November 15, 2007
* Estimates of the likely credit losses on outstanding mortgages have grown sharply in recent months. A back-of-the-envelope calculation using past default experience in different home price environments now suggests losses of around $400 billion.
* Even a $400 billion loss does not look all that large compared to the vast size of the US financial markets, and one sometimes hears that it is just equivalent to one bad day in the stock market. But this analogy is wrong. There is a big difference between stock market losses, which are mostly borne by long-only investors, and mortgage credit losses, which are mostly borne by leveraged investors such as banks, broker-dealers, hedge funds, and government-sponsored enterprises.
* The key difference, shown in a paper by Tobias Adrian of the New York Fed and Hyun Song Shin of Princeton, is that long-only investors passively accept a hit to their net worth, while leveraged players actively scale back lending to keep their capital ratios from falling. For example, a bank that targets a constant capital ratio of 10% needs to shrink its balance sheet by $10 for every $1 in credit losses, all else equal.
* The macroeconomic implications could be quite dramatic. For example, if leveraged investors see $200 billion of the $400 billion aggregate credit loss, they might need to scale back their lending by $2 trillion. Even if this occurs gradually, and even if there are some offsets from reduced credit demand and increased lending by other sectors, the drag on economic activity could be substantial.