Comments on: U.S. Subprime Mortgage Market Meltdown by James Barth Randall K Filer CERGE-EI and...
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Transcript of Comments on: U.S. Subprime Mortgage Market Meltdown by James Barth Randall K Filer CERGE-EI and...
Think of a Market With
• Rapidly Falling Prices
• Accumulating Unsold Inventories
• Many Owners with Negative Equity
The Housing/Subprime Problem
Look at it from three perspectives:
1) Homeowners
2) Investors in Mortgage-Backed Securities
3) The Financial System
Homeowners
Start with Banjari, Lanier and Krainer, Journal of Urban Economics, 2005
• Welfare Effects of Housing Price Changes = 0
• Basic Insight, for every seller there is a buyer
• And these offset each other
In Reality – Distribution Effects
Owner House Price
Randy 1,000,000 HK
Oleh 800,000 HK
Ricardo 600,000 HK
Boris 400,000 HK
Now, Randy Meets His Maker and Everyone Moves Up the Ladder
House Price Change in Cash
Randy’s
Heirs 0 HK +1,000,000 HK
Oleh 1,000,000 HK - 200,000 HK
Ricardo 800,000 HK - 200,000 HK
Boris 600,000 HK - 200,000 HK
Tomislav 400,000 HK - 400,000 HK
SUM 0 HK
Suppose House Prices Have Fallen By 50%
House Price Change in Cash
Randy’s
Heirs 0 HK + 500,000 HK
Oleh 500,000 HK - 100,000 HK
Ricardo 400,000 HK - 100,000 HK
Boris 300,000 HK - 100,000 HK
Tomislav 200,000 HK - 200,000 HK
SUM 0 HK
Comparison
Net Change in Cash Positions is Still Zero
BUT
4 of the 5 participants are BETTER OFF
ONLY One is WORSE OFF
In General
• Losers from Housing Price Decreases– Those who take cash out on sale– Typically heirs of deceased or elderly
downsizing and planning on using assets for retirement
– Also Credit Constrained who want to use housing equity as collateral for other purposes (e.g. business start-ups)
• Gainers from Housing Price Declines– Anyone who is putting cash INTO a
transaction– Families trading up to larger houses– First time home buyers– Also lateral movers due to factors such as job
changes (transaction costs are lower)
What About Negative Equity?
For MOST units no problem
They were purchased to deliver a certain amount of housing services at a certain price
Neither of these have changed, why would occupant renege?
Especially since reputation effect would preclude obtaining a new unit
Price Decline would make it cheaper to trade up, but for this it does not matter if cash is used to retire negative equity or obtain new house
If you think about it, almost EVERY new car bought on credit has a period when value is less than outstanding loan but nobody cares
Could Be a Barrier to Mobility
Negative equity might inhibit mobility if occupant lacks cash to pay off mortgage when opportunity arises in a new area
Easy Solution –
Attach mortgages to individual not property and allow transfer so long as new collateral is at least as great as old
Investors in Mortgage-Backed Securities
There has not been much, if any meaningful analysis.
Current market prices are uninformative
Real question is risk and return on portfolio of assets if held to maturity
Thought Experiment
Imagine buying two assets:
1) Diversified portfolio of Subprime Mortgages
2) Mutual Fund of Junk-Rated Corporate Bonds
Hold each for 10 years
Which Portfolio Would Have Higher Yield Over 10-Year Period?
Remember, 10-year cumulative default probability on B-rated bonds is 43%
Do we really believe the default rate on even subprime mortgages will be that high?
Center for Responsible Lending projects cumulative foreclosure rate for subprime mortgages issued in 2006 at 19%.
Even sensitivity analyses with extreme assumptions have a hard time getting foreclosure rate as high as 40%
And, repossessed houses will have a much higher recover rate than defaulted bonds
Conclusion
• There is not now, nor is there likely to be, evidence that investors in subprime mortgage backed securities who hold to maturity will receive abnormally low returns
• Those who sell while the market is distressed may take a haircut but this will be offset by excess returns for the buyers
Financial Markets• HERE IS THE REAL PROBLEM
• LIQUIDITY IN GENERAL HAS DRIED UP
• CREATES TWO MAJOR DANGERS:
1) Lack of landing affects the real economy – investment and/or consumption collapse
2) FED feels it must inject liquidity, igniting inflation or causing “rolling asset
bubbles”
Causal Change?
Dot Com Bubble Bust → Low Interest Rates → Housing Bubble, Housing Bubble Bust → Low Interest Rates → Weak Dollar & Commodity Market Bubble??
The “Problem” Is Almost Entirely Artificial
• At the moment there is almost no “market” in mortgage-backed paper.
• This has led to a excessive price collapse when compared to fundamentals
• OECD estimate is that to justify current prices, recovery rate on foreclosed properties would have to be NO GREATER than ZERO
Regulatory Failure
• “Mark-to-Market rules force institutions to value these holdings at their totally unrealistic trading prices
• This reduces’ institutions capital and loanable funds
• In large part these reported losses are paper losses that will be restored to the books when the real assets underlying the securities are sold, even at depressed prices
Result
Creates Real Economic Damage from Unreal Paper Losses.
Solution: Mark-to-Market must be suspended when no effective market exists
Allow Mark-to-Model or Fraction of Book. Paul Craig Roberts suggests 85-90%. I might be more conservative, but even 60-75% would recapitalize without dangerous injections