The Financial Crisis: Where Do We Go From Here?

Thursday, September 25, 2008

MORT ZUCKERMAN: Good morning, everybody. My name is Mort Zuckerman, and I'm delighted to be able to chair this particular panel. We were asked to cancel it by the candidates. (Laughter.) But we refused. Actually, somebody said there was a great deal of interest in this, and we said the word is panic, not interest.

So here we are, dealing with one of -- perhaps the most serious financial crisis that anybody here has had to witness in their lifetime. And fortunately we have an extraordinary panel to discuss this.

You all know who they are, but I'm going to just start by asking Professor Roubini the following question: How did we get to where we are today, and what does he think the implications are for the real economy, the Main Street economy, we get from the consequences of the crisis on Wall Street?

NOURIEL ROUBINI: Yes. Certainly I agree, this is the worst financial crisis in the United States since the Great Depression. Of course, the degree of economic contraction is not going to be as severe as the Great Depression, but I think that, from a financial point of view, we have not seen anything like this.

I mean, how did we get to it? I think the simple answer might be this was the biggest asset and credit bubble in the U.S. history. It was fed by, one, easy money, the Fed cutting the fed funds rate and keeping it too little, too low -- too low for too long; easy credit, a situation in which there was no proper supervision and regulation, not just for mortgages but also for financial intermediation. And we got a cycle with a massive bubble.

And, of course, when the bubble goes bust with the housing crash and the subprime, you have the process of deleveraging after the period of re-leveraging. Why this time around this has been much more virulent -- we've had these credit cycles in the U.S. before, in other countries. But I think it has been more virulent for the following reasons.

One is a huge amount of financial innovation that created a financial system that is much more kind of opaque and non-transparent. You know, when you take a mortgage, and through securitization you convert it to an NDS, and then an NDS and a CDO, and then a CDO and a CDO of a CDO of a CDO, you have, at the end, a CDO cubed that is a new instrument that is new, exotic, complex, illiquid, marked to--(inaudible)--by rating agencies, and you create a situation of generalized uncertainty.

Agents can price risk when you have distribution over the (band ?), so you can see what the distribution is. If you have generalized uncertainty, then there is panic and there's (run ?). There is risk aversion. Everybody wants illiquid assets. It's like walking on a mine field blindfolded. You don't know where the next mine is. You don't know how much toxic waste is out there. You don't know who's holding it. And therefore, you have massive amount of panic and -- (inaudible). You don't trust anybody. Today, the interbank market is totally frozen because we've created a monster of this sort, where there is no transparency in the financial system.

The other reason why this is kind of much worse is the point I made in the column I wrote for the Financial Times on Monday, because of the greater regulation of the banking system, most of the financial intermediation in the last 20 years occurred in the shadow banking system. So you got, you know, the non-bank mortgage lenders, the--(inaudible)--the broker-dealers, the hedge funds, the private equity, the money market funds.

Now, the trouble is, they look like banks. They, like banks, mostly borrow short. They're highly leveraged, more than banks. They lend long and illiquid ways. But unlike banks that have access to, one, deposit insurance, and two, the lender-of-last-resort supporter, the Fed, these shadow banks did not have access, at least until recently, to those safety valves that are essentially what prevent a self-fulfilling run on a solvent but illiquid bank.

So what we have observed for the last few months has been literally demargining and unraveling and the collapse of the shadow banking system. It's started with the collapse of these 300-plus non-bank mortgage lenders. When their financing disappeared, then there was the collapse of the Sigs (ph) and the conduits. When the asset-backed commercial paper behind them unraveled when we realized that they were investing to toxic stuff, then you had the--(inaudible)--run on all the broker-dealers.

Six months ago I said that there's not going to be any independent major broker-dealer left in the next two years. It didn't take two years. It took literally six months for all of them to disappear, one after the other. Two of them collapsed. One of them merged with Bank of America. The other two essentially decided to be converted into banks and be regulated like banks.

Then the next round of it was, of course, the collapse of Fannie and Freddie, and now we've had the run on the money market funds. We're also investing some of the toxic stuff so it's supposed to be safe. That way, we extended deposit insurance even to them. And I would say the next--(inaudible)--is going to be private equity and hedge funds.

So literally we have the entire collapse of the shadow banking system. Most of it is being folded into traditional one, and at the end of the day will have to be regulated like banks. There is no substantial difference between Citigroup, Goldman Sachs and a hedge fund. They're all like hedge funds. They borrow short. They're highly leveraged. They lend long. And institutions of a certain size should be regulated all the same way, because this regulatory--(inaudible)--has been the disaster that led us to the creation of the shadow banking system, not regulated at all or lightly regulated, and to this collapse of the system right now. So we're going towards a completely different financial system.

Now, the collateral damage to real economy is going to be massive. Even if this (process ?) is going to be done right--and we're going to discuss it later on--I think the recession train has left the station. The recession started--(inaudible)--this year, it's going to continue at least until the middle of next year. The banking financial crisis train has left the station as well.

We are in a recession. We are in a financial and banking crisis. And if we're going to do everything right -- and that's a big if, so even if the Treasury plan is implemented properly, at this point the differences between a severe, nasty, U-shaped recession is going to last two years--(inaudible)--financial banking crisis is going to last two years; and instead, if we don't do it right, ending up like Japan in the '90s when, after the bursting of the real estate and equity bubble, there is the L-shaped recession that lasted something like 10 years.

So at this point it's going to be severe, regardless of -- the only thing we can do is try to minimize it and make it less severe than otherwise. But the interaction, the perverse interaction between now and the financial shock hitting the real economy and the real economy contracting leading to greater credit losses, where we would integrate the losses of profits. It's going to be a vicious circle. It's going to be very hard to stop in the short term. (Laughter.)

