Is the United States Banking System Effectively Insolvent?
If you don't know who Nouriel Roubini is, you should.
Roubini made a name for himself by correctly predicting the housing bust and deep recession that we currently find ourselves in.
Nouriel Roubini is a professor of economics at the Stern School of Business at New York University. He has been given the nickname "Dr. Doom" due to his incredibly pessimistic views on the future of the global economy.
That being said - his pessimistic views have largely come true, leading some to call him a "prophet" and "sage". His views are respected and he has appeared before Congress and the World Economic Forum.
How accurate his predictions were.
One of his quotes taken from a September 2006 speech to the International Monetary Fund: "In the coming years, the United States will likely face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession."
He said that he saw "homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unraveling worldwide and the global financial system shuddering to a halt." Roubini has become an adviser to a number of central bank governors and finance ministers.
Roubini now says that global equities will fall "20 percent" from current levels due to a slowdown in China's economy.
He says that despite recent data to the contrary, China is in a recession and this will have dire consequences for economies and markets throughout the world.
So where would that leave the S&P 500, Nasdaq and DJIA if Roubini's prediction comes true?
DJIA is currently at 8,122.50
Nasdaq is currently at 1,465.49
S&P 500 is currently at 827.50
If all three averages receive a 20% haircut over the next year, then:
DJIA would be at 6,498
Nasdaq would be at 1,172.39
S&P 500 would be at 662
What do you think? Will Roubini continue to be right?
Or will the markets put in a bottom this year and start to recover?
"The United States banking system is effectively insolvent," Roubini said.
The banking industry bridles at such broad-brush analysis. The industry defines solvency bank by bank, and uses the value of a bank's assets as they are carried on its books rather than the market prices calculated by economists.
"Our analysis shows that the banks have varying degrees of solvency and does not reveal that any institution is insolvent," said Scott Talbott, senior vice president of government affairs at the Financial Services Roundtable, a trade group whose members include the largest banks.
Edward Yingling, president of the American Bankers Association, called claims of technical insolvency "speculation by people who have no specific knowledge of bank assets."
"In a more severe recession, it will take $1 trillion or so to properly capitalize the banks," said Johnson, an economist at the Massachusetts Institute of Technology.
At the end of January, the IMF raised its estimate of the potential losses from loans and other credit securities originated in the United States to $2.2 trillion, up from $1.4 trillion last October. Over the next two years, the IMF estimated, United States and European banks would need at least $500 billion in new capital, a figure more conservative than those of many economists.
Still, these numbers are all based on estimates of the value of complex mortgage-backed securities in a very uncertain economy. "At this moment, the liabilities they have far exceed their assets," said Posen of the Peterson institute. "They are insolvent."
Yet, as Posen and other economists note, there are crucial issues of timing and market psychology that surround the discussion of bank solvency. If one assumes that current conditions reflect a temporary panic, then the value of the banks' distressed assets could well recover over time. If not, many banks may be permanently impaired.
"We won't know what the losses are on these mortgage-backed securities, and we won't until the housing market stabilizes," said Richard Portes, an economist at the London Business School.
Raghuram Rajan, a professor of finance and an economist at the University of Chicago graduate business school, draws the distinction between "liquidation values" and those of calmer times, or "going concern values." In a troubled time for banks, Rajan said, analysts are constantly scrutinizing current and potential losses at the banks, but that is not the norm.
"If they had to sell these securities today, the losses would be far beyond their capital at this point," he said. "But if the prices of these assets will recover over the next year or so, if they don't have to sell at distress prices, the banks could have a new lease on life by giving them some time."
That sort of breathing room is known as regulatory forbearance, essentially a bet by regulators that time will help heal banking troubles. It has worked before.
In the 1980s, during the height of the Latin American debt crisis, the total risk to the nine money-center banks in New York was estimated at more than three times the capital of those banks. The regulators, analysts say, did not force the banks to value those loans at the fire-sale prices of the moment, helping to avert a disaster in the banking system.
In the current crisis, experts warn, banks need to get rid of bad assets quickly. The Treasury's public-private investment fund is an effort to do that.
But many economists and other finance experts say that the government may soon have to move in and take on troubled assets itself to resolve the credit crisis. Then, they say, the government could have the patience to wait for the economy to improve
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