11/2007-2/2008: Nouriel Roubini on mark to market accounting

Excerpt from Liquidity and Credit Crunch in Financial Markets is Back to Summer Peaks, Only Much Worse and More Dangerous
By Nouriel Roubini

The credit boom and easy liquidity of the 2001-2006 period led to a massive releveraging of households, financial institutions and parts of the corporate sector in a credit boom that became a credit bubble and where we observed a Minsky credit cycle where asset prices went into bubble territory given the credit leverage. Now, capital losses, credit crunch and reintermediation is leading to the unraveling of this credit house of cards. Using analytical models developed by research scholars - such as Adrian and Shin - Goldman Sachs estimated that losses in the $400 billion range ($200 b among financial institutions) will lead to a deleveraging of credit of the order of $2 trillion. The overall deleveraging could be higher than that as a variety of institutions (financial and others including households and corporate firms) that will experience a hit to their balance sheet and net worth will have to start deleveraging their balance sheets. Indeed, the latest data suggest that corporate earnings have already fallen 8.5% in Q3 2007 relative to the third quarter of 2006.

Such academic and analytical research also suggests that illiquidity that forces fire sales of assets – of the sort we are starting to see in financial markets - has contagious effects from one financial institution to the other causing a chain of losses that can become systemic and exacerbate liquidity and capital losses (while implementation of FASB 157 will not prevent the past fudge of marking to model rather than marking to market such illiquid and impaired assets). So a contagious unraveling of the Minsky Credit Cycle is now underway.

And now a perverse cycle of financial conditions and credit crunch worsening leading to a worsening of the real economy and, in turn, a worsening of the real economy increasing the financial losses and worsening the liquidity and credit crunch is creating a vicious circle that has significantly increased the likelihood of a now effectively inevitable US recession and of a global economic slowdown. Bernanke and Mishkin know a lot about the “credit channel” and “financial accelerator” effects as they have extensively written about these in their former academic life. This vicious circle is leading to fall in asset prices, fall in net worth, deleveraging, tightening of the quantity and price of credit and fall in durable and non durable spending by households and financial and corporate firms that, in turn, will worsen the financial conditions.

Excerpt from The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial Disaster By Nouriel Roubini

Twelfth, a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices will ensue leading to a cascading and mounting cycle of losses and further credit contraction. In illiquid market actual market prices are now even lower than the lower fundamental value that they now have given the credit problems in the economy. Market prices include a large illiquidity discount on top of the discount due to the credit and fundamental problems of the underlying assets that are backing the distressed financial assets. Capital losses will lead to margin calls and further reduction of risk taking by a variety of financial institutions that are now forced to mark to market their positions. Such a forced fire sale of assets in illiquid markets will lead to further losses that will further contract credit and trigger further margin calls and disintermediation of credit. The triggering event for the next round of this cascade is the downgrade of the monolines and the ensuing sharp drop in equity markets; both will trigger margin calls and further credit disintermediation.