Roubini; This will be the worst recession in 40 years

Bloomberg reports what Nouriel Roubini says about the coming recession:

Oct. 14 (Bloomberg) -- Nouriel Roubini, the professor who predicted the financial crisis in 2006, said the U.S. will suffer its worst recession in 40 years, driving the stock market lower after it rallied the most in seven decades yesterday.

``There are significant downside risks still to the market and the economy,'' Roubini, 50, a New York University professor of economics, said in an interview with Bloomberg Television. ``We're going to be surprised by the severity of the recession and the severity of the financial losses.''

The economist said the recession will last 18 to 24 months, pushing unemployment to 9 percent, and already depressed home prices will fall another 15 percent. The U.S. government will need to double its purchase of bank stakes and force lenders to eliminate dividends to save them from bankruptcy, Roubini added. Treasury Secretary Henry Paulson said today he plans to use $250 billion of taxpayer funds to purchase equity in thousands of financial firms to halt a credit freeze that threatened to drive companies into bankruptcy and eliminate jobs.

``This will be the first round of recapitalization of the banks,'' Roubini said. ``The government has to decide to intervene much more directly in the provision of credit and the management of these companies.''

Paulson made it clear today that he is being forced into recapitalizing the banks instead of just buying off the toxic loans, and he hates it. PRI's "The World" reports that Europeans have real doubts as to how effective the American actions to prevent/alleviate the credit crisis will be because of the slow and ideological reaction from Secretary of the Treasury Hank Paulson.

As Ezra Klein says, Pauson is not going to come out of the current crisis with much of a reputation for effective decision-making.

To say Hank Paulson has not done a good job during this financial crisis may be going too far. Since no one else has held this job during this period, there's relatively little compare him to. Maybe others would have made worse mistakes. But we can certainly say that he's proven eminently fallible. His decision to let Lehman Brothers collapse now looks like a catastrophic error. As Dani Rodrik says, "As bad as things were, what caused credit markets to seize up was Treasury Secretary Henry Paulson's refusal to bail out Lehman Brothers. Immediately after that decision, short-term funding for even the best-capitalized firms virtually collapsed and the entire financial system simply became dysfunctional." And Paulson made that decision over the objections of others, like Timothy Geithner, head of the New York Federal Reserve.

Whether it was Lehman's collapse that turned a crisis of liquidity into a crisis of capitalization, Paulson also didn't see that capitalization had become the nature of the crisis. The powers he now promises to use to recapitalize the banks were powers he didn't want. He wanted to buy assets and address a liquidity crisis. He didn't include -- and in fact opposed -- a provision for the possibility that capitalization was the problem. Democrats gave him capitalization powers because they were listening to economists like Jamie Galbraith and Nobel prize winner (it's so fun to say that!) Paul Krugman. Now those powers are central to his strategy and public statements.

Banking is a highly technical business. Political ideology is a risk bankers can afford only during very good markets. The political "free market" ideology as bought into by Alan Greenspan (an Ayn Rand Libertarian) and by Henry Paulson has led directly to to the current credit crisis because in large part Greenspan, depending on his Libertarian ideology, refused to apply the Federal Reserves' powers to regulate underwriting standards used by banks to issue mortgages. Similarly the bank bail-out bill demanded by Paulson only three weeks ago was inadequate because - for ideological reasons - it did nothing to recapitalize the banks. Neither of these poor decisions made for ideological reasons were the only reasons why the American and the international banking system are failing, but those decisions are strongly implicated in causing and delaying effective preventive regulatory reactions to keep the collapse from getting much worse than it had to.

When the honest history of the worst recession since the Great Depression of the 1930's is written it will begin with a statement "The predictable working out of the anti-regulation philosophy embodied in the Reagan Revolution led directly to the massive Recession that started in 2008."

An economy cannot be based on primarily banking and finance. Those functions are themselves derivative of the underlying real economy. This was proven first by the British Empire and now again by the collapse of the American Empire. America's effort to outsource or abandon the real economy and replace it with banking and finance as the leading functions of the economy have now failed. Only bankers, Libertarians and conservative deregulators should be surprised.

The prove it we are now going into the worst Recession in four decades or more.

Here is some of the discussion on the Paulson Proposal

• Politico has a good article stating that Dems say they won’t get fooled again.

  Sen. Patrick Leahy (D-Vt.) says he’s seen this movie before: The Bush administration, citing an unprecedented national threat, puts the hammer on Congress to ram through gargantuan legislation with a minimum of review — and the murkiest of repercussions.
  
  “We will do something this week — but if we learned anything from right after 9/11, it’s that the biggest mistake is to pass anything they ask for just because it’s an emergency,” Leahy says.

  Good for Leahy.
• Chris Dodd is pushing for additional things to make the legislation workable.

  Among the major provisions Dodd is adding:
  
  * Authority for bankruptcy judges to restructure mortgages for homeowners facing foreclosure.
  
