Banks May Need to Shrink by $2 Trillion on Subprime Losses
Mortgage losses,
(editorial note by JP: some interesting blog posts below this WSJ article..... JP)
February 29, 2008, 11:59 am
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.<?u>
“The interaction ofMu> 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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WSJ…Good job. Now you are on the road and following the… “Yellow Brick Road”! I vague-ugly remember telling the WSJ 9-10 months ago that this would transpire… 400-500 Billion…you think!
But yet again that’s hinder-sight! Now… go look at the Mortgage Rates over the last 3-4 years and compare where it is to day… oh what a surprise you say… rates aren’t coming down, I wonder why? “Credit quality is declining.” –Greg Ip… you think!
The OZ
Comment by Keep IT afloat... follow the "Yellow Brick Road"! - February 29, 2008 at 12:16 pm
Every time I read your blog the problem seems to have gotten worse. It’s obvious that the people feeding us this information don’t know their jobs or they are forced to lie to us by vested interests. Bring back the Gold/Reality Standard and these problems will go away.
You can’t print gold!
Comment by Bystander - February 29, 2008 at 12:41 pm
When jobs are outsourced, plants closed and workers laid off or have their wages severely reduced, the workers move. They leave behind real estate and its supporting infrastructure (schools, roads etc). There is little economic activity left to support it and the value drops at least in half if not more. The investors that financed it take the hit.
Are we now starting to see the real cost of globalization?
Two $T’s sounds like a lot but could it be an underestimate.
Comment by LD Fraley - February 29, 2008 at 12:54 pm
The reason for the losses are poor execution, horrible management, and lack of intellectual courage. The accounting and risk management practices cited only shed truth to idiots in denial.
Comment by The Prince of Darkness - February 29, 2008 at 1:22 pm
But Bernanke and Bush said we aren’t going to have a recession!!!!
Comment by Confused - February 29, 2008 at 1:24 pm
Confused…. Listen to the above guys since they are only the one’s that are really in the know!
The rest of the bloggers on this site are just senior citizens worrying about their interest rates on their cd’s!
Comment by Wall Street Warrior - February 29, 2008 at 1:28 pm
Major price mark-downs for distressed mortgage debt will come - soon. We will buy such distressed debt and want to talk to others who share our enthusiasm for this contrarian strategy. Economic stability will also come - the stakes are too high to neglect an all out effort by the Congress/Fed/Treasury. Calling all optimists - let’s hear from you!!
Comment by Willis McDoodleson - February 29, 2008 at 1:45 pm
The relationship between asset values, equity and capital adequacy ratios and requirements is fairly simple: For every x dollar of lending, banks need y dollars in equity (good CAR’s are 7-10%). The big banks have already started recapping themselves (ML, C, MS, etc…) for EXISTING losses, but it remains unclear what will happen if their losses persist. Will they be able to fill future equity holes with new capital? Their options are:
–Raise more equity. Not likely since all existing re-cap investments are already 10%+ below initial investment value
–Lower/kill dividend: Minor improvement in equity retention in comparison to the losses
–Lend less: Its already starting–per the above study. If they don’t have adequate equity to back their loans, they can’t lend–even if they have the deposits/cash. This becomes a vicious cycle of less lending > less fees > less cash/earnings > less equity…as Ben said, banking failures are certainly on the horizon, and thus…
–Fail and sell.
Other issues to consider:
–Reconsideration events that bring off-balance sheet debt onto the balance sheet–which will then need to be funded w/more equity. FASB is meeting next week to take a look at the rules which may force banks to put these debts on their balance sheets, with the basic premise that if the off-balance sheet vehicles require the banks to fund them in the event of failure, that is a direct liability.
–De-leveraging of the economy is a good thing given record consumer debt/income ratios and record mortgage/income ratios. However, its going to shrink the economy–1.3% may be conservative given our credit-dependent consumer spending cycle of credit cards > home equity > home re-fi’s > credit cards. Now, people are tapping into their 401(k)s because the equity is gone. That will translate into negative savings and investment–creating a continued downward spiral until we reach a new equilibrium of cash/equity/debt for consumers, banks and businesses.
