Mar

20

A Swiss bank's research says Alt-A and Subprime adjustable mortgages account for 13.8% of outstanding first lien mortgages. Let's say a third of those were issued most recently, populating the oft-cited cratering indices. That would be around 4.55% of outstandings.

Now, let's say a quarter of those are in trouble. That would be 1.14% of outstandings. Finally, let's say the underlying value of the paper is only 60 cents on the dollar, for a 40% haircut. Forty percent of 1.14% is 0.46%, a loss of 46 bp of outstandings.

Away from the human tragedies of folks losing their houses, etc., it is very hard for me to come up with a scenario where a market-wide loss of less than half a percent foreshadows material macro fallout.

Bear in mind the securities losses will be concentrated in funky first-to-die paper, much of which is held overseas. And the unfortunate folks losing their homes weren't among the economy's biggest spenders.

Bud Conrad writes:

I like your method of looking at the situation. I come up with a worse number starting with the Alt A added into the sub prime as likely candidates for failure added in. Another view has Alt A about 18% of new issues in 2006 for $350B according to inside MBS & ABS. Subprime was 25% of new lending in 2005 and was said to be $600B.

Combining these gets closer to 40% or say a third of the loans for a guess. I leave one reduction step out entirely, the number of such loans just recently, as they might all have some risk.

I give a higher recovery rate of 75% so 25% loss. Now apply the 25% in trouble, and I get 30% X 25% X 25% = 1.9%

2% loss on all mortgages would be much worse in the sector that I suggested was 30%, more like 6% to them. So I can concoct a problematic, if not catastrophic scenario on this back of a napkin.

Charles Sorkin adds:

I'm not sure the focusing on the dollars lost directly through bad loans is the proper approach for predicting the impact on the economy going forward. After all, with prices of lower-rated residential mortgage backed securities now well below par, much of that money has already been lost, and with the GSEs playing a diminished role these days, much of that money has been lost by private entities.

Tighter lending standards will reduce the amount of consumer spending that was derived from cash-out refinances. Homeowners that do not default on their ARMs will still have less discretionary income to support purchases of big-ticket items (cars, appliances, retail electronic gizmos, etc.). Consumer psychology is generally such that negative headlines can easily convince the marginal buyer to put off homebuying for a couple of quarters. So on and so forth.

Will it be enough to generate a recession? Futures markets are now implying 2-3 rate cuts in 2007, so perhaps we are at a key rate-setting juncture Fed-wise. Keep in mind that if a rate-cut is implemented with the expressed hope that it will support adjustable-rate mortgage debt, it is important to keep in mind that many loans reset only annually.


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