Brian Wesbury’s Definitive Take on the Subprime Crisis

The real problem with the financial markets is that extreme leverage and extreme uncertainty have met in the subprime loan market. No one knows how many loans will go bad, who owns these mortgages and what leverage they have applied. We do know that subprime lending is just 9% of the $10.4 trillion dollar mortgage market, and delinquencies are running at about 18%. The Alt-A market is about 8% of all mortgages and about 5% of this debt is delinquent.
As an example, let’s take a very low probability event and assume that losses triple from here. Let’s assume that 54% of all subprime loans and 15% of all Alt-A loans actually move to foreclosure. Then, assume that lenders are able to recover 50% of the value of their loans. In this scenario, total losses in the subprime market would be 27%, while total losses in Alt-A would be 7.5%.
From this we can estimate a price for the securitized pools of these assets. Without doing any actual adjustment for yields, or for different tranches of this debt, the raw value of the underlying assets would be 73 cents on the dollar for subprime pools and 92.5 cents for the Alt-A pools. Getting a bid on this stuff should be easy, right? After all, the market prices risky assets every day.
But this is the rub. A hedge fund, or financial institution, that uses leverage of 4:1 or more, would be wiped out if it sold subprime bonds at those levels. A 27% loss on Main Street turns into a 100% loss on Wall Street very easily. But because hedge funds can slow down redemptions, at least for awhile, and because they are trying desperately not to implode, they hold back from the market. At the same time, those with cash smell blood in the water, patiently wait, and put low-ball bids on risky bonds. The result: No market clearing price in the leveraged, asset-backed marketplace.
Additional Fed liquidity can’t fix this problem. An old phrase from the 1970s comes to mind — “pushing on a string.” In the 1970s, no matter how much money the Fed pushed into the system, it could not create a sustainable economic recovery that did not include a surge in inflation because high tax rates and significant government interference in the economy prevented true gains in productivity.
There is a lesson here. Populism is in the air these days, and the threat from tax hikes, trade protectionism and more government involvement in the economy, is rising. This reduces the desire to take risk. Congress is working on a legislative response to current mortgage market woes as well. And as with the savings and loan industry (forcing S&Ls to sell junk bonds at fire-sale prices), and Sarbanes-Oxley, the legislative response almost always compounds the problems.
The interaction of an uncertain regulatory and tax environment with a highly leveraged, illiquid market for risky mortgage debt creates conditions that look just like an economy-wide liquidity crisis. But it’s not. A few rate cuts will not help.
What can help is more certainty. Tax cuts, or at least a promise not to raise taxes, and immunity — or at least a safe harbor from criminal prosecution for above-board institutions in the mortgage business — could help loosen up a rigid market in a more permanent way than sending out the helicopters to dump cash in the marketplace.
The best the Fed can do is to stand at the ready to contain the damage. In this vein, their decision to cut the discount rate and allow a broad list of assets to be used as collateral for loans to banks, was a brilliant maneuver. It increases confidence that the Fed has liquidity at the ready, but does not create more inflationary pressures. It was a helping hand, not a bailout.

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10 thoughts on “Brian Wesbury’s Definitive Take on the Subprime Crisis”

  1. Multiplying out those percentages I came up with a trillion dollar loss. And that is just the start. This will take many years to completely unwind.

    The teaser rates on these Subprime and Alt-A loans are just about over and it is time for them to recast and for the buyers to actually start paying the real cost of their inflated house. Should be interesting watching Jane Q. Public and Joe Sixpack with a total household income of about $65,000 make the payments on that $400,000 mortgage. Can they make the payments? No. Can they sell? Sure. And bring a check for several years of take-home pay to closing to make up the difference. They could rent the property out of course. And make up the %50 mortgage (PITI) shortfall every month. Maybe their mortgage company will let them have a shortsale and eat the loss for them. Of course when the 1099 arrives for the difference with the IRS in hot pursuit the homeowners might not feel so fortunate.

    And don’t forget all of the Prime borrowers that have siphoned out and spent their inflated equity using Heloc’s. They are (or will be very shortly) under water. Then there is the massive economic slowdown in anything construction related due to the financing spigot being cut-off and the incredible glut in the residential and commercial markets. If all of the stuff in the pipeline where construction has actually begun is completed it should only take about five years to clear the market (as long as nothing else is built in the meantime.) Then there is the reverse wealth-effect as all of that Heloc money spent on toys over the last couple of years has to be paid back. Fasten your seatbelts, we are in for a bumpy decade.

  2. I am wondering if/when the bank (my mortgage is actually held by a local bank, not a mortgage company) will offer to let me buy out of my mortgage at a discount if I had the cash, mark to market if you prefer. This happened to my parents several years ago. My mortgage is relatively small, and my interest rate is about as low as I could have gotten at the time (4.875% on a 15 year).

  3. There is also the fact that AAA doesn’t mean much anymore. What’s the price for that failure?

  4. This one is a lot more like Long Term Capital than the S&L crisis, or the late 1970s inflation/dollar collapse crisis. It looks like the blow off for hedge funds — the real economy will go a long unimpeded.

  5. The subprime collapse can’t be good for the economy. It will surely slow growth, as the practice of home equity borrowing rather suddenly recedes. The question is how much will it slow growth.

    Some analysts are saying that the expansion of middle classes in China, India, Brazil and Russia, along with solid, steady growth in Europe will help keep global demand humming along, supporting U.S. exports, even as domestic demand wanes.

    There is also the theory that the widening income gap in the U.S. — which is actually the rapidly growing ranks of wealthy people — helps recession proof the economy. The upper class of people who are rich enough to keep spending right through downturns in economic growth are, the theory goes, cushioning any such declines.

    But I do tend to be an optimist…

  6. China, India and Russia, most probably, Oliver. Not Brazil, where middle classes have been diminishing for quite some time now.

    Besides, can these people all assembled compete with consumption levels in the US? Sounds like a tall order.

  7. I think that you are both overestimating the losses from subprime mortgages and underestimating the restorative powers of economic growth.
    Fairytale thought vs. analysis

    Privatize profits, socialize losses.
    from Peter T.

    Read this blog.

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