ZUCKERMAN: Somebody, when we were just meeting before, described Professor Roubini as an optimist or a pessimist. (Laughter.) But I will share with you the difference today. An optimist thinks this is the best of all possible worlds, and a pessimist fears he may be right. (Laughter.) You can think about it, folks. You'll get it in a while. (Laughter.)

Well, the real issue is, will we get this solution right? So why don't I start with you and ask you what you think of the Treasury plan and its process through the system and whether you think it'll work and what its shortcomings are and where it ought to be strengthened. I'm going to ask both of you to comment on that.

BENN STEIL: The first central point to make here is that we've already had some significant intervention in the market. I think a lot of people have already forgotten that we nationalized Fannie Mae and Freddie Mac, and that had a significant effect on the marketplace. Mortgage rates came way down as soon as that was announced.

And since Fannie Mae and Freddie Mac currently account for about 75 percent of all new mortgages originated, that's bound to have a significant supportive effect for the market. I am concerned about the long-term effects of having these two institutions under government control, but for the time being, that's a significant step forward.

With regard to the Paulson-Bernanke plan, I don't really think too highly of it. I think any effective plan has, first of all, to distinguish between institutions that are facing a liquidity problem, on the one hand, and I think we can deal with that through a rather narrow, targeted program, and other institutions that are effectively insolvent or are likely to become insolvent.

I'm thinking in particular of AIG. And I think we handled that very well. We loaned them an enormous amount of money, but at a penal rate, and we took 80 percent of the company. And that's' exactly the right way to deal with it.

So when we're faced with companies that are likely to be insolvent, they should either be liquidated or they should be nationalized partially or in toto. And the Paulson-Bernanke plan does nothing to distinguish between institutions that are facing liquidity problems and those that are effectively insolvent.

It exposes the taxpayer to utterly enormous potential losses. They're not limiting--planning to limit their purchase of assets to--for example, mortgages, at least things that can be reasonably valued. They're planning to buy all sorts of toxic products, many of which cannot be reasonably valued and probably won't be worth very much ever.

Bernanke has emphasized the fact that this is an auction. It's a form of market mechanism. But there won't be any market competition among buyers. The government will be the only buyer. So I did myself propose a form of Resolution Trust Corporation to address liquidity problems back in December in the Financial Times, but it was a much more targeted program. It would have been focused on mortgages.

The government would have offered to buy up mortgages at very deep discounts, much deeper than Bernanke is envisioning. And it would have involved, A, the private sector being invited to bid more than the government, knowing that the government would only provide a very deep floor.

And second, I think the government would have wound up buying almost nothing under my plan, because many of the institutions who are facing problems now are facing problems because their counterparties don't trust their valuations of their assets. In other words, they're supposed to be marking their assets to market, but their counterparties don't trust those valuations.

If they could go to the government and say, "Give us a floor," they could mark the valuations of those assets credibly to the government floor price, then turn around to the market and say, "Well, now do you believe me? Even at these prices, I'm solvent." And that could kick-start the interbank credit market again without the government actually having to take on these responsibilities for the assets.

ZUCKERMAN: Do you want to --

BRAD SETSER: Sure. I mean, I guess I'm in the unusual position of being the comparative optimist. I think that, up until now, the government has managed this crisis as a series of liquidity crises. And if you look at how the government has responded, it's been through an enormous adjustment in the assets that the Fed holds on its balance sheet and has taken in ballpark $500 billion of less high-quality assets and pulled off $500 billion, ballpark, of treasuries, thus managing it by providing liquidity to a financial system that was fundamentally illiquid for the reasons Nouriel described.

If I wanted to synthesize Nouriel's argument for why we're into trouble, I would say we're in trouble because we had institutions levered 30 to 1, lending to households levered 20 to 1, which left no resilience on either side of the balance sheet. And it's been managed up to now as a sort of liquidity event and through a series of ad hoc interventions in individual institutions as they got into trouble. And I think that process had gone as far as it could have gone.

And what I find positive about the Paulson plan and Bernanke plan is that it is a recognition that the entire system has more bad assets than the system can sustain and support, and that the system cannot -- if everybody has the same basic bad bet, ballpark, it's very hard for that bad bet to be transferred to another institution, because everybody is trying to get rid of the same bad bet at the same time. So you need another actor to come in. And unfortunately, I do think that actor has to be the government.

My concerns with the Paulson plan are about the technicalities -- about the price, what price you buy the bad assets off the banks, and what you get in return.

ZUCKERMAN: Would you describe your concerns in terms of the price? Because Bernanke has said several things. If these institutions sell these assets, particularly the paper, he said they would have to be at fire-sale prices. And then he says, "We would buy it on some kind of economic valuation that would, in a sense, see securities through to maturity."

Now, nobody, it seems to me, really can understand these securities well enough to figure that out. Why do we think some kind of public agency can do it? And, if so, if they're going to be, in effect, buying it at a price well above the market price, the current market price, isn't that a huge subsidy to these institutions?

On the other hand, if they buy them at the market price, these institutions will have to take such significant write-offs that they may literally be insolvent, at least for purposes of thinking about lending again. So could you comment on how you think this kind of purchase price can be determined, or if it can be determined other than by the market?

SETSER: I think you perfectly described the dilemma. That is precisely it. If you pay a high price, you're recapitalizing the banking system by overpaying for bad assets. And that's effectively a hidden equity infusion into the banking system, which deals with some of these concerns. But it's a huge assumption of risk by the taxpayers.

