IMF predicts close to $1 trillion losses due to US sub-prime mortgage crisis

09 Apr 2008


The International Monetary Fund (IMF), which last week cut its global growth forecast to the slowest in six years; (See: IMF joins ADB in predicting slower growth in 2008) has estimated the accumulated losses due to the ongoing financial crisis at a staggering $945 billion, or close to one trillion dollars. 

This is quite in contrast to the $232 billion written down by banks and financial institutions at present, but very much in agreement with similar forecasts made by rating agency Moody's and investment bank Goldman Sachs.

In its latest Global Financial Stability Report (GFSR) released during its semi-annual conference currently in progress in Washington DC, IMF provides a break up of this $945 billion. It estimates losses of $565 billion on US home mortgages, $240 billion on debt backed by commercial real estate such as office buildings and shopping centres, $120 billion on corporate loans such as those used to acquire businesses, and $20 billion on consumer loans such as credit cards.

Already, banks and other financial institutions that report publicly have marked down the value of their assets by about $232 billion. Hedge funds and other investment vehicles that do not have to disclose their losses have probably also recognized significant losses.

The report indicated that by mid-March, US banks had reported ''most of their estimated losses,'' with European banks now catching up. But institutions other than banks, such as insurance companies, ''may yet also report sizable additional writedowns.''

Dividing this amount by the total world and US populations respectively, they average a debt of $143 per person on earth, or $3100 for every US resident.

Beyond sub-prime mortgages
Even though the situation is somewhat under control at the moment, the report speaks about the distinct possibility of it worsening and spreading its tentacles beyond the assets directly affected by the sub-prime mortgage crisis. ''What began as a fairly contained deterioration in portions of the US sub-prime market has metastasized into severe dislocations in broader credit and funding markets that now pose risks to the macroeconomic outlook in the United States and globally,'' the IMF said in the GFSR.

''Financial markets remain under considerable stress because of a combination of three factors,'' said Jaime Caruana, head of the IMF's Monetary and Capital Markets Department. ''First, the balance sheets of financial institutions are weakening; second, the de-leveraging process continues and also that asset prices continue to fall; and, finally, the macroeconomic environment is more challenging because of the weakening global growth,'' he added. (See: The Jaime Caruana videocast)

Even the US Federal Reserve shares the IMF's concerns. The chairman Ben Bernanke had already spoken on the possibility of a US recession, while yesterday, the Fed released minutes of the March meeting at which it cut the interest rate it controls by three-quarters of a percentage point, showing that members of the central bank's policymaking committee just such an occurrence.

The IMF feels that the parties affected by the current crisis will not be limited to banks and financial institutions who have seen their asset bases and capital raising capabilities curtailed drastically. It feels that uncertainty about the size and distribution of bank losses, reduced capital buffers, and the normal reduction in credit as the cycle turns are also likely to weigh heavily on household borrowing, business investment, and asset prices. This, in turn, would affect employment, output growth, and balance sheets, thereby creating worrying macroeconomic feedback effects. In a nutshell, everybody is affected, and adversely so.

The IMF report said that the feedback dynamic now is potentially more severe than in earlier credit cycles, as it was fueled by a proliferation of new credit products that allowed more people to obtain credit, and hence the effects are likely to be ''broader, deeper, and more protracted''.

Also, even though the US is the centre of the current economic turmoil, other countries around the world cannot expect to be insulated forever, according to the report. This is because of the prevalence of the same reasons that started the crisis in the first place, what the report called ''overly benign global financial conditions, an inattention to appropriate risk management systems, and lapses in prudential supervision''.

Additionally, there are also signs that house prices in mature markets other than the US could fall. Therefore, countries in which house prices have been more inflated or corporate or household balance sheets have been more stretched are particularly at risk, the report pointed out. Also emerging markets which have so far been sheltered from the brunt of the storm, may also be susceptible to the dangers of the crisis as they try to support large deficits which had earlier fueled rapid credit growth.

The report is sharply critical of banks and other financial institutions, which it accuses of ''excessive risk-taking'' and ''weak underwriting''. It says they were ''too complacent'' about liquidity risks - the problems that would happen if they ran out of ready cash - and too ready to rely on wholesale money markets and central banks to help them if they got into trouble.
And its says that there was a failure of banks' risk management systems to appreciate that the new ''structured finance vehicles'' that they used to offload their risky sub-prime investments were not really viable. It says that the new instruments increased the danger of a ''liquidity spiral'' in which markets and institutions' funding problems reinforced each other.

The report is not too kind on the roles played by national governments either. It feels that lax government regulations were collectively one of the major contributing factors behind the crisis and said that they ''lagged behind the rapid innovation and shifts in business models, leaving scope for excessive risk-taking''.

The GFSR not only outlines the contours of the present crisis and its causes, but also speaks about possible solutions – both short-term and long-term. Immediate measures proposed are to limit the spread of dislocations to other markets and to repair banks' balance sheets by raising capital, even if that be costly in the present situation. Further, more rapid and informative disclosure of financial institutions is needed, and national authorities should seek to quell misconceptions by providing timely and accurate aggregate information, with central banks filing special financial stability reports.

The report also asks for government intervention in certain areas, lauding the Federal Reserve's initiative in the takeover of Bear Stearns by JP Morgan by infusing government funds. It says that  governments should frame tougher rules to stop banks putting assets off the balance sheet, and requiring banks to put aside more capital to protect against losses.

For long-term recommendations, the report examines the role of structured credit markets and the liquidity aspects of the crisis, and proposes measures to address related issues. These recommendations are addressed to the private as well as the public sector,and are based on analyses mentioned in two chapters of the report.

Analyses of the crisis
One chapter focuses on two key factors - first, it examines the valuation and accounting practices for structured finance products and, second, it discusses the business and regulatory incentives that prompted the fast growth of these products, including the role of credit rating agencies.

The second examines the liquidity aspects of the crisis, noting how complex linkages between funding and market liquidity produced a downward spiral of lack of liquidity. The analysis finds that many financial firms became complacent about liquidity risk management, given their dependence on wholesale funding sources, and implicitly relied on central bank intervention to meet emergency liquidity requirements. The central banks also didn't help matters by bailing out such institutions without specifying measures to prevent a repeat performance.

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