Wednesday, September 17, 2008

Great Recession

Forbes

Great Recession

By Nouriel Roubini

Dear Forbes.com readers:

This will turn out to be the worst financial crisis since the Great Depression and the worst U.S. recession in decades.

I first said so in August and, since I wrote those words, financial and economic conditions have deteriorated further--and severely. Stock prices are sharply down and there is a risk of a market crack. Interbank and credit spreads are wider than ever since the beginning of this crisis, Lehman Brothers (nyse: LEH - news - people ) and Merrill Lynch (nyse: MER - news - people ) are gone, and soon enough Morgan Stanley (nyse: MS - news - people ) and Goldman Sachs (nyse: GS - news - people ) will need to find a larger partner with deep pockets or they risk getting into severe trouble.

The biggest insurer in the world--American International Group (nyse: AIG - news - people )--is teetering near bankruptcy and has been bailed out by the taxpayer at an astronomical expense. The biggest U.S. savings and loan, Washington Mutual (nyse: WM - news - people ), is effectively insolvent and close to going bust, while dozens of other banks are near bankruptcy.

There is the beginning of a silent bank run as depositors are nervous about their assets. The panic is mounting in the financial markets, and the credit default swap market is frozen because of the Lehman collapse and the state of affairs at AIG, WaMu and other financial institutions. Many hedge funds are now teetering as their losses mount. Investors in fixed income--including preferred stocks--have experienced massive losses and the financial turmoil is becoming global as stock markets all over the world plunge. Worst of all, policymakers are running out of bullets. Think Spaghetti Westerns and a parched desperado in a dry gulch.

The Lehman collapse is leading to the risk of a generalized run on the shadow banking system. The policy reaction is to try to build a new set of levees after the financial perfect storm of the century destroyed the first set. This reaction includes the following steps.

First: The Fed is accepting even more toxic collateral for the Term Securities Lending Facility (TSLF) and Primary Dealer Credit Facility (PDCF), including even equities. So now, after having nationalized the mortgage market via the takeover of Fannie Mae (nyse: FNM - news - people ) and Freddie Mac (nyse: FRE - news - people ), the government is also starting to manipulate the stock market directly. This started with the SEC restrictions on naked short sales of primary dealers, so the process of turning the U.S. market system into a socialist system controlled by the government is now in full swing. By its effective purchase of equities, the Fed takes massive credit and market risks.

Second: The Fed is waiving Section 23A of the Federal Reserve Act, which restricts how much commercial banks can re-lend liquidity to their investment banking affiliates. These restrictions are sensible prudential rules aimed at making it difficult for banks to subsidize their broker-dealer affiliates with insured deposits. Now this prudence is thrown to the wind, so Citigroup (nyse: C - news - people ), JPMorgan Chase (nyse: JPM - news - people ) and Bank of America (nyse: BAC - news - people ) can happily use or raid their FDIC-insured deposit to support bankrupt broker-dealer operations. This is reckless, and is a form of connected lending that eventually caused the Japanese financial and banking crisis.

Third: An attempt to bail-in the private sector and provide private lender-of-last-resort support to the financial system is at work. Ten major global banks will fork out $7 billion each to create a $70 billion fund. Each of these firms could borrow up to a third of such a fund, or $23 billion. But this private lender-of-last-resort (LOLR) facility will not work. If any firm were to access this facility in case of a run on its liabilities, panic will ensue--as the use of it will signal severe trouble--and the run will continue.
Read more:
http://www.forbes.com/opinions/2008/09/17/depression-crisis-banks-oped-cx_nr_0918roubini.html

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