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Archive for the ‘housing’ Category

Simple question, complex answer

with 4 comments

A former physicist (but non-financier) writes:

I have a question, and who better to ask than you. …something isn’t adding up.

I keep hearing that mortgage defaults are what is bringing down many financial institutions, and the the default rate in some particularly bad mortgage pools is up to 50%. Because housing prices are down about 20%, financial institutions can still regain 80% of the value of those loans, no? Actually the real value is probably a bit better, as most loans will be partially paid off. At any rate, doesn’t this imply that even in the worst loan pools, there is only a total 10% loss. And most financial institutions will have some higher quality loan pools also, and stocks, etc. So the total effect is going to be smaller than 10%, unless financial institutions were all constructing some sort of horrible options based high risk bets on housing prices, but I doubt this would happen except in some risky hedge funds.

Is this reasoning correct? If so, I don’t understand how our system can be so fragile that a few percent drop would bring everyone down. Of course everyone holding a share of these funds will have a small portfolio dip, but this happens every few years anyway.

Your calculations are reasonably correct (see comments for more detail). So why the crisis?

1) Leverage. Many I-banks had 30:1 ratios, so a small movement in value of a subcomponent of their portfolio could wipe them out. It’s like a guy who puts 10% down on his house, who can lose everything if the price goes down by 10%. Of course this only matters if he is forced to sell, or, in the bank case, if shareholders and counterparties start losing confidence. This is happening simultaneously in financial markets due to the second factor…

2) Complexity. No one knows who is holding what, who has sold insurance (credit default swaps) to other parties and is on the hook, etc. So trust is gone and credit markets are paralyzed — no muni bond issuance, no short term loans to businesses, no car loans, etc.

The efficient functioning of our economy is built on trust — I have to trust that the grocer will give me food in exchange for a dollar bill, that I can get my money out of the bank, that my employer will pay me at the end of the month, that its customers will pay it, etc.

We are nearing a dangerous point. Confidence, once destroyed, is very hard to rebuild.

Relative to the size of our economy, the amount of money involved is not that great. If we had perfect information we could solve the whole problem with about $1 trillion. (About the cost of the Iraq war; not bad for a bubble that involved housing — our most valuable asset.)

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Written by infoproc

October 2, 2008 at 4:18 pm

Orders of magnitude and timescales

with 13 comments

As a physicist I can’t help making some comments about orders of magnitude and timescales ๐Ÿ™‚

If home prices return to normal (historical) levels, total mortgage debt losses will be about $1 trillion. This is a staggering sum, but won’t destroy our economy. After all, our misadventure in Iraq will end up costing us about the same amount. [Insert anti-Bush diatribe here.] If necessary, we could socialize the whole loss like we’ve done with Iraq — put it on the nation’s and taxpayers’ balance sheet.

The problem is that the credit bubble losses are concentrated in financial firms, which are getting hit with a huge shock as their portfolios approach the day of mark to market reckoning. This shock is going to have to be worked through the system over a relatively short timescale if we are to avoid systemic paralysis, or worse. Once a particular entity becomes insolvent, the entire web of counterparty transactions between it and the rest of Wall St. is in jeopardy.

Dealing with that relational web is the real challenge — can we recognize the losses without impairing the functioning of our financial and banking system?

Written by infoproc

September 16, 2008 at 2:56 am

A trillion in the balance

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Via Calculated Risk. If house prices return to historical norms, mortgage credit losses will be roughly $1 trillion.

From Jan Hatzius, Goldman Sachs chief US economist, presented at the Brookings conference, Beyond Leveraged Losses: The Balance Sheet Effects of the Home Price Downturn. Here is a short excerpt on estimating mortgage credit losses (note that Goldman is now forecasting prices to decline another 10%):

If nominal home prices remain at their 2008 Q2 level until mid-2009, before reverting to a +3% annualized trend, our model implies that mortgage credit losses realized in the 2007-2012 period will total $473 billion. If nominal home prices fall another 10% through the middle of 2009, the model projects losses of $636 billion. Finally, if prices drop another 20%, predicted losses increase to $868 billion. Moreover, the table suggests that losses peak in the third quarter of 2008 if home prices are flat going forward; in the fourth quarter of 2008 if prices drop another 10%; and in the second quarter of 2009 if prices drop another 20%.

Written by infoproc

September 12, 2008 at 9:53 pm

Credit crisis: half way through?

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Case-Shiller is down about 20% since the peak in real terms, and we have another 20% to go before the metrics are back in normal range. This would give back all the housing gains since the late 90s. Commercial real estate and consumer debt crises have yet to materialize but are likely to follow.

10 million Americans are underwater on their mortgages. The UK is in even worse shape, with a 70% drop in mortgage approvals.

Bear is gone.

Paulson and Treasury looked closely at the GSEs and decided it would be better to move now than to pay more later. Was there a trigger event? Were there scared Chinese bankers on the phone with Paulson? (Who do you think are the biggest holders of GSE paper?)

The Korea Development Bank looked closely at Lehman and took a pass. Lehman’s stock is now in free fall.

Merrill financed 75% of its recent sale of $30B in mortgage securities at 22 cents on the dollar. The counterparty is a straw man, so Merrill will have to take the securities back if the price falls even further. That means Merrill could still go the way of Bear and Lehman eventually.

