It looks like people in power are getting beyond the point of denying that subprime is a problem. And now they're onto the next stage of trying to decide just how big a problem it is. I have seen estimates ranging from as high as $4 trillion to as little as $104 billion. (This is one area where the son will beat the father. Bush I's Savings & Loan crisis cost $240 billion but Bush II's looks likely to be far more costly.)
While each estimate covers different aspects of the cost, the big questions that need to be answered are:
- What caused the problem?
- What can and should be done to minimize the damage? and
- What changes can be made to keep it from happening again?
I don't have real answers to these questions but I think a look at the different estimates of the subprime mortgage meltdown's damage can shed some light on the problem. Here's my take on the three estimates:
- $4 trillion. Several economists estimate the loss of home price wealth at between $2 trillion and $4 trillion in the wake of the collapse of the subprime mortgage market. The basic logic of this figure is that foreclosures on bad loans throw more houses on the market. In order for these homes to sell -- given lower demand -- their prices must drop. This decline seems reasonable assuming a 15% to 20% drop in housing value which currently totals $21 trillion.
- $400 billion. Some economists estimate that financial firms could face aggregate losses of $400 billion from expanding troubles related to the subprime mortgage market fallout. I am not quite sure I understand the underlying assumptions for this estimate.
- $104 billion. By my calculation, it appears that the Joint Economic Committee of Congress has come up with a $104 billion cost -- which includes $71 billion in lost real estate wealth from foreclosures on subprime loans, $32 billion in lost value for homes in the neighborhood of foreclosed houses, and $917 million in lost property tax revenue to state and local governments.
As for those three questions, I think the big lesson to bear in mind is that housing is an economic system consisting of many participants. It's impossible to understand the problem or to envision a solution without looking at all the parts of the system, what motivates them and how they interact.
For instance, it would be easy to blame the borrowers who took on loans to buy houses that they knew they couldn't afford.
- But the two million foreclosures likely by the end of 2008 is going to cost those borrowers their homes.
- They were encouraged to lie on their mortgage applications by unscrupulous mortgage brokers.
- And those brokers were getting big commissions from mortgage lenders.
- The lenders were getting fees from the investment banks that packaged the mortgages into mortgage-backed securities (MBSs)
- The credit rating agencies got big fees from the investment banks for wrapping the MBSs in gold-plated AAA ratings
- The investment banks got fees from investors who bought the MBSs
- And the investors got above average yields for buying them -- until the house of cards fell apart.
This financing chain does not even take into account all the jobs related to building houses -- which includes design, construction, building materials, transportation, and furniture.
If we keep this financing system in place, then it needs to be much more honest. This means no more liar loans, no more confusing loan terms pushed by greedy brokers, and no more MBSs valued based on mathematical models. Such a system would be much smaller. That is either housing prices would need to drop to make them affordable to people with less money or fewer people would own the higher priced homes.
It's a big problem. What do you think ought to be done?
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.
Mergers I'd like to see -- Mattel (MAT) and Waste Management (WMI)
Entrepreneur's Journal: Bootstrap it like Google
Comfort Zone Investing: Can the market go higher? Definitely maybe
Reader Comments (Page 1 of 2)
1. Probably we can be sure the meltdown will be deeper than forecast months ago and will last longer than the positive prediction people want us to think.
Posted at 3:46PM on Oct 26th 2007 by Suzanne
2. Never underestimate the ingenuity of politicians to stave off the inevitable (think of Japan's 15 year not growth misery)
Posted at 5:28PM on Oct 26th 2007 by Malcolm
3. There wouldn't have been any subprime mess if our government regulated the mortgage industry better. Giving someone 10% interest rate because they have a credit score of 550 is not really helping. These subprime lenders know the borrowers will defualt sooner or later. It's all a scam just like our government!
Check out this website it exposes the mortgage industry mess http://www.rmdirect.net
Posted at 5:34PM on Oct 26th 2007 by Jess
4. I wondered how long it would be before the liberals would blame Bush Now Cohan is blaming the Bush's ??? I guess the Bush's also control the market, weather, wild fires, volcano's, and earthquakes.
Posted at 5:49PM on Oct 26th 2007 by erickson
5. The solution is simple. The politicans will allow for run away inflation and that will pay off the loans with easy money and hurt the less well off that they always profess to want to help. My parents lived in South America in the 50's when I was growing up and I saw this first hand. The well to do that had tangible property always skated through it and the less well off always suffered.
Posted at 5:52PM on Oct 26th 2007 by Dave
6. It unfortunately looks like the $4 trillion figure will be more correct. In June of 2005 Prof. Shiller of Yale pointed out that the real estate bubble consisted of the amount that houses increased in the past few years above the inflation rate. His study show the steady relationship between the price of houses and inflation, except for the past few years. Do the math, as they say.
Posted at 5:54PM on Oct 26th 2007 by Robert Tangel
7. Do you think that the people (mortgage Brokers) need to go to jail for what they did? I am a real estate and mortgage broker and never participated in the scam..I simply refused and told all my clients not to get involved..Yes, I made no money, but I could not lie.
