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How on earth could a measly $400 billion in losses from the mortgage meltdown cause the massive slowdown in the economy that we're witnessing? Or as Frederic Mishkin, a Fed Governor, asked at the U.S. Monetary Policy Forum in New York this past Friday:

How could the recent residential mortgage-market meltdown, which the authors of the paper - "Leveraged Losses: Lessons from the Mortgage Meltdown" - estimate will lead to credit losses of around $400 billion - less than 2 percent of the outstanding $22 trillion in U.S. equities - possibly have such large negative effects on economic activity in the United States?

Or put more simply, "after all, a 2 percent decline in stock market prices sometimes happens on a daily basis and yet leads to hardly a ripple in the U.S. economy."

Mishkin goes on to discuss the paper written by an all-star cast from Wall Street, the Chicago Fed, and academia - David Greenlaw, Jan Hatzius, Anil Kashyap, and Hyun Song Shin:

The authors conclude that these losses have such a large potential impact because they are borne by highly leveraged financial institutions, primarily banks. Their theory is basically as follows: Because banks have so much leverage, they reduce their lending by a multiple of their credit losses in order to restore their balance sheets. The resulting contraction in bank lending then leads to a substantial decline in aggregate spending, because bank loans cannot be replaced by credit from other sources. Banks are "special" - that is, they have intermediation capabilities not fully shared by other financial market participants, and those capabilities allow banks to overcome informational barriers between borrowers and lenders and thus make loans that otherwise could not be made.

It's this unique role that the banks play in our economy that is leading to this recession, which is probably already underway, and it's not a pretty picture. The authors estimate that this mortgage/lending contraction is directly responsible for a 1 - 1.5% reduction in the GDP.

Finally, this spillover effect seems to mirror the micro effect we're seeing in neighborhoods around the country:

More than 44 million homeowners could experience a decline in the value of their properties of about $5,000 on average over the next two years because of foreclosures in their neighborhoods.

Among other things, however, foreclosed homes can depress neighborhood values because lenders often sell the homes at a discount to recoup their investments, and vacant homes can also attract crime, according to real estate professionals.

In Suffolk and Nassau, the counties in the New York City region facing the most subprime-related foreclosures, 9,450 homes are expected to be lost to foreclosure, and 549,000 surrounding homeowners would be affected. In Nassau, those living within one-eighth of a mile of a foreclosed home would face decreases in value of nearly $7,100, while in Suffolk, they would lose $4,200 on paper.

It ain't pretty out there, that's for sure...

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