Last Update: October 28, 2008
I am also posting my book's future section of the financial system, while I am writing it (thus, it is not yet complete). Nevertheless, if you have the background of a first course in finance, it should help you to understand what these financial innovations were, and how they came about.
| Households | Corporations | Financials | Total (NOT NET!) | |
|---|---|---|---|---|
| Tangible Assets (incl Real Estate) | $26.7 trillion | $27.4 trillion | $7.9 trillion | $62 trillion |
| ...Real Estate | $22.5 trillion | $8.9 trillion | $7.3 trillion | $39 trillion |
| Financial Assets | $45.3 trillion | $12.9 trillion | $3.1 trillion | $61 trillion |
| All Assets | $72.1 trillion | $27.4 trillion | $11.0 trillion | $110 trillion |
| Home Mortgages | $13.8 trillion | NA | NA | $14 trillion |
| Commercial Mortgages | $0.2 trillion | $1 trillion | $2.5 trillion | $4 trillion |
| All Liabilities | $14.4 trillion | $11.3 trillion | $5.0 trillion | 31 trillion |
| Net Worth | $57.7 trillion | $16.1 trillion | $6.0 trillion | N/A |
| Owner's equity as percentage of household real estate | 48% | |||
| Debt to Value | 47% | 59% |
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It is the debt accumulated from 2001 to 2007 that may be most vulnerable to default due to the rise and then collapse of real estate values. Holding everything else constant, the closer to 2006 a mortgage loan was taken out, the more risky it is now.
| Subprime | Alt-A | |
|---|---|---|
| Outstanding | $537b | $726b |
| Originated before 2004 | 23% | 15% |
| Originated in 2005 | 26% | 28% |
| Originated in 2006 | 38% | 36% |
| Originated in 2007 | 15% | 21% |
| Loan-To-Value at origination | 85% | 81% |
| High Credit Score (>660) | 21% | 80% |
| Percent w/ Current Payments | 57% | 81% |
| in Foreclosure | 10% | 6% |
Gary Gorton has written a more detailed analysis of subprime mortgages in The Subprime Panic.
| Year | to-2004 | 2005 | 2006 | 2007 | 2008 |
|---|---|---|---|---|---|
| Real Estate Value Index | 183 | 212 | 226 | 216 | 176 |
| Relative Value at 140 | 76% | 66% | 62% | 65% | 80% |
| "Underwater" at LTV=85% | 9% | 19% | 23% | 18% | 5% |
| Originated Subprime | $124b | $140b | $204b | $81b | |
| Originated Alt-A | $109b | $203b | $261b | $152b | |
| Total Mortgages | $232b | $343b | $465b | $233b | |
| Total Loss | $21b | $65b | $107b | $42b |
The total loss attributable to subprime and Alt-A should thus be around $235 billion. Add a fudge factor and make it $300 billion.. Add another $100 billion for another 10% drop in real estate values (to 125), if you wish. I believe the loss will be well below $500 million when all is said is done.
Please note that I have broken many rules on how one properly aggregates probabilities and random variables [with dispersion] in estimating this loss number. I have also ignored:
Update, Oct 31, 2008: First American CoreLogic reports that 7.63 million properties (18%) were underwater, possibly followed by another 2.1 million soon. (2/3 of all properties have mortgages.) In Nevada, 48% of owners have negative equity; in New York, only 4.4%. Unfortunately, they do not tell us what the average dollar amount or LTV is by which these underwater mortgages are underwater. From another source, the average U.S. house price is about $250,000. The average mortgage is thus probably around $200,000. If the average underwater amount is 10% ($20,000), then we are talking $140 billion. This is again the same order of magnitude for the mortgage losses as my estimate above.
Given that mortgage losses by banks are likely to be less than 1% of our economy's assets, it cannot be that they are principally responsible for our current economic state. Moreover, one would think that the potential loss should already be covered by the financial bailout passed by Congress. The fact that it has not stopped the mortgage crisis is an indication for how much loss in trust there is, how messy and complex the structure of our mortgage-backed securities are, and that the crisis is now much bigger.