If you pay a price that's even somewhat above a fire-sale price, you probably will reveal the insolvency of a couple of institutions, and that creates another problem that has to be addressed.

So you have to choose which of those two you want to do. And I think that's a very hard choice to make. And I don't think -- I think you can't really value it. I think you just have to take a guess. I mean, if the market can't value it, the government can't value it. We just have to recognize it's fundamentally impossible to value assets with so much uncertainty about the future trajectory of the economy and the future trajectory of housing. You're taking a gamble.

STEIL: I think it's also important to point out, although we're calling this an auction, and the lowest bidder gets to sell his assets to the government, these are not homogeneous assets here. I don't know how you're reasonably going to take this huge pool of very diverse toxic assets and put them into clear groups and then have an auction for the group. It's almost certain to wind up with the government vastly overpaying for this stuff.

I don't really like the auction plan. But if there's going to be an auction, at the very least, it should include private-sector bidders, not just the government committing to buy up what institutions are willing to sell to them.

ZUCKERMAN: Nouriel, do you want to comment here?

ROUBINI: Yes. I mean, I think there's this fundamental valuation question that we could discuss for, you know, hours whether they should be bought at, you know, market value or something further to hold the maturity. I think the only way to resolve it is going to be then that the government will, after some upside, is going to buy these assets. So I think you resolve that incentive problem by having the government taking--(background noise)--in exchange for valuing the assets. And therefore, if they're going to overpay, then there's going to be a benefit in terms of the value of that equity participation. I think that's one of the ways to resolve this question.

STEIL: I'm surprised they didn't specifically propose something like that, given that that's precisely what we did in the case of AIG. I think that was handled very well. It was handled very quickly, okay. So this was a decision that had to be made on the fly, but it was made very responsibly and, I think, very effectively. And I think it's very likely that the taxpayer will come out very well on that deal.

ZUCKERMAN: Let me go to something that was implicit in one of the things you said, which was the fact that mortgage rates went down when Fannie and Freddie, in effect, were more or less nationalized. Let me go to the other side of it. The word credit comes from the Latin word credere -- to believe. I think all of the lenders have stopped believing in each other and, frankly, even in their own financial condition.

So let me just give you an idea of what's happening with mortgage lenders on the residential side. They're insisting on much higher credit verification on the part of the borrower. There are going to be much more loan-to-value ratios. The appraisals -- the interest rates are going to at least be higher, I think, unless they are going to be completely bought out by Fannie and Freddie in one form or another.

But also the appraisals, on the basis of which they're going to make loans, are going to be much more conservative than they had before. So I still do not see how, particularly when the appraisers are going to be looking forward and seeing further declines in the value of homes, I don't see how this is going to really stimulate the housing world, even though it sounds good on paper.

Nouriel, do you want to comment on that?

ROUBINI: Yeah. I mean, in my view, actually, the trouble in the U.S. economy is that we have, for the last 20 years, subsidized the most unproductive form of capital accommodation. This housing capital gives you some, you know, utility services, but it's not productive in terms of increasing the productivity. We've not invested enough in machinery and other stuff and more in housing stock.

And I think to try artificially to prop up the housing market doesn't make sense. There's still a huge excess inventory of homes. If we start producing new homes today for almost a year to get rid of that excess inventory, the price adjustment will continue.

And I think we at some point realize that probably continuing subsidizing of property is not going to be the right solution. There has to be a price adjustment. The inventory has to be worked out. This housing recession is going to continue for a while. Home prices have fallen from the peak already 25 percent. My own work suggests they're going to fall another 15 percent, 14 percent, just to bring it back to what the real home prices were before this bubble started.

So we have a huge bubble, and we should not do things essentially artificially to try to prevent that market process from occurring. And I think that, over time, actually, if we have less homes and less investment in housing and more investment in productive capital, that's going to be good for the U.S. economy.

STEIL: I don't think it's a bad thing for the economy, Mort, if people have to put down 10 (percent) or 20 percent when they go to buy a house. I don't think it's a bad thing if houses are appraised and if people's incomes and credit are checked. I think that's something we should have done a long time ago. (Laughter.)

I also think we've made too much, perhaps a fetish, out of home ownership over the years; the notion that somehow to rent is a terrible, terrible thing and that really we should get everybody into his or her own home, even if that involves massive personal risk for that person; and not only that, as we've learned, socialization of utterly enormous risk for all of us.

ZUCKERMAN: Let me go to another point, which is what's happening to home prices. There are an estimated 10 million homes where the mortgages exceed the value of the homes. If you have another 15 percent drop in prices, that number may go up to between 15 (million) and 20 million homes.

Now, some of those homes, a much larger proportion of those homes than we have ever imagined, are going to be foreclosed and thrown on the market. That will change the supply and demand by, in effect, accelerating or supercharging the decline.

Do you foresee anything like that happening? And what would be the significance if you didn't have the 15 percent, which might be a normal decline in relation to where house prices have really sort of grown by 3 percent a year from 1945 to the year 2000. I think they grew by 16 percent a year between 2002 and 2006.

If it gets back to some more normal value, but it may also be distorted by now not artificially attractive financing but an artificial supply to the market from foreclosed homes where lenders, particularly if these mortgages have been securitized, are just going to want to get rid of them as quickly as possible. What do you think will happen then?

ROUBINI: Well, I think you pointed out rightly the most crucial thing with homes falling about 30 (percent), 35 percent, about 40 percent of households that have a mortgage, or about 21 out of the 51, their mortgages are going to be underwater with negative equity in their homes, essentially, where the value of their home is below the value of their mortgages.