The real question is: What is a sustainable debt/income/equity ratio for consumers, banks and businesses and what is the corresponding GDP growth?
Comment by FIG Guy: What is sustainable debt/income ratio? - February 29, 2008 at 1:46 pm
Every time a bank or investment house give’s their guideline its pretty mush their loose if the best situation happens. How-ever what we are seeing is that the worst is happening. So double or triple any guidelines they are saying. If Citi says it will loose 10billion and that’s all when then its really 20 if not more.
I meet a mortgage broker in Vegas back in the summer of 2006. He told me at that time there was 15,000 foreclosures in Vegas. That was 18 months ago. If a plain investor like me saw this coming how come those financial wizards did not? This picture was been painted for a long time.
Comment by scote00@yahoo.com - February 29, 2008 at 1:50 pm
Peloton Partners LLP, the London- based hedge-fund manager being forced to liquidate a $1.8 billion asset-backed fund, said it’s a victim of the lending drought on Wall Street.
“Credit providers have been severely tightening terms without regard to the creditworthiness or track record of individual firms, which has compounded our difficulties and made it impossible to meet margin calls,” Peloton co-founders Ron Beller and Geoff Grant said in a letter yesterday to clients.
Peloton joins Thornburg Mortgage Inc. and Sailfish Capital Partners LLC on the list of funds and companies that have had to sell securities or shut down after banks restricted how much they could borrow, or demanded more collateral as values of securities backed by mortgages slumped. The world’s biggest financial institutions are cutting off lines of credit to hedge funds after at least $163 billion of asset writedowns and market losses.
“More hedge funds will blow up this year than ever before,” said Michael Hennessy, who helps oversee $10 billion of hedge fund investments at Morgan Creek Capital Management in Chapel Hill, North Carolina. “Financing is much harder to get. The bubble has burst.”
Also see:
Yesterday on the New York Mercantile Exchange, oil surged $2.95 to $102.59 a barrel, a new high in nominal terms. After rising 12% this month, oil prices are now just below their inflation-adjusted peak of $103.76 set in 1980.
But oil has been a laggard compared with other commodities. So far this year, natural-gas prices are up 26%, coal is up 56%, platinum up 41%, wheat up 32% and cocoa up 38%.
Instead, commodities have been riding a wave of investment money diverted from stocks and bonds by investors chasing better returns. A weaker dollar, lower interest rates and fears of inflation have added momentum to the rally.
“People are wondering where they should put their money. Treasury bonds are overpriced, they’re scared to death about equities, and they’re even afraid of money markets,” says Shawn Rubin, a senior adviser at Smith Barney. “So everybody is asking about commodities.”
Hyper-inflation, liquidity trap and denial = global chaos!! We have idiots telling retards how to put fires out, by using soiled diapers! We are in BIG trouble!! HELP!!
Comment by SOS (HELP) SOS (HELP) - February 29, 2008 at 1:52 pm
Doom and gloom! A perfect time to buy equities!
Comment by Wall Street Warrior - February 29, 2008 at 2:10 pm
So the same set of questions that were asked too late for the subprime mess needs to switch over and start examining the run up in commodities - the article on phibro on the front page surely is pointing to a top. Isn’t reflation just creating a different set of problems with the money flowing into oil, gold, and grains. As the subprime market pointed out, the last buyer is in trouble and once you ignore economics and fundamental demand, a bust is inevitable. At least with the subprime, there was an illusion or receiving a market interest rate - there is no return on commodities unless the price changes in the same direction of your holdings. No doubt some of the math PHDs have figured out a way to securitize your holdings and leverage your position.
