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

Yesterday’s post on the cuts the banks would have to incur as losses mounted seemed to garner a lot of interest so I decided to look into it further. I found the article below from Market Watch, which shed more light on the subject. I also found a copy of the paper at a Brandeis University site.

Finally, I am beginning to see stories in the press that jive with what I am being told by contacts in the commercial and investment banking industry. Since the beginning the year the risk managers or others close to the capital markets they are all very pessimistic. (I did not use “extremely” pessimistic because I may have to use that term in a few months and I did not want to run out of adjectives.) Make no mistake we are living in historic times in terms of the economy. As a result there is no clear path to success. In addition, many of the policies that are now being deployed (rate cuts, stimulus packages, etc.) are methods used to fight the last war, the Great Depression, and this situation is different.

The economic impact of the mortgage crisis and credit crunch will be huge, and it has barely begun, a new study prepared by several prominent economists and released Friday has concluded.

"Feedback from the financial market turmoil to the real economy could be substantial," it said. Unless they can quickly recapitalize, banks are likely to cut back their lending to consumers and businesses by more than $1 trillion, cutting economic growth by more than a percentage point over the next 12 months.

After an initial period where several financial markets seemed immune from the crisis, the credit crunch is now gathering storm.

The report estimates that the credit crunch is expected to push down growth by 1.3 percentage points over the next 12 months.

Almost as alarming is the report's conclusion that this crisis is unique in the annals of U.S. economic history but now may serve as the template for more crises to come.

What is different this time is the amount of leverage. Bank balance sheets were forced to expand in the wake of the mortgage crisis, as off-balance-sheet investments were forced onto their books.

This so-called "unwanted lending" is set to reduce bank loans to business and consumers.

The paper estimates that total mortgage credit losses will cost $400 billion, up from initial estimates in August of $150 billion. Roughly 50%, or $200 billion, will be on the books of U.S. banks and securities firms.

This will result in an estimated contraction in lending of $1.13 trillion.

UBS analysts published a report Friday saying global losses could be $600 billion.

Banks have a choice to contract their balance sheets so that their capital on hand is sufficient, or else seek new capital from sovereign wealth funds or other investors.

There is little chance that the economic environment will improve any time soon to avoid this choice, the study said.

As of the end of January, banks had raised $75 billion in new capital and suffered $121 billion in losses.

The report urges banks to cut their dividends to preserve their existing capital. Central banks and governments should encourage this action across the globe so that there is no competitive disadvantage or stigma from the reduction.

For U.S. regulators, the study suggests the resumption of a monthly survey that details how much bank lending is truly voluntary.

A worse-than-expected economic outlook would cause a downward revision to these estimates.
A sharp decline in home prices could lead to many U.S. homeowners with negative equity, the report said.

At the moment, 50 million households have mortgages. If home prices drop 15%, it would put 21% of these mortgages, or $2.6 trillion, underwater.

The findings were presented at a forum organized by the University of Chicago Graduate School of Business. Presenters included Jan Hatzius of Goldman Sachs, Anil Kashyap of the Federal Reserve Bank of Chicago and Hyun Song Shin of Princeton University.

At the forum, two top Fed officials -- Boston Fed President Eric Rosengren and Fed Governor Frederic Mishkin -- were asked to respond to the paper. Both said they agreed with the basic story.

"I agree ... that relatively small losses in one sector of the credit market can have outsized impact on aggregate economic activity if they case a disruption to the financial system that leads to an amplified impact on lending," Mishkin said.

In fact, Rosengren said the authors may have underestimated the economic impact because of the risk of rising unemployment and a sharper drop in home prices.

At the moment, the consensus forecast of economists is for the U.S. to skirt a recession with only a small decline in home prices nationwide.

Rosengren said it was prudent for the Fed to take account of the downside risks to the economy in crafting its policy. He said the rate cuts to date have helped keep home prices from falling and the unemployment rate from rising.

So far, Rosengren said, the capital losses in the banking system have been concentrated in large banks. Small and medium-sized firms have not complained about a lack of credit.

In a separate speech, Dennis Lockhart, president of the Atlanta Fed, said that the financial markets remain fragile and vulnerable to shock.

"Looking ahead, I believe resolution of the current financial market problems requires some stabilization of U.S. housing markets. At this time, it's difficult to determine when that stability will materialize," Lockhart said in a luncheon speech in Atlanta.