And as you know, in the United States, mortgages are effectively no-recourse loans. So if you decide to walk away from your home, you're underwater--what people refer to as jingle mail--you know, you put the keys in an envelope, you send it to the bankers and you say goodbye -- then the creditor cannot go after you for the differences in the value of the home, in the value of the mortgage.

By the way, there are entire websites, like, where they teach you how to walk away from your home, minimizing the legal risk. Well, this has become a big issue. And it's actually a bigger issue not just for subprime, because, you know, if you're a subprime borrower, you eventually might be kicked out because, you know, you cannot pay and they're going to evict you.

But actually, think about all the people who were essentially buying second homes, vacation homes, the condo clippers (ph), the speculative homes. They're putting zero down, so they're starting with no equity. Now they're deeply into negative equity. Why would they want to service it? So it's Alt A, the--(inaudible)--the jumbo, the other stuff.

And I've made some estimate that on top of the 300 (billion), $400 billion of write-downs from subprime, this walk-away phenomenon is going to give you at least, even in the best of circumstances--it's good that only one out of five people that are underwater--only 20 percent of them are going to walk away. You get another additional $400 billion losses from the financial system.

If the number is 50 percent, meaning half of the people underwater eventually walk away, you get a number of $1 trillion. That's because you wipe out most of the capital of the U.S. banking system. But even in the most conservative assumption of one out of five, you get another $400 billion of losses on top of the $500 billion already written down. So the effects on the financial system of this particular thing are going to be absolutely disastrous.

ZUCKERMAN: Boy, I thought this was going to be serious. (Laughter.)

But let me go to other dimensions of it. We are talking about a huge expenditure, in one form or another, on the part of the Treasury, on the part of the federal government. It's going to take the deficit, which is presently running at around $500 billion, into some stratospheric level. It may be well over $1 trillion. What is that going to do to the dollar? What's that going to do to interest rates? What's that going to do to the support of -- you know, or the willingness of other countries to continue to hold the dollar? And what is it going to do to the heating system here in the Council on Foreign Relations? (Scattered laughter.)

Go ahead.

STEIL: It's a serious potential risk. I think the most essential thing that we have to do is preserve the integrity of the Federal Reserve's balance sheet. I'm at least pleased that what we're talking about now will be done, as it were, on the Treasury's balance sheet; that, at least in the short term, there's not an imminent risk of printing money to finance it.

Having said that, the temptation over time to inflate our way out of this debt that we're building up is enormous. And we must reckon with the fact that we're very dependent on foreign capital inflows into the United States. And foreigners are going to be very, very concerned about the obligations that we're taking on.

In terms of the potential down-side risk, it's important to understand that the current valuation of the dollar is founded in a world in which about two-thirds of global trade is denominated in dollars. About two-thirds of global foreign exchange reserves are denominated in dollars. If we move towards a very different world where people outside the United States do not need to or wish to continue to trade and save in dollars, that means that the dollar has a long way further down to go. So we need to be very, very careful about containing not just the size of this crisis but the size of the intervention.

SETSER: If I could jump in really quick. I mean, I think the deficit, per se, is unlikely to get that much bigger than $1 trillion. It will get bigger because of countercyclical or fiscal policies. But in addition to this sort of fiscal deficit, the U.S. government is effectively becoming a financial intermediary. We're selling $200 billion of Treasury to buy $200 billion of agencies to keep credit flowing to the housing sector. That's effectively the U.S. government acting as a bank.

The U.S. government's going to buy up $700 billion if Paulson's plan is passed. Bad assets off the banking system, which means there will be another increase of $700 billion of Treasury's into the market. The net effect is that there will certainly be well over $1 trillion in Treasury bonds that are issued over the next four quarters. I think that's unambiguously the case.

And there is a race between whether the Treasury's issuing more bonds than investors want to buy and a point in time when investors are flocking into the Treasury market. And if you look at what has happened in the Treasury market, yields are going down, not going up, because for now the panic in the market is stronger than the increase in supply.

I'm not convinced that will continue. In some sense, I would hope it doesn't continue and that there's a little bit of upward pressure on Treasury interest rates because that would signal there's been some return of confidence into the financial sector. But I think it's very tough balance.

And the other small point I would make is that if central banks act as central banks have acted in the past and our creditors continue to peg their currencies to the dollar, there's a very consistent pattern which is the worse the dollar does, the more foreign central banks buy, which provides an element of stability, but this also will perpetuate a very large deficit for a very long time. If that continues, I think we can avoid the worst.

ZUCKERMAN: Well, let me just sort of talk about what the possibilities are going forward. You have a situation in which we may have, let's say, somewhere between 1 trillion (dollars) and $1.5 trillion in the federal deficit looking forward. You have a major drop in the value of homes, which is bound to affect consumer spending. You have a major change in the confidence of lenders, both into the housing market and, frankly, into the business market which, in part, is, as you describe what's happening to the flow of funds, people are not translating the money into the sector that lent it but just into Treasury's and government-backed securities.

And you're going to have lenders in the business world, banks in particular, be much more conservative about their lending practices. This seems to me, when you have a drop in consumer confidence, a drop in housing values, a drop in the ability of the credit system to enhance credit, given where we are starting from, that we may have a very serious recession next year. Is that a view that any of you share? And if so, what are the tools available to the federal government to turn this around?

ROUBINI: Yes. My view is that we are already in a recession. I mean, if you look at the data carefully, the recession started in Q1. And if you look at the latest data for consumption, you know, the scary stuff about the tax rebate was it was supposed to stimulate consumption into August and September, right, $100 billion -- two-thirds of it being spent.

