Source : The Business Times, Dec 31, 2007
Projections of US$650b losses from the credit crunch tell only part of the story.
IN this season of stock taking, the picture past and future for financial markets is far from pretty. The reason? Sub-prime. If you didn’t know what sub-prime 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 sub-prime 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 sub-prime-credit products were US$50 billion to US$100 billion. Those numbers ‘are far too low,’ Jan Hatzius, New York-based chief US economist at Goldman Sachs Group, said in a mid-November report.
Based ‘on historical default and loss patterns in different home-price environments,’ he estimates US losses will be roughly US$400 billion.
Assuming that US and European residential property prices fall 5 per cent to 10 per cent 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 US$350 billion and US$500 billion, according to London-based consultants Independent Strategy. Adding in expected losses from prime mortgages would lift the tally to more than US$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.
US commercial banks on average have capital ratios of 10 per cent, which means that for every US$1 of capital lost, they reduce lending by US$10. Thus, assuming that US$200 billion of the projected US$400 billion mortgage-credit loss is borne by leveraged institutions, the supply of credit will decline by US$2 trillion, Mr Hatzius said. ‘The likely mortgage-credit losses pose a significantly bigger macroeconomic risk than is generally recognised.’ Meanwhile, Independent Strategy figures that banks will have to shrink lending by 15 per cent to 20 per cent to return their capital ratios to pre-crisis levels, and hedge funds and brokers by US$18 to US$25 for every US$1 lost. ‘A 10 per cent 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 sub-prime 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 per cent 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 US 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 realised 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 Mr 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 sub-prime 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.
The writer is a Bloomberg News columnist. The opinions expressed are his own.
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