Banks' losses could put $900 billion squeeze on consumers

Troubled loans – from homes to cars – could trim economic growth by 1 percentage point, a new forecast says.

SOURCE: National Association for Business Economics/Rich Clabaugh–STAFF

The retailer Sharper Image offers a stark image of how the credit crisis on Wall Street is becoming a widespread credit crunch for the rest of America: The purveyor of gadgets recently declared bankruptcy, citing a tougher climate for financing among the reasons.

That company is not an isolated case. Consumers and businesses now face an economic downturn made more difficult by a contraction among banks and other lenders. In fact, the health of banks has become perhaps the biggest source of uncertainty about the economy.

How bad is the damage?

By one new estimate, troubled mortgages alone could knock a full percentage point off economic growth in the year ahead. And mortgages are just part of the problem. With losses also rising on loans for everything from cars to commercial real estate, banks effectively will have less money available to make new loans – perhaps $900 billion less.

"The reality is that banks are in trouble," says Ed Yardeni, an economist who until recently has been optimistic about the economy's prospects for avoiding recession. "I don't think they'll go bankrupt. [But] we're in the process of cleaning up the mess that the financial engineers created" by reselling shaky home loans to investors.

The mess doesn't have to have an unhappy ending, he says.

First, not all banks and lenders are in equal trouble. Many large banks pushed as a herd into complex and risky financial products. Citigroup, for one, has lost more than half its stock market value in the past year and declined further Tuesday as a Wall Street analyst predicted deeper losses ahead. But small or mid-size banks, ones that avoided the push into subprime lending, may see the current environment as an opportunity to keep lending and grab a bigger share of the market.

Second, the decline in credit is in part a necessary adjustment for an economy that had been artificially supercharged.

Finally, the Federal Reserve has been cutting interest rates, and many analysts expect that trend to continue. That may not spur a big increase in lending, but it does help banks work through their problems, by widening the "spread" between short-term borrowing costs and the longer-term income banks earn on loans.

Still, Mr. Yardeni, founder of a research firm in Great Neck, N.Y., concludes that the US is entering a recession now.

He hopes the economy and banking system will navigate through these challenges, but he and other analysts see the possibility of darker outcomes as well.

"The concerns are quite real," says James Hamilton, an economist at the University of California, San Diego. "I think we are talking about very significant losses and possible failures."

Late last week, a team of researchers put forward a detailed analysis of the problem – or at least the biggest known chunk of the problem.

The most likely outcome is that mortgage losses in the current cycle will total $400 billion, concluded the four economists involved, Jan Hatzius of Goldman Sachs, David Greenlaw of Morgan Stanley, Anil Kashyap of the University of Chicago, and Hyun Song Shin of Princeton University.

When the stock market loses that much money (as can occur on a single bad day), it doesn't rattle the economy. But credit is a vital underpinning of much economic activity, and when banks lose that much money, it depletes the capital reserves that they rely on for making new loans.

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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