Instead, you look at the data. April and May, real spending, retail sales go up. And then starting in June -- June, July and August, real retail spending and real personal spending is the--(inaudible)--users for consumptions have been falling. So in the Q3 number, we already see consumption dropping for the first time since 1991. It did not happen in 2001, so we are in a consumer recession right now. And with consumption being 70 percent of GDP, then we're going to see already in the Q3 number negative GDP growth.

So the debate at this point is not any more on whether consumption is going to fall but rather how much and for how long. And given there have been some consumption, my view of it is it's going to continue this drop into at least the middle of next year.

Think of it. You have the U.S. consumer that's, one, shopped out, saving less, debt burden. The debt to disposable income in the household sector has gone from 100 percent eight years ago to 140 (percent) today. And now the U.S. consumer is buffeted by (cyclical ?) headwinds -- you know, the fall of your home price so you cannot use your home as an ATM machine, your home equity withdrawal collapsing to zero from $700 billion three years ago. You have the fall in the equity market by 20 percent negative wealth effect.

You have a credit crunch that's going from subprime to nearprime to prime, to credit cuts to auto loans through the months. You look at the Q2 flow of funds data, there is already contraction of credit. The price of credit is going up. You have not only debt ratios that are high but debt services ratios for the houses going higher because of resets of mortgages, credit cards, auto loans, student loans.

You have the increase in oil and food prices squeezing real purchasing power. You have consumer confidence down to the level of the 70s speculation. And all this happens, people say are aware, but as long there is job generation, we're going to keep the consumer because of the income generation -- (inaudible) -- from nine months for nine months in a row today. We have had the falling private employment for eight months in a row. We've had the falling employment through the public employment. And every indicator of the labor market, like (initial pay ?), suggests is worse to happen. We're going to have an unemployment rate above 8 percent at the bottom of this thing.

So essentially, the consumer right now is faltering, and the tax rebate that was supposed to boost consumption through August, September was gone by May. Why? Because people are so burdened with debt that the tax rebate they've been saving it, they've been using it to pay their credit cards, their mortgages. At this point, we're going to have a nasty consumer recession, there's not going to be much to avoid it.

ZUCKERMAN: Would either of you care to add to -- (scattered laughter).

SETSER: Well, I mean, we are using all policy tools available. We've cut interest rates down to 2 percent. Conceivably, they could go lower. We've increased the fiscal deficit. We could, conceivably, increase the fiscal deficit more. We've had the government agencies dramatically increase their lending to households to offset a contraction in the private mortgage-backed securities market. We could have that continue. You can take all these steps and turbo charge them, but that has a cost.

The other angle is that the rest of the world could adopt policies to support their economies which would help support the one bright engine or bright spot in the American economy which has been exports. So if the rest of the world adopts policies directed at stimulating their domestic economies and their domestic demands rather than supporting their exports, that would tend to help support economic activity here.

ZUCKERMAN: Do you want to add anything to this at all?

STEIL: I agree with Nouriel that we're probably already in recession. If not, it's imminent. The question is how deep it's going to go. In terms of the traditional tools we use to address recessionary forces, monetary and fiscal policy, I think we're probably in agreement that we've gone as far as we can go in terms of fiscal policy.

I don't know if we're in agreement on monetary policy. I think we went way too far. I think we've built up inflation expectations to a level at which we're going to have tremendous difficulty beating them back down again. And that means higher real interest rates in the future.


ROUBINI: Yeah, two additional points. You know, six months ago, we could have helped the rest of the world by growing fast could rescue us from the recession, or either one that was more short or more shallow. The trouble is when you look at the second quarter number, right now 55 percent of global GDP, practically all of the advanced economies are contracting. The Euro zone is contracting, U.K. is contracting, Canada is contracting, Japan is contracting, Brazil is contracting. So the idea that the rest of the world is going to essentially--(inaudible)--our experts get us out of a problem is not there anymore because this series of financial shocks, housing busts in other parts of the world, tight monitoring credit conditions have led to essentially most of the advanced economies to tip over into a recession.

Now, this is a Euro zone recession, it's a G-7 recession, it's an advanced economy recession. The only question mark right now is whether even emerging market economies are going to slow down so sharply, as it may occur, that we'll end up into something like a global recession. That's one risk right now.

In terms of the policy tools, monetary policy has not been effective. It's like pushing on a string. Interbank spreads are as wide as ever because of counterparties. This is a solvency problem. It's not a illiquidity problem. Traditional fiscal policy has not made any difference because, again, people are saving it.

I think the critical thing about the kind of program of the government is that in addition to buying the bad assets, you have to work them down. The housing sector has a bad problem, it's insolvent. So when Argentina, Russia and Ecuador are insolvent, you default, you reduce the case value of the debt, you start growing again. When a corporation is distressed, too much debt, you go in Chapter 11, you reduce the face value of the debt and you start growing again.

When the housing sector has too much debt, there is a debt overlap, and they cannot stand it. There's no discretionary income. So you need across-the-board debt reduction. If that doesn't occur, if that's not part of the plan, you're not going to resolve anything. So a plan that just buys the assets and pass somewhere is not going to make a difference.

You need something more than the RTC. You need what was done during the Great Depression. During the Great Depression, the Home Owners Loan Corporation, HOLC, was created. It bought all the mortgages from the banks, reduced the face value, converted people to fixed-rate, longer-term mortgages and allowed them to stay in their homes. You avoided the tsunami of foreclosures because if you're going to have tsunami of foreclosures, the borrowers lose their homes, the lenders go bust and then the fiscal cost of bailing out the banks through deposit insurance is going to be massive.

