Subprime's hidden cost is shrinking leverage
Sunday, 6 January 2008
Michael R. Sesit
In this season of stock taking, the picture past and future for financial markets is far from pretty. The reason? Subprime
If you didn't know what subprime meant at the start of the year, it was hard to avoid its meaning by year end.
The big question now is what will the subprime crisis and ensuing credit crunch cost. In mid-July, Federal Reserve Chairman Ben Bernanke told the Senate Banking Committee that estimates of losses associated with subprime-credit products were $50 billion to $100 billion. Those numbers "are far too low,'' Jan Hatzius, New York-based chief U.S. economist at Goldman Sachs Group Inc., said in a mid-November report.
Based "on historical default and loss patterns in different home-price environments,'' he estimates U.S. losses will be roughly $400 billion.
Assuming that U.S. and European residential property prices fall 5 percent to 10 percent over the next year, investors in non-prime mortgages and securities linked to them -- including banks, hedge funds, asset managers and mortgage insurers -- stand to lose between $350 billion and $500 billion, according to London-based consultants Independent Strategy. Adding in expected losses from prime mortgages would lift the tally to more than $650 billion.
Yet these loss projections tell only part of the story. The other portion relates to the impact of the losses on the willingness and ability of so-called leveraged investors, institutions that finance their activities with borrowed funds, to keep lending. These include banks, broker-dealers, government- sponsored enterprises, savings institutions and hedge funds.
A September 2007 study by Tobias Adrian of the Federal Reserve Bank of New York and Hyun Song Shin of Princeton University, published by the New York Fed, found that leveraged investors, particularly banks and brokers, seek to maintain constant capital ratios. As such, when they lose money, they scale back lending to keep their capital ratios -- assets divided by equity or risk-free capital, such as cash -- from falling.
U.S. commercial banks on average have capital ratios of 10 percent, which means that for every $1 of capital lost, they reduce lending by $10. Thus, assuming that $200 billion of the projected $400 billion mortgage-credit loss is borne by leveraged institutions, the supply of credit will decline by $2 trillion, Hatzius said. ``The likely mortgage-credit losses pose a significantly bigger macroeconomic risk than is generally recognized.''
Meanwhile, Independent Strategy figures that banks will have to shrink lending by 15 percent to 20 percent to return their capital ratios to pre-crisis levels, and hedge funds and brokers by $18 to $25 for every $1 lost. ``A 10 percent reduction in global bank lending would damage corporate investment and consumer-spending growth, adding significantly to the risk of economic recession,'' the firm said in a Nov. 15 report.
Apart from a decision to supply wads of money to relieve the logjam in global credit markets, the performance of central banks has been anything but sterling. They woke up late to the subprime mortgage mess, and some people still doubt that they fully grasp the risks involved -- especially following the Federal Reserves' decision to cut its federal funds rate by 25 basis points to 4.25 percent on Dec. 11, when the market was looking for more.
``The timid move by the Fed was very disappointing and even appalling in the wake of intense financial-market turmoil,'' Chen Zhao, Montreal-based head of global strategy at BCA Research Ltd., wrote to clients on Dec. 12. ``The most troubling aspect of yesterday's decision is that it reveals a lack of coherent strategy and focus at the Fed.''
The Fed also has been struggling to restore its credibility and retain its consumer-protection status in the face of congressional criticism that it was lax in overseeing mortgage lenders. Last week, the U.S. central bank proposed various rules barring deceptive loan practices and making lenders responsible for determining whether borrowers can afford their mortgages.
Duh! Like the Fed never realized that some lenders might be unscrupulous, or that there were folks who couldn't compute whether they could afford a mortgage. This from an institution whose New York district bank publishes comic books -- that's right, comic books -- to explain topics such as how the banking system creates money and the meaning and purpose of monetary policy.
The situation in Europe isn't much brighter.
With banks balking at lending to one another out of fear of not being repaid -- effectively turning the economy's motor oil into sludge --Jean-Claude Trichet, head of the European Central Bank keeps talking about raising interest rates to battle inflationary pressures.
The massive injections of liquidity by the Fed, ECB and other major central banks have succeeded in lowering interbank lending rates -- for now.
But central bankers, especially Trichet, continue to insist that these operations are separate from monetary-policy decisions. ``Reduced stress in money markets will not deliver a cure for financial markets, which are absorbing the pain of substantial credit losses,'' wrote Bruce Kasman, chief economist at JPMorgan Chase & Co. on Dec. 21.
Now that we all know what subprime means, let's hope it plays a less destructive role in 2008 and becomes a word we can afford to forget. If not, it may become a synonym for the next recession.
