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Subprime Debacle to Shrink US. Credit by $2 Trillion

Subprime Debacle to Shrink US. Credit by $2 TrillionMonetary Policy Forum report

March 3, 2008


Outstanding credit in the United States will contract by around $2 trillion as a result of the subprime mortgage market meltdown, a new study estimates.

International losses from the mortgage crisis are estimated at $400 billion, according to Leveraged Losses: Lessons from the Mortgage Market Meltdown issued by the U.S. Monetary Policy Forum Conference Friday. About half of those losses are expected to be borne by U.S. financial institutions with exposure to mortgage securities.

The report was prepared by David Greenlaw, chief U.S. fixed income economist, Morgan Stanley; Jan Hatzius, chief U.S. economist, Goldman Sachs; Anil Kashyap, professor of economics and finance, The University of Chicago Graduate School of Business; and Hyun Shin, professor of economics, Princeton University

“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,” the authors wrote.

As subprime mortgage originations slowed, other sectors of the mortgage market were impacted. Jumbo loans, which account for 17 percent of the dollar value of all first-lien U.S. mortgage debt, went from a spread of between 20 to 40 basis points over conforming mortgages before August 2007 to around 100 BPS subsequently.

The report noted the London Interbank Offered Rate serves as an adjustable-rate index for most U.S. subprime loans.

Until recently, losses on subprime mortgages were estimated based on historical data. Forecasts would extrapolate data from earlier vintages, which didn’t experience falling home prices.

“It is likely that simply extrapolating from the historical progression of defaults and losses will produce an overly optimistic picture,” the report said. “We suspect strongly that defaults on the 2006 vintage will not just grow in line with the progression observed in the past, but that the rise in defaults will exceed the historical norm, perhaps by a considerable margin.”

Based on a 15 percent home price decline, about $2.6 trillion in mortgages would be in a negative equity position, the authors explained. And borrowers who have less equity or negative equity have fewer options to deal with defaults.

Using an estimate of subprime losses from Goldman Sachs of $243 billion and factoring in “negative equity dynamics,” credit losses could reach as much as $400 billion. When factoring Alt-A and jumbo losses, credit losses could be well above $400 million.

When home prices previously fell in the states of California, Massachusetts, and Texas, they fell by about 10 percent to 15 percent. Foreclosures kept rising until prices bottomed out, then took another three to six years to normalize.

But since credit standards were much looser during recent years than in prior real estate market declines, the national foreclosure rate could be tripled over the next few years. The authors suggested foreclosures could go from 0.4 percent in mid-2006 to 1.2 percent by next year. Most of the anticipated foreclosures will be from the current stock of loans, as loans made after 2007 will reflect far tighter credit standards.

Foreclosures will start on an estimated $1.5 trillion of the current book — though only about 57 percent of all filings will end in repossessions. This level of foreclosures translates into credit losses of around $400 billion — of which around half will be suffered by U.S. institutions.

As institutions expanded their balance sheets, unqualified borrowers were granted easy credit as companies had intense urges to employ surplus capital. But in downturn of the credit cycle, the opposite occurs.

Estimated write-downs so far of $120.9 billion have been offset by $75 billion in recapitalization from sovereign wealth funds.

The report indicated about $20.5 trillion in total assets at leveraged institutions. Leverage ratios varied at these companies from 8.4 at savings institutions and credit unions to 24.7 at Fannie Mae and Freddie Mac to 31.6 at hedge funds and brokers.

Factoring in all these figures, the report concluded balance sheets will likely decrease by about $1.98 trillion.

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