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The Big Threat of Mortgage Credit Losses

In various publications, Ben Stein has been flogging the meme that because the sub-prime mortgages are such a relatively small percentage of the total US Economy, its really not all that problematic.

Its a rather foolish, overly simplistic analysis that ignores far too many other elements of the sub-prime slime. The pyramid of Derivatives built on top of them, for instance.  It reminds me of an argument you might get intro with a child: "But daddy, the economy is so big and sub-prime is so small..."

I never bothered to respond to that meme, other than to get annoyed enough to note that malignant tumors are small relative to a person's body weight.

Fortunately, Goldman Sachs U.S. economist Jan Hatzius has looked into the issue of sub-prime foreclosures. His conclusions, discussed in this week's Barron's, are noteworthy:

"Hatzius caused quite a stir with a report last week countering the simplistic arguments that the losses in subprime mortgages constitute a mere drop in the ocean that is the U.S. financial system and all this talk about their dire consequences is scaremongering.

After all, the losses in all mortgages -- subprime, alt-A, prime and jumbo -- come to about $400 billion. That would be equal to about 2.5% of the capitalization of the U.S. stock market, "equivalent, in other words, to one bad day in the market," Hatzius writes.

What's different about mortgages is, in a word, leverage, he continues. Most stocks are owned by traditional investors, such as individuals, mutual funds, pension funds and insurance companies, who don't use margin and don't short. In contrast, most owners of mortgages are highly leveraged, including banks, savings and loans, broker-dealers and government-sponsored enterprises such as Fannie Mae and Freddie Mac, according to Fed data, which don't count hedge funds.

This distinction makes a huge difference. If, say, these leveraged players account for $200 billion of mortgage-related credit losses, and they lever up 10 times, that hit results in a $2 trillion reduction in credit, Hatzius theorizes.

This would be a shock equal to 7% of total debt. Such a credit contraction could produce a large recession, if it happened in a short period such as a year, or a long period of sluggish growth -- say, over two to four years, he adds.

Hatzius admits this assumes all else being equal (as would any card-carrying economist), including the rest of the economy, and that markets carry on with business as usual, a heroic assumption. He adds that Goldman already assumes knock-on effects beyond residential construction on consumer spending in its forecast for relatively subdued growth. And he says that regulators may persuade strong banks to keep credit flowing despite their losses, though he doubts how long they would be willing to keep that up. Finally, foreign investors may pump capital into affected institutions, as with China's Citic Securities acquiring a 9.9% stake in Bear Stearns.

The bottom line is that mortgage credit losses, although highly uncertain, pose a bigger threat to the economy than generally is acknowledged, Hatzius concludes."

Hence, its the mere size of sub-prime foreclosures are merely the starting point of analyzing this issue -- and derivatives are only the second point. Add in the leverage, and you have a real substantial economic threat  that even Ben Stein can understand . . .

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Source:
The Goldy Standard
RANDALL W. FORSYTH   
Barron's, NOVEMBER 19, 2007   
http://online.barrons.com/article/SB119525694137596359.html

Saturday, November 17, 2007 | 08:00 AM | Permalink | Comments (48) | TrackBack (1)
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Comments

Amazing rhetoric and logic when it serves its purpose Golman states that its level 3 assets are a mere 7 Pct of its total assets when begging for lower interest rate they recognise the level 3 as a proportion of capital.
No need to drink hard Alcohol just read Wall Street

Posted by: Philippe | Nov 17, 2007 8:30:53 AM

Very interesting side effect of securitization...

http://snipurl.com/1ts7u

Posted by: bostonian | Nov 17, 2007 8:58:36 AM

Slowly the curtain is being pulled away from the Wizard of Oz, known as the Financials. It has been snowing poppies in their worlds for too long! Two trillion is going to have a gigantic affect. Are we counting all the credit card defaults that are coming down the pipe? Oh! I'm sorry they're using the pipe to smoke the poppies...so how would they know?

Posted by: justin | Nov 17, 2007 9:06:38 AM

No disrespect to Ben Stein but his papa was a moron. I lived through the stagflation 70's when his dad was Nixon and Fords economic council chairman. Truely this guy was clueless. Ask Kudlow if he ever wore a WIN button. What did WIN stand for? Anyone? Anyone?
As far as I can tell, inflation is MUCH worse than in the 70's. We haven't got to the hoarding stage yet but it too will come.
"Better buy now instead of tomorrow, when things will cost more, you'll find to your sorrow."

