Will the Center Hold?

Sobering testimony from Nouriel Roubini from the Stern school of Business. In addition to his strongly argued belief that we are headed for a severe recession, that may last up to 8 quarters, he also laid out a black swan event (one that he believes isn't a low potential event anymore, but rather a real possibility). This Black Swan hinges on the shift from home to house. If the majority of the American middle class makes a shift to "economic man" from the historical "American dreamer", we are all truly hosed:

I will argue that currently the most important first-order risk for financial markets derives from the likelihood that 10 million to 15 million households may walk away from their homes if – as likely - home prices fall another 10% in 2008 and further in 2009.

Thi would lead to systematic banking failure (on top of a bear market and the host of other financial failures in associated markets we are currently seeing):

What will be the consequence of losses of over $1 trillion and, possibly, as high as $2 trillion? That would wipe out most of the capital of most of the US banking system and lead most of US banks and mortgage lenders – that are massively exposed to real estate – to go belly up. You would then have a systemic banking crisis of proportions that would be several orders of magnitude larger than the S&L crisis, a crisis that ended up with a fiscal bailout cost of over $120 billion dollars. And the worrisome part of this scenario is that – with home prices likely to fall by 20% or more – this scenario of systemic banking crisis is becoming increasingly likely.

This could plunge the US into some very bad times. It would also likely trigger a reset in middle class expectations about the future (as in, "you can never progress, but you can fall hard.") If this occurs, it will likely apply to an upsurge in domestic terrorism as well. Why? A precipitous collapse in expectations, particularly if this collapse is seen to be unfairly imposed by external factors, is often a major reason for terrorism. While this usually occurs on an individual level and at the margins (which limits its occurrence), we would be manufacturing it en mass with this crisis.

Comments

[Walter]

This is kind of where the economy seems to be heading:

http://www.boingboing.net/2008/02/25/wind-turbine-self-de.html

[Fabius Maximus]

Bad news: the shift he describes is imaginary. Models used by mortgage professionals clearly show that the primary factor affecting default rates is home equity. Always has been.
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This was masked until now by the fact that 20% downpayments (no capitalizing closing costs) AND no interest-only mtgs (de facto forbidden since the Depression; they were common in the 1920's) meant that almost everyone had equity.
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The scenario Roubini describes is obvious to our senior decision-makers, therefore it is unlikely to happen. I describe the alternative they will choose in this post:
http://fabiusmaximus.wordpress.com/2008/02/12/happy-ending/