Why Sub-prime Is Such a Big Deal?

It is estimated that the direct loss of subprime by the banks will be $250 billion after this is settled and done. Is $250 billion that big a blow to the economy? It does not sounds so.

The bigger probles though, is one rule that guides the banks' lending behaviour.

The rule is: A bank can not lend money unlimitedly. For each dollar of the shareholders' equity that shows on the balance sheet, the bank can only lends out ten dollars.

The subprime did not show up on the balance sheet because the banks can do this after twisting some rules. Now suddenly, it is required that these needs to be shown on the balance sheet.

What happens then? For example, if Citibank lost $2B on subprime, it needs to show up on the balance sheet, so the shareholders' equity decreases by $2B. Remember the rule stated above? Yes now the bank's lending capacity needs to reduce ten times of that, $2B * 10 = $20B. The problem just enlarged by ten times.

For the total estimated $250B loss, the total lending capacity needs to be reduced by $2,500B. That is almost twice of China's foreign exchange accumulations!

It is this ten times enlargement that makes the subprime a big deal.