By Rob Lever
Dec 26, 2007
SourceWASHINGTON (AFP) -
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 economist Jan Hatzius says his "back-of-the-envelope calculation" now suggests "losses of around 400 billion dollars" for global banks and investors.
Although this may not seem large in the overall economy, Hatzius says 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 two trillion dollars.
"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'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 United States. But any slump in the US is still likely to have a global impact.
"We think 2008 will be the 'year of recoupling,'" says 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, 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 percent pace in the third quarter of 2007.
A Merrill Lynch report calls for "modest growth to take hold late in 2008" in the United States but predicts that the Federal Reserve will need to cut interest rates to 2.0 percent from the current 4.25 percent by mid-2009 to sustain the recovery.
Merrill Lynch said the impact will be muted as other regions become less dependent on the US for their exports.
"Imbalances in the global economy, stemming from historic dependence on the US consumer, have peaked and will unwind throughout the coming year," the Merrill report said.
Merrill predicts oil prices could spike further to near 100 dollars a barrel before demand weakens and prices fall below 70 dollars by the final quarter of the year.
It also expects the dollar to fall further against the euro and yen before starting to recover against major currencies but that "more heavily managed currencies, such as those in Asia, Middle East and Russia, will continue to appreciate."
In a more upbeat outlook, Societe Generale global economist Brian Hilliard in London says the worst may be over for the US and global economies, even if the hit from housing and credit was bigger than initially expected.
"We remain more optimistic about the ability of the world economy to withstand the shock from this liquidity event," he said.
"Our forecast for US growth of 2.6 percent in 2008 is higher than consensus. The Fed has signaled that is less keen to make further rate cuts because the real economy looks in relatively good shape, but it is flexible."