American Enterprise Institute

October 30, 2008

[Edited transcript from audio tapes]

1:45 p.m.	Registration
2:00	Panelists:	Desmond Lachman, AEI
		John H. Makin, AEI and Caxton Associates
		Nouriel Roubini, New York University
		R. Christopher Whalen, Institutional Risk Analytics
		Thomas Zimmerman, UBS Investment Bank
	Moderator:	Alex J. Pollock, AEI
4:00	Adjournment

Proceedings:

American Enterprise Institute

The Deflating Mortgage and Housing Bubble
Part IV: Where Is the Bottom?
October 30, 2008

Alex J. Pollock:  -- and welcome to “The Deflating Mortgage and Housing Bubble IV” in our series.  I’m Alex Pollock, a resident fellow at the American Enterprise Institute, and we have the same outstanding panel that we have previously had for our Deflating Bubble series, which by the way, we fully intend to continue next spring with Deflating Bubble V, because this will all still be going on by the spring.

Now this panel has previously brought you notable insights into and accurate pessimistic forecasts of the problems of what happens when you have the collapse of a really big financial bubble which we had, of course, centered on mortgages but by no means limited to mortgages.  This conference is co-sponsored by the American Enterprise Institute and the Professional Risk Managers International Association, which is represented today by Chris Whalen who is on the other end down there, and Chris has been my partner in putting these together.

Before I introduce the panel, I want to share a few thoughts.  We have the subtitle today as “Where Is the Bottom?”  Something we’d all like to know.  I’ve seen a number of forecasts that suggest mid-2009 as a bottom for house prices and mortgages; Jeremy Grantham is at 2010.  Where the bottom is, is quite complicated by the fact that we now have a recession beginning and there will be, I guess, what the Fed calls the adverse feedback loop between the real economy and the financial system.  But as to where is the bottom, we’ll see what the panel says.

An interesting fact about this bust is according to National Mortgage News, that federal lawsuits filed relating to the mortgage problems now exceed the total of lawsuits filed from the savings and loan crisis of 20 years ago.  So as always, we know that a certain class of people benefit from any set of problems.

So to begin with, let’s look at the bubble.  This is the Case-Shiller National House Price Index over its entire life at which it’s been calculated starting in 1987 and running up to almost the present.  This particular index they publish quarterly so the last real point up there -- I’m just going to get this to work -- that one is the second quarter 2008.  Here’s the peak in mid 2006, and that red line is simply the trend line drawn through the whole previous series up to 2000.  And if you just put a trend line through that and stretch it out, you can see, as we all know, how far the prices and there are some argument of course over which price index is best but they have this pattern, this huge departure from the mean.  And so if in a simple-minded way, we say, well, now we’ve corrected about 18 percent downward from the mid-2006 peak.  And if you think that you’re going to meet back up with the trend line in a year or so, that would suggest about another ten percent that is ten percent of the peak prices to go, so that would be one way to look them.

This is, as those of you who know may know The Plank Curve.  The Plank Curve is the behavior of risk-averse short-term investors and short-term lenders when we pass a threshold of fear and uncertainty and what results is -- a kind word for it is a discontinuity.  That is to say a disappearance of short-term credit from the market and that’s what we’ve been experiencing over the last year.  The theme that goes with this Plank Curve picture is a cartoon that I found in James Grant’s new book, Mr. Market Miscalculates, and the cartoon shows a good-looking young guy, obviously a Wall Street type but he is looking very harassed and he is on the phone and he’s saying, “Okay, okay.  I’ll try it again.  Please, please, Mr. Margin Clerk sir, would you extend my loan?”

Now this next one is the inverse of the Plank Curve.  So if short-term credit is withdrawn from assets that are going to private parties, this “L” on its side here -- I hope you can all see this vertical line over here that happens in 2008 -- is deposits with Federal Reserve banks not counting reserve balances.  So what are people -- and look at here, these little bumps -- I'm trying not to shoot you here, Chris -- but these little bumps are little things like the ‘80s crisis, and then we’ve got this thing up here.  So what this is, is well, we’re not putting the money out in the market.  We want to hold our money in the form of liabilities of the central banks, so this is the institutional equivalent of putting your currency in the mattress and thinking of that brings us to the combined balance sheet of the 12 Federal Reserve banks, and what I have done here is just compared the last date in July before the August 2007 panic with October 15th of this year.  As it has been well publicized, assets of the Federal Reserve banks have doubled from about $800 billion to a trillion seven.  This next line is the treasury bills and this -- oops, sorry – the treasury bills in this balance sheet, obviously shrinking nearly to nothing and then, of course, other kinds of credit that didn’t exist before including Maiden Lane, LLC which is the portfolio taken over from Bear Stearns.

If you look down another line, to this number, this is deposits with the Federal Reserve by banks and this is where you see the number that goes with that “L” on its side with just keeping your money in the bank.  And then I thought it would be fun to calculate the leverage of the Federal Reserve banks, since of course, their assets are greatly outstripping their capital and they have run their leverage up from 26 to 42 times.

This is just a little history of what I consider to be bailout slogans.  We had Bear Stearns of which the slogan is too interconnected to fail which I think is legitimate.  We had Fannie Mae and Freddie Mac, which was, note, an intervention to save and intervention since Fannie Mae and Freddie Mac were themselves, government interventions created to help the mortgage market so that now we needed a big intervention to save the intervention.  We had AIG which I say the slogan is “punish the equity but protect the creditors.”  Washington Mutual, “punish the creditors and save the FDIC fund.”  I had some interesting conversations recently with European investors who owned Washington Mutual senior bonds and simply couldn’t believe that they were taking the trimming that they are. 

And finally, the Paulson Plan which started off, as we all know, as a buying-assets plan and turned into a recapitalizing plan, which I had myself recommended and agree with but there is a question, and my question up there, I hope you can see is, “What is Jessie Jones?”  And for those of you don’t know who Jessie Jones was, he was in his day, one of the most powerful men in the country.  He ran the Reconstruction Finance Corporation during the 1930’s when they were recapitalizing the banks and they made preferred stock investments and around 6000 banks during the 1930’s.  And to do that well, you have to have somebody running it who is knowledgeable, hard-minded, and a tough old guy which Jessie Jones was.  Well, I’ll just leave that question hanging in the air.  Where is the Jessie Jones who is going to run all this?

Turning to our excellent panel, we’ll hear first from Desmond Lachman, a Resident Fellow at AEI, having previously worked as an economic strategist on Wall Street.  Desmond’s research includes global currencies, emerging markets, multilateral lending institutions, and of course the housing bubble.  He and I have been reinforcing each other’s bearish outlook on this now since 2006 at least and his pessimistic analysis have been correct including his long-ago call that the housing bust would be a major issue in the 2008 presidential election, and here we are.

Next will be Nouriel Roubini, who is a professor of economics at the New York University Stern School of Business, as well as Chairman of Roubini Global Economics.  He served as the senior economist for international affairs at the Council of Economic Advisers, among many other assignments.  He has written and spoken provocatively as a “super bear” on the housing bust, was the first to predict that losses and write-downs out of this generalized deflation of the financial bubble would exceed $1 trillion in losses and you heard it here and that was a call far in advance of others who have subsequently also made that prediction.

Tom Zimmerman will be our third speaker, bringing us fixed income securities market perspectives.  Tom is a Managing Director at UBS Investment Bank, where he manages mortgage credit and asset-backed securities research, and he knows the most about the inside of mortgage securities of certainly anybody I know.  His research has appeared in numerous fixed-income reference works, a member of the UBS team voted first in the Institutional Investor survey and he continues to present exceptionally detailed and insightful looks into the inside of the MBS world.

Our fourth speaker will be Chris Whalen, Senior Vice President and Managing Director of Institutional Risk Analytics.  Chris brings his experience as an investment banker, research analyst, and journalist, including on both the equities and fixed income side as well as risk management.  As I mentioned, Chris has been my partner in organizing this series of conferences and it’s really a pleasure to work with him.

Our last speaker will be John Makin, who is both a visiting scholar at AEI, where he writes the very insightful monthly Economic Outlook, which the latest is entitled Panic, I believe.  John?  More Panic.  More Panic.  Panic was the one before and now we have More Panic.  John is also a principal at the investment firm of Caxton Associates.  He has been an adviser to various U.S. government agencies, the Federal Reserve and the Bank of Japan.  He is the author of numerous books and articles, and the author of the prediction that the housing bust would lead to a recession which has now indeed started.

Each member of the panel will speak from 12 to 15 minutes.  After that we will give them a chance to react to each other.  Then we will open the floor for your questions, and we will adjourn by 4 o’clock or whenever your questions run out, whichever happens first.  Well, thank you all again for being here.  Desmond, you have the floor.

Desmond Lachman:  Thank you very much, Alex, and thanks once again for arranging this and I really have to give you credit again, you and Chris, for having foreseen this as long ago as March of 2007.  You saw this coming in a big way, and I recall at that time, Ben Bernanke was just beginning to figure out that there might be a minor problem with subprime mortgages.  I’ve got very mixed feelings about being on a panel like this that has been right and I’m reminded pretty much of the story in England when Edward Heath -- a rather angular looking figure -- was elected Prime Minister, not the most competent.  They asked a cartoonist, what was his reaction, and his reaction was that as a private citizen he mourned but as a cartoonist he rejoiced, and I feel the same way as a forecaster.

I’m not going to leave you in any suspense about the basic question as to where I am on the issue.  I’ve titled this Far From a Housing Market Bottom.  I guess I take issue with Alex in looking at a trend and expecting that we’re just going to be returning to the trend.  I would just make the argument and I’ll try to elaborate it going forward.  That in the same way as we could have overshot fundamental values by perhaps 80 percent, there’s no logical reason why we’re not going to undershoot, and what I’ll try to explain is that there are dynamics involved here that can really just take us to the lowest side, and my view is that unless there’s government intervention of a big scale in the housing market, we’re really not going to bottom.  That this thing is just going to keep melting down and this has really by now it should be clear that this has really got grave implications for asset price deflation and the deleveraging process that we’re in.

