"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.