The subprime spread continues: A Goldman Sachs report says the overall impact of mortgage losses on economic activity could be huge
Just a few months ago, analysts believed the collapse of subprime mortgage securities and related investments would lead to losses of $50 billion to $100 billion, a large but manageable number. Now, a new report from Goldman Sachs (GS) says losses from subprime exposure could be much larger than recently assumed, hitting as much as $400 billion. But that's not the extent of the financial carnage: Goldman said the full impact on the economy could be even more substantial, because the losses could compel banks and other lenders to curtail lending by as much as $2 trillion.
If banks trim their lending by that amount, consumers and businesses won't be able to borrow the money they need to maintain strong economic expansion. "This is a large shock. It corresponds to 7% of the total debt owed by U.S. nonfinancial sectors," wrote Goldman Senior Economist Jan Hatzius, the author of the report. "The drag on economic activity could be substantial."
Doing the Math
How does a $400 billion loss in the credit markets translate into $2 trillion of economic damage? The answer is debt, or leverage. Banks, hedge funds, and private equity firms often borrow $10 or more for each $1 of equity they use in a transaction, according to estimates by the New York Federal Reserve. When the investments pan out, the use of debt boosts their return. When the investments go south, the use of debt exacerbates the loss and often leads lenders to be more conservative in the future.
Citing a recent analysis by Tobias Adrian of the New York Fed and Hyun Song Shin of Princeton University in the Goldman report, Hatzius estimated about half the $400 billion in losses will fall on the shoulders of highly leveraged investors such as banks, hedge funds, and brokers. He said they typically cut back on lending when the value of their assets falls, to maintain their targeted ratios of capital to loans. If those lenders take half of the $400 billion hit, they will have to reduce lending at a rate of $10 for every $1 of loss, which would add up to $2 trillion.
The subprime crisis already has hit investment banks hard. Merrill Lynch (MER) reported a loss of $8.4 billion (BusinessWeek.com, 11/15/07), and analysts think more could be on the way. Citigroup (C) reported a loss of $6.5 billion in the third quarter, and says it could lose as much as $11 billion more in the fourth (BusinessWeek.com, 11/13/07). If banks cut back on lending, the damage could spread to other parts of the economy. The default rate on corporate debt (BusinessWeek.com, 10/26/07) could rise if corporations can't borrow more money to roll over their debt.
Other market experts agree that mounting losses in the credit markets could compel banks to roll back lending. "The real issue is how much of the losses in the credit markets are leveraged and what that means to banks, which might have to reduce lending to keep their capital ratios," says Martin Senn, chief investment officer of Zurich Financial Services (ZURN), which manages about $200 billion in assets. "If banks are forced to cut back on lending…, that could become a serious stress on the U.S. economy. I see the risk of recession in the U.S. definitely rising."
For the moment, Zurich Financial Services is still forecasting the U.S. economy will grow in 2008, albeit at a much slower rate, about 2%. That's about half the pace of the third quarter.
Damaging Time Frame
The extent of the damage will depend on a variety of factors, such as the speed with which the projected $400 billion in losses are realized. If the losses are realized in one year, the shock could trigger "a substantial recession," according to Hatzius. If they occur over a period of two to four years, the result could be "very sluggish growth." It's possible the damage could be offset by unexpected strength in other parts of the economy, or by government intervention.
But it's also possible the economic effects of the credit crunch could be compounded by other problems. "Oil prices are a huge risk. If it stays at $100 a barrel, the economy is in pretty bad shape," says Joe LaVorgna, chief U.S. economist at Deutsche Bank (DB). He still thinks the economy can avoid recession. But credit-driven fears "are in the market." He adds that high oil prices (BusinessWeek.com, 11/14/07) could shave an additional 1.5 percentage points of growth from the economy.
Not so long ago, some analysts were quick to write off the problems in the credit market as a case of the summer doldrums. They hoped the markets would come back to life after Labor Day, and when the Fed cut interest rates in September, it seemed they might be right. However, the hope for a quick fix has faded like memories of the beach.