Now the reasons that I’m rather sure that the housing market doesn’t bottom anytime soon is that there are many factors forcing it down, that the first of the factors that I say is just the economic condition.  Since we’ve met last, there’s no question now that the economy is going in for a deep recession; that unemployment’s going to be rising above eight percent, probably by end of next year.  So the basic conditions for housing demand aren’t there.  At the same time there’s a huge amount of inventory overhang that is weighing on this market, the market’s not clearing.  The third reason that I’m going to be substantiating is that we’ve now got a massive problem with foreclosures and that the market’s not that stable in the sense that as prices go down, we get negative equity, we get foreclosures.  Foreclosures drive the price lower and we’re just in another one of these vicious cycles.  And the last point that I’ll be making is that mortgage finance has certainly dried up in the private sector and even Fannie and Freddie, what’s occurring is that mortgage rates, if you can get mortgages, are at higher rates than before.  So I see no reason why house prices don’t continue falling.

Let me just take each of those points in turn just in terms of the recession that I think the process as I see it is that we’re in the grips of a major asset price deflation; which you can see in the first chart that I’ve put up there is equities down globally or down by something like 50 percent from their peak.  If I look at the next chart, that looks at it in relation to GDP.  What we’ve done is we’ve just wiped out something like 50 percent of GDP in wealth just through the equity market.  If I add to that the amount of wealth that has been destroyed through housing and through lower bond prices, I’d come up with a figure something like 80, 90 percentage points of GDP has been wiped out.  If I apply the usual Fed  model that there’s something like four cents on the dollar, that’s something like three-and-a-half percentage points of GDP reduction and consumption right there.  But I don’t believe in those kinds of models.  I think that we’re out of sample and I think that when you get such a dramatic reduction in wealth, I’d be very surprised if you don’t get a more severe downturn in consumption than the four cents on the dollar is worth.

At the same time that we’ve got this asset price deflation, we’ve got a major problem in the financial sector, and just to put it into perspective, I thought this chart from one of the IMF’s reports, it’s rather instructive.  It’s telling you they’re looking at -- the U.S. they’re looking now at $1.4 trillion of losses by the time that this is all over.  And if you look at it even in relation to GDP, it dwarfs anything that we saw in the savings and loan.  That we’re looking at something that’s becoming very comparable to what we saw in Japan.  So this is a major credit market event, this is a once-in-a-hundred-year kind of event that is very likely to crush growth.

You see it as well in this chart; it’s just showing that this is before the October events that bank credit already was contracting at the fastest rate in the post war period.  And I’m sure John Makin will tell me that that’s irrelevant when you look at the whole of the securitization market is totally bust, so that the shadow banking system’s not pumping out credit as well.  So if you’re getting a credit crunch at the same time as you’ve got asset price deflation, you’ve got to expect the economy to ready decline.  It looks to me as if it’s baked in the cake that even -- you’re going to be getting the recession, rising unemployment and that’s not too good for house markets.

Just the last thing is just getting the spreads on corporate bonds are just blowing out, so the fact that the Fed is reducing interest rates to one percent, in my view, is neither here nor there.  If the spreads are so high and people are having -- if they can get credit, they are having to pay higher rates than they were before, that’s hardly supportive of the economy.  So that’s the first reason that I think house prices fall.

The second is, this is the Case-Shiller index.  It came out yesterday.  When I look at a chart like this, I don’t see any sign -- this goes through August -- I don’t see any sign that the second derivative is moving in the right direction.  That this just looks to me like it’s very much in a freefall and while that is occurring, that we might be coming back to the trend that Alex is mentioning, this red line is what the forward prices show.  The forward prices are telling you, on the Case-Shiller, is that house prices are going to be falling another 15 percent, but I’m not sure that I would buy that.  I think that we’re going to see more because what is occurring that even though housing starts -- that’s the green line -- are going down a lot, and the inventories of unsold houses are now something like 11-month supply so you’ve probably got a million houses overhanging the market at a time that demand is declining.

Next, let me just quickly go to the foreclosure story that ran about, there are various estimates but something like one in three households by now have got negative equity in their homes so they don’t really have an incentive to service the mortgage.  And what we’re just seeing is we’re just seeing delinquencies, these are different vintages of prime Alt-A and subprime.  And if you’re just looking at the line on the extreme, it’s 2007, the amount of delinquencies are just literally doubled what they were before for the stage at which they’re in right now, and what you’re getting is you’re just getting foreclosures surging.  So that foreclosure procedures initiated now are running at something like three million units a year so I would think that what’s occurring is those houses come back on the market, they push the prices down.  You get the negative equity increasing so you get more foreclosures.  So we’re somewhat in a vicious cycle and that’s the reason why I think that we’ve got to get some kind of intervention to stop it.

Lastly, the mortgage financing has dried up.  That you’re just not getting lending by the private sector and then the mess that we’ve had Fannie and Freddie going back and forth doesn’t look like there’s too much lending coming out of them either.  And when I look at the mortgage interest rates, the black line is for the jumbo loans, it’s rising at a time that economic conditions are crumbling.  So bottom line is I think that there needs to be intervention on the housing and I think that the only really interesting question is, how do you do that intervention?  Do you change contracts?  Do you buy the mortgages like the Home Loan Corporation?

I’ll just end with one last thought is that I think that stabilizing the housing market, I think this is a point that Marty [indiscernible] keeps making and I think that he is right about it.  Stabilizing the housing market is a necessary condition for stabilizing the economy.  But I would be very quick to add that it’s nowhere near a sufficient condition.  What we’re going to need is we’re going to need stabilizing of the housing market through unorthodox means, coupled with a massive fiscal stimulus packaged, coupled with monetary policy accommodation and then we might have a chance of not having what I think is baked in the cake for the first and second quarters of next year, morphing into something a lot more horrible to contemplate.

Alex J. Pollock:  Thank you.  Nouriel.

Nouriel Roubini:  Well, Desmond called it very well.  I think, many aspects of why things are getting worse rather than better in the housing market and I share his outlook and pessimism.  I would like to elaborate on the broader picture about what’s happening in the economy and the financial markets.  I’ve been saying for a while this will be the worse financial crisis the U.S. has experienced since The Great Depression.  It looks like the worst one.  I don’t think that anything has happened since The Great Depression looks so severe.  Of course, the real economic consequences in terms of output contraction aren’t going to be as bad as The Great Depression because there is a massive amount of policy action but in terms of financial shock, I mean, what has happened in the last few months is really quite unbelievable.  Every other week a major financial institution going belly up.

The other observation is that while we’re talking about subprime mortgages and housing, I think there is a growing recognition that this was not just a subprime mortgage problem where there’re much more generalized asset bubble and credit bubble in the economy -- was subprime, was near prime, was prime mortgages -- there were massive excesses also of underwriting and commercial real estate, the boom and the indebtedness of the household sector.  Include also unsecured consumer credit like credit cards, auto loans, student loans with all these other excesses in the corporate sector coming from; LBOs that should have never occurred financed by these leveraged loans, a trillion plus of LBOs with debt to equity ratios that do not make any sense; excesses of borrowing also by municipalities.  During the last real estate recession, money bonds were trading like junk bonds because there are many municipalities going belly up, same thing’s going to happen right now.

And even in the corporate sector, that it was, on average, in better shape than the household sector.  There was [indiscernible] of corporates that were highly indebted with little profits.  They issued a huge amount of junk bonds and corporate default rates that have been very, very low, for the last couple of years are going to be surging in a major way.  And once these major surges of corporate defaults start to occur, this is another huge time bomb of the CDS market where about $55 trillion of nominal protection has been sold against an outstanding stock of only $6 trillion of corporate bonds. 

So when you add it all up, as you remember, I’d estimated that the losses will be at least a trillion dollar and more likely close to $2 trillion.  At that time people thought I was exaggerating but of course, a few weeks later IMF came with an estimate of $945 billion then Goldman Sachs $1.1 trillion then John Paulson said $1.3 trillion then IMF revised their estimate to $1.4 trillion.  Most recently, Bridgewater Associates said that the loss is going to be $1.6 trillion.  So we don’t know how large they are going to be.  What we do know is that the $1 trillion number at this point is not the ceiling, it’s just barely a floor and the losses are going to be much more. 

And there’s also implication for, of course, for TARP program and the recapitalization of the bank because if all these losses are going to occur, the idea that they are injecting only $250 billion into the banking system, financial system is going to do the job I think is very far-fetched.  I think the eventual number is going to be more like $600 billion, $700 billion especially now that it is just not the banks but also broker-dealers, insurance companies.  Soon enough the financing arms of GMs and GEs, and you name it whatever. 

So the size of the problem is huge.  And of course, there is this vicious circle that has been discussed between the financial shock leading among other reasons today, economic contraction, and now with the economic contraction occurring then the financial losses, the credit losses, the delinquencies for households and corporate arising making their financial strains even more severe.

This leads me to the second point, that is, we are in a very severe recession in the United States.  I’m not going to go into the detail of it but I do believe that this is going to be the worse economic contraction that U.S. has experienced for the last few decades.  The typical U.S. recession lasts about ten months.  The last two lasted only eight months each.  The 2001 recession, actually contraction of outputs from the peak was only 0.4 percent.  For the average recession, it’s has been at less than two percent.  I fear this is going to be a cumulative form of output of the order of four to five percent and the worse we’ve add in the last 50 years.  We have eight quarters of contracting output and they put the beginning of this economic contraction, the first quarter of this year. 

