Steps to Halt the Slide

Nouriel Roubini, a professor of economics at New York University and the founder of the financial analysis firm RGE Monitor, has made his name by correctly predicting financial problems. Dubbed "Dr. Doom" by the New York Times Magazine, Roubini correctly warned of the impending housing market bust back in 2006, and, last February, of a rising probability of "catastrophic" financial system failure. At the time, he says, people called him a "lunatic," but his predictions have proven prescient.

In an interview with CFR.org, Roubini says the $700 billion financial bailout package passed by the U.S. Congress last week is unlikely to end the present crisis of confidence in financial markets. The plan, he says, does not get at the "much more urgent problem" of a "generalized run on the short-term liabilities both of the banks, of the non-bank shadow system, and now of the corporate sector." Roubini encourages a multi-pronged policy approach to the crisis, including: 1) coordinated interest rate cuts by all major world economies; 2) a move by the U.S. Federal Reserve to guarantee that it will provide liquidity in the event of any major bank run; 3) increased Fed action to provide short-term liquidity to non-bank actors that lend to corporations; and, if that doesn’t work, 4) a willingness to make short-term loans directly to corporations. Roubini adds that despite having predicted much of the present crisis, he has been surprised at the speed at which it has unfolded.

Despite the so-called bailout plan passing the House of Representatives on Friday, there are obviously still some major strains to global financial markets, and it now appears as if commercial paper markets could be seizing up as well. How much of a help was the bailout plan, and where do you think things stand now?

The bill, first of all, in many dimensions is flawed. But leaving aside the flaws of the bill, there is a much more urgent problem that we’re facing right now. It is one of a generalized run on the short-term liabilities both of the banks, of the non-bank shadow system, and now of the corporate sector. In the case of the banks, there is the beginning of a silent run on the uninsured debts of the banking systems, which are still over $2 trillion despite the increased deposit insurance. Many institutions in the non-bank shadow financial system are also finding that they cannot roll over their debts. There is a situation of generalized panic and lack of trust in counterparties. And worst of all, at this point, the commercial paper [short-term debt issued by large banks and corporations] to the corporate sector, and other types of funding to the corporate sector, is frozen right now. That can tip a corporation into a situation of defaults. They might not be able to pay interest on maturing debts, they might not be able to roll over maturing debts, and they might not be able to finance their working capital. So we’re seeing a generalized liquidity run, and it’s something that this bill cannot directly address. It’s something that needs to be addressed with different sorts of tools.

What sorts of tools do you recommend? I see you’ve called for major coordinated interest-rate cuts, on the order of one hundred points across the board, in all major world economies.

That’s only part of the solution. It has to do with coordinated rate cuts, but it’s not obvious [even after the cuts] that liquidity is going to flow to those who need it. We need to do something slightly more radical than just an interest rate cut. Most likely the Fed will have either to guarantee all deposits on a temporary basis, since that’s the only way you can essentially stop a run. But since that requires legislation and it’s not obvious that Congress will pass a temporary blanket guarantee, the Fed has to stand ready to provide the liquidity to any bank that needs liquidity. So if there is a run on any bank, the Fed has to increase the money supply by as much as is needed to essentially prevent that particular institution from collapsing. That’s the first thing.

The second thing is that the Fed is already, through its own emergency authority, allowed to provide liquidity to non-bank primary dealers that are systemically important. But the money the Fed is giving to the banks and to the primary dealers is not being re-lent to the other financial institutions in the shadow banking system. So the transmission of monetary policy is locked. Fixing that might require the Fed to start extending the PDCF [Primary Dealer Credit Facility], that is the facility that provides liquidity to non-banks, also to other financial institutions like finance companies, leasing companies, and you name it, in a way to provide liquidity to those financial institutions that directly lend to the corporate sector.

And if all that doesn’t work, the Fed might be forced to directly liquefy the corporate sector by using its emergency powers to directly lend to the corporate sector, essentially buying commercial paper, providing cash.

Those are all three radical actions, but some combination of all three at this point is necessary. The problem is that once the bill was passed, the stock market reacted negatively both to the passage of the bill in the Senate--on Thursday, equities fell by 4 percent--then on Friday, after the House voted, the Dow fell almost 400 points. So the stock market is not reacting positively, and for the last couple weeks, interbank markets and commercial paper and other kinds of short-term lending in the financial system and the corporate system have come to a freeze. And this particular legislation doesn’t have any role in essentially restoring the confidence and the liquidity in interbank and short-term credit markets. And in the short run, in the next few weeks, that’s what you need to do. Because that legislation, even if implemented properly, is going to take a few months--if you don’t reliquefy the banking system, the shadow banks, and the corporate sector, you’ll have a financial meltdown in a matter of two or three weeks. That’s much more urgent than anything else.

If we do start to see spillover into the corporate sector, where would you see that starting? Are there specific firms or specific industries that you think are most susceptible?

