last money?

Goldman Sees Subprime Cutting $2 Trillion in Lending

By Kabir Chibber

Nov. 16 (Bloomberg) -- The slump in global credit markets may force banks, brokerages and hedge funds to cut lending by $2 trillion and trigger a ``substantial recession'' in the U.S., according to Goldman Sachs Group Inc.

Losses related to record home foreclosures using a ``back- of-the-envelope'' calculation may be as high as $400 billion for financial companies, Jan Hatzius, chief U.S. economist at Goldman in New York wrote in a report dated yesterday. The effects may be amplified tenfold as companies that borrowed to finance their investments scale back lending, the report said.

``The likely mortgage credit losses pose a significantly bigger macroeconomic risk than generally recognized,'' Hatzius wrote. ``It is easy to see how such a shock could produce a substantial recession'' or ``a long period of very sluggish growth,'' he wrote.

Goldman's forecast reduction in lending is equivalent to 7 percent of total U.S. household, corporate and government debt, hurting an economy already beset by the slowing housing market. Wells Fargo & Co. Chief Executive Officer John Stumpf said yesterday that the property market is the worst since the Great Depression.

Citigroup Inc., the biggest U.S. bank, and Merrill Lynch & Co. have led companies writing down more than $50 billion on securities linked to subprime mortgages. The risk of further losses by banks has pushed their borrowing costs above the average for investment-grade companies, according to Merrill Lynch indexes. Citigroup paid bondholders the highest yield relative to benchmark interest rates in its history this week.

`Conservative Estimate'

The Federal Reserve has responded to surging borrowing costs by cutting its target interest rate twice in the past two months to 4.5 percent from 5.25 percent. Fed Governor Randall Kroszner said in a speech in New York today that the central bank probably won't need to cut the rate again to help the economy weather the current ``rough patch.''

Fed Bank of St. Louis President William Poole, who voted in favor of last month's rate cut, told Dow Jones yesterday he's an ``optimist'' about ``credit market problems clearing up.''

Hatzius said his report is based on a ``conservative estimate'' of financial companies cutting lending by 10 times the loss to their capital. Investors realizing half of the potential losses, at $200 billion, would have to scale back lending by $2 trillion, he said.

``The response to those kinds of risks is to lower interest rates, and we think the Fed will lower interest rates,'' Hatzius said in an interview today. Goldman predicts a quarter-point cut when the Fed meets on Dec. 11.

Recession Risk

If Goldman's forecast reduction in lending occurs over a single year, the U.S. economy could fall into recession, Hatzius wrote. The drop in lending over two to four years would probably result in ``very sluggish growth,'' he said.

Goldman's outlook matches forecasts by Joseph Stiglitz, the Nobel-prize winning former World Bank economist, who said in an interview today that the U.S. faces a ``very major slowdown, maybe recession'' because of a ``consumption binge'' fueled by household borrowing.

``What it all comes down to is that Joe Six-Pack has been taking equity out of his house and supporting the U.S. economy,'' said Simon Ballard, global credit strategist at ABN Amro Asset Management in London. ``Now house prices are correcting, the bubble is deflating. You're going to see the engine of global growth significantly weaker.''

Economic Forecast

Goldman's U.S. economic forecasts already assume lending will fall by $1 trillion over the next two years, or half of the potential decline, the report said, without providing an updated forecast. The New York-based bank expects growth to slow to 1.9 percent in 2008, less then the 2.4 percent median forecast of 70 economists surveyed by Bloomberg News on Nov. 1 to 8.

Deutsche Bank AG, Germany's biggest bank, also said in a report this week that credit losses may be $400 billion. That's equivalent to ``one bad day in the stock market,'' or 2.5 percent of the value of U.S. equities, Hatzius wrote.

``No serious analyst would argue that a 2.5 percent equity market decline will make an important difference to the economic outlook,'' Hatzius wrote. ``So what's different about the mortgage credit losses? In a word, leverage.''

Hatzius joined Goldman in 1997 from the London School of Economics, and became chief U.S. economist in October 2005. He predicted in December 2005 that 10-year U.S. Treasury yields would rise to 4.5 percent by the end of 2006 from 4.39 percent. The yield rose to 4.7 percent.

-- With reporting by Steve Rothwell in London. Editor: Serkin (ajr)

To contact the reporter on this story: Kabir Chibber in London at kchibber@bloomberg.net

Last Updated: November 16, 2007 10:30 EST