In a recent paper, David Greenlaw, Jan Hatzius, Anil K Kashyap, Hyun Song Shin exposed us outsiders to the inside workings of those estimates we see of how the credit crunch affects output. The paper, entitled “Leveraged Losses: Lessons from the Mortgage Market Meltdown”, was widely covered (, , , Calculated Risk, Big Picture) but I still think that the conclusions, as well as the methodology, bear some repeating for emphasis. And in any case, it’s a long paper, and different people have focused on different aspects.
Essentially, the authors trace how the souring of so many mortgage loans resulted in elimination of equity capital in the leveraged financial institutions in the economy. Assuming some injection of new capital (think of injections into Citibank, for instance ), and some deleveraging as institutions try to build in a cushion of capital, and one sees easily enough a reduction in lending, i.e., the asset side of the balance sheets shrink.
The final step in the chain is to see how reduced lending leads to decelerating economic growth.
I can’t do justice to the entire paper, but I can highlight a few choice bits. The first aspect I want to highlight is the characteristics of the financial sector (what’s called the leveraged system in the paper), such as the size of the balance sheets, and in particular how much equity capital there is.
The authors begin with an estimate of the losses falling on the leveraged system (the total losses are estimated at twice the size of that on the leveraged system).
Our baseline scenario (marked in grey) is that leverage will decline by 5%, and that
recapitalization of the leveraged system will recoup around 50% of the $ 200 billion loss
incurred by the banking system. Under this baseline scenario, the total contraction of
balance sheets for the financial sector is $1.98 trillion.
Although the degree of recapitalization is uncertain, it is notable that our estimate for the
contraction of balance sheets is not particularly sensitive to the choice of k. For instance,
if k were to turn out to be 25% rather than 50%, the contraction would be only somewhat
larger (at $2.45 trillion) than our benchmark case. Alternatively, if k were to turn out to
be 75% rather than 50%, the contraction would fall to $1.50 trillion.
Calibrating the baseline estimate for the change in leverage is more challenging. As
shown in both Exhibits 4.1 and 4.2, there have been occasions in the past when the
leverage of intermediaries has shrunk by more than 5%. One reason for choosing this as
the reference point is the “lending against their will” phenomenon noted earlier. Because
leverage actually increased for both large investment and commercial banks during the
third quarter of 2007, some of the contraction from that point forward is required just to
move back towards the target value that had obtained before the crisis. Given the more
than 50% increase in Value at Risk relative to a year earlier, the 5% assumption strikes us
as conservative. But this baseline is admittedly arbitrary. Unfortunately, as can be seen
by scanning across any row in the table, the implied size of the contraction is more
sensitive to this assumption than to the one on k.
The various calculations, with the baseline highlighted in gray, are shown in Exhibit 4.7.
Now, as they point out, there’s double counting of assets and liabilities in financial sector, so one needs to figure out what is the shrinkage in leveraged system’s assets with respect to the nonfinancial sector. The baseline estimate is $0.91 trillion.
The linkage between domestic non-financial debt (DNFD) and economic output is estimated, in an admittedly ad hoc, but not unreasonable fashion, using an autoregression in GDP growth rates, augmented with 4-quarter growth DNFD. From this, they obtain this conclusion:
As a back of the envelope calculation, we can use the estimate from Exhibit 5.2 along
with the potential $910 billion contraction in end-user credit to calculate a GDP effect
from the deleveraging. This contraction is equivalent to a 3.0-percentage-point drop in
DNFD growth. The results in Exhibit 5.2 imply that this corresponds to a hit to real GDP
growth of 1.3 percentage points over the course of the following year. This impact
should be viewed as additive to the impact of housing on real GDP growth via other
channels, such as the decline in residential investment and any potential wealth effects
tied to falling house prices. We emphasize that the calculation is very rough, and should
be viewed as quite speculative. But, it does suggest that the feedback to the economy
from the deleveraging could be substantial.
In our estimate of the impact on GDP, we have taken account only of the contraction of
end-user credit to borrowers outside the leveraged sector. However, the diminished
activity of the leveraged institutions and other entities involved in the securitization chain may well have an effect on GDP more directly through employment and other real
decisions. We have not included such effects here, and so our estimates of the impact on
GDP should be seen as being conservative.
In my view, this is a very sober — and sobering — paper. Especially if you think that losses might exceed $400 billion…(see e.g. Calculated Risk, again). Oh, and by the way, these are only mortgage losses. Yet to be realized losses on auto loans, credit cards, and commercial real estate are of course not in these calculations.
href="http://www.technorati.com/tags/bank+lending">bank lending, href="http://www.technorati.com/tags/capital+crunch">capital crunch,