Friday, February 29, 2008
Leveraged Losses Lessons from the Mortgage Market Meltdown
The WSJ Real Time Economics blog fans a chilly breeze of pessimism in it's reporting of a new paper [Leveraged Losses Lessons from the Mortgage Market Meltdown, 2008 U.S. Monetary Policy Forum, February 29, 2008 - New York, N.Y.] detailing projected shrinkage of $2 trillion which the banks are expected to take on, on account of mortgage losses, and the resultant havoc that will accompany this figure vanishing off the banks' balance sheets.
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.
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.
More on this from Maurna Desmond, Forbes. The bad news bears, David Greenlaw of Morgan Stanley, Jan Hatzius of Goldman Sachs, Anil Kashyap of the University of Chicago, and Hyun Song Shin of Princeton University said that as hurting financial institutions hustle to get capital in hand, they'll lend about $910 billion less than previously expected. The paper reported that stress in the financial sector is worse than anything experienced in the last eighteen years.
This is the link to the actual conference - "Leveraged Losses Lessons from the Mortgage Market Meltdown" and this is the link to the full report. Brief excerpt below.
The characteristic feature of the financial intermediary sector is that it is composed of leveraged institutions whose capital is a small proportion of the total assets they hold. Credit losses deplete their capital cushion. We show that in past episodes, when faced with capital losses, intermediaries scale back their leverage and try to rebuild their capital. Consequently, the overall decline in lending following the losses depends not only on the size of the initial shock, but also on the ability to raise new capital and on the extent to which the intermediaries reduce their target level of leverage. We provide a range of possible adjustments, but as a rule the overall lending reduction is many times larger than the capital losses. Our baseline estimates imply just under a $2 trillion contraction in intermediary balance sheets, of which roughly $900 billion would represent a decline in lending to households, businesses and other non-levered entities.
I don't want to say much about this report, because there is nothing much to say, except that the figures are dismaying. What worries me is the growing fears about leveraging. Seems like we're moving to another stage of this crisis. In this stage, we bump across instances where banks, and their traders 'gone wild', have made massive leveraged bids and bet the house using money they didn't have, with no means to cover their behinds if the bets went sour.
One of the side effects of a $2 trillion contraction in the balance sheets is that they can no longer cover bad bets with new leveraged bets. So the ferris wheel comes to a standstill because there's no capital to fuel further leveraging and everyone can see the traders with the pants down, holding billions of dollars worth of leveraged bids for which they have no means of taking responsibility. Something tells me you're going to hear a lot more about the dirty underbelly of leveraging in the near future. Probably billions of dollars, and tears' worth...
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.
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.
More on this from Maurna Desmond, Forbes. The bad news bears, David Greenlaw of Morgan Stanley, Jan Hatzius of Goldman Sachs, Anil Kashyap of the University of Chicago, and Hyun Song Shin of Princeton University said that as hurting financial institutions hustle to get capital in hand, they'll lend about $910 billion less than previously expected. The paper reported that stress in the financial sector is worse than anything experienced in the last eighteen years.
This is the link to the actual conference - "Leveraged Losses Lessons from the Mortgage Market Meltdown" and this is the link to the full report. Brief excerpt below.
The characteristic feature of the financial intermediary sector is that it is composed of leveraged institutions whose capital is a small proportion of the total assets they hold. Credit losses deplete their capital cushion. We show that in past episodes, when faced with capital losses, intermediaries scale back their leverage and try to rebuild their capital. Consequently, the overall decline in lending following the losses depends not only on the size of the initial shock, but also on the ability to raise new capital and on the extent to which the intermediaries reduce their target level of leverage. We provide a range of possible adjustments, but as a rule the overall lending reduction is many times larger than the capital losses. Our baseline estimates imply just under a $2 trillion contraction in intermediary balance sheets, of which roughly $900 billion would represent a decline in lending to households, businesses and other non-levered entities.
I don't want to say much about this report, because there is nothing much to say, except that the figures are dismaying. What worries me is the growing fears about leveraging. Seems like we're moving to another stage of this crisis. In this stage, we bump across instances where banks, and their traders 'gone wild', have made massive leveraged bids and bet the house using money they didn't have, with no means to cover their behinds if the bets went sour.
One of the side effects of a $2 trillion contraction in the balance sheets is that they can no longer cover bad bets with new leveraged bets. So the ferris wheel comes to a standstill because there's no capital to fuel further leveraging and everyone can see the traders with the pants down, holding billions of dollars worth of leveraged bids for which they have no means of taking responsibility. Something tells me you're going to hear a lot more about the dirty underbelly of leveraging in the near future. Probably billions of dollars, and tears' worth...
Subscribe to Posts [Atom]
