Banks May Need to Shrink by $2 Trillion on Subprime Losses
housingMortgage losses, compounded by contemporary risk management and accounting practices could prompt banks and other lenders to shrink their lending and other assets by a staggering $2 trillion, a new study concludes.
The resulting withdrawal of credit could knock one to 1.5 percentage points off economic growth, significantly compounding the impact of collapsing home construction and softer consumer spending due to lower home wealth, the study, presented at a joint academic-Wall Street forum in New York Friday.
The study is one of the most exhaustive efforts to date to pinpoint the scale and location of mortgage losses and how those losses will affect economic growth.
In the initial stages of the crisis, some optimists noted that early estimates of subprime losses of $50 billion to $100 billion were about the same as one bad day in the stock market.
But the latest study argues that the losses will be far larger, at about $400 billion, and cause far more economic damage than if the same losses had occurred in stocks or corporate bonds. That’s because about half the losses will be borne by banks and other highly leveraged institutions. Such institutions hold equity and other capital of just 4% to 10% of total assets. For each dollar of loss not made up for with new capital, they will have to shrink their balance sheets by $10 to $25, by reducing lending or selling securities. That’s not just to keep their capital ratio steady, but because current risk management practices usually causes banks to raise those ratios when markets turn volatile.
“The interaction of marking assets to their market prices and the risk management practices of levered financial institutions” amplifies the impact of the initial losses, according to the authors, David Greenlaw of Morgan Stanley, Jan Hatzius of Goldman Sachs, Anil Kashyap of the University of Chicago and Hyun Song Shin of Princeton University. “The feedback from the financial market turmoil to the real economy could be substantial,” at one to 1.5% percentage points of gross domestic product.
The authors calculate mortgage losses three ways: by extrapolating losses on earlier subprime mortgages to more recently issued mortgages and adjusting for a 15% cumulative decline in home prices; by looking at the size of losses discounted by prices of derivatives based on subprime mortgages; and by extrapolating the experience of California, Texas and Massachusetts with large home price declines. All three methods yielded total losses (defaulted loans minus value recovered from the foreclosed home) of about $400 billion.
They then examined the distribution of mortgages and concluded about half is held by “leveraged” institutions: banks, thrifts, investment dealers, and the mortgage agencies Fannie Mae and Freddie Mac. They noted that many such institutions hold capital based on the “value at risk” of their holdings which tends to drop when markets are calm and go up when they are volatile. Based recent experience, they calculate such institutions on average will want to boost their capital to asset ratios by 5% because of increased risk. Even assuming they offset half their losses by raising $100 billion in new capital, these institutions will still try to shrink their assets, now about $20.5 trillion, by about $2 trillion. They estimate, based on historic experience, that that loss of lending will restrain GDP growth by 1.3 percentage points.
The study helps quantify a phenomenon called the financial accelerator, first coined by Fed Chairman Ben Bernanke when he was an academic and now a major factor in his decision to step up the pace of interest rate cuts recently. Mr. Bernanke told Congress this past week that that accelerator is “perhaps even more enhanced now than usual in that the credit conditions in the financial market are creating some restraint on growth. And slower growth, in turn, is concerning to financial markets because it may mean the credit quality is declining.” –Greg Ip
housingMortgage losses, compounded by contemporary risk management and accounting practices could prompt banks and other lenders to shrink their lending and other assets by a staggering $2 trillion, a new study concludes.
The resulting withdrawal of credit could knock one to 1.5 percentage points off economic growth, significantly compounding the impact of collapsing home construction and softer consumer spending due to lower home wealth, the study, presented at a joint academic-Wall Street forum in New York Friday.
The study is one of the most exhaustive efforts to date to pinpoint the scale and location of mortgage losses and how those losses will affect economic growth.
In the initial stages of the crisis, some optimists noted that early estimates of subprime losses of $50 billion to $100 billion were about the same as one bad day in the stock market.
But the latest study argues that the losses will be far larger, at about $400 billion, and cause far more economic damage than if the same losses had occurred in stocks or corporate bonds. That’s because about half the losses will be borne by banks and other highly leveraged institutions. Such institutions hold equity and other capital of just 4% to 10% of total assets. For each dollar of loss not made up for with new capital, they will have to shrink their balance sheets by $10 to $25, by reducing lending or selling securities. That’s not just to keep their capital ratio steady, but because current risk management practices usually causes banks to raise those ratios when markets turn volatile.
“The interaction of marking assets to their market prices and the risk management practices of levered financial institutions” amplifies the impact of the initial losses, according to the authors, David Greenlaw of Morgan Stanley, Jan Hatzius of Goldman Sachs, Anil Kashyap of the University of Chicago and Hyun Song Shin of Princeton University. “The feedback from the financial market turmoil to the real economy could be substantial,” at one to 1.5% percentage points of gross domestic product.
The authors calculate mortgage losses three ways: by extrapolating losses on earlier subprime mortgages to more recently issued mortgages and adjusting for a 15% cumulative decline in home prices; by looking at the size of losses discounted by prices of derivatives based on subprime mortgages; and by extrapolating the experience of California, Texas and Massachusetts with large home price declines. All three methods yielded total losses (defaulted loans minus value recovered from the foreclosed home) of about $400 billion.
They then examined the distribution of mortgages and concluded about half is held by “leveraged” institutions: banks, thrifts, investment dealers, and the mortgage agencies Fannie Mae and Freddie Mac. They noted that many such institutions hold capital based on the “value at risk” of their holdings which tends to drop when markets are calm and go up when they are volatile. Based recent experience, they calculate such institutions on average will want to boost their capital to asset ratios by 5% because of increased risk. Even assuming they offset half their losses by raising $100 billion in new capital, these institutions will still try to shrink their assets, now about $20.5 trillion, by about $2 trillion. They estimate, based on historic experience, that that loss of lending will restrain GDP growth by 1.3 percentage points.
The study helps quantify a phenomenon called the financial accelerator, first coined by Fed Chairman Ben Bernanke when he was an academic and now a major factor in his decision to step up the pace of interest rate cuts recently. Mr. Bernanke told Congress this past week that that accelerator is “perhaps even more enhanced now than usual in that the credit conditions in the financial market are creating some restraint on growth. And slower growth, in turn, is concerning to financial markets because it may mean the credit quality is declining.” –Greg Ip
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