[NYTr] The Economy's $2 Trillion Worry

[All the News That Doesn't Fit]

sent by Steven L. Robinson - activ-l

Business Week - November 19, 2007
http://www.businessweek.com/bwdaily/dnflash/content/nov2007/db20071119_601375.htm


The Economy's $2 Trillion Worry

The subprime spread continues: A Goldman Sachs report says the overall
impact of mortgage losses on economic activity could be huge

by Steve Rosenbush

Just a few months ago, analysts believed the collapse of subprime
mortgage securities and related investments would lead to losses of $50
billion to $100 billion, a large but manageable number. Now, a new
report from Goldman Sachs (GS) says losses from subprime exposure could
be much larger than recently assumed, hitting as much as $400 billion.
But that's not the extent of the financial carnage: Goldman said the
full impact on the economy could be even more substantial, because the
losses could compel banks and other lenders to curtail lending by as
much as $2 trillion.

If banks trim their lending by that amount, consumers and businesses
won't be able to borrow the money they need to maintain strong economic
expansion. "This is a large shock. It corresponds to 7% of the total
debt owed by U.S. nonfinancial sectors," wrote Goldman Senior Economist
Jan Hatzius, the author of the report. "The drag on economic activity
could be substantial."

Doing the Math

How does a $400 billion loss in the credit markets translate into $2
trillion of economic damage? The answer is debt, or leverage. Banks,
hedge funds, and private equity firms often borrow $10 or more for each
$1 of equity they use in a transaction, according to estimates by the
New York Federal Reserve. When the investments pan out, the use of debt
boosts their return. When the investments go south, the use of debt
exacerbates the loss and often leads lenders to be more conservative in
the future.

Citing a recent analysis by Tobias Adrian of the New York Fed and Hyun
Song Shin of Princeton University in the Goldman report, Hatzius
estimated about half the $400 billion in losses will fall on the
shoulders of highly leveraged investors such as banks, hedge funds, and
brokers. He said they typically cut back on lending when the value of
their assets falls, to maintain their targeted ratios of capital to
loans. If those lenders take half of the $400 billion hit, they will
have to reduce lending at a rate of $10 for every $1 of loss, which
would add up to $2 trillion.

Mounting Losses

The subprime crisis already has hit investment banks hard. Merrill Lynch
(MER) reported a loss of $8.4 billion (BusinessWeek.com, 11/15/07), and
analysts think more could be on the way. Citigroup (C) reported a loss
of $6.5 billion in the third quarter, and says it could lose as much as
$11 billion more in the fourth (BusinessWeek.com, 11/13/07). If banks
cut back on lending, the damage could spread to other parts of the
economy. The default rate on corporate debt (BusinessWeek.com,
10/26/07) could rise if corporations can't borrow more money to roll
over their debt.

Other market experts agree that mounting losses in the credit markets
could compel banks to roll back lending. "The real issue is how much of
the losses in the credit markets are leveraged and what that means to
banks, which might have to reduce lending to keep their capital
ratios," says Martin Senn, chief investment officer of Zurich Financial
Services (ZURN), which manages about $200 billion in assets. "If banks
are forced to cut back on lending., that could become a serious stress
on the U.S. economy. I see the risk of recession in the U.S. definitely
rising."

For the moment, Zurich Financial Services is still forecasting the U.S.
economy will grow in 2008, albeit at a much slower rate, about 2%.
That's about half the pace of the third quarter.

Damaging Time Frame The extent of the damage will depend on a variety of
factors, such as the speed with which the projected $400 billion in
losses are realized. If the losses are realized in one year, the shock
could trigger "a substantial recession," according to Hatzius. If they
occur over a period of two to four years, the result could be "very
sluggish growth." It's possible the damage could be offset by
unexpected strength in other parts of the economy, or by government
intervention.

But it's also possible the economic effects of the credit crunch could
be compounded by other problems. "Oil prices are a huge risk. If it
stays at $100 a barrel, the economy is in pretty bad shape," says Joe
LaVorgna, chief U.S. economist at Deutsche Bank (DB). He still thinks
the economy can avoid recession. But credit-driven fears "are in the
market." He adds that high oil prices (BusinessWeek.com, 11/14/07)
could shave an additional 1.5 percentage points of growth from the
economy.

Not so long ago, some analysts were quick to write off the problems in
the credit market as a case of the summer doldrums. They hoped the
markets would come back to life after Labor Day, and when the Fed cut
interest rates in September, it seemed they might be right. However,
the hope for a quick fix has faded like memories of the beach.

Rosenbush is a senior writer for BusinessWeek.com in New York.