Bloomberg
In this season of stock taking, the picture past and future for financial markets is far from pretty. The reason? Subprime
If you didn't know what subprime meant at the start of the year, it was hard to avoid its meaning by year end.
The big question now is what will the subprime crisis and ensuing credit crunch cost. In mid-July, Federal Reserve Chairman Ben Bernanke told the Senate Banking Committee that estimates of losses associated with subprime-credit products were $50 billion to $100 billion. Those numbers "are far too low,'' Jan Hatzius, New York-based chief U.S. economist at Goldman Sachs Group Inc., said in a mid-November report.
Based "on historical default and loss patterns in different home-price environments,'' he estimates U.S. losses will be roughly $400 billion.
Assuming that U.S. and European residential property prices fall 5 percent to 10 percent over the next year, investors in non-prime mortgages and securities linked to them -- including banks, hedge funds, asset managers and mortgage insurers -- stand to lose between $350 billion and $500 billion, according to London-based consultants Independent Strategy. Adding in expected losses from prime mortgages would lift the tally to more than $650 billion.
Yet these loss projections tell only part of the story. The other portion relates to the impact of the losses on the willingness and ability of so-called leveraged investors, institutions that finance their activities with borrowed funds, to keep lending. These include banks, broker-dealers, government- sponsored enterprises, savings institutions and hedge funds.
A September 2007 study by Tobias Adrian of the Federal Reserve Bank of New York and Hyun Song Shin of Princeton University, published by the New York Fed, found that leveraged investors, particularly banks and brokers, seek to maintain constant capital ratios. As such, when they lose money, they scale back lending to keep their capital ratios -- assets divided by equity or risk-free capital, such as cash -- from falling.
U.S. commercial banks on average have capital ratios of 10 percent, which means that for every $1 of capital lost, they reduce lending by $10. Thus, assuming that $200 billion of the projected $400 billion mortgage-credit loss is borne by leveraged institutions, the supply of credit will decline by $2 trillion, Hatzius said. ``The likely mortgage-credit losses pose a significantly bigger macroeconomic risk than is generally recognized.''
Meanwhile, Independent Strategy figures that banks will have to shrink lending by 15 percent to 20 percent to return their capital ratios to pre-crisis levels, and hedge funds and brokers by $18 to $25 for every $1 lost. ``A 10 percent reduction in global bank lending would damage corporate investment and consumer-spending growth, adding significantly to the risk of economic recession,'' the firm said in a Nov. 15 report.
Apart from a decision to supply wads of money to relieve the logjam in global credit markets, the performance of central banks has been anything but sterling. They woke up late to the subprime mortgage mess, and some people still doubt that they fully grasp the risks involved -- especially following the Federal Reserves' decision to cut its federal funds rate by 25 basis points to 4.25 percent on Dec. 11, when the market was looking for more.
``The timid move by the Fed was very disappointing and even appalling in the wake of intense financial-market turmoil,'' Chen Zhao, Montreal-based head of global strategy at BCA Research Ltd., wrote to clients on Dec. 12. ``The most troubling aspect of yesterday's decision is that it reveals a lack of coherent strategy and focus at the Fed.''
The Fed also has been struggling to restore its credibility and retain its consumer-protection status in the face of congressional criticism that it was lax in overseeing mortgage lenders. Last week, the U.S. central bank proposed various rules barring deceptive loan practices and making lenders responsible for determining whether borrowers can afford their mortgages.
Duh! Like the Fed never realized that some lenders might be unscrupulous, or that there were folks who couldn't compute whether they could afford a mortgage. This from an institution whose New York district bank publishes comic books -- that's right, comic books -- to explain topics such as how the banking system creates money and the meaning and purpose of monetary policy.
The situation in Europe isn't much brighter.
With banks balking at lending to one another out of fear of not being repaid -- effectively turning the economy's motor oil into sludge --Jean-Claude Trichet, head of the European Central Bank keeps talking about raising interest rates to battle inflationary pressures.
The massive injections of liquidity by the Fed, ECB and other major central banks have succeeded in lowering interbank lending rates -- for now.
But central bankers, especially Trichet, continue to insist that these operations are separate from monetary-policy decisions. ``Reduced stress in money markets will not deliver a cure for financial markets, which are absorbing the pain of substantial credit losses,'' wrote Bruce Kasman, chief economist at JPMorgan Chase & Co. on Dec. 21.
Now that we all know what subprime means, let's hope it plays a less destructive role in 2008 and becomes a word we can afford to forget. If not, it may become a synonym for the next recession.
Bloomberg