Regular dose of pessimism

Every once in awhile you've gotta go over to Nouriel Roubini's blog for the latest pessimistic outlook on the economy. In his latest post, he asks whether the U.S. has reached the peak of a Minsky cycle:

Specifically, the crucial macro question that we should ask ourselves today is whether we are at the peak of a Minsky Credit Cycle. Or as the UBS economist George Magnus – an expert of financial instability - put it: “Have we reached a Minsky moment?”

Hyman Minsky was an American economist who died in 1996. His main contribution to economics was a model of asset bubbles driven by credit cycles. In his view periods of economic and financial stability lead to a lowering of investors’ risk aversion and a process of releveraging. Investors start to borrow excessively and push up asset prices excessively high. In this process of releveraging there are three types of investors/borrowers. First, sound or “hedge borrowers” who can meet both interest and principal payments out of their own cash flows. Second, “speculative borrowers” who can only service interest payments out of their cash flows. These speculative borrowers need liquid capital markets that allow them to refinance and roll over their debts as they would not otherwise be able to service the principal of their debts. Finally, there are “Ponzi borrowers” cannot service neither interest or principal payments. They are called “Ponzi borrowers” as they need persistently increasing prices of the assets they invested in to keep on refinancing their debt obligations.

The other important aspect of the Minsky Credit Cycle model is the loosening of credit standards both among supervisors and regulators and among the financial institutions/lenders who, during the credit boom/bubble, find ways to avoid prudential regulations and supervisions.

Minsky’s ideas and model fit nicely the last two US credit booms and asset bubbles that ended up in a recession: the S&L-based real estate boom and bust in the late 1980s; and the tech bubble and bust in the late 1990s. But the experiences of the last few years suggest another Minsky Credit Cycle that has probably now reached its peak. First, it was the US households (and households in some other countries) that releveraged excessively: rising consumption, falling and negative savings, increased in debt burdens and overborrowing, especially in housing but also in other categories of consumer credit, an increase in leverage that was supported by rising asset prices (housing and, more recently, equity). We know now that many sub-prime borrowers, near-prime borrowers and many condo-flippers were exactly the Minsky “Ponzi borrowers”: think of all the “negative amortization mortgages” and no down-payment and no verification of income and assets and interest rate only loans and teaser rates. About 50% of all mortgage originations in 2005-2006 had such characteristics. Also, many other households (near prime and subprime borrowers) were Minsky “speculative borrowers” who expected to be able to refinance their mortgages and debts rather than paying a significant part of their principal...

We are clearly now observing a significant worsening in US financial conditions and a peaking of the Minsky Credit Cycle in a variety of markets:
- a housing recession that is getting worse by the day and home prices now falling (for the first time since the Great Depression) as the housing asset bubble has now burst.
- a credit crunch in subprime that is now spreading to near prime (Alt-A) and prime mortgages (see the Countrywide financial results) and to subprime credit cards and subprime auto loans;
- massive losses - at least $100b in subprime alone and most likely to end up higher – in the mortgage markets;
- a significant recent increase in corporate yield spreads (by 100 to 150 bps);
- the beginning of a liquidity crunch in capital markets that starts to look like the one experienced during the LTCM crisis (10 year swap spreads are - at 70bps - at their highest levels since 2002 and close to the levels that triggered the 1998 LTCM crisis);
- the effective shut down of the CDO and CLO markets as investors risk aversion towards complex derivative instruments - whose official ratings are clearly bogus given the subprime ratings debacle - is sharply up;
- up to 40 LBO deals now in serious trouble (restructured, postponed or cancelled) as the credit crunch is spreading to the leveraged loans and LBO market;
- the overall increasing stresses in a variety of credit markets ("a constipated owl" where "absolutely nothing is moving" is how Bill Gross of Pimco described the effective recent shutdown of the CDO market);
- credit default swap spreads being sharply up;
- the ABX, TABX, LDCX, CMBX, CDX, iTraxx indices all showing rising risk aversion of investors, sharply rising credit default spreads and significant concerns about credit risk in a variety of credit markets (US, Europe and Japan corporate, high yield corporate, commercial real estate, leveraged loans), not just in subprime or in mortgage markets.

Of course, last year Roubini predicted that the U.S. would be in a recession by now, so maybe he's being chicken little. Or maybe he's just off by a few months.

So far the Dow is down 800 points in the last two weeks. One gets the sense that this is a different type of "correction" from the one in February.