Comments from David Rosenberg – Chief Economist Merrill Lynch
We are increasingly concerned that a full-blown credit crunch will increase the odds of a recession in 2008 and lead to an extra-long U-shaped recovery. This underscores our view that investors should adopt a high-quality, income-oriented defensive strategy. We believe Washington-based efforts – including further Fed rate cuts, the Fed’s newly-unveiled Term Auction Facility (TAF), and Treasury-backed subprime bailouts – are too little and too late to forestall a dramatic and widespread downturn in the credit cycle that transcends the subprime epicenter. Eventually, much lower interest rates will likely be required to underpin economic growth. Before the cycle is
over, we look for a funds rate of 2% and a 3.5% 10-year note yield.
When all is said and done, the figure for total mortgage-related losses could be in the area of $500 billion. How did we arrive at that staggering number? It is the sum of projected losses of $250 billion in subprime loans, $50 billion for Alt-A
loans, $100 billion in negative amortization mortgage-backed security option ARMS, and $100 billion in synthetic CDO losses (synthetic CDOs gain credit exposure to the underlying subprime assets via credit default swaps).
But problems are not contained to just residential mortgages; credit problems are spilling into credit cards, student loans, and commercial real estate areas. Thus it appears the banking system may be heading into a “perfect storm” that could increasingly see lenders scrambling to raise equity and aggressively tighten lending standards while their loan losses are rising and their capital ratios are declining. The ongoing sharp decline in residential real estate prices is leading to more
downgrades and projected subprime loan defaults far beyond the initial estimates.
This is forcing banks to move large amounts of the securitized assets back onto their balance sheets. Citigroup and HSBC, for example, transferred $49 billion and $45 billion respectively in off-balance-sheet assets to the balance sheet in order to prevent a fire sale of these assets. The once free-flowing ABS real estate lending channel has been shut down. The repatriation of unwanted assets to
banks’ balance sheets significantly reduces the traditional bank lending channel by tying up the banks’ capital at a time when equity is in decline due to rising writedowns and losses.
Based on our conservative forecast for another 10% decline in home prices in 2008, following a 5% contraction this year, our Merrill Lynch mortgage analysts have just revised up their direct subprime cumulative loss projection by $50 billion, to $250 billion, which represents about 18% of the $1.4 trillion subprime market. In addition, our analysts now peg losses for Alt-A loans, which were prime but required little or no documentation, at $50 billion. And the risks lie to the upside, in our opinion, because home prices could contract another 10% or more.
There are additional losses that may accrue to individual entities through the synthetic ABS market, though these are not net losses – the seller of protection incurs a loss while the buyer of protection gains in proportion. It is extremely
difficult to quantify, but in our view there could easily be another $100 billion in synthetic subordinates referencing subordinate ABS in one form or another. Our desk economists determined that a substantial portion of the loans are
unsecuritized (ie, the debt is still on the balance sheets of the bank originators – it never even made it to the “shadow” banking system). Our mortgage analysts project that the defaults on negative amortization MBS ARMs could reach $100 billion. That would take the total mortgage loan losses to a staggering $500 billion – $250 billion for subprime, $50 billion for Alt-A, $100 billion in synthetic losses plus another $100 billion in NegAm losses.
Many pundits argue that banks will not be forced to severely tighten credit because, unlike during the prior 1989-92 credit crunch, banks are very well
capitalized, with Tier 1 regulatory capital at more than 10% of their total assets. This is true only given today’s balance sheet. With record profitably posted during the last few years behind them, looming large loan writedowns and defaults and
the repatriation of off-balance-sheet assets can be expected to erode the equity-to-asset ratios of banks dramatically. In summary, we see increasing evidence that the acute credit strains that first hit the subprime mortgage market are now spreading out to the prime residential mortgage market, commercial real estate market, credit cards and other consumer loans. Efforts by the Fed and US Treasury are too little, too late. The intensifying credit deterioration, highlighted by an upwardly revised projection of $500 billion in total residential mortgage losses, places enormous pressure on banks’ capital ratios. This can be expected to lead them to continue to aggressively tighten the reins on all types of lending from mortgages, to consumer and business loans – in other words a full-blown credit crunch that
significantly increases the odds of a recession next year. We believe investors should seek safety in high-quality, income-oriented defensive investments.