And as pointed out essentially by Desmond, this housing recession is not bottoming out.  The production of new homes in terms of starts has fallen sharply but demand, until recently, had fallen even more.  Therefore this excess of supply of inventory of new existing homes kept on becoming larger and that put downward pressure on home prices.  Based on Case-Shiller, home price have already fallen by about 20 percent from the peak, given the excess supply and a number of other factors, I would expect home prices are going to fall another 20 percent for a cumulative fall of 40 percent from the peak.  Now, in 1991, that cumulative fall based on Case-Shiller was only five percent and now we’re going to have 20 and another 20, 40, something we have not seen since The Great Depression.

Now this fall in home prices is important for three reasons as long as it occurs, residential constructions are going to keep on falling, in absolute terms, as a share of GDP.  Secondly, there is the huge wealth effect coming from a fall of $6 trillion of housing wealth.  But most important factor I think that is right now ongoing is that with such a fall in home prices, by the end of next year about 40 percent of all households with a mortgage are going to be underwater; negative equity with the value of their homes below the value of the mortgages, so about 21 million out of the 51 million houses that were mortgaged.  And there’s a huge incentive to walk away from your home because the U.S. mortgages are not a course loans [sounds like].

Now not everybody’s going to walk away.  Let’s be even conservative.  Let’s assume that only one out five people that are underwater are going to walk away, if you do the math -- I’m not going to go into detail of it -- you get additional losses for the financial system of the order of $400 billion.  This is on top of all the other write-downs that have already been made through subprime [indiscernible] write-down so that’s another huge loss for the financial system.  This is just assuming that only one out of five people underwater are going to walk away.  If it’s more like 40 percent, then the loss is another $800 billion.  So you’re in a situation in which you can wipe out a good chunk of the capital of the financial system.  So that’s what we are observing.

The other important point to put things in the global context, I think, is that while six months ago, it looked like the U.S. economy is undergoing an economic contraction, starting with the second quarter of this year -- so even before the major financial shock of September or October occurred and these financial shock are now making credit conditions even more tight but even before then, if you look at the second-quarter data, Euro zone growth was becoming negative, U.K. growth was becoming negative, Canadian growth was becoming negative, same in New Zealand, same for Japan, same for most of the other advanced economies.  About 60 percent of GDP -- that is most of the GDP of the advanced economy was already contracting in the second quarter of this year.  This is before these other shocks are going to make these things more severe. 

At this point, it looks like we’re not going to have just the U.S. recession or advanced economies recession.  We’re also going to have a global economic recession because there is a massive amount now of recoupling in financial markets and also in real economies, also among emerging market economies.  Of course, the recoupling in financial markets has already called big time equity prices in Europe and emerging markets have fallen even more than United States.  But now you see a significant challenge of transmission to emerging markets, creative channels, financial channels, currency channels, commodity channels, confidence channels, the massive slowdown of growth, and I would estimate that already in the third quarter of this year and certainly by the fourth quarter, global GDP growth measured at market prices are going to already be negative.  So we’re going to have a global economic recession.  And by the way, within the emerging markets, there are about a dozen economies that are now on the verge of a financial crisis taking emerging European countries like Latvia, Estonia, Lithuania, Hungary, Bulgaria, Romania, Turkey, Belarus, Ukraine, and going to Asia, travel to Pakistan, Indonesia, and Korea, going to Latin America, travel to Argentina, Ecuador, Venezuela, just to name a few.  So this is a global economic recession.

Now going back to the financial market, the other thing that [indiscernible] kind of a matter of concern, there is a bit of a disconnect right now, a thing that is worrisome between the more and more aggressive policy actions that the policy authority are taking, I would say even going the right direction, and the fact that the markets have seem to lose confidence in the ability of the policymakers do the right thing.

I will give you a couple of examples.  When the bailout of the creditors of Bear Stearns occurred in March and then we created the TSLF and the PCCF that essentially bailed out the broker-dealers, providing them with liquidity for the first time since The Great Depression, through the Feds, there was a rally in the stock market, in the money market and in credit markets.  That rally lasted about eight weeks.  Then when trouble started to occur in July with Fannie and Freddie, and Hank Paulson went to Congress says, “Give me the power of the bazooka.  If you do, I’m not going to have to use the bazooka but given that power is going to stabilize Fannie and Freddie.”  There was also a rally, it lasted about four weeks.  Then in early September when Paulson had to use the bazooka and actually bailout and essentially make public $6 trillion of assets and liabilities of Fannie and Freddie and inject a couple of hundred billion dollars, there was a rally; it lasted one day, on that Monday after the bailout.  By the next day as you remember, the panic was about Lehman.  And then the next week when the collapse of AIG and the bailout of AIG occurred, there was not even a rally.  On that Wednesday as you remember, it was utter panic and market fell five percent. 

Then they went for the TARP legislation.  You’d expect that that would improve the markets.  On the Thursday after the Senate passed it and on the Friday the next day when House passed it, stock prices fell sharply both on Thursday and Friday.  And at the following week when the Fed was doing all the new option, doubling and tripling the TF, the TSLF, the swap lines, coordinated policy reduction, the new commercial paper facility, it was a slaughter.  Monday, Tuesday, Wednesday, Thursday, Friday, market fell that week by 20 percent.  By that Friday before the IMF meeting we’re literally one afternoon away from a systemic financial meltdown.  At that point, the policymakers got religion [sounds like] they realized that this step-by-step, ad hoc, approach to managing the crisis is not making sense and they started doing something more systematic. 

So you have the G7 Communiqué and then the U.S. Summit [sounds like].  Now what did they decided?  They decided, first of all, that no systemically important financial institution is going to be allowed to fail, i.e., they decided that they had made the mistake letting Lehman go.  Secondly they said they were going to provide unlimited liquidity to the financial system as a way to unfreeze this kind of liquidity crunch.  Three, we’re going to recapitalize financial institution with public money, these preferred shares.  Four, we’re going to guarantee a wide variety of liabilities of the banking system that poses new debts, maybe the interbank lines.  And fifth, we’re going to do everything that is necessary to avoid the systemic financial meltdown.  Now, massive aggressive policy response.  The market rally on that Monday, for a day, ten percent.  And then a slew of lousy news about the economy, that markets fall all of that week and then the last week it was all the slew of bad earnings, news in market became worse and worse and worse.  And just the other day when the market went up ten percent, what were the good news that day?  That consumer confidence collapsed like never before in 50 years and the Case-Shiller number was still showing a freefall of the market. 

What that tells me is that, currently, financial markets are dysfunctional.  Fundamentals don’t matter.  Evaluations don’t matter.  It just flows.  And in most days, what has happened for the last couple of weeks in spite of this major policy effort has been that there is a flow of sellers and there are not that many buyers and most days, markets are falling very sharply.  So, it’s becoming a really dysfunctional financial market which even very aggressive policy action do not seem to make a difference and that’s something that worries me.

Now, why do I think that the bottom in financial market has not been reached yet?  For three reasons and I’ll conclude on that.  That first one is that I think that the flow of market economic news are going to surprise on the downside for the next few weeks and months.  People apprise [sounds like] now U.S. recession but if this U.S. recession is I believe is going to be more like 24 months rather than only eight months and it’s going to be global, then there’ll be surprises on consumption, investment, on housing, on employment, and [indiscernible] production.  Those surprises are going to be negative for the market.

Secondly I think there’ll be negative surprises also for earnings.  Not just earnings of financial firms but, also, in a severe recession, a sharp contraction of the earnings of the non-financial corporate sector.  That’s going to be a negative for the financial market.

And the third reason is that, while the sources of a systemic financial meltdown have been somehow contained, I still see a lot of potential threats to the financial system.  One is this major surge of corporate default that’s going to occur in the next year or so.  The second one is related to it, the blow up is going to occur in the CDS market as a major source of a systemic risk.  Third of all, you’re going to have hundreds of hedge funds that are going to go bust in the next few months, and while none of them is as large or as leveraged as LTCM was in 1998, if you have 300 to 600 of them going bust all at the same time and having to deleverage and sell assets in a distressed market, then the consequences are going to be negative for asset prices. 

And finally there is this other time bomb of many emerging market economies that are at risk of a financial crisis and any of them going bust could have contagious and systemic effects. And one example, take Iceland, a little, small island of 300,000 folks in the middle of the Atlantic, their banks had borrowed an amount of money was 12 times the GDP of the country to buy toxic MBS, CDOs and you name it.  Now the banks are bust.  The government doesn’t have resources to bail out the banks and these banks will have to sell in highly distressed in a liquid market a huge amount of distressed assets.  And even a small tiny island like Iceland can have systemic effects on asset prices, let alone fear of blow up of Hungary or Argentina or Korea or other economies. 

So for the last few months people have always been calling the bottom.  Every time there was a major event, they said this is the cathartic event that says the markets are bottomed out.  They said it after Bear Stearns, after Fannie and Freddie, after AIG, after TARP, after the G7 Communiqué and each time markets have rallied for a little bit and then they’ve gone further south.  Unfortunately I don’t think we’re at the bottom of the housing crisis, we’re not at the bottom of the mortgage crisis, we’re not at the bottom of the financial and banking crisis, and certainly we’re not at the bottom of this severe economic crisis.  So I’m quite still pessimistic looking ahead.  Thanks.

Alex J. Pollock:  Thank you, Nouriel.  I hope you’re all feeling better.  Just before we go ahead to Tom, I have one question, Nouriel, for you.  I think it was implied in your comments that you would recommend the entirety of the TARP, the $700 billion, be used for capital additions to financial firms, would that be a fair conclusion from your comments?