Posted by: Ross | Nov 17, 2007 9:08:00 AM

Stein doesn't understand very much either deliberately or because he really is as obtuse as he appears. I suspect it's the former. He's basically a Republican shill, a bit like Kudlow, who makes his living peddling justifications to the faithful. He had some beauties in the NYT last Sunday. For example. The failure of big institutions like Citi and Merrill to properly monitor the performance of management was because their boards were stacked with university professors. Someone made money out of all this mess so everything's ok. Bob Rubin was principally responsible for the tech bubble. I'm not kidding read the piece. Just as good as anything Malpass, Moore or Kudlow could come up with.

Posted by: John | Nov 17, 2007 9:09:37 AM

Although Hatzuis's analysis seems
quite plausible, we should not forget that Blankfein mentioned on Wednesday that Goldman is net short the mortgage sector. Are they 'talking their book?'

Posted by: Jim Richards | Nov 17, 2007 9:14:13 AM

Stein also tried to hedge that position a little bit with a column last week in the NY Times, in which he argued that the sub-prime problem was created by political correctness. He never fully explained the causality behind the claim, but it was certainly one of the stupidest business columns I have ever read in my life.

Posted by: Florida | Nov 17, 2007 9:29:58 AM

Stein is a perfect example of my meme that just because you get published doesn't mean you know anything...financial journalism is often an oxymoron. And when a hedge fund guy writes a column or starts a blog (present host excluded, of course) hold on to your wallet and think for yourself.

Posted by: lurker | Nov 17, 2007 9:31:31 AM

Is it possible that the foreclosure rate is elevated right now because the speculators are getting flushed out, but the owner occupied rate is still low, so the situation looks worse now than it really is? I just heard this argument and it makes sense, but I wasn't able to find any data.

Posted by: stu | Nov 17, 2007 9:41:50 AM

Benny boy should stick to teen movies, IE: Bueller? Bueller?

And yet, he has a voice in the media as some sort of economic guru.

I figure real inflation at 13.6%

What happened to WIN?

Posted by: Bucky Katt | Nov 17, 2007 9:44:11 AM

Ben Stein's column last week hit a new high, on the fatuous commentary scale. He basically implied that people who used easy credit to buy homes at the peak of the market were the winners--the ones who could make their payments, of course.

He reasoned that they were able to buy a more expansive house due to the lower borrowing costs. The fact that the lower borrowing costs only allowed the buyers to pay inflated prices seems to have slipped by him.

There are a lot of bad business writers (check out the article at Baron's about theprospects for Japan's stock market, but fails to mention th eimpact of a slowdown in the U.S.), but Ben Stein is such an ass he makes me angry...

Posted by: Bob_in_MA | Nov 17, 2007 9:56:10 AM

Are they 'talking their book?'

No Recession in Sight by Paul Kasriel

No the economist (undertaking his usual beggar plea before Fed meeting) is inferring that lower interest rate is the panacea , should it be, it would shore up the real estates and make all short position uncomfortable.
The economist seems to ignore that solvency is the real problem.
May be a consultation to this site would help l No Recession in Sight by Paul Kasriel 10-15-2007.htm
PS Banks like Goldman should issue new shares capital increase? their profits are high enough to offset the market fears their stock price is at its best, its chairman is not seing threat at any level 2/3, its equities representative is seing the SP at 1600 at year end. All is for the best in the best of the possible world.

Posted by: Philippe | Nov 17, 2007 10:00:19 AM

Bloomberg interviewed Gregory Peters from Morgan Stanley this week who made a similarly dire warning about a systemic financial system shock, placing the probability at greater than 50%.

I'm sure Bernanke will return Blankfein and John Mack's calls. They could express their concerns privately. So is the point of coming public with these scenarios to generate pressure outside of Goldman and Morgan Stanley for more and deeper rate cuts?

Posted by: Groty | Nov 17, 2007 10:10:09 AM

I like Ben Stein, but he has consistantly taken this issue. I never understood why he doesnt see the big picture. The housing market is a big ladder. If you take out the bottom 3 rungs no one gets to move up. Also he has never talked about the 'wealth effect'... consumers are going to spend less... and these 2 issues will affect the economy. Finally some one has taken him to task. In the long run he will probably be proven correct but why wait for 5-8 years and all that pain... cash out and re-enter

Posted by: Brian B. | Nov 17, 2007 10:18:02 AM

What Mr. Stein fails to recognize is the subprime is not the problem but only a symptom of a much larger problem - the cough that won't go away that signifies lung cancer.

Behind this mess is the unbridled greed that accompanies bubbles - and it was everywhere, from residential real estate to commercial real estate to credit cards to leveraged buyouts to bank SIVs - all overextended and overleveraged based on a misguided assumption of a continuation of higher demand and higher prices.

