April 11, 2008
A Trillion Here, A Trillion There
It’s become the latest jelly bean in the jar contest. This week’s entry was from the IMF, which estimated that financial institutions face a nearly $1 trillion hit in the fallout from America’s mortgage mess. That seems miles away from the just over $300 bn figure we offered up only a couple of months ago. As they say, a trillion here, a trillion there, and pretty soon we’re talking about real money, and a protracted global slump. In fact, these figures are apples and oranges. First, our estimate looks only at residential mortgages, the core of the crisis. The IMF mortgage figure is $575 bn, but then adds in all other consumer and corporate debt. Here broader isn’t necessarily better. Every business cycle would entail a run-up in defaults on credit cards or corporate debt. Remember the bust in high yield bonds after the 1980s? And, if the IMF is including financial losses for pensions and insurers, why stop at debt? What about equities? The high tech stock market crash created mark-to-market losses on equities on the order of $5 trillion, some of which was clearly borne by pensions and hedge funds. And what followed was a relatively mild recession. Secondly, the IMF’s $575 bn figure for residential mortgages takes default losses on non-securitized loans (just over $100 bn), then adds in current mark-to-market losses on mortgage-related securities. Unfortunately for the IMF and upcoming reports from US financials, March is starting to look like it was the low for ABX indexes, so look out for some further bad news. Our method looked at the totality of all mortgages outstanding (whether securitized or not), and the projected defaults and losses net of proceeds after foreclosure. That yields a much less scary figure. As the IMF admits, “prices in illiquid markets can overshoot” to the downside, showing losses that subsequently are recaptured if the underlying mortgages perform better than feared. Why expect such a recapture? Well, for one, turn to the very last sentence buried in the IMF’s appendix.
“Implementation of remedial measures, including modification of mortgage loan terms, could lower loss
estimates.” And that’s exactly where the Congress is starting to move. Even previously intransigent John McCain offered his first olive branch, with a proposal akin to (if somewhat smaller) the bailout being touted by Senator Dodd and Representative Frank. The gap between mark-to-market valuations on securities and their potential realized value on maturity does shed light on how financials will report losses in this cycle. In the less securitized world of days gone by, banks took charges against loans that seemed likely to be impaired, based on the borrower’s financial status. Today, they are taking writedowns based on a skittish market’s pricing of CDOs, CDS contracts and the like, which can be divorced from underlying cash flows and their impairment. The net result is a more volatile set of earnings reports for the banking system, and a stock market that is going to have to get used to that world before it will learn to love bank stocks again.
Avery Shenfeld
Senior Economist