So you need the macro equivalent of a Chapter 11 in which you avoid the liquidation of the entire banking system or liquidation of the housing sector. And that's not part of the plan. And unless that's part of the plan, that reduction is going to be central to it. We're not going to resolve the fundamental problem of why we are in a recession.

ZUCKERMAN: Well, I'm going to turn this session open now for the Q&A part of our meeting. I'd like to invite members to join our conversation with their questions. Please wait for the microphone and speak directly into it. Please stand, state your name and affiliation, and limit yourself to one question and certainly not even one speech. Keep it as concise as possible so that as many members as possible could ask their question.

First question over here.

QUESTIONER: Thank you. I'm Tony Holmes from the Council here. Thank you for the very vivid and graphic picture you've painted. Would you please overlay on top of that picture and give us a sense of timing, both in terms of the timing of the impact on the real economy as well as place a second overlay with some sort of outline of the U.S. presidential campaign and the implications of all this in the aftermath of the election on the choices and flexibility of the new administration?

ZUCKERMAN: Would anybody care to try that? Would you like to chime in here? (Off mike.)

STEIL: I think both candidates are going to find themselves severely constrained. There will be some sort of big intervention plan. And we know that whatever that's going to be, it's going to be exceptionally expensive, that there's going to be little opportunity for either candidate as president to introduce his own plan on top of that. So another sort of fiscal intervention, I think, is really impossible, really absolutely impossible.

I think the best thing that the next administration can do is start building the groundwork for a more effective regulatory system. And that's much easier said than done because we've had lots of well-intentioned ideas in the past, extremely well-intentioned ones, that have turned out rather badly.

Let me give you just one example. Imposing a tiered capital standard on banks in the late 1980s and early 1990s was intended to ensure that we wouldn't have problems like the S&L crisis, that banks would be well capitalized. But what it encouraged financial institutions to do was to get these assets off their books, to securitize them and pass them on to someone else.

So if you ask how did we get where we are now, certainly, at least part of it, was the effect of very well-intentioned interventions in the past. So building a sound regulatory framework to make sure that we don't get into this problem in the future is going to be a major challenge.

I would say as well that we're likely to begin having a real debate again, for the first time in a long time, about what good monetary policy is. There had been an impression that because consumer price index inflation did not soar in the early part of this decade that we were okay, we didn't have to worry about soaring asset prices.

But I would point out that in the 1990s, we saw the same sort of thing in Asia and Latin America before their crises. In the run-up to the crises, asset prices boomed and consumer price index inflation remained very low. When the crises hit, when the currency crises hit, inflation soared.

We're experiencing the same sort of thing now. So I think we're going to start having a debate again about what proper monetary policy is, that perhaps inflation targeting is not the be-all and end-all, that we have to pay attention to asset prices, not because government officials are so smart and know what asset prices should be, but when people start moving en masse into certain assets, for example like gold, what they're saying is, we want alternative monetary assets, we don't trust the monetary asset that the government is producing, and central banks need to take account of that.

ZUCKERMAN: Question over there.

QUESTIONER: Hi, my name is Michael Prawley (ph). I'm with JAR Partners and we have a lot of real estate investments in emerging markets, so my question is for Professor Roubini. I mean up until at least the last few days, a lot of the economists and analysts were saying that, you know, the emerging markets would not be as impacted, and in fact they could actually help avoid a global recession because emerging markets account for maybe 40 percent of global GDP on a purchasing power parody basis. And my question is do you think that emerging markets, because of their domestic liquidity, will remain largely isolated from the European and U.S. financial crisis or will they be significantly adversely impacted?

ROUBINI: Well, I expect a pretty significant adverse impact, you know, because of trade links, because also of financial links, between our currency links, between our confidence links. You know, the global economy for the last few years has been one in which the U.S. was the consumer of first and last resort, spending more than its income, running current account debts because we're like China, Asia and other emerging markets where they're producer of first and last resort, spending less than their income, running current account surpluses.

So what you have to ask yourself is whether the sharp falling U.S. private consumption demand -- is there enough domestic private demand in the rest of the world in emerging markets that can grow to suspend global economic growth, and my answer is no because, you know, in U.S. the total consumption's about $9.5 trillion. Take the entire consumption of 1 billion Chinese, it's about $1 trillion. Take all of the consumption of almost 1 billion Indians, it's $600 billion. So the sum of the consumption of 2 billion Chindians is about one sixth of the U.S. consumption, right?

So if there's a shortfall U.S. consumption, can their consumption go up by 500 percent in order to compensate for the falling U.S.? The answer is no. The question in this country is whether we're relying especially China some parts of Asia some parts of Latin America on expert to the United States is the main engine of goods, and the rest of the demand is essentially production of investment goods that produce more exportables is the question of whether their policy stimulus in terms of monetary and fiscal policy can be aggressive enough to avoid a hard landing.

And for China -- by the way, a hard landing means a growth that's gone from 11 (percent) to 6 percent because China needs a growth rates of 10 percent in order to move about 15 million--(inaudible)--investment sector every year to maintain social and political stability. And my concern is that while now they're going to have a fiscal stimulus, they cannot so aggressively flow all of the infrastructural spending they want to do over the next five, 10 years over a year or two. And if that's the case actually, their policy response may not be aggressive enough to control the fall out coming from the collapse of demand in the United States and the recession and the rest of the advanced economy. And if China goes into essentially a hard landing, then the two main engines of global growth, that were U.S. and China, one on the consumption, the other one on the production are going to have a recession or a near recession, then you have real trouble for the global economy.

