How big a slump?

by John Q on August 17, 2007

With stock markets down 10-15 per cent in the last few weeks, it’s a good time to ask whether this will have real effects beyond the value of our superannuation. The immediate starting point of the current disruptions was evidence that defaults on US mortgage markets were worse than expected. An obvious question is whether this underlying shock is large enough to have substantial effects in itself, or whether the problem is mainly one of liquidity and confidence.

Ben Bernanke has estimated possible losses from subprime mortages at between $50 billion and $100 billion. As this article notes, that figure may sound large, but it would represent a tiny fraction of the $56.2 trillion in U.S. household net worth. To be precise, it’s somewhere between 0.1 per cent and 0.2 per cent of net worth.

Arguably, to the extent that real resources are dissipated, as commonly happens in a process of default the relevant comparator is something like annual output. Expressed relative to annual output, a loss of $50 billion to $100 billion bit larger (between 0.5 and 1 per cent) but still not really scary. We could get to a similar number by supposing that house values will decline modestly in response to the crisis.

It appears that there is around a $1 trillion dollars in sub-prime debt outstanding, and much of this is likely to go into default this year, as house prices fall and interest rates (initially at low teaser rates) reset. The loss from default is confined to the costs of foreclosure and the shortfall in recovery when the house is sold, but it seems likely to be at or above the high end of Bernanke’s range.

The real problems emerge if there are more bad loans elsewhere in the economy. It’s already become apparent that housing defaults go beyond the sub-prime sector to the Alt-A sector (low-doc loans to borrowers with good credit) and maybe beyond. More generally, a lot of recent financial market activity has been premised on the assumption of cheap debt or, more precisely, a low price for risk. A higher price of risk implies that there must be quite a few heavily geared assets that are worth less then the debt they secure.

We’re still waiting to see how large the losses are. As a rough guess, I’d say that a quick response from the central banks can deal with liquidity problems if the total losses are less than about $500 billion. After that, it’s anyone’s guess.

For those interested, here are a couple of scary stories I wrote five years ago about how something like this might pan out.



abb1 08.17.07 at 12:06 pm

…it’s a good time to ask


Dan Karreman 08.17.07 at 12:20 pm

Sweden experienced something that looks awful similar to what’s happening in the US right now in 1990-91: a bursting housing bubble, poorly regulated finance markets, and poorly priced risks. The result wasn’t pretty: the banking industry almost completely collapsed, the economy went into the worst recession since 1930, and we had two years with contracting GDP. It took more than 7 years for the housing market to bounce back, and it changed the Swedish economy in a fundamental way (no more chockfull employment). Granted, the crisis was further fueled by simply idiotic monetary policies (for example, the Riksbank raised the funds rate to 500% in a futile attempt to defend the fixed exchange rate regime) that Helicopter-Ben is unlikely to emulate (I hope). If the Swedish scenario holds out, this is the beginning of the beginning…


tom 08.17.07 at 2:17 pm

A quick pump of liquidity has sent markets back up. Will be interesting to see how shortlived this recovery is. Are we seeing a genuine liquidity crisis or is it a more sinister solvency crisis?


robertdfeinman 08.17.07 at 3:37 pm

The Japanese banks experienced a similar situation for most of the 90’s. Technically most of them were insolvent. So with the connivance of the government they branded all their worthless mortgages as “non-performing” and they were exempted from their reserve requirements.

It took a decade but they worked themselves out of the hole. It did put a big damper on economic growth, but that was the trade off to prevent a worse problem.

The Fed could easily engineer something similar, or congress could create another resolution trust entity to handle the clean up. At the moment people are over reacting and statements like:

“It appears that there is around a $1 trillion dollars in sub-prime debt outstanding, and much of this is likely to go into default this year,” only add to the fear.

Wise people with lots of time and ready cash are probably already buying under-priced assets. Warren Buffet certainly is.


Michael Sullivan 08.17.07 at 3:44 pm

Was the fraud so bad that we’re really like to see 50%+ of the subprime mortgage market in default? Or 50% of the typical mortgage lost in foreclosure costs/depressed sales?

I would have thought a typical cost to foreclosure to the lender, even on a pretty bad loan (say 100-105%LTV) might be around 20-30%. And even in the subprime market, I’d have thought that a 5-10% default rate would be quite high, and much more very unlikely barring a major recession.

Even looking conservatively, a 15% default rate with 40% loss ends up being 6% of the market, comfortably in Bernanke’s range. To get more than 10% of the market, either default rate or loss rate has to be *very* high, higher than the stats I’ve been seeing on how bad things are suggest is likely.

Of course how that number rebounds in the derivatives market is another question, but as an estimate of the underlying sub-prime problem, 5-10% of the market seems fairly reasonable.

I also don’t get the scariness of scary story 3. Or rather why the lender’s problem in the US is any different than in australia. What mortgage lenders in the US have done is to limit their upside. The downside is exactly the same as with a fixed-interest, fixed-term loan.

If anything, the downside is better for US banks, because some borrowers will pay back early, even if it is not in their interest. When interest rates are high relative to outstanding loans, even small percentages of early payback are a huge boon to the lender.

Secondly, on first thought, it seems more efficient to allow early payback. How do Australian lenders deal with a property sale? Can you pay back the loan early without penalty if you sell the mortgaged property? If so, then people will probably sell to get out of bad loans. If not, what do you do when someone needs to sell anyway? Do they need the consent of the mortgage holder? Does the loan carry over to another property? What if there isn’t another one or the value is less than the loan? Does it become unsecured?

