By Steve Schifferes
Economics reporter, BBC News, New York
The scale of the losses that will hit Wall Street banks could approach half a trillion dollars as large numbers of sub-prime home loans go bad.
And the carnage in the financial markets could cause a credit squeeze that will dampen economic growth for years to come.
The US sub-prime crisis is leading to a wave of reposessions across the US that is having a devastating effect on the US housing market, and is likely to lead to the halving of the US economic growth rate in the next six months.
At the root of the problem is the breakdown of the new model of mortgage lending, when instead of giving mortgages directly to their customers, banks borrowed money from credit markets to fund a growing volume of mortgages.
But its biggest impact is likely to be on the financial sector, which made billions of dollars in profits in the past few years by betting heavily on the sub-prime market.
Already the big Wall Street banks have revealed losses totalling $50bn (£24bn), and the head of the biggest bank - Chuck Prince of Citigroup - and the biggest investment firm - Stan O'Neill of Merrill Lynch - have departed.
Show and tell
But experts estimate that the total losses facing the financial sector could amount to between $150bn and $450bn, and that many of the banks have hidden losses that have been concealed in off-balance sheet instruments like "structured investment vehicles (SIVs)".
SUB-PRIME LOSSES SO FAR
Merrill Lynch: $8bn
Morgan Stanley: $3.7bn
Bear Stearns: $3.2bn
Deutsche Bank: $3.2bn
Credit Suisse: $1bn
Source: Company reports
The big Wall Street banks and investment houses who are most exposed could find their profits, and much of their capital base, wiped out.
To restore their profits, and indeed in some cases to remain solvent, they will be forced to sell off many assets and lay off many workers, as well as cutting the bonuses of their remaining staff and limiting their future lending.
The size of the financial sector in the US economy - with banks making up 30% of the profits of all US companies last year - means that the effects will be felt both in the real economy and on the stock market.
And with $2.8 trillion in distressed mortgage bonds, including $1.3 trillion in sub-prime bonds, there is enough distress to go around.
Dick Syron, the head of Freddie Mac, a government-sponsored agency that also trades mortgage-backed securities, reckons he has never seen circumstances so bad, and that the credit crunch is having a "dramatic effect" on the US housing market.
But even that impact could be dwarfed by the effects of the credit squeeze spreading beyond sub-prime loans to other sectors of the bond market.
The non-government mortgage backed securities market has grown rapidly in recent years, and mortgages are now the largest part of the $27bn bond market.
But since 9 August, bondholders have effectively gone on strike, refusing to buy some $2.8 trillion worth of sub-prime, Alt-A, and other types of securities not guaranteed by government-sponsored agencies.
Meanwhile, the value of sub-prime mortgage-backed bonds has plummeted since the beginning of the year.
The fear is that the whole of the bond market, which funds everything from government debt to company borrowing to credit cards and car loans, will begin to dry up as investors worry about undisclosed problems.
According to US Federal Reserve chairman Ben Bernanke, "although it was the problems with sub-prime mortgages that initiated the financial turmoil, credit concerns quickly spread into a number of other areas".
"In the short term, these events do imply a greater measure of financial restraint on economic growth as credit becomes more expensive and difficult to obtain."
Already there are signs that it is getting harder to sell bonds linked to credit cards and car loans, and there are worries that spreads on corporate bonds are tightening.
The tightening of credit will hurt economic growth because in the US consumers have borrowed heavily to fund their consumption.
The latest figures indicate that consumer and business confidence is slumping both in the US and Europe as worries about the effects of the credit crunch grow.
How big are the potential losses?
The credit markets are frozen because of uncertainty and lack of information.
No one knows how much mortgage-backed securities are now worth, and no one wants to sell them to find out.
Also, no one knows where these losses are hidden among the banks and other financial institutions.
The gargantuan scale of potential losses is terrifying investors in banking stocks - which have fallen by 30% - as well as mortgage-bond investors.
