US economy may see $2 trillion shock: Goldman Sachs

November 17, 2007

The impact of the U.S. mortgage market crisis on the underlying economy could be “dramatic” as leveraged investors may need to scale back lending by up to USD 2 trillion, according to investment bank Goldman Sachs.
Chief U.S. economist Jan Hatzius said a “back-of-the-envelope” estimate of credit losses on outstanding mortgages, based on past default experience, was around USD 400 billion.

But unlike stock market losses, which are typically absorbed by “long-only” investors, this mortgage-related hit is mostly borne by leveraged investors such as banks, broker-dealers, hedge funds and government-sponsored enterprises.

And leveraged investors react to losses by actively cutting back lending to keep capital ratios from falling — A bank targeting a constant capital ratio of 10 percent, for example, would need to shrink its balance by USD 10 for every USD 1 in losses.

“The macroeconomic consequences could be quite dramatic,” Hatzius said in the note to clients. “If leveraged investors see USD 200 billion of the USD 400 billion aggregate credit loss, they might need to scale back their lending by USD 2 trillion.”

“This is a large shock,” he said, adding the number equates to 7 percent of total debt owed by U.S. non-financial sectors.

“It’s basically another downside risk to the macroeconomy at a time when the macroeconomy already isn’t doing that well,”  Hatzius told CNBC.

He said such a shock could produce a “substantial recession” if it occurred over one year, or a long period of sluggish growth if it occurred over two-to-four years.

Hatzius underscored the macroeconomic nature of the shock in his interview with CNBC.”I don’t think there’s a direct stock market implication from this, perhaps with the exception that it does point to a slow-growth environment, significant risk of recession, and that’s probably in an envrionment in which the cyclical sectors are going to underperform.”

One of a number of caveats outlined in the report was that baseline economic forecasts may already include significant reductions in the pace of mortgage lending. But the conclusion remained a gloomy one regardless. “The likely mortgage credit losses pose a significantly bigger macroeconomic risk than generally recognized,” he wrote.

“While the uncertainty is large, the associated downward pressure on lending raises the risk of significant weakness in economic activity.”


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