Nouriel Roubini:  Yes.  I think that the capital needs of the financial system are going to be much more than the $250 billion.  I thought that even originally the TARP, as an idea of buying at high prices, toxic assets, was a bad idea.  If you look, any history of systemic banking crises, in most cases the way you capitalized the banks is by injection of public capital either common shares or preferred shares or sub debt.  It’s really the exception, the idea of buying toxic assets so I think most of it is going to be used for that and maybe we’ll have a TARP 2 at this point, maybe need it to buy more stuff, to re-capitalize more.  I would not exclude that.

Alex J. Pollock:  Okay.  Thanks.  Tom.

Thomas Zimmerman:  Thanks, Alex.  Good afternoon everyone.  I must say, I speak at quite a few conferences and over the past several years, I’ve usually been viewed as one of the most bearish commentators at the mortgage and housing conference I go to but one of the reasons I enjoy coming here is that I am not, by far, the most -- this is a pleasure.  A little scary but it’s a pleasure.

So that light at the end of the tunnel, it may not be a train.  I’ll show you a few glimmers of hope here.  At lunch we talked about, is there any good news out there?  Well, it’s not really good news but the thing about markets, they do look a long way away and I’m going to present some data which -- keep watching for the next six months and maybe some of it will help us get through this.  It’s not conclusive the housing markets going to go down but I think there’s some data which says that there may be some turning points not that far away.  I agree with Nouriel in terms of the global disaster we’re facing but in terms of the housing market that triggered this, there are some minor, minor positives.  So let’s take a look at this.

Believe it or not, I see a couple of small positives.  I’ll qualify them but they’re small.  Existing home sales.  These things, for about ten months, they were flat, they popped last month.  Now the housing market is in shambles, it will be for a while.  But what’s happening is in some spots like Cleveland-Ohio, Stockton-California, Riverside, the year-over-year unit sales are up substantially from where they were a year earlier.  So what’s going on?  Well, a third of these or 40 percent of this is foreclosed properties but somebody wanted to buy that property and somebody felt that after the prices have been knocked down enough, say 50 percent on average, they could but that house, rent it to somebody and make 15 to 20 percent on their money.  So there are some investors out there who think there’s a bottom at least in some of these areas.  Now, I’m not saying this in New York City right now, believe me, I would be selling everything in New York but there are certain areas in the country that led this collapse, are stabilizing at the level.  I suspect the prices will not go down much further there and I suspect that we’ll see this sort of a bottomming out when prices -- I'm not saying the rest of the country does this but in some areas where high-flying properties are off 50 percent, somebody thinks it’s a trade.  So there is bottom fishing, bottom buying of properties going on.

Inventories are still high.  They haven’t risen a whole lot.  I think they’ll stay high for quite some time because the defaults are going on.  That’s going to weigh on the market.  Prices will still sag across the country.  But we have this balance between foreclosures pushing more properties out there [indiscernible] home sales taking them out of the system.  My guess is these inventories will go up some more but not dramatically more. 

This is the good news.  There is lot worse news coming.  This is not bad though.  There’s a different way of looking at price data.  This is Case-Shiller and this data is month-over-month change, annualized.  This may not be over but at least in this chart, the really severe part of this collapse in the housing market may be behind us in terms of prices.  Beginning of January of this year through June, those prices were falling like 20 percent annualized rates.  We’re only falling ten percent now.  Well, that’s not good but falling at ten percent is a hell of a lot better than falling at 20 percent.  Now year-over-year numbers keep going down but the monthly changes annualized look like they start here so we’re not falling.  And if you took these 20 metropolitan areas, you’d find [indiscernible] have been to the positive area for quite some time and the ones that were sharply negative are not nearly as negative.  So I think the housing market is going to down, it’s 20 percent.  It’s got at least another ten or 15 percent to go, maybe the 20 percent that Nouriel was talking about.  Yes, it’s going to go down further but I think that acceleration thing we saw in early part of this year is not going to increase.  I think it’s going to stabilize, it’s going to be slowed down a little bit, continue to grind down but at least some of that shocking decline in the housing crisis may be behind us.

Are we still at risk?  Well, let’s see.  Here’s state-by-state Case-Shiller, data house price changes, quarter-to-quarter.

Alex J. Pollock:  Let me point out, we used to call this HPA.

Thomas Zimmerman:  Exactly.  Now it’s --

Alex J. Pollock:  And now it’s HPB.

Thomas Zimmerman:  Right.  HPA went to HPB.  So here in the last year or so, almost every state has been negative.  But if you take a look at five-year period -- this is back to the earlier chart that Alex showed -- over a five-year period, many of these states were still significantly positive and these are annualized numbers.  You multiply them by five-plus and you’ll see that they’re still up from where they were five years ago.  I’m not saying the housing market decline is over but I’m saying that the acceleration part, I think, is behind us but there are still elevated prices in a lot of parts of the country despite looking at this chart.  There’re still ways to go, believe me.

This next chart is affordability.  It’s kind of a mixed picture.  It’s up from where it was but it’s not fantastic.  It’s on a national basis.  I don’t want to spend too much time with that.

The next chart still shows us that the price of homes has come down but compared to income, it’s still very elevated compared to historical norms.  There’s no doubt about that.  So there’s a few slight positives.  Negative, we’ve got a lot of those and some pretty significant ones.  For the short term, the very next six months, the next nine months I think is going to be really ugly.

Delinquencies have moved beyond subprimes to the rest of the sectors.  The roll rates which are -- in mortgage statistics we measure what percentage of a cohort moves from current to 30 days late and then from 30 days late to 60 days late and 60 to 90.  Those are up sharply.  Severities continue to climb and pre-payments are very slow because no one is going to mortgage.

But let’s take a quick look at this.  The subprime disaster is that red line and it’s been going up sharply for quite some time.  These are 60-plus day delinquencies.  These are serious delinquencies.  The bottom two lines are the Alt-A and the prime market.  What’s interesting is they lagged a lot.  They’re just not really kicking in.  So I think what’s happening is that sharp decline in the housing depreciation we saw earlier, that’s what’s triggering some of this.  This stuff is really hitting other people now, where before, the subprime is primarily underwriting, just terrible disgusting underwriting, now we’re seeing a more broad based kind of a thing.

You take a look at this next chart, this is Freddie/Fannie and this is the good stuff.  There’s two parts of Freddie/Fannie’s portfolio.  The bad line is the loans with MI on it.  About 20 percent of their portfolio has mortgage insurance because there’s more than 80 percent of LTB [sounds like].  The bottom line down here is the good stuff, less than 80 percent of LTB.  Here’s the weighted average for Freddie/Fannie.  But the high LTB stuff really kicked in back here.  It was doing fine until the start of decline in the housing market, and now it’s going up.  The bad news is it has spread well beyond subprime.  This is Freddie/Fannie which is supposed to be the best of all possible loans.

The roll rates we talked about for the non-agency market and these are quarter versus quarter; a year ago versus second quarter of this period and if you take a look, what’s interesting is subprime is always the bad guy, which is still bad, but the other sectors of this non-agency market -– Jumbo's and Alt-A’s have started to perform pretty ugly as well.  So this problem we saw mainly in subprime has certainly moved over into other sectors of this mortgage market.

Loss severities are climbing like crazy.  It’s a combination of a housing crisis going down and these loans staying in foreclosure longer and more problems being associated with those long foreclosure timelines.

The next chart says it’s going to get worse before it gets better.  See, I started with the good stuff.  Now, here’s what’s really bad.  And I agree with Desmond that these are the things that are going to drive it lower in the next six months, next nine months, next year.  Foreclosure way will peak sometime in the middle of next year, toward the end of next year.  The recession is going to cause a lot more problems than we’ve seen so far and the credit crunch just destroys the ability for people to finance.

This is the most important chart, I think.  This is the number of loans in units -- number of homes -- that we expect to see in foreclosure, in REO, and what you see is a hump that peaks somewhere in the middle of next year, then it starts to go down.  This is sort of the light at the end of the tunnel.  And what’s also important is this line right here, this is the sum of all these five or six different areas.  This big hump is the subprime world, and the subprime world will peak at some point in the middle of next year or late next year and then it’s going to start going down.

Here’s a statistic for you, for the past six months, the number of subprime loans in 30-, 60-, 90-day delinquencies have been going down, six months going down.  The number in the foreclosure bracket in REO is still going up but that “pig in the python,” that subprime disaster is working its way through the system and delinquencies in subprime are coming down.  They’ve been coming down for six or seven months.  The back end of this thing is still going through the system.  It’s going to go through and peak sometime next year.  Now, I don’t know if it’s going to peak in the middle of the year or later in the year, but it will peak because this is mainly an underwriting problem, much more so than anything else.  They don’t make those kinds of loans anymore.  They’ve stopped making those back in the middle of ‘07 or something like that.

And the point I think that’s really important is the number.  We’re talking like -- in our analysis and what’s it’s based on is like for the loans that were created in 2006 and 2007, we’re talking like 70 percent of those guys default.  We’re not talking about 20 percent, we’re talking about 70 percent of this subprime guys going default.  Now if we hit a recession which we are, that’s going to push these numbers up a bit, but once you have 70 percent of the people defaulting, I don’t think the recession is going to change that a whole lot, so maybe you go to 75 or something like -- It’s not going to 90, it might. 

But I think there’s substance to this chart.  In fact, this bulk of this foreclosure problem will work its way through the system and life will get better later on.  That doesn’t mean that the housing market’s going to get better because all other stuff is going to be in foreclosed REO properties so maybe we talk about the beginning of 2010 or something like this with maximum (indiscernible) but the point I want to make was that I think markets are really forward-looking and once people start to take a look and think that, “Oh, maybe this thing will not go on forever.”  Maybe there is an end to this thing that some people will start saying, “More valuations for some of these subprime securities that were trading at 50, maybe they’re worth 55 or 60, et cetera, et cetera.”  So that’s the process that we’re in the middle of right now.