Posted at 6:11PM on Oct 26th 2007 by Kathy Paolucci
8. Soon enough big banks will CHARGE you interest to save your money for YOU! They already charged you fees for ATM, teller service, etc. Sure, you can hide your money in your mattresses or elsewhere but if someone found it, it is a keep. So the big banks is still providing a free service that is keeping your money in a safe place. I can see banks charging you 1% to 4% annually for carrying your checking or saving accounts while homebuyers will be able to take out 2-4% mortgages down from 6-7% today. It will be back to business as usual... Are you still a believer in home price appreciation, huh? Go ahead!
Posted at 6:39PM on Oct 26th 2007 by Gumby
9. The defining issue of the 2008 campaign will be the mortgage mess. Wall Street, The Treasury, and The Fed have all gone through their period of blame, then denial and are now moving towards acknowledgment. No one is yet willing to accept the magnitude of the problem, including Presidential candidates of both parties.
More than 250,000 Americans are facing foreclosure each month, and the number is growing. What may have started as "irresponsible buying/irresponsible lending" is now an undeniable cancer growing on our economy. Homeowners who are excellent credit risks are unable to sell their property when employment or another situation requires relocation. These same homeowners, with superior credit and good jobs, are unable to obtain the value necessary to refinance their homes or obtain financing for worthwhile reasons, such as college or medical emergencies.
Every American homeowner has, and will continue to experience personal financial loss due to the declining market. Many have experienced the even greater loss of their homes through foreclosure, and in too many cases, the loss of their family, as the financial stresses result in the blame game in the household as well.
This is only the tip of the iceberg. Corporate America continues to down play the crisis, fearing the deprecation of their stock values. Loss reserves based on today’s optimistic home values will prove totally inadequate. It does not require a degree in economics to see how this will spread to the construction industry, material supply industries, auto industry and other trickle down industries that rely on the housing market. The Federal Government does not have the desire to bail out the financial institutions, nor does it have the ability or capacity to intervene in the multiple markets subject to potential collapse.
The solution to this problem is not a change in policy, but a change in philosophy. Sixty-eight percent of adult Americans are homeowners. All homeowners have already experienced a significant equity loss as a result of this crisis. From Wall Street to Main Street, Americans need to see a solution to this problem. It’s time to create an American Homeownership Act. Why can't we have home mortgages available to all Americans on a fixed rate basis they can afford? The rate should be the same in 2008 as it will be in 2028. Parents should know what it will take to get their children through college and into homes. Builders should know that the homes they build can be sold. Financial institutions should be able to rely on the value of their collateral. Homeowners who accept these loans should not have the ability to refinance and withdraw their equity at will or place a 2nd mortgage behind this type of loan. Perhaps we as a society could truly become homeowners with the security of equity again. "Burning the mortgage" might replace being burned by the mortgage. Social Security could be enhanced by a nation of citizens who truly had equity in their homes, their communities, and themselves. What kind of rate? Maybe 4%. Who qualifies? Every American Citizen to a one million maximum loan amount. How does America pay for this? How do we not? Perhaps we should consider the elimination of the interest deduction. Builders would benefit, lenders benefit, municipalities would benefit. All would contribute. Our society would be improved, and all of us would realize greater personal and financial security. Everyday the window of opportunity is closing. We need a solution, not a bailout, not a band aid. We need someone as our new President with the courage, the wisdom, and the vision if we are to continue as the economic and moral leader of the world.
Posted at 7:09PM on Oct 26th 2007 by skylinemike
10. Hi Pete:
Try to answer the basics: Cause:
In this case opportunity and greed is the obvious culprit. However it could also be something that is not on the radar. To this, I have only the history book. It is a cycle. If this is so, prepare for bad times. Start with King Georges War in 1740, add 35-40 and you have the revolution. 1816,1857,1893, 1930, 1972 were all bad years and periods. Not one cause/reason is the same. There were plenty of small bumps along the way, but these are the big events.
Blame: Capitalism and free market condtions.
It's our system, but not error free. Personally, I think that this mess could never have happended without financial investments from across the pond, meaning the London banks and investment houses. Just about every nation on earth is represented there in the financial sense and only they know how much of their money is now over here. The building in the U.S. between 2002-06 was so massive that our institutions could never have financed it. The whole building and selling frenzy was based in folly. There was so much money available that "0" down, 120% financing, balloon notes, finance closing, etc., became the rage. While sub-prime is the goat, this was mostly investor driven and those doing it were not well heeled enough to withstand a drop. Most of the default is in the 400,000 plus market which is hardly "sub prime". Worse, these houses are "dead ducks" as there will be no takers. Worse still, they are still being built. The builders have contractural obligations and can't get out either. It certainly has the average homeowner who sold and bought up and all others that were caught in the whirlwind in it's grip. Captialism as it's best. The housing market was turned into a stock market and everyone with a buck wanted in. The difference is that a stock is a piece of paper, but a house is tangible reality. Even vacant and in default it will still be owned. If it is the bank they have to pay taxes and insurance and in most places pay to have the lawn cut. It is not a free ride. If it goes to tax sale the municipality will try to auction it. If they can't - it's a defecit. If it is HUD, they do the same.
