Newspaper article The Christian Science Monitor

Banks' Losses Could Put $900 Billion Squeeze on Consumers

Newspaper article The Christian Science Monitor

Banks' Losses Could Put $900 Billion Squeeze on Consumers

Article excerpt

The retailer Sharper Image offers a stark image of how the credit crisis on Wall Street is becoming a widespread credit crunch for the rest of America: The purveyor of gadgets recently declared bankruptcy, citing a tougher climate for financing among the reasons.

That company is not an isolated case. Consumers and businesses now face an economic downturn made more difficult by a contraction among banks and other lenders. In fact, the health of banks has become perhaps the biggest source of uncertainty about the economy.

How bad is the damage?

By one new estimate, troubled mortgages alone could knock a full percentage point off economic growth in the year ahead. And mortgages are just part of the problem. With losses also rising on loans for everything from cars to commercial real estate, banks effectively will have less money available to make new loans - perhaps $900 billion less.

"The reality is that banks are in trouble," says Ed Yardeni, an economist who until recently has been optimistic about the economy's prospects for avoiding recession. "I don't think they'll go bankrupt. [But] we're in the process of cleaning up the mess that the financial engineers created" by reselling shaky home loans to investors.

The mess doesn't have to have an unhappy ending, he says.

First, not all banks and lenders are in equal trouble. Many large banks pushed as a herd into complex and risky financial products. Citigroup, for one, has lost more than half its stock market value in the past year and declined further Tuesday as a Wall Street analyst predicted deeper losses ahead. But small or mid-size banks, ones that avoided the push into subprime lending, may see the current environment as an opportunity to keep lending and grab a bigger share of the market.

Second, the decline in credit is in part a necessary adjustment for an economy that had been artificially supercharged.

Finally, the Federal Reserve has been cutting interest rates, and many analysts expect that trend to continue. That may not spur a big increase in lending, but it does help banks work through their problems, by widening the "spread" between short-term borrowing costs and the longer-term income banks earn on loans.

Still, Mr. Yardeni, founder of a research firm in Great Neck, N.Y., concludes that the US is entering a recession now.

He hopes the economy and banking system will navigate through these challenges, but he and other analysts see the possibility of darker outcomes as well.

"The concerns are quite real," says James Hamilton, an economist at the University of California, San Diego. "I think we are talking about very significant losses and possible failures."

Late last week, a team of researchers put forward a detailed analysis of the problem - or at least the biggest known chunk of the problem.

The most likely outcome is that mortgage losses in the current cycle will total $400 billion, concluded the four economists involved, Jan Hatzius of Goldman Sachs, David Greenlaw of Morgan Stanley, Anil Kashyap of the University of Chicago, and Hyun Song Shin of Princeton University.

When the stock market loses that much money (as can occur on a single bad day), it doesn't rattle the economy. But credit is a vital underpinning of much economic activity, and when banks lose that much money, it depletes the capital reserves that they rely on for making new loans.

Not all those losses will be borne by banks. But even nonbank financial firms often operate on the same principle of leverage: Each $1 of capital can fund perhaps $10 of loans.

"It's a multiplier effect," says Brian Bethune, an economist at Global Insight in Lexington, Mass. …

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