John Berry: Subprime Fallout Won't be as Bad as Some are Predicting

John Berry says losses from the subprime mess will be big, but "not nearly enough to sink the U.S. economy":

Subprime Losses Are Big, Exaggerated by Some, by John M. Berry, Commentary, Bloomberg: As the U.S. savings and loan crisis worsened in the 1980s, analysts tried to top each other's estimates of the debacle's cost... Much the same thing is happening now with losses linked to subprime mortgages, with figures of $300 billion to $400 billion being bandied about.

A more realistic amount is probably half or less than those exaggerated projections -- say $150 billion. That's hardly chicken feed, though not nearly enough to sink the U.S. economy. ...

There are two reasons why the losses aren't likely to be so large.

First, the mortgages are backed by collateral, a house or condominium, and in a foreclosure a home typically retains significant value. When it is sold, the lender often will get 50 percent to 60 percent or more of the loan amount after foreclosure expenses.

Second, most subprime borrowers aren't going to default. ...

What does that mean for the broader economy, particularly consumer spending? ...

The economic repercussions of the housing bust and mortgage woes are limited to a great extent because less than half of American families own a home with a mortgage... Almost a third of all families rent their house or apartment, almost a fourth own and have no mortgage and the vast majority with a mortgage are current in their payments.

Even with about a tenth of all subprime mortgages now in foreclosure, only a small share of all American families -- about 0.3 percent -- own a home in foreclosure...

Comparisons in dollars of constant value between likely subprime losses and those incurred during the S&L crisis indicate the 1980s hit was significantly greater, though the current episode still has a long way to run. ...

Comments

[cm]

I presume Mr. Berry would be resting entirely at ease were he to learn that he will be getting 50-60% of his investments and account balances back when the investment house where he banks fails, as furthermore not all banks will fail and it is not quite made out that it will be precisely his bank.

For most of my purposes, a few-percent stopper in our quite growth-sensitive economy will be worse enough for starters.

[Bruce Wilder]

The real worry on Wall Street is not home mortgages -- it is commercial construction loans. The middle tier of banks, having been driven out of the mortgage market, are, some of them, heavily committed to commercial construction loans. Unlike a home mortgage, a commercial construction loan, although theoretically collateralized, can have very poor salvage prospects. The middle tier of banks may not find it so easy to whistle up a few billion in new capital from China and Abu Dhabi.

[kharris]

What I think needs to be examined is the source of the distance between, say, the $700 bln estimate for total mortgage-related losses that has been floating around ("market sources" rather than math, are cited in press coverage), the $500 bln figure that had preceeded the $700 bln figure, and Berry's $150 bln. Berry seems to be suggesting that other analysts haven't counted the value of the collateral. Maybe so, but we don't know that to be true. Berry is good, but he can make mistakes, too.

[Ken Houghton]

"First, the mortgages are backed by collateral, a house or condominium, and in a foreclosure a home typically retains significant value."

I believe this was the TX theory that led to the S&L Crisis: the loan is collateralised by property in West Texas that may have oil underneath it. And if it has oil, it's worth what we loaned out. (If not, of course, it's a pile of dust in the middle of no infrastructure and even less HOH.)

[FairEconomist]

Berry is either confused by, or confusing people with, the definition of "subprime". "Subprime" has a technical meaning of loans to people with very low credit scores. That's not a huge market and Berry's estimates are reasonable *for those loans only*. HOWEVER, most people are interested in any bad loan the bank is likely to lose money on, and that's what the man on the street thinks is "subprime". By *that* definition the standard expected losses of 500-700 billion are, if anything, conservative. Berry's position depends on the fact that most loans the man-on-the-street considers "subprime" are technically defined in the mortgage biz as Alt-A, Option ARM, home equity, negative amortization, and just plain excessively large loans on overpriced homes.

[calmo]

...may have oil underneath.
Right.
And if not, there could be gas or coal or uranium.
No worries, there will be something.
I dunno, Berry is usually a little more rock solid than this: Don't forget Polandthat the house is worth something (Are the other estimators claiming the foreclosed house is worth zero?...could Berry's assessment of their position be so uncharible?)[Izit contagious?]
From Berry I expect a detailed comparison with the last housing boom/bust cycle (and the commentary then as well).
Not only don't I get that but I get this:The economic repercussions of the housing bust and mortgage woes are limited to a great extent because less than half of American families own a home with a mortgage... Almost a third of all families rent their house or apartment, almost a fourth own and have no mortgage and the vast majority with a mortgage are current in their payments. and the specter of 1 in 5 homeowners having no equity in their house by the end of 2008 should the median house price decline 20% from its peak (CR's estimate). Has Berry in failing to distinguish "ownership" from "equity" just had one too many Fannie commercials?
This is not his best work.