There are three ways to estimate the size of the possible losses from the sub-prime crisis.
- Estimate how many sub-prime mortgages will eventually end in foreclosure
- Look at the current market valuation of sub-prime mortgage bonds
- Look at the books of the major banks and estimate the size of their potential liabilities and the proportion of those which will turn into losses
The first method should give the best estimate of the long-term cost of the crisis.
The range of plausible estimates goes from $150bn (US Federal Reserve) to $450bn (Moodys.com worst-case scenario).
According to Mark Zandi of Moody's, there are $1.3 trillion-worth of sub-prime and other distressed mortgages that were issued in 2005, 2006 and the first half of 2007 that will see their terms change for the worse in the next two years.
POTENTIAL SUB-PRIME LOSSES
Distressed sub-prime mortgages:
Foreclosed sub-prime mortgages:
Percent sub-prime foreclosed: 15%-25%
Current market value of sub-prime mortgages
$300bn - $900bn
Sources: Federal Reserve, Moodys.com
He estimates that about half of these, $625bn, are likely to go into arrears leading to court action, and that after reschedulings and foreclosures, about $220bn is likely to be lost, net of the auction sales of such properties.
Other organisations, such as the Center for Responsible Lending, also estimate that about 20% of sub-prime mortgages will go into foreclosure.
But, as Mr Zandi points out, both his estimate and the Fed's are very sensitive to changes in house prices.
If house prices were to fall by 20% rather than 12% as Mr Zandi's model currently estimates, he says that the total losses could double to $450bn.
And if the US goes into recession, or if the Fed raises interest rates to combat inflation, then the losses would also increase dramatically.
Meanwhile, fear has led the bond markets - through derivative trading - to cut the value of sub-prime mortgage bonds by an even larger amount.
Since the beginning of the year, sub-prime mortgage bonds issued in early 2007 have dropped in value by between 20% and 80%, depending on their bond rating.
Using an arithmetic average, and assuming that other mortgage bonds are equally distressed, this implies they have lost at least half their value, or $625bn.
Truth or consequences
Measuring the likely losses faced by individual banks is an even more difficult task.
But what is clear is that most financial institutions have not begun to reveal the full scale of their potential losses.
"The reality is that most financial institutions have barely started to recognise the lower 'fair value' of their impaired securities," says Professor Nouriel Roubini of New York University.
"The credit crunch is getting much worse and its financial and real fallout will be severe."
Some estimates suggest that banks may have vastly under-estimated their potential liability, especially in connection with off-balance sheet activities.
One look at Citigroup, using SEC data, suggested that their potential liability could be $343bn rather than the $55bn they declared.
You don't begin to get resolution of these questions until you get price discovery
Dick Syron, chairman, Freddie Mac
Another issue is how much of the potential liabilities may eventually have to be written off. In recent announcements, Citigroup wrote off 20% of its admitted $55bn liability, while other banks have written off between 10% and 40%.
Another key measure of the stress on banks is the amount of so-called "tier 3" capital they are carrying on their books. These are risky loans that cannot be valued except by an economic model because there is no market for them..
By that measure, the big investment banks like Goldman Sachs and Morgan Stanley are much more exposed, relative to their total capital , than Citigroup or Merrill Lynch.
Changes in US accounting rules which come into force on 15 November, known as FASB 157, may force the big Wall Street banks to come clean on the scale of their losses - especially when accountants have to sign off their annual accounts in January.
It has been a bad year for many Wall Street banks
In particular, it may force them to reveal some of the hidden losses which they have concealed through the use of off-balance-sheet funds (such as structured investment vehicles, or SIVs.)
These are bank-sponsored financial funds which buy up mortgages - using money borrowed from the short-term commercial paper markets - bundle them up and then sell them to the bond markets.
Thus the banks charge two fees - one at each side of the transaction - and officially have no risk, as they never owned the mortgages.
