Leveraged Losses: Lessons from the Mortgage Market Meltdown

My buddy Paul is off skiing in Aspen, Colorado leaving us worker drones to do the heavy lifting. Ski boy managed to forward me this report: Leveraged Losses: Lessons from the Mortgage Market Meltdown.

The abstract and graphs below are quite compelling:

"This report discusses the implications of the recent financial market turmoil for central banks. We start by characterizing the disruptions in the financial markets and compare these dislocations to previous periods of financial stress. We confirm the conventional view that the current problems in financial markets are concentrated in institutions that have exposure to mortgage securities. We use several methods to estimate the ultimate losses on these securities. Our best (very uncertain) guess is that the losses will total about $400 billion, with about half being borne by leveraged U.S. financial institutions. We then highlight the role of leverage and mark-to-market accounting in propagating this shock. This perspective implies an estimate of the eventual contraction in balance sheets of these institutions, which will include a substantial reduction in credit to businesses and households. We close by exploring the feedback from credit availability to the broader economy and provide new evidence that contractions in financial institutions balance sheets’ cause a reduction in real GDP growth."






UPDATE: February 29, 2:30pm

Just got back from a lunch meeting (bumped into Lindsey from WallStrip on the way back!) and saw the WSJ Real Time Economics post on this:

Banks May Need to Shrink by $2 Trillion on Subprime Losses

Mortgage losses, compounded by contemporary risk management and
accounting practices could prompt banks and other lenders to shrink
their lending and other assets by a staggering $2 trillion, a new study

The resulting withdrawal of credit could knock one to 1.5 percentage
points off economic growth, significantly compounding the impact of
collapsing home construction and softer consumer spending due to lower
home wealth, the study, presented at a joint academic-Wall Street forum
in New York Friday.

The study is one of the most exhaustive efforts to date to pinpoint
the scale and location of mortgage losses and how those losses will
affect economic growth.



Leveraged Losses: Lessons from the Mortgage Market Meltdown
David Greenlaw, Jan Hatzius, Anil K Kashyap, Hyun Song Shin
US Monetary Policy Forum Conference Draft, February 29, 2008

Download usmpf_2008.pdf

Banks May Need to Shrink by $2 Trillion on Subprime Losses
Greg Ip
WSJ Real Time Economics, February 29, 2008, 11:59 am


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What's been said:

Discussions found on the web:
  1. The Jersey Bear commented on Feb 29

    Has anyone brought up how the new, more stringent credit card bankruptcy laws make it easier to walk away from your home than it does to walk away from credit cards?

    It seems like that also has to be adding some fuel to this fire.

  2. Michael C. commented on Feb 29

    Other than government bailouts, I haven’t read any other viable solution to this mess.

    Many in the blogosphere advocate leaving the housing market alone and letting home prices fall as they may, and while this may also be a solution, none in the blogoshpere acknowledge that this line of action (or rather inaction) will have pretty dire effects on the economy.

  3. shoeless commented on Feb 29

    “Other than government bailouts, I haven’t read any other viable solution to this mess.

    Many in the blogosphere advocate leaving the housing market alone and letting home prices fall as they may, and while this may also be a solution, none in the blogoshpere acknowledge that this line of action (or rather inaction) will have pretty dire effects on the economy.”

    You don’t give the junky more crystal meth hoping he gets better. The pain will come – one way or another – in short order or over a longer period of time. Death by 1000 cuts still equals death. The sooner we take the pain, the sooner we can recover.

  4. Tradertim commented on Feb 29

    Quick question. For all the non-conforming loans out there paying PMI, what happened to those premiums?

  5. scorpio commented on Feb 29


  6. odograph commented on Feb 29

    shoeless … is there a middle ground?

  7. Ben commented on Feb 29

    Hey, bought anything today? Stocks look cheaper than yesterday.

  8. Street Creds commented on Feb 29

    Hey, Steve Liesman from Bubblevision is covering this paper being delivered by its four authors. Liesman finished with ” thank you for a perfectly lousy paper” to David Greenlaw I’m not sure that was meant to be funny. BUY BUY

    I’m on page 26 now, but will have to reread it tomorrow.

  9. JustinTheSkeptic commented on Feb 29

    May I offer this quote from Ludwig von Misis: ” There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion. or later as a final and total catastrophe of the currency system involved.”

  10. Street Creds commented on Feb 29

    Crap I just found the conclusions on pages 43 and 44. I’ll just read those and be able to operate heavy machinery for the rest of the afternoon.

  11. Quantum commented on Feb 29

    Saw the capitulation. The uptrend will resume, beware of the huge rebound! By the way, can Ben wait until March 18th? Will we see an immediate rate-cut? 75 to 100 basis point?


  12. AGG commented on Feb 29

    Just curious, but speaking of negative equity (as in “they couldn’t make the margin call”), did anyone of you rich folks get burned with the Peloton hedge fund closing ? There was some SERIOUS money lost.
    Scratch two more geniuses from Goldman Sachs.

  13. E commented on Feb 29

    What’s the rumor that’s going to goose the markets in the next hour? Anyone got any good guesses?