[Callahan]

If there is any good in this, it is that bush no longer touts his "ownerschipp schoschiety".

[donna]

It's the cascade effect of the entire housing market imploding, not just the subprimes. They were merely the trigger event.

The problem with the subprimes was the inflation of housing prices and the introduction of buyers who could not afford their homes. The speculation of some having five or six homes and nowhere to sell them and walking away from these "investments", the deafault of those who simply cannot afford their homes, and the closing of the housing ATM will all cascade, along with lenders, appraisers, realtors, etc. all being forced out of business.

It is going to cause recession. There is no question.

[fiskhusjim]

BUSH & CHENEY KILLED PINKY!!!

[The Baron]

The problem isn't in the originating amount of the loans and the left-over value of the collateral. The problem is that each of these was put into highly leveraged investment vehicles, that were then further chopped and shopped for even more leveraging.

A $600k house loan, on a house now only worth $480k (and which the bank recovery will typically only be $240k), would have been used as collateral on a $800k short-term loan, that was later included, bundled with other loans, and represented as worth $1M for 30-day financing of $100M debt... The 'credit market freeze' is these 30-day loans that the originators depend on rolling over, aren't being bought by anyone, at any price, because no one knows what portion of that $100M is only actually worth $240k.

It's not the original loans that will destroy us, it's the unregulated leveraging.

[kharris]

FairE,

You seem to have answered my question. And yes, that is a silly pretext for an article. Berry tends to err on the side of calm and complacency, and in today's journalism, that is a sterling quality. In his usual Fed beat, it seems to match pretty well with the Fed we have. In this case, though, it does seem a bit like the "move along, move along, nothing to see here, folks" treatment.

[dirtyal]

John: I think you are about as right as anybody about this. I happen to agree with you.

The difference between the S&L meltdown and what we are seeing now lies in the fact that the mechanism is not readily apparent for sorting out the whole mess.

The FSLIC was there to protect us from the stupidity of the owners of the little S&L's that made loans that were a lot too ambitious. When the S&L's failed, there was already a mechanism in place and an obligation by a government supported institution that was put in place to protect those who had money in the S&L's.

I can't see that the FDIC will be forced to come to the rescue soon enough to do any good. Of course, when some of the banks fail, there will be a mechanism in place to get the assets passed along to a "stronger institution" with no loss to the public at large. But there are a lot of "investments" that are not protected by the government and I believe this is the main problem that could result in a liquidity crisis and a run on the institutions that put out the "investments" that we now see are far from AAA.

So, we could get a liquidity crisis. That could end up feeding on itself and the whole house of cards that is supporting the credit market in the US could come falling down.

It may not sound as if I agree with your assessment, but I really do. I think most people have not really though about how this problem will be sorted out.

When you look back at the S&L crisis, it's a very interesting parallel to what we have today. And it was caused by a similar set of events. It was easy to set up an S&L, borrow money from the FHLB and lend it to your cronies. Sounds a lot like what has gone on this time around. I don't think it should be surprising at all that the S&L melt down occurred during the first few years under Reagan, when the mantra was deregulate, deregulate, deregulate.

[howard]

to add to kharris' comments, if i have a choice between believing john berry, a good journalist, or goldman sachs, who not only have skin in the game but unlike all their peers have made money on the debacle, on the potential scale of losses, i'm going to side with goldman sachs.

[Tom]

"i'm going to side with goldman sachs."

I'd do the opposite. Goldman Sachs has much more to gain from a bailout than does John Berry. Much more reason to hype.

John Berry has history on his side, as these things alway turn out to be less than half the debacle they first seem to be.

[Robinia]

Tom-- I tend to think of this kind of article as the pre-cover-up "nothing to see here" kind of prep for not being shocked by what eventually is necessary to clean up the "debacle." As per S&L crisis-- the losses, and the charges to the taxpayers, are not insubstantial, but "calmer heads" prevail and keep reassuring us that there is nothing there worth getting upset about... and then, a couple of decades later, they are back at it again... all with virtually no political fallout or widespread social learning.