But in practice, when these funds go bad, the banks are liable either to continue to fund them, or to repurchase the underlying mortgages.
Currently the banks have an estimated $340bn in such SIVs, and since the market in short-term asset-backed commercial paper (ABCP) has dried up completely, they are forced to put up the short-term funding themselves.
Citigroup, JP Morgan Chase, and Bank of America are the most exposed by this measure.
The big banks are hoping that they can rescue about $75bn of this debt, which they say is perfectly sound, by putting it in a special super-SIV, a plan endorsed by US Treasury Secretary Hank Paulson in the hope that it will calm the credit markets and help restart their normal functioning.
But even Mr Paulson now admits that the fund will do only a little to reassure investors about the broader mortgage-backed securities market.
And others are clear that the only thing that will restore confidence in the markets is the full disclosure of all the potential losses.
Dick Syron, the chairman of Freddie Mac, says he has experienced many financial crises during his work at the Federal Reserve.
"You don't begin to get resolution of these questions until you get price discovery," he says.
"The problem in the market is not just liquidity. The problem in the market is lack of certainty and lack of information."
Why did the financial sector get it so wrong?
But why did it take so long for the banks and the mortgage bond market to realise the scale of the problem that sub-prime lending would cause?
The main reason was that the new system broke the link between the lender and the borrower.
The institutions who owned the loans - the people who bought bonds - had too little information about how dangerous they were.
They relied on the ratings agencies to reassure them that the complex mortgage bonds they were buying were indeed investment-grade.
But those ratings agencies did not understand how, under conditions of "stress," i.e., falling house prices, those bonds would fall in value.
And since most pension funds are managed by several different fund managers who all compete with each other to get the best quarterly rate of return, there was a strong incentive to buy as much as they could of these supposedly safe yet high-yielding bonds.
According to David Pitt-Watson, who manages the pension fund business at Hermes, the pension funds failed to exercise their rights to find out enough about what they were buying - or question the way the banks were run.
And he says the system did not give the right financial incentives to encourage lenders to be careful.
The system created challenges at the other end as well.
"Gone are the days when a homebuyer only went to the corner bank to take out a mortgage," says US Treasury Secretary Hank Paulson.
"Today the mortgage system is disaggregated and less personal... a homeowner having trouble making payments does not know who to turn to for assistance."
In addition, the new system of mortgage finance did not give the right financial incentives to ensure that proper checks were made on the individuals who applied for sub-prime mortgages.
The banks who offered mortgages and sold them on did not care as much whether the loans went into foreclosure. They were paid a fee for selling the mortgage on, and another fee for servicing (collecting the loan payments), and even got additional fees if they had to foreclose.
As the banks who sold on these mortgages were not putting up their own money as collateral, they no longer used their own in-house bank managers to assess the income of their borrowers and check the real value of the house they were giving a mortgage on.
Instead, they increasingly turned to mortgage brokers to sell them even more mortgages.
And there is evidence that the poorly-regulated mortgage brokers - whose job it was to check the income of potential mortgagees - and the home appraisers, who had to value the property - began to exaggerate both the income of their clients and the value of the homes, thus getting higher fees themselves.
"The sub-prime mortgage market in recent years was also accompanied by a deterioration in underwriting standards, says Fed governor Randall Kroszner.
"In some cases, abusive or fraudulent lending practices resulted in homeowners taking on mortgage obligations they could not afford, with terms they may not have fully understood."
It is now up to the regulators and policy makers in Washington to correct the broken mortgage system - before the damage to home owners, banks and the US economy becomes too great.
But whatever is done, it is bound to be painful.
"We can't make all the pain go away," says Mr Syron.
""We can ameliorate it and most importantly we can try and prevent it happening again but we can't eliminate all of it."
Further articles in this series will explore the attempts in Washington to repair the damage caused by the sub-prime mess, and its effects on the world economy.