SETSER: If I could just make one small amendment to what Nouriel said which is that over the last two years, Europe has been a bigger engine of demand growth for most of them, the emerging world than the United States because our net exports have been contributing to growth and so for much of the emerging world, the economic trajectory of Europe over the next 12 months will matter as much if not more than that of the United States, which is a significant change from the world of, say, five years ago.

STEIL: And in terms of the so-called--very briefly, in terms of the so-called BRIC countries--Brazil, Russia, India, and China--I'm particularly concerned about Brazil and Russia. The reason is that we really haven't seen fundamental reforms in those economies, their boom has been very much based on the rise in commodities prices. If global demand really does take a deep hit, I think Brazil and Russia go down with it.

MR ROUBINI: And commodity prices have already fallen about 20 percent from their peak in July, given that people are now pricing in at global economics--(inaudible)--U.S. recession. So that's already negatively effecting among other reasons both Brazil and Russia.

ZUCKERMAN: (Off mike.)

QUESTIONER: My name is Rick Salomon, East End Advisors. Let me make one comment and ask one question. Benn commented about inflation expectations. Yesterday, for the first time that I can remember, the real yield in tips was exactly the same as the yield on treasuries, which would suggest that inflation expectations in the market are almost non-existent over the term of those treasuries, which is either five years or 10 years. I think the expectations today are much more in line with what Mort was saying, these highly contractionary forces, which we have to weather first -- I mean, inflation may be a Chapter II problem, but it's certainly not the Chapter I problem that people are worried about. That was the comment.

Question for Professor Roubini. In your sequence of troubled institutions, you listed investment banks and then you mentioned hedge funds and private equity funds. I'm just in that sequencing. In the case of investment banks, you have institutions which will leverage 30-to 40-to-1, that finance their business very short term, daily, weekly, monthly. In the case of hedge funds and private equities even more extreme, but in the case of hedge funds, you have for the most part institutions which are levered 2-to-1, that have long term locked up capital. So I don't see how the sequencing plays out the way you described.

ROUBINI: On your question, actually before you question, I agree that inflation, in the short term is not going to be an issue of lacking good markets, lacking labor markets, lacking commodity markets, going to imply that it fits in the short term, inflation is going to be the least problem to the Fed and other advanced economies that the bank will have to face. So your question about the roll offs for private equity in hedge funds, hedge funds have a lock up period of about a year and then within a month or a quarter you can have redemption, or really mass redemption. Hedge funds -- some of them leverage a lot and most of their financing like for the broker dealers is overnight repo. And now with the squeeze of the prime brokers, to the risk of those that are hedge funds are weaker, higher levered, poor performing, you're not going to have essentially the credit line cut off. So you're not going to have the same run you can get on a bank or a money market fund or a (Sig ?) or a broker dealer, but even in the case of hedge funds you're going to have over time roll offs of credit and of redemptions.

So private equity among the shadow members of the banking system is the only one with a longer term financing. In some sense, the problems are even bigger because the typical LBO a few years ago had a debt to earnings ratio of 3-to-4. The last batch of a trillion-plus had a debt to equity ratio of something like 10 or 15 or even more. It was crazy LBOs that should have never occurred. Now it's going to be a slow fuse run. Why? Because you have common and life clauses, you have--(inaudible)--and all sorts of things implied that refinancing prices is going to occur maybe six months from now, a year from now, but with credit spreads that a year ago in June were 250, and now they're closer to 1,000, once that the refinance has to occur, many of these LBOs that should have never occurred are going to go bust, so the private equity bubble is also going to go bust. It's going to be a slow motion run, not the same way you have on the other members of the shallow banking system, but I think it's going to happen as well.

STEIL: To address Rick's point, treasury prices have a very bad track record in terms of predicting inflation, and that's for good reason because you have obviously countervailing effects determining whether people go into or out of treasury bonds. Last week, at one point at the height of the crisis, as you know, short term treasury yields went down to a fraction of 1 percent, so that the flight to safety effect makes it very difficult to measure. If you look at asset prices that have historically had a good track record predicting inflation, you would look at gold prices and I think you'd be concerned.

ZUCKERMAN: Question in the back -- (inaudible).

QUESTIONER: George Zivaneil (ph), the Paris School of Economics. There's a criticism that's been made of the Paulson/Bernanke rescue plan, that the focus on the balance sheet is misguided and that $700 billion would be better spent by buying equities selectively and bringing capital to those institutions that are deemed to be solvent and letting those that are not go. Would you comment on it? It's a -- George Soros takes this position in the FT this morning.

ROUBINI: No, I agree with you. I mean, I think that you had -- you need to do a combination of three things to resolve the financial crisis. One is and RTC type of thing -- you take some of the assets off the balance sheet at a certain price, you re-liquify part of the financial system after having done the three Rs, of course, between those who are insolvent and should be let go and those that are distressed and then capitalize them. Once you provide liquidity capital, it can work.

The second thing you need to do is debt reduction. A third thing is of course once the bank takes their write-down, they're undercapitalized and therefore if they are to get credit to recapitalize how you do it, I think you do it in three or four different ways.

The first way you do it is essentially the government takes some preferred shares for each injection of liquidity. The second thing you do is like the RFC during the Great Depression where 4,000 banks got preferred shares from the government and increased their capital.

The third thing you do is that if the government's going to put preferred shares, then they see the other common shareholders would also inject capital and they should suspend that dividend payment. Otherwise, the government takes the first risk while they should be sharing to that. So inject capital through private capital. And the final thing you do is the thing that even the unsecured creditors of the banks, meaning the sublet and other one--(inaudible)--should take a hit. You can do a debt for equity swap.

