Thursday, October 02, 2008

Simple question, complex answer

A former physicist (but non-financier) writes:

I have a question, and who better to ask than you. ...something isn't adding up.

I keep hearing that mortgage defaults are what is bringing down many financial institutions, and the the default rate in some particularly bad mortgage pools is up to 50%. Because housing prices are down about 20%, financial institutions can still regain 80% of the value of those loans, no? Actually the real value is probably a bit better, as most loans will be partially paid off. At any rate, doesn't this imply that even in the worst loan pools, there is only a total 10% loss. And most financial institutions will have some higher quality loan pools also, and stocks, etc. So the total effect is going to be smaller than 10%, unless financial institutions were all constructing some sort of horrible options based high risk bets on housing prices, but I doubt this would happen except in some risky hedge funds.

Is this reasoning correct? If so, I don't understand how our system can be so fragile that a few percent drop would bring everyone down. Of course everyone holding a share of these funds will have a small portfolio dip, but this happens every few years anyway.

Your calculations are reasonably correct (see comments for more detail). So why the crisis?

1) Leverage. Many I-banks had 30:1 ratios, so a small movement in value of a subcomponent of their portfolio could wipe them out. It's like a guy who puts 10% down on his house, who can lose everything if the price goes down by 10%. Of course this only matters if he is forced to sell, or, in the bank case, if shareholders and counterparties start losing confidence. This is happening simultaneously in financial markets due to the second factor...

2) Complexity. No one knows who is holding what, who has sold insurance (credit default swaps) to other parties and is on the hook, etc. So trust is gone and credit markets are paralyzed -- no muni bond issuance, no short term loans to businesses, no car loans, etc.

The efficient functioning of our economy is built on trust -- I have to trust that the grocer will give me food in exchange for a dollar bill, that I can get my money out of the bank, that my employer will pay me at the end of the month, that its customers will pay it, etc.

We are nearing a dangerous point. Confidence, once destroyed, is very hard to rebuild.

Relative to the size of our economy, the amount of money involved is not that great. If we had perfect information we could solve the whole problem with about $1 trillion. (About the cost of the Iraq war; not bad for a bubble that involved housing -- our most valuable asset.)


Anonymous said...

Very good analysis - and why we should be looking at the CDS market, as well as how 5 investment banks were exempted from reasonable margin requirements. All this nonsense on the left and right about what caused this is just noise.

gregoryw said...

This is a terrible analysis in that it assumes zero transaction cost, litigation and legal fees, repossession cost, carrying cost, taxes while the home is REO, etc.

With 20% down payments in stable home markets, lenders used to get back about 70% of their money after selling. With no down payments in a stable market, lenders were only getting back 50%. No down payment in a market declining 20% a year, and lenders are getting back as little as 30% of what they laid out. To further complicate this, the tranches in MBS mean that half of the investors are getting nearly nothing. The down payment mortgage investors are getting back 0, as are 2nd mortgage, 3rd mortgage and home equity investors on failed properties. There's nearly 12 months supply of houses. Also, the defaults and the most expensive defaults are concentrated around the loan pools which dared to go where no one else would. Up to 30% of owners paid interest only, or actually accumulated additional principal paying less than I/O.

We're watching $22 trillion of US real estate deflate to $12 trillion. Even if only half of it is mortgaged and 15% of them default, the losses are tremendous. Here's an example of a home sold to an investor on February 2007 for $1.19 million. Asking price is $575k, short sale. Some poor bank is going to take a $600k hit on ONE TOWNHOUSE.

Steve Hsu said...

Sure, if 15% of all mortgages default we are toast. I doubt that will happen.

The $22 trillion number is a bubble number.

Have a look at this paper, which gives a detailed balance sheet calculation in the scenario of, e.g., a further 20% fall in home prices, which would bring us back to historical norms:

"Finally, if prices drop another 20%, predicted losses increase to $868 billion. Moreover, the table suggests that losses peak in the third quarter of 2008 if home prices are flat going forward; in the fourth quarter of 2008 if prices drop another 10%; and in the second quarter of 2009 if prices drop another 20%."

Jan Hatzius, Goldman-Sachs chief US economist

Anonymous said...

"If we had perfect information we could solve the whole problem with about $1 trillion."


And beggars would ride!

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