No mark to market, no resolution in sight.

Socializing losses after privatizing gains in the fat years.

Of related interest: great podcast interview with Robert Shiller. Act now, because Bloomberg has a tendency to take these down after a while.

Written by infoproc

September 11, 2008 at 12:55 pm

Bye bye Fannie and Freddie

with 5 comments

On my way back from Europe, I noticed that Fannie and Freddie have been nationalized, with shareholder value going to zero! It’s a huge development — much bigger than Bear earlier in the year. The housing bubble still has further to pop, so stay tuned!

Here’s economic guru John McCain on the subject — his sentiments are right, but the fact that he can’t get the exec compensation to within 3 orders of magnitude is a bit worrisome. (I suppose Palin could have nailed it within two orders of magnitude or better ๐Ÿ˜‰

NYTimes: โ€œItโ€™s hard, itโ€™s tough, but itโ€™s also the classic example of why we need change in Washington. Itโ€™s an example of cronyism, special interest, lobbyists. A quasi-governmental organization, where the executives were making hundreds of โ€” hundred some billion dollars a year, while things were going downhill, going to hell in a handbasket,โ€ Mr. McCain said, adding that the two companies need โ€œmore regulation, more oversight, more transparency, more of everything, and frankly, a dramatic reduction in what they do.โ€

But not to worry, McCain / Palin’s grasp of economics and finance is every bit as solid as that of our most recent great Republican leader George W. Bush, and look how well he did!

Video: [Bush, blathering off the record on something he doesn’t understand — was that Bush on July 18, or McCain this weekend?] “There’s no question about it. Wall Street got drunk —that’s one of the reasons I asked you to turn off the TV cameras — it got drunk and now it’s got a hangover. The question is how long will it sober up and not try to do all these fancy financial instruments.”

I’d post the video itself here except it’s old news, and, well, nobody wants to talk about GW anymore — especially not the people (the same ones who are backing McCain and Palin, more or less) who predicted what a great president he’d be. Too bad we don’t judge voters on their records like we do traders. I know who I’d fire.

You voted for GW? Twice?!? Your P&L is negative one trillion dollars for the united states. Put your stuff in this box and follow the security guard out the door. No, you don’t get to take a position on this election or advise any geneticists on evolution.

Note I’m not trying to blame Bush for the credit disaster — the trillion dollars is for Iraq alone.

Written by infoproc

September 7, 2008 at 7:27 pm

LA Times: no bottom yet for housing

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The article Should You Buy A House Now? runs with the figure below, which pretty much summarizes the situation. They should have printed these statistics repeatedly in 2003, 2004, 2005, 2006, 2007 together with patient explanations of what price to income and price to rent ratios mean. Maybe that would have slowed down the bubble. Then again, maybe not ๐Ÿ˜ฆ

Written by infoproc

August 3, 2008 at 8:50 pm

Bay area housing market begins to crack

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It’s about time! See Calcuated Risk for further discussion. (Note this data covers some regions which are quite far from the bay itself.)

Standard bubble wisdom: they last longer than you think is possible, then pop faster than anyone expects.

I’ve been calling the bay area bubble since as far back as 2004 / 2005 (actually, from before I started this blog!). I expect the last bubble market to pop will be Manhattan, but pop it will.

It must hurt to think that a house you purchased a year ago might be worth a third less today, with still further to go.

SF Chronicle: Across the nine counties, the median price paid for resale homes, new homes and condos in June plunged 27.1 percent from a year ago to $485,000, dipping below the half-million-dollar mark for the first time in four years, DataQuick Information Systems of La Jolla (San Diego County) reported Thursday.

Among resold homes, bank-repossessed foreclosures – which usually are discounted – accounted for 28.7 percent of all existing-home sales, up from just 3.5 percent in June 2007. Solano County, with foreclosures at 57.7 percent of all resales, had the highest percentage; San Francisco, at 3 percent, had the lowest.

Affluent areas such as Marin County and San Francisco, which until now had resisted most price erosion, saw existing single-family home median prices fall by about 11 percent. Including new homes and condos, the Marin County and San Francisco medians fell about 12 percent to $846,000 and $726,750, respectively.

“This is pretty grim; double digits across the board,” said Christopher Thornberg, principal at Los Angeles’ Beacon Economics. “It was eminently predictable if you had a realistic view of the world. I heard a lot of people say the Bay Area was never going to see prices fall, San Francisco was untouchable; in San Mateo, it was impossible; San Jose, not with all the tech money, blah, blah, blah. But prices at the peak relative to people’s incomes never made any sense.”

Note the 27% figure for change in median price is a bit tricky to interpret: it’s alway possible that the composition of units sold has changed, with a lot of owners of high end homes sitting on them, refusing to accept the current market price. In that case the average price decline would be less than 27%. It is typical in a real estate crash for sellers to remain in denial for some time, during which the big decline is in number of transactions rather than actual price levels. It’s only after the sellers have capitulated that the big price drops occur. In light of that, it’s rather ominous that only 7,178 new and resale homes changed hands in June – the lowest June figure since 1993 ๐Ÿ™‚

Written by infoproc

July 20, 2008 at 9:38 pm