Now the situation is that even triple-A corporations [corporations with AAA credit ratings, the highest level] cannot roll over [defer payment on] commercial paper at any maturity past overnight. So we’re already seeing a situation in which essentially commercial paper is frozen, and even corporations that are going to the banks now to try to draw down on their credit lines are finding that they are being refinanced at much higher rates. So it’s becoming very expensive, and it’s really squeezing the corporate sector. Unless the government steps in and directly provides liquidity to the corporate sector, I think we’ll be in big trouble.

You have said that Goldman Sachs and Morgan Stanley converting themselves to bank holding companies was a "cosmetic" move and that they should be looking to merge at this point to avoid a run on their overnight liabilities. How big of a risk do you see at this point of a run?

They wanted to convert themselves as banks to have a stable base of insured deposits in the same way that brokerages in JP Morgan and Citi[group] have it, and the same way that Merrill [Lynch], being a part of Bank of America, will have it. You’re not going to see Goldman Sachs or Morgan Stanley branches on the corner anytime soon. And even acquiring other banks over time, as a way to acquire deposits, is going to take a lot of time. Ninety percent of their borrowing is still overnight; they’re leveraged thirty times, and they lend in ways that are illiquid and longer term. So there is a serious risk. Morgan Stanley, over the last ten days, has lost a good third of their hedge-fund clients. So the foundations of what they do are being undermined. Of course the Fed is providing both institutions with mass amounts of liquidity to try to compensate for whatever lack of finances they have, but how much? $100 billion? $200 billion? At some point there has to be a limit. So I think both institutions would be well-advised to do what Merrill did, as a way to avoid ending up like Lehman [Brothers, which collapsed]. Just do whatever to avoid ending up like Lehman is the basic thing, and just converting yourself to bank holding companies is not enough at this point. You really have to merge.

Obviously in many ways this is metastasized into a global crisis, but how evenly spread is the crisis across the globe?  We’ve been seeing some pretty ugly news out of Europe.  Which  parts of the world are most vulnerable, and which are best buffered?

Certainly European banks are very vulnerable, for a variety of reasons. They bought a lot of the securitized debt, there is a bursting of housing bubbles in the UK, Ireland, Spain, even in Italy, Portugal, and France. There is the beginning of a recession in the Eurozone. The liquidity credit crunch in the United States is negatively affecting liquidity conditions in Europe. Plus European banks are exposed to Eastern Europe, Scandinavian banks are exposed to Iceland, Lithuania, Latvia, and Estonia-which are on their way to a hard landing. German and Austrian banks are exposed to countries in southern Europe like Hungary, the Czech Republic, Romania, Bulgaria, and Turkey-and they all look shaky. On top of all that the Fed at least has been cutting the Fed funds rate aggressively, while the ECB [European Central Bank] was first on hold and then they hiked from 4 [percent] to 4.25. They’re going to cut them soon enough, but it’s too little, too late. So the Eurozone and the rest of Europe is already in a recession, and it’s getting worse, and now it’s hit by a liquidity and credit crunch. And there is a crisis of confidence in European banks since several of them now from Germany, to the UK, to Iceland, to other parts of Europe, are now in trouble and need to be rescued. So the European banking crisis is getting severe.

Asia is less affected in terms of banks, even if you’ve had a couple of problems with banks in Hong Kong and there has been some nervousness there. The impact has been more on the stock market. The real economy is about to start to slow down, and hit Asian financial institutions.

Back in February, you predicted, or at least predicted the possibility, of much of what has happened.  What about the way it has actually unfolded has surprised you the most?

I predicted most of these things happening, but what has surprised me the most is the speed at which things have happened. In February, back before Bear Stearns, I wrote this piece in which I said there are a couple major broker-dealers that could go belly-up and that in a couple years there won’t be any major independent broker-dealers left, because I knew that their business model at this point was fundamentally flawed. But I said two years. Instead it took literally seven months, for first Bear Stearns to go, then Lehman, then Merrill merged with Bank of America, and now Morgan Stanley and Goldman Sachs have been forced to convert to bank holding companies. At that point people thought I was a lunatic to say two years, but it took seven months. In the last months we’ve had an acceleration of the collapse of the financial system. We had to go to a $700 billion package, but even that has not restored calm in the stock market, and it has not restored any calm in money markets or credit markets. The last few weeks since the proposal passed, interbank spreads have widened, TED spreads [the spread between interest rates on interbank loans and those on U.S. Treasury bills] have widened, credit spreads have widened, CDS [credit default swaps, essentially a kind of insurance on credit products] spreads have widened, and now there is even a run on commercial paper for corporations. So everything has gotten much worse. There is a generalized loss of confidence like we’ve never seen before. That was something that even somebody as bearish as myself wouldn’t have thought would happen so quickly.