What we are observing now is a validation of how dependent is the U.S. economy on the availability of credit. The first pinch hit subprime residential customers; next, leveraged buyouts were nullified; the next shoe to drop will be commercial real estate, as demand expectations grossly exceeded estimates; credit cards will most likely be the last area affected, as consumers can make minimum payments and delay default. It is a daisy chain effect and will take many months to play out.

What we are seeing now is that companies who don't need to borrow have free access to credit, but those who depend on credit are having trouble finding it at any price. As with any severe economic slowdown or recession, those companies strongly positioned financially will be O.K., while those dependent on credit will be squeezed - some out of existence.

Posted by: Winston Munn | Nov 17, 2007 10:39:29 AM

There are two sides to every argument. The two sides here seem to be:

One side is saying sub prime fallout will be worse than what EVERYONE thinks.

The other side is saying sub prime fallout will be better than what EVERYONE thinks.

The two sides seem equally divided. So where exactly is this EVERYONE they keep talking about?

Posted by: ken | Nov 17, 2007 10:56:16 AM

Ben Stein is an idiot. I have never read anything he wrote that made much sense to me because they all left OUT large portions of whatever the topic du jour was. He NEVER examines the Big Picture (heh) from an objective standpoint. No serious, well informed investor, analyst, or economist ever takes anything he says seriously. Ever. I hope. I know someone who, after reading one of Stein's perma-bull goldilocks articles on housing, bought into WM at around $38, along with quite a few other stocks, and nearly all of them have been hit hard. I tried to lay things out for the guy, and all I needed were two charts, but I guess Ben Stein's overly simplistic (and utterly retarded) "analysis" of the situation took the foreground in his mind. Needless to say, he's regretting that now. Indeed, Stein should return to making movies and commercials and STOP producing faux financial commentary that ends up with the little guy getting hurt.

Posted by: Robert | Nov 17, 2007 11:14:11 AM

winston munn ( see above) said it right!
Subprime (or its derivatives) is not the problem, just the first (weakest) symptom).

When you go from an overleveraged credit boom to riskaversion and de-leveraging (especially in a recession), it will affect all assets (negatively), while you liabilities stay the same, impairing you balance sheet (especially financial services). Banks and other financial companies are going to need capital, right at the moment when the mkt is reluctant to give it to them. All assets are at risk, including commercial real estate, credit card, private equity etc etc
My guess is that this cycle is not over until one or more major financial services (including banks) have gone under!

Posted by: pjfny | Nov 17, 2007 11:21:08 AM

Ben Stein's larger agenda appears to be to cheerlead the economy, and I suspect this is part of his larger agenda to show just how "good" the Bush economy (read: massive tax cuts) have been.

Of course, he's lining it up to claim that the next President (or perhaps this Congress) is actually to blame for the economic mayhem that is coming down the pipeline.

The reality of the Bush "ownership" society is that it's been, on both a macro and micro level, all about borrowing to "own" stuff. The easy credit from early in the Bush administration, the high budget deficits incurred by his massive (supply-side) tax cuts, the huge current account deficits, etc. etc. etc. have all had the purpose and/or effect of encouraging rational actors to borrow heavily to fuel GDP growth.

The collateral damage from the subprime crisis will be huge. First, you'll see a massive tightening of the credit markets (already occuring), as all investors pull out of residential mortgage-backed securities (and their derivatives such as CDOs), and as foreign investors pull out of US debt markets completely. This will tighten consumer and business spending in the US, proving (again) that supply side incentives don't lead to business investment in the absence of demand.

Second, you will potentially see an avalanche of foreclosures that won't just be limited to subprimes. As subprimes start defaulting and then being foreclosed upon in the next 6-9 months en masse, you'll see a large decline in property values, which may lead to a sudden and severe decline in homebuying. The glut of supply vs. demand is likely to be sticky, and stagnant/declining home prices could last into 2010-11, when a wave of prime ARMs (5 yr, 7 yr, largely taken out by yuppies) start resetting. These homeowners will be better positioned to survive their ARM resets, but some of them will most definitely default.

And let's not forget the devaluation of the dollar vis-a-vis other currencies. Inflation appears to be just around the corner, which will exacerbate the enormous loss of household wealth already being suffered by Americans. This, coupled with far tighter credit, should lead to large declines in consumer spending.