  * A provision that would require the Treasury to take 65 percent of any profits it makes from the newly purchased assets and put it into the federal government's HOPE program, an affordable housing program.
  
  * An oversight board that not only includes the chairman of the Federal Reserve and the SEC, but congressionally appointed, non-governmental officials.
  
  * Limits on executive compensation. This is a major stumbling point for Paulson in his negotiations with Congress, but cracking down on Wall Street executive salaries will be a major selling point for lawmakers. Dodd and Frank have put in place what's known as a "claw back" provision aimed at revoking compensation that executives received based on fraudulent claims.
  
  * An independent inspector general to investigate the Treasury asset program, appointed by the president.

  That's a start.
• Here's a biggie. CEO pay emerges as bailout barrier.
• Glenn Greenwald describes the growing right wing opposition to Paulson's propoasl.

  "Prominent economists, who had previously been defending Paulson for the most part, began voicing serious doubts about his plan. As the AP put it yesterday: "Many of the same economists and opinion-makers who'd provided a bipartisan sheen of consensus to Treasury Secretary Henry Paulson's previous moves have quickly begun casting doubts on the wisdom of a policy that would allow Treasury to purchase without oversight hundreds of billions of dollars of difficult-to-price assets from financial institutions." Not only Paul Krugman, who was a skeptic from the start, but conservative economic experts have also now expressed opposition, including former Bush and Romney advisor Greg Mankiw and -- in an excellent column on Saturday -- Sebastian Mallaby, who described the rapid move to embrace Paulson's plan as "extremely dangerous."

  And now, some of the most rabid ideologues on the Right are voicing increasingly strident opposition as well. At National Review last night, Newt Gingrich wrote that "watching Washington rush to throw taxpayer money at Wall Street has been sobering and a little frightening" and said he "hopes Congress will slow down and have an open debate." Thereafter, NR's Yuval Levin proclaimed that nobody could read through the Paulson proposal "without concluding that everyone in Washington has lost their minds." In The New York Times today, Bill Kristol said he's "doubtful that the only thing standing between us and a financial panic is for Congress to sign this week, on behalf of the American taxpayer, a $700 billion check over to the Treasury," while Michelle Malkin posted a lengthy alarmist screed warning that "Hank Paulson must be contained."

  Right-wing opposition to the Paulson plan is vital for having any meaningful chance to stop it. Does anyone have any confidence at all in the Democrats' willingness and/or ability to impede this bailout train if the Bush administration and the Right were vigorously behind it, warning the nation of impending doom unless we submit to vast, unchecked government power of the type Henry Paulson is demanding? "

• Digby dives in and describes how the right-wingers will use their vote against Paulson's proposal to distance themselves from the politically toxic Bush administration.

Then add this ARG poll to everything that has been in the news. NO Americans think the economy is getting better! That's zero Americans. Atrios comments "Wow. I'm not sure I've ever seen a poll with a '0' on anything."

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Addendum 4:07 pm CDT
Interesting. Calculated Risk points out that Paulson has agreed to let the government "take an equity stake" in the rescued banks - that is, take some ownership in them. At the same time CR says the Bush administration has "...agree[d] to compensation limits for bank chief executives taking part in the plan and [to] the need for more help for homeowners facing foreclosure...".

A President with a 17% approval rating on his handling of the economy really does not have a lot of influence in the Congress.

The government will have to take over the failed non-regulated investment banks

Compare Krugman's four step listing of what has happened in the financial markets in the previous post to Nouriel Roubini's similar list of how we got to the current stage of the crisis. Roubini states that what is happening is a run on banks generally, especially on the unregulated shadow banking system at the moment. This is a run which can only be stopped by government action.

The failed investment banks will have to be taken over, brought under regulation, and their assets sold off if taxpayer money is used to bail them out. According Io Nouriel Roubini's analysis, that is an inevitable action. The only decision left is how soon it can be done. Any delay will deepen the financial crisis and make the recovery cost more.

Last week saw the demise of the shadow banking system that has been created over the past 20 years. Because of a greater regulation of banks, most financial intermediation in the past two decades has grown within this shadow system whose members are broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds and non-bank mortgage lenders.

Like banks, most members of this system borrow very short-term and in liquid ways, are more highly leveraged than banks (the exception being money market funds) and lend and invest into more illiquid and long-term instruments. Like banks, they carry the risk that an otherwise solvent but liquid institution may be subject to a self-­fulfilling and destructive run on its ­liquid liabilities.

But unlike banks, which are sheltered from the risk of a run – via deposit insurance and central banks’ lender-of-last-resort liquidity – most members of the shadow system did not have access to these firewalls that ­prevent runs.

A generalised run on these shadow banks started when the deleveraging after the asset bubble bust led to uncertainty about which institutions were solvent. The first stage was the collapse of the entire SIVs/conduits system once investors realised the toxicity of its investments and its very short-term funding seized up.

