2007 November 18 Sunday
Goldman Sachs Warns On $2 Trillion Credit Hit

My guess: recession in 2008. As financiers worry the entire credit market could freeze up Goldman Sachs chief economist Jan Hatzius, in a note entitled "Leveraged Losses: Why Mortgage Defaults Matterí", argues that housing loan losses might range of $200 billion to $400 billion and that an amplifying effect of those losses might reduce financing by $2 trillion dollars.

The sub-prime mortgage crisis in the US could lead to the opening up of a $2 trillion (£978bn) black hole as banks and financiers stop lending money because of mounting losses, the leading Wall Street bank Goldman Sachs warned yesterday.

The bank's chief economist, Jan Hatzius, who is regarded as an expert on the domestic housing market, warned that losses on outstanding loans could balloon to $400bn as borrowers struggled to repay debts. That figure is well ahead of the $50bn or so losses already announced by major banks including Citigroup and Merrill Lynch, and well ahead of the Federal Reserve's own estimates. In July the Fed chairman, Ben Bernanke, estimated that losses on loans could be up to $100bn.

Why a recession? Consumers are experiencing declining home values, rising oil prices, and some are experiencing a big reduction in credit availability. Plus, many have mortgages with interest rates which are going up and increasing their monthly payments. Worse, the trend in world oil production (the second graph is really bad news) suggests we can't expect any relief on oil prices and gasoline prices.

The bright news? Technology continues to raise productivity and the declining dollar is increasing export demand. Want job security? Get into an industry (if it exists) that exports energy. If such an industry doesn't exist then come up with a discovery that produces exportable energy. Then you can make money off selling to the Chinese.

The losses by financial companies get amplified in the larger economy because they cut back much more in lending.

And leveraged investors react to losses by actively cutting back lending to keep capital ratios from falling -- A bank targeting a constant capital ratio of 10 percent, for example, would need to shrink its balance by $10 for every $1 in losses.

So then total losses of $400 billion would possibly shrink available credit by $4 trillion. Though in theory the Federal Reserve could inflate the US economy out of the dampening effects such a loss caused. What I want to know: How much of the exposure to these losses is for foreign investors?

A week ago some major banks put together a fund to help stabilize credit markets. Will it help?

The countryís three biggest banks have reached agreement on the structure of a backup fund of at least $75 billion to help stabilize credit markets, a person involved in the discussions said yesterday, ending nearly two months of complicated negotiations against a worsening economic backdrop.

Officials from Bank of America, Citigroup and JPMorgan Chase reached agreement late Friday, settling on a more simplified structure than had been proposed, said this person, granted anonymity because he was not authorized to talk for the group.

BusinessWeek says the decline in housing prices should cut consumer spending.

The question, though, is just how much consumers will restrain their free-spending ways. Research by economist Carroll suggests that every $1 decline in house prices lops about 9 cents off of spending. The current value of residential housing is about $21 trillion, according to the Federal Reserve. So if home prices fall by 10%, as many people expect, that would lead to roughly a $200 billion hit to spending over the next couple of years. A 15% tumble in home prices would produce a $300 billion pullback in spending, or about 3% of personal income.

That accords well with calculations by BEA economists. They figure that households took out $340 billion in cash from mortgage and home-equity financing in 2006. That source of funding could largely disappear over the next couple of years.

Still, always look on the bright side of life. New York Times columnist David Leonhardt argues that the news about stocks, housing prices, and oil prices all are really good news for many people.

So unless youíre about to retire or sell stock for some other reason, you shouldnít get too upset about the marketís fall. As long as you are planning on more buying than selling over the next decade or two, a market correction is your friend.

Itís also likely to improve the nationís long-term economic prospects. The bull market of 1990s, combined with the housing boom, fooled many people into thinking they didnít need to save money. They evidently figured that their existing assets would continue to soar in value and could serve as their nest egg. Last year, Americans saved only 0.4 percent of their disposable income, down from 7 percent in 1990.

This decline in personal savings has set the stage for all kinds of problems. The biggest may be that less savings, by definition, equals a smaller pool of capital available for overall investment. Less investment ó be it in medical technology or software ó will mean slower economic growth and lower standards of living down the road.

Cheaper housing prices are good news for people who don't own a house. Cheaper stock prices are great news for people who need to buy lots of stocks in the future to save for their retirement. I personally want to see the stock market lose half its value so that I can buy cheaply. So I agree.

The high oil prices are a very useful signal that we need to move away from using oil. In fact, high oil prices are causing a boom in venture capital funding of cleaner energy alternatives. That is great news.

Share |      By Randall Parker at 2007 November 18 06:08 PM  Economics Business Cycle

Your Image Here said at November 19, 2007 3:44 AM:

You mentioned inflation, it's already happening IMHO. Note that when the Government calculates ''the inflation rate'' they just somehow seem to exculde the prices of energy and food (hmm, aren't those an important part of my personal budget?).
I know why the Government is ''gaming the system'' on inflation, its to keep annual raises in Social Security (and other welfare programs) down.
IMHO the REAL inflation rate is about 7-8% about twice ''offical'' rate.
Just like Clinton dumped an exploded economy on Bush's lap, Bush will return the favor...

John S Bolton said at November 19, 2007 10:56 PM:

When these people who tell us not to worry when we actually should, turn around and tell us to be scared, be very scared, my suspicion meter goes off, and makes me wonder, is there something in it for them, like maybe bailouts, if they can panic us into doing something politically to cover them? We may have lost the bottom 20% of the market for housing units for years or even decades. No money down, no need for valid ID, those irresponsibilities must not come back. Threaten however they will, loyalty to the net taxpayer should come first. If they want to inflate the federal reserve has all the power they need to do that.

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