[bostonian]

Does anyone know how much the banks and institutional investors have written off due to the credit markets? I get the feeling its not too far off from Berry's projected whole loss that apparently couldnt effect the economy. Not to mention the rate adjusted mortgages have just begun to reset and we'll see much higher foreclosure rates unless Bush's interest rate freeze goes into effect. Also he doesn't appear to take into account the drop in home prices which is eating away at the value of the potential collateral and making it harder for banks to even get rid of these foreclosed homes.

[howard]

Tom, it may be too late to respond (i've been travelling), but first off, what does a "bailout" have to do with a goldman sachs analyst opinion? and second, why does goldman "benefit" from a "bailout," given that they have avoided exposure and writedowns? and finally, just what precise "history" are you talking about? there is no comparable history to this situation, because we've never seen a situation quite like this.

[dirtyal]

Howard: Although admittedly not an exact parallel, the S&L crisis is enough like what's going on to give us a road map. During that crisis, the Federal Savings and Loan Insurance Company was overwhelmed because too many S&L's became insolvent. The feds formed a new body called the Resolution Trust Corporation and they took ownership of the property that had been collateral for all the bad loans that the defunct S&L's had made.

With respect to the property that was not under water, the RTC simply sold them to solvent financial institutions with appropriate discounts for market value etc.

With respect to all of the non-performing assets, they took ownership of them and sold them off to investors, again at appropriate pricing.

The point is that there was still value left in a lot of the collateral and people would buy it at the right price. So the difference between the gross loss, as calculated by the value of the assets taken over by the RTC, and the net loss, as calculated by the difference between the original mortgange amount and the salvage sale value, was quite a bit less. I don't have the precise difference, but it was probably in the range of 50 to 65% of the amount that was originally loaned to the borrower.

Admittedly, again, the parallel is not 100%. The federal government had to act to insure depositors of the S&L's who were actually insured under the FSLIC. But that was really a pretty small part of the whole problem. Most of the money that went out in bad loans was money that was borrowed from the Federal Home Loan Bank in a manner that is similar to what federally chartered banks do when they borrow money from the federal reserve. So that's the biggest difference, there may not be a compelling mechanism in place to effect a "bail out" since there is nothing similar to the FSLIC unless it happens that someone like Merrill Lynch goes belly up and the SIPC has to be called upon--not that likely.

[mannfm11]

I think John is missing the point. I too used his argument until it sunk in what was going on in these loans. I used to be in the mortgage business and I lived and worked through much of the Texas problems in the 1980's. There is a lot more piled into this mess and we are merely looking at the conduits when reading about the brokers and banks. How much of this stuff is out in the public as in pensions and insurance companies. Again, we are hearing about what they hadn't dumped yet through the SIV's and other conduits. Then comes the other problem, the idea of not just losses, but capital losses. The money lost in the S&L problem went way beyond the capital of the institutions. In fact, I think the entire deposits of the Texas S&L's I recall going under probably didn't exceed $25 billion max. The label was for interest and forever and ever, not the real losses. We have already blown the doors off $25 billion. The problem as I see it has more to do with who owns the bad tranches than whether the losses are $150 billion or $500 billion. It is pretty clear the strong tranches won't be exposed too much, but those that are in the levels that take the losses will be totally wiped out. Either they or their counter parties in the default swap games.

The other problem is subprime is the tip of the iceberg. The demand curve for a fixed amount of housing was shitfted outward, first by interest rates, then by financing. This financing is gone and the result is going to be nationwide pain in housing. The MI companies probably go down as do the GSE's. The GSE's, as I understand it, are supporting the moral hazard of being the lenders of last resort again, as they were in the financial problems in the 1990's and early 2000's. The S&L problems weren't due to subprime lending, but interest rate increases that undermined their paper. The foreclosures in Texas homes hit FHA and FNMA hard, along with other lenders. This is Texas on steroids. The big question is, can the banks stand to back off lending due to losses of $150 billion and the system not collapse? The next tranches will be the credit card debt (25% is a nice return until it isn't paid).

[ernest]

just found this blog by accident.. not looking too optimistic anymore ...