This Weekend’s Contemplation – The Financial Institutions Will Shrink by $2T

The post below from the WSJ discusses potential losses from the mortgage industry and the resulting decrease in financial institution assets. Using three different methods to forecast total mortgage losses it appears that $400B seems to be a consistent estimate. The last I heard the financial institutions had written off about $163B. That means that the financial institutions are only 40% of the way done and look at the problems it is causing. Ultimately, this will cause the financial institutions to shrink their asset size by about $2T to accommodate the losses. It is estimated that this will cut about 1% – 1.5% from economic growth. Text in bold is my emphasis. Also the a copy of the original study can be found at a Brandeis University site.

Mortgage losses, compounded by contemporary risk-management and accounting practices, could prompt banks and other lenders to shrink their lending and other assets by $2 trillion, a study concludes.

The resulting withdrawal of credit could knock one to 1.5 percentage points off economic growth, compounding the impact of collapsing home construction and softer consumer spending due to lower home wealth, the study said. It was presented Friday at a forum in New York on the Federal Reserve organized by the Brandeis International Business School and the University of Chicago Graduate School of Business.

The study is one of the most exhaustive efforts to date to pinpoint the extent and impact of mortgage losses.

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 the losses will be far larger -- about $400 billion -- and cause much more damage than if they had occurred in stocks or corporate bonds. That is because about half the losses will be borne by banks and other highly leveraged institutions, which hold equity and other capital of just 4% to 10% of total assets.

For each dollar of loss not made up for by new capital, these institutions will have to shrink their balance sheets by $10 to $25 by reducing lending or selling securities. They would do that not just in order to keep their capital ratios steady, but also to raise those ratios to align with risk-management practices.

"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 Group Inc., 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."

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 foreclosed homes) of about $400 billion.

After examining the mortgages' distribution, they concluded about half is held by "leveraged" institutions such as banks, thrifts, securities dealers and Fannie Mae and Freddie Mac. Based on recent experience, they calculate such institutions on average will want to boost their capital-to-asset ratios 5% because of increased risk. Even assuming they offset half their losses by raising $100 billion in new capital, these institutions still will try to shrink their assets, now about $20.5 trillion, by about $2 trillion.

The study helps quantify a phenomenon called the financial accelerator, first coined by Federal Reserve Chairman Ben Bernanke as an academic and now a major factor in his decision recently to speed up interest-rate cuts. Mr. Bernanke told Congress this past week that the 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."

(Double click to enlarge.)