The true extent of the sub-prime mortage crisis may be far greater than previously thought, a new report by Goldman Sachs warns.
The losses could even compel banks and other lenders to curtail lending by as much as $2 trillion, claims the report. Analysts had believed the collapse of sub-prime mortgage securities and related investments would lead to losses of $50 billion to $100 billion.
“This is a large shock. It corresponds to 7% of the total debt owed by U.S. nonfinancial sectors,” writes Goldman Senior Economist Jan Hatzius, senior economist, Goldman Sachs and author of the report. “The drag on economic activity could be substantial.”
Banks, hedge funds, and private equity firms routinely 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 stabilise, the use of debt increases their return. When the investments fail, the use of debt amplifies the loss and usually lenders are more conservative in the future.
Drawing on a recent analysis by Tobias Adrian of the New York Fed and Hyun Song Shin of Princeton University in the Goldman report, Hatzius estimates about half the $400 billion in losses will fall on highly leveraged investors such as banks, hedge funds, and brokers.
He says 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. Other market experts agree that mounting losses in the credit markets could compel banks to reduce their lending.
However, Zurich Financial Services is still predicting that the US economy will grow in 2008, although at a much slower rate, around 2%.
The extent of the damage will depend on a variety of factors, such as the speed with which the predicted $400 billion in losses comes about.
The economic effects of the sub-prime crisis could be exacerbated 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 US economist, Deutsche Bank.