Comment by gkb - February 29, 2008 at 2:12 pm
Good comments all to a solid report. I remember the S&L bust of the late 80’s, which cost the taxpayer $400 billion (at least) and resulted in the closure of virtually every bank and S&L in Texas. I don’t see a government bailout like we had then, in part because that bailout was foreordained by FDIC and FSLIC insurance. Most of the highly leveraged investments that are going bad today don’t have existing government insurance behind them. They don’t even have government scrutiny. Instead, they are highly opaque investments, whose value (perhaps especially in a falling market) is difficult to determine. Little wonder that lenders are tightening up lending to hedge funds. Who wants to be the lender into a highly leveraged deal whose real value is still opaque? The banks are taking a double whammy too — a hit on their balance sheets the result of highly leveraged investments turning south, and another hit on the value of loans they themselves have made to others who were looking to leverage their positions. Merrill, B of A, Citi, Morgan Stanley, JP Morgan — they are both lenders and borrowers.
Commodity prices are worrisome too, because we have to import oil, and oil is dollar-denominated. With a weak dollar (made weaker by interest rate cuts), oil futures have to rise — but that crimps the US economy, which runs on oil and has to buy most of it overseas (and no, Mr. President, we are not going to be able to produce enough of our own oil to offset imports — that day is long since gone).
We have a massively overleveraged consumer out there too — and with consumer spending making up such a large percentage of the national economy, we all ought to worry about how that debt problem is going to resolve itself (if it ever does). Debt carrying costs as a percentage of take home income are, I understand, at all time highs. If gasoline and food costs start spiking, I don’t see how the consumer can keep on purchasing.
Comment by Michael - February 29, 2008 at 2:35 pm
Not to worry. Bush says that we are not headed into a recession and he never lies. A depression is different than a recession isn’t it?
Comment by TWstroud - February 29, 2008 at 2:41 pm
This is amazing! With all the talks on housing bubble on CNBC and other media, there is no one in any government agency bring up the imminent danger. Who is responsible? Or this is just free market?
Comment by Who is Responsible? - February 29, 2008 at 3:07 pm
Gold soared to record levels again on Friday, pushed by a weaker dollar that has pushed investors towards the hedge. April gold closed at $975.00, up $7.50 on the session. The metal reached as high as $978.50, again setting a new intraday all-time best. …
Gold… Follow the Yellow Brick Road!
The OZ
Comment by Here is your new… Econ… accelerator peddle! - February 29, 2008 at 3:13 pm
The sky is falling, the sky is falling………… this time it just might be true. I have read a number of economists’ reports as of late and don’t pretend to understand many of the terms that seem to be from another language or some distant planet. I do see a lot of doom and gloom mostly related to housing and poor credit management. I don’t see a lot of concern about the increasing level of foreign ownership in American banking, businesses and real estate. I also don’t see a whole lot of emphasis on the fact that the bloodline of our nation’s economy is oil AND that this most precious blood is for the most part controlled by those who have disdain for our nation. At any time, a tourniquet could be applied that would bring our economy to an abrupt halt. Not that it is a mass conspiracy but it makes you wonder. Let’s turn down the violence in Iraq and lull the American’s into a feeling of accomplishment, maybe they won’t notice record setting prices of oil. They are so distracted by the election, crime and Hollywood scandal that they won’t even notice. Maybe we can get another Bush elected and keep America in Iraq for another fifty years or more. Just in case you are wondering, the terrorists haven’t left the country. They are running shops, going to school, trying to work, and fading back into the dysfunctional society that exists in Iraq. When it is to their advantage to come back out and play with us, they will. With the endless war against the invisible army of terror, it looks like the deficit is not going to be moving in a positive direction anytime soon. Just how much debt can we as a nation go into without eventually having to borrow money from the folks we are warring against? All the while, Exxon makes record profits and the misery index for America’s working class continues to get worse. Am I wrong, are we living on the brink?
Comment by Grandpafoos - February 29, 2008 at 3:16 pm
We are spending junkies running out of fixes. Very kind of borrowing is headed for trouble… muney’s and even T-bills. The world will soon tire of carrying our debt…with the dollar continuing to decline. The stock market decline is at very early stage…what are stocks worth when there are no profits?
Comment by mars kuehne - February 29, 2008 at 3:33 pm
gloom, maybe; doom not yet. wait until the dow breaks 10,000.
Comment by i.b.sage - February 29, 2008 at 4:51 pm
Sorry kids,
there’s no way to go back to the Gold Standard. This nations debt of close to ten
trillion would most likely require all the gold that’s ever been mined, all the jewelry in existance, and all the gold used in teeth to
even approach that sum!
