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Subprime fact of the day
..the problems in the subprime mortgage market are relatively small. Currently, losses are estimated to be at most $35 billion – equivalent to a stock market decline of about 0.2%. (Last week the value of stocks traded in US markets were down a not terribly unusual 1.5%, or 7 times the total expected decline in the value of these mortgages).
That is from an excellent short essay by Stephen Cecchetti.
Addendum: Michael Mandel gives his look at the bright side.
Posted by Tyler Cowen on August 13, 2007 at 04:55 PM in Economics | Permalink
Comments
Stephen Cecchetti
Posted by: angus at Aug 13, 2007 5:17:18 PM
Tyler,
I am not quite sure what the point of your comment
is. There is no problem? If not, then why have
the Fed and the ECB been pumping humongous amounts
of liquidity into the system? Maybe it has sometnhing
to do with the fact that as with a bank run, a very
small trigger can lead to a huge result? After all,
we have had major banks in Europe, like BNP in France,
suffering major problems, even though they are
quite far from this miniscule subprime problem in
the US.
Posted by: Barkley Rosser at Aug 13, 2007 5:32:32 PM
The subprime thing IS big because it's the canary for the HUGE raft of Collateralized debt obligations (CDOs) that are a web of unknowns (and unknowables). A lot of hedge funds are going to see their "equity" evaporate when CDOs are marked-to-market. (They are avoiding liquidation now to keep their fantasy prices intact.)
This may be a good post to save when you need humility in the future :)
Posted by: David Zetland at Aug 13, 2007 5:36:25 PM
David,
Wouldn't the losses on all the CDOs still be capped at $35 billion, regardless of how they're sliced and who owns them?
Posted by: CD at Aug 13, 2007 5:47:19 PM
CD,
Not if those losses trigger losses on associated
derivatives, which in turn trigger losses on other
derivatives, which in turn trigger further losses.
Last fall, NY Fed prez Geithner complained about
the opacity of the set of interrelated derivatives
out there and how, in effect, he had no idea what\
the heck was going on. That we see BNP suffering
from problems in the US subprime market is exactly
the problem.
Think how a some minor problems at the Vienna
Creditanstalt in spring of 1931 led it to collapse,
led to the collapse of German banks, then French
and British banks, then US banks, then Japanese
banks, with the upshot being turning what had
been an unpleasant recession into the Great
Depression.
But then, perhaps this was Tyler's point, to
remind us how small initial problems can lead
to really big and nasty outcomes in interlinked
financial markets...
Posted by: Barkley Rosser at Aug 13, 2007 6:48:34 PM
Trust me Tyler this statistics would not make any sense to you if you work in real estate.
Posted by: omodudu at Aug 13, 2007 7:04:03 PM
omodudu...help me out; of COURSE it's a problem in real estate, because 100% loans to subprime borrowers increases the pool of potential customers (and potential closing costs) to the glut of real estate agents.
Posted by: shawn at Aug 14, 2007 7:58:56 AM
CD,
No because it was easy to make a virtual bet that pays the same as a sub prime bond, without a real sub prime bond backing it.
If you take a small number of bonds (say $100 million worth), and write $1 billion worth of insurance (also called credit default swaps or CDS) you can then structure those to create $100 million junior positions in your Synthetic CDO and $900 million senior exposure (which could be retained or sold off). This is all well and good, until the insurance bet exceeds the funded portion of the Synthetic CDO.
The Synthetic CDO structure looks very similar to a bank, and Synthetic runs on those mini-banks have been behind the drying up of liquidity.
Posted by: nelsonal at Aug 14, 2007 8:52:42 AM
Stephen Cecchetti did an outstanding job. But where I would disagree with him is on the economic outlook. He says there is no change. But there is a very significant change showing up in credit spreads. The market is starting to become a "credit snob". This will show up as slower growth because fewer people will get credit.
Posted by: spencer at Aug 14, 2007 9:38:20 AM
Great essay by Cecchetti. What I did not was that the ECB, unlike the Fed, pays interest on excess reserves. I wonder what effect this has on banking practices and the market as a whole?
Doesn't this raise the European "federal funds rate" compared to the American one, because banks will just borrow more for safety from other banks and put it back at the ECB with much less negative effect than in the US?
Also, is there any way a bank can go bankrupt if they can always borrow through the discount window? Or will the regulators then step in and force its assets to be taken over by better managed banks?
Posted by: RRE at Aug 14, 2007 3:46:42 PM
The Synthetic CDO structure looks very similar to a bank, and Synthetic runs on those mini-banks have been behind the drying up of liquidity. That's the same problem for banks in China, and we call it 我们是一家上海翻译公司。
Posted by: James Van at Aug 14, 2007 9:59:36 PM
The Naked Capitalist blog explains this best :
Here's an excerpt:
Second example: today any wealthy individual can take $1 million and go to a prime broker and leverage this amount three times; then the resulting $4 million ($1 equity and $3 debt) can be invested in a fund of funds that will in turn leverage these $4 millions three or four times and invest them in a hedge fund; then the hedge fund will take these funds and leverage them three or four times and buy some very junior tranche of a CDO that is itself levered nine or ten times. At the end of this credit chain, the initial $1 million of equity becomes a $100 million investment out of which $99 million is debt (leverage) and only $1 million is equity. So we got an overall leverage ratio of 100 to 1. Then, even a small 1% fall in the price of the final investment (CDO) wipes out the initial capital and creates a chain of margin calls that unravel this debt house of cards. This unraveling of a Minskian Ponzi credit scheme is exactly what is happening right now in financial markets.
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Posted by: 无缝管 at Nov 13, 2007 8:22:50 PM
Posted by: 翻译公司 at Feb 13, 2008 10:32:48 AM
So, this is all about chained-debts with just a mere percentage of the initial capital going down and everything blows out of proportion.
BTW, who the hell invented this economic model anyway? And why bo international banks with all their PHDs and MAs subscribed to this model??
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