Let me explain: IBM shares have a unique value. They are traded in in a perfect market, with many buyers and many sellers. The market for IBM shares is liquid. Contrast this close-to-perfect market for IBM shares with the market in real estate. Even in a normal market, only a fraction of the population is potentially ready to purchase a new house. A small change in the number of people or houses on the market can make a big difference in terms of the sale price or the time-to-sale. The housing market is rarely liquid, and certainly not at the moment. Now, if the owner needs the cash tonight, there are not many buyers that can buy so quickly, even if the price were a little lower (than if the seller can wait). Thus, the value of the house depends on who the owner is (how quickly she needs cash), and how liquid the market is (how many potential buyers there are, especially in the short-term). Let me call the fact that the house has no unique value an "indeterminacy."
Right now, the value of so-called "bad bank assets" has itself become a function of the liquidity crisis. Because the market for bank assets (loans) is no longer liquid, many banks have been trying to hoard liquidity and sell their assets (loans) very quickly. In turn, because many banks have been trying to hoard liquidity, the market for these assets is no longer liquid. It is a direct consequence of illiquidity that the market for bank loans is no longer perfect and thus that the value of the bank assets is no longer unique. (Economists can disagree about how bad the indeterminacy is in the current liquidity crisis—how far from a perfect market the current situation is.)
On the positive side, I expect the Treasury and other investors who do not fear a run on themselves (such as foreign sovereign wealth funds) to make money from buying assets from banks (unless the Treasury pays ridiculously high prices).
Remarkably, the management groups of our banks were so bad that they did not take the appropriate steps to insure themselves. (This was a sign of poor governance. Gambling on continuation of the "easy money" lending situation, even in the face of information that it was becoming less and less likely, was more in their self-interest than cutting short-term profitability and bonuses. For more, see below.)
Situated roughly in the middle layer, there is the fall in real-estate prices. This decline in real estate values has caused many mortgages to be either in actual default or unlikely to be paid back. These mortgages are disproportionately owned, in one form or another, by financial institutions.
Shallower causes are:
Deeper causes include the following:
It was poor corporate governance that made it in the interest of management and employees in banks to gamble with the shareholders' money, much more than the shareholders would have wanted to gamble themselves.
Shareholders would have wanted some gambling (call it risk-taking), especially if it was smart and had positive expected returns—which it did for many years. Arguably, it was also in the shareholders' interest to gamble with the taxpayers' money. I judge that this was of much lesser importance than the misaligned CEO incentives.
It is the task of the Chairman of the Board (and the Board) to make sure that the CEO does a good job—not just in terms of current earnings, but also in terms of controlling risk, investing in long-term ventures, etc. Unfortunately, it is rare that poor CEOs are fired by their Chairmen, because in most corporations the CEO is also the Chairman. The fact is that shareholders in large, old companies have very little influence. This is not an easy problem to fix, but if we want to improve the economic system in the United States, improving our corporate governance is of paramount concern.
(Note: none of the above were my ideas.)
I have also read many other good suggestions, both in the financial and academic press. In fact, there are so many that I cannot possibly repeat them all.
There is strong evidence that housing structures deteriorate quickly when homeowners walk away. We should try to stem such abandonment when it makes financial sense. Unfortunately, this is not as simple as it may seem. In a perfect market, we would just let the bank and borrower negotiate a good settlement. We do not live in a perfect market.
If the Fed were to purchase mortgages, it would not be a bad idea to renegotiate the loans to lower the interest rate and principal to the point where it would no longer be in the interest of homeowners to walk away—even if it is a wealth transfer from the tax payers to the homeowners.
The most worrisome short-run fix to me is that we are creating even bigger financial giants, which are more stable right now, but which will be even more "too-big-to-fail" when the crisis is over. Moreover, the resulting lack of competition means that these few banks may then have enough market power to charge businesses very high interest rates, which will cost us future economic growth.
Long-run reforms are also best undertaken with some perspective. Thus, this is best done not right now (in October 2008), but when the immediate crisis has blown over.
