All For The Want of A Nail

So, John Berry looks like the standard bearer for those who think the sub-prime crisis is overblown. So Berry says

A more realistic amount is probably half or less than those exaggerated projections -- say $150 billion. That's hardly chicken feed, though not nearly enough to sink the U.S. economy

There are a couple of problems here. One, Berry isn't factoring in the effect of declining collateral values when he says

First, the mortgages are backed by collateral, a house or condominium, and in a foreclosure a home typically retains significant value. When it is sold, the lender often will get 50 percent to 60 percent or more of the loan amount after foreclosure expenses.

That’s in world where the value of the home often exceeds the value of the loan. This is not where many of the defaulting sub-prime borrowers will find themselves.

More deeply, however, Berry is conflating losses with defaults. Indeed, a commenter on Naked Capitalism summed up the no-big-deal viewpoint nicely when he said

If for the want of a nail the battle is lost, then the battle can be won for the price of a nail.

This comes from a poem often used to describe the Butterfly Effect

For want of a nail a shoe was lost,
for want of a shoe a horse was lost,
for want of a horse a rider was lost,
for want of a rider a charge was lost,
for want of a charge a battle was lost,
for want of a battle the war was lost,
for want of the war the kingdom was lost,
and all for the want of a little horseshoe nail.

Berry and the commenter seem to be implying that a $150 Billion nail is not a hefty price for the US economy to pay. The problem, however, is that we don’t know which nail is bad.

This is the essence of risk.

If for example, we knew exactly which homeowners were going to default then we could correctly value each Mortgage Backed Security. Once, we had written them down for the value of the bad loans they would be AAA securities, since there is no remaining default risk. The CDOs which hold those securities could be written down, the SIVs that hold them could be written down and so forth until the $150 Billion had been distributed accordingly. We could then all go about our business as if nothing had happened.

Alas, this is not the situation we find ourselves in. We don’t know which nails are bad and we don’t have the resources to check every horseshoe. To make matters worse the CDO revolution convinced us that bad nails didn’t matter and so we went about shoeing horses like crazy and sending their riders into far flung battles around the world.

In other words, because there seemed to be little risk in making loans, we made lots of very risky loans and drove up asset prices on the basis of those loans. Now, the whole thing is supported on a foundation that is not only not as secure as we thought but due to lax underwriting standards, less secure than normal. So we have higher assets prices supported by weaker fundamentals. That’s a prescription for a fall.

The real question then is not, how much we will lose from defaults. The real question is how much of a return would we have demanded to risk these types of defaults and how low asset values have to fall before they can guarantee us that type of return.

For example, Berry estimates a 12% loss after default rate for subprime mortgages. Well that means that we have to shed 12% of the value just to bring us back to the expected return we had before. We have to shed much more than that to compensate investors for the fact that an individual security might lose a great deal more than 12%.

Even more stunning than that is the fact that the huge profits coming out of the financials drove increases in stock indicies. Now the financials are taking losses on the very securities that made them so profitable. This means not only is there less capital inside of those companies but that the run of profits we saw before was an illusion. It wasn’t possible to generate those types of returns without taking on lots of risk.

So we have a smaller company now with lower growth prospects. This implies quite a bit of fall in value.

Stack on top of that the fate of the US consumer. For a while now the consumer has been spending like gangbusters no matter what happened to the aggregate economy. Now, it seems that this spending was likely fueled by imprudent loans.

Going into detail about this requires another post, but imagine if the American spending spree was conducted by a small portion of the population spending way beyond their means. Now, imagine that this is the very population who is being foreclosed upon right now. It is at least possible then, that the American economy could swing from a negative savings rate to a more traditional savings rate very rapidly.

That is, imagine that most people are saving just as they were 25 years ago, but a select few have been borrowing so much that it drove the average savings rate negative. When those free speding few have their Home Equity Lines of Credit canceled, we will be left with only the spending of the traditional consumer.

In the long run that’s a good thing. In the short run it’s a very painful thing.

All of these possibilities are why the credit defaults imply asset value collapses that are much greater in magnitude.