Unemployment’s going to get worse and that is bad.  Here’s a chart which shows the relationship between unemployment and default rates and mortgages.  And roughly -- I’m not going to go through all the data –- roughly, the ratio is like you move unemployment up by one percent, you get increased default rates by 20 percent.  Now that’s in a normal kind of recession.  Now we’ve got this crazy thing called subprime crisis and it’s already, as we said, you’re not going to increase 70 or 80 percent of defaults by 20 percent so that’s not going to apply there.  But in general, it clearly will apply to the Freddie/Fannie portfolio and the more normal kind of mortgage loans that were created. 

So yes, that’s going to have an impact going forward.  And the problem, of course, is California, where a lot of mortgages are located, is leading the nation again in unemployment, so that’s not great.  So there’s a lot of negative stuff.  The worse thing though -- how much time do I have?

Alex J. Pollock:  Four minutes.

Thomas Zimmerman:  Four minutes, okay.  The worst thing of course that Desmond spoke about is this lack of liquidity in the market, in the financing system for owned homes and many of these are feedback loops which are devastating.  This is the one I talk about here as the one where home prices fall, these mortgage-backed securities that all the banks own getting marked down, the banks need more capital and therefore they constrain their bank lending.  We all know that’s going on in spades.  In addition to that, we’ve got this situation where that big securitization market that no longer exists, that was 40 percent of our home lending back in ‘05 and ‘06.  That’s 40 percent that was subprime, Alt-A and Jumbo.  That’s gone completely.  The banks are tightening up dramatically.  Freddie/Fannie has tightened dramatically. 

And of course, that’s the big question mark, what are they going to do going forward.  And I was amazed to read something on the Internet this morning where, I think it was MUD [sounds like], I think it was saying that they’re going to evaluate what’s the minimal capital return is before they decide what kind of lending they’re going to make, because they’re going to first decide what’s a realistic kind of -- so it sounds like -- I thought the government might use Freddie/Fannie as a real lever to push out lending, to push out liquidity to the market.  It sounds like first, somebody’s going to figure out what it takes to keep them reasonably solvent, then go back and compare what kind of loans they can make.  If they do that, then they’re not going to be a big help going forward.  If that’s the process, this is not going to help the housing crisis.  I swear to God, I read that this morning.  I don’t know what that means but I’ve not yet heard anybody in Washington say, “We’re going to use Freddie/Fannie to solve the housing market.”  I’ve not heard those words.  They really contributed to what happened in the last six months so they really tightened dramatically their lending.  And the FHA is growing but that can’t handle everything.  So I think that’s one of the major problems here. 

So as I see it, the legislation that was passed –- there were several pieces of legislation, pretty meaningless.  It’s not going to stop this tsunami coming through the “pig in the python” sort of subprime lending coming through here.  The FHA program is not fantastic.  So I think I agree that if you want to stop this next year of really terrible pressure on the housing market, you have to intervene some way.  If you take a look at that data I was showing earlier and say, well, we’ll let it go for a year or so, it’s going to burn itself out, maybe that’s better than trying to save this thing.  That may be a policy option too.  So I don’t know which way the politicians will jump.  My best guess is that they’ll probably come down and decide on some sort of a bailout, some sort of a something serious because this is going to get a lot worse during the next six months, next nine months, next year.  Number of foreclosures, the pressure in the housing market, that real physical stuff is going to be there, you can’t take that away. 

I think the other problem that the politicians don’t really get is that if you go back to this chart with that subprime chart and there are a ton of people in this subprime, up here, and there’s Alt-A market down here that never should have been in a home.  I don’t know whether it’s three million or what that number is.  I don’t know how you resolve that problem.  These people probably should have been renters and not homeowners with all that entails, and that’s a big problem that no one really talks about. 

We’re talking about “saving the housing market,” but there were some big mistakes that were made during the last seven or eight years and so, and no one has a good answer, I don’t have a good answer.  I don’t know which direction it goes.  I just know the pressure is downward.  There probably will be some federal help of some sort.  God I have no clue -- I know Sheila Bair has a plan coming up from the FDIC.  They have a plan they’re talking about but we can talk about that for three or four hours, what options one might take to just to solve that so –- I’ll stop here.  I have some other data but we’ll save that for another day.

Alex J. Pollock:  Thank you, Tom.  Chris?

R. Christopher Whalen:  Thank you.  And on behalf of PRMIA and the D.C. Steering Committee, I want to thank you and AEI, once again, for co-sponsoring this series with us.  I’m going to focus my remarks on the banking industry which has been my role in these conversations we’ve had over the last two years, and I’m hopefully going to give you some reason for optimism but unfortunately, banks are lagging indicators.  So bear with me.

Where are we in the process?  If you look at bank industry, we would tell you we’re about halfway through the adjustment process and you might think, “Well, gee Chris, we’ve been at this for two years,” but unfortunately that’s just the way banks are.  If you take the collapse of New Century Financial -- remember that one? -- It's kind of the starting point, when everyone was forewarned in a very public and visible way.  We’re two years into this but really, New Century was kind of unusual for the last couple of years because it was real loss, that was a real bankruptcy.  Most of what we’ve been reading about and what the public has been reacting to have been the headlines associated with the economic recognition of losses.  That is to say, fair-value accounting.  In fact, I found a banker the other day who told me that she has had to start fair-valuing her loan portfolio because of this lunacy.  This is absolute insanity.  I mean, imagine we’re in a kitchen with a big knife and we’re just chopping fingers off one after another and laughing about it.  That’s what fair-value accounting is, okay?  I can’t put it anymore bluntly than that without offending somebody.

Now, where are we going?  Well, we’re kind of in the next phase of the crisis which is much more basic and much more old-fashion.  You all have seen the Jimmy Stewart movie, It’s A Wonderful Life.  What we’re talking about here is loss realization, that is to say old-fashion charge-offs, sales of assets and the actual realization of a loss by investors and by financial institutions. 

Now as of where we are today, in Q3 2008, we are continuing to see charge-off rates rise.  As I said, banks are a lagging indicator.  And based on where we are, in other words looking at banks, looking at their ratios, looking at what where they are compared to where they were even a year or year-and-a-half ago, which, let us remember were fairly low-loss rates, actually historically low loss rates.  We’re still looking for the peak that some of my colleagues have referred to next year at two times 1990.  Now those of you who are old enough to remember the 1990’s and the S&L crisis know that at that time, the U.S. banking industry reached at charge-off rate of two percent across the board and people like City Bank NA reached three-and-a-half percent.  That institution almost went bankrupt.  Imagine what the industry looks like at two times those loss rates next year.  And in particular, if you listen to Tom and the other speakers, imagine what happens if we get to those loss rates and we stay there for a while.  In other words, it’s not just a peak and we come off, but imagine if the recession is extended, we get the banking industry up to historic loss rates and then we hang out at those levels for a while.

Now why do I give you all these cheerful preparatory commentaries?  Because I don’t think that the second phase, the realization, is the last phase.  I think we’re going to see a third phase in this crisis where the losses, not only from financial assets that we can see on the balance sheets of financial institutions but in particular, the off-balance sheet derivative contracts that are “notional” now but as consumer defaults and commercial defaults rise, they become real. 

What do I mean?  We wrote about this on Monday.  We put out a piece called In the Fog of Volatility: The Notional Becomes Payable.  And what I meant by that is that if you’re a German bank and you took a punt two years ago on Lehman Brothers failing and you wrote a credit default swap that said I will indemnify you, the holder of Lehman Brothers bonds, and you paid me, let’s say 150 basis points.  Two years go by, Lehman Brothers files bankruptcy, you German Landesbank bank have to come up with 9,700 basis points of cash.  Okay?  You’ve got paid a couple of hundred basis points each year for that insurance contract you wrote.  You just had to come up with 9,700 basis points for the cash to perform on that contract.  That’s a liquidity black hole.  And I don’t think our policymakers realize what it’s going to cost our economy and the global economy in terms of liquidity, as many of the speakers were talking about before, to make these contracts good.  In fact, I think when the politicians really get to understand that the bailout of AIG and the bailout of other firms on Wall Street is not to help mom and dad, and not to get lending restarted in this country, but to bail out the credit default swap market.  I think there’s going to be a political reaction in this country that’s going to burn the sides of people’s heads off, I really do.  Nice happy thought, right?  We’ve covered that.

Now, let me show you a little picture.  This is the credit index that we launched a couple of months ago.  What is this?  Well, as you can see the current value at the end of the second quarter is a little over 1.4.  The base year which was 1995 is one.  This is an explicit census of the entire U.S. banking industry.  In other words, we calculate the index value for every FDIC insured bank and then we roll them up into a single index like this.  What it tells you is that the entire industry today is at levels of stress based on things like charge-offs, capital, return on equity, efficiency, all the basic factors you look at when you’re assessing a bank that we haven’t seen in 20 years and we’re going higher.  In fact, my guess is from the 1.43 at the end of the second quarter, this index is probably going to get up to 1.5, maybe 1.6 by the end of the year. 

Now the good news is, is that of the 8,400 FDIC-insured banks in this country, the vast majority of them are fine.  Not only are the vast majority of them below 1.4 but the vast majority of them are below one.  They haven’t even gotten up to the 1995 levels of stress because they’re, by and large, very conservative banks.  This is your typical community bank; underleveraged, under-risked, and very happy.  They go home and have dinner with their families at night. 