If you need an example of bad governance, just look at the most recent one: Sarbanes-Oxley (SOX) is an example of how the Enron debacle settled us with terrible new regulations, potentially for decades. SOX is inefficient, ineffective, and expensive. From my perspective, it is depressing how momentary gut instincts and political lobbies can determine economic regulations, rather than sound economic principles and common sense.
For more detail on the broken governance system and potential remedies, you might find the last chapter of my book to be interesting.
I do not have it worked out how this should best be fixed, but one can think, for example, of alternatives such as:
In addition,
My specific suggestion: Every financial institution with assets of more than $50 million should have to upload its daily estimated NAV (one single number!) to a website run by the Fed, with no more than 1 week delay. (Most financial institutions should already have such an estimate. Indeed, I know for a fact that most big banks and hedge funds already compute this information every night in real-time. The upload of this data to a Fed website itself can be easily automated. The estimated regulatory cost: 5 minutes for one employee per day.) In an advanced version, banks would also report a "confidence"< in this number.
This kind of high-frequency information would allow the Fed to run models in-house to determine whether financial institutions are exposed to systemic risk—for example, if too many banks are exposed to yield curve or oil price risk, or simply how strongly it all moves together. After a 6 month delay, academic research on this data should be permitted by the Fed, though with strict publication anonymity controls. Finally, after 3-5 years, this information should be released to the public, similar to how Edgar information is released.
This simple disclosure would do a whole lot more for the system than onerous detailed regulations about what banks should do in-house. Remember: even if it worked perfectly, banks could still only work out their own risks. They are not able to detect the systemic risks that we are really most afraid of. Systemic risk detection requires systemic data. Of course, my recommendation is not a panacea—for one, it still requires on getting accurate data from the banks to the Fed. Still, it is a whole lot better than what we have today. It would also augment the Basel accords
For many reasons, the second option is a losing proposition in the long run. The market should determine which banks survive, not government regulation. Most likely, we will need both. Hopefully, smarter people than myself will work on the too-big-to-fail issue.
There are also many other parties with secondary faults who contributed:
An analogy is an airline that does not conduct any airplane maintenance. It can make more money for a long time. Ultimately, the plane may crash and people may die. The airline did not want the accident to happen, but may have profited handsomely by taking the chance that it might happen. (For economists, I consider bank practicies to have been the equivalent of writing out-of-the-money options and/or selling liquidity—profitable most of the time, catastrophic every once in a while.)
Shareholders would have wanted some gambling (call it risk-taking), especially if it was smart and had positive expected returns—which it did for many years. Arguably, it was also in the shareholders' interest to gamble with the taxpayers' money. I judge that this was of much lesser importance than the misaligned CEO incentives.
So, should we try to claw back the bonuses, stocks, and options that Wall Street employees earned in the past from high-risk activities, such as subprime lending? Interesting question.
Confiscating the profits of those executives would also appeal to my sense of fairness. However, net-in-net, we are probably better off if we all swallow hard and let this go.
Again, the current political proposal has argued for limiting future executive compensation in banks in which the government invests. This would punish the wrong party. It is not future investment bankers (and credit ratings agencies) who committed the sins that led to the crisis, but past ones. Effective discipline should punish those that were responsible for the mess, not those who are responsible for cleaning it up. (Fortunately, the executive compensation constraints seem more like political theater than they do like binding constraints.)
The remainder of this FAQ is less technically focused, and more for the layperson.
There is also another way in which this crisis may be an opportunity: you may realize that speculating on getting wealthy is not a good meaning of life.
Fortunately, there is no shortage of foreign healthcare systems that demonstrate how it is possible to function much better than the U.S. health care system. We would "only" need to imitate them. Pick your choice: the U.K, Taiwan, Japanese, or German health care systems all have their flaws, but they are all a lot better than the U.S. system. PBS Frontline had a great episode on the subject.
(Not an economic opinion: I consider basic healthcare a fundamental human right, on par with not letting our fellow human beings starve.)