Question 1 - Big economic impact or not?
The logic is simple. US consumers have a negative savings rate and have long depended on ever rising asset prices. These asset prices have stopped rising – real estate and possibly equities, too. Savings need to be restored at a time when banks are less willing to extend credit, terms on credit cards and mortgage resets are much worse, and at a time when possibly some of them are likely to lose their jobs in construction or finance. A host of rules of thumb are signalling a recession currently, indeed.
Dick Berner, our US economist, estimates the chances of a recession at 40%, although he still thinks the economy can escape a real contraction (see The Credit Recession, by Dick Berner and Dave Greenlaw, November 5, 2007). The housing slump, the liquidity crunch, surging energy prices and the credit downturn are the threats, with strong global growth and government outlays the offsetting factors. He expects 1.8% GDP growth in 2007, 2.9% in 2008. He does expect an earnings recession, with -4.2% after tax profits in 2008, after 2.9% growth in 2007. Eric Chaney, our European economist, believes that Euroland GDP growth would be as low as 1.5% next year if oil stays at US$100 and the US$/€ at 1.50 (see Oil at $100, € at 1.50, Credit Crunch: The Bill by Eric Chaney, November 5, 2007). His ‘compass’ forecasting tool indicates that the risk of a recession has increased.
Clouds over banks’ balance sheets and the securitisation machine. The appetite for securitised products, especially those linked to mortgages, will remain very low for some time. This is one of the factors that restricts lending standards. Further writedowns or downgrades of derivatives could lead to a deterioration in Tier 1 capital, especially if one takes into consideration that despite the many downgrades of 2006 CDOs for instance, none of the AAA rated paper has been downgraded yet. While 92% of 2006 vintage RMBS backed by 1st lien subprime mortgages have been downgraded by Moody’s already, only 13% of the total value has been, and non of the AA and AAA grades have been downgraded yet.
How big could the financial losses be? There are many sources of financial losses in this credit crunch, and question marks hang over the strength of banks’ balance sheets. Moody’s economy.com estimates $225 billion from risky mortgages, versus cumulative total write-offs related to subprime by the eight big investment banks so far of around$30 billion. The size of various segments of fixed income markets are the following:
• There is $45 trillion of debt in the US, more than 3x GDP, a 100-year high. In addition, there are $320 trillion of notional derivatives outstanding, up from $35 trillion ten
years ago
• US$10 trillion mortgage market, $2 trillion of which is sub-prime and alt-a.
• Consumer credit including credit cards and auto loans is $2.5 trillion
• 2006 CDO issuance of $1 trillion CDO issuance partly based on mortgages and loans.
• Potential forced selling could occur among ABCP and conduit owned paper of more than $1 trillion, and SIVs of $400 bn. $2.5 tr munibonds market now at risk in case of a downgrade of one of the financial guarantors could mean further big writedowns in the system plus obvious repercussions to state and local government spending power.
In summary, says Draaisma, the Morgan Stanley team believe this financial crisis is deepening and has the potential to hurt economic growth in the US substantially, at a time that US consumers’ savings rate is negative to begin with, and asset prices have stopped rising.
