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Friday, February 29, 2008

Leveraged Losses Lessons from the Mortgage Market Meltdown

by Calculated Risk on 2/29/2008 09:06:00 PM

From the 2008 U.S. Monetary Policy Forum

"Leveraged Losses Lessons from the Mortgage Market Meltdown" by David Greenlaw (Morgan Stanley), Jan Hatzius (Goldman Sachs), Anil Kashyap (Chicago GSB) and Hyun Shin (Princeton).

Hatzius summarizes (via email):

Our story is as follows. While the mortgage credit losses still don’t look huge relative to the size of the economy or the financial markets -- the baseline assumption in the paper is $400bn in losses ... they are nevertheless responsible for much of the financial and economic turmoil of the past 6 months. We estimate that roughly half of the total losses are likely to be borne by leveraged US financial institutions ... Assuming that these institutions will aim to lower their leverage by 5%, our baseline estimate is that they will scale back their lending by close to $2 trillion in response to these losses, even if we assume that they manage to “replace” 50% of the lost equity via inflows of unlevered capital, e.g. from sovereign wealth funds. Further, we estimate that just under $1 trn of this credit supply hit is a “ Main Street ” event and will hit unlevered entities such as households and nonfinancial businesses; the remainder is a “Wall Street” event and will hit other leveraged institutions. Finally, we (very tentatively) estimate that the credit supply hit could shave 1-1½ points from real GDP growth over the next year, over and above the “traditional” hit from reduced homebuilding demand, a negative wealth/MEW effect on consumer spending, and the multiplier effects working via the labor market.