This article is going to blow your socks off. Expanding on David Einhorn excellent speech from over three months ago.
Also see my earlier post today on the market’s recent trading action: This Will Be Interesting.
Stock Market to the Fed: “It’s Insolvency, not Just Illiquidity, Stupid!”…and the Systemic Financial Meltdown Risk from the Monolines’ Crisis
Nouriel Roubini | Jan 30, 2008
The reaction of the stock market to the unexpected 75bps cut by the Fed last week and its reaction today to the further 50bps cut clearly shows that markets and investors are now fully realizing that the US economy is suffering from serious credit, i.e. insolvency, problems, not just illiquidity ones; and that Fed monetary policy can partly tackle illiquidity problems but cannot resolve insolvency ones.
Last Tuesday when the Fed unexpectedly cut the Fed Funds rate by 75bps the US stock market fell by over 1% in spite of that cut (but by less than the 5% that the futures had priced before that surprise cut). The next day – Wednesday – the S&P tumbled by another 2.5% for most of the day giving the market verdict on the Fed action: too little, too late and useless to resolve the massive credit problems in the economy, including the serious market concerns that a downgrade of the monolines would lead to massive financial write-downs and a financial meltdown. The late day whopping rally in the last two hours of trading on Wednesday last week – 600 points on the Dow and over 5% on the S&P – was triggered instead by the news that the New York insurance regulator had met with banks to try to work out a plan to recap the monolines and thus avoid a catastrophic downgrade of their triple AAA rating. So that day the market told the Fed (with a 3.5% stock market drop following the rate cut): your 75bps cut means practically nothing to us and unless the credit problems of the economy are resolved. And the 5% rally was indeed triggered by news that maybe the monocline downgrade could be avoided.
Same story – in reverse – today Wednesday after the additional 50bps cut by the Fed. The initial reaction of the stock market was a relief rally – with the S&P500 index up about 1.7% after the Fed announcement and its signal of more monetary easing ahead. But this rally totally fizzled again in the last two hours of trading as reality sank in that the rescue of the monolines is much harder than hoped for after Fitch revoked its top AAA ranking on Financial Guaranty Insurance Co, one of the bond insurers. So the S&P fell from its day peak by 2.2% and finished the day 0.5% below its opening level in spite of the 50bps gift by the Fed and in spite of the fact that the Fed had reduced policy rates by a whopping 125bps in eight days!
So both following the 75bps cut last week and the 50bps cut today the stock market told the Fed: “it’s not just an illiquidity problem; it’s most importantly a credit or insolvency problem we worry about, stupid!” And the market reaction on both occasions highlights the relative impotence of monetary policy in addressing credit problems.
Let me elaborate on these issues and also discuss how the problems of the monolines are now at the core of the markets, of the financial regulators and of the Fed’s concerns about the risk of a catastrophic financial market’s meltdown….
First, note that we have now an insolvent subprime economy where at least two million of households with subprime mortgages may default; where at least 10 million households will have their entire housing equity wiped out (negative equity) if home prices fall – as likely – between 20 and 30% thus giving them a large incentive to use “jingle mail” (default on their mortgage, abandon their home and send the keys to their bank); where 220 subprime mortgage lenders have already gone bankrupt or our of business; where dozens of home builders have gone out of business and now some of the largest ones may also go bankrupt; where dozens of highly leveraged and insolvent financial institutions have gone out of business or suffered massive losses; where a large number of corporate firms will start to default on their junk bonds once a recession leads to severe financial distress for them; where monoline bond insurers are severely undercapitalized and possibly insolvent if – as likely – the losses on their insured RMBS, CDOs, other ABS products and even muni bonds – are much larger than their capital base and larger than the $15 billion capital injection that the rescue plan is considering.
Indeed, while the total value of these monoline losses is fuzzy and hard to estimate, the last two days events – and recent research by a number of outfits – has suggested that monolines’ losses may be much higher than $15 billion, especially in some extreme scenarios in which default rates on muni bonds sharply increase during a severe US recession. Thus, the hope that $15 billion of bank money would be enough to recap them and prevent their AAA rating downgrade has been dashed today.
