The financial losses that are being announced almost daily are starting to blur. What sense should we make of the $11.1 billion write-down that AIG, the giant insurance company, took on its investment portfolio? Is this stupefyingly large, or just very large? A lot of the loss related to subprime mortgage securities and credit default swaps, and AIG said more losses are to be expected this year. Will these be much bigger? Since AIG isn’t saying, we have to guess.

Which means we have to pay attention to the estimates of losses for the financial industry as a whole that are starting to be published. This past week the Swiss bank UBS said it estimated that total global financial industry losses from the credit crisis will be around $600 billion. That sounds gargantuan, but who is included in the definition of the global financial industry, and how much of total industry capital is at stake? It is time, therefore, to put these losses into context and see if the financial industry is being hurt, crippled, or mortally wounded by these losses.

To help us on our way, we can turn to an interesting quasi-academic study published Friday by four leading economists in academia and on Wall Street. It was submitted to the U.S. Monetary Policy Forum at Brandeis University and is titled Leveraged Losses: Lessons from the Mortgage Market Meltdown

· The credit crisis that began in August last year was related to mortgages and mortgage-backed securities, and other credit or equity markets were unaffected, at least initially.

· The losses were borne largely by the financial industry, including banks and brokers, but also other players involved in the securitization process.

· Who bears these losses is critical, because the more leverage that is used by a financial company, the more that company must scale back activity to cope with losses. Leverage is defined as the ratio of assets to capital.

· The banking and savings industry in the U.S. operates on a leverage ratio of 10:1. The brokerage and hedge fund industry has far less capital; its leverage is 32:1. Interestingly, the Government Sponsored Enterprises (GSEs), which consist mostly of Fannie Mae, Freddie Mac, and Sallie Mae, operate like a hedge fund and have leverage of 25:1.

· Leveraged institutions, when faced with large losses, almost always scale back on their main business of lending money to businesses and consumers. Because they are by nature leveraged institutions, the amount of lending that is eliminated is a multiple of the losses incurred.

· Based on their research of existing and projected mortgage market default rates, they estimate total U.S. financial industry losses from mortgages and mortgaged-backed securities will be $400 billion. Half of this will be allocated to the banking industry. These numbers do not include losses from other products such as credit default swaps, or from any weakness in the economy caused by these losses.

· $400 billion of losses will translate into a reduction in lending of nearly $2 trillion. This in turn will reduce GDP growth anywhere from 1% to 1.5% in the coming four quarters.

The authors present a very interesting table in their paper, among many charts and tables worth studying. This one shows the U.S. financial industry by sector, the assets and liabilities, capital, and leverage.

Several things stand out from this table. First, the commercial banking industry has total capital of $1.1 trillion. This is highly concentrated, in that the top ten banks out of over 7,000 commercial banks in the country have more than 50% of the capital. They will be sharing a proportionately larger amount of the losses, at least from the initial go-round of mortgage losses. The authors estimate this to be $200 billion out of the total $400 billion, or nearly 20% of the capital of the industry.

Commercial banks have so far announced about $60 billion in losses, so according to this study they have quite a bit more to go. But the study does not include losses from credit default swaps or other derivatives, from municipal securities, from commercial real estate, which is just starting to contract, and from a severely weakened economy that will ratchet up losses from auto, credit card, and other consumer loans. It is certainly possible to see total losses for commercial banks coming to 33% to 50% of their total industry capital.

The industry has been working hard to replenish capital, mostly by taking infusions from the sovereign wealth industry, as it is called. These are the governments of oil producing countries and large exporters like Singapore, who have been happy doling out $5 - $10 billion here and there, but who are showing signs of reluctance to take on too much more risk in this environment. Banks are also issuing calls for equity capital, usually in the form of preferred stock, but the stock market is getting progressively weaker and pretty soon will be an uncongenial source for new capital.

The Federal Reserve has a traditional method for rebuilding capital in the banking industry – it lowers short term interest rates and counts on a positive sloping yield curve to help banks generate almost guaranteed profits. In other words, banks can borrow at 2% short term and lend at 5% long term for a fat 3% spread on the loan. This is one reason why Alan Greenspan dropped short term rates to 1% after the Tech bubble collapsed in 2001. It worked then: banks lent at generous returns and reaped extraordinary profits. Greenspan even gave a speech telling bank executives they would be fools if they didn’t garner the funding profits he was providing them.

Ben Bernanke is trying the exact same thing, only this time it’s not working. The places where the fat returns are, like home mortgages, commercial real estate, and junk bond finance, are precisely those places where the loan losses have been greatest, and where banks now fear to tread. Instead, they would like to put their money in ultra safe U.S. Treasuries, but here the yields have collapsed as everyone has been rushing into the safety of these government securities. In some maturities, the yield on a Treasury is less than the cost of short term money from the Fed.

Desperate to make this sure-fire profit-building exercise work for the banking industry, Bernanke has suggested last week that he will push short term rates even lower, despite the weakness of the dollar and the clear signs that inflation is now exceeding the Fed’s maximum target of 2%. The market is expecting another whopping 75 basis point cut in the Fed Funds rate soon. This may help, but the guaranteed, sure-fire profits for banks even so will be much reduced from what has typically occurred in a recession.

