We’re in the eye of the storm, not past the storm

A “delusional optimism” that the worst of the credit crunch is behind us has been propping up financial markets since the Bear Sterns rescue in March, according to Nouriel Roubini, professor of economics at New York University Stern School of Business.

Earlier this week, Roubini had a powerful article on his personal website RGE Monitor (now nourielroubin.com) in which his message was that a veritable tsunami of loan defaults is about to swamp our already creaking financial system. He suggests that, compared to the fall-out from the sub-prime crisis seen so far, we ain’t seen nothing yet.

Prof Roubini writes:

“Independent analysts of the banking system and of other financial intermediaries have clearly pointed out that the massive writedowns and losses of financial institutions will continue as the credit losses will spread from subprime to near-prime and prime mortgages; to commercial real estate loans that had similarly poor underwriting standards; to unsecured consumer credit (credit cards under stress given the balance sheets of households, auto loans that are in big trouble with auto sales plunging, student loans whose market is now frozen); to leveraged loans and bridge loans that financed reckless LBOs that should have never happened in the first place; to municipal bonds now that distressed municipalities – see Vallejo in California as the canary in the mine – will experience an onslaught of muni bonds defaults; to monoline insurers battered by a double whammy of muni bonds under stress on top of the trouble of toxic MBSs and CDOs that were wrapped into monoline guarantees; to industrial and commercial loans as many debt-burdened firms are in trouble; to corporate bonds as hundreds of billions of dollars of junk bonds were issued in the last four years by heavily indebted and poorly performing corporations; to the CDS market where $62 trillion of nominal protections – that was sold by a small group of broker dealers, hedge funds and monoline insurers – is sitting on top of an outstanding stock of only $6 trillion of corporate bonds; with the ensuing risk that the losses among the sellers of protection will lead to some of them going belly up and thus show to the buyers of protection that there was no hedge as counterparty risk rears its ugly head.

These delinquencies, defaults and bankruptcies have only started to rise outside subprime mortgages but they are now mounting in a tsunami of rising losses as the subprime disaster was only the tip of an iceberg of a credit bubble that ran amok across the economy and across many and different credit markets ….

We are in the eye of the storm rather than past the storm; and the recent events and developments suggest that the worst is ahead of us, for the economy, for equity markets, for credit markets and for money markets.

Wow. I sincerely hope that Prof Roubini is wrong. However, if he’s right those investors who bought into the Royal Bank of Scotland’s rights issue at £2 a share today are going to come to rue their decision.

And we’ll be in for some interesting times ahead.

This blog post was published on 6 June 2008.