And if the monolines’ rating is downgraded a scary chain reaction of other losses will occur. Banks and money market funds will have to write down another $150 billion of ABS assets that are currently insured by the monolines. Then, many money market funds would show NAVs below par and risk a run on them. Those money market funds that bought protection against a fall in their NAV via liquidity and credit support from their underwriters (banks and broker dealers) would be rescued but then their liquidity and capital problems would be transferred to these underwriters.
Thus, the risk of a systemic financial meltdown would sharply rise. And indeed to understand the behavior of the Fed – a whopping 125bps policy ease in eight days – one needs to understand that the Fed is currently specifically concerned about a financial meltdown. That is why the Fed has consigned gradualism to the dustbinand has followed a most aggressive – much more than under Greenspan – approach to risk management.
The way Fed officials have put it clearly in private and even in public – see the recent Mishkin speech – is that there is some positive probability of a “catastrophic” outcome, i.e. a vicious circle where a deep recession make the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe.
Even if the probability of a catastrophic event is still small in the view of the Fed such an outcome would be so disastrous for the real economy – let alone the financial markets – that prudent risk management and insurance policy requires an aggressive monetary easing and a complementary set of actions to avoid such a financial meltdown. These actions include a private rescue of the monolines supported by the regulators; the provision of liquidity to the financial markets to reduce the liquidity crunch; the recapitalization of the banks by the SWF to prevent a severe credit crunch; the prompt and full recognition of losses by financial institutions to restore confidence; but also the avoidance of a self-destructive liquidation or fire sale of illiquid assets in an illiquid market as current market prices reflect not just lower fundamentals but also such illiquid conditions.
Unfortunately a key element of the Fed and financial authorities plan to avoid a systemic financial meltdown is now faltering as there is a growing realization that $15 billion will not be enough to rescue the monolines. Much more will be needed; but the banks that bought insurances from the monolines don’t have $15 billion – let alone the much much larger likely sums needed – to rescue the monolines from a now unavoidable downgrade. That is why some are now starting to talk about the need for a public bailout of the monolines. But the moral hazard implications of such public bailout of reckless insurers would be altogether sickening. So one would hope that such public bailout will be altogether ruled out as absolutely reckless by sensible financial regulators.
Add to this total mess the point that a private plan that requires those who bought protection/insurance from the monolines to rescue those insurers in order to avoid the financial distress of such insurers is conceptually perverse.
It is like having folks who bought home or fire insurances from an insurance company having to rescue the insurance company to prevent it from going bankrupt after a hurricane or major fire has led to massive losses for the insurers. I.e. what is the purpose and logic of insurance if those who bought insurance not only pay insurance premia but also pay for the value of the losses following damage? That is not insurance but perversion of the concept of insurance. And indeed, as I argued a few weeks ago, before the monoline crisis fully blew up in public, no business that requires a AAA rating in order to be viable deserves a AAA rating in the first place.
Thus, since Plan A ($15 billion recap of the monolines by the banks) is now faltering as being unfeasible one does hope that the Fed has a Plan B – short of a public bailout – to avoid the financial meltdown that will follow the downgrade of the monolines. The trouble is that there is no sensible plan that one can conceive of that would resolve this total mess with a private sector solution and with private funds. And using public funds is out of the question.
So what is the likely result? The monolines’ downgrade will not be avoided and the next leg of this systemic financial meltdown will not be avoided. Then, the modest 2.2% drop in the S&P500 today from its post-FOMC announcement peak will look like spare change. A serious crack – or better crash – in the stock market or the financial system – as the one in 1987 – cannot be ruled out at this point following a massive – and at this point likely unavoidable – downgrade of the monolines. No wonder the Fed eased 125bps in eight days. But no wonder that such a massive ease – and much more ahead – will make no difference for the severe insolvency problems that the economy is now facing. Monetary policy is altogether impotent in dealing with these insolvency issues and the specter of a severe systemic financial crisis that is looming ahead.