The idea that I presented in a recent article that we face the risk of a "financial meltdown" is becoming more mainstream. Today Munchau in the FT discussed it by analyzing the risk of a Great Depression style of debt-deflation; he argued that such a scenario - or a Japanese style decade long stagnation - is unlikely.

I do agree that such a scenario of a protracted economic US stagnation is unlikely and have been quoted to say so in a NYT article over the weekend that discussed the risk of a Japan style stagnation in the US: "Still, even Mr. Roubini sees scant chance of the United States following Japan’s path. “I’m very pessimistic, but I don’t think it will be anything like Japan,” he said."

But I believe that cannot rule out a severe short-term (as opposed to long-term) financial meltdown that will lead to a severe and painful US recession and global near recession. While the chances of ending up in a Great Depression or Japan decade long stagnation scenario are very low, the chances of a severe recession and a systemic financial crisis more severe than we have had since the 1980-82 recession are now high. And my view is that the ability of the Fed and policy makers to avoid such as systemic financial crisis is highly limited.

And here is below an article from Forbes magazine reporting on my financial meltdown scenario:

Out Front Look Out Below
Robert Lenzner 02.25.08 Forbes magazine

If you get depressed easily, don't read this story. Here's one sage's prediction of a long, deep recession.

It may be time to christen a new Dr. Doom. The candidate: Nouriel Roubini, an economist at New York University's business school. He makes the old Dr. Doom, bond pessimist Henry Kaufman, look like Dr. Phil. No mincer of words, Roubini thinks a full-blown panic will scorch the global economy. He recently laid out his scenario for central bankers in Davos and had them chewing it for hours.

He thinks the immediate spark will be the collapse of bond insurers (MBIA, Ambac, FGIC and others). These insurers have guaranteed $72 billion worth of collateralized debt obligations, now crumbling in value as housing prices fall.

Cheerier sages see an economy lifting off in the second half, fueled by the Fed's rate cuts, and a rebound in the shares of bond insurers. Roubini says lower rates won't help. There are significant risks of insolvency. Here's his prediction of how it'll play out:

Bond Insurers Lose the Triple-A

At press time New York State was trying to arrange a capital infusion for the bond insurers. Roubini doesn't think it'll work, and there's no Plan B--yet. Lacking that, insurers will lose their gilt-edged rating. Then the banks (Merrill, Citi and others) that paid them for protection against default of their collateralized debt obligations will face more writedowns--well beyond the $100 billion that's been written down already. Financial losses in subprime mortgages could be $400 billion and in the whole financial system more than $1 trillion. A big bank might go under.

Contagion Spreads

Writedowns will begin percolating up from subprime mortgages to near-prime and prime mortgages, commercial real estate, auto loans, credit cards, corporate buyout loans, corporate bonds and derivatives. If leveraged banks, brokers and hedge funds should suffer $200 billion in domestic credit losses, they would have to pull back on $2 trillion in lending, according to a Goldman Sachs analysis. Roubini says the rest of the world will "recouple" rather than decouple, as financial losses spread to other world capital markets, especially Europe. Sovereign wealth funds will not be large enough to play savior. Credit spreads will keep widening. Equities, housing, commodities, emerging market assets and the dollar will get hurt. "Cash is king in 2008," says Roubini.

A Protracted Recession Ensues

Roubini says the U.S. went into recession in December and will stay there for at least a year. We've got excess inventories of unsold goods (consumer durables, autos), a shopped-out consumer and a growing weakness in labor markets with no new jobs (net of losses) and no rise in real wages. Home prices, down 8% currently, could fall by 20% to 30% total before bottoming.

The Shadow Banking System Dies

Banks got hooked on off-balance-sheet entities like structured investment vehicles, which Roubini calls the "shadow banking system." But the shadow system has no access to the "lender of last resort" support of central banks. When the banks tire of bailing out their sivs, holders of siv paper will have losses.