Banks' losses could put $900 billion squeeze on consumers

Not all those losses will be borne by banks. But even nonbank financial firms often operate on the same principle of leverage: Each $1 of capital can fund perhaps $10 of loans.

"It's a multiplier effect," says Brian Bethune, an economist at Global Insight in Lexington, Mass.

For reference, all US banks tracked by the Federal Deposit Insurance Corp. had capital of more than $1 trillion as of the end of last year.

During good times, that seemed like plenty. But now banks are "going into a recession with just barely enough capital in the system," Mr. Bethune says. "What if additional write-offs come?"

Delinquency rates have been rising from credit cards to car loans, for example. And on the business side, banks are taking a tougher look at whether clients with faltering revenues, such as Sharper Image, deserve more credit.

The losses are already denting the banks' capital cushion – and will perhaps pose a severe test for some large banks.

Mr. Hatzius and the other researchers figured that banks will be able to raise some new capital from investors, to replenish some of their lost reserves. Even so, their baseline forecast is that lenders will reduce lending by $900 billion or so, as they scramble to maintain their desired (and required) capital-to-loan ratios. That in turn could hold back economic growth by 1 to 1.5 percentage points.

Currently, consumers and businesses hold some $30 trillion in debt, so the $900 billion drop represents roughly a 3 percent cut in credit, according to Yardeni.

He says that doesn't sound too hard for the economy to bear.

Much depends however, on the trajectory of economic activity in the months ahead. The big danger would be if the problems evolved into what some call "debt deflation."

Here's the risk: If a glut of real estate is suddenly for sale by banks and at-risk borrowers, the price of real estate could keep deflating. Instead of seeing a bargain, potential buyers see a hazard, which could make prices drop even more. The result could be new foreclosures, as more homeowners walk away from loans that are bigger than the value of their homes. That would further erode the capital of banks and other lenders.

This danger, coupled with the risk of souring loans in other economic sectors, prompts New York University economist Nouriel Roubini to say that loan losses could total $1 trillion, far above the Hatzius forecast.

That, in turn, would carry deeper multiplier effects.

"The Fed is seriously worried about this vicious circle and about the risks of a systemic financial meltdown," Mr. Roubini testified recently to Congress.

He added that while financial crises have come repeatedly, this one has the potential for wider ripples both geographically and in terms of the way loans are now bundled into securities to be bought and sold by investors.

To rebuild capital, banks can raise money by issuing new stock to the public or by finding the equivalent of a rich uncle. So-called sovereign wealth funds, owned by foreign governments, have recently bought stakes in corporations including Citigroup. Another way to hoard cash is to temporarily reduce dividend payments to shareholders.

Analysts say that mainstream banks aren't the only ones with a capital challenge. The issue also confronts Fannie Mae and Freddie Mac, government-sponsored enterprises designed to stimulate home lending and stabilize mortgage markets.

The enterprises have been able to keep processing mortgages at a time when other parts of the market have stalled. But they acknowledge that this will be a tough year as losses climb.

James Lockhart, the government's regulator for Fannie Mae and Freddie Mac, recently testified that falling home prices are exposing the agencies to more risk. Their potential exposure "increased dramatically," he said, taking into account the current market value of homes.

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