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

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