US faces $2 trillion credit crunch, warns Goldmans

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The Independent Online

Ballooning losses from the US mortgage market could force the global financial industry to scale back lending by $2 trillion and trigger a substantial recession, according to a bearish analysis.

The startling figure was suggested yesterday by the chief US economist at Goldman Sachs, Jan Hatzius, who said that an estimated $400bn (£290bn) in losses on mortgages would be magnified as lenders reacted to stay within their solvency requirements.

"Even a $400bn 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," Mr Hatzius told clients. "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, he said, is that long-only investors, such as pension funds and mutual funds, passively accept a hit to their net worth. Leveraged players actively scale back lending to keep their capital ratios from falling. These capital ratios determine how much money the institution can put at risk by lending out.

Low-income Americans have begun defaulting on home loans in record numbers, and with low introductory interest rates set to expire on some 2-3 million mortgages in the next two years, arrears and repossessions are forecast to soar, while house prices are already falling. Estimates of the likely losses have risen from $50bn-$100bn in the summer to around $400bn now, and the resale of mortgage debts across the global financial markets means that at least half of that is set to be borne by leveraged investors, Mr Hatzius said, potentially triggering a $2 trillion contraction in lending.

"This is a large shock," he said. "Assuming a proportional change in GSP growth – and historically the correlation between debt and GDP growth has been reasonably tight – it is easy to see how such a shock could produce a substantial recession, if it occurred over a single year, or a long period of very sluggish growth if it occurred over two to four years."

Randall Kroszner, a governor at the Federal Reserve, signaled that he believed the Fed's two interest-rate cuts would be enough. "The current stance of monetary policy should help the economy get through the rough patch during the next year, with growth then likely to return to its longer-run sustainable rate," he said.

The US equity markets put in a more optimistic performance, but the Dow Jones Industrial Average did not hold its 100-point early gain, and investors digested a profit warning from economic bellwether FedEx.