Comments on:U.S. Subprime Mortgage Market Meltdown

byJames Barth

Randall K FilerCERGE-EI and CUNY

Sometimes We Act As If Falling Prices Are a Crisis

But Sometimes They’re A Good Thing

And SometimesWe Aren’t Sure

Think of a Market With

• Rapidly Falling Prices• Accumulating Unsold Inventories• Many Owners with Negative Equity

YESIt’s the Dreaded

I-Phone Market Meltdown!

The Housing/Subprime Problem

Look at it from three perspectives:

1) Homeowners2) Investors in Mortgage-Backed Securities3) The Financial System

Homeowners

Start with Banjari, Lanier and Krainer, Journal of Urban Economics, 2005

• Welfare Effects of Housing Price Changes = 0

• Basic Insight, for every seller there is a buyer

• And these offset each other

In Reality – Distribution Effects

Owner House Price

Randy 1,000,000 HK

Oleh 800,000 HK

Ricardo 600,000 HK

Boris 400,000 HK

Now, Randy Meets His Maker and Everyone Moves Up the Ladder

House Price Change in Cash

Randy’s Heirs 0 HK +1,000,000 HK

Oleh 1,000,000 HK - 200,000 HK

Ricardo 800,000 HK - 200,000 HK

Boris 600,000 HK - 200,000 HK

Tomislav 400,000 HK - 400,000 HK

SUM 0 HK

Suppose House Prices Have Fallen By 50%

House Price Change in Cash

Randy’s Heirs 0 HK + 500,000 HK

Oleh 500,000 HK - 100,000 HK

Ricardo 400,000 HK - 100,000 HK

Boris 300,000 HK - 100,000 HK

Tomislav 200,000 HK - 200,000 HK

SUM 0 HK

Comparison

Net Change in Cash Positions is Still Zero

BUT

4 of the 5 participants are BETTER OFFONLY One is WORSE OFF

In General

• Losers from Housing Price Decreases– Those who take cash out on sale– Typically heirs of deceased or elderly

downsizing and planning on using assets for retirement

– Also Credit Constrained who want to use housing equity as collateral for other purposes (e.g. business start-ups)

• Gainers from Housing Price Declines– Anyone who is putting cash INTO a

transaction– Families trading up to larger houses– First time home buyers– Also lateral movers due to factors such as job

changes (transaction costs are lower)

On Balance

FAR MORE GAINERS THAN LOSERS

GAINERS ARE LIKELY TO HAVE LOWER INCOMES

What About Negative Equity?

For MOST units no problemThey were purchased to deliver a certain

amount of housing services at a certain price

Neither of these have changed, why would occupant renege?

Especially since reputation effect would preclude obtaining a new unit

Price Decline would make it cheaper to trade up, but for this it does not matter if cash is used to retire negative equity or obtain new house

If you think about it, almost EVERY new car bought on credit has a period when value is less than outstanding loan but nobody cares

Could Be a Barrier to Mobility

Negative equity might inhibit mobility if occupant lacks cash to pay off mortgage when opportunity arises in a new area

Easy Solution –Attach mortgages to individual not property

and allow transfer so long as new collateral is at least as great as old

Investors in Mortgage-Backed Securities

There has not been much, if any meaningful analysis.

Current market prices are uninformativeReal question is risk and return on portfolio

of assets if held to maturity

Thought Experiment

Imagine buying two assets:

1) Diversified portfolio of Subprime Mortgages

2) Mutual Fund of Junk-Rated Corporate Bonds

Hold each for 10 years

Which Portfolio Would Have Higher Yield Over 10-Year Period?

Remember, 10-year cumulative default probability on B-rated bonds is 43%

Do we really believe the default rate on even subprime mortgages will be that high?

Center for Responsible Lending projects cumulative foreclosure rate for subprime mortgages issued in 2006 at 19%.

Even sensitivity analyses with extreme assumptions have a hard time getting foreclosure rate as high as 40%

And, repossessed houses will have a much higher recover rate than defaulted bonds

Conclusion

• There is not now, nor is there likely to be, evidence that investors in subprime mortgage backed securities who hold to maturity will receive abnormally low returns

• Those who sell while the market is distressed may take a haircut but this will be offset by excess returns for the buyers

Financial Markets• HERE IS THE REAL PROBLEM• LIQUIDITY IN GENERAL HAS DRIED UP• CREATES TWO MAJOR DANGERS:

1) Lack of landing affects the real economy – investment and/or consumption collapse2) FED feels it must inject liquidity, igniting inflation or causing “rolling asset

bubbles”

Causal Change?Dot Com Bubble Bust → Low Interest Rates → Housing

Bubble, Housing Bubble Bust → Low Interest Rates → Weak Dollar & Commodity Market Bubble??

The “Problem” Is Almost Entirely Artificial

• At the moment there is almost no “market” in mortgage-backed paper.

• This has led to a excessive price collapse when compared to fundamentals

• OECD estimate is that to justify current prices, recovery rate on foreclosed properties would have to be NO GREATER than ZERO

Regulatory Failure

• “Mark-to-Market rules force institutions to value these holdings at their totally unrealistic trading prices

• This reduces’ institutions capital and loanable funds

• In large part these reported losses are paper losses that will be restored to the books when the real assets underlying the securities are sold, even at depressed prices

ResultCreates Real Economic Damage from Unreal

Paper Losses.

Solution: Mark-to-Market must be suspended when no effective market exists

Allow Mark-to-Model or Fraction of Book. Paul Craig Roberts suggests 85-90%. I might be more conservative, but even 60-75% would recapitalize without dangerous injections

As Always, Marx Understood the Problem

“[In Florida] you can get any kind of house you want.”

“You can even get stucco.”“Boy, can you get stucco!”

Groucho Marx, Cocoanuts, 1929