It seems like all the possible answers to these questions will have unintended consequences, People will make less efficient real estate decisions in some interest rate markets because of the mortgage consequences. Allowing prepayment decouples interest rate exposure from property exposure, and also means that lenders are providing insurance against interest rate risk to borrowers. Which seems like an efficient proposition to me — who can stomach more risks, MBS investors or individual home and business owners? It’s efficient to package this risk and sell it to big institutional investors with huge portfolios. If you pawn it off on individuals, the cost will still be there (and be greater), it will just show up in lower property prices and higher appreciation expectation.

And of course, the availability of variable rate loans means that people can opt out of buying that insurance, although the current cost of that insurance is so low and the structure of variable rate loans so strange that whether to go variable has much more to do with a long/short hold bet than whether it’s worth paying to insure against interest rate risk.


Matt Kuzma 08.17.07 at 8:18 pm

I appreciate your point about comparing the losses to the annual output, but I think the question of annual output is a trickier one when it comes to the housing market. Most sales of homes in a given year are exiting homes, and for the most part the people buying are selling a different home and the people selling are buying a different home. The real annual production on the supply side comes from new home construction, and on the demand side from first-time home buyers.

But this sub-prime disaster comes on the heels of the biggest influx of first-time home buyers in a very long time, because lax standards in lending meant more people could qualify for more than ever. Now defaults are putting those homes back on the market and taking those owners out of the market, and strengthened lending standards will all but halt the influx of new buyers into the market. Without first-time buyers, most of the market is incapable of moving.


James Wimberley 08.17.07 at 11:39 pm

John: any thoughts on the social impact of half a trillion dollars’ worth of mortgages going belly-up? A lot of rather badly off Americans, many I suppose black or Hispanic, will lose their houses, have to move to worse rented accommodation, and even go into bankruptcy, which makes it unlikely they can borrow for another house any time soon. The losses to creditors are very asymmetrical.


Shelby 08.18.07 at 12:58 am

Without first-time buyers, most of the market is incapable of moving.

Not strictly true. Many “first-buyer” houses are purchased by investors as rental properties, but the figures have to work — mortgage payments have to drop into the vicinity of potential rents.


tzs 08.18.07 at 2:29 am

I’m not going to worry too much yet. The major conniptions are being made by the financial industry, and that because they’re all suddenly realizing that all those lovely engineered financial securities based on mortgages are tagged with risk ratings that have no basis to reality. Plus, they’ve been swapping them around for so long that everyone’s gotten tied up in one humungous game of Hot Potato and nobody knows who is IT. So they’ll be hysterical for some time yet, worried about defaults popping up in unforseen places.


John Quiggin 08.18.07 at 4:01 am

James, I plan a post on the distribution of the losses soon.


Tim Worstall 08.18.07 at 8:42 am

One thing that makes the US mortgage market different from, say, the UK one (early 90s, lots of negative equity around) is the repsonse that D2 and I got from Dean Baker when we asked him a year or so ago. That (as long as it is the prime mortgage) in most US states if the house is worth less than the mortgage, the owner can walk away leaving the bank with the loss. Sure, annhilates the credit score, but it can be done. UK mortgages, by contrast, such an excess of debt over value follows the borrower.
No idea what effect that’ll have on the distribution of losses etc, but it does mean, at least I think it does, that the US situation is not directly comparable to that earlier UK one.


albertchampion 08.20.07 at 5:04 am

actually, doesn’t it get very ugly very quickly?

firstly, what do the lenders do with the foreclosed properties? HOW DO THEY DISPOSE OF THEM? most of these subprime production-built properties are junk. in a very real sense, they were the mechanism by which the retillians purchased voters. study that major bushit pioneer bob perry and his home-building empire for instance. was cheap money the method of rewarding major reptillian “contributors”?

the next major issue is “imputed” income. how does the irs respond to the mortgage walk-aways?

next, the changes in the bankruptcy laws that the congress[reptillian/demtillian]enacted some months ago….how will those changes influence this round of musical chairs?

one interesting aspect of all this is the “second” residence market. how many of those “jumbo” mortgages are out there as stranded properties, do you think? i had a friend just return from a vacation to wiscasset, me. she uses a family house for a couple weeks every summer. this july/august she tells me that the number of FOR SALE signs exceeded anything that she has ever seen.

how long can residential properties go unoccupied before they require demolition? as was the situation some years ago when the bushit 1 was running the S&L bust-out, metro houston, metro dallas have an extraordinarily large number of foreclosures, imminent foreclosures. in spite of the purportedly meteoric texas boom economy.

to my way of thinking, welcome to the new dark ages.


abb1 08.20.07 at 5:20 pm

…dark ages

Nah, not ages. I’ve seen this in 1991-92 in the North-East: unoccupied properties, foreclosures, FOR SALE signs, the whole enchilada. People with money will buy them and everything will spring back in a few years. Life goes on.


albertchampion 08.21.07 at 5:27 am

you don’t know enough.

you failed to address virtually all of my points.

and it is the imputed income that is the most interesting, i think. today, the issue was addressed in the front page of the nyt.

you may have been there, but you were not paying attention.


abb1 08.21.07 at 7:09 am

Why, I agree with your points and I agree that we’re probably looking at a few miserable years ahead. But to convincingly predict “the new dark ages” you need a bit more, I think.

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