That’s a logical starting point in the analysis, but there are additional considerations relevant to trying to figure out how precarious the financial system is.
— You noted a snapshot of non-performing loans. But the financial institutions have already been weakened by losses incurred since the beginning of the housing crisis. Imagine blowing up a balloon - that last breath of air that makes the balloon pop may not seem like a lot of air, but the balloon’s capacity to hold air has already been affected by the amount of air put into the balloon before that last breath of air.
— Historical patterns of default rates are not a good guide to the current crisis. Households are more highly leveraged than in past periods of house value stagnation or decline. Many prime loans or Alt-A loans may end up in a similar posture as subprime loans if the borrower has other debt such as home equity loans or credit card debts that leave a high total household debt-to-total asset value ratio. Furthermore, increases in mortgage defaults do not linearly follow house price declines. A decline of another 15% in average house prices in an area from current conditions might trigger, say 40% of the mortgages in the area to go underwater, just to pick numbers. Also, a change in attitudes towards home ownership by flippers and the unknown effect of illegal aliens who have mortgages may mean a higher percentage of people willing to simply walk away from their mortgage debt instead of trying to continue to pay it or work out a payment plan with the lender, compared to the past.
— In creating a mortgage-backed security, a large number of mortgages are pooled. Someone above asked if you mixed 5% of crap into 95% of ice cream, would you still eat it? But that even assumes one knows that the percentage of crappy mortgages is 5%. The unknown percentage of crappy mortgages mixed into trillions of dollars of mortgage-backed securities introduces valuation uncertainty into much of the total amount of the mortgage-backed securities. The problem is compounded because in the MBSs where the first losses are allocated to certain tranches so as to enhance the credit of other tranches, it is unclear whether and to what extent the amount of crappy mortgages is enough to “breach the levee” and affect even formerly AAA-rated tranches. Also, it is impossible to generalize the problem because the extent of the problem may vary with each different mortgage pool. Furthermore, the investors who bought the AAA-rated tranches often have no experience in holding and valuing mortgage-related assets, they bought them solely as a AAA-rated security roughly fungible with non-mortgage-backed AAA-rated securities, increasing their uncertainty as to how to deal with their holdings.
— We are dealing with a dynamic system with feed-back effects. If the government bailout were to work and the economy avoided a serious recession, the amount of total mortgage-related losses that would end up being absorbed by capital in the financial system would be dramatically less than the situation if there was no bailout (or other governmental action as effective as the bailout) and the economy went into a severe recession or worse, with sharply higher unemployment. This is one of the arguments why many believed it was conceivable the government could actually make a profit on the bailout scheme, at the end of the day.
— The concern of bad debt is not limited to residential mortgages. Commercial mortgage debt is of serious concern, as is credit card debt, in terms of potential losses. The residential mortgage problem is thought by many to be a greater problem in terms of effect, so that if pressure can be relieved on this component the financial institutions might have enough resources to weather the problem in the other sectors.
— The uncertainty as to the value of much of the mortgage-backed securities outstanding and the so far institution-by-institution way the crisis has unfolded has left market participants uncertain as to solvency or staying power of potential counterparties in various credit markets. This introduces an additional illiquidity factor, exacerbating the illiquidity premium resulting from the valuation uncertainty. It also makes it extremely difficult for the banks to increase their capital by selling stock to investors, even at what a bank might consider very attractive prices to the investor.
And one could list a number of other relevant factors as well that should be considered if thinking about this problem.
Well thought out post to which I must reply point by point:
1) The problem is not liquidity, it’s velocity. The Fed is pumping money into the economy but the banks are sitting on it. If people could get loans they’d refinance to be able to make their payments. Mortgage lenders and banks would take their closing costs and pass the mortgages up the chain. Mortgage lenders and banks would then have more money to lend to new homeowners. etc.
2) Sub-primes, for the most part, have already been digested. The ones that were going to fail have failed. We are now entering into the Alt-A portion as longer term ARMs start kicking in. Then will be primes as people who are underwater (negative equity - usually from maxing their equity lines of credit and then watching home prices drop) decide to bail. Each of these two latter groups represent a larger portion of the total mortgage market, but a much smaller risk of default than the sub-primes.
3) Freddie, Fannie, Moody’s and S&P all share blame in first packaging those securities and then rating them AAA. There’s no way they were AAA. Call it your Democrat corruption machine at work. At the end of 2007, the spread between sub-prime and prime loans was down to less than 1%, ignoring the fact that the known default rate spread then was closer to 10%.
4) I’m not against a bailout per se to avoid another great depresson. I’m simply trying to put a number on how large the bailout needs to be. Of course the price we are paying for staying home in 2006 is that the Dhimmi controlled congress who caused the problem in the first place will end up doing more harm than good.
5) Credit card debt will be a problem, but if banks had some liquidity, they could refinance that debt at current interest rates. Don’t tell me they wouldn’t rather you continue to pay your unsecured debt at 9% (instead of the 25% you may be paying now) rather than have you declare bankruptcy and just walk away.
6) Panic. Panic caused by uncertainty. So pull a number out of the hat and call that the value. Now you need some serious chops to be taken seriously when you do that, but I think that was what Paulson and Bernanke were attempting to do. Give the debt a value. Any value. But make it stick.