Finally, if foreign investors decide that the US economy is no longer where they want to be, and start divesting or stop investing in US assets and USD denominated assets, this could get really ugly. Foreign banks have essentially been subsidizing US debt (both private and public) for some time now. If they decide to stop doing that, you'll start seeing some pretty rough interest rate spikes, and stagflation is a real possibility.

Which is all to say that Republican economic policies may just have ruined this country of ours.

Posted by: Ben Stein the Hack | Nov 17, 2007 11:27:44 AM

agree with all negative portrayals above re BS the politico-economic-market sage. but in his defense may i recommend a small title he wrote back in the '70s called "Ludes" (as in the drug of choice at that time) about a real estate macher's rise and fall in booming SoCal. it was really a wonderful Gatsbyesque little work. he got that little picture right. but he's a flak on the big picture.

Posted by: scorpio | Nov 17, 2007 11:37:57 AM

I have to agree with most of what has been said on inflation. I also think there seem to be many Pollyanna types out there who seem to make their judgments and calls more as a sign of political support rather than thinking the situation through and making an apolitical conclusion.

It's like the goldilocks scenario. We all know the goldilocks scenario. Well let’s say the fairy tale is true. What do we know of the girl's past? We do know she breaks into people's (da bears) homes and eats their food and sleeps in their beds (notice nothing is said of whether she even took her shoes off and whether she remade the beds she slept in. No her only criteria is whether she found something comfortable for her as an individual. Sounds like the neocon approach of "as long as I got mine". What it does not tell us is whether Goldilocks was subsequently tracked down by the bear family and dismembered and eaten, or if the bear family sued her and a lien was taken out against her. I suspect the possibility that Miss Goldilocks might have become an unwed mother who is addicted to crack cocaine or even worse an economist.

This morning I saw on CNN a blipvert / mini program on how to reduce your grocery costs. If ever there was a warning call for inflation this is it. By the time it is on CNN it is in full swing.

There are some interesting etfs based on the commodity investment indexes that Jim Rodgers set up.

There is a song by the late Warren Zevon that was made in the Era of Gerald Ford being president. It is called Mohamed’s Radio.

"Everybody's desperate trying to make ends meet
Work all day, still can't pay the price of gasoline and meat
Alas, their lives are incomplete

Don't it make you want to rock and roll
All night long Mohammed's Radio
I heard somebody singing sweet and soulful
On the radio, Mohammed's Radio

You've been up all night listening for his drum
Hoping that the righteous might just might just might just come
I heard the General whisper to his aide-de-camp
"Be watchful for Mohammed's lamp"

Don't it make you want to rock and roll
All night long Mohammed's Radio

I threw in the lyrics after the part that deals with inflation cause I just want to encourage people to check out his work

Posted by: alexd | Nov 17, 2007 11:49:34 AM

AlexD:
Nice Zevon reference!!

Posted by: Joe Klein's conscience | Nov 17, 2007 12:06:20 PM

Feldstein during his speech at Jackson Hole in Sept noted these items:

40% of mortgage holders in 2005 did a home refi

Subprime by the media has been focused on 1st time buyers but only 15% of subprime went to 1st time buyers the rest was used by the refi crowd How many went to 100% cash out or 125% of value we don't know but during this time many converted their fixed rate mortgage into ARM or IO to max their leverage. So I don't think its out of the question to assume that a significant portion of the mortgage holders today are unside down their mortgage relative to its market value since a large # of refi's have taken place since 2002. Feldstein also noted that 9 trillion dollars of MEW withdrawl between 1997 and 2005.
When BB during the Q&A during his congressional visit carried the idea forward that the GSE's should raise their lending caps this is a clear indication by the FED that the problem is beyond just lower interest rates and Congress can't look to the FED for answers or hope.

Posted by: ron | Nov 17, 2007 12:33:11 PM

How 4% of Mortgages Have Brought Down the Entire Market

If the parameters in the Pareto distribution are suitably chosen, then one would have not only 80% of effects coming from 20% of causes, but also 80% of that top 80% of effects coming from 20% of that top 20% of causes, and so on (80% of 80% is 64%; 20% of 20% is 4%, so this implies a "64-4 law").

Posted by: a guy called john | Nov 17, 2007 1:01:50 PM

The only comments uttered from B. Stein that I have ever found myself applauding were those he voiced when he was expressing his disdain and disgust for the creation of the M-LEC super SIV. He called it square at that time. Yet, except for those comments, everything else I've heard or read from him, seems to view dynamics and machinations of the market risks in an extremely simplistic and naive fashion. He doesn't get it. Still he did get the SIV scam, and I at least give him some kudos for that.

Posted by: Stuart | Nov 17, 2007 1:12:58 PM

December 2008

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