OECD Raises Estimate of Subprime Losses to $422 billion
The Organisation for Economic Cooperation and development today raised its estimate of subprime-related losses to $422 billion, assuming 40% recovery on defaulting loans. This figure is up from the OECD’s September estimate of $300 billion, but still well short of the $1 trillion cited as possible by the International Monetary Fund last week.
In a comprehensive paper running through numerous scenarios, the OECD in essence dismisses the IMF number, which used a mark-to-market approach.
Liquidity problems and panic are causing major problems for price discovery, rendering this type of approach invalid.
The OECD uses a default-model based estimate of losses in the paper The Subprime Crisis Size, Deleveraging and Some Policy Options.
The point estimate on a default-model basis developed here is $422bn, assuming 40% recovery on defaulting loans and an economic and house price scenario benchmarked against previous episodes.
“To get anything like recent mark-to-market losses (of virtually double our estimate) would require a 0% recovery rate—which seems extreme even for the most bearish.”
Still, the two organizations are closer together than it appears. The IMF used a broader definition of subprime-related losses, according to Reuters. On a narrower approach the IMF comes in around $480 billion.
The OECD says about $60 billion of direct losses may be put down to US commercial banks, with four possible outcomes: (i) commercial bank deleveraging, causing a credit crunch; (ii) banks can earn back the capital (with help from interest rate and dividend policy) and get back to intermediating; (iii) capital can be injected by investors (e.g. sovereign wealth funds and hedge funds); and (iv) public sector intervention can be used to separate problem bonds and mortgages from the intermediation process.
It could take at least 6 months (with maximal interest rate and dividend cutting) and possibly up to 2 years (with more pessimistic assumptions on rates and dividends).This is too long for the economy, and risks early 1990s credit crunch scenarios.
Capital raisings/injections from risk-taking private institutions or Sovereign Wealth Funds are a big help, the OECD says, but the arithmetic of getting quickly back to “business-as-usual”, which requires much more capital than simply offsetting the losses, argues for more action if possible. “If the losses were socialised with government money—in the spirit of the Resolution Trust Corporation (RTC) or the emerging market debt bail out via the Brady Bond mechanism, then the commercial bank balance sheets could be directly cleansed of all the RMBS, and normal intermediation could begin without waiting for SWFs and earnings to kick in. This option turns the problem into an RTC, capital markets and mortgagee issue. If this were done quickly, the tone in the markets would change and the banks would have some chance to go about raising capital from private sources—get back to business as usual.”
Direct holding losses of US-listed prime brokers/investment banks could be around $27 billion, the OECD estimates. “They are less capitalised and problems for the economy arise through their linkages to other sectors, particularly hedge funds.”
Moral hazard issues arising from actions taken to date underline that the private sector should be encouraged to do the maximum of which it is capable, the paper says. “Even so, the perceptions that the trade-off between returns-to-risk is now asymmetric must be addressed in the future, and may require more fundamental financial system reforms.”
Looking at the spillover into broader markets, the paper says that while corporate balance sheets are in good shape on average, there is a fat tail of overleveraged companies that will default in the advent of a recession, creating pockets of turmoil in corporate bonds (non-investment grade) and equities.
Avoiding such spill over from the mortgage sector is essential, and underlines why a broad approach to policy to minimise the size of the economic impact is required.
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