Just keep the presses rolling President Bush and very soon
the Euro will be three to one for every US dollarette.
Comment by The Gold Bug - February 29, 2008 at 7:25 pm
I wonder if that is 1.5% less than than last year’s GDP or 1.5% less than last quarter’s GDP. Factor in less spending when baby boomers retire, and possible lower stock market returns - that would be a pretty low GDP.
longwavepress.com
Comment by JustBill - February 29, 2008 at 10:23 pm
This article in Harpers says it all about how we got here and a likely outcome. It all boils down to an unregulated financial modality and a “Baghdad Bob” administration that refuses to face up to the real economy and implications long term of where we are headed as a nation.
harpers.org
Comment by ctman2 - March 1, 2008 at 8:46 am
The Gold Bug,
Hey dude you are on to something here, along with some other bloggers above. Let’s try and discover the time line to a US balanced recovery. Most faithful followers like “Working Mon… from Yale”, believe that it will take 2-3 years. Just take the Trillions of Debt $’s on today’s books etched in clay and sand of the all powerful… (Paper Tiger Muck$) + (plus interest) and multiply by the base 66.6% of the rolling average pay scale in America… then divide by the Un-employed #’s coming out next week and the housing distressed markets plus the so called credit crunch along with the divided totaled up Tax Payers actual dividends to our great corporate nation of lies and deceit… oh and just for kicks add in the rising cost of petro dollars and commodities… then you may see the real truth behind the “Vail or Curtain” of the Federal Governments imposable odds of balancing a true balanced budget by 2020! But… what the hell everyone says there is tons of Liquidity out there somewhere! Go and check out the UAE, China and the Euro VS> the G6-7-8-9-10 and still growing in mountains of debt profiling! So all will be well in 2-3 years… you think? Good Fn’ing Luck! All I know is… I’ve bought (2) brand new Porsches in the last (2) months and paid cash for both… just shorting Gold Futures… Later, all you poor Gators looking for a dyeing dog lying on the shore line to neek up on! You guys and girls have been listening to the world’s largest talking dog too long… “Cramming Cramerica”… you think, I do! I think I’ll stay with the “Best in the West”… the WSJ and FOX, the free press is still alive and well doing very well thank you! Keep… “Following the Yellow Brick Road”!
The OZ
Comment by Where is the Country going? - March 1, 2008 at 1:24 pm
Is there a web link to the research paper reported on in this article?
Comment by anonymous - March 1, 2008 at 2:19 pm
anomymous,
Yep there is a link,
~
bigpicture.typepad.com
~
Just scroll down to 02-29-08…
BINGO! Cool site I use it all the time, just helping out my “boys & girls” @ the WSJ… later.
The OZ
Comment by Wake Up Dorothy... Wake the hell up! - March 1, 2008 at 2:40 pm
Contrary to Wall st warriors comments above, Sell equities before its too late.Severe correction is going to happen , as asset prices (housing, stocks, commodities) are already inflated(overpriced by 30%) due to cheap money supply.
Comment by Anonymous - March 1, 2008 at 5:22 pm
- By making the “money” worth less and less the bankers force us to provide even more of our real labour to get the same things that cost us less labour in the past. In effect they push down the value of our labour without our consent
- The quality of what we buy goes down so that nothing lasts and we have to keep replacing it; hence demanding even more of our labour.
- However, we acquiesce as we believe we have no choice.
The end result is that we are effectively slaves; not bound by chains and shackles but by debt. Debts of money that the system has created out of nowhere but we have to pay back with our very real labour. The legal system, credit card system, banking system - the whole system - is set up to enforce this form of indenture, this form of servitude.
We are serfs in the New Feudal World Order.
Not many people recognize it for what it is yet. But they will do very soon, it is to this that we should now turn.
Banking system collapse
When banks collapse, as they did in 1929, the entire economy collapses with them. Savings are lost (money becomes worthless), jobs are lost and only those things that are essential to survival become important and even they can become impossible to obtain and people starve. However, pay attention here: two things do not change, 1) the debts that are owed remain and 2) the assets they financed, for the most part, remain. To the extent that debt was used not to buy real things but rather for financing a certain “lifestyle”, then just the debt remains with no assets connected to that debt.