Changes:
First, it all has to unfold. At present I don't think that there is anyone with full knowledge.
Things I would like to know and worth looking at:
Nomenclature: Just what the hell is a "write down". Does this reflect the value loss of a note being paid to term or is this the value at default, or something else? Is this a fancy way of putting "write off". Write off when applied to depreciation of equipment means end of usefule life and of no value. In a financial sense it means there is no way of recovery of funds.
Can it be stopped: Prolonged Yes. Stopped: NO.
Posted at 7:58PM on Oct 26th 2007 by wildbill
11. You left out one other culprit...builders who overbuilt thinking the market would quickly absorb anything they built. Down in Florida there are many unsold (and unfinished) condos and homes, putting a drag on the market. I assume the same is true elsewhere.
Posted at 9:14PM on Oct 26th 2007 by don
12. Turning around the unrealistic expectations of many people today is part of the solution. Our first house thirty years ago was less than a thousand square feet. Everyone now expects to move into a McMansion. Partly because builders and lenders, etc, don't want to bother with building small, because they can't make as much money in it.
Posted at 9:16PM on Oct 26th 2007 by Tom Lains
13. Question: Why do the banks lose money when a mortgage is supposed to be covered by PMI insurance. Yet no PMI insurance companies are affected?
Posted at 9:55PM on Oct 26th 2007 by chuck
14. There are so many levels of blame from the borrower who was fortunate enough to have the opportunity to own instead of rent and choose a variable rate that was less expensive to the loan officer who was not properly trained to the lenders that had money sitting waiting lend to the realtors who said theres another offer coming in to the fico scoring system which allows creditors from prior years to whack your credit each time it's pulled.
So maybe the system in retrospect got out of hand ,unfortunately the reality is people and there variable rate mortgages are going to go up at it's next adjustment if the credit and income support it
the rates are great and all will be fine..but if that bill from 3 years ago was not taken care than the credit is tarnished ,if property value is not great or income dropped you got problems so what can they do ?
Posted at 11:56PM on Oct 26th 2007 by robert
15. Very professional, competent and deep commentay. Congratulations!
Posted at 1:59AM on Oct 27th 2007 by giorgio breglia
16. With 250,000 foreclosures per month, it seems pretty obvious that lenders or who ever now holds the mortgages will be holding property for which there is no market. It is in the best interest of the lenders to refinance as many of the mortgages as possible on terms that the borrowers can pay. That insures some cash flow. Lenders are not in the position to be real estate property managers keeping the utilities functioning and paid for and paying the property taxes while the houses are empty and vandalized into worthless wreckages or burnt to the ground.
The gamble was that only a smaller % of the houses would default and the number would be manageable. The smarmy lenders and lying borrowers both lost the bet.
Unless we want to have a depression and wipe out all value, both property and investments, these loans have to be renegotiated on terms that are realistic and doable. Again, the lenders can not be the owners of 20-30% of the homes in a community (Maple Heights, Ohio, for example), pay the taxers and watch as the property burns down or is vandalized into trash.
Posted at 8:04AM on Oct 27th 2007 by John Mader
17. Stock market and housing markets run in cycles and have crashed in the past about every 30-40 years ; but as time goes by these events become larger because there is more population. This one will surely be the higher number , not the one congres is estimated [104 billion]. The government will low ball it and then later adjust the # up , like the war.
Posted at 8:11AM on Oct 27th 2007 by mike
18. The problem is that renters became homeowners. Why, because Realtors, Builders and Title Companies were allowed to become partners and owners of mortgage companies. That should never ever be allowed. Loans got approved for the wrong reasons and people got homes that did not deserve them. Huge incentives were built into the financing and now you have a problem. Never should the person selling the home receive incentive from the financing of the home.
Posted at 8:21AM on Oct 27th 2007 by Bruce Calabrese
19. Let's be realistic. The lenders can not afford to repossess all this property, manage it, mow the lawn, pay the taxes and keep the utilities paid and functional. They simply can't handle all the potential numbers. They can't do without cash flow from mortgages being paid on a regular, monthly basis.
Politicians, stupid as they are, are smart enough to know that if 250,000 homes are repossessed every month, that 500,000 - 1,000,000 people are on the streets without a place to live. The nation simply can not accept the homeless problems that will cause. There are not enough vacant apartments to accomodate those numbers.
You tell me what you plan on doing, at the end of the first year, with 12,000,000 homeless people.
Posted at 8:33AM on Oct 27th 2007 by John Mader
20. Chew on Skylinemike's solution of a fixed rate mortgage within the reach of all, or nearlyl all, citizens backed by the government. It is reasonable to expect a downpayment of some attainable amount - 5% -10% of value to establish equity. We need to outlaw second mortgages/equity loans for anything but direct expenditure on the house (like replacing a furnace).
Posted at 9:08AM on Oct 27th 2007 by John Mader