So many different ways in which you can recapitalize the banks, and that's a necessary component of illiquids. If you don't recapitalize the banks and you take a hit then you're going to have a massive credit contraction. So it's the combination of all the things. You need an RTC, you need a HOLC, and you need an RFC, you need the three Rs. And if you do it right, combined together, we're going to eventually get out of this thing. And the trouble with the treasury plan that originally it was just a bad version of an RTC -- it didn't have all the other components of it.

STEIL: The Swedish rescue plan, which we haven't discussed so far today, did in fact involve the government taking very significant equity stakes in banks.

QUESTIONER: Thank you. I'm Jeffrey Rosen from Lazard. What you suggest for fiscal policy and monetary policy, massive stimulous deficits, low interest rates, implies an inflationary risk in the future. What you described for the asset market, a real estate market, commercial real estate market perhaps, certainly the residential real estate market, suggests an asset deflation risk. And I'm just curious which of the two you think is more serious and whether you think there are implications for what's happening now, for asset deflation in the future which brings back to mind the Japanese type of scenarios. And if I'm allowed and he'll take a minute, I'm just curious what Mort's views are on the impact of all of this on the political season.

STEIL: I think both of them are serious, and the RTC fund I put forward with Mark Fisch in December was meant to address precisely that problem. But the inflation risk is also serious and we know that we can experience the two together in some combination. And the 1970s was a particularly bad period. I think in many senses the next five to 10 years are going to look like the 1970s; in other words we're going to have at best very sluggish growth, we're going to have elevated real interest rates, elevated inflation rates, elevated commodity prices. It's going to be a painful period that's going to involve both asset depreciation and an element of higher inflation.

ZUCKERMAN: Anybody else want to -- ?

SETSER: I guess both of us.

ZUCKERMAN: Go ahead.

SETSER: I would put slightly more emphasis on the risk of asset deflation in large part because I think the process by which loose U.S. monetary policy was producing, super loose monetary policy in places like China and the Gulf that were pegging to the dollar and generating globally loose monetary policy, I think that process is about to go into reverse and that you'll see a much stronger contractionary element from the global economy from the emerging world which will take some of the inflationary pressure off.


ROUBINI: I don't know. I think like in the cycle of 2001, 2003 in six months we're going to start worrying about deflation, where suddenly asset deflation, slacking good labor and commodity market means inflation's going to be the least of the problems the Fed has to worry.

You're right about one point, if you're going to essentially monetize all the fiscal deficit, that's going to be made eventually inflationary. But I think that the way it's going to be financed is going to be by public debt which is going to increase interest rates, but it's not going to be monetized. Of the liquidity injection in the short run are satisfying a demand for liquidity that you can take away once the demand for liquidity goes away, so that's not inflationary. And most of the -- what the Fed does with the swap line doesn't increase the money supplies, that's the swap of bad assets for good assets.

So if we were to monetize, reduce the fiscal problem, absolutely, we'll have a massive inflation problem down the line. But even--(inaudible)--said what Bernanke cannot afford essentially is throwing the inflation kind of expectation rise then because if inflation expectation comes out of the bottle then to bring it back you're going to need a nasty bulk of this inflation, and we have a severe inflation. And even a--(inaudible)--Fed cannot afford to essentially monetize this problem. Then if we're going to fiscalize it, we'll have to raise taxes, cut spending, pass them onto the next generation. I think that's the way that this crisis is going to be resolved, not with inflation.

ZUCKERMAN: I'll just make a brief comment about the last part of your question. I believe if the election had been held two weeks ago, that McCain would've won. He was ahead in all of the key battle ground states as a quota. It's amazing to me how close the election -- the polls are to this moment. And since I don't believe that the polls accurately reflect where the votes are going to come out and that votes will be much more than the polls indicated in McCain's favor, it's still a close election.

I cannot imagine that the impact of this crisis, which is going to make the economy the dominant issue from now until the end, unless there was some enormous gaffe or differential effect of the first debate, I just don't see how Obama loses. If he does, it will really say something very, very serious about race relations, I have to say, because I think that's the only issue that would defeat him if it were a generic poll. If it were any other Democrat, I think it would be a walk-away.

Question over there.

QUESTIONER: Thank you. (Name inaudible). The question I have is with respect to the 700 billion (dollar) package and whether the number is right, if you assume it's only directed at what you'll refer perhaps if I read it right which is capitalization of the banking system, it was--if it was moving in that direction, what is the--is that an adequate size?

ROUBINI: I would separate two things. One, you need to recapitalize the banks. That means additional public money and also private money and some debt for equity swaps to transform some of the debt on the balance sheet of the banks into equity from the need to buy some of these assets and take them off the balance sheet of the financial system. I think the impaired assets are probably closer to a trillion and a half (dollars) -- with a discount of about, you know, 30 percent, you need about a trillion (dollars), not 700 (billion dollars).

If the discount is even smaller than that, eventually this plan is not going to be a $700 billion plan, it's going to be more than that if the size of the problem is a 1.5 trillion (dollars) bad assets. And then you have to also make a political decision of how you locate -- (inaudible) -- public capital how much of it is going to go into truly recapitalizing the banks as opposed to buying off the bad assets and you have to make the right trade offs in that direction. But you're going to need even more money most likely.

ZUCKERMAN: I'm sorry, but we're come to the end of the hour. I'll just make two small comments, one personal and one general. We now understand why economics is known as the dismal science. (Laughter.) And the second one is with all due respect, I hope you all will allow me to use the word Chindians first in my editorial, and then afterwards--(laughter)--anybody else can use it.

Thank you very, very much. (Applause.)







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