Few people knew at the start of 2007 the meaning of “subprime” real estate loans or how they might affect the US and global economies.
Today, worries are growing that the crisis that began with mortgage failures and spread to banks and brokerages may push the US economy into a downturn and put the entire global economy at risk.
Subprime loans flourished at the end of the US housing boom as lenders offered mortgages to people with shaky credit in an effort to cash in on surging prices.
These loans were packaged into securities that were sold to investors around the world, with little regard to what would happen when low “teaser” rates were reset to increase payments from homeowners.
When a wave of defaults began to hit, US and global banks began to see billions of dollars in losses on their balance sheets. The lenders had to tighten credit, crimping consumer and business spending and threatening the overall economy.
Goldman Sachs Group Inc. economist Jan Hatzius said his “back-of-the-envelope calculation” now suggests “losses of around $400 billion (about Rs15.8 trillion)” for global banks and investors.
Although this may not seem large in the overall economy, Hatzius said the effect is magnified because banks need to scale back their lending to keep capital ratios intact after accounting for the losses. As a result, he said lending could be cut by $2 trillion.
“Even if this occurs gradually, and even if there are some offsets from reduced credit demand and increased lending by other sectors, the drag on economic activity could be substantial,” said Hatzius in a note to clients.
Adding to the woes from housing are near-record energy prices and a weak dollar that could fuel inflation and hurt business confidence. Some say a recession is a possible scenario.
“The US is on the precipice of its first consumer recession since 1991, which was the last time the market suffered from a confluence of high energy prices, weakening employment conditions, real estate deflation and tightening credit,” said David Rosenberg, Merrill Lynch & Co.’s chief North American economist.
While debate is raging on whether the US economy will avert recession, another question is how much a US slowdown will affect the global economy.
Some experts say there has been a “decoupling,” meaning the rest of the world is less dependent on the US. But any slump in the US is still likely to have a global impact. “We think 2008 will be the ‘year of recoupling,´” said Peter Berezin, a Goldman Sachs global economist.
“The mortgage meltdown in the US has clearly affected global financial markets,” he noted, adding that “the weakness in the US housing market is starting to raise concerns that the global housing market may suffer a similar fate.”
Paul Sheard, economist at Lehman Brothers Inc., is guarded, saying: “2008 is shaping up to be more challenging for the global economy than 2007 was. We expect growth to be lower.” The global economy will feel an impact of a US slowdown, even if the world’s largest economy averts recession, Sheard said.
“If the US slows and other developed economies follow on, these economies will not be able to escape knock-on effects via the trade channel in particular but also via financial and confidence channels,” Sheard said.
“We expect growth in Asia ex-Japan and in emerging markets to decelerate but given strong growth momentum, particularly in China and India, to maintain a healthy clip.”
Economists are also debating whether the US Federal Reserve will be able to continue its interest rate cutting drive amid signs that inflationary pressures are spiking. Experts are warning of a slowdown even though the US economy expanded at a robust 4.9% pace in the third quarter of 2007.