These debts are legally enforceable and are historically enforced by the full weight of the law; truncheon, taser, 9mm and all. That means that you lose everything - all your assets, everything - to repay loans for money created by bankers, worth nothing in reality, but used by you to finance a certain “lifestyle” (buying an overpriced house or vehicle, take vacations, send the kids to private schools, dance lessons, etc) or perhaps just to survive.
When banks collapse, at the extreme, there is no money available. This was deliberately engineered by the Federal Reserve in 1929 as they withdrew huge sums from the banking system and only partially reversed under the New Deal. In 1929, with less money and fewer jobs even those still in employment were paid less and less until the banks seized the assets that the debt was secured on. Homes, farms, businesses, all were seized by the banks. Even seemingly large companies were bankrupted and seized by the bankers and their friends,
Conclusion
It is my conjecture based on the data I have collected that we are being set up for a total financial system collapse. The UK government has been persuaded by bankers to keep the system alive for a while longer, an act of great folly but one so well engineered that no politician could fail to fall into the trap.
The Federal Reserve would seem to be illegally and secretly supporting the US banks in a similar way.
The rich are getting richer not through the rise in value of their assets but because they are pulling vast amounts of cash out of the system and using it to buy more and more real assets while the poor are getting poorer and everyday more people join their ranks as they desperately struggle to maintain a quality of life that is advertised via the media as the “right” of all.
Certainly, one would not consider owning a home, a car, or feeding one’s family a “quality of life” but the elite do. From the elite’s point of view, all the masses deserve is a hovel and rags, just as long as you can work.
When the system is finally allowed to collapse we will all find ourselves stripped of those things we thought we owned. We will lose our homes, our savings (if we even have any), our jobs (in the most part) and much else besides. The money system will collapse.
At this point we will be offered a deal:
- You can remain in your house but it will be owned by a central housing company.
- Your will work at a designated job and credits for that work will be used to pay the housing company for you accommodation.
- You will travel by company owned transport within your local area only.
- You may not travel nationally or internationally unless you have enough credits and are approved by the system.
- Your children will be educated in company controlled schools the way we want them to be educated.
- You will eat food that the company will provide you with using your credits regardless of whether or not this is the diet you prefer.
- You may not question the content of your food; we will add as many chemicals as we see fit to ensure the shelf life of the food.
- You will get what healthcare is available to you depending upon your credits and your behaviour. If you do not behave as we tell you to, you will get no healthcare.
- Nobody will survive outside this system.
You will be a serf in a new feudal society. In the immortal words of Tennessee Ernie Ford:
You load sixteen tons, what do you get?
Another day older and deeper in debt.
Saint Peter, don’t you call me, ’cause I can’t go;
I owe my soul to the company store…
You may think this is too much, that I’ve gone nuts, but think about it for a while; most feudal societies ended up with the serfs taking their pitchforks, raiding the lord’s castle and lynching him. Could we do that in the society of today?
I doubt it. With no ability to buy anything without “credits”, no independent food supply, all your communications monitored whether by telephone or internet, all your movements monitored via RFID chip, GPS or CCTV and your thinking dictated by corporately controlled media not to mention the widespread use of secret prisons, torture, wars for profit and terrorism to keep you sufficiently fearful, repressed and impotent, you can do nothing.
Comment by truth hurts - March 2, 2008 at 4:59 pm
truth hurts,
Amen… to that brother… look out scouts this blogger speaks the truth and it’s going to hurt for a long time now if you don’t wake up… and I mean wake up real soon and vote your conscious in November to curb this trend and correct the current downward trends with a signed contract of your choice for our next Commander in Chief… of the people by the people and for the people and not for the corporations, financials and politicians… you think? The $1200 dollar night out on the town coming to your bank account is just another vote bought and paid for by our great establishment… you think?
The OZ
Comment by "Wake up Dororthy... wake the hell up!" - March 2, 2008 at 8:08 pm |
