Monday, October 27, 2008

Subprime factoids -- we've seen most of the bad news

I was just looking through a fascinating collection of data relating to the mortgage disaster put together by the Milken Institute. At the peak of subprime mortgage lending in 2006, there were about $1.2 trillion of outstanding subprime mortgages. By March of this year that had dropped to just under $900 billion. To date, financial institutions around the world have recorded losses (most of them related to subprime lending) of just over $500 billion.

The eventual losses suffered by holders of defaulted mortgages will be equal to the original value of the mortgages less the recovery value of the homes that are sold in foreclosure. Let's be very pessimistic and assume that every single subprime mortgage ever made was a zero down loan; that they all default; and that the foreclosed homes all sell for only 50% of their original value. That would translate into total subprime losses of roughly $600 billion.

That's most likely the upper limit for subprime losses. Derivatives and leverage can't magnify these losses. Derivatives only distribute losses. Leverage magnifies the losses of the leveraged loser, but leverage doesn't increase the total losses to the system.

So, it would appear that we are closing in on the tail end of the subprime-related losses. The vast bulk of the losses have been taken, realized, and written down. There's not much left to this sad and tragic story. But it sure seems like a pretty small tail to be wagging the big global dog.


Mark Gerber said...

Hi again Scott,
Boy, do I hate to play devil's advocate, but I respect your opinion, so I would sure like to have my fears proven wrong:

Aren't the subprime mortgages just the canary in the coalmine of the credit bubble? For example, it is looking like Alt-A loans are now starting to default at increasing rates.

The entire value of homes in the USA was about $22 Trillion at the top, according to the Fed. We know all these assets, not just subprime, were used by homeowners to lever up via home equity loans and low down payment purchases. Home equity loans alone ran at a rate of about 3% of GDP each year from 2003-2006 (I don't have 2007 or 2008 figures). That's about $1.5 Trillion withdrawn from home equity during those four years alone!

Now, we know those $22 Trillion in homes have already dropped around 20% from the high valuation. That is a loss of about $4.4 Trillion in assets. Furthermore, housing prices may be poised to drop another 10% bringing the total loss to around $6.6 Trillion. This is a significant loss, and is placing an increasing number of homes in a negetaive equity situation. Thus, the source of funding for the bulk of consumer spending growth over recent years (and thus GDP growth) is at best no longer available and probably a source of decline in consumer spending now and in future years.

So, isn't a focus on subprime losses alone misleading with regard to getting a handle on the size of the credit contraction and the extend of deleveraging generated from the housing delcine?

Best regards,

Scott Grannis said...

Subprime loan defaults are an order of magnitude higher than other types of loans. My point in the post is that we've almost surely seen the worst of the news. Total losses from all mortgage defaults aren't likely to be more than $1 trillion (I think).

Home equity withdrawal has been way over-rated as a source of the economy's strength. How can the economy get stronger if I spend some of the equity in my home? I have to borrow money from someone else. I'm spending his money, not my money; no new money was created in the process.

By the same logic, a slowdown in equity withdrawal can't weaken the economy.

In economics jargon, this is all about the "wealth effect" of changes in asset prices. No one really knows what it is (i.e., what fraction of a rise in home prices translates into stronger growth), but I side with those who think it is not very big.

I would also note that the equity losses that occurred during the 2000-2002 period were roughly $5 trillion, and yet we had only a mild recession.

Mark Gerber said...

Thanks for that clear response. Your analysis of the subprime problem is very close to my own one year ago, but given the credit crisis and subsequent market reaction, it just seems like something bigger than a $600B loss due to subprime defaults.

After rereading your post, I'm wondering about your remark that leverage only makes the loss larger for the holder, not the system. I don't understand this because it would seem that the losses to the system would be aggregated from all leveraged holders. In other words, if the subprime paper was leveraged at banks at a 10:1 ratio, the loss of $600B would reduce available credit to the entire system by $6T, everything else being equal, of course.

I also wonder if the popping of this housing bubble has a deeper effect than the usual wealth effect for two reasons:
1) When a homeonwer goes into negative equity they have a great awareness of their loss of wealth.
2) The popping of this housing bubble is the end of the myth that houses always go up in price.

I also wonder about the worldwide feedback effects of all this. We know that Asians have been big buyers of our mortgage and other securities. I assume they have been motivated to do this because they have excess savings and they want to keep their currencies cheap to sell us more junk. A few months ago I saw an amazing chart from Gavkal (let me know if you want to see it) that showed an unbelievable high correlation between our trade deficit and the aggregate value of NEW homes sold in the USA. Needless to say, as our new home sales plummeted in recent months, so has our trade deficit, and the monetary fuel that deficit was pumping out into the world economy.

Thanks for your thought as always.

Seven Star Hand said...

Hey Scott,

So, why should all of humanity be forced to suffer and struggle any longer, now that the entire global financial system has been exposed as a mind-boggling deception, within many other deceptions? No one in their right mind would continue to be enslaved by a proven deception, which is also proven to be undeniable slavery-by-proxy !!!

The derivatives scams alone have grown to more than 20 times the entire global GDP (at last counting) and are now failing because the scam/pyramid scheme broke and exposed the deception for all to see. A significant portion of global wealth and power was created and propped-up using these and other now-proven smoke and mirrors and house of cards illusions and delusions.

These deceptions have grown many times larger than the rest of the entire world economy. Consequently, there is no way that all of the world's governments combined, who themselves borrow so-called "money" from other central-bank smoke and mirror deceptions, can solve this debacle, by using more smoke and mirrors money scams. The only solutions they are offering will take centuries to repay, if ever.

Here is Wisdom...

Scott Grannis said...

seven star, you need to take a crash course in derivatives. You're way off base and wrong by a mile.

Scott Grannis said...

Mark, a few comments: Moral hazard has finally found its way back to the housing market. That is good. It will be a long time before housing gets overvalued again, or lenders make zero down loans again. The link between the trade deficit and housing makes sense. Lots of money was coming into our market from overseas, and it ended up funding a lot of the mortgages that they went bust. Foreigners have taken a big bath as a result. But the positive side to that is that instead of buying mortgages with the money they earn from selling things to us, they are now buying our exports of goods and services. Net exports is by far the strongest part of the economy right now, thanks to the housing bust.