Economics & Finance

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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I used to have a few co-workers who lived in Boston in the 80’s. In the 80’s Boston had a massive real estate boom that ended in a bust. Two stories stood out in my mind:

1) when the first guy sold his condo, he had to bring actual cash to the closing because the sales price wasn’t enough to cover the mortgage debt
2) the second story was more complex. A woman’s parents lived in a small house in an affluent area near Boston. The couple was up to date on their mortgage payments. However, the value of the house plummeted to a point where the mortgage was significantly higher than the value of the underlying house. As such, the bank had the right to “call” in the mortgage even though her parents were current on their payments. Since they didn’t have enough money to refinance, they lost their home

Now the real estate boom is collapsing, but not due to plummeting housing values (like the Boston crisis, above) but due to a liquidity crisis. Existing buyers who put little or no equity into their homes are going to find that they can’t refinance – per this article (which is consistent with what I have seen elsewhere) deals aren’t getting done unless the buyer has a solid credit score and is willing to put down 10% of the value in a down payment. New buyers also face this 10% down hurdle which will effectively shut them out of the market for more expensive homes.

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