Can Lender Retreat Spur Recession?

Source: American Banker | Monday, November 19, 2007

A bleak report by a Goldman Sachs Group Inc. economist predicting that subprime mortgage losses could trigger a recession drew support from a number of industry observers Friday — though they differed on the probability of such an event, as well as the extent of the sector's likely losses.

Jan Hatzius, Goldman's chief U.S. economist, wrote in a report Thursday that the credit losses on outstanding mortgages could total as much as $400 billion. If leveraged financial institutions absorb about half of that amount, the crisis could translate to a $2 trillion pullback in lending.

That's about 7% of lending to the nonfinancial sectors, Mr. Hatzius wrote, and assuming that a historically proportional relationship with economic growth holds, "it is easy to see how such a shock could produce a substantial recession."

At the heart of the report are some key assumptions about how individual banking companies would respond to such losses — and whether rival lenders would take up the slack if others pull back. Alan Blinder, a professor at Princeton University and a former vice chairman of the Federal Reserve Board, said a number even half the size of Mr. Hatzius' projection for mortgage losses "seems on the high side," though it would certainly be feasible.

"They keep mounting," he said. "We think they're this big, and they turn out to that big." In addition, "if the losses, and especially the implications of those losses for credit granting, are as severe as Jan projects, then recession is an extremely realistic possibility — indeed, a probability." However, "it seems like a not-impossible but pretty pessimistic scenario," Mr. Blinder said. "I'm not that pessimistic."

Joshua Rosner, a managing director at Graham Fisher & Co. and a longtime bear on housing, said he agrees with Goldman's assessment of the financial service industry's losses on mortgages. "I think $400 billion is a realistic number. I think it could be even more," he said. Mr. Hatzius wrote that a $400 billion wipeout would represent about 2.5% of the total market capitalization of U.S. equities. But even though households might not be expected to adjust asset holdings in the face of such a loss, he wrote, financial institutions are likely to withdraw credit to preserve capital ratios — 10% on average for commercial banks, and a lower amount for brokerages.

A key question for Prof. Blinder is whether a $1 billion loss at a financial institution would lead to a $10 billion contraction in credit. "You have to believe that nobody else comes in and picks up the slack," he said. Mr. Rosner agreed that a recession is a strong possibility. He said either the lending industry will shrink, as the Goldman report suggests, or companies will have to ramp up efforts to raise capital in international markets. Doing the latter, he said, could drive up interest rates, and either scenario could hurt the general economy. However, Nancy A. Bush, the president of NAB Research LLC, called the Goldman report misleading and irresponsible.

"I have no idea how they came up with this. I just totally don't get it," Ms. Bush said in an interview Friday. The $2 trillion and $400 billion figures are "totally hypothetical," she said. "He doesn't seem to account for future Fed interest rate cuts, and he seems to assume that today's credit problems will just continue on forever. This is just one more reason for people to say, 'Oh my God, we're so scared.' " Similarly, Ernie P. Goss, an economist at Creighton University in Omaha, called the Goldman numbers outrageous.

"It'll get Goldman headlines, but I don't see how it's even possible to know that," Mr. Goss said. "If they actually did cut lending by $2 trillion, that would definitely trigger recession, but that figure is way high." Scott A. Anderson, a senior economist at Wells Fargo & Co., agreed that the concerns outlined in the Goldman report are legitimate. But he also said that, barring a dramatic plunge in consumer confidence, the economy should avoid a recession. "Housing continues to decline, and there will be big hits to consumer spending," Mr. Anderson said. "But I'm not sure about the Goldman Sachs numbers. They tend to be more pessimistic than me. We think we'll avoid a recession, but only by the skin of our teeth."

Eugene Ludwig, the president of Promontory Financial Group LLC and a former comptroller of the currency, agreed that "there are sectors both geographical and productwise that are going to be in recession." However, "do those sectoral recessions translate into a national recession?" he asked. "There are so many exogenous variables here. … My view is, tighten your seat belt. It's going to be a bumpy ride."

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