The next step was the run on the big US broker-dealers: first Bear Stearns lost its liquidity in days. The Federal Reserve then extended its lender-of-last-resort support to systemically important broker-dealers. But even this did not prevent a run on the other broker-dealers given concerns about solvency: it was the turn of Lehman Brothers to collapse. Merrill Lynch would have faced the same fate had it not been sold. The pressure moved to Morgan Stanley and Goldman Sachs: both would be well advised to merge – like Merrill – with a large bank that has a stable base of insured deposits.

The third stage was the collapse of other leveraged institutions that were both illiquid and most likely insolvent given their reckless lending: Fannie Mae and Freddie Mac, AIG and more than 300 mortgage lenders.

The fourth stage was panic in the money markets. Funds were competing aggressively for assets and, in order to provide higher returns to attract investors, some of them invested in illiquid instruments. Once these investments went bust, panic ensued among investors, leading to a massive run on such funds. This would have been disastrous; so, in another radical departure, the US extended deposit insurance to the funds.

The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken excessive risks with high leverage and are poorly managed may collapse. A massive shake-out of the bloated hedge fund industry is likely in the next two years.

Even private equity firms and their reckless, highly leveraged buy-outs will not be spared. The private equity bubble led to more than $1,000bn of LBOs that should never have occurred. The run on these LBOs is slowed by the existence of “convenant-lite” clauses, which do not include traditional default triggers, and “payment-in-kind toggles”, which allow borrowers to defer cash interest payments and accrue more debt, but these only delay the eventual refinancing crisis and will make uglier the bankruptcy that will follow. Even the largest LBOs, such as GMAC and Chrysler, are now at risk.

We are observing an accelerated run on the shadow banking system that is leading to its unravelling. If lender-of-last-resort support and deposit insurance are extended to more of its members, these institutions will have to be regulated like banks, to avoid moral hazard. Of course this severe financial crisis is also taking its toll on traditional banks: hundreds are insolvent and will have to close.

The run on banks has spread to almost all the unregulated banks, and is going to take down many of the regulated banks soon. When that happens then the government is going to take over those regulated banks as Krugman states it should.

But only the government can stop the run on the unregulated banks. That means giving the unregulated banks access to the federal reserve's money through the discount window or by exchanging loans the bank holds for government cash as Paulson proposes. The price for that has to be that the unregulated banks accept regulation.

If the problem of bailing out the current gamblers running the banks with taxpayer money is to be avoided, then the government is going to have to treat the failed banks in the shadow banking system just like the rest of the regulated banks. They will also have to be taken over by the government and sold off, just as was done during the S&L crisis by the Resolution Trust Corporation (RTC.)

By the looks of these two analyses, Paulson's proposal will be left in the dust. The solution is going to have to be for the government to take over the failed banks. The problem is going to be that every delay in actually taking over the banks will increase the level of the crisis and cause the recovery to cost more.

Politically this is going to be very hard for the bankers and their tame Republicans to accept.

Krugman on what's wrong with the Paulson proposal

Paul Krugman explains what has happened to cause the current financial crisis.

1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in the prices of mortgage-backed securities — assets whose value ultimately comes from mortgage payments.

2. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt. This problem is especially severe because everyone took on so much debt during the bubble years.

3. Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs.

4. Financial institutions have been trying to pay down their debt by selling assets, including those mortgage-backed securities, but this drives asset prices down and makes their financial position even worse. This vicious circle is what some call the “paradox of deleveraging.”

The Paulson plan calls for the federal government to buy up $700 billion worth of troubled assets, mainly mortgage-backed securities. How does this resolve the crisis?

Well, it might — might — break the vicious circle of deleveraging, step 4 in my capsule description. Even that isn’t clear: the prices of many assets, not just those the Treasury proposes to buy, are under pressure. And even if the vicious circle is limited, the financial system will still be crippled by inadequate capital.

Or rather, it will be crippled by inadequate capital unless the federal government hugely overpays for the assets it buys, giving financial firms — and their stockholders and executives — a giant windfall at taxpayer expense. Did I mention that I’m not happy with this plan?

The logic of the crisis seems to call for an intervention, not at step 4, but at step 2: the financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.

Krugman's analysis says that Paulson's proposal isn't going to work. All it does is tax taxpayers to provide a new stake to the same banker gamblers who caused the current problems in the first place.

Why should the taxpayers be expected to pay taxes to let the same bankers go back to the game with no more controls than they had in the first place? In addition, if the gamblers win, the taxpayers get none of the profits. That sounds to me like a good reason to stop paying taxes.

Instead, the government needs to take over the failed banks, replace the executives, regulate all the banks in the industry, and then carefully sell off the loans the banks hold with the profits going to the taxpayers.

In my next post I will show why Nouriel Roubini's analysis suggests that is going to be the inevitable result of the financial crisis anyway.