Subprime's Hidden Cost Is Shrinking Leverage: Michael R. Sesit

In this season of stock taking, the picture past and future for financial markets is far from pretty. The reason? Subprime

If you didn't know what subprime meant at the start of the year, it was hard to avoid its meaning by year end.

The big question now is what will the subprime crisis and ensuing credit crunch cost. In mid-July, Federal Reserve Chairman Ben Bernanke told the Senate Banking Committee that estimates of losses associated with subprime-credit products were $50 billion to $100 billion. Those numbers ``are far too low,'' Jan Hatzius, New York-based chief U.S. economist at Goldman Sachs Group Inc., said in a mid-November report.

Based ``on historical default and loss patterns in different home-price environments,'' he estimates U.S. losses will be roughly $400 billion.

Assuming that U.S. and European residential property prices fall 5 percent to 10 percent over the next year, investors in non-prime mortgages and securities linked to them -- including banks, hedge funds, asset managers and mortgage insurers -- stand to lose between $350 billion and $500 billion, according to London-based consultants Independent Strategy. Adding in expected losses from prime mortgages would lift the tally to more than $650 billion.

Yet these loss projections tell only part of the story. The other portion relates to the impact of the losses on the willingness and ability of so-called leveraged investors, institutions that finance their activities with borrowed funds, to keep lending. These include banks, broker-dealers, government- sponsored enterprises, savings institutions and hedge funds.

Ripple Effect

A September 2007 study by Tobias Adrian of the Federal Reserve Bank of New York and Hyun Song Shin of Princeton University, published by the New York Fed, found that leveraged investors, particularly banks and brokers, seek to maintain constant capital ratios. As such, when they lose money, they scale back lending to keep their capital ratios -- assets divided by equity or risk-free capital, such as cash -- from falling.

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