Unfortunately, the thing that’s dragging up this index -- I'm going to show you the picture now -- if you take a look at that green line, what is that thing that’s at the very top there?  That’s return on equity, mark-to-market losses.  That hits income, hits equity returns.  Now you’ll notice, the next line that’s visible there, the red line is the return on equity, the green ones your defaults which was really leading the parade.  But if you take a look, the third line, capital adequacy has barely moved.  Why?  Capital’s leading indicator.  We haven’t started chewing into that capital yet.  That’s where we [cross-talking]

Alex J. Pollock:  Chris, excuse me just a minute.  The return on equity must be an inverse measure, right?  If that line’s going up, it means return on equity is going down.

R. Christopher Whalen:  Yes, up is bad.  That’s right.  Each of this is evidence of stress.  The higher the number goes, the worse it gets.  Let me put that copy on out there.  My friends in California did this; they’re all geeks.  They all come out at aerospace business.  But what I’m trying to say to you is that normally when you see banks reacting to a severe economic downturn, you’re going to see return on equity affected, you’re going to see efficiency affected.  That’s all to come.  We haven’t seen it yet, and when I said that we’re still early in the adjustment process, that’s what this chart evidences.  It’s really saying to you, when we start seeing equity, capital adequacy affected, when you start seeing efficiency, in particular, going higher than it already is-- efficiency, by the way, is how much money does it cost a bank to generate revenue. 

So if the whole industry was about 60 cents on the dollar a year ago, they’re now all up to 80.  Why?  Because they’re all spending money on advertising.  They’re trying to keep deposits, customer service.  They’re pushing it as hard as they can because they’re all trying to hold their position in the marketplace.  That’s what efficiency really measures.  So the point of all this is that the industry has got at least another year, maybe longer before it gets, in terms of the internal ratios of banks, to the point where we say, “Ah, we’re at the peak.”

So what does this suggest to us?  Well, as I said before, we could see peak charge-offs next year getting up to two times 1990.  That means five, five-and-a-half percent for Citigroup.  That means the government ends up owning that bank, sorry to say.  We could see the industry up to three, three-and-a-half percent charge-offs across the board.  That’s serious.  The little banks will still be fine but they won’t be reporting dividends for quite a while.

Now, let me show you what I’m talking about.  This is Citi versus the large bank peers through the third quarter this year.  Now, as you can see, Citi is the blue line and they’re up a little over 200 basis points of default.  That’s two percent charge-offs against total loans and leases.  Now, is that unusual territory for Citi?  No, absolutely not.  Citi normally has a much higher loss rate than other banks, more consumer. 

If you look at somebody like JPMorgan who’s included in this peer group by the way, they’re not going to show the same kind of loss behavior because they’re much more commercial.  Even though they have a very big retail book at that bank, they have a very large business lending operation so you’re going to see the pain hitting them next year, year after; whereas in HBC or Citi with the consumer exposure, you can see it now.  This line’s going to go higher.  We could take some comfort from the fact that second quarter to third quarter, line flattens down a little bit.  Maybe everything’s fine, right?  No, I don’t think so.  I think the hockey stick continues after that.

So as I said before, the 2x 1990-91 range, I think, implies that Citi, JPMorgan, at least, are going to have to get additional injections of capital.  I don’t think there’s any question in my mind that they’re going to have to have at least as much capital injected in those banks as they already have.  Now I don’t think all large banks are going to have to do that but I do think, if my friends are right about the severity and the duration of the recession, you could see the government controlling some of the larger banks in the U.S. 

And I think we’re going to have a very interesting public policy debate, perhaps right here, about what the government ought to do.  My personal belief is that if we do have to see the Treasury take explicit control of Citi and JP, they ought to break them up.  They ought to sell every one of those branches at auction because the result would be a more healthy, better capitalized broader banking industry.  And I’m not just talking about Wells Fargo and U.S. Bancorp.  There’re probably 40 or 50 institutions who would happily bid for those assets with private investors helping them.  That’s the good news.  There’s tons of capital out there that want to get involve. 

But until -- going back to this chart -- until we can figure out where the peak loss rate is, it’s very hard for investors to kind of jump in with both feet because you can’t come up with a number.  A classic example is the acquisition of Nat City.  In that case, you have a bank that’s been above peer losses for four years, where is it going to end?  I don’t know.  The guys at Corsair Capital put equity into Nat City earlier this year and -- brave souls.  I just don’t know where the end is for that bank given its geography, given its other attributes, and yet the Treasury seems to think they can get past this crisis by just merging banks together and unfortunately, I think they’re wrong.

So let me just add up and end with a question that I’m going to be trying to answer over the next couple of months.  I think we’ve got to have a discussion in this country, not only about how to stabilize and re-build the banking system and what it’s going to look like, but particularly what the business model is.  The model we’ve had over the last few years, in addition to being ill-advised and reckless, basically makes a mockery of the whole Basel process, eight percent capital of total assets.  Clearly, the activities we were all engaged in over the last few years probably needed more than eight percent capital to support them prudently.  If we’re now going to bring banks back to a model that’s less risky, more prudent, more stable, I have a feeling the returns of that model are going to be much lower than people think.  You know, banks aren’t going to make 20 percent return on equity; they’ll be lucky to make half that.  There’ll be utilities. 

And in that kind of a business model, I think the regulatory issues, the social issues, everything else, are going to come to the fore because there’s no free lunch here whether you’re talking about Community Reinvestment Act, you’re talking about broad-based programs for loan modification, this is going to cost a lot of money.  And I think once politicians realize just how much of a subsidy is not going to helping consumers, businesses, the real economy, and how much of it is really going to the virtual speculative economy, we’re going to have a very interesting political debate in this country.  Thank you, Alex.

Alex J. Pollock:  Thanks, Chris.  I guess we could note that some of those 20 percent returns which were booked were actually never profit.  It should have been booked as loan loss reserves.  And the profits weren’t real but of course, they were booked as profit, they generated dividends, bonuses and taxes.

R. Christopher Whalen:  Let me mention just quickly this last chart at the end of our deck.  This is a study we did with Deloitte earlier this year and this is real risk-adjusted return on capital for the top 20 banks going 20 years.  What do you see?  You see that not only were their returns much lower than they were 15, 20 years ago but the variants among the group are declining.  Everybody’s converging on the same business model.  And I suspect this is going to change rather radically going forward but this is where the industry is today.

Alex J. Pollock:  Thanks, Chris.

John Makin:  Thank you, Alex.  Well, as I was listening to the previous speakers, I was reminded that it’s almost Halloween and the favorite movies at this time of the year are called Chainsaw -- I think we’re up to Chainsaw 4 now, and certainly our discussion here strikes me as sort of the kind of mayhem that we see in those films.  But I’m going to try to take a little more top-down view.  I think maybe a little bit along the lines that Nouriel has done.  I think that it’s very important to look at these things on a case-by-case basis and also on a systemic basis. 

And my bottom line is that all of the lines and graphs and things that we see in Tom’s chart book and Chris’s and some of the others are all conditional lines, they are systemically conditional.  That is that bottoms-up analysis has to be modified in a world where there is substantial systemic risk so that the whole outcome here is conditional on what’s going on in the U.S. economy and our focus here has been the deflating and housing mortgage bubbles in the United States.  But I think one of the things that this session IV has revealed to us or has brought us to a point where this is a global issue and that we’re not just looking at what’s happening to the housing sector.  We started off subprime, then it was the mortgage sector, then it was the derivative-based mortgage sector, then it was the housing sector, then it was the financial system, then it was the U.S. economy and now we’re talking also about the global economy. 

And what I think, if could describe briefly what’s happened, it is that we had a bad credit crisis in the U.S. and so maybe we’re halfway through it, if the world economy doesn’t collapse.  That has induced the movement into a severe recession for the U.S. and that, in turn, has implications for the global economy and will feed back negatively onto the problems in the housing and mortgage sector. 

So that’s a dynamic that’s fairly well understood or has become to be fairly well understood.  I don’t -- I would have to say that our policymakers are still not acting as if they fully understood how bad a dynamically unstable adverse feedback loop is; that is credit gets worse, the economy gets worse, credit gets worse, that’s not good.  The vortex analogy or metaphor is operating.

So why -- and Nouriel listed and I’m in admiration, I’m in awe at how he can remember every one of the steps that the Fed and the Treasury has taken over the past four months because frankly, I’ve lost track.  One of the reasons I lost track is, as many of the speakers have suggested, it doesn’t seem to make any difference and that’s eventually not going to be the case but I think Nouriel went through the action-reaction pattern that we’ve seen starting with the Bear rescue and the eight-week rally to the last and larger and more systemic approach to the problem and a one-day rally in the financial markets. 

So in my past two economic outlooks, the first one I wrote at the end of September was called Panic, and the next one that I just finished, last week, is called More Panic.  And I think that captures pretty well what’s going on in the financial sector, both domestically and globally, and the implications for the real economy are dangerous.  So what I’m trying to figure out is why isn’t anything working or why doesn’t it seem to be working or why after we take what seem to be substantial steps and almost unlimited commitments of funds are we still experiencing what seems to be an accelerating negative adverse feedback loop, and a couple of suggestions.

First of all, the -- and this goes back to how these crises develop.  I mean, well-known phase [sounds like] is we have a shock and the shock was probably, we’ll call it Bear Stearns.  We have denial; that was the stock market rally.  We have efforts to make more things right and then we get into panic and we’re not yet integrating the problem.  So what’s going on here?  Well, let’s first look at the U.S.  In the U.S., the Fed’s response is, essentially, goes back, if you go back and here I’m relying heavily on reading the histories of The Great Depression in the United States and the depression or whatever you want to call it in Japan or in the 1990s.  In other words, bubble burst, aftermath, what are the lessons?

