on a
year-over-year basis. Home prices will fall much more in the
next two years – by at least 15% - because of five factors that
will make the huge excess inventory of new and existing homes –
already at historic highs – even larger: first production of new
home is still excessive as demand for new homes has fallen more
than the now lower supply; the credit crunch in mortgage markets
will further reduce the demand for new homes; millions of
households will default on their mortgages and go into
foreclosure and once the creditor banks will repossess these
homes they will dump them in the market adding to the excess
supply; about $1 trillion of adjustable rate mortgages will be
reset – at much higher interest rates – in the next 12 months:
the households that cannot refinance them and/or afford the
higher interest rates will sell their homes at distressed
prices; and those who bought homes for speculative reasons with
little equity will now try to sell their homes as prices are
falling. So expect a much faster and deeper fall in home prices
for the next two years.
A housing recession alone cannot lead to an economy-wide
recession as housing is only 5% of GDP. But now the housing
slump is spreading to other parts of the economy: the auto
sector is in a recession; the manufacturing sector is sharply
slowing down; demand for housing related durable goods
(furniture, home appliances) is falling. Moreover, US private
consumption – that represents over 70% of aggregate demand – is
now under pressure. The US consumer is now saving-less,
debt-burdened and buffeted by many negative forces. As long as
home prices were rising it made sense for US households to use
their homes as their ATM machines, borrow against their rising
home equity and spend more than their income (negative savings).
But now that home prices are falling there is the beginning of a
retrenchment of consumption whose growth rate slowed down from a
4% average until the first quarter of 2007 to a weak 1.3% in the
second quarter, even before the summer financial market turmoil.
There are now many negative factors squeezing US consumers and
forcing them to retrench spending: falling home values leading
to a negative wealth effect; sharply falling home equity
withdrawal preventing households from overspending; a credit
crunch in mortgages and consumer debt markets rising debt
servicing costs for consumers; still high oil and gasoline
prices; the beginning of a serious weakening of the labor market
– as signaled by today’s employment report and other data - that
will significantly reduce income generation in the months ahead.
As long as income generation and job generation was robust, one
could dismiss the risks of a hard landing; but the signal from
today’s employment report is that the only force that was
preventing a hard landing (jobs and income generation) is now
starting to falter.
Thus, in the next few months you can expect a further slowdown
of consumption growth from its already mediocre growth rate of
1.3% in the second quarter. Indeed, after an ok July, retail
sales were weak in August: based on the Redbook Johnson and the
UBS Securities/ICSC data same store retail sales in August
actually fell relative to July; and in real terms such retail
sales in August were lower than in August 2006. Thus, the
deceleration in consumption in Q3 is already clear in the data.
And if consumption slows down the build-up of inventories of
unsold goods will force firms to slow down production,
employment and capital spending. Such investment spending by the
corporate sector was already weak in the last few quarters in
spite of the high corporate profitability. Now you can expect
further weakening of such real investment because of expected
lower consumption demand, higher credit spreads for the
corporate sector, uncertainty about the future given the
volatility in the markets. The sharp re-pricing of risk that
took place in the summer – with higher credit spreads for a
broad variety of instruments – implies much higher borrowing
costs for consumers, buyers of homes, corporations and financial
institutions. Thus, the slowdown of private consumption and
capital spending in residential, non-residential and corporate
investment will get more severe.
On top of a weakening of the real economy the current financial
markets turmoil will get worse – not better - in the next few
months. This was never just a sub-prime problem as the same
reckless and toxic lending practices in sub-prime – no
down-payment, no verification of income and assets, interest
rate only mortgages, negative amortization, teaser rates – were
occurring in near prime mortgages, Alt-A loans, piggyback loans,
home equity loans, and prime hybrid ARMs. About 50% of all
mortgage origination in the last two years was made of this
toxic waste and utterly junk lending practices.
And now what started as a credit crunch in the sub-prime
mortgage market has spilled over to near prime and prime
mortgages and to a variety of other credit markets: money
markets, interbank lending markets, asset backed commercial
paper, structured investment vehicles (SIVs) of banks, CDO
markets, other securitization markets, and the LBO market. All
these markets are now literally frozen with a dearth of
liquidity, serious refinancing problems and severe credit
problems. The mess in the SIV products is particularly serious
and dramatic as it is generating severe liquidity and capital
problems for both banking and non-banking institutions.
