Rogoff - the pessimist

Ken Rogoff, Harvard professor, leading international finance economist and former chief economist for the IMF is one pessimistic forecaster. He comments about large potential bank failures.

"The U.S. is not out of the woods. I think the financial crisis is at the halfway point, perhaps. I would even go further to say ‘the worst is to come…

We’re not just going to see mid-sized banks go under in the next few months, we’re going to see a whopper, we’re going to see a big one, one of the big investment banks or big banks…

We have to see more consolidation in the financial sector before this is over…Probably Fannie Mae and Freddie Mac — despite what U.S. Treasury Secretary Hank Paulson said — these giant mortgage guarantee agencies are not going to exist in their present form in a few years."

However, his pessimism may be well-placed. Prof. Rogoff has researched banking and currency crises so he is familiar with the numbers. A close study of banking and currency crises usually suggests that failures of large institutions is not out of the question and actually is the norm. When there is a systemic crisis in a lending area such as housing, it is highly unlikely that a large institutions will be able to avoid the risks. Even if a large bank's lending portfolio in this area is smaller, the power of leverage tells us that it takes a lot of good loans to make up for a few bad ones. Or put more bluntly, lending within a sector may outstrip the capital of even large firms. Similar firms that may have less diversification are at even more risk.

There is no easy way out of these crises and they have taken years to solve. The solution often entails nationalization of some portion of the banking system. The talk about a Freddie and Fannie bail-out is a form of bank nationalization.

The biggest problem with a banking crisis is the ongoing cutback on lending to good institutions. The reduction in leverage means that the the failure will have a ripple effect to many good parts of the economy.

Any failure in the United States will lead not only to an equity sell-off but to a reversal of the current dollar rally.