Subprime macroeconomic risk

Subprime's Hidden Cost Is Shrinking Leverage

Excerpt:

... leveraged investors, particularly banks and brokers, seek to maintain constant capital ratios. As such, when they lose money, they scale back lending to keep their capital ratios -- assets divided by equity or risk-free capital, such as cash -- from falling.

U.S. commercial banks on average have capital ratios of 10 percent, which means that for every $1 of capital lost, they reduce lending by $10. Thus, assuming that $200 billion of the projected $400 billion mortgage-credit loss is borne by leveraged institutions, the supply of credit will decline by $2 trillion, Hatzius said. ``The likely mortgage-credit losses pose a significantly bigger macroeconomic risk than is generally recognized.''

Pulling Back

Meanwhile, Independent Strategy figures that banks will have to shrink lending by 15 percent to 20 percent to return their capital ratios to pre-crisis levels, and hedge funds and brokers by $18 to $25 for every $1 lost. ``A 10 percent reduction in global bank lending would damage corporate investment and consumer-spending growth, adding significantly to the risk of economic recession,'' the firm said in a Nov. 15 report.

Apart from a decision to supply wads of money to relieve the logjam in global credit markets, the performance of central banks has been anything but sterling. They woke up late to the subprime mortgage mess, and some people still doubt that they fully grasp the risks involved -- especially following the Federal Reserves' decision to cut its federal funds rate by 25 basis points to 4.25 percent on Dec. 11, when the market was looking for more.

``The timid move by the Fed was very disappointing and even appalling in the wake of intense financial-market turmoil,'' Chen Zhao, Montreal-based head of global strategy at BCA Research Ltd., wrote to clients on Dec. 12. ``The most troubling aspect of yesterday's decision is that it reveals a lack of coherent strategy and focus at the Fed.''



Comment: See earlier CFG post: Subprime Economic Shock