This means it will be years before banks can rebuild their capital. No wonder they are cutting back on loans and other risky ventures. They are conserving every penny of capital that they can. If losses get to around 50% of industry capital, we can certainly say that the banking industry will be temporarily crippled, meaning for the next 3 – 5 years. A number of banks won’t make it, including some in the top 10. The FDIC, which insures consumers against bank failures, is already predicting an increase in bank defaults, and interestingly is pointing to commercial real estate as the biggest risk to banks. Commercial real estate losses aren’t even in the studies we have been looking at here.

Going back to the table above, you will remember we will have covered only half of the $400 billion in mortgage losses predicted by the authors. The other half is likely to be borne by the brokers, hedge funds, and the GSEs. Notice, however, that these sectors of the industry have only $237 billion in total capital, and are the most highly leveraged sectors. They have on average nearly $28 of assets for every $1 of capital, and as they frantically try to reduce their assets, they are driving down the prices of these assets for themselves and everyone else, causing even more losses. It’s a death spiral of destruction, spread systemically through mark-to-market accounting.

This study suggests that about 85% of the capital for brokers, hedge funds, and the GSEs could be wiped out by mortgage losses alone. Clearly in such a circumstance many of these institutions will not survive, and the remainder will be among the walking wounded in the financial industry. Two of the four authors of the study come from Wall Street, and are relatively sanguine about the leverage of their firms, arguing that the assets are all short term rather than loans. But it is the short term, Aaa securities that have been shown wanting in this crisis, and we can’t take too much comfort from the supposed liquidity of Wall Street firms. Merrill Lynch has already written off 20% of its capital, so it is easy to see how they and other brokers could wind up with little or no capital left.

The two main mortgage GSEs, Fannie Mae and Freddie Mac, have long operated on very modest capital bases, arguing that if they got into trouble the U.S. government would be behind them. They are, after all, chartered by the federal government, but no one in the Treasury or Congress has seriously thought that they would have to recapitalize these companies to the tune of $100 billion of more. Quite the contrary – the GSE regulator has just authorized Fannie Mae and Freddie Mac to begin increasing its balance sheet, having set caps on growth just a few years ago due to the inability of GSEs to properly manage their portfolio risks.

Perhaps the GSEs have substantially improved their risk management skills, but increasing their portfolios now could have the perverse affect of damaging these two companies. The derivatives used by the GSEs to hedge their mortgage portfolios are even less liquid now than four years ago, when problems first emerged in Fannie Mae’s portfolio. It’s not even clear that derivatives, which help manage interest rate and prepayment risk in mortgages, can do anything about the treacherous default risks that are permeating mortgage books.

For example, mortgage problems are extending to the Alt-A and even prime categories of mortgages, previously thought immune to serious default risks. The problems are affecting not just mortgages booked since 2004, when credit standards virtually disappeared in the market, but even earlier for fixed rate mortgages to borrowers with high credit scores. It seems that an increasing number of homeowners are in financial distress, and are late paying their mortgage as they struggle with a job loss, health problem, or merely coping with the accelerating costs of food and energy.

This is the point where the financial market implosion meets up with an economy in recession. These two forces are symbiotic and reinforcing. We saw this past week an unprecedented large spread develop between interest rates for municipal bonds vs. interest rates for Treasury securities. Normally municipal bonds trade close to the yields on Treasuries, due to the tax-exempt feature of municipals. But the complete collapse of the variable rate auction market for municipal securities has forced the many users of this market to begin issuing traditional fixed rate bonds. This sudden surge of fixed rate paper on the market is overwhelming buyers of such paper and driving yields up, meaning much higher interest costs for the municipalities involved.

Whereas a month ago many municipalities were blithely auctioning off short term securities costing them about 2% p.a., they are now paying 5.5% p.a. or more and forced to lock in this cost for the long term. The auction process suddenly collapsed because the investment banks/brokers which managed the process stopped buying any left-over paper not purchased by investors at the auction, because these brokers themselves could no longer stomach adding more assets of any sort to their balance sheet. They are, in other words, trying to reduce leverage, not increase it. It is exactly as the authors of the paper speculated – the credit crisis will cause huge cutbacks in the amount of money available for loans.

What happens when the Port Authority of New York or the Los Angeles Airport authority have to pay nearly triple the amount of interest on their debt? Job cutbacks, service reductions, and tax increases that are going to hurt the local economy. This is exactly how the credit crisis exacerbates the economic recession.

We are only at the beginning of this process. We haven’t yet seen large numbers of layoffs as corporations hunker down during the recession. There are other capital markets that are wobbly and prone to collapse – and let’s bear in mind that the markets that collapsed in August, for products such as mortgage-backed securities, collateralized debt obligations, and asset-backed commercial paper, have not come back. This alone is far beyond the usual experience in a recession. Nor has the stock market truly come to grips with the full impact of these market and economic calamities, though that may happen soon.

We appear to be approaching a flashpoint of recognition for all the markets, and for most investors. Part of this recognition will find investors digesting the dire situation facing the financial industry. If we are lucky, the U.S. and global economy will avoid a stampede of investors and depositors out of suspect banks and brokers and insurance companies. But at this stage, avoiding a “run on the bank” is really a matter of luck, since the regulators and government officials can do little to stop it, especially as the crisis is aimed at the largest institutions as well as the smallest.

Sophisticated investors are already asking “where will my money be safe,” because they have already experienced having some of their “liquid” assets frozen, or they know someone who has. At the pace at which this financial crisis is unfolding, we’ll all be asking that question soon.