    I’ll start first – an AMZN/C merger.

  14. farmera1 commented on Feb 29

    Can anyone explain the first graph, the one that is called:

    ABX Indices (AAA rated vintages).

    OK I think ABX is an index for houses. From there I am lost. There are vertical lines that seem to be for S and P, Citi group and Merrill. This makes no sense to me. Also the key in the lower left part of the graph makes no sense.

    Help and thank you.

  15. Quantum commented on Feb 29

    What? Capitulation 2.0? lol

  16. Street Creds commented on Feb 29

    Well, I ration my time on Bubblevision (even with the sound off). But I gotta watch Cramer tonight explain what when wrong today. Maybe we need to inflate the economy like he said. Ratigan is in Miami standing in what looks to be a large outdoor funeral home, with no one there.

  17. Estragon commented on Feb 29


    The ABX-HE index series tracks home equity (mortgage) prices. As risks have grown, yields have increased and prices have decreased.

    The vertical lines show events which (apparently) impacted prices.

    The key indicates the various vintages (i.e. when the mortgages were originated and pooled). The chart shows that the more recent pools are dropping more than more seasoned ones.

    Hope this helps.

  18. s0mebody commented on Feb 29

    Some things from the report:

    “Clearly, if the real economy were to
    deteriorate markedly going forward, our estimates would have to be revisited in order to take account of the second-round effects. Nevertheless, we believe that our restriction to mortgage assets imposes some discipline on the exercise.”

    Who doesn’t think there will be second round effects?

    “Nonetheless, it is interesting to see that through 2007 Q4 the commercial banks had also not shown signs of deleveraging.”

    No one has sold a thing yet. Then the report makes some calculations of effects on GDP which seems like a wasted exercise to me. Only time will tell what the GDP effects are. Then the reports ends with at least one bothering recommendation.

    “A more effective means to attack directly the financial turmoil would be to facilitate the raising of new equity capital by the banks, and to encourage them to retain cash flow by cutting dividends if necessary. Of course, the cutting of dividends will need to overcome the considerable stigma attached to doing so. On this score, ministers of finance and central bankers may have a role to play in facilitating coordinated action so as to overcome the stigma across regions.”

    How exactly does a central bank help overcome the “stigma” of cutting a dividend?

  19. Baby Ben commented on Feb 29

    There is no lack of credit. There is never lack of credit in a fiat system, except if premeditated. There is a lack of productive assets or investment opportunities (in the US). The business environment is poisoned by red tape and regulatory grabs, promiscuous legal system, obscenely inefficient health care, politicized education, rigged patent system, ridiculous tax code, military bill explosion, monopolization, market scamming, etc. Sure, it’s not just in the US, but we’ve become much worse than our competitors. No wonder the business is running to Asia. Then consider an investment bank, “investing” printed money in far away lands? Then lobbies congress for regulations impeding their entrenched, US-vested competitors – essentially forcing them to run out too. It’s not only the labor differential… (Look who rushed to help our “top” fat banks when they did the poo all over)

    And all you hear from the mess-media is cute, tearful stories about Baby Ben’s dilemma:

    “To print or not to print”

    This mantra is getting tired.

  20. Winston Munn commented on Mar 1

    Baby Ben,

    While I appreciate your passion you are misguided in your conclusions. The Federal Reserve cannot force banks to lend or customers to borrow. It is the willingness to borrow and lend than caps a debt-currency system.

  21. wunsacon commented on Mar 1

    >> none in the blogoshpere acknowledge that this line of action (or rather inaction) will have pretty dire effects on the economy.
    >> Posted by: Michael C. | Feb 29, 2008 1:29:16 PM

    Everyone in the blogosphere saying “no bailout” acknowledges that this line of action (or rather inaction) will allow the economy to work through the unavoidably dire effects on the economy brought on by the past 7 years of recklessness and fraud. Attempts to obfuscate will not help but will merely bring on other distortions — and will ROB non-reckless/non-fraudulent persons of their wealth.

    I submit that’s markedly different than your interpretation of the “no bailout” argument.

  22. Baby Ben commented on Mar 1

    “It is the willingness to borrow and lend than caps a debt-currency system”

    Dear Winston Munn,

    That was precisely my point. The lenders don’t lend because there are no worthy investment opportunities. Read that again, please.

    It’s not about shoring up the banks, it’s about shoring up the productive sector. There is only one way out – close all hundred something bases abroad, bring back the troops from Iraq, cut military spending in half and engage the military in infrastructure projects. Also regulate the trade appropriately. If you carefully look at my list of malaises, these are the only items which can be done fast.

    If that is not done, the party is over. Baby Ben can’t deal with the problem – it’s way above and beyond the abilities of the FED. Rate manipulations can do that much and no more.

    If I understand correctly, you want a Big Daddy to save your toys. Baby Ben is not him. Don’t push him or we’ll have a lot more of the smelly stuff to clean up. For generations.

    Look here:


  23. EconGuy commented on Apr 19

    Thank Ski Boy for the report! :- ) Come to think of it, I could go for a ski vacation too…

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