And this liquidity and credit crunch will get worse in the weeks
ahead as this financial markets crisis is much more severe than
the liquidity crisis of 1998 when LTCM – the largest US hedge
fund – almost collapsed. In 1998 you had only a liquidity
problem as the economy was strong – growing at 4% plus - and we
were still in the rising cycle of the internet boom. Today, in
addition to severe liquidity problems in the financial system (a
near total freezing of the entire financial system liquidity
plumbing), we have serious credit and insolvency problems too.
The credit and solvency problems derive from a massive credit
boom that lead to excessive borrowing that, in turn fed for a
while rising asset prices that are now going bust, in a typical
Minsky credit cycle. It is a insolvency problem as you have now
millions of US households that are near insolvent and will
default on their mortgages; dozens of sub-prime mortgage lenders
who have already gone bankrupt; dozen of home building companies
that are under distress; many financial institutions in the US
and abroad - such as hedge funds and other highly leveraged
institutions – that have already gone belly up; and the rise in
credit spreads will also lead soon to a rise in corporate
defaults that had been artificially low in the last few years
given the excessively easy credit conditions. So we do not face
only a most severe liquidity crisis; we are also observing a
serious credit crisis and credit crunch. And you cannot resolve
credit problems – as opposed to liquidity problems – with
liquidity injections. That is why the forthcoming cuts in the
Fed Funds rate by the Fed will be ineffective in stemming the
real and financial problems of the economy.
Indeed, the forthcoming easing of monetary policy by the Fed
will not rescue the economy and financial markets from a hard
landing as it will be too little too late. The Fed
underestimated the severity of the housing recession, its
spillovers to other sectors, and the contagion of the sub-prime
carnage to other mortgage markets and to the overall financial
markets. Fed easing will not work for several reasons: the Fed
will cut rate too slowly as it is still worried about inflation
and about the moral hazard of perceptions of rescuing reckless
investors and lenders; we have a glut of housing, autos and
consumer durables and the demand for these goods becomes
relatively interest rate insensitive once you have a glut that
requires years to work out; serious credit problems and
insolvencies cannot be resolved by monetary policy alone; and
the liquidity injections by the Fed are being stashed in excess
reserves by the banks, not relent to the parts of the financial
markets where the liquidity crunch is most severe and worsening.
The Fed provided liquidity to banking institutions but it cannot
provide direct liquidity to hedge funds, investment banks, other
highly leveraged institutions and parts of the credit markets –
such as asset backed commercial paper – where the crunch is
severe. Thus, the liquidity crunch in most credit markets
remains severe, even in the usually most liquid interbank
markets.
Unfortunately, financial globalization together with
securitization and mushrooming of complex credit instruments has
lead to greater opacity and less transparency in the financial
system. And this lack of transparency breeds unmeasurable
uncertainty rather than priceable risk. Risk can be priced as
you have a distribution of probabilities on various events. But
unmeasurable uncertainty causes higher risk aversion under
conditions of market distress. This generalized uncertainty is
now coming from two sources: first, we do not know the size of
the overall losses in credit markets: sub-prime alone could lead
to losses of $100 billion or much higher depending on how much
home prices will fall. And other losses from other illiquid
financial instruments remain unmeasured in a world where
institutions were marking to model rather than marking to market
and where credit rating agencies were mis-rating complex credit
instruments. Second, as securitization implies that financial
risks have been spread out of banks and to the corners of the
global financial system we do not know which firms are holding
the toxic waste and thus which firms will go belly up next. It
is like walking blind in a minefield where you have no idea of
where the mines are. This uncertainty breeds large fear – after
the massive greed of the previous credit and asset bubble has
now burst – and lack of trust of financial counterparties, even
otherwise respected ones: everyone want to hoard liquidity and
hold the safest assets as even large financial institutions do
not trust each other and are unwilling to lend to each other.
This greater opacity of financial globalization and
securitization implies that the re-pricing of risk that we have
observed in the last few weeks is a permanent rather than a
transitory phenomenon. And the sharp spike in the cost of credit
will further weaken an already weakened economy. This is thus
the first real crisis of the new world of financial
globalization and securitization.
Nouriel Roubini, Professor of Economics and International
Business, Stern School of Business, New York University. E-Mail:
nroubini@stern.nyu.edu - Advisor to the U.S. Treasury
Department, July 2000 - June 2001. Senior Advisor to the Under
Secretary for International Affairs; Director of the Office of
Policy Development and Review (U.S. Treasury) , July 1999 - June
2000. Senior Economist for International Affairs, White House
Council of Economic Advisers, 1998-1999 Please visit: - Nouriel
Roubini's Blog
http://www.rgemonitor.com/blog/roubini
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