And the first lesson The Great Depression, if you read the Friedman-Schwartz monetary history, which I highly recommend, it is that you don’t -- the central bank should not let the money supply fall and should not, as the Fed did at the time is actually accentuate the drop in the money supply by noting that interest rates are falling and suggesting to itself that oh, there must be plenty of cash around because interest rates are going down.  So in an environment where a bubble has burst and there’s an endemic collapse, it’s probably not a good idea for the central bank to, essentially, cut the money supply by a third as the Federal Reserve did between 1930 and 1932.  Because that coincided with the onset of a very nasty deflation and a collapse in industrial production nothing like we’ve seen now.  Just look at the pictures.  

And what was happening there was straightforward.  The collapse in the stock market and the negative effect on the real economy made banks very cautious.  Banks were hoarding money and as the Fed collapsed the monetary base, the so-called money multiplier, which is really a measure of how active the banks are in utilizing the reserves provided by the Fed, the money multiplier was collapsing and the money supply was collapsing. 

Well, the good news today is that although the money supply has not collapsed, the monetary base I should say, the stuff that the Fed puts into the system is not collapsing, the money multiplier is collapsing.  And so the supply of money is not growing very fast because the banks are not operating as financial intermediaries.  We look at the amount of funds that the Fed has pumped into the banks, they said “bring us your toxic crap and we’ll take it and we’ll make you more liquid.”  But the liquidity in the banking system has not created any kind of lending. 

The big triumph of the last two weeks is that after hefty cajoling and the injection of plenty of cash, the banks have started to think about not lending to each other at a lower interest rate, that’s the so-called Libor story.  Before they weren’t lending to each other at four percent, now they’re not lending very much to each other at three percent.  If that makes you feel better, be my guest.  The folks on CNBC every day jump up and down and say “oh, Libor’s down.  It must be wonderful.”  And even if the banks were lending to each other, they’re certainly not going to lend to you or me or anybody else for that matter because of the stories that we’re hearing up here, banks are in a risk-reduction, de-leveraging mode and so they’re not about to lend. 

The injections -- banks got their checks from the Treasury on Monday, and of course, as we learned, when an enterprising New York Times reporter snuck on to a conference call for JPMorgan employees, learned that the JPMorgan management was telling its employees, “Don’t worry, those capital injections aren’t going to go anywhere but to acquire other banks.  Certainly we’re not going to lend it out in an environment like this,” we’re beginning to wonder if this is working very well.

Well, so what’s going on?  The supply of liquidity of the U.S. is not growing because the multiplier is falling so fast even though the Fed is injecting tons of money.  Now, okay, that’s one problem.

And then in the last outlook called More Panic, I went to John Maynard Keynes to look at the other side of the problem, the “what’s happening to the demand for money?”  And I took pains to remind my readers that there’s a big difference between Keynes and Keynesians.  Keynes was a brilliant monetary theorist.  I spent a lot of time in the money course in Chicago and in the money workshop in Chicago and Milton Friedman made it amply clear that he was a great admirer of Keynes, not of the Keynesians.  And what Keynes understood was that in an environment like the current one, the demand for money can rise very rapidly; uncertainty is certainly something that increases the demand for cash.  If you doubt that there is a big demand for cash, look at the yield on four-week T-bills.  It has gone negative and it’s very low because most prudent cash holders in the United States, myself included, but many other corporations and individuals do not want claims on depository institutions, they only want claims on the government, i.e., T-bills.  And T-bills are virtually cash now because cash is a non-interest bearing liability of the government and T-bills are becoming just that.

Now the best thing that’s been done on the policy front in the past month has been the establishment of widespread deposit insurance.  So that institutions and individuals don’t have to be afraid of an interruption in access to their liquidity because they have deposits of more than $250,000 at Citi or JP or some other place.  This became a real issue and finally the Fed figured it out that, “Gosh, maybe the people are worried about their deposits at major institutions,” indeed they are.  So that was a good step to say we’re going to guarantee those deposits.  The problem is that every institution whose deposits didn’t get guaranteed has suffered a drain on their holdings and then the question about whether —- and again the question about whether the liabilities of Fannie and Freddie are guaranteed or effectively guaranteed has not been productive, let’s say. 

So, the demand for liquidity that is the demand for riskless claims on the government has skyrocketed at a time when the increase in supply of those claims has been stable but not falling and the fact that the money multiplier is collapsing means that it’s difficult for individuals to get hold of enough cash that is unconditionally guaranteed in a highly risky environment.  Other symptoms include -- and the shortage of dollars by the way is global.  The dollar has appreciated sharply in the past two weeks and there’s some adjustment in the past few days because there were huge structures outstanding in the global economy where people were short-dollars. 

You remember, the smart money in Europe was essentially saying, when the crisis comes, the dollar’s going to collapse and so many structures were created which were essentially short-dollar structures.  Likewise, the Carry Trade where you financed your trade in Japan and put the money elsewhere.  All this thing is running in reverse and so there’s a huge excess demand for yen and dollars which the central banks have not fully satisfied.  And so the countries which are experiencing an excess demand for their currency are experiencing a deflationary shock which is what currency appreciation is.  Prices go down when your currency gets stronger.  You don’t want that in an environment like this.  So although one may puff up with pride that there’s a tremendous demand for dollars and yen, one has to be careful here.

So part of the reason that all of the efforts that we’ve seen undertaken here are not working is that we still are in the grips of a huge excess demand for safe liquidity.  That has created an intensifying real economic slowdown, both in the U.S. and globally.  The slowdown in the U.K. is perhaps even more abrupt than the slowdown in the U.S.  Europe is going into negative growth.  The Japanese economy is in negative growth and in the last three days after people said they’ll never cut rates, the Japanese were saying, well we’ll probably have to cut rates and do a big fiscal stimulus package. 

So, the other thing that’s happening here is the pace at which this is unfolding is blinding and so one of the reasons the policymakers haven’t got on top of it is it’s simply moving too fast for them.  We are now, in the U.S., as far as monetary policy goes, yesterday, we went to a one-percent Fed funds rate.  We are approaching the fairly well known zero bound problem that central banks face in situations of powerful incipient and natural [sounds like] deflation where there is an excess demand for cash which has not been satisfied by the central bank.  And in that case, once the Federal funds rate is pushed close to zero, the central bank faces the zero bound problem.  That is if you crank up the Taylor equation and you plug in an inflation rate of around two percent, it’s now 2.6, and an unemployment rate of eight percent, it’s now 6.  You find that the Fed funds rate that’s called for is minus two percent.  Well, zero bound problem is that you can’t set the Fed funds rate at minus two percent.  You can only set it at zero. 

So in that situation where the equilibrium Fed funds rate is below zero, that’s sort of a red alarm bell that goes off and says you really have to start printing money here because you have to arrest the deflation because if you don’t and the Fed funds rate is zero and the inflation rate is minus three, what’s the real return on cash?  Three percent.  I want more.  I get more.  What happens to the deflation rate?  It goes to four percent, et cetera.  So it is a dangerous, dynamically unstable disaster.  Meanwhile, as deflation accelerates, the real burden of the many debts which you’ve seen on the charts here goes up rapidly and the system quickly implodes.

Alex J. Pollock:  You’re getting to the end.  One minute.

John Makin:  I sure am.  We already imploded here.  Okay.  The end is easy or straightforward at least as far as I can see and that is the way you deal with this situation.  It is that the central bank comes out and says all right, we will print money to buy equity.  We’ll print money to buy long-term bonds.  We’ll print money to buy anything and we promise you folks that the price level next year will be higher than it is now.  We promise you inflation.  And when the central bank gets around to promising you inflation, we will begin to move out of this crisis.  The central bank -- and for five years I tried to convince the Bank of Japan that they had to do this, no success.  And so they simply ended up in a lengthy recession/depression which didn’t end until they actually started printing money and the world economy recovered in 2003, et cetera.

So when the Fed gets around to promising you that the price level next year will be higher than it is now, a lot of good things start to happen.  The demand for cash goes down, the real burden of debt is relieved by a higher price level.  And what are you doing?  You are levying a broad-based, low-rate tax on nominal assets and if in terms of my public finance theory, broad-based, low-tax rates are a good thing.  The tax rate is the inflation rate on nominal assets.  So I’ll stop there.

Alex J. Pollock:  Thanks, John.  We’re going to find a way for real asset prices to come down while nominal ones don’t fall as fast, another way to say that with your inflationary program.  In thinking about all these series of very interesting presentations we’ve heard and I keep thinking about the underlying issue which is, of course, the amount of leverage in the entire global system which was built up and it can’t help but make me think if my old friend Haymenski [phonetic] who sometimes summarized his theory as stability creates instability.  The point being that long periods of stability such as the one we call the “great moderation” induce people to believe that high levels of leverage are safe because high levels of leverage are safe in periods of stability but they’re extremely dangerous in periods of instability.

Let me give the panel a chance.  If anybody wants to add a thought or respond to what somebody else has said.  Nouriel.

Nouriel Roubini:  To elaborate on an important point that John made.  I think that three months ago, the Fed and other central banks were still worrying about the inflation but if you ask yourself, what are you going to be worrying six months from now, I think deflation is going to be the story or what I refer to as a “stagdeflation”, a period of economic stagnation and recession and deflation.  And why do I say that?  We’re now seeing the beginning of a slacking goods market, with aggregate demand falling and [indiscernible] supply.  And by the way, the supply is sharply rising because of the huge amount investment that China and Asia has made in new capacity to produce goods and services therefore pricing power of corporate is going to fall.  And by the way, we’re starting to see price deflation already in housing and consumer durables, in automobiles.

Secondly we’re going to have a slack in labor market with the rise in unemployment rates are going to put lids on wage and cost of labor pressures.  And three, commodity prices have already fallen by about 25 percent from their peak, and actually oil prices have already fallen more than 60 percent from their peak of July and in this Canada, U.S. and global recession I see another 20 to 25 percent downside raise to commodity prices.  So slacking goods market, slacking labor market, slacking commodity prices, we’re going to start to worry about deflation.  In the previous recession, though short and shallow, eight months, remember, by 2002, the Feds started to worry about deflation and Ben Bernanke was writing speeches titled Deflation: Making Sure "It" Doesn't Happen Here, an orthodox modern-day policy to avoid it.  That’s going to be the story six months from now, deflation or stagdeflation.

Alex J. Pollock:  Chris?

R. Christopher Whalen:  Just listening to the different speakers today, we’ve heard a lot about a dearth of dollar liquidity, and if you’ve been following the Fed over the last few years, that’s an astounding statement.  I mean, how many dollars do we have to print?  But clearly there aren’t enough of them.  I want to come back to a point I made because I think Alex will be talking about this next year which is, if you think about the global banking system and you compare that to things like securitization which we largely ignored.  That’s why we’re here today.  We didn’t recognize that we had the shadow banking system which is now collapsed.  I think the next crisis -- and it’s going to contribute to what Nouriel was saying about the real economy shrinking is going to be, as a financial system, it has to make good on $55 trillion worth of credit default contracts. 

Just imagine if you take the low estimate, the smiley face scenario for corporate defaults and each one of these insurance contracts has to be liquefied upon a default.  Well, if we have a global banking system that has what in total assets?  $25 trillion, $30 trillion?  U.S. has 13, I don’t know how big the total is but it’s not that big.  If you even have a modest number of credit default contracts require performance out of that $55 trillion, that’s going to suck liquidity out of the financial system for years.  Because remember these things don’t exist yet.  Until they’re in the money, it doesn’t require a significant payment.  But Lehman Brothers, you had to pay 97 cents on the dollar.  So if you have more real defaults where the loss rate is high, you’re going to see financial institutions have to fund these things.  And I have to believe that next year, this is going to be a big policy issue as we get our minds around this.

Alex J. Pollock:  Desmond?

Desmond Lachman:  I pretty much agree with what John has to say about money multipliers collapsing or demand for money increasing but I don’t know that I would go along with him in thinking that the central bank alone is going to be able to get us out of this.  I would’ve thought that it’s a mistake if we’re looking for silver bullets therefore what we’re really going to be needing is a lot of fiscal stimulus to be coming together with fairly much easier monetary policy, ideas that John has got and what one’s also going to do which I think is critical is stabilizing the housing markets by direct intervention on that side.  So unpalatable as it is for us to have more intervention, you know it’s got all of these long-term costs, I don’t think that we’ve got an alternative as we melt down and I think that just to rely on people to go out and spend because you’re pumping in liquidity there, I’m not sure that that’s going to work.

Alex J. Pollock:  Okay, let’s come around to the time for your questions.  Karen, maybe we can get a general title slide up here for the question periods and then there’ll be a microphone.  Karen, [indiscernible] microphone Karen so we’ll start here.  Wait for the microphone.  Please give us your name and affiliation and then your question and we’ll start here.  Thanks.

Robert Sherretta:  Robert Sherretta with International Investor.  Mr. Pollock, maybe I’ll start with you because you’ve got 35 years of banking and I, as well, have served some time for some of those institutions.  One of the big changes I noticed and again another connection between the banking world and the securities world was the lending side.  We’ve seen banks learn, particularly this decade, that it was more profitable to lend to hedge funds and other traders than it was to other traditional forms of loans.  Do you see that being reined in and is it not true that lot of this lending is still taking place today?

Alex J. Pollock:  I’ll come back to my story about the trader talking to the margin clerk.  A lot of the selling we see, I believe, is forced selling out of investors who no longer can convince their lenders to keep on lending to them, for one thing, because they can’t put out enough collateral as the price of the collateral falls and so we’re getting a typical, cyclical correction here although one of a very severe kind and I remind everybody that, in banking, at least based on my four decades of observing it, there are no truly new ideas.  There is simply cyclical repetition including cyclical repetition of ideas.  Bert?

Bert Ely:  Thank you, Bert Ely, a banking consultant here in town.  I want to pick up on something that Tom mentioned.  That there were probably several million homes that were sold to people who had no business buying a home, they should’ve continued as renters.  If that is the case, why does it make sense to say that well, now that they are an owner of that home, we ought to modify their mortgage so that they can stay in it?  And kind of another way to put this question is, to what extent are we nearly postponing a recognition of the problem with a lot of these financially marginal homeowners and might we, as a country, and for the housing market be better off if we just go through the foreclosure process, get it behind us and let the markets clear. 

I remember saying from the 1980’s about the S&L’s, “A rolling loan gathers no loss,” which was why the justification for a lot of loan modifications back in the ‘80s.  And it’s not clear to me that that phenomenon has really changed, that the recovery in the housing markets may actually be delayed in many markets if we merely roll forward problem loans to marginal lenders.  And so I –- and I know this is politically incorrect to ask this question but are we possibly, potentially going to go overboard on this mortgage modification business specifically with borrowers who lied about their loans or speculators and really had no business buying the house in the first place?

Alex J. Pollock:  Who would like to take that?  John.

John Makin:  Well you haven’t said anything yet and one of the points I would’ve suggested is we have now reached the stage of bad policy initiatives which will start when Congress comes back to town in a few weeks.  And I’m guessing what we will see as a very serious and possible proposal that we were discussing at lunch that is let’s have a national moratorium on foreclosures because that’s an emotionally appealing notion -- hey we’ve got a problem, foreclosures, poor folks, got to help them out, let’s pass a law that you can’t foreclose.  Now talk about prolonging the crisis, that’s where we’re going.  But if I were thinking in positive rather than normative terms, I would plan on some such nonsense very likely to occur to prolong the crisis.

Alex J. Pollock:  Chris?

R. Christopher Whalen:  Just a couple of quick points.  Let’s remember why we’re here.  We’re here because of the partnership for affordable housing so it’s perfectly logical for the Democrats to greet [sounds like] this six, seven percent of all homeowners as new, compliant, submissive constituents who they will take care of for the rest of their lives.  It’s pretty clear from the historical evidence that modification does not slow default and frankly, I think, for most of these homeowners who were part of that group from the 65 percent up to 70 percent homeowner, they ought to walk away if they had independent, really objective advice, they would simply walk away because there’s no point in them paying rent.  That’s exactly what they’re doing.

Alex J. Pollock:  Okay.  We’re going to go here and then I’ll pick you up back here, right here.  Right in front here.  Thank you.

John Serrapere:  My name is John Serrapere with Arrow Insights, I’m becoming a regular mainstay here.  I have spoken with Chris about this at the Federal reserve bank in Philadelphia and Thomas Zimmerman and Nouriel Roubini about one of the things I wanted to lay out, a scenario is, I think, the biggest default rate was like 16 percent, historically, and there have been some analysts now saying it could go to 20 because the quality of the credit is more junk than historical base of credit, and what would happen if we approached the 16 percent of the 20 percent default rate given the credit default swap crisis and I just thought maybe a general discussion, I mentioned this to you in, I think, February in Philadelphia, Chris, so let’s start with Chris first and whoever else wants to --

Alex J. Pollock:  You’re talking about the junk bonds?

John Serrapere:  Yes, the corporate default rate, if it approaches 16 percent of historical heights or reaches toward 20, what would that do?

R. Christopher Whalen:  It’s like [indiscernible] to before just looking at credit default swaps but this goes across the board.  As you have default events, payment has to be made.  And remember these are options.  It’s like you’re running an insurance company, you have all these obligations but you have no assets.  That’s by and large how this game has worked because remember, people wrote CDS for the last five, six years on the expectation that there would be no defaults and the spreads were very tight.  There were a lot of people who wrote CDS on Lehman for less than a hundred basis points three or four years ago, you know?  So when you look at the funding requirements, if for example CDS written against structures where you have corporate loans inside or buyout paper or whatever it is, you’re going to see a huge liquidity drain as the system tries to perform on those contracts.  And that’s why I think it’s going to become a political issue globally, not just in the U.S.

Alex J. Pollock:  Nouriel?

Nouriel Roubini:  Yes.  I mean, historically for the last 40 years default rates on speculative grade bonds have been, on average, 3.8 percent of the outstanding stock per year but then less two years, 2006 and 2007, that number was 0.6.  So 1.6 that was normal, essentially close to zero.  Why the slosh of liquidity, credit spreads were very low, junk bond [indiscernible] spread, bottomed at 250, [indiscernible] Treasury is June of last year and now you’re going to see a tsunami of corporate default.  You start from zero default rates and during the last two recessions actually that were short and shallow, 1991, 2001, those default rates actually peaked at 13 percent. 

So think about the counter going from zero towards 13 percent in a shallow recession, much higher if it’s a severe recession.  And it’s a double whammy because not just the default rate was higher but the recovery rates given default in a normal year of no recession about 70 cents on the dollar, in a recession year at about 35 cent on the dollar so you get a double whammy.  And then the consequences, as was discussed by Chris on the CDS market, of this major tsunami of default is going to be then lots of these contracts are going to belly up with those with sole protection essentially going belly up and those without protection discover big time counterparty list there was not an edge and that’s going to be quite, quite scary.

Alex J. Pollock:  Tom, one more comment on that.

Thomas Zimmerman:  [cross talking]  that last thing was so important because in a perfect world, and I think that’s where the Fed always has its trouble with current default swaps for the last 10 years and all swaps in general as you know.  If your counterpart doesn’t go down, then whoever wins, somebody else loses right?  So a lot of the banks lost a lot of money but a lot of hedge funds made a lot of money on the ABX and other mortgage derivatives and somebody made a lot of money on this, right?  Paulson made several billion, right?  So we lost several billion.  So somebody who [indiscernible] transfer if money here, the system didn’t lose it.  It moved from us to them so the real risk is this last part, when Lehman went down and you lose a