Over the last 6 weeks financial stocks have rallied prompting some market commentators to declare that most of the losses banks will suffer during this downturn have already been written off. I strongly disagree believing that we are still in the early innings of this credit crisis and things are likely to get much worse before they get better. Let me explain.
As I argued here and here, home prices are likely to fall by 30% resulting in approximately 20 million homeowners with negative equity in their homes of which 5 million could face foreclosure. If the average mortgage balance of foreclosed homes is $250,000 and half of the balance is recouped after foreclosure then the total loss for lenders would amount to more than $600 billion.
Since the total mortgage market for single family homes is currently valued at over $10 trillion, this represents a loss of 6%. Some lenders will face greater defaults than others. The GSE’s which guaranteed approximately half of the total mortgages outstanding will probably experience only a 2-3% loss (though that would be disastrous for them considering their thin capital cushion). Commercial banks and savings and loan institutions may experience 8-9% losses; investment banks and hedge funds which speculated on subprime mortgages and CDOs may suffer losses of well over 10%.
According to the FDIC, depositary institutions had $3 trillion of residential real estate loans on their books at the end of 2007. A 8% haircut on this would lead to a loss of around $250 billion. Though mortgage lending is getting all the attention now, it’s important to understand that lending standards were lowered for all types of loans and banks are likely to suffer significant losses in other areas of their loan portfolios as well.
My estimate of these other losses for depositary institutions include at least 7% of their $1 trillion of consumer loans, 10% of their $630 billion of construction and land development loans, 5% of their $970 billion of commercial real estate loans, and 5% of their $1.5 trillion of commercial and industrial loans. In total banks are likely to write down their loan portfolios by at least $500 billion. The problem is that the entire equity capital of banks amounts to $1.35 trillion of which $350 billion is goodwill. This means that half of the tangible equity of US depositary institutions would get wiped out leading to hundreds of bank failures.
But also consider that these banks have entered into $166 trillion of derivatives contracts with one another meaning that if a significant number of banks fail due to loan losses, their counterparties on derivative transactions would be unable to collect payment and could also be dragged down into insolvency and the entire banking system would collapse.
And I have not factored in losses at other financial institutions such as GSEs, investment banks, insurance companies, and hedge funds. In total I think we are looking at losses of at least $1 trillion at US financial institutions and $2 trillion globally over the next few years. Keep in mind that only $500 billion have been written of thus far, and that is why I believe that we are still early in this credit crisis.
This makes me very concerned. It’s quite possible that my estimates could be wrong, but I think I have been conservative enough that any substantial error in loss estimates will understate the actual values. Do I believe the entire banking system is about to collapse? No… at least not anytime soon. We live in a fiat monetary system which means that the government can print as much money as it wants to bail out the creditors of failed banks. To be sure, governments will soon